Managerial Economics: Comprehensive Learning Assessment

Issues in Economics Today Eighth Edition

gue46399_fm_i-xxxii.indd 1 16/03/17 2:50 PM

The McGraw-Hill Economics Series

ESSENTIALS OF ECONOMICS Brue, McConnell, and Flynn Essentials of Economics Third Edition Mandel M: Economics, The Basics Third Edition Schiller and Gebhardt Essentials of Economics Tenth Edition

PRINCIPLES OF ECONOMICS Asarta and Butters Connect Master: Economics First Edition Colander Economics, Microeconomics, and Macroeconomics Tenth Edition Frank, Bernanke, Antonovics, and Heffetz Principles of Economics, Principles of Microeconomics, Principles of Macroeconomics Sixth Edition Frank, Bernanke, Antonovics, and Heffetz Streamlined Editions: Principles of Economics, Principles of Microeconomics, Principles of Macroeconomics Third Edition Karlan and Morduch Economics, Microeconomics, Macroeconomics Second Edition McConnell, Brue, and Flynn Economics, Microeconomics, Macroeconomics Twenty-First Edition Samuelson and Nordhaus Economics, Microeconomics, and Macroeconomics Nineteenth Edition Schiller and Gebhardt The Economy Today, The Micro Economy Today, and The Macro Economy Today Fourteenth Edition

Slavin Economics, Microeconomics, and Macroeconomics Eleventh Edition

ECONOMICS OF SOCIAL ISSUES Guell Issues in Economics Today Eighth Edition Register and Grimes Economics of Social Issues Twenty-First Edition

ECONOMETRICS Gujarati and Porter Basic Econometrics Fifth Edition Hilmer and Hilmer Practical Econometrics First Edition

MANAGERIAL ECONOMICS Baye and Prince Managerial Economics and Business Strategy Ninth Edition Brickley, Smith, and Zimmerman Managerial Economics and Organizational Architecture Sixth Edition Thomas and Maurice Managerial Economics Twelfth Edition

INTERMEDIATE ECONOMICS Bernheim and Whinston Microeconomics Second Edition Dornbusch, Fischer, and Startz Macroeconomics Twelfth Edition Frank Microeconomics and Behavior Ninth Edition

ADVANCED ECONOMICS Romer Advanced Macroeconomics Fourth Edition

MONEY AND BANKING Cecchetti and Schoenholtz Money, Banking, and Financial Markets Fifth Edition

URBAN ECONOMICS O’Sullivan Urban Economics Eighth Edition

LABOR ECONOMICS Borjas Labor Economics Seventh Edition McConnell, Brue, and Macpherson Contemporary Labor Economics Eleventh Edition

PUBLIC FINANCE Rosen and Gayer Public Finance Tenth Edition

ENVIRONMENTAL ECONOMICS Field and Field Environmental Economics: An Introduction Seventh Edition

INTERNATIONAL ECONOMICS Appleyard and Field International Economics Ninth Edition Pugel International Economics Sixteenth Edition

gue46399_fm_i-xxxii.indd 2 16/03/17 2:50 PM

Issues in Economics Today

Eighth Edition

ROBERT C. GUELL Indiana State University

gue46399_fm_i-xxxii.indd 3 16/03/17 2:50 PM

ISSUES IN ECONOMICS TODAY, EIGHTH EDITION Published by McGraw-Hill Education, 2 Penn Plaza, New York, NY 10121. Copyright © 2018 by McGraw-Hill Education. All rights reserved. Printed in the United States of America. Previous editions © 2015, 2012, and 2010. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of McGraw-Hill Education, including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning.

Some ancillaries, including electronic and print components, may not be available to customers outside the United States.

This book is printed on acid-free paper.

ISBN 978-1-259-74639-0 MHID 1-259-74639-9

Chief Product Officer, SVP Products & Markets: G. Scott Virkler Vice President, General Manager, Products & Markets: Michael Ryan Vice President, Content Production & Technology Services: Betsy Whalen Managing Director: Susan Gouijnstook Executive Brand Manager: Katie Hoenicke Product Developer: Jamie Koch Editorial Coordinator: Christian Lyon Marketing Manager: Virgil Lloyd Marketing Coordinator: Brittany Bernholdt Director of Digital Content Development: Douglas Ruby Director, Content Design & Delivery: Linda Avenarius Program Manager: Mark Christianson Content Project Managers: Melissa M. Leick & Karen Jozefowicz Buyer: Catt Mattura, Jolyn Thomas, Abby Davis Design: Studio Montage, Inc. Content Licensing Specialists: Beth Thole Cover Image: Cala Image/Glow Images Compositor: MPS Limited

All credits appearing on page or at the end of the book are considered to be an extension of the copyright page.

Library of Congress Cataloging-in-Publication Data

Guell, Robert C., author. Issues in economics today/Robert C. Guell, Indiana State University. Eighth edition. | New York, NY : McGraw-Hill Education, [2018] LCCN 2017003633 | ISBN 9781259746390 (alk. paper) LCSH: Economics. LCC HB87 .G83 2018 | DDC 330—dc23 LC record available at https://lccn.loc.gov/2017003633

The Internet addresses listed in the text were accurate at the time of publication. The inclusion of a website does not indicate an endorsement by the authors or McGraw-Hill Education, and McGraw-Hill Education does not guarantee the accuracy of the information presented at these sites.

mheducation.com/highered

gue46399_fm_i-xxxii.indd 4 16/03/17 2:50 PM

To Susan, Katie, Manny, Angel, Matt, and Lilly

gue46399_fm_i-xxxii.indd 5 16/03/17 2:50 PM

vi

About the Author Dr. Robert C. Guell (pronounced “Gill”) is a professor of economics at Indiana State University in Terre Haute, Indiana. He earned a B.A. in statistics and economics in 1986 and an M.S. in economics one year later from the University of Missouri–Columbia. In 1991, he earned a Ph.D. from Syracuse University, where he discovered the thrill of teaching. He has taught courses for freshmen, upper-division undergraduates, and graduate students from the principles level, through public finance, all the way to mathematical economics and econometrics.

Dr. Guell has published numerous peer-reviewed articles in scholarly journals. He has worked extensively in the area of pharmaceutical economics, suggesting that the private market’s patent system, while necessary for drug innovation, is unnecessary and inefficient for production.

In 1998, Dr. Guell was the youngest faculty member ever to have been given Indiana State University’s Caleb Mills Distinguished Teaching Award. His talent as a champion of quality teaching was recognized again in 2000 when he was named project manager for the Lilly Project to Transform the First-Year Experience, a Lilly Endowment–funded project to raise first-year persistence rates at Indiana State University. He was ISU’s Coordinator of First-Year Programs until January 2008, when he happily stepped aside to rejoin his depart- ment full time.

Dr. Guell’s passion for teaching economics led him to request an assignment with the larg- est impact. The one-semester general education basic economics course became the vehicle to express that passion. Unsatisfied with the books available for the course, he made it his calling to produce what you have before you today—an all-in-one readable issues-based text.

gue46399_fm_i-xxxii.indd 6 16/03/17 2:50 PM

vii

Brief Contents Preface xviii Issues for Different Course Themes xxviii Required Theory Table xxx

1 Economics: The Study of Opportunity Cost 1

2 Supply and Demand 19 3 The Concept of Elasticity and Consumer

and Producer Surplus 40 4 Firm Production, Cost, and Revenue 56 5 Perfect Competition, Monopoly, and

Economic versus Normal Profit 68 6 Every Macroeconomic Word You

Ever Heard: Gross Domestic Product, Inflation, Unemployment, Recession, and Depression 79

7 Interest Rates and Present Value 98 8 Aggregate Demand and Aggregate

Supply 107 9 Fiscal Policy 119 10 Monetary Policy 131 11 Federal Spending 145 12 Federal Deficits, Surpluses, and the

National Debt 155 13 The Housing Bubble 168 14 The Recession of 2007–2009: Causes

and Policy Responses 177 15 Is Economic Stagnation the

New Normal? 186 16 Is the (Fiscal) Sky Falling?: An

Examination of Unfunded Social Security, Medicare, and State and Local Pension Liabilities 193

17 International Trade: Does It Jeopardize American Jobs? 201

18 International Finance and Exchange Rates 213

19 European Debt Crisis 222 20 Economic Growth and Development 231 21 NAFTA, CAFTA, GATT, TPP, WTO:

Are Trade Agreements Good for Us? 238 22 The Line between Legal and Illegal

Goods 248 23 Natural Resources, the Environment,

and Climate Change 258 24 Health Care 271 25 Government-Provided Health Insurance:

Medicaid, Medicare, and the Children’s Health Insurance Program 283

26 The Economics of Prescription Drugs 296 27 So You Want to Be a Lawyer: Economics

and the Law 304 28 The Economics of Crime 310 29 Antitrust 319 30 The Economics of Race and Sex

Discrimination 327 31 Income and Wealth Inequality:

What’s Fair? 339 32 Farm Policy 349 33 Minimum Wage 358 34 Ticket Brokers and Ticket Scalping 366 35 Rent Control 373 36 The Economics of K–12 Education 379 37 College and University Education: Why Is

It So Expensive? 390

gue46399_fm_i-xxxii.indd 7 16/03/17 2:50 PM

viii Brief Contents

38 Poverty and Welfare 400 39 Head Start 411 40 Social Security 418 41 Personal Income Taxes 429 42 Energy Prices 440 43 If We Build It, Will They Come?

And Other Sports Questions 455 44 The Stock Market and Crashes 467

45 Unions 478 46 Walmart: Always Low Prices

(and Low Wages)—Always 488 47 The Economic Impact of Casino

and Sports Gambling 494 48 The Economics of Terrorism 499

Index 505

gue46399_fm_i-xxxii.indd 8 16/03/17 2:50 PM

ix

Table of Contents Preface xviii Issues for Different Course Themes xxviii Required Theory Table xxx

Chapter 1 Economics: The Study of Opportunity Cost 1 Economics and Opportunity Cost 1

Economics Defined 1 Choices Have Consequences 2

Modeling Opportunity Cost Using the Production Possibilities Frontier 2 The Intuition behind Our First Graph 2 The Starting Point for a Production Possibilities Frontier 3 Points between the Extremes of a Production

Possibilities Frontier 3 Attributes of the Production Possibilities Frontier 5

Increasing and Constant Opportunity Cost 5 Economic Growth 6

How Is Growth Modeled? 6 Sources of Economic Growth 7

The Big Picture 7 Circular Flow Model: A Model That Shows the

Interactions of All Economic Actors 8 Thinking Economically 8

Marginal Analysis 8 Positive and Normative Analysis 8 Economic Incentives 9 Fallacy of Composition 9 Correlation ≠ Causation 10

Kick It Up a Notch: Demonstrating Constant and Increasing Opportunity Cost on a Production Possibilities Frontier 10 Demonstrating Increasing Opportunity Cost 11 Demonstrating Constant Opportunity Cost 11

Summary 11

Appendix 1A Graphing: Yes, You Can. 15 Cartesian Coordinates 15 Please! Not Y = MX + B . . . Sorry. 16

What on God’s Green Earth Does This Have to Do with Economics? 18

Chapter 2 Supply and Demand 19 Supply and Demand Defined 20

Markets 20 Quantity Demanded and Quantity Supplied 20 Ceteris Paribus 22 Demand and Supply 22

The Supply and Demand Model 22 Demand 22 Supply 23 Equilibrium 24 Shortages and Surpluses 25

All about Demand 25 The Law of Demand 25 Why Does the Law of Demand Make Sense? 25

All about Supply 26 The Law of Supply 26 Why Does the Law of Supply Make Sense? 26

Determinants of Demand 27 Taste 28 Income 28 Price of Other Goods 28 Population of Potential Buyers 29 Expected Price 29 Excise Taxes 29 Subsidies 29 The Effect of Changes in the Determinants of Demand

on the Supply and Demand Model 29 Determinants of Supply 31

Price of Inputs 31 Technology 32 Price of Other Potential Outputs 32 Number of Sellers 32 Expected Price 32 Excise Taxes 33 Subsidies 33 The Effect of Changes in the Determinants of

Supply on the Supply and Demand Model 33 The Effect of Changes in Price Expectations on the

Supply and Demand Model 35

gue46399_fm_i-xxxii.indd 9 16/03/17 2:50 PM

x Table of Contents

Kick It Up a Notch: Why the New Equilibrium? 35 Summary 37

Chapter 3 The Concept of Elasticity and Consumer and Producer Surplus 40 Elasticity of Demand 41

Intuition 41 Definition of Elasticity and Its Formula 41 Elasticity Labels 42

Alternative Ways to Understand Elasticity 42 The Graphical Explanation 42 The Verbal Explanation 43 Seeing Elasticity through Total Expenditures 44

More on Elasticity 44 Determinants of Elasticity of Demand 44 Elasticity and the Demand Curve 44 Elasticity of Supply 46 Determinants of the Elasticity of Supply 47

Consumer and Producer Surplus 49 Consumer Surplus 49 Producer Surplus 49 Market Failure 50 Categorizing Goods 50

Kick It Up a Notch: Deadweight Loss 51 Summary 52

Chapter 4 Firm Production, Cost, and Revenue 56 Production 57

Just Words 57 Graphical Explanation 58 Numerical Example 58

Costs 59 Just Words 59 Numerical Example 60

Revenue 62 Just Words 62 Numerical Example 63

Maximizing Profit 64 Graphical Explanation 64 Numerical Example 64

Summary 65

Chapter 5 Perfect Competition, Monopoly, and Economic versus Normal Profit 68 From Perfect Competition to Monopoly 69

Perfect Competition 69 Monopoly 70 Monopolistic Competition 70 Oligopoly 71 Which Model Fits Reality 71

Supply under Perfect Competition 73 Normal versus Economic Profit 73 When and Why Economic Profits Go to Zero 73 Why Supply Is Marginal Cost under Perfect Competition 74 Just Words 74 Numerical Example 74 Graphical Explanation 75

Summary 76

Chapter 6 Every Macroeconomic Word You Ever Heard: Gross Domestic Product, Inflation, Unemployment, Recession, and Depression 79 Measuring the Economy 80

Measuring Nominal Output 80 Measuring Prices and Inflation 81 Problems Measuring Inflation 83

Real Gross Domestic Product and Why It Is Not Synonymous with Social Welfare 86 Real Gross Domestic Product 86 Problems with Real GDP 86

Measuring and Describing Unemployment 87 Measuring Unemployment 87 Problems Measuring Unemployment 89 Types of Unemployment 90

Productivity 90 Measuring and Describing Productivity 90

Seasonal Adjustment 91 Business Cycles 92 Kick It Up a Notch: National Income and Product

Accounting 94 Summary 95

Chapter 7 Interest Rates and Present Value 98 Interest Rates 99

The Market for Money 99 Nominal Interest Rates versus Real Interest Rates 99

Present Value 100 Simple Calculations 100 Mortgages, Car Payments, and Other Multipayment

Examples 101

gue46399_fm_i-xxxii.indd 10 16/03/17 2:50 PM

Table of Contents xi

Future Value 102 Kick It Up a Notch: Risk and Reward 104 Summary 104

Chapter 8 Aggregate Demand and Aggregate Supply 107 Aggregate Demand 108

Definition 108 Why Aggregate Demand Is Downward

Sloping 108 Aggregate Supply 109

Definition 109 Competing Views of the Shape of Aggregate

Supply 109 Shifts in Aggregate Demand and Aggregate

Supply 110 Variables That Shift Aggregate Demand 110 Variables That Shift Aggregate Supply 113

Causes of Inflation 114 How the Government Can Influence

(but Probably Not Control) the Economy 115 Demand-Side Macroeconomics 115 Supply-Side Macroeconomics 115

Summary 116

Chapter 9 Fiscal Policy 119 Nondiscretionary and Discretionary

Fiscal Policy 119 How They Work 119 Using Aggregate Supply and Aggregate Demand

to Model Fiscal Policy 120 Using Fiscal Policy to

Counteract “Shocks” 121 Aggregate Demand Shocks 121 Aggregate Supply Shocks 122

Evaluating Fiscal Policy 123 Nondiscretionary Fiscal Policy 123 Discretionary Fiscal Policy 123 The Political Problems with Fiscal Policy 124 Criticism from the Right and Left 125 The Rise, Fall, and Rebirth of

Discretionary Fiscal Policy 125 The Obama Stimulus Plan 126 Kick It Up a Notch: Aggregate Supply

Shocks 128 Summary 128

Chapter 10 Monetary Policy 131 Goals, Tools, and a Model of Monetary Policy 132

Goals of Monetary Policy 132 Traditional and Ordinary Tools of Monetary Policy 132 Modeling Monetary Policy 133 The Monetary Transmission Mechanism 134 The Additional Tools of Monetary Policy Created

in 2008 135 Central Bank Independence 137 Modern Monetary Policy 138

The Last 30 Years 138 Summary 143

Chapter 11 Federal Spending 145 A Primer on the Constitution and Spending Money 146

What the Constitution Says 146 Shenanigans 146 Dealing with Disagreements 147

Using Our Understanding of Opportunity Cost 148 Mandatory versus Discretionary Spending 148 Where the Money Goes 149

Using Our Understanding of Marginal Analysis 151 The Size of the Federal Government 151 The Distribution of Federal Spending 151

Budgeting for the Future 151 Baseline versus Current-Services Budgeting 151

Summary 152

Chapter 12 Federal Deficits, Surpluses, and the National Debt 155 Surpluses, Deficits, and the Debt: Definitions

and History 156 Definitions 156 History 156

How Economists See the Deficit and the Debt 159 Operating and Capital Budgets 159 Cyclical and Structural Deficits 159 The Debt as a Percentage of GDP 160 International Comparisons 160 Generational Accounting 161

Who Owns the Debt? 161 Externally Held Debt 162

A Balanced-Budget Amendment 162 Projections 165 Summary 166

gue46399_fm_i-xxxii.indd 11 16/03/17 2:50 PM

xii Table of Contents

Chapter 13 The Housing Bubble 168 How Much Is a House Really Worth? 168 Mortgages 170 How to Make a Bubble 172 Pop Goes the Bubble! 173 The Effect on the Overall Economy 174 Summary 175

Chapter 14 The Recession of 2007–2009: Causes and Policy Responses 177 Before It Began 177 Late 2007: The Recession Begins as Do the

Initial Policy Reactions 180 The Bottom Falls Out in Fall 2008 181 The Obama Stimulus Package 182 Extraordinary Monetary Stimulus 183 Summary 184

Chapter 15 Is Economic Stagnation the New Normal? 186 Periods of Robust Economic Growth 187 Sources of Growth 187 Causes and Consequences of Slowing

Growth 187 Causes 187 Consequences 188

What Can Be Done to Jump-Start Growth, or Is This the New Normal? 189

Summary 191

Chapter 16 Is the (Fiscal) Sky Falling?: An Examination of Unfunded Social Security, Medicare, and State and Local Pension Liabilities 193 What Is the Source of the Problem? 193 How Big Is the Social Security and Medicare

Problem? 194 How Big Is the State and Local Pension

Problem? 196 Is It Possible That the Fiscal Sky Isn’t

About to Fall? 198 Summary 199

Chapter 17 International Trade: Does It Jeopardize American Jobs? 201 What We Trade and with Whom 201 The Benefits of International Trade 204

Comparative and Absolute Advantage 204 Demonstrating the Gains from Trade 205 Production Possibilities Frontier

Analysis 205 Supply and Demand Analysis 206 Whom Does Trade Harm? 206

Trade Barriers 207 Reasons for Limiting Trade 207 Methods of Limiting Trade 208

Trade as a Diplomatic Weapon 209 Kick It Up a Notch: Costs of Protectionism 210 Summary 210

Chapter 18 International Finance and Exchange Rates 213 International Financial Transactions 213 Foreign Exchange Markets 215 Alternative Foreign Exchange Systems 217 Determinants of Exchange Rates 219 Summary 220

Chapter 19 European Debt Crisis 222 In the Beginning There Were 17 Currencies

in 17 Countries 222 The Effect of the Euro 223 Why Couldn’t They Pull Themselves Out?

The United States Did 226 Is It Too Late to Leave the Euro? 228 Where Should Europe Go from Here? 229 Summary 229

Chapter 20 Economic Growth and Development 231 Growth in Already Developed Countries 231 Comparing Developed Countries and Developing

Countries 233 Fostering (and Inhibiting) Development 234

The Challenges Facing Developing Countries 235 What Works 236

Summary 236

gue46399_fm_i-xxxii.indd 12 16/03/17 2:50 PM

Table of Contents xiii

Chapter 21 NAFTA, CAFTA, GATT, TPP, WTO: Are Trade Agreements Good for Us? 238 The Benefits of Free Trade 239 Why Do We Need Trade Agreements? 239

Strategic Trade 240 Special Interests 240 What Trade Agreements Prevent 240

Trade Agreements and Institutions 241 Alphabet Soup 241 Are They Working? 242

Economic and Political Impacts of Trade 243 The Bottom Line 245 Summary 245

Chapter 22 The Line between Legal and Illegal Goods 248 An Economic Model of Tobacco, Alcohol,

and Illegal Goods and Services 249 Why Is Regulation Warranted? 249

The Information Problem 249 External Costs 250 Morality Issues 252

Taxes on Tobacco and Alcohol 253 Modeling Taxes 253 The Tobacco Settlement and Why Elasticity

Matters 254 Why Are Certain Goods and Services

Illegal? 254 The Impact of Decriminalization on the Market

for the Goods 254 The External Costs of Decriminalization 255

Summary 255

Chapter 23 Natural Resources, the Environment, and Climate Change 258 Using Natural Resources 259 How Clean Is Clean Enough? 259 The Externalities Approach 260

When the Market Works for Everyone 260 When the Market Does Not Work for Everyone 260

The Property Rights Approach to the Environment and Natural Resources 262 Why You Do Not Mess Up Your Own Property 262 Why You Do Mess Up Common Property 262

Natural Resources and the Importance of Property Rights 262

Environmental Problems and Their Economic Solutions 263 Environmental Problems 263 Economic Solutions: Using Taxes to Solve

Environmental Problems 265 Economic Solutions: Using Property Rights

to Solve Environmental Problems 265 No Solution: When There Is No Government

to Tax or Regulate 267 Summary 268

Chapter 24 Health Care 271 Where the Money Goes and Where

It Comes From 271 Insurance in the United States 272

How Insurance Works 272 Varieties of Private Insurance 273 Public Insurance 273

Economic Models of Health Care 274 Why Health Care Is Not Just Another Good 274 Implications of Public Insurance 275 Efficiency Problems with Private Insurance 276 Major Changes to Insurance Resulting from PPACA 277 The Blood and Organ Problem 279

Comparing the United States with the Rest of the World 279

Summary 281

Chapter 25 Government-Provided Health Insurance: Medicaid, Medicare, and the Children’s Health Insurance Program 283 Medicaid: What, Who, and How Much 284 Why Medicaid Costs So Much 285

Why Spending Is Greater on the Elderly 286 Cost-Saving Measures in Medicaid 287

Medicare: Public Insurance and the Elderly 287 Why Private Insurance May Not Work 287 Why Medicare’s Costs Are High 288

Medicare’s Nuts and Bolts 289 Provider Types 289 Part A 289 Part B 290 Prescription Drug Coverage (Part D) 290 Cost Control Provisions in Medicare 291

gue46399_fm_i-xxxii.indd 13 16/03/17 2:50 PM

xiv Table of Contents

The Medicare Trust Fund 292 The Relationship between Medicaid and

Medicare 293 Children’s Health Insurance Program 293 Summary 294

Chapter 26 The Economics of Prescription Drugs 296 Profiteers or Benevolent Scientists? 297 Monopoly Power Applied to Drugs 297 Important Questions 299

Expensive Necessities or Relatively Inexpensive Godsends? 299

Price Controls: Are They the Answer? 301 FDA Approval: Too Stringent or Too Lax? 301

Summary 302

Chapter 27 So You Want to Be a Lawyer: Economics and the Law 304 Private Property 304

Intellectual Property 305 Contracts 305 Enforcing Various Property Rights and Contracts 305 Negative Consequences of Private Property Rights 306

Bankruptcy 306 Civil Liability 306 Summary 308

Chapter 28 The Economics of Crime 310 Who Commits Crimes and Why 310 The Rational Criminal Model 311

Crime Falls When Legal Income Rises 311 Crime Falls When the Likelihood and Consequences

of Getting Caught Rise 312 Problems with the Rationality Assumption 312

The Costs of Crime 312 How Much Does an Average Crime Cost? 313 How Much Crime Does an Average Criminal

Commit? 313 Optimal Spending on Crime Control 314

What Is the Optimal Amount to Spend? 314 Is the Money Spent in the Right Way? 315 Are the Right People in Jail? 315 What Laws Should We Rigorously Enforce? 315 What Is the Optimal Sentence? 316

Summary 317

Chapter 29 Antitrust 319 What’s Wrong with Monopoly? 319

High Prices, Low Output, and Deadweight Loss 319

Reduced Innovation 320 Natural Monopolies and Necessary Monopolies 320

Natural Monopoly 320 Patents, Copyrights, and Other Necessary

Monopolies 321 Monopolies and the Law 322

The Sherman Anti-Trust Act 322 What Constitutes a Monopoly? 323

Examples of Antitrust Action 323 Standard Oil 323 IBM 324 Microsoft 324 Apple, Google, and the European Union 325

Summary 325

Chapter 30 The Economics of Race and Sex Discrimination 327 The Economic Status of Women and Minorities 327

Women 327 Minorities 328

Definitions and Detection of Discrimination 330 Discrimination, Definitions, and the Law 330 Detecting and Measuring Discrimination 331

Discrimination in Labor, Consumption, and Lending 332 Labor Market Discrimination 332 Consumption Market and Lending Market

Discrimination 333 Affirmative Action 334

The Economics of Affirmative Action 334 What Is Affirmative Action? 335 Gradations of Affirmative Action 335

Summary 336

Chapter 31 Income and Wealth Inequality: What’s Fair? 339 Measurement of Inequality 339

Income Inequality 339 Wealth Inequality 342

The Shrinking Middle Class 343

gue46399_fm_i-xxxii.indd 14 16/03/17 2:50 PM

Table of Contents xv

Causes of Household Income and Wealth Inequality 344 Costs and Benefits of Income Inequality 345 Summary 347

Chapter 32 Farm Policy 349 Farm Prices Since 1950 349

Corn and Gasoline 350 Price Variation as a Justification for Government

Intervention 351 The Case for Price Supports 351 The Case against Price Supports 352

Consumer and Producer Surplus Analysis of Price Floors 352 One Floor in One Market 352 Variable Floors in Multiple Markets 353 What Would Happen without Price Supports? 353

Price Support Mechanisms and Their History 353 Price Support Mechanisms 353 History of Price Supports 355

Is There a Bubble on the Farm? 355 Kick It Up a Notch 356 Summary 356

Chapter 33 Minimum Wage 358 Traditional Economic Analysis of a Minimum

Wage 359 Labor Markets and Consumer and Producer Surplus 359 A Relevant versus an Irrelevant Minimum Wage 360 What Is Wrong with a Minimum Wage? 361 Real-World Implications of the Minimum Wage 361 Alternatives to the Minimum Wage 362

Rebuttals to the Traditional Analysis 362 The Macroeconomics Argument 362 The Work Effort Argument 363 The Elasticity Argument 363

Where Are Economists Now? 363 Kick It Up a Notch 364 Summary 364

Chapter 34 Ticket Brokers and Ticket Scalping 366 Defining Brokering and Scalping 367 An Economic Model of Ticket Sales 367

Marginal Cost 367 The Promoter as Monopolist 367 The Perfect Arena 368

Why Promoters Charge Less Than They Could 369 An Economic Model of Scalping 369 Legitimate Scalpers 370 Summary 371

Chapter 35 Rent Control 373 Rents in a Free Market 373 Reasons for Controlling Rents 374 Consequences of Rent Control 375 Why Does Rent Control Survive? 377 Summary 378

Chapter 36 The Economics of K–12 Education 379 Investments in Human Capital 379

Present Value Analysis 380 External Benefits 380

Should We Spend More? 381 The Basic Data 381 Cautions about Quick Conclusions 383 Literature on Whether More Money Will Improve

Educational Outcomes 385 School Reform Issues 385

The Public School Monopoly 385 Merit Pay and Tenure 386 Private versus Public Education 386 School Vouchers 387 Collective Bargaining 387

Summary 388

Chapter 37 College and University Education: Why Is It So Expensive? 390 Why Are the Costs So High? 390 Why Are College Costs Rising So Fast? 392 Why Have Textbook Costs Risen So 

Rapidly? 393 What a College Degree Is Worth 395 How Do People Pay for College? 396 Summary 398

Chapter 38 Poverty and Welfare 400 Measuring Poverty 400

The Poverty Line 401 Who’s Poor? 401

gue46399_fm_i-xxxii.indd 15 16/03/17 2:50 PM

xvi Table of Contents

Poverty through History 402 Problems with Our Measure of Poverty 403 Poverty in the United States versus Europe 404

Programs for the Poor 404 In Kind versus In Cash 404 Why Spend $789 Billion on a $96 Billion

Problem? 406 Is $789 Billion Even a Lot Compared to

Other Countries? 406 Incentives, Disincentives, Myths,

and Truths 406 Welfare Reform 407

Is There a Solution? 407 Welfare as We Now Know It 408 Is Poverty Necessarily Bad? 408

Summary 408

Chapter 39 Head Start 411 Head Start as an Investment 411

The Early Intervention Premise 411 Present Value Analysis 412 External Benefits 412 The Early Evidence 412 The Remaining Doubts 412

The Head Start Program 413 The Current Evidence 414

Evidence that Head Start Works 414 Evidence that Head Start Does Not Work 415 More Evidence Is Coming and Some Is In 415

The Opportunity Cost of Fully Funding Head Start 416

Summary 416

Chapter 40 Social Security 418 The Basics 418

The Beginning 418 Taxes 419 Benefits 419 Changes over Time 419

Why Do We Need Social Security? 420 Social Security’s Effect on the

Economy 421 Effect on Work 421 Effect on Saving 421

Whom Is the Program Good For? 422 Will the System Be There for Me? 424

Why Social Security Is in Trouble 424 The Social Security Trust Fund 424 Options for Fixing Social Security 425

Summary 426

Chapter 41 Personal Income Taxes 429 How Income Taxes Work 429 Issues in Income Taxation 434

Horizontal and Vertical Equity 434 Equity versus Simplicity 434

Incentives and the Tax Code 434 Do Taxes Alter Work Decisions? 435 Do Taxes Alter Savings Decisions? 435 Taxes for Social Engineering 435

Who Pays Income Taxes? 435 The Tax Debates of the Last Two Decades 436 Summary 437

Chapter 42 Energy Prices 440 The Historical View 440

Oil and Gasoline Price History 440 Geopolitical History 441 A Return to Irrelevancy 442

OPEC 445 What OPEC Tries to Do 445 How Cartels Work 445 Why Cartels Are Not Stable 445 Back from the Dead 446

Why Do Prices Change So Fast? 446 Is It All a Conspiracy? 447 From $1 to $4 per Gallon in 10 Years? 447

Electric Utilities 449 Electricity Production 449 Why Are Electric Utilities a Regulated Monopoly? 450

What Will the Future Hold? 451 Kick It Up a Notch 452 Summary 453

Chapter 43 If We Build It, Will They Come? And Other Sports Questions 455 The Problem for Cities 455

Expansion versus Luring a Team 455 Does a Team Enhance the Local Economy? 457 Why Are Stadiums Publicly Funded? 458

gue46399_fm_i-xxxii.indd 16 16/03/17 2:50 PM

Table of Contents xvii

The Problem for Owners 458 To Move or to Stay 458 To Win or to Profit 459 Don’t Feel Sorry for Them Just Yet 460

The Sports Labor Market 461 What Owners Will Pay 461 What Players Will Accept 461

The Vocabulary of Sports Economics 461 What a Monopoly Will Do for You 464

Summary 465

Chapter 44 The Stock Market and Crashes 467 Stock Prices 468

How Stock Prices Are Determined 468 What Stock Markets Do 469

Efficient Markets 470 Stock Market Crashes 470

Bubbles 470 Example of a Crash: NASDAQ 2000 471

The Accounting Scandals of 2001 and 2002 472 Bankruptcy 473 Why Capitalism Needs Bankruptcy Laws 473 The Kmart and Global Crossing Cases 473 What Happened in the Enron Case 474 Why the Enron Case Matters More Than

the Others 475 Rebound of 2006–2007 and the Drop

of 2008–2009 475 Summary 476

Chapter 45 Unions 478 Why Unions Exist 478

The Perfectly Competitive Labor Market 478 A Reaction to Monopsony 479 A Way to Restrict Competition and Improve Quality 480 A Reaction to Information Issues 481

A Union as a Monopolist 481 The History of Labor Unions 482

Where Unions Go from Here 485 Kick It Up a Notch 486 Summary 486

Chapter 46 Walmart: Always Low Prices (and Low Wages)—Always 488 The Market Form 488 Who Is Affected? 490

Most Consumers Stand to Gain—Some Lose Options 490 Workers Probably Lose 491 Sales Tax Revenues Won’t Be Affected Much 491 Some Businesses Will Get Hurt; Others Will Be

Helped 491 Community Effects 491

Summary 492

Chapter 47 The Economic Impact of Casino and Sports Gambling 494 The Perceived Impact of Casino Gambling 494 Local Substitution 494 The “Modest” Upside of Casino Gambling 495 The Economic Reasons for Opposing Casino

Gambling 495 Sports Gambling and Daily Fantasy 496 Summary 497

Chapter 48 The Economics of Terrorism 499 The Economic Impact of September 11th and

of Terrorism in General 499 Modeling the Economic Impact of the Attacks 500

Insurance Aspects of Terrorism 501 Buy Insurance or Self-Protect or Both 502

Terrorism from the Perspective of the Terrorist 502 Summary 503

Index 505

gue46399_fm_i-xxxii.indd 17 16/03/17 2:50 PM

xviii

Preface This book is designed for a one-semester issues-based general education economics course, and its purpose is to interest the nonbusiness, noneconomics major in what the discipline of economics can do. Students of the “issues approach” will master the basic economic theory necessary to explore a variety of real-world issues. If this is the only economics course they ever take, they will at least gain enough insight to be able to intelligently discuss the way eco- nomic theory applies to important issues in the world today.

Until the first edition of this book was published, instructors who chose the issues approach to teaching a one-semester general economics course had to compromise in one of the follow- ing ways: they could (1) pick a book that presents the issues but that is devoid of economic theory; (2) pick a book that intertwines the issues with the theory; (3) ask students to buy two books; or (4) place a large number of readings on library reserve.

Each of these alternatives presents problems. If the course is based entirely on an issues text, students will leave with the incorrect impression that economics is a nonrigorous discipline that assumes that all of the issues are relevant to all students in the course. In fact, some issues are not relevant to some students and others are relevant only when the issue makes news. For example, at Syracuse my students never understood why farm price supports were interesting, whereas at Indiana State no student that I have met has ever lived in a rent-controlled apartment. The prob- lem associated with using multiple books is the obvious one of expense. Having multiple reserve readings, still a legitimate option, requires a great deal of time on the part of students, teachers, and librarians and is usually not convenient to students.

The eighth edition of this book meets both student and instructor needs simultaneously. By making the entire portfolio of chapters available for instructors to select and include in a print book as they see fit within McGraw-Hill’s CREATE platform, we allow instructors maximum flexibility to design a product that keeps students interested.

HOW TO USE THIS BOOK

Issues in Economics Today includes 8 intensive core theory chapters and 40 shorter issues chapters. The book is designed to allow faculty flexibility in approach. Some colleagues like to intertwine theory and issues while others like to lay the theoretical foundation first before heading into the issues. Some faculty will choose to set a theme for their course and pick is- sues consistent with that theme while others will let their students decide what issues interest them. There is no right way to use the book except that under no circumstances is it imag- ined that the entire book be covered.

McGraw-Hill CREATE To address the recommendation that no instructor should assign the entire book to be cov- ered in their course, the eighth edition takes advantage of the capabilities in McGraw-Hill’s CREATE platform (www.mcgrawhillcreate.com) to give instructors the flexibility to easily design a print product customized to their issues course: instructors can easily add chapters to their product in the same way someone might add purchases to their cart when online shop- ping. Once the table of contents is set, the instructor can easily view the net price of their

gue46399_fm_i-xxxii.indd 18 16/03/17 2:50 PM

Preface xix

course text (often much lower once extraneous chapters have been removed). When the prod- uct is approved by the instructor, the system will generate an ISBN for the customized product, which can be provided to the bookstore. Once an order is placed, the copies will be printed on demand for each institution. The process is very straightforward; however, a McGraw-Hill representative can assist instructors or build products based on syllabi if required. This work- flow makes it feasible for an instructor to revisit their product and make tweaks every time they teach the course. It also makes it a possibility for me to author and make available chap- ters that address current economic issues in a timely manner as events arise.

Organization of the Issues Chapters There are 40 issues chapters that I have divided into the following categories: Macroeco- nomic Issues (Chapters 9–16), International Issues (Chapters 17–20), Externalities and Market Failure (Chapters 22–23), Health Issues (Chapters 24–26), Government Solutions to Soci- etal Problems (Chapters 27–31), Price Control Issues (Chapters 32–34), and Miscellaneous Markets (Chapters  36–48). These groupings will be helpful as you navigate through the Contents looking for a particular topic. To help you decide which issues chapters to cover, see the table on pages xxx–xxxi, entitled “Required Theory Table.” It shows at a glance which theory chapters need to be covered before pursuing each of the issues chapters. On pages xxviii–xxix, the table entitled “Issues for Different Course Themes” includes my recommendations for courses that focus on social policy, international issues, election year issues, or business. Within the CREATE platform these different course structures are al- ready assembled into ready-made Express Books to make it easy for you to customize your text according to these themes.

CHANGES TO THE EIGHTH EDITION

Due to the CREATE-delivery of the eighth edition, issues chapters that have previously been hosted on the website have now moved back within the table of contents so instructors can more easily add them to custom products. These chapters include:

• Chapter 21 NAFTA, CAFTA, GATT, WTO: Are Trade Agreements Good for Us? • Chapter 28 Antitrust • Chapter 35 Rent Control • Chapter 39 Head Start • Chapter 48 The Economics of Terrorism

Furthermore, many instructors have requested with previous editions that we provide assign- able material within Connect, McGraw-Hill’s online assessment platform. We are happy to report that Connect is now available with the eighth edition including an adaptive reading ex- perience, assignable homework (with additional quantitative and graphing problems beyond what is found at the end of each chapter), test bank content, and a host of instructor resources. For more information, please review the Connect portion of this preface.

Chapter 1: An entire section has been added on modeling economic growth using a pro- duction possibilities frontier. Both generalized and specialized growth are depicted in both a world of increasing and constant opportunity cost. In addition, the sources of economic growth are explicated.

Chapter 2: Content and data updates have been made as needed to reflect the most current information available.

gue46399_fm_i-xxxii.indd 19 16/03/17 2:50 PM

Chapter 3: Added to the discussion of substitutes by describing the inclination to use goods already in our possession longer when newer substitutes increase in price. Added an entire section on the determinants of elasticity of supply. Added a description of network goods.

Chapter 5: Content and data updates have been made as needed to reflect the most current information available. Textbox added to illustrate the importance of exit and entry using oil drilling.

Chapter 6: Content and data updates have been made as needed to reflect the most current information available. Added textbox that answers frequently asked questions regarding how particular situations (products made in one year and sold in the next, used cars, equities, and illegal drugs) are handled in GDP accounting.

Chapters 7–9: Content and data updates have been made as needed to reflect the most current information available.

Chapter 10: Content and data updates have been made as needed to reflect the most current infor- mation available. Added a section that described the monetary policies of other countries and how the unprecedented actions of the Federal Reserve can be undone when the times comes to do so.

Chapter 11: Content and data updates have been made as needed to reflect the most current information available.

Chapter 12: Content and data updates have been made as needed to reflect the most current information available. Added World Bank measures of debt-to-GDP measures.

Chapter 13: Content and data updates have been made as needed to reflect the most current information available. Added a comparison of home affordability in 2006 vs. 2015 for selected major markets.

Chapter 14: Content and data updates have been made as needed to reflect the most current information available.

Chapter 15: The chapter reshapes the “Japan” chapter from the previous edition to take on the broader question of economic stagnation in the U.S. and other western economies.

Chapter 16: Content and data updates have been made as needed to reflect the most current information available. Extensively revised the section on state and local pension problems using updated information. Focused particular attention on the intractability of the pension problem in Illinois.

Chapters 17–18: Content and data updates have been made as needed to reflect the most cur- rent information available.

Chapter 19: Content and data updates have been made as needed to reflect the most current information available. Reference made to ECB stimulus and to Brexit.

Chapter 20: Content and data updates have been made as needed to reflect the most current information available.

Chapter 21: Content and data updates have been made as needed to reflect the most current information available. References also made to the Trans-Pacific Partnership.

Chapter 22: Content and data updates have been made as needed to reflect the most current information available. The impact of the availability of e-cigarettes as substitutes for tobacco is discussed, particularly as it relates to tobacco elasticity.

xx Preface

gue46399_fm_i-xxxii.indd 20 16/03/17 2:50 PM

Chapter 23: Content and data updates have been made as needed to reflect the most current information available. The responsiveness of average temperatures to changes in CO2 concen- trations is also discussed in the context of climate change.

Chapter 24: Content and data updates have been made as needed to reflect the most cur- rent information available. Clarifications are included regarding the impact of the PPACA on Medicaid expansions. International comparisons for five-year survival rates of various cancers are included.

Chapter 25: Content and data updates have been made as needed to reflect the most current in- formation available. The Congressional action to address the perpetual “Docfix” is discussed.

Chapter 26: Content and data updates have been made as needed to reflect the most current information available. Issues involving expensive life-saving drugs (Harvoni, Vivitrol, etc.) and their coverage (or lack thereof) by Medicaid are discussed.

Chapter 27: A discussion of class-action lawsuits and the example of Takata airbags was inserted.

Chapter 28: Content and data updates have been made as needed to reflect the most current information available. Significant modifications to the impact of various crime policies on crime was added stemming from a Brennan Center for Justice report that showed diminishing returns to increasing levels of incarceration.

Chapter 29: A discussion of the Apple and Google cases before the EU anti-trust agencies was included.

Chapter 30: Content and data updates have been made as needed to reflect the most current information available.

Chapter 31: Content and data updates have been made as needed to reflect the most current information available. A Pew Charitable Trusts monograph on the state of the middle class is examined. A discussion regarding the economic and political consequences of the shrinking middle class is offered.

Chapter 32: Content and data updates have been made as needed to reflect the most current information available.

Chapter 33: Content and data updates have been made as needed to reflect the most current information available. The textbox on state and local minimum wage statutes is completely redone. The difference, in terms of consequences, between modest and large increases in the minimum wage are examined in the context of efforts to raise wages to $15/hr.

Chapter 34: Content and data updates have been made as needed to reflect the most current information available. The secondary market for tickets is examined through the examples of StubHub, Ticketmaster, and NFL Ticket Exchange.

Chapter 35: No substantive changes.

Chapter 36: Content and data updates have been made as needed to reflect the most cur- rent information available. A discussion of the decline in inflation-adjusted K–12 per-student spending is offered.

Chapter 37: Content and data updates have been made as needed to reflect the most current in- formation available. Notes drawing attention to the fact that tuition increases at state institutions or higher education have slowed at the same time that state subsidies to those schools have also

Preface xxi

gue46399_fm_i-xxxii.indd 21 16/03/17 2:50 PM

decreased. Attention is also drawn to the fact that young adults in the United States are now no longer the likeliest to have a college education. In fact, the United States is now eighth on that list.

Chapters 38–40: Content and data updates have been made as needed to reflect the most cur- rent information available.

Chapter 41: Content and data updates have been made as needed to reflect the most current information available. The reform of the AMT is discussed.

Chapter 42: Content and data updates have been made as needed to reflect the most current information available. Hydraulic Fracturing and directional drilling and the impact of these tech- nologies on the elasticity of supply of crude oil are examined. The impact of these technologies and the increase in U.S. capabilities on OPEC are discussed. Data shows the link between U.S. rig counts and prices is displayed.

Chapter 43: Content and data updates have been made as needed to reflect the most current information available. The relocation of the Rams to L.A. is discussed. The fact that fewer constraints on soccer talent exist is related to the dominating position of Spain’s Barcelona and Real Madrid and the Premier League’s top five teams.

Chapters 44–46: Content and data updates have been made as needed to reflect the most cur- rent information available.

Chapter 47: Content and data updates have been made as needed to reflect the most current information available. Daily Fantasy gambling is discussed.

Chapter 48: More recent terror attacks in France, Belgium, and San Bernardino included.

FEATURES • A conversational writing style makes it easier for students not majoring in economics to

connect with the material. The book puts students at ease and allows them to feel more confident and open to learning.

• Chapter Outline and Learning Objectives set the stage at the beginning of each chapter to let the student see how the chapter is organized and anticipate the concepts that will be covered.

• Key Terms are defined in the margins and recapped at the end of the chapters. • Summaries at the end of each chapter reinforce the material that has been covered. • Issues Chapters You Are Ready for Now are found at the end of each theory chapter, so

students can go straight to the issues chapters that interest them once they’ve mastered the necessary theoretical principles.

• Quiz Yourself presents questions for self-quizzing at the end of each chapter. • Think about This asks provocative questions that encourage students to think about how

economic theories apply to the real world by putting themselves in the economic driver’s seat. For example, one Think about This asks, “Suppose you buy a new car. What is the opportunity cost of doing so?” This feature facilitates active learning so that the students will learn the concepts more thoroughly.

• Talk about This includes questions designed to trigger discussion. • For More Insight See sends the students to websites and publications to find additional

material on a given topic. Since economic issues are particularly time-sensitive, this

xxii Preface

gue46399_fm_i-xxxii.indd 22 16/03/17 2:50 PM

feature not only helps students learn to do research on the web but also keeps the course as fresh and current as today’s newspaper.

• Short Answer Questions are included so that faculty may ask students questions that will help faculty assess student understanding of complex economic phenomena.

RESOURCES TO SUPPORT LEARNING

The content and reliability of supplements is of primary importance to the users of the book. Because of this, I am personally involved in crafting and checking all of the following an- cillaries, which are available for quick download and convenient access via the instructor resource material available through Connect.

Instructor’s Manual In addition to a traditional outline of each chapter’s content and updated we references to data sources for each chapter, the Instructor’s Manual offers key-point icons to emphasize the im- portance of particular concepts. Another distinctive feature is that each figure is broken into subfigures with explanations that can be offered at each stage. Solutions to the end of chapter questions are also provided.

Test Bank The test bank includes 80–200 multiple-choice questions for the core theory chapters and 60–100 multiple-choice questions for the issues chapters. These questions test students’ knowledge of key terms, key concepts, theory and graph recognition, theory and graph application, and numeracy, as well as questions about different explanations given by economists regarding particular economic phenomena.

Computerized Test Bank TestGen is a complete, state-of-the-art test generator and editing application software that al- lows instructors to quickly and easily select test items from McGraw-Hill’s test bank content. The instructors can then organize, edit, and customize questions and answers to rapidly generate tests for paper or online administration. Questions can include stylized text, symbols, graphics, and equations that are inserted directly into questions using built-in mathematical templates. TestGen’s random generator provides the option to display different text or calculated number values each time questions are used. With both quick-and-simple test creation and flexible and robust editing tools, TestGen is a complete test generator system for today’s educators.

PowerPoint Presentations An extensive set of editable PowerPoint slides accompany the text to support instructor lectures.

Assurance of Learning Ready Many education institutions today are focused on the notion of assurance of learning, an important element of some accreditation standards. Issues in Economics Today supports as- surance of learning objectives with a simple, yet powerful solution.

Instructors can use Connect to easily query for learning outcomes/objectives that directly relate to the learning objectives of the course. You can then use the reporting features of Con- nect to aggregate student results in similar fashion, making the collection and presentation of assurance of learning data simple and easy.

Preface xxiii

gue46399_fm_i-xxxii.indd 23 16/03/17 2:50 PM

Required=Results

McGraw-Hill Connect® Learn Without Limits Connect is a teaching and learning platform that is proven to deliver better results for students and instructors.

Connect empowers students by continually adapting to deliver precisely what they need, when they need it, and how they need it, so your class time is more engaging and effective.

Connect Insight® Connect Insight is Connect’s new one- of-a-kind visual analytics dashboard that provides at-a-glance information regarding student performance, which is immediately actionable. By presenting assignment, assessment, and topical performance results together with a time metric that is easily visible for aggregate or individual results, Connect Insight gives the user the ability to take a just-in-time approach to teaching and learning, which was never before available. Connect Insight presents data that helps instructors improve class performance in a way that is efficient and effective.

73% of instructors who use Connect require it; instructor satisfaction increases by 28%

when Connect is required.

Analytics

Using Connect improves retention rates by 19.8%, passing rates by 12.7%, and exam scores by 9.1%.

©Getty Images/iStockphoto

gue46399_fm_i-xxxii.indd 24 16/03/17 2:50 PM

SmartBook® Proven to help students improve grades and study more efficiently, SmartBook contains the same content within the print book, but actively tailors that content to the needs of the individual. SmartBook’s adaptive technology provides precise, personalized instruction on what the student should do next, guiding the student to master and remember key concepts, targeting gaps in knowledge and offering customized feedback, and driving the student toward comprehension and retention of the subject matter. Available on tablets, SmartBook puts learning at the student’s fingertips—anywhere, anytime.

Adaptive

Over 8 billion questions have been answered, making McGraw-

Hill Education products more intelligent, reliable, and precise.

THE ADAPTIVE READING EXPERIENCE DESIGNED TO TRANSFORM THE WAY STUDENTS READ

More students earn A’s and B’s when they use McGraw-Hill Education Adaptive products.

www.mheducation.com

gue46399_fm_i-xxxii.indd 25 16/03/17 2:50 PM

AACSB Statement McGraw-Hill Global Education is a product corporate member of AACSB International. Un- derstanding the importance and value of AACSB accreditation, Issues in Economics Today has sought to recognize the curricula guidelines detailed in the AACSB standards for business accreditation by connecting questions in the test bank and end-of-chapter material to the gen- eral knowledge and skill guidelines found in the AACSB standards.

It is important to note that the statements contained in Issues in Economics Today are provided only as a guide for the users of this text. The AACSB leaves content coverage and assessment within the purview of individual schools, the mission of the school, and the fac- ulty. While Issues in Economics Today and the teaching package make no claim of any spe- cific AACSB qualification or evaluation, we have labeled questions according to the general knowledge and skill areas.

ACKNOWLEDGMENTS

This text would not have been possible but for the efforts of a number of people. I thank Indiana State University and its Department of Economics for their continued support of this project. In particular, I thank my chair, John Conant, for his unflagging support, both moral and material. I am indebted to the personnel of McGraw-Hill Education for their work in gathering and compiling peer reviews. Katie Hoenicke, Senior Brand Manager, Jamie Koch, Product Developer, and Christina Kouvelis, Senior Product Developer, were always encouraging and willing to help at every stage. Finally, I want to thank Kelsey Darin. Kelsey, an undergraduate student at Indiana State, spent countless hours updating each data reference, table, and graph. Her careful and unending attention to detail helped me put together this edition in a way that I will be relying upon for editions to come. She cheerfully completed each task at a time when the University (almost inexplicably) assigned me to chair a department in another college. I will forever be in her debt.

I thank the many participants in McGraw-Hill Symposia who happily offered great insight on the best way to teach interesting issues. Finally, I thank the following peer reviewers whose insight substantially enhanced this book:

Alex Aichinger Northwestern State University Thomas Andrews West Chester University Michael Araujo Quinsigamond Community College Lee Ash Skagit Valley College Robert J. Bartelli Labette Community College Daria J. Bernard University of Delaware Roberta Biby Grand Valley State University Ann Marie Callahan Caldwell College

R. Edward Chatterton Lock Haven University Russ Cheatham Cumberland University Joab Corey Florida State University Ann M. Eike University of Kentucky Herb Elliott All Hancock College John A. Flanders Central Methodist University Holly Fretwell Montana State University Neil Garston CSULA

xxvi Preface

gue46399_fm_i-xxxii.indd 26 16/03/17 2:50 PM

E. B. Gendel Woodbury College Glenn Graham SUNY–Oswego Abbas P. Grammy California State University, Bakersfield Sheryl Hadley Johnson Community College Suzanne Hayes University of Nebraska, Kearney Rolf Hemmerling Greenville Technical College John S. Heywood University of Wisconsin–Milwaukee Richard Hoogerwerf Marian College Scott Hunt Columbus State Community College Hans Isakson University of Northern Iowa Debra Israel Indiana State University Allan Jenkins University of Nebraska, Kearney Dick Johnson Skagit Valley Community College Gary Langer Roosevelt University Tom Larson California State University–Los Angeles Raymond Lee Benedict College Gary D. Lemon DePauw University Alston Lippert University of South Carolina Patrick McMurry Missouri Western State University Tom Means San Jose State University Kimberly Merritt Oklahoma Christian University Daniel Morvey Piedmont Technical College Richard Newton Augusta Technical College

Inge O’Connor Syracuse University Nathan Perry University of Utah Chris Phillips Somerset Community College Patrick Price University of Louisiana at Lafayette Taghi Ramin William Patterson University Michael Ryan Western Michigan University John Sabelhaus University of Maryland Sue Lynn Sasser University of Central Oklahoma Brenda M. Saunders Somerset Community College Robert D. Schuttler Marian University Millicent M. Sites Carson-Newman College Rebecca Smith Mississippi State University Arun K. Srinivasan Indiana University Southeast Frank Tenkorang University of Nebraska, Kearney Tara Thornberry Maysville Community and Technical College Michelle Villinski DePauw University Darlene Voeltz Rochester Community and Technical College William Walsh University of St. Thomas Wendel Weaver Oklahoma Wesleyan University Janet L. Wolcutt Wichita State University Derek K. Yonai Campbell University Ben Young University of Missouri, Kansas City Johnson County Community College

Preface xxvii

gue46399_fm_i-xxxii.indd 27 16/03/17 2:50 PM

xxviii

Social Policy 22. The Line between Legal and Illegal Goods 24. Health Care 25. Government-Provided Health Insurance:

Medicaid, Medicare, and the Children’s Health Insurance Program

26. The Economics of Prescription Drugs 30. The Economics of Race and Sex Discrimination 31. Income and Wealth Inequality: What’s Fair? 33. Minimum Wage 36. The Economics of K–12 Education 37. College and University Education: Why Is It

So Expensive? 38. Poverty and Welfare 47. The Economic Impact of Casino and Sports

Gambling

Election Year 9. Fiscal Policy 11. Federal Spending 14. The Recession of 2007–2009: Causes and Policy

Responses 15. Is Economic Stagnation the New Normal? 16. Is the (Fiscal) Sky Falling? An Examination of

Unfunded Social Security, Medicare, and State and Local Pension Liabilities

17. International Trade: Does It Jeopardize American Jobs?

23. Natural Resources, the Environment, and Climate Change

24. Health Care 27. So You Want to Be a Lawyer: Economics and

the Law 28. The Economics of Crime 30. The Economics of Race and Sex Discrimination 33. Minimum Wage

37. College and University Education: Why Is It So Expensive?

40. Social Security

International Issues 12. Federal Deficits, Surpluses, and the

National Debt 15. Is Economic Stagnation the New Normal? 17. International Trade: Does It Jeopardize American

Jobs? 18. International Finance and Exchange Rates 19. European Debt Crisis 20. Economic Growth and Development 22. The Line between Legal and Illegal Goods 23. Natural Resources, the Environment, and Climate

Change 32. Farm Policy 42. Energy Prices

Business Issues 10. Monetary Policy 11. Federal Spending 13. The Housing Bubble 14. The Recession of 2007–2009: Causes and Policy

Responses 17. International Trade: Does It Jeopardize American

Jobs? 24. Health Care 26. The Economics of Prescription Drugs 34. Ticket Brokers and Ticket Scalping 41. Personal Income Taxes 42. Energy Prices 44. The Stock Market and Crashes 45. Unions 46. Walmart: Always Low Prices (and Low

Wages)—Always

Issues for Different Course Themes

gue46399_fm_i-xxxii.indd 28 16/03/17 2:50 PM

Issues for Different Course Themes xxix

Social Justice 14. The Recession of 2007–2009: Causes

and Policy Responses 15. Is Economic Stagnation the New Normal? 23. Natural Resources, the Environment,

and Climate Change 24. Health Care 25. Government-Provided Health Insurance:

Medicaid, Medicare, and the Children’s Health Insurance Program

26. The Economics of Prescription Drugs 30. The Economics of Race and Sex Discrimination 31. Income and Wealth Inequality: What’s Fair? 33. Minimum Wage 35. Rent Control 36. The Economics of K–12 Education 37. College and University Education: Why Is It So

Expensive? 38. Poverty and Welfare 39. Head Start 40. Social Security

Health and Education Policies 11. Federal Spending 16. Is the (Fiscal) Sky Falling?: An Examination of

Unfunded Social Security, Medicare, and State and Local Pension Liabilities

23. Natural Resources, the Environment, and Climate Change

24. Health Care

25. Government-Provided Health Insurance: Medicaid, Medicare, and the Children’s Health Insurance Program

26. The Economics of Prescription Drugs 30. The Economics of Race and Sex Discrimination 31. Income and Wealth Inequality: What’s Fair? 36. The Economics of K–12 Education 37. College and University Education: Why Is It So

Expensive? 38. Poverty and Welfare 39. Head Start 40. Social Security

The Most Popular Issues Chosen by Students 14. The Recession of 2007–2009: Causes and

Policy Responses 17. International Trade: Does It Jeopardize

American Jobs? 22. The Line between Legal and Illegal Goods 23. Natural Resources, the Environment,

and Climate Change 24. Health Care 28. The Economics of Crime 30. The Economics of Race and Sex Discrimination 33. Minimum Wage 42. Energy Prices 43. If We Build It, Will They Come? and Other

Sports Questions 44. The Stock Market and Crashes 47. The Economic Impact of Casino and Sports Gambling

gue46399_fm_i-xxxii.indd 29 16/03/17 2:50 PM

xxx

Required Theory Table Core Theory Required

1 2 3 4 5 6 7 8

X X X 9. Fiscal Policy

X X X 10. Monetary Policy

X 11. Federal Spending

X X 12. Federal Deficits, Surpluses, and the National Debt

X X X 13. The Housing Bubble

X X X 14. The Recession of 2007–2009: Causes and Policy Responses

X X X 15. Is Economic Stagnation the New Normal?

X X X 16. Is the (Fiscal) Sky Falling?: An Examination of Unfunded Social Security, Medicare, and State and Local Pension Liabilities

X X X 17. International Trade: Does It Jeopardize American Jobs?

X 18. International Finance and Exchange Rates

X X X X X 19. European Debt Crisis

X X X 20. Economic Growth and Development

X X X 21. NAFTA, CAFTA, GATT, TPP, WTO: Are Trade Agreements Good for Us?

X X X 22. The Line between Legal and Illegal Goods

X X X X X X 23. Natural Resources, the Environment, and Climate Change

X X X 24. Health Care

X X X 25. Government-Provided Health Insurance: Medicaid, Medicare, and the Children’s Health Insurance Program

X X X X X 26. The Economics of Prescription Drugs

X X X X 27. So You Want to Be a Lawyer: Economics and the Law

X X X 28. The Economics of Crime

X X X X 29. Antitrust

X 30. The Economics of Race and Sex Discrimination

X X X 31. Income and Wealth Inequality: What’s Fair?

X X X 32. Farm Policy

X X X 33. Minimum Wage

X X X 34. Ticket Brokers and Ticket Scalping

X X 35. Rent Control

X X 36. The Economics of K–12 Education

X X X X X X 37. College and University Education: Why Is It So Expensive?

X 38. Poverty and Welfare

X X 39. Head Start

X 40. Social Security

gue46399_fm_i-xxxii.indd 30 16/03/17 2:50 PM

Required Theory Table xxxi

Core Theory Required

1 2 3 4 5 6 7 8

X 41. Personal Income Taxes

X X X 42. Energy Prices

X X 43. If We Build It, Will They Come? And Other Sports Questions

X 44. The Stock Market and Crashes

X X X X 45. Unions

X X X X X 46. Walmart: Always Low Prices (and Low Wages)—Always

X X X X 47. The Economic Impact of Casino and Sports Gambling

X 48. The Economics of Terrorism

gue46399_fm_i-xxxii.indd 31 16/03/17 2:50 PM

This page intentionally left blank

1

C H A P T E R O N E

Economics: The Study of Opportunity Cost Learning Objectives

After reading this chapter you should be able to:

LO1 Define the key terms of economics and opportunity cost and understand how a production possibilities frontier exemplifies the trade-offs that exist in life.

LO2 Distinguish between increasing and constant opportunity cost and understand why each might happen in the real world.

LO3 Analyze an argument by thinking eco- nomically, while recognizing and avoiding logical traps.

Chapter Outline

Economics and Opportunity Cost

Modeling Opportunity Cost Using the Production Possibilities Frontier

Attributes of the Production Possibilities Frontier

Economic Growth

The Big Picture

Thinking Economically

Kick It Up a Notch: Demonstrating Constant and Increasing Opportunity Cost on a Production

Possibilities Frontier

Summary

This chapter lays the foundation for understanding how to think like an economist. It begins by defining the discipline of economics and its most basic concept: opportunity cost. Opportunity cost is modeled and further explained through the use of a diagram called a production possibili- ties frontier. A road map to the economy and to the remainder of the book is presented in the form of a circular flow diagram. The chapter continues with a discussion of what “thinking economi- cally” means. To understand this concept, we look at why economists use marginal analysis, ex- plore the difference between positive and normative analysis, and examine economic incentives. We conclude by examining logical traps that obstruct our path to such economic thinking.

Economics Defined Some define economics as a hard requirement for general education or a major; others, a “dis- mal science”; and still others, the study of the allocation and use of scarce resources to satisfy unlimited human wants. The reality is that economics is all three. It deserves its reputation as a difficult course, its practitioners are always disappointing the public by insisting that there is a cost to everything, and it really is a social science dealing with the fact that humans want more than resources are capable of satisfying.

Economics and Opportunity Cost

economics The study of the alloca- tion and use of scarce resources to satisfy unlimited human wants.

gue46399_ch01_001-018.indd 1 16/03/17 11:37 AM

2 Chapter 1 Economics: The Study of Opportunity Cost

On another level, the study of economics is the application of complicated jargon and graphs to common sense. You already know a lot of economics. You know, for instance, that choices have consequences; that having more money is more fun than having less; and that even though you are rich relative to a starving refugee, you are less rich than you would like to be. Of course, there are many other economic lessons that you learn simply by being alive. What you do not have is a systematic way of thinking about those economic ideas, and that is what this course and this book provide.

In this book all jargon with special meaning to economists will be in bold, with its defini- tion, sometimes also in jargon, close by in the text as well as in the margin. If the definition is in “econ-speak” rather than commonsense English, you will also find an English translation nearby. Two terms in our definition of economics need clarification because they have special meaning to economists. First, you find the word scarce. Something is scarce when there is not a freely available and infinite source of it. Second, a resource is anything we either consume directly or use to make things that we will ultimately consume.

There are four basic resources that society can allocate: land, labor, capital, and the entre- preneurship of its people. Any other resource, like oil, steel, or corn, is made available to a society when it allocates one or more of the basic resources to uncover, create, or harvest it.

Choices Have Consequences In this course and with this book you will be faced with a choice: Do you read and study, or do you sleep and party? This choice illustrates the first and most basic concept of economics: opportunity cost. Opportunity cost is the forgone alternative of the choice made.

Translated into English, opportunity cost is “what you would have done had you not done what you did.” It is important to keep in mind that the “forgone alternative” is the next best choice. It is not all the things “you could have done had you not done what you did,” but it is the best of these alternatives because presumably that is “what you would have done.”

If, for example, you decide at some point before finishing your assigned reading to put down this book, you will be implicitly saying that you would rather do something other than read this book. In terms of the course you are taking, the “opportunity cost” of such a poor decision could well be the lower grade that results from lost understanding.

Unfortunately, no matter what you do, you cannot escape opportunity cost. If you stay responsible and continue to read your text, the opportunity cost would be what you would do with the time saved. You are giving up the opportunity to watch something on Netflix, play the latest Call of Duty, Halo, or Assassin’s Creed game, sleep, or study something else. To you, the preferred one of these would be the opportunity cost of reading the text.

As an aside, professors today see many students trying to avoid opportunity cost by multi- tasking. Scanning your Facebook account, reading your English, texting your significant other, or studying your biology during your economics class may seem like you are simply using time that has no opportunity cost. It is not. Students who attempt it frequently miss details, instructions, or concepts when they are only partially tuned in. The opportunity cost of the multi-tasking attempt is the lost understanding that could have been gained had you focused your attention in class.

The Intuition behind Our First Graph The concept of opportunity cost can be further illustrated by looking at something called a production possibilities frontier. This graph, Figure 1.1, is the first of more than 100 that you will see in this book. It is an example of a model, a simplification of the real world that we

scarce Not freely available and lacking an infinite source.

resource Anything that is con- sumed directly or used to make things that will ultimately be consumed.

opportunity cost The forgone alternative of the choice made.

production possibilities frontier A graph that relates the amounts of different goods that can be pro duced in a fully employed society.

model A simplification of the real world that can be manipulated to explain the real world.

Modeling Opportunity Cost Using the Production Possibilities Frontier

gue46399_ch01_001-018.indd 2 16/03/17 11:37 AM

Modeling Opportunity Cost Using the Production Possibilities Frontier 3

can manipulate to explain the real world. This particular one relates the amounts of different goods that can be produced in a fully employed society.

Because chalkboards and book pages have only two dimensions, our explanation is limited. This gives us the first opportunity to introduce something called a simplifying assumption. A simplifying assumption is one that may, on its face, be silly but allows for a clearer explana- tion. A good one also has the characteristic that the conclusions that spring from it are valid in its more complicated scenario. For our produc-

tion possibilities frontier we will make several simplifying assumptions. We will assume that there are only two goods in the world, that these goods are pizza and soft drinks, and that these goods will be produced with a fixed number of resources and fixed technology.

For another simplification, suppose that there are five types of people in the world: (1) those really good at producing pizza but lousy at producing soda; (2) those pretty good at producing pizza and not so good at producing soda; (3) those sort of OK at both; (4) those good at pro- ducing soda and not so good at producing pizza; and (5) those really good at producing soda but lousy at producing pizza.

The Starting Point for a Production Possibilities Frontier If we imagine that our resource is the time of our workers, it can be consumed directly in the form of their leisure or it can be combined with other resources to produce goods and services. This resource is also scarce because there is not an infinite number of people to work, those people can do only so much work, they will not work without being paid, and there is only so much soda that can be produced—even if all the people on the planet devote their lives to the production of soda. Of course this point also holds if we apply the scarce resource to the production of pizza. There is only so much pizza that can be produced even if everyone on the planet is producing pizza. This notion of scarcity gives us a starting point and an ending point for Figure 1.1.

Point S in Figure 1.1 represents the situation where all resources are devoted to the produc- tion of soda; point P represents the situation where all resources are devoted to the production of pizza. In both cases all the resources in the world are devoted to the production of a specific good and production is still limited. It is limited by the ability of people and by the number of people and machines we have to help those people do their jobs. So that it is clear, remember that the production possibilities frontier is giving us a series of choices. We can pick only one of them. We cannot have both S sodas and P pizzas; thus, it is an either–or situation.

Points between the Extremes of a Production Possibilities Frontier We can have some soda and some pizza, so many points between S and P are possible; we need to determine them. To proceed, assume you want something to eat with your soda, and ask yourself what kind of people you would remove from soda production to foster pizza production. Clearly, you would remove those who are not contributing much to the soda pro- duction but would contribute greatly to pizza production. That is, those with the attributes of people in group 1 above: really good at pizza, lousy at soda.

Figure 1.2 shows us what happens if we go ahead and move that group. As you see, this increases pizza production to a respectable level while not costing society much soda. Point X in Figure 1.2 represents that new soda–pizza combination. There everyone except those whom

simplifying assumption An assumption that may, on its face, be silly but allows for a clearer explanation.

S

P

Pizza

S o

d a

FIGURE 1.1 Production possibilities frontier: the starting point.

gue46399_ch01_001-018.indd 3 16/03/17 11:37 AM

4 Chapter 1 Economics: The Study of Opportunity Cost

we will call the “pizza chefs” are still making soda, and the pizza chefs are efficiently crank- ing out as many pizzas as they can on their own. The thing is, though we gained a great deal of pizza production, we lost some soda production. That’s why point X, while to the right of point S, is also lower than point S.

If we continue this process further, we are not blessed with a similar effect. The reason is that if we move toward greater pizza production, we do not have those pizza chefs to call on; instead we have our group 2, who are pretty good at pizza and not so good at soda. What that means is that even though pizza production rises, it does not rise as much as it did before. On top of that, our soda production falls more than it had before because when we moved the pizza chefs, they were “lousy” at soda. Now we are moving workers who are simply not so good at soda. Our soda losses are growing at an increasing rate. Thus we have point Y in Figure 1.3.

Going further, point M in Figure 1.4 results from moving the workers from group 3 (OK at both) from soda to pizza, point Z results from moving group 4 workers to pizza, and point P results from moving group 5 workers to pizza.

Connecting points like this creates Figure 1.5: a production possibilities frontier. This curve represents the most pizza that can be produced for any given amount of soda or, interpreted differently, the most soda that can be produced for any given amount of pizza.

XS

P

Pizza

S o

d a

FIGURE 1.2 Production possibilities frontier: moving pizza chefs to their rightful place.

X

Y

S

P

Pizza

S o

d a

FIGURE 1.3 Production possibilities frontier: moving to even more pizza production.

X

M

Z

Y

S

P

Pizza

S o

d a

FIGURE 1.4 All points on a production possibilities frontier.

Unemployment ( just inside the curve)

Unattainable (outside the curve)

S o

d a

Pizza0

Attainable (on the curve and on the inside)

FIGURE 1.5 A fully labeled production possibili- ties frontier: the case when people are different.

gue46399_ch01_001-018.indd 4 16/03/17 11:37 AM

Attributes of the Production Possibilities Frontier 5

Of course, if you can produce on the curve, you can produce less than that as well. If you do produce at points inside a production possibilities frontier, there are unemployed resources, or unemployment for short. Therefore, all points on or inside the production possibilities frontier are attainable.

Conversely, since the production possibilities frontier represents the maximum amount of one good that you can produce for a given level of production of another, those points outside the production possibilities frontier are unattainable. This means that currently available re- sources and technology are insufficient to produce amounts greater than those illustrated on the frontier. On the graph, everything beyond the frontier is unattainable.

The preceding discussion illustrates something you need to be wary of in this book. Words you think you know may mean something entirely different to economists. Thus far we have at least three such words: unemployment, frontier, and good. You think of unemployment as the condition of someone wanting a job but not having one. Economists do not disagree but expand that defini- tion to resources other than labor. For example, on the interior of the production possibilities fron- tier there is unemployment, but that unemployment may be of capital. The word frontier is used to describe the boundary of production, not a wooded area with bears to avoid. The word good, to an economist, is a generic term for anything we consume. In the example, soda and pizza are goods.

In the soda and pizza example there were people of different talents at soda and pizza production. The pizza chef had far different skills from the soda master. If, on the other hand, everyone were identical in their soda and pizza production capabilities, then points would fall on the line, as seen in Figure 1.6.

Increasing and Constant Opportunity Cost Figures 1.5 and 1.6 have important similarities and differences. In both, the points on the production possibilities frontier are the most of one good that can be produced for a given amount of the other good. In both, the points on the curve and inside it are attainable and those on the outside of it are unattainable. In both, the opportunity cost of moving from one point

Attributes of the Production Possibilities Frontier

unemployment A situation that occurs when resources are not being fully utilized.

attainable Levels of production that are possible with the given resources.

unattainable Levels of production that are not possible with the given resources.

S o

d a

0

Unemployment ( just inside the curve)

Unattainable (outside the curve)

Pizza

Attainable (on the curve and on the inside)

FIGURE 1.6 A fully labeled production possibilities frontier: the case when people are the same.

gue46399_ch01_001-018.indd 5 16/03/17 11:37 AM

6 Chapter 1 Economics: The Study of Opportunity Cost

to another is the amount of one good you have to give up to get another. They differ in one important way, however: whether opportunity cost is increasing or constant.

If the production possibilities frontier is not a line but is bowed out away from the origin, then opportunity cost is increasing. The reason for this is that as we add more resources to the produc- tion of pizza, we are using fewer resources to produce soda. Compounding that problem, at each stage as we take the resources away from soda and put them into pizza, we are moving workers who are worse at pizza production and better at soda production than those moved in the previous stage. This means that the increase in pizza production is diminishing and the loss in soda pro- duction is increasing. An economist would call this an example of increasing opportunity cost.

If the production possibilities frontier is a straight line that is not bowed out away from the origin, then opportunity cost is constant. If every worker possesses identical skill, though you still have to give up some soda to get pizza, this is not compounded by anything. The resources you put into producing more pizza are just as good as the resources used to get you to that point, and the resources taken away from the soda are similarly just as good as the resources used up to that point. An economist would call this an example of constant opportunity cost.

How Is Growth Modeled? We can use the production possibilities frontier to model economic growth. In the top-left frame of Figure 1.7 we see what happens when there is increasing opportunity cost between pizza and soda, and a new process allows more soda to be produced from the same resources when that process doesn’t apply to pizza. In the top-center frame the reverse is true: Techno- logical progress allows for greater pizza production but doesn’t impact soda. The bottom-left and bottom-center frames show the same thing when there is constant opportunity cost. These four cases show the result of specialized growth, where there is an increase in the ability to produce a particular good because there is an increase in, or an increase in the ability of, re- sources to produce a particular good that does not generalize to other goods.

When there is generalized growth, that is typically the result of an increase in, or an increase in the ability of, resources to produce all goods. Generalized growth is depicted on the top-right and lower-right frames of Figure 1.7 for when there is increasing and constant opportunity cost, respectively.

Economic Growth

Specialized Growth

S o

d a

S o

d a

S o

d a

S o

d a

S o

d a

S o

d a

Generalized Growth

0 Pizza0 Pizza0 Pizza

0 Pizza 0 Pizza 0 Pizza

FIGURE 1.7 Modeling Economic Growth.

gue46399_ch01_001-018.indd 6 16/03/17 11:37 AM

The Big Picture 7

Sources of Economic Growth In terms of productive capacity of a society, economic growth results from either an increase in the availability of resources or an increase in the ability of resources to produce goods and ser- vices. In the first case, a newly discovered source of energy, or a source of energy that had, under previous technology, not been exploitable would constitute a newly available resource. Reaching not that far back in our history, having women enter the labor force in large numbers during the 1960s through the 1990s increased the availability of labor. In the second case, sometimes the resources remain the same but the ability to utilize them to produce goods and services increases. For instance, when computers and lasers are added to saw mills, the same logs, saw blades, and labor can produce more lumber. That is, technology makes resources more productive. Similarly, education makes labor more productive and can be a source of generalized growth in capacity.

Now that we have looked at our first “simplified” model of the economy, it’s time to get an idea of the “Big Picture.” Think of Figure 1.8 as your road map to the book. This circular flow model is designed to put all of the pieces that follow in perspective. It has firms, workers, investors, savers, buyers, and sellers all interacting in markets and dealing with government. It

The Big Picture

circular flow model A model that depicts the interactions of all eco- nomic actors.

Factor Markets

Goods and Services Markets

GovernmentFirms Households

Foreign Exchange Markets

The Rest of the World

The Rest of the World

Natural Resources and the Environment

Natural Resources and the Environment

Payments (rent, wages, etc.)

Payments (rent, wages, etc.)

Payments (rent, wages, etc.)

Labor, Savings

Labor, Savings

Labor, Savings

Taxes

Taxes

Transfer Payments, Services

Services

Goods and Services

Goods and Services Goods and Services

Payments for Goods and Services

Payments for Goods and Services

Payments for Goods and Services

Exports Imports

Wastes

WastesResources

Natural Beauty

$ $

£

£

FIGURE 1.8 The Circular Flow Model.

gue46399_ch01_001-018.indd 7 16/03/17 11:37 AM

8 Chapter 1 Economics: The Study of Opportunity Cost

has humanity taking natural resources from the environment, combining them with domestic and foreign financial and human resources to produce goods and services, and then buying and selling those goods and services in domestic and foreign markets.

Circular Flow Model: A Model That Shows the Interactions of All Economic Actors The ovals in the diagram represent entities of specific kinds: There are households, firms, and governments. Households provide labor for wages. They use those wages to buy goods and services and pay their taxes. They receive services from government. Some save, some bor- row, and many do both. Firms provide wages to households and pay taxes to government while getting labor from their workers and services from the government.

The rectangles in the diagram represent markets of various kinds: There are factor markets, foreign exchange markets, and goods and services markets. Factor markets are where workers and firms, and borrowers and savers interact to set wages and interest rates. Foreign exchange markets are where holders of various currencies interact to facilitate international trade. Goods and services markets are where consumers and producers interact to negotiate exchange of goods like cars, and services like dry cleaning.

Surrounding the whole thing are “The Rest of the World” and “Natural Resources and the Environment.” The former allows us to explicitly think about foreign trade and foreign exchange while the latter lets us think about the use of natural resources and the implications of economic activity on the environment.

Marginal Analysis One of the central tools of economics is marginal analysis. Economists typically look at prob- lems by analyzing the costs and benefits of various solutions. When people buy something, they have to compare the value of what they purchase to the value of what they give up. When companies produce goods for sale, they have to compare the money they generate from sales to the costs they will incur from the production process. When you clean up your dorm room, you weigh the cleanliness gained against the time required to clean it.

Economists generally make an optimization assumption. This is an assumption that sug- gests that the person in question is trying to maximize some objective. For example, consum- ers are assumed to be making decisions that maximize their happiness subject to a scarce amount of money. Companies are assumed to maximize profits. People are assumed to clean things until the benefits of cleaning more are not worth the time or effort.

Economists see that all of these problems can be looked at using the same framework. Economists compare the marginal benefit of an action with its marginal cost. Something is worth doing only if the increase in benefits equals or exceeds the increase in costs. If the marginal benefit of an action steadily decreases and the marginal cost of an action steadily increases, then a person maximizes net benefit by doing that action until the marginal benefit equals the marginal cost. This is the essence of marginal analysis, and we will see it in action throughout this book.

Positive and Normative Analysis When people look at the world they often see things as they are and compare the way things are to the way they think things should be. They see a major league shortstop sign a con- tract for a quarter of a billion dollars over 10 years while their high school teachers make

market Any mechanism by which buyers and sellers negotiate an exchange.

factor market A mechanism by which buyers and sellers of labor and financial capital negotiate an exchange.

foreign exchange market A mechanism by which buyers and sellers of the currencies of various countries negotiate an exchange.

goods and services market A mechanism by which buyers and sellers of goods and services negotiate an exchange.

optimization assumption An assumption that suggests that the person in question is trying to maximize some objective.

marginal benefit The increase in the benefit that results from an action.

marginal cost The increase in the cost that results from an action.

net benefit The difference between all benefits and all costs.

Thinking Economically

gue46399_ch01_001-018.indd 8 16/03/17 11:37 AM

Thinking Economically 9

less than $40,000 a year. Economists, and social scientists in general, distinguish views of “the way things are” from “the way things should be,” calling the former positive analysis and the latter normative analysis. Although there are economists who utilize both forms of analysis, more economists are comfortable explaining why things are the way they are than are comfortable suggesting the way things should be. Some critics look at this as self- delusion on the part of economists, using the argument that we choose which information to weigh more heavily based on normative beliefs.

Economic Incentives What kinds of choices we make as individuals and as a society depend on our preferences. Returning to the soda and pizza example, whether we like soda or pizza, or in what combina- tions we most like them, will have an important impact on what we choose to produce and consume. But also high on the list of things that determine what combinations of things we will produce and consume are incentives. Something is an incentive if it influences a decision we make. Some incentives are part of a market, like prices. Others are put on by an outside force like a government, and they can positively reinforce behaviors that are desired or deter behaviors that are not. What this means is that you are still able to produce and consume what you want, but something—perhaps a tax or a government regulation—is encouraging a par- ticular choice. For example, by taxing beer and not soda, the government encourages you to steer toward soda and away from beer.

On a deeper level, an incentive may motivate you to do something you would not or- dinarily do. For instance, many incentives are offered in the tax system. Tax credits and deductions for college tuition are considered incentives that will persuade people to get an education. For many people who would go to college anyway, these are not incentives. However, to some people who were perhaps considering college but had not made a de- cision, any influence these tax benefits would have on the decision would constitute an incentive.

An important and sometimes unfortunate aspect of incentives is that they create unintended consequences. Taxes are an area where some argue that the unintended consequences can be predicted from the incentives that arise out of programs. If welfare payments were reduced when the recipient found part-time employment, some predict the result that the recipient would not look for part-time employment.

Fallacy of Composition One of the key traps to thinking economically is assuming that the total economic impact of  something is always and simply equal to the sum of the individual parts. The fallacy of composition is an important logical trap to avoid because invalid economic conclusions will inevitably be drawn.

Outside of economics, cake constitutes a famous illustration of why the fallacy of composi- tion is just that—a fallacy. Imagine a cake. Now imagine the ingredients that go into making the cake. Imagine eating the cake and the satisfaction you get from that. Now compare that level of satisfaction to what you would have if you separately poured flour, sugar, and bak- ing powder down your throat, washed it down with a couple of raw eggs and some cooking oil, and then stuck your head in an oven. The baked combination is obviously better than its individual parts.

As an example within economics, we will learn in Chapter 5 that when many farmers are making high profits, others will want to join in. If they do join in, will all of the old and new farmers be making high profits? We will see that the new farmers’ extra production will ul- timately drive prices down so far that neither the older nor the newer farmers make money.

positive analysis A form of analysis that seeks to understand the way things are and why they are that way.

normative analysis A form of analysis that seeks to understand the way things should be.

incentives Something that influences a decision we make.

fallacy of composition The mistake in logic that suggests that the total economic impact of something is always and simply equal to the sum of the individual parts.

gue46399_ch01_001-018.indd 9 16/03/17 11:37 AM

10 Chapter 1 Economics: The Study of Opportunity Cost

What this means is that when we are making economic judgments, we must do so with care. The sums of the individual parts must not be confused with the whole. The two can be, and often are, different.

Correlation ≠ Causation When people are attempting to think economically, another trap they may fall into is assuming that because two variables changed simultaneously, one caused the other to happen.

For instance, if you weighed all people under age 30 and also asked them how many dates they had had in their lifetime, you would find a direct correlation, meaning that it appears that the more people weigh, the more dates they have had. This does not imply causation. Heavier people do not necessarily get more dates and dating does not make us gain weight. In this case the two variables happen to be correlated with age. People in their twenties weigh more and have had a longer opportunity to have dates than have teens, preteens, and young children.

When politicians attempt to take credit for good economic times with the claim that their policies caused the good economic times to happen, we must be suspicious. Of course, we must be equally suspicious if they attempt to pin the blame on their incumbent opponent if bad economic times existed in their opponent’s time in office. While their claims may be true, it is perfectly plausible that the policies and the economy were unrelated, or that the economy did well or did poorly despite the policies.

When economists look at cause and effect, they frequently attempt to generate a counter­ factual. A counterfactual is an educated guess about what would have happened had a policy or an event not occurred. A well-constructed and convincing counterfactual can help deter- mine whether a policy (like the 2008 Troubled Asset Relief Program or TARP) made things better than they otherwise would have been. It is not enough to say that the economy lost mil- lions of jobs after a policy was passed and therefore the policy was bad. You have to be able to construct a scenario of what would have happened had the policy not been enacted. This is often the reason why economists will disagree and seem absolutely convinced that those with whom they are disagreeing are wrong. Whether the Bush administration’s TARP program, the Federal Reserve’s lowering of interest rates through unprecedented purchases of long-term debt, or the Obama stimulus package made the economic downturn of the time better than it would have been depends entirely on what your counterfactual is.

Sometimes two variables move in opposite directions. This inverse correlation can also be misinterpreted as being causal. If you were to get season tickets to your college’s football games and observe the amount of skin (bare arms, legs, and midriffs) showing on the fans and compare that to the amount of hot chocolate sold during the game, you would find that when people show more skin they also consume less hot chocolate. If you came to the conclusion that one caused the other to happen you would, of course, be wrong. Obviously, the weather caused each to occur.

direct correlation A higher level of one variable is associated with a higher level of the other variable.

causation A change in one variable makes another variable change.

counterfactual An educated guess as to what would have happened had a policy or an event not occurred.

inverse correlation A higher level of one variable is associated with a lower level of the other variable.

DEMONSTRATING CONSTANT AND INCREASING OPPORTUNITY COST ON A PRODUCTION POSSIBILITIES FRONTIER

Economists use the production possibilities frontier to show the concepts of increasing and constant opportunity cost. If we start with no pizza and only soda but then move in increments to change our mix, there is opportunity cost. Just how much depends on whether it is increas- ing or constant.

Kick It Up a Notch

gue46399_ch01_001-018.indd 10 16/03/17 11:37 AM

Summary 11

S o

d a

10 9 8 7 6 5 4 3 2 1

0 1 2 3 Pizza

FIGURE 1.9 Illustrating increasing opportunity costs.

S o

d a

9

8

7

6

5

4

3

2

1

0 1 2 3 Pizza

FIGURE 1.10 Illustrating constant opportunity costs.

Demonstrating Increasing Opportunity Cost For example, in Figure 1.9, if we go from the point on the graph where we are producing no pizza to the point where we are producing a single unit, a unit whose numbers could be in the billions, our opportunity cost would be characterized by lost units of soda. On Figure 1.9, the opportunity cost of going from 0 units of pizza to 1 unit of pizza is 1 unit of soda. Moving from 1 unit of pizza to 2 units has an opportunity cost that is 3 units of soda. Similarly, moving from 2 to 3 units of pizza has an opportunity cost of 6 units of soda. As is visually obvious, the opportunity cost of going from 0 to 1 is smaller than going from 2 to 3. This is why we say that the opportunity cost is increasing.

Demonstrating Constant Opportunity Cost Similarly, we can use Figure 1.10 to show constant opportunity cost. The opportunity cost of moving from producing no pizza to 1 unit is 3 units of soda. Moving from 1 unit to 2 units and from 2 to 3 units also has an opportunity cost of 3 units of soda. In this case the opportunity cost of going from 0 to 1 is the same as going from 2 to 3. This is why we say that the oppor- tunity cost is constant.

What this all means is simple: Choices have consequences. Sometimes those consequences are great and sometimes they are small. If studying for five hours moves you from an F to a B on a test, then the higher grade has a low opportunity cost in terms of lost television watching. Viewed from the other side, the opportunity cost of another five hours of television watching (instead of studying to get a good grade) could be substantial. Opportunity cost is everywhere and is a consequence of every decision you make.

In this chapter we learned the definition of economics, that choices have consequences, and that those consequences are called opportunity cost. We learned how to model choices using a production possibilities frontier. We also learned that, depending on our assump- tions, opportunity cost can be increasing or constant. We created a road map to the entire

Summary

gue46399_ch01_001-018.indd 11 16/03/17 11:37 AM

12 Chapter 1 Economics: The Study of Opportunity Cost

economy and to the rest of this book by creating a circular flow diagram with all the various markets, individuals, firms, and governments interacting in society. Last, we explored the meaning of thinking economically by examining marginal analysis, positive and normative analysis, incentives, and the flaws of logic that may get in the way of economically accurate thinking.

Key Terms attainable causation circular flow model counterfactual direct correlation economics factor market fallacy of composition foreign exchange market goods and services market

incentives inverse correlation marginal benefit marginal cost market model net benefit normative analysis opportunity cost optimization assumption

positive analysis production possibilities

frontier resource scarce simplifying assumption unattainable unemployment

Issues Chapters You Are Ready for Now

Federal Spending Poverty and Welfare If We Build It, Will They Come? And Other Sports Questions

Quiz Yourself 1. Scarcity implies that the allocation scheme chosen by society can a. not make more of any one good. b. always make more of any good. c. typically make more of a good but at the expense of making less of another. d. always make more of all goods simultaneously.

2. A production possibilities frontier is a simple model of a. scarcity and allocation. b. prices and output. c. production and costs. d. inputs and outputs.

3. The underlying reason that there are unattainable points on a production possibilities frontier diagram is that there a. is government. b. are always choices that have to be made. c. is a scarcity of resources within a fixed level of technology. d. is unemployment of resources.

4. The underlying reason production possibilities frontiers are likely to be bowed out (rather than linear) is a. choices have consequences. b. there are always opportunity costs. c. some resources and people can be better used producing one good rather than another. d. there is always some level of unemployment.

gue46399_ch01_001-018.indd 12 16/03/17 11:37 AM

Summary 13

5. The optimization assumption suggests that people make a. irrational decisions. b. unpredictable decisions. c. decisions to make themselves as well off as possible. d. decisions without thinking very hard.

6. Imagine an economist ordering pizza by the slice. When deciding how many slices to order she would pick that number where the enjoyment of the equals the enjoyment she could get from using the money on another good. a. first slice b. last slice c. average slice d. total number of slices

7. Of course, all individual students are better off if they get better grades. If you were to conclude that all students would be better off if everyone received an A you would a. have fallen victim to the fallacy of scarcity. b. be right. c. have fallen victim to the fallacy of composition. d. be mistaking correlation with causation.

8. If you were to conclude, after carefully examining data and using proper evaluation tech- niques, that a tax credit for attending college benefits the poor more than a tax deduction (of equal total cost to the government) would, you would have engaged in analysis to reach that conclusion. a. negative b. positive c. normative d. creative

Short Answer Questions

1. Suppose you buy a new car. What is the opportunity cost of doing so? 2. Suppose you decided to study all last week for this exam instead of doing anything fun.

What was the opportunity cost of doing so? Why might the opportunity cost (defined in terms of fun lost) be expected to increase?

3. Suppose you hear a political candidate claim credit or lay blame for an economic outcome. How can you tell whether the candidate is correct? What would you need to know?

4. If you get a 25 percent pay increase, you are better off. Explain why some people would not be better off if their employer gave them a 25 percent pay increase.

5. Suppose you were to analyze the state and the economy at the moment. You say to your friends, “The economy has been growing more slowly in the last 10 years than it did in the previous 20 years. The government should cut taxes to stimulate the econ- omy.” What portion of that statement is “positive” and what portion of that statement is “normative”?

Think about This What was your opportunity cost of attending college? Think about the most expensive thing you have ever purchased. What could you have done with the money? Which outcome would have made you better off—what you did or what you could have done?

gue46399_ch01_001-018.indd 13 16/03/17 11:37 AM

14 Chapter 1 Economics: The Study of Opportunity Cost

Think about the last time you took a series of tests during a short period of time (high school or college finals work here). How did you decide how much time to spend on each subject? How might the study of economics help you make that allocation decision in the future?

Talk about This Discuss whether you believe people make rational decisions based on the optimization assumption. Discuss what kinds of noneconomic (something you would normally not think of as an eco- nomic decision) trade-offs could be modeled with a production possibilities frontier?

gue46399_ch01_001-018.indd 14 16/03/17 11:37 AM

A P P E N D I X 1 A

Graphing: Yes, You Can. Whether you like it or not, graphing is an important part of “getting” economics. If you have ven- tured to this appendix it is likely that your instructor agrees and wants you to have a firm founda- tion for what you are about to do. This appendix is geared to the student who never understood what a graph was trying to tell them; to those poor souls who look at a complex diagram and see a bunch of stray lines that have no meaning. In the movie Jerry Maguire, Tom Cruise bursts into his home to offer a long, heartfelt apology to his wife, who finally interrupts him to say, “You had me at ‘Hello.’ ” Those of us who teach economics have often lost our students at “Hello,” or at least at the moment we went to the board, overhead projector, or computer display to draw a graph. Let’s get off on the right foot with learning what a graph is and what it can tell us.

CARTESIAN COORDINATES As the subheading suggests, Cartesian coordinates are named for their inventor, Frenchman René Descartes. As the legend goes, he was staring at the ceiling and began following the path of a fly. He discovered that he could use just two numbers to pinpoint the placement of the fly on the ceiling every time it landed. So lie back for a moment and look at the ceiling.

Now pick a corner of the room where the ceiling meets two walls; that will be your refer- ence point. (In math it is called the origin.) Assuming the walls are square to one another, call the wall that runs on your left the y­axis and the wall on your right the x­axis. Now find a spot on the ceiling that stands out; a spider, a small stain, a vent, anything. Draw the shortest pos- sible imaginary line from your spot to the ceiling to the wall on the right. Call that point A. Do the same thing for the wall on the left and call that point B. You can identify that point on the ceiling using just two numbers. The first number is the distance along the x-axis from the cor- ner to A and the second is the distance along the y-axis from the corner to B. In Figure 1A.1 the point that is marked is 9 units along the x-axis and 11 along the y-axis, so it is shown as (9,11).

origin The point on the graph where both the variables are zero (0,0).

y­axis The vertical axis.

x­axis The horizontal axis.

y- ax

is

9

10

11

12

8

7

6

5

4

3

2

1

0 1 2 3 4 5 6 7 8 9 10

x-axis Origin

(9,11)

FIGURE 1A.1 Graphing a point.

gue46399_ch01_001-018.indd 15 16/03/17 11:37 AM

16 Chapter 1 Economics: The Study of Opportunity Cost

PLEASE! NOT Y = MX + B . . . SORRY. Whether you want to recall the experience or not, you were first exposed to the slope, x­intercept, and y­intercept of a line and the dreaded y = mx + b form of the line in your first algebra class. Whether that was in 7th, 8th, 9th, or 10th grade, enough time has passed that a refresher on the ideas is in order. The equation y = mx + b is a line because if you get all of the x, y combinations that come about from plugging in random values of x and computing what you get for y and then graph them, they end up in a line. That line will cross the y-axis at b, because if you plug in 0 for x in the y = mx + b equation, mx is 0 (because anything times 0 is 0), so all you are left with is b. Therefore, b is the y-intercept. It will cross the x-axis at −b/m. Therefore, the x-intercept is −b/m. As you will (perhaps not so vividly) recall, the slope is the “rise over the run.” That means it is the amount by which y rises divided by the amount by which x rises. Suppose we let x start at 3 and rise to 4. If that happens, then y goes from m3 + b to m4 + b. Therefore, y rises by m. The rise is m, the run is 1, so the slope is m. There is nothing magic about the choice of 3; we could have used any number and we would have gotten the same result. The slope is m.

If m and b are positive, you get a graph like Figure 1A.2. If m is positive and b is nega- tive, you get something like Figure 1A.3. If m is negative and b is positive you get a graph like Figure 1A.4, and finally, if they are both negative, you get something like Figure 1A.5. If m is large and positive, that means the line is upward sloping and steep; small and posi- tive means that it is upward sloping and relatively flat. If m is really negative, then the line is downward sloping and steep, and if it is slightly negative, then the line is downward sloping and flat.

slope The increase in the value of the y-axis variable for a 1-unit increase in the value of the x-axis variable.

x­intercept The value of the x-axis variable when the y-axis variable is zero.

y­intercept The value of the y-axis variable when the x-axis variable is zero.

y

y

x x

FIGURE 1A.2 Graphing a line y = mx + b m > 0, b > 0.

gue46399_ch01_001-018.indd 16 16/03/17 11:37 AM

Please! Not Y = MX + B . . . Sorry. 17

y

y

x x

FIGURE 1A.3 Graphing a line y = mx + b m > 0, b < 0.

y

y

x x

FIGURE 1A.4 Graphing a line y = mx + b m < 0, b > 0.

gue46399_ch01_001-018.indd 17 16/03/17 11:37 AM

18 Chapter 1 Economics: The Study of Opportunity Cost

WHAT ON GOD’S GREEN EARTH DOES THIS HAVE TO DO WITH ECONOMICS? To simplify things some, the only things that matter on our graphs will be those things that happen in the first quadrant (where both x and y are positive). We will have downward-sloping lines and upward-sloping lines. We will have some lines that are steep and some that are flat. Often, what we graph will not be a line at all but a curve (such as Figures 1.5 and 1.8). That is less important than this: An upward-sloping line or curve means that as the variable on the x-axis increases, so does the variable on the y-axis; a downward-sloping line or curve means that as the variable on the x-axis increases, the variable on the y-axis decreases.

This will become apparent when we talk about supply and demand in Chapter 2 and costs of production in Chapter 4. As you will see in Chapter 2, economists put price on the vertical axis (the y-axis) and the amount people want to buy or firms want to sell on the horizontal axis (the x-axis). The upward-sloping line will be supply and will suggest that companies will produce more stuff if you pay them more for each one, and the downward-sloping line will be demand and will suggest that consumers will buy less stuff when the price per unit rises.

We will also make a big deal out of two lines or curves crossing. When supply crosses demand in Chapter 2, when marginal revenue crosses marginal cost in Chapter 5, and when aggregate demand crosses aggregate supply in Chapter 8, this is going to have particular significance. It is important that when you get there and you don’t understand why two lines crossing matters at all . . . ASK!

y

y

x x

FIGURE 1A.5 Graphing a line y = mx + b m < 0, b < 0.

gue46399_ch01_001-018.indd 18 16/03/17 11:37 AM

19

C H A P T E R T W O

Supply and Demand Learning Objectives

After reading this chapter you should be able to:

LO1 Illustrate and explain the economic model of supply and demand.

LO2 Define many terms, including supply, demand, quantity supplied, and quantity demanded.

LO3 Utilize the intuition behind the supply and demand relationships as well as the variables that can change these relationships to manipulate the supply and demand model.

Chapter Outline

Supply and Demand Defined

The Supply and Demand Model

All about Demand

All about Supply

Determinants of Demand

Determinants of Supply

The Effect of Changes in Price Expectations on the Supply and Demand Model

Kick It Up a Notch: Why the New Equilibrium?

Summary

This is the make-or-break chapter of the book: You cannot understand economics without understanding supply and demand. Only if you understand this topic will you be able to read the issues chapters with a good level of comprehension.

You probably are familiar with the words supply and demand through television, newspa- pers, or conversation. The phrase frequently is used by people in a way an economist would not use it. This chapter is intended to show you what economists mean when they use the phrase and how they use the model behind the phrase so you understand the supply and demand model enough that you will be able to use both the model and the jargon correctly when we discuss a variety of economic issues.

Arriving at that level of understanding will take some time. We begin by setting out some of the language we will be using. It may be tempting for you to read too fast, to skim through, figuring that you have heard all the words before. Don’t. As we discussed in Chapter 1, the language has precise meaning to economists, and it is not necessarily the same as the meaning you have associated with it before.

Our next move is laying out the supply and demand model itself, starting with brief expla- nations of the term demand and then the term supply. We then put them together on one graph to form our first look at the model and our first look at what economists call equilibrium. We then step back a moment to examine in detail demand and then supply.

With a rudimentary understanding of the supply and demand model, we explore what happens in it when demand changes and then explore what happens in it when supply changes. Our last step shows why supply or demand changes require a change in the equilibrium.

gue46399_ch02_019-039.indd 19 16/03/17 11:38 AM

20 Chapter 2 Supply and Demand

Supply and Demand Defined

Markets Supply and demand is the name of the most important model in all of economics. Economists use it to provide insight into the movements in price and output. Remember from Chapter 1 that a model is a simplification of a complicated real-life phenomenon. This model assumes that there is a market where buyers and sellers get together to trade. Consumers are assumed to bring money to the market, whereas producers are assumed to bring goods or services to the market. Consumers want to exchange their money for goods or services while producers want to exchange the goods or services they have for money.

It is important that you understand that the word market has a very specific meaning to economists and that it is very different from the business idea of “marketing.” A market exists anywhere that buyers and sellers negotiate price and perform an exchange. There- fore, they have to be able to communicate and they have to be able to exchange. Take, as an example, the market for used midsized sedans. There are people who are looking to buy them and people who are looking to sell them. Prior to the Internet, most of the com- munication was geographically constrained. Buyers went to used-car lots or read ads in the newspaper. People who wanted to unload a car advertised by word of mouth, by newspaper, or sold to a dealer. With the Internet, the market is greatly expanded because communica- tion (autotrader.com; craigslist.com, etc.) is easier, but you still are unlikely to buy a car in Seattle if you live in Miami because the cost of getting the car from Seattle is prohibitive. Finally, “marketing” is what the used-car sales staff does to convince you to buy their cars. Try not to confuse the two.

The supply and demand model assumes that there are many consumers and producers, so that no one of them can dictate price. There is a price at which neither consumers nor produc- ers leave with less value than they came with; no consumers wish they could have purchased more goods at the price; no producers wish they could have sold more at that price—in short, everyone is better off for participating. Economists call such a price an equilibrium price and the amount that consumers buy from producers an equilibrium quantity. The nuts and bolts of this model are the supply and demand curves. The demand curve shows the relationship between the price consumers have to pay and how much they “want to buy,” whereas the sup- ply curve shows the relationship between the price firms receive and how much producers “want to sell.” Economists refer to the amount that consumers want to buy at any particular price as the quantity demanded and the amount that firms want to sell at any particular price as quantity supplied.

People participate in markets because markets make their participants better off. Mar- kets evolved because our ancestors recognized that self-sufficiency, though possible, did not allow people to take advantage of their particular skills. A social creation of humans, markets have been shaped by humankind to bring people together to exchange goods and ser- vices and, because these exchanges have always been voluntary, participants have always left them content that they have gained from the market’s existence. Thus markets have endured as a useful social institution because they continue to advance our individual and societal standard of living.

Quantity Demanded and Quantity Supplied This is one place where everything you have read, heard, or seen in the media will con- fuse you because economists use these terms very differently from the way they are used outside of economics. Economists insist on highlighting the difference between demand and quantity demanded. If you look carefully at the paragraph that is two above, paying

supply and demand The name of the most important model in all of economics.

price The amount of money that must be paid for a unit of output.

output The good or service produced for sale.

market Any mechanism by which buyers and sellers negotiate an exchange.

consumers People in a market who want to exchange money for goods or services.

producers People in a market who want to exchange goods or services for money.

equilibrium price The price at which no consumers wish they could have purchased more goods at the price; no producers wish that they could have sold more.

equilibrium quantity The amount of output exchanged at the equi- librium price.

quantity demanded The amount consum- ers are willing and able to buy at a particular price during a particular period of time.

gue46399_ch02_019-039.indd 20 16/03/17 11:38 AM

Supply and Demand Defined 21

particular attention to the last sentence, the quantity demanded is how much consum- ers are willing and able to buy at a particular price during a particular period of time. Demand, on the other hand, shows how much consumers want to buy at all prices. Demand is a relationship, whereas quantity demanded is a particular point on that relationship. An identical distinction exists with supply. Quantity supplied is how much firms are willing and able to sell at a particular price during a particular period of time, whereas supply alone shows how much firms want to sell at all prices.

quantity supplied Amount firms are will- ing and able to sell at a particular price during a particular period of time.

Markets exist whether the underlying economic sys- tem is capitalist, socialist, or communist. A capi- talist economy is so-named because in addition to there being free markets in most goods and services, there are free markets in financial capital. Whether people have money to lend because they have saved it or inherited it, in a capitalist system they control it. The profit that the capital generates goes to the owner of the capital. In a communist system, capital and the profit that it generates are controlled by a government authority. The government authority de- cides how the money is used. In a socialist system, a significant part of the profit generated by financial capital goes to the government in the form of taxes. The government then uses the tax money to counter

the wealth impacts of the distribution of profit. No country is completely capitalist and few (possibly North Korea) are completely communist. Each coun- try exists along a spectrum. The politically conser- vative Heritage Foundation, in conjunction with the Wall Street Journal, developed an Index of Economic Freedom that measures the degree to which coun- tries have free capital flows, minimal government regulation of business and labor, minimal limits on trade, and a legal system conducive to business. Selected countries are listed in the table below.

It is also worth noting that this is the first, but cer- tainly not the last time that this text will use a source with a political agenda. That usage, however, will be balanced.

capitalist economy An economic system where markets, in particular markets for financial resources, are free.

socialist economy An economic system where a significant part (but not all) of the decisions regarding the allocation of financial resources is made by a governmental authority.

communist economy An economic system where governmental authorities determine the allocation, use, and distribution of financial resources.

M A R K E T S B O X

Index of Economic Freedom Table

Top 20 Bottom 20 Other Countries and their Rank

Hong Kong Ecuador South Korea 27 Singapore Bolivia Austria 28 New Zealand Solomon Islands Norway 32 Switzerland Ukraine Colombia 33 Australia Congo, Dem. Rep. Israel 35 Canada Chad Uruguay 41 Chile Kiribati Spain 43 Ireland Uzbekistan Belgium 44 Estonia Timor-Leste Peru 49 United Kingdom Central African Republic Mexico 62 United States Argentina France 75 Denmark Equatorial Guinea Saudi Arabia 78 Lithuania Iran Italy 86 Taiwan Congo, Republic of Brazil 122 Mauritius Eritrea India 123 Netherlands Turkmenistan Greece 138 Germany Zimbabwe China 144 Bahrain Venezuela Russia 153 Luxembourg Cuba Iceland Korea, North

Source: www.heritage.org/index/Ranking

gue46399_ch02_019-039.indd 21 16/03/17 11:38 AM

22 Chapter 2 Supply and Demand

Ceteris Paribus Social scientists in general, and economists in particular, believe in something called the “sci- entific method,” one aspect of which suggests that to isolate the effect of one variable on another you have to separate out the impacts of everything else. Unlike chemistry or biology, though, economists are rarely able to put their subjects (people) into a lab and experiment on them. For instance, economists cannot create a capitalist system in one area of town, a socialist system in another, and a communist system in a third so as to test which economic system serves society best. Economists have to observe in the context of their models. So, even though life does not progress one change at a time, our model allows us to focus on one change at a time. This brings us to the Latin most commonly used by economists: ceteris  paribus, which means “other things equal.” This phrase, when added to a definition or a conclusion, means that though there are many other factors that could affect a phenomenon in real life, this is focusing on the impact of one while holding those other factors constant.

Demand and Supply For our demand curve we want to know what the relationship is between price and quantity demanded. Determining this relationship is difficult because the relationship depends on such things as whether people are rich or poor, whether the good is in or out of fashion, or how much rival goods cost. To get around this we assume we are looking at the relationship be- tween price and quantity demanded in such a way that none of the other things are changing. Thus, demand is the relationship between price and quantity demanded, ceteris paribus.

Precisely the same logic applies to supply. There are many things upon which the relation- ship between price and quantity supplied depends: how much workers must be paid, the cost of materials, or the availability of technology. Again we assume these things do not change, so supply is the relationship between price and quantity supplied, ceteris paribus.

The Supply and Demand Model

Demand We have put it off long enough—let’s look at the model. To plot a demand curve, let’s first tell ourselves a reasonable story and put the relevant information in a table. In many city downtown areas, there are vendors selling food and drink from stands. To simplify the issue, let’s suppose we are looking at the market for bottled orange juice sold by these street vendors and that the customers buy the bottles of orange juice from those vendors and consume the juice throughout the day in their downtown offices. There are obviously lots of things that will affect the supply and demand for these bottles of orange juice, but for the moment we are going to assume they are held constant.

We start this inquiry with the price of a bottle of orange juice at zero and ask how many will be wanted. Probably a lot, but not as many as you might think. People get tired of drink- ing the same thing over and over again, and even if they were going to get a bunch to save for later, they still have to carry it to their offices. Suppose, for mathematical simplicity, that there are only 10,000 people in this downtown area and that at a price of zero each person wants only five bottles per day. That would mean that, at a price of zero, there would be a quantity demanded of 50,000 drinks.

Suppose the price were raised to 50 cents per bottle. Each individual would have to weigh whether they wanted a bottle of orange juice or 50 cents. Let’s say the average person decides to buy only four per day at that price. As a result of the price increase, the quantity demanded for the market would be 40,000. Suppose another 50-cent increase would decrease the amount

ceteris paribus Latin for “other things equal.”

demand The relationship between price and quantity demanded, ceteris paribus.

supply The relationship between price and quantity supplied, ceteris paribus.

gue46399_ch02_019-039.indd 22 16/03/17 11:38 AM

The Supply and Demand Model 23

wanted by the average person to three. Quantity de- manded in the market would fall to 30,000. Without belaboring the point further, price increases would decrease the amount the average  person would buy until at $2 per bottle the average person wanted only one, and at $2.50 the average person would buy none. Table 2.1 depicts the options we have just suggested in the form of what is called a demand schedule. A demand schedule presents the price and quantity de- manded for a good in a tabular form.

This information can also be displayed on a graph. As a matter of fact, that is how you will nearly always

see it from now on. Figure 2.1 is a graph of a demand curve. Note that the vertical axis is labeled P for price per unit and the horizontal axis is labeled Q/t for quantity per unit time. You probably anticipated the first label, but the second may require a short explanation. Quan- tity per unit time is that number of orange juice bottles that the 10,000 people will want per day. There always has to be a time reference for quantities demanded and for quantities sup- plied. The dark dots represent the points from our demand schedule, and when we connect the dots we have a demand curve.

Supply Now, using the same example, let’s think about the sellers of orange juice bottles. Sup- pose for the sake of this example that there are 10 completely independent street vendors selling orange juice bottles, and that there aren’t any brand names of the vendors or for the orange juice. Now ask yourself how many orange juice bottles a business would at- tempt to sell at various prices. Obviously they would not want to give any away, so at a price of zero, quantity supplied would be zero. Even at a very low price, such as 50 cents a bottle, they might not want to sell any because the cost to the vendor of either buying or filling the bottle might be more than the 50 cents per bottle they would get. As prices go up, they would probably be willing to put forth more and more effort to make more and more money. For the sake of this example, we will assume that at $1.00 per bottle each business will sell a bottle to anyone who would come up to them but won’t go out of their way to sell more than that. They will station themselves where there are a lot of people and simply sell to them.

Suppose that as the price people are willing to pay rises, the vendors hire people to hawk the orange juice bottles to drum up sales. Let’s say that at $1.50 they will each want to hire enough hawkers to sell 2,000 bottles per day and that at $2.00, they will hire enough to sell

demand schedule Presentation, in tabular form, of the price and quantity demanded for a good.

TABLE 2.1 Demand schedule for bottles of orange juice.

Price ($)

Individual Quantity Demanded

Market Quantity Demanded (10,000 people)*

0 5 50,000 0.50 4 40,000 1.00 3 30,000 1.50 2 20,000 2.00 1 10,000 2.50 0 0

*This is ceteris paribus at work, holding the number and type of people constant.

$2.50

$0.50

0

$1.00

$1.50

$2.00

10 20 30 40 500

Demand

P

Q/t

FIGURE 2.1 The demand curve.

gue46399_ch02_019-039.indd 23 16/03/17 11:38 AM

24 Chapter 2 Supply and Demand

3,000 per day. Finally, suppose that at $2.50 per bottle, they will hire enough hawkers to sell 4,000 per day. Table 2.2 displays this information in what is called a supply schedule, which presents in tabular form the price and quantity supplied for a good.

This information can also be displayed on a graph. Figure 2.2 shows the supply curve with the axes labeled the same as Figure 2.1: price and quantity over time. Here the dark dots represent the points from our supply schedule. When we connect the dots we have a supply curve.

Equilibrium Table 2.3 combines the supply schedule and the demand schedule into a single schedule, and Figure  2.3 combines the supply curve and demand curve on one diagram. They both show us that at prices below $1.50 con- sumers want more orange juice bottles than vendors are willing to provide and that at prices above $1.50 they want fewer bottles than vendors are willing to sell. Where the supply and demand curves cross, the amount that consumers want to buy and the amount firms want to sell are the same. This is called an equilibrium.

supply schedule Presentation, in tabular form, of the price and quantity supplied for a good.

equilibrium The point where the amount that consum- ers want to buy and the amount firms want to sell are the same. This occurs where the supply curve and the demand curve cross.

TABLE 2.2 Supply schedule for bottles of orange juice.

Price ($)

One Vendor’s Quantity Supplied

The Market’s Quantity Supplied (all 10 concession vendors)

0 0 0 0.50 0 0 1.00 1,000 10,000 1.50 2,000 20,000 2.00 3,000 30,000 2.50 4,000 40,000

TABLE 2.3 Supply and demand schedules with shortage and surplus.

Price ($)

Individual Quantity Demanded

Market Quantity Demanded

One Vendor’s Quantity Supplied

Market Quantity Supplied

Shortage (excess demand)

Surplus (excess supply)

0 5 50,000 0 0 50,000 0.50 4 40,000 0 0 40,000 1.00 3 30,000 1,000 10,000 20,000 1.50 2 20,000 2,000 20,000 2.00 1 10,000 3,000 30,000 20,000 2.50 0 0 4,000 40,000 40,000

Supply$2.50

$0.50

0

$1.00

$1.50

$2.00

10 20 30 40 500

P

Q/t

FIGURE 2.2 The supply curve.

FIGURE 2.3 The supply and demand model and equilibrium price and quantity.

Supply

Demand

Equilibrium

Equilibrium quantity

Equilibrium price

$2.50

$0.50

0

$1.00

$1.50

$2.00

10 20 30 40 500

P

Q/t

gue46399_ch02_019-039.indd 24 16/03/17 11:38 AM

All about Demand 25

Shortages and Surpluses When the price is too low we have a shortage. Firms do not want to sell as many goods as consumers want to buy. When the price is too high we have a surplus. Firms want to sell more goods than consumers want to buy.

Imagine that the vendors start to run out of bottled orange juice. There is an obvious short- age. According to the model of supply and demand, this will have occurred because the price was too low. With long lines of people wanting to buy bottles in front of them, the vendors will see that in the face of a shortage, or excess demand, they can raise the price and still sell their product. The opposite will occur if there is a surplus, or excess supply. If the price is too high, the vendors will want to sell more bottles than consumers will want. Instead of long lines, there will be excess inventory and firms will see that in the face of a surplus they should lower the price to get rid of it.

With self-interested sellers, shortages and surpluses are short-lived. Firms react to changes in inventories by changing the price they charge. They react to shortages with price increases and surpluses with price cuts, and as a result either situation is temporary.

All about Demand

The Law of Demand We know from this chapter’s section on definitions that demand is the relationship between price and quantity demanded, ceteris paribus, and we followed a reasonably believable story about orange juice vendors. That story implied that there was a negative relationship between price and quantity demanded. Because of the relationship, the demand curve we drew was downward sloping. The negative relationship between price and quantity demanded is called the law of demand. This “law” is not really a law but is common sense applied to the following rather constant observation: When prices are higher, we tend to buy less.

Why Does the Law of Demand Make Sense? Why do we see this negative relationship so often? There are three distinct reasons. First, when you go to the store and find that the good you want is highly priced, you search for an acceptable substitute that costs less. If you buy something else, you are substituting another good for the one that you originally wanted because its price was too high. Economists say that this is a substitution effect. You buy less of what you originally wanted when its price is high because you use something else instead.

Second, suppose you cannot find an acceptable substitute. In this case, you are stuck buy- ing less of the good because you cannot afford as much. What has happened is that your real buying power has fallen (even though the money you have in your wallet is the same) because prices have risen. This does not necessarily work for all goods (especially basic necessities like water), but generally economists call this a real-balances effect because when a price increases, it decreases your buying power, causing you to buy less.

The third reason we see a negative relationship between price and quantity demanded can be explained with either great detail, or a useful, though not always completely accu- rate, shortcut. You are in this course and your professor has chosen this book because you do not need the great detail, so you will get the shortcut. It starts from the premise that what you are willing to pay for something depends on how many you have recently had. With this in mind, consider the following very silly but illustrative example. Suppose I give you $10 and I want to know how much you would pay for pizza slices at lunch. Suppose further that as part of this experiment you are given truth serum so you have

shortage The condition where firms do not want to sell as many goods as con- sumers want to buy.

surplus The condition where firms want to sell more goods than consumers want to buy.

excess demand Another term for shortage.

excess supply Another term for surplus.

law of demand The statement that the relationship between price and quantity demanded is a negative or inverse one.

substitution effect Purchase of less of a product than origi- nally wanted when its price is high because a lower priced product is available.

real-balances effect When a price increases, your buying power is decreased, causing you to buy less.

gue46399_ch02_019-039.indd 25 16/03/17 11:38 AM

26 Chapter 2 Supply and Demand

to honestly tell me two things: (1) on a scale from 1 to 10, how happy your belly is; and (2) how much you valued each slice in terms of money. Starting hungry at a belly happiness index of 1, suppose that you eat one slice and tell me that it was worth $3 and rated a 5 on the belly happiness index. Now you eat another slice and tell me it wasn’t worth as much because you were not as hungry, so you say it was worth $2 and your belly happiness index rose to 8. You eat the third slice and tell me that, because you were somewhat full at the time you ate the third slice, your belly happiness index only rose to 9 and the slice was only worth $1.

In this scenario, each time you consume a slice, the value you place on the next slice falls. This means that the value you place on a good depends on how many you have already had. Economists refer to the amount of extra happiness1 that people get from an additional unit of consumption as marginal utility and say that it decreases as you consume more. This law of diminishing marginal utility suggests that the amount of additional happiness that you get from an additional unit of consumption falls with each additional unit. Stated more simply, because each additional slice increases your happiness less than the previous slice, the most you would be willing to pay for each additional slice is less than before. The third reason why a demand curve is downward sloping, then, is that for most goods there is diminishing marginal utility.

It is often helpful to view the demand curve as more than a way of finding how much of a good a person wants at a particular price. In addition, you can use it to find out how much a person is “willing to pay” for a particular amount of the good. Whenever you come across this phrase, think “the most they would be willing to pay.” Of course you would always want to pay less, but looked at this way the demand curve also represents the most you would be willing to pay for different amounts of the good, ceteris paribus.

All about Supply

The Law of Supply We also know from our section on definitions that supply is the relationship between price and quantity supplied, ceteris paribus, and we followed a story about how many orange juice bottles a vendor would want to sell in a city. That story implied that there was a positive relationship between price and quantity supplied. Because of that the supply curve we drew was upward sloping. The positive relationship between price and quantity supplied is called the law of supply. Like all other laws in economics, this one isn’t a law either but is more like a hypoth- esis that is supported by nearly all the evidence nearly all the time. Stated more simply: When prices are higher, firms tend to want to sell more.

Why Does the Law of Supply Make Sense? Although believable intuitively, the technical reason that a supply curve is upward sloping takes up much of Chapters 4 and 5. What follows is a simplified (though probably not simple) explanation that will be repeated and expanded in Chapters 4 and 5.

Suppose the downtown area where the vendors are selling orange juice bottles has varying areas of population density. It is relatively easy to sell where there are more people, like at a subway exit, and progressively more difficult to sell as you get away from those population centers. As a result, even if vendors hire hawkers to go out and sell orange juice bottles, it is

marginal utility The amount of extra happiness that people get from an additional unit of consumption.

law of diminishing marginal utility The amount of ad- ditional happiness that you get from an additional unit of con- sumption falls with each additional unit.

law of supply The statement that there is a positive relationship between price and quantity supplied.

1 This is why this discussion has been an intellectual shortcut. Most economists do not believe that you can measure happiness in the same way that you measure distance or temperature. This means that though you can say you are happier in one circum- stance than in another, you cannot say how much happier you are. All is not lost, though, because we can get the same idea through the concept of indifference. The reason no one-semester course textbooks explain the downward-sloping nature of demand using the concept of indifference is that it takes too long and gets you no further in your understanding than the last two paragraphs have. Thus the shortcut of marginal utility nets the same result in a lot less time and is judged by most teachers of one-semester economics courses as useful.

gue46399_ch02_019-039.indd 26 16/03/17 11:38 AM

Determinants of Demand 27

going to get harder and harder to sell a lot when they spread out. Even though it is harder to sell, as the price rises, it is still possible and even likely that it would be worth it for vendors to hire hawkers. So even when the last hawkers sent out sell far fewer bottles than the ones sent out originally, the vendors hire them because they make money doing so. So when the price is low, the high-cost sales methods aren’t worth it, and when the price is high, they are worth it. There might even be a price high enough that the vendors would be willing to deliver individual bottles to individual offices. While this would be very inefficient relative to simply standing at a subway exit, if the vendors have sold all they can this way and the price is high enough, it could still be profitable to the vendors to do so.

What this means, and what Chapters 4 and 5 attempt to demonstrate in detail, is that the reason the supply curve is upward sloping is that it costs more per unit to sell more units. In this example, the orange juice bottles were not any more expensive, but the cost of hawking them or transporting them was higher when we sold to more remote areas.

In addition, when firms decide which good to produce, they will want to produce the one that makes them the most money. Suppose our orange juice vendors have only so much space in the coolers in their carts. In this case, the vendors do not care whether they sell orange juice or water; they simply want to make a profit. If consumers are willing to pay more for bottled water, the vendors will stock their carts with bottled water. What this means is that relative to water, when orange juice prices are higher, the vendor is willing to take water out of the cart and replace it with orange juice. When orange juice prices are lower, the vendor does the opposite.

Determinants of Demand

In the previous section we talked about holding other things constant. Now is the time to con- sider what happens when things change. As we alluded to in the section on definitions, there are many things that affect the demand relationship for a good. These include how much the good is liked, how much income people have, how much other goods cost, the population of potential buyers, and the expectations of the price in the future. These variables will change how much of the good is wanted as well as how much someone is willing to pay for it. Again “willing to pay” is shorthand for the most someone is willing to pay. If people want more of the good, this also translates into willingness to pay prices that they would not have paid before.

Taste Determinant of whether the good is in fashion or whether con-

ditions are right for many people to want the good.

Income Inferior goods: You buy less of a good when you have more

income.

Normal goods: You buy more of a good when you have more income.

Price of other goods Substitute: Goods used instead of one another.

Complement: Goods that are used together.

Population of potential buyers The number of people potentially interested in a product.

Expected price The price that you expect will exist in the future.

Excise taxes A per unit or percentage tax on a good or service that must be

paid by consumers.

Subsidies A per unit or percentage subsidy for a good or service that is

granted to consumers.

D E T E R M I N A N T S O F D E M A N D

gue46399_ch02_019-039.indd 27 16/03/17 11:38 AM

28 Chapter 2 Supply and Demand

Taste Taste is the word that economists use to describe whether the good is in fashion or whether conditions are right for many people to want the good. A high level of taste means that the good is in fashion or highly desired; a low level of taste means that few people want it. It works on demand in an obvious way: The more people like the good (the higher the taste for the good), the more they are willing to pay higher prices for any particular amount and the more of it they will want. Going back to the orange juice example, the taste for orange juice would rise during cold and flu season as people were trying to boost their immune systems believing that orange juice would aid in keeping viruses at bay.

Income For most goods, an increase in income will lead to an increase in the amount that consumers want. In cases where you buy more of a good when you have more income, economists call the good normal. If the good is normal and your income rises, you are able to buy more and you want to buy more of the good and you are willing to pay more for it.

How much income people have to buy the good also matters but not always in a positive way. Consider a couple of staples in the college diet, instant ramen noodles and macaroni and cheese. No matter which of these you eat, you can fill your belly for under a dollar. Now ask yourself how many pouches, boxes, or bags of this stuff you would buy if your grandmother died and left you $25,000. Answer: not many, particularly if you have been eating them because you could not afford other things to eat. This example shows you that it is not always the case that the more you make, the more you buy. In cases where you buy less of a good when you have more income, economists call the good inferior. If the good is inferior and your income rises, you are able to buy more, but you want to buy less of the good and you will need lower prices to induce you to buy any particular quantity.

Returning to our orange juice example, if people consume more bottles of orange juice as their incomes rise, then orange juice is a normal good. If they consume fewer bottles of orange juice when their incomes rise, it is an inferior good.

Price of Other Goods Similarly, there is no straightforward answer to the question of how you will change your willingness to purchase a good if the price of another good rises. It is possible that if the price of a good like Pepsi rises, you will switch to Coke. In that case, you would be willing to pay more for Coke and want to buy more of it. Likewise, if the price of hot dogs increases, you will decide to buy fewer of them. Since hot dog buns have little good use other than to surround hot dogs, you will need fewer of these too. Economists say that goods used instead of one another (e.g., Coke and Pepsi) are substitutes and that goods that are used together (e.g., hot dogs and hot dog buns) are complements.

Examples of substitutes and complements abound. Peanut butter and jelly are often consid- ered complements because they are typically used together to produce sandwiches. Pepperoni and sausage might be considered substitutes because they are alternative meats for a pizza. To confuse matters, though, goods can be substitutes to some and complements to others. My father-in-law considers peanut butter and jelly to be equally good bagel spreads, so to him they are substitutes. The Meat Lover’s Pizza by Pizza Hut includes both sausage and pepperoni, so to people who like this pizza the two may be complements.

Once again, returning to orange juice bottles: Orange juice and grapefruit juice are likely substitutes for one another while orange juice and vodka are likely to be complements because people (of legal drinking age) may mix them together to form a “screwdriver.”

gue46399_ch02_019-039.indd 28 16/03/17 11:38 AM

Determinants of Demand 29

Population of Potential Buyers The number of people potentially interested in a product will clearly have an impact on the demand for the product. So, as the downtown population rises, more are potentially interested in buying bottles of orange juice. Clearly the larger the city, the more people come downtown to work and shop, and the more people will buy orange juice. Or, for instance, in the dark ages of the 1970s, when there were only a few computer-literate people, only a few people were interested in buying computers. Then schoolchildren, and especially college students, began to rely on computers for their schoolwork, creating a group of potentially interested customers when they graduated. Economists shorten this concept of the number of people potentially interested in a product to call it the population.

Expected Price When the expected price of a good rises, this induces a stock-up effect. Let’s suppose that a winter freeze destroys a large number of the orange groves. Forward-thinking consumers will see the impending increase in orange juice prices and be motivated to stock up now before the price increase takes hold. Similarly, smokers stock up on cigarettes when a tax increase is expected. Frugal drivers buy gas on Wednesdays, before the nearly universal weekend price increase. If there is an expectation that an increase in price is imminent, consumers will be willing to pay more and they will want to buy now rather than later.

Excise Taxes Sometimes governments want to discourage the consumption of a good and will place a tax on that good. Such a tax would mean that consumers would have to pay more per unit than they otherwise would have to and as a result would decrease the amount that they wished to purchase. Suppose that a city wanted to encourage the recycling of plastic bottles and that consumers had to pay $1 extra per orange juice bottle that they purchased. That would mean that the new demand curve would be $1 lower at every quantity than the old one.

Subsidies Sometimes governments want to encourage the consumption of a good and will create a sub- sidy for that good. Such a subsidy would mean that consumers would have to pay less per unit than they otherwise would have to and as a result would increase the amount that they wished to purchase. Suppose that a city in Florida wanted its citizens to be seen by tourists drinking Florida orange juice. To encourage consumers to do so it would allow them to pay $1 less per orange juice bottle that they purchased. That would mean that the new demand curve would be $1 higher at every quantity than the old one.

The Effect of Changes in the Determinants of Demand on the Supply and Demand Model Tables 2.4 and 2.5 summarize how the determinants of demand work on the supply and demand diagram. Table 2.4 indicates the impact of increases in the variables listed above, whereas Table 2.5 indicates the impact of decreases in those variables. The final column of each table refers to the figure corresponding to the change. Figure 2.4 shows the impact of an increase in demand while Figure 2.5 shows the impact of a decrease in demand. In each figure, the original supply and demand curves are shown in black and the new demand curve is shown in the gold color. The original equilibrium is shown with the big black dot, and the new equilibrium is shown with the big gold-colored dot.

gue46399_ch02_019-039.indd 29 16/03/17 11:38 AM

30 Chapter 2 Supply and Demand

TABLE 2.4 Movements in the demand curve: increases in the values of the determinants.

An Increase in Causes Demand to Causes the Demand Curve to Move to the

And Is Shown in Figure

Taste Increase Right 2.4 Income, normal good Increase Right 2.4 Income, inferior good Decrease Left 2.5 Price of other goods, complement Decrease Left 2.5 Price of other goods, substitute Increase Right 2.4 Population Increase Right 2.4 Expected future price Increase Right 2.4 Excise Tax Decrease Left 2.5 Subsidy Increase Right 2.4

TABLE 2.5 Movements in the demand curve: decreases in the values of the determinants.

A Decrease in Causes Demand to Causes the Demand Curve to Move to the

And Is Shown in Figure

Taste Decrease Left 2.5 Income, normal good Decrease Left 2.5 Income, inferior good Increase Right 2.4 Price of other goods, complement Increase Right 2.4 Price of other goods, substitute Decrease Left 2.5 Population Decrease Left 2.5 Expected future price Decrease Left 2.5 Excise Tax Increase Right 2.4 Subsidy Decrease Left 2.5

$0.50

0

$1.00

$1.50

$2.00

$2.50

P

0 10 20 30 40 50

Demand

New demand

Supply

Q/t

FIGURE 2.4 The effect of an increase in demand on the supply and demand model.

$0.50

0

$1.00

$1.50

$2.00

$2.50

P

0 10 20 30 40 50

Demand

New demand

Supply

Q/t

FIGURE 2.5 The effect of a decrease in demand on the supply and demand model.

Tables 2.4 and 2.5 as they apply to Figures 2.4 and 2.5 may seduce you into thinking the best way of using this information is to memorize it. As the verb seduce suggests, that is a very bad learning strategy. The best use of these tables and figures is to use them as a check against your economic intuition. As an example, suppose you are tasked with drawing a supply and demand diagram for hot dog buns showing the impact of an increase in the price of hot dogs. First, you would recognize hot dogs and hot dog buns as complements and that when the price

gue46399_ch02_019-039.indd 30 16/03/17 11:38 AM

Determinants of Supply 31

of a complement rises, you will consume fewer hot dogs (because the demand for hot dogs is downward sloping) and so you would need fewer hot dog buns. Second, you would recognize that as a decrease in the demand for hot dog buns. Third, you would draw a supply and demand diagram for hot dog buns showing a leftward movement in demand for hot dog buns because a decrease in demand shows up as demand shifting to the left. You would then check that against the information in Table 2.4 (because it is an increase in the price of hot dogs impacting hot dog buns); look down to the “Price of other goods, complement” row then across to see that your intuition that demand should move left was correct and that the drawing of a figure like Figure 2.5 is correct.

Determinants of Supply

Again, the definitions section alluded to the types of things that can change the supply re- lationship. They include changes in the price of inputs, technology, price of other potential outputs, the number of sellers, and expected future price. Again we are assuming that other things are held constant.

Price of Inputs The price of inputs refers to the costs to firms of all the things necessary to produce output. If an input is used to make a product, then the input costs money and therefore has a price even though its name may change. Obvious examples of inputs are raw material, labor, and equipment. The price of a raw material is simply its price. (Though this sounds like a circular definition, think about our orange juice bottles example. The bottles, the orange juice itself, and coolers to keep the bottles in each have a price.) The price of labor is the wage + benefit cost to employers associated with hiring a person. (Everything that employ- ers pay for that is not paid directly to workers—health insurance, unemployment insurance, worker’s compensation, and so on—is defined as benefits.) The price of equipment can affect supply, but just as often, what matters is the rental cost of leased equipment or the interest + depreciation rates that must be paid on the equipment bought with borrowed money. (Interest is the price of borrowed money, and depreciation is the rate at which machines lose value owing to wear and tear.)

Price of inputs Costs to firms of all the things necessary to produce output.

Technology The ability to turn input into output.

Price of other potential output When firms have to decide which good to produce, they will want

to produce the one that makes them the most money.

Number of sellers The number of firms competing in the same market.

Expected future price Firms want to hold back sales to wait for higher prices and

unload inventory before prices fall.

Excise taxes A per unit or percentage tax on a good or service that must be

paid by producers.

Subsidies A per unit or percentage subsidy for a good or service that is

granted to producers.

D E T E R M I N A N T S O F S U P P L Y

gue46399_ch02_019-039.indd 31 16/03/17 11:38 AM

32 Chapter 2 Supply and Demand

Technology Within economics, the word technology refers to the ability to turn input into output. In our previous example of selling bottles of orange juice in a city, a technological advance that would allow vendors to keep the bottles fresh without ice or refrigeration would reduce costs. This technology would increase output and lower costs. As we are using it here, the technol- ogy variable can change because of increases in the ability of employees to work harder and smarter, or it can change because new devices make employees more efficient.

Another example of how increases in technology change markets can be seen in the very illegal term-paper business. If you wanted to buy term papers in the 1960s, you would have had to pay people to go to the library to look stuff up in card catalogs of alphabetized index cards and indices of periodicals to find source material. Because access to copy machines was limited, they would have then had to read the material in the library. Finally, they would have had to type the paper on a typewriter, and they would have been able to fix mistakes only with a pasty liquid called Wite-Out®. Paying people to do this would have been expensive.

In the 1970s, all the steps were the same except copy machines would have allowed the people you hired to read source material in their homes. In the 1980s, primitive computers would have allowed them to gather limited quantities of source material on a computer and to write the paper using a hard-to-use, not very flexible word processor. By the 1990s, writers of term papers could look up material on the Internet, print it, read it, and write the paper, all from the comfort of their own bedrooms. In each of these periods, producers of such con- traband had to find a way to sell their papers. Often informal networks had to be created and payment had to be in cash. Today, you can go to any number of term-paper sites on the Internet and download a paper by simply entering a credit card number. You, of course, would never do this because your college can easily catch you and throw you out of school. But because it is easier to produce papers in less time than used to be the case, sellers of term papers can charge lower prices and produce more papers.

Price of Other Potential Outputs The price of other potential outputs refers to the same idea that we referenced when indicating why the supply curve is upward sloping, except now we focus on what happens to the exist- ing supply curve when the price of the other good changes. As we said, vendors have only so much space in the coolers in their carts. During a hot summer’s day they may discover that they sell out of bottles of water and have plenty of leftover bottles of orange juice. If consum- ers are willing to pay more for bottled water, the vendors will stock their carts with bottled water. They will stock those carts with the combination of water and orange juice that makes them the most money. As the price of water rises, the supply of orange juice will fall because vendors want to stock water.

Number of Sellers The number of sellers, that is, the number of firms competing in the same market, is important because the more firms there are, the greater is total market production. Using the orange juice example, we assumed that there were 10 different vendors. If these vendors are all mak- ing a significant profit, it is likely that other entrepreneurs will want to set up their competing stands. This raises total market supply. Similarly, if there were losses, some of those vendors may quit the business, reducing total market supply.

Expected Price The expected future price should sound familiar because it is also something that will change demand. In the context of supply, it refers to a firm’s desire to hold back sales to wait for

gue46399_ch02_019-039.indd 32 16/03/17 11:38 AM

Determinants of Supply 33

higher prices and its desire to sell its goods and thus lower its inventory before prices fall. Firms want to sell their goods when they can make the most money regardless of when that time is. A warning that a hurricane is coming will bid up the current price of gas-powered generators because firms will want to retain those they have in stock to sell at high prices after the hurricane hits. Conversely, if firms figure that the goods they hold will be out of fashion soon, they will want to get rid of them now.

Let’s return to the example of the freeze that decimated the orange groves. Not only will buyers of orange juice be motivated to stock up to avoid the increase in price, sellers will know that a price increase is coming and will want to hold on to what they have. As a result, the ex- pected future price not only changes demand for a good, it changes supply as well. Of course, it also works in the other direction. If a bumper orange crop is expected, orange juice prices will be expected to fall and those currently holding orange juice will be motivated to sell their current inventories before the price falls too much.

Excise Taxes As we indicated in the context of demand, sometimes a government wants to discourage the consumption of a good. In so doing it can tax producers or consumers. If it wants the tax to be collected on the production side, it will place a tax on that good and compel firms to pay the tax. It should be noted here that it doesn’t matter whether the tax is on the demand side or the supply side; the impact will be the same and will depend on the Chapter 3 concept of elastic- ity, not the intention of policy makers. In any event, this tax is modeled by moving the supply curve vertically higher by the amount of the tax. So a city can encourage recycling of plastic bottles by charging firms $1 extra per orange juice bottle that they sell. That would mean that the new supply curve would be $1 higher at every quantity than the old one.

Subsidies Similarly, subsidies can be applied to the firm producing the good rather than the consumer. A $1 subsidy would be modeled with the new supply curve $1 lower at every quantity than the old one.

The Effect of Changes in the Determinants of Supply on the Supply and Demand Model Tables 2.6 and 2.7 summarize how determinants of supply work on a supply and demand model. Table 2.6 indicates the impact of increases in the variables listed above, whereas Table 2.7 indicates the impact of decreases in those variables. It is important to understand that on the supply side, an increase in supply is shown by a movement to the right in the sup- ply curve and that a decrease in supply is shown by a movement to the left in the supply

TABLE 2.6 Movements in the supply curve: increases in the values of the determinants.

An Increase in Causes Supply to Causes the Supply Curve to Move to the

And Is Shown in Figure

Price of inputs Decrease Left 2.7 Technology Increase Right 2.6 Price of other potential outputs Decrease Left 2.7 Number of sellers Increase Right 2.6 Expected future price Decrease Left 2.7 Excise Tax Decrease Left 2.7 Subsidy Increase Right 2.6

gue46399_ch02_019-039.indd 33 16/03/17 11:38 AM

34 Chapter 2 Supply and Demand

curve. As with Tables 2.4 and 2.5 the final columns of Tables 2.6 and 2.7 refer to the figures corresponding to the changes. Figure 2.6 shows the impact of an increase in supply while Figure 2.7 shows the impact of a decrease in supply. Just as it was for Tables 2.4 and 2.5 and Figures 2.4 and 2.5, the original supply and demand curves are shown in black and the origi- nal equilibrium is shown with the big black dot. This time the new supply curve is shown in the gold color with the new equilibrium shown with the big gold-colored dot.

After having read the admonition against memorizing regarding the demand shifts, you can guess what’s next: Don’t try to memorize Tables 2.6 and 2.7 as they apply to Figures 2.6 and 2.7. The best use of these tables and figures is to use them as a check against your eco- nomic intuition. As an example, suppose you are tasked with drawing a supply and demand diagram for gasoline showing the impact of an increase in the price of crude oil. First, you would recognize that crude oil is the primary input to gasoline so that, when crude oil prices rise, refineries would have to increase their gasoline prices to make up for those higher pro- duction costs. Second, you would recognize that as a decrease in the supply of gasoline. Third, you would draw a supply and demand diagram for gasoline showing a leftward movement in supply for gasoline because a decrease in supply shows up as supply shifting to the left. You would then check that against the information in Table 2.6 (because it is an increase in the price of crude impacting gasoline); look down to the “Price of inputs” row then across to see that your intuition that supply should move left was correct and that the drawing of a figure like Figure 2.7 is correct.

TABLE 2.7 Movements in the supply curve: decreases in the values of the determinants.

An Decrease in Causes Supply to Causes the Supply Curve to Move to the

And Is Shown in Figure

Price of inputs Increase Right 2.6 Technology Decrease Left 2.7 Price of other potential outputs Increase Right 2.6 Number of sellers Decrease Left 2.7 Expected price Increase Right 2.6 Excise Tax Increase Right 2.6 Subsidy Decrease Left 2.7

$0.50

0

$1.00

$1.50

$2.00

$2.50

P

0 10 20 30 40 50

Demand

New supply

Supply

Q/t

FIGURE 2.6 The effect of an increase in supply on the supply and demand model.

$0.50

0

$1.00

$1.50

$2.00

$2.50

P

0 10 20 30 40 50

Demand

New supply

Supply

Q/t

FIGURE 2.7 The effect of a decrease in supply on the supply and demand model.

gue46399_ch02_019-039.indd 34 16/03/17 11:38 AM

The Effect of Changes in Price Expectations on the Supply and Demand Model 35

The Effect of Changes in Price Expectations on the Supply and Demand Model

If you have not already noticed, expected future price shows up in both the determinants of demand and the determinants of supply. This means that if the expected future price changes, both the supply and demand curves change as well. If the expected future price rises, con- sumers will want to stock up, thereby increasing demand. Firms, on the other hand, will want to hold back their inventory to wait for the price increase, thereby decreasing supply. In this case, we do not know what will happen to equilibrium quantity because the demand shift will, by itself, increase quantity, whereas the supply shift will, by itself, decrease quantity. Whether there is a net increase or decrease in equilibrium quantity depends on which shift is greater. On the other hand, the effect on price is known, and it amounts to a self-fulfilling prophecy because a credible prediction of a future price increase will lead to an actual current price increase.

When expected prices rise, we know that the current price will rise, but we do not know what will happen to the quantity. This is because we do not know whether firms’ desire to wait for price increases will be stronger than consumers’ desire to stock up. When the price is expected to fall, firms will want to get rid of their inventory and consumers will want to wait for the new lower prices.

When expected prices fall we know that the current price will fall, but we again, do not know what will happen to the quantity. This is because we do not know whether firms’ desire to unload inventory will be stronger than consumers’ desire to wait for lower prices.

WHY THE NEW EQUILIBRIUM?

When either the supply curve or the demand curve shifts, the equilibrium has to change. If it does not, one of two things will happen: There will be a shortage where consumers want to buy more than firms want to sell, or there will be a surplus where firms want to sell more than consumers want to buy.

To show that this is the case, imagine that there is an increase in the demand for a good and firms do not increase the price. As shown in Figure 2.8, keeping the price at the old equi- librium would set up a situation where consumers would want more (40) than firms would be willing to sell (20). The resulting shortage would not be eliminated unless there was an increase in the price.

A somewhat different problem would happen if firms did not lower their price in the face of decreased demand. Figure 2.9 shows that keeping the price at the old equilibrium with a decrease in demand would set up a situation where consumers would want fewer (0) than firms would be willing to sell (20). The resulting surplus would not be eliminated unless there was a decrease in the price.

Just as we needed a new equilibrium when there was a change in demand, we need one when there is a change in supply. Figure 2.10 shows that keeping the price at the old equilib- rium when supply increases sets up a situation where consumers want fewer (20) than firms are willing to sell (40). The resulting surplus will not be eliminated unless there is a decrease in the price.

Finally, if firms do not raise their prices in the face of decreased supply, there will be a shortage. Figure 2.11 shows that keeping the price at the old equilibrium in the face of de- creased supply sets up a situation where consumers want more (20) than firms are willing to sell (0). The resulting shortage will be eliminated unless there is an increase in the price.

Kick It Up a Notch

gue46399_ch02_019-039.indd 35 16/03/17 11:38 AM

36 Chapter 2 Supply and Demand

$0.50

0

$1.00

$1.50

$2.00

$2.50

P

0 10 20 30 40 50

DemandShortage

New demand

Supply

Q/t

FIGURE 2.8 The shortage that is created when demand increases if price and quantity do not.

$0.50

0

$1.00

$1.50

$2.00

$2.50

P

0 10 20 30 40 50

Demand

Surplus

New demand

Supply

Q/t

FIGURE 2.9 The surplus that is created when demand decreases if price and quantity do not.

$0.50

0

$1.00

$1.50

$2.00

$2.50

P

0 10 20 30 40 50

Demand

Surplus

Supply

New supply

Q/t

FIGURE 2.10 The surplus that is created when supply increases if price and quantity do not.

$0.50

0

$1.00

$1.50

$2.00

$2.50

P

0 10 20 30 40 50

Demand

Shortage

Supply

New supply

Q/t

FIGURE 2.11 The shortage that is created when supply decreases if price and quantity do not.

What lesson can you draw from all of this? A change in either the supply or demand curve will change the price at which the quantity consumers want to buy equals the quantity that firms want to sell. If the price does not change, either a surplus or a shortage will ensue.

There are circumstances when a new equilibrium will not be achieved. For instance, price gouging is the name given to the situation in which a rapid increase in demand is followed by a rapid increase in price. When demand increases, firms do not have to raise prices to cover costs; they raise prices because they can. Laws preventing price gouging are relatively common.

If you sell ice and have a freezerful to sell, in many states you are not allowed to raise the price of it more than a specified percentage if your community loses electrical power. Econo- mists call the maximum price allowed by law a price ceiling. Once the price hits that level, it cannot rise further and you have a shortage for that good. Other examples of price ceilings involve rent control and laws that prevent ticket scalping.

Similarly, equilibrium will not be achieved if there is a price floor. This exists when a price may not fall below a certain legally proscribed level. In that circumstance, there is a surplus of the good. Examples of this include farm price supports and the existence of the minimum wage.

Detailed descriptions of the effects of price ceilings and floors are left to their applications in the chapters on rent control, ticket scalping, farm price supports, and the minimum wage.

price gouging The pejorative term applied to the circum- stance when firms raise prices substantially when demand increases unexpectedly.

price ceiling The level above which a price may not rise.

price floor Price below which a commodity may not sell.

gue46399_ch02_019-039.indd 36 16/03/17 11:38 AM

Summary 37

Key Terms capitalist economy ceteris paribus communist economy consumers demand demand schedule equilibrium equilibrium price equilibrium quantity excess demand excess supply

law of demand law of diminishing marginal

utility law of supply marginal utility market output price price ceiling price floor price gouging

producers quantity demanded quantity supplied real-balances effect shortage socialist economy substitution effect supply supply and demand supply schedule surplus

Issues Chapters You Are Ready for Now

International Finance and Exchange Rates

The Economics of Race and Sex Discrimination

Quiz Yourself 1. The supply and demand model examines how prices and quantities are determined a. in markets. b. by governments. c. by churches. d. by monopolists.

2. A change in the price of eggs will impact a. the demand for eggs. b. the supply of eggs. c. the quantity demanded and quantity supplied of eggs but neither demand nor supply. d. both the supply and demand for eggs.

3. When an economics student draws a supply and demand diagram to model an increase in the income, she is assuming this change happens a. semper fidelis. b. ceteris paribus. c. ipso facto. d. de facto.

Summary The supply and demand model is the single most important model in economics. More than half the issues that you deal with in the latter part of this book will rely on your ability to put an economics problem into the context of this model. In the course of this chapter we explained the supply and demand model by providing all of the language up front. We explained both supply and demand in isolation and then put them together in the form of a coherent model. We then talked about what variables might change demand and then which ones might change supply. We showed that prices and quantities sold would have to change to maintain an equilibrium.

gue46399_ch02_019-039.indd 37 16/03/17 11:38 AM

38 Chapter 2 Supply and Demand

4. If the supply and demand curves cross at a price of $2, at any price above that there will be a. an equilibrium. b. a surplus. c. a shortage. d. a crisis.

5. If the supply and demand curves cross at a quantity of 100, then the price necessary to get firms to sell more than that will have to be equilibrium. a. above b. at c. below d. within 10 percent either way of

6. An increase in which of the following determinants of demand will have an ambiguous (uncertain) effect on price? a. Taste b. Price of a complement c. Income d. Price of a substitute

7. Which of the following will impact both supply and demand? a. A change in price b. A change in quantity c. A change in expected future price d. A change in income

8. An increase in the income of consumers will cause the a. supply of all goods to rise. b. demand for all goods to rise. c. supply of all goods to fall. d. the demand for some goods to rise and for others to fall.

9. Without an increase in price, an increase in demand will lead to a. a shortage. b. a surplus. c. socialism. d. equilibrium.

10. The underlying reason for the upward-sloping nature of the supply curve is that a. the production of most goods comes with increasing marginal benefits. b. the production of most goods comes with increasing marginal costs. c. the consumption of most goods comes with decreasing marginal utility. d. the consumption of most goods comes with increasing marginal utility.

11. If Midwestern grain farmers can plant either soybeans or corn on their land with equal profitability and there is an increase in the price of soybeans, which of the following will result? a. A movement to the right in the demand for corn b. A movement to the left in the demand for corn c. A movement to the right in the supply of corn d. A movement to the left in the supply of corn

gue46399_ch02_019-039.indd 38 16/03/17 11:38 AM

Summary 39

12. Part of the Patient Protection and Affordable Care Act involved a tax on indoor tanning that tanning salons are required to collect from tanners and send to the federal govern- ment. Which of the following would be the predicted result? a. A movement to the right in the demand for tanning b. A movement to the left in the demand for tanning c. A movement to the right in the supply of tanning d. A movement to the left in the supply of tanning

13. As the baby boom generation (born between 1946 and 1964) ages, which of the following is a likely outcome? a. A movement to the left in the demand for nursing home beds b. A movement to the left in the supply of nursing home beds c. A movement to the right in the supply of nursing home beds d. A movement to the right in the demand for nursing home beds

Short Answer Questions

1. Use your own demand for pizza to illustrate the notion of diminishing marginal utility. Explain why that concept means your demand for pizza-by-the-slice is downward sloping.

2. Suppose you have been given money by your friends and sent to get beverages for a party. Use your demand for those beverages to illustrate why the concept of the “real balance effect” will mean your demand is downward sloping.

3. If there is an alteration to the price of a complement to a good, why is that a change in demand when an alteration in the price of the good itself is a change in the quantity demanded?

4. If there is an alteration in the price of an input used to produce a good, why is that a change in supply when an alteration in the price of the good itself is a change in the quantity supplied?

Think about This Using simple supply and demand analysis, think about the system of allocating human kid- neys. The law that forbids the sale of human organs, but allows their voluntary donation, means that there is a bigger shortage of kidneys than there otherwise would be. Does this fact alter your view of the law forbidding the sale of human organs? How about blood?

Talk about This Are markets always right? List some markets that you think get the production or price of a good wrong. What do these goods have in common?

gue46399_ch02_019-039.indd 39 16/03/17 11:38 AM

40

C H A P T E R T H R E E

The Concept of Elasticity and Consumer and Producer Surplus Learning Objectives

After reading this chapter you should be able to:

LO1 Define elasticity as the responsiveness of quantity to changes in price, recognize its importance in economics, and apply the con- cept to various real-world goods and services.

LO2 Connect the relationship between the concept of elasticity and the appearance of the demand curve.

LO3 Illustrate that a market equilibrium provides both buyers and sellers with benefits. Con- sumers pay less than they are willing to pay and producers make a profit. Economists call the former consumer surplus and the latter, producer surplus.

LO4 Define deadweight loss as the measure of inefficiency that exists when prices are too high or too low and apply this to various policies.

Chapter Outline

Elasticity of Demand

Alternative Ways to Understand Elasticity

More on Elasticity

Consumer and Producer Surplus

Kick It Up a Notch: Deadweight Loss

Summary

We now change gears a bit and reconsider the individual supply and demand curves. Our focus here is on the ability of consumers and producers to react to price changes with changes in the amounts they wish to buy or sell. That ability to react, called elasticity, will be very important to us as we prepare to use the supply and demand model for issues. We will see how differently shaped demand curves will reflect the degree to which price changes affect quantity.

The last third of the chapter is central in our analysis of several issues. We will see how the supply and demand model can be used to explain why markets are effective in pleasing both consumers and producers. Though we know that consumers long for low prices and producers for high prices, we will see that when a consumer buys something from a producer, both can be pleased with the outcome. We will also see why the net benefit to society is lower when prices are not at equilibrium than it would be if equilibrium were at work.

gue46399_ch03_040-055.indd 40 16/03/17 11:38 AM

Elasticity of Demand 41

Elasticity of Demand

Intuition In the previous chapter, we saw that a change in supply or demand changes the equilibrium price–quantity combination, but we did not discuss which one changes more. For instance, if costs to a firm go up, it is reasonable to ask whether the firm will pass that price increase on to consum- ers or be willing to accept lower profits. Exploring this question brings in the concept of elasticity.

If the good is one that you need to survive and that has no good substitutes, or if it is one that you spend very little money on, the firm may be able to pass on its increased costs to you in the form of higher prices. On the other hand, if it is a luxury, that is, a good you can do without, if there are many other things that will serve just as well, or if you already spend a lot of your income on it and could not afford a price increase, you may buy a lot fewer. In this case the firm’s profits are eaten up.

Definition of Elasticity and Its Formula There are many kinds of elasticity. In general, elasticity is the responsiveness of quan- tity to a change in another variable. The two most commonly referred to elasticities are the price elasticity of demand and the price elasticity of supply. Respectively, these are the responsiveness of quantity demanded to a change in price and the responsiveness of quan- tity supplied to a change in price. Other elasticities include the income elasticity of demand and the cross-price elasticity of demand. The former measures the responsiveness of quan- tity to changes in income, and the latter measures the responsiveness of quantity to changes in the price of another good.

The price elasticity of demand is measured by looking at how a percentage change in price affects the percentage change in quantity demanded. The formula for elasticity is:

Elasticity = %ΔQ

_____ %ΔP

= ΔQ∕Q*

_______ ΔP∕P*

where,

% = percent Δ = change

P* = price (read as “P star”) Q* = quantity (Q star)

The other elasticities are similar in that the percentage change in either quantity demanded or quantity supplied is in the numerator and the percentage change in the price, income, or other price, is in the denominator. Because the bulk of the issues that deal with elasticity deal with price elasticity of demand, we focus here on this particular form of the concept.

From here there are two ways of proceeding: We can explain everything in a great deal of mathematical detail or not. Guessing that the chorus is singing “not,” we will skip the math. You will need now to follow the “English” explanations to understand and accept the conclu- sions about elasticity.

When you use the elasticity of demand formula, you will always get a negative number for it. For our purposes we will simplify things by ignoring the negative sign. The negative sign appears because the demand curve is downward sloping, and an increase in price will therefore cause a decrease in quantity. To illustrate, if a 5 percent increase in price leads to a

elasticity The responsiveness of quantity to a change in another variable.

price elasticity of demand The responsiveness of quantity demanded to a change in price.

price elasticity of supply The responsiveness of quantity supplied to a change in price.

income elasticity of demand The responsiveness of quantity to a change in income.

cross-price elasticity of demand The responsiveness of quantity of one good to a change in the price of another good.

gue46399_ch03_040-055.indd 41 16/03/17 11:38 AM

42 Chapter 3 The Concept of Elasticity and Consumer and Producer Surplus

1

0

2

3

4

5

6

7

8

9

10

11

12

13

P

0 1 2 3 4 5 6 7 8 9 10 11 12 13 Q/t

D1

FIGURE 3.1 At a given price, a flatter demand curve is more elastic than a steeper one.

1

0

2

3

4

5

6

7

8

9

10

11

12

13

P

0 1 2 3 4 5 6 7 8 9 10 11 12 13

D2

Q/t

FIGURE 3.2 At a given price, a steeper demand curve is more inelastic than a flatter one.

10 percent decrease in quantity, the elasticity fraction is –0.10∕.05. Since the important thing about elasticity is the value of the fraction itself, it is acceptable and less complicated for us to ignore the minus sign.

Elasticity Labels This brings us to an important distinction that will be vital when we look at issues that hinge on whether demand is elastic or inelastic—for example, whether increasing the tax on cigarettes leads to decreases in teen smoking. Economists say that demand is elastic when the percentage change in quantity is larger than the percentage change in price and inelastic when the percentage change in quantity is smaller than the percentage change in price. Looking at the formula, if the computed elasticity is greater than 1, then demand is elastic; when it is less than 1, then demand is inelastic. When the percentage change in quantity is the same as the percentage change in price (the computed elasticity is exactly 1), demand is unitary elastic.

Alternative Ways to Understand Elasticity

To see this more clearly let’s look at it using three different thought processes. First we look at elasticity using the graph of our demand curve. Then we look at it using only words. Last, we look at it in terms of how much money is spent on the good.

The Graphical Explanation We first examine the elasticity phenomenon using graphical skills. Figure 3.1 shows that the flat- ter the demand curve, the greater the elasticity. This is not to say that slope and elasticity are the same thing; it just means that slope matters. To see that slope matters look at Figures 3.1 and 3.2.

elastic The circumstance when the percentage change in quantity is larger than the percentage change in price.

inelastic The circumstance when the percentage change in quantity is smaller than the percentage change in price.

unitary elastic The circumstance when the percentage change in quantity is equal to the percentage change in price.

gue46399_ch03_040-055.indd 42 16/03/17 11:38 AM

Alternative Ways to Understand Elasticity 43

Though they are in separate diagrams, both go through the point P = $8, Q = 4. Suppose you were to ask how much price would have to rise in order to induce a reduction in quantity demanded to 3. In Figure 3.1, you can see that it would take an increase to $9, whereas in Figure 3.2 it would require an increase to $12. What that implies is that on the steeper curve (Figure 3.2) demand is less elastic and on the flatter one ( Figure 3.1) it is more elastic. In Figure 3.1, a 12.5 percent increase in prices results in a 25 percent reduction in quantity.1 In Figure 3.2 it takes a 50 percent increase in price to generate a 25 percent decrease in quantity.

Figure 3.3 shows that the higher the price, the greater the elasticity. The price increase from 2 to 3 causes a decrease in quantity from 10 to 9. The same size

increase in price from 8 to 9 causes the same size decrease in quantity from 4 to 3. This is because the slope of this demand curve is the same at all those points. Looking at the formula again, we see it is the percentage changes that matter and not just the size of those changes. Even though the price increases and quantity decreases are the same, the percentage changes are very different.

From point D to C the percentage change in price from 2 to 3 is a sizable 50 percent while the percentage change in quantity from 10 to 9 is negligible, only 10 percent. Since the percentage change in the price is greater than the percentage change in the quantity, demand is inelastic here (elasticity is low). On the other hand, from point B to A the percentage change from 8 to 9 is only 12.5 percent, whereas the percentage change in quantity from 4 to 3 is large (25 percent, visually about 33 percent). As a result, demand here is elastic (elasticity is high).

The Verbal Explanation Although the graphical explanation of elasticity is highly accurate, if it does not make sense to you, it is useless. Recall the original definition of elasticity (the reaction of quantity to a change in price). If you really need a product because there are no good substitutes (like insulin to a diabetic), you will hardly change the amount you buy when the price changes. Thus there is little, if any, reaction of quantity to changes in price. The demand curve for a good you “need” is going to be rather steep. If the good is a luxury item, you are more likely to eliminate it from your budget if it becomes overly expensive. In this case, there is a substantial reaction of quantity to a change in price. The demand curve for a luxury is likely to be flatter.

In addition, price changes for goods that take up little of your income (like drinking water) are not likely to lead to big quantity changes. This is because even if their price increases greatly, you can easily afford those price increases. Goods that take up a significant portion of your income are more likely to have elastic demand because you are less able to afford large price increases. In this case, goods with low prices are likely to have inelastic demand and goods with high prices are likely to have elastic demand.

1

0

2

3

4

5

6

7

8

9

10

11

12

13

P

0 1 2 3 4 5 6 7 8 9 10 11 12 13

A

B

C

D

Q/t

Demand

FIGURE 3.3 The higher the price, the greater the elasticity.

1 A price increase from 8 to 9 is a 12.5 percent increase because it is the fraction 1∕8. It is a 25 percent decrease in quantity because it went from 4 to 3 (1∕4).

gue46399_ch03_040-055.indd 43 16/03/17 11:38 AM

44 Chapter 3 The Concept of Elasticity and Consumer and Producer Surplus

Seeing Elasticity through Total Expenditures If we wanted to, we could use math to show that if the price and the amount you spend both go in the same direction, then demand is inelastic. If they go in opposite directions, however, demand is elastic. This total expenditure rule of elasticity also allows us to quickly judge whether demand is elastic or inelastic. For instance, when the price of cigarettes goes up, smokers usually have to spend more on them. When the prices of luxuries go up, many of us spend less on them (because we do without them). In this way, we can find out for ourselves whether our demand for a good is elastic or inelastic. All we need to do is to ask ourselves whether a price increase will cause us to spend more on that good.

More on Elasticity

Determinants of Elasticity of Demand Key factors of the three elasticity explanations are important in determining whether a good is elastic or inelastic. The first is the number and closeness of substitutes. When there are many substitutes that all serve nearly as well as the good in question, demand is likely to be more elastic, because price increases induce changes to other goods. Whether price increases can be easily absorbed into a person’s budget also matters. If price increases can- not be absorbed—which is likely to be the case if the good takes up a significant portion of the budget of consumers—when they occur, significant quantity reductions will follow. And although timing was not mentioned above, given time, close substitutes can be found or invented, or methods to avoid the price increase will be developed.

One of those substitutes could be the continued use of something the consumer already has. Cars, for instance, have greater elasticity than razor blades because owners can easily continue to drive the cars they have until a sale price induces them to buy a replacement, whereas shav- ers can stretch the use of a razor for only a limited number of days.

Elasticity and the Demand Curve Elasticity is important because supply changes will have very different results depending on the elasticity of demand. As you can see from the figures on the next page, an identical supply change can affect only price (Figure 3.4), only quantity (Figure 3.5), price much more than quantity (Figure 3.6), or quantity much more than price (Figure 3.7).

total expenditure rule If the price and the amount you spend both go in the same direction, then demand is inelastic, whereas if they go in opposite directions, demand is elastic.

Number and closeness of substitutes The more alternatives you have, the less likely you are to pay

high prices for a good and the more likely you are to settle for an adequate alternative.

Portion of the budget When a good takes up a significant portion of a consumer’s

budget, it is more likely to be elastic.

Time The longer you have to come up with alternatives to paying

high prices, the more likely it is you will shift to those alternatives.

D E T E R M I N A N T S O F E L A S T I C I T Y O F D E M A N D

gue46399_ch03_040-055.indd 44 16/03/17 11:38 AM

More on Elasticity 45

Q1 = Q2

P

Q/t

D

P1

P2

S2

S1

FIGURE 3.4 Perfectly inelastic demand.

D

Q1Q2

P1 = P2

P

Q/t

S2

S1

FIGURE 3.5 Perfectly elastic demand.

D

P1

P2

Q1Q2

P

Q/t

S2

S1

FIGURE 3.6 Inelastic demand.

D P1

P2

Q1Q2

P

Q/t

S2

S1

FIGURE 3.7 Elastic demand.

In Figure 3.4 demand curve is perfectly inelastic because price changes have no ef- fect on quantity. In Figure 3.5 the demand curve is perfectly elastic because price cannot change. As we saw in Figures 3.2 and 3.3, a linear demand curve is elastic at high prices and inelastic at low prices. In Figure 3.6 demand is inelastic over the entire range shown because at every point the percentage change in price is larger than the percentage change in quantity. This will be true when the demand curve is nearly vertical. In Figure 3.7 demand is elastic over the entire range, because at every point the percentage change in price is smaller than the percentage change in quantity. This will be true when the demand curve is nearly horizontal.

If we look back at the elasticity formula, we can use this explanation to compute the ap- propriate elasticity numbers for each of these elasticity labels. For perfectly elastic demand the computed elasticity is ∞ (infinity), while for perfectly inelastic demand the computed elastic- ity is 0 (zero). Remembering that unitary elastic demand computes to 1 (one), it makes sense that elastic demand will compute to greater than 1 but less than ∞ and inelastic demand will compute to less than 1 but greater than 0.

perfectly inelastic The condition of demand when price changes have no effect on quantity.

perfectly elastic The condition of demand when price cannot change.

gue46399_ch03_040-055.indd 45 16/03/17 11:38 AM

46 Chapter 3 The Concept of Elasticity and Consumer and Producer Surplus

Sometimes it is easier to see the importance of elasticity with partic- ular goods. There are economists who spend their days and nights estimating the elasticity of demand for particular goods. This is not because they have nothing else to do. It is because the elasticity of demand for a good is important information to have if you are interested in the impact of a price increase or a tax on that good. For instance, if you take up the chapter on tobacco, alcohol, drugs, and prostitution later in the course, you will find that the question of how much impact a tax on cigarettes will have in decreasing smoking depends greatly on the elasticity of demand for cigarettes.

Consider the goods listed in the following table and their elastici- ties. You should be able to tell a story about why short-run gasoline demand is less elastic than long-run gasoline demand. You should be able to figure out why demand for foreign travel is quite elastic while demand for food is not. The key to the question of whether a good is elastic or not is whether there is an acceptable substitute.

SAMPLE STORY 1 There are few substitutes to driving to and from work. Though you may or may not be able to take public transportation or carpool, though you may or may not be able to trade in your SUV for a fuel-efficient car, it would take a substantial change in the price of gasoline to cause you to make the substitution immediately upon seeing an increase in gas prices. This is especially true if you did not anticipate that prices would remain high. On the other hand, if you did see that gasoline prices were going to remain high, you might, over the next year or so, consider trading in the gas guz- zler for something more miserly. Similarly, you cannot easily change your electric bill, but over time you can replace an inefficient electric forced-air furnace with an efficient heat pump, and you can decide to put electronic devices that draw electricity even when they look

like they are off (such as TVs, coffeepots, and even cell phone char- gers) on switches.

Type of Good Price Elasticity

Inelastic Goods Consumer electricity (short-run) 0.13 Eggs 0.06 Food 0.21 Health care services 0.18 Gasoline (short-run) 0.08 Gasoline (long-run) 0.24 Highway and bridge tolls 0.10 Unit Elastic Good (or close to it) Shellfish 0.89 Cars 1.14 Elastic Goods Luxury car 3.70 Foreign air travel 1.77 Restaurant meals 2.27 Consumer electricity (long-run) 1.89

Sources: Variety of sources combined by author

SAMPLE STORY 2 Suppose you wanted to take your family on an interesting vaca- tion. Suppose further that your family had narrowed its choices to hiking in the Grand Canyon or seeing the sights in Paris. Given the acceptability of the substitute, a relatively small change in the price of flights and accommodations for the trip to France would have a significant impact on your choice.

E L A S T I C I T Y : S O M E I L L U S T R A T I V E E X A M P L E S

Elasticity of Supply Before moving on, we need to stop and say that nearly everything we have just said about the price elasticity of demand can also be said about the price elasticity of supply. Firms selling goods may be in a situation where they have already brought goods to market that are quite perishable and, therefore, must be sold regardless of their price. We may have other situa- tions where producing more of the goods can be accomplished but only at a sharply increased price. We can imagine a third circumstance where prices do not have to rise much in order to motivate further sales and, finally, it is possible that firms may be willing to produce as many goods as buyers want at the current market price. In the first scenario, the supply curve would be vertical. In the second and third scenarios, the supply curve would be upward sloping, with the second being a steeply sloped supply curve, and the third being a relatively flat one. The final scenario would likely result in a horizontal supply curve. Some examples of goods with varying elasticities might be helpful here. In the very short run, the elasticity of supply of fresh fruit at a farmers’ market is perfectly inelastic as long as the fruit will spoil if it goes unsold. In the relatively short run and in the United States, the supply of gasoline is inelastic because

gue46399_ch03_040-055.indd 46 16/03/17 11:38 AM

More on Elasticity 47

Q/t

D1 Q1 = Q2

P1

D2

P2

P S

FIGURE 3.8 Perfectly inelastic supply.

Q/t

P

P2

Q1 Q2

D2 D1

P1

S

FIGURE 3.9 Inelastic supply.

Q/tQ2

D1

D2

S

Q1

P1

P2

P

FIGURE 3.10 Elastic supply.

Q/tQ2

D1

D2

S

P

Q1

P1 = P2

FIGURE 3.11 Perfectly elastic supply.

most refineries are not easily capable of expanding or contracting output. They run 24 hours per day, seven days a week, and are brought offline only for maintenance. In the longer run, there are myriad goods where producers can bring new production online. A relatively small increase in the profit margin on a good can motivate significantly greater production. There are very few real-world examples of perfectly elastic supply.

Replicating the idea of Figures 3.4 through 3.7 where we had a constant shift in supply and saw what happened with varying elasticities of demand, Figures 3.8 through 3.11 show what happens when demand shifts with varying elasticities of supply. In Figure 3.8 the supply curve is perfectly inelastic and is vertical. As a result of an increase in demand, price rises greatly, but quantity does not change at all. In Figure 3.9, the supply curve is inelastic and steeply sloped so the change in demand causes prices to rise quite a bit and quantity to rise, albeit not very much. If supply is elastic, such as it is in Figure 3.10, the demand increase causes prices to rise only a little and quantity to rise substantially. Finally, in the case where supply is per- fectly elastic, as it is in Figure 3.11, the increase in demand causes only an increase in quantity and no effect is seen on price.

Determinants of the Elasticity of Supply Just as with demand, supply elasticity has key factors that are important in determining whether a good has elastic or inelastic supply. The first is the degree to which the relevant resources used for production are available. That availability can be achieved either by their

gue46399_ch03_040-055.indd 47 16/03/17 11:38 AM

48 Chapter 3 The Concept of Elasticity and Consumer and Producer Surplus

When there are win–win scenarios such as the case outlined, econo- mists generally favor uninhibited exchange. When there are losers, economists look to consumer surplus–producer surplus analysis to weigh the gain to the gainers against the loss to the losers. To you, whether free trade is a good thing or not depends on whether you are a Kia owner who saved several thousand dollars on your car or an unemployed United Auto Workers union member. Whether a new Walmart Supercenter is good for your town depends on whether

you are a consumer paying lower prices for steak or a meat cutter unemployed because the Kroger that you worked for closed. Gener- ally, but by no means universally, economists favor market outcomes because they make the calculation that the gain to the gainers out- weighs the loss to the losers. Whether it is trade between the United States and Korea or Walmart outcompeting Kroger, free-trade econ- omists insist that lower prices generate a gain in consumer surplus that is greater than the net loss in producer surplus.

C O M P A R I N G T H E G A I N T O T H E G A I N E R S W I T H T H E L O S S T O T H E L O S E R S

development or by the ability to attract those resources into the industry. For a natural resource where the location is known and the prospect for finding new deposits is low, supply elasticity will be smaller than for a resource where finding new deposits is common. Similarly, if higher prices motivate firms to raise wages and that results in many new applicants for positions, productive capacity can increase quickly in response to price changes.

The second is the degree to which an industry exhibits some agility in their production or has the time to respond appropriately to price changes. An industry that requires long periods of time to increase production will have a lower supply elasticity than one that can quickly bring in new labor and capital to exploit minor price changes. Here, the energy industry is a good example in that it took many years to develop the technology associated with hydraulic fracturing (fracking) and horizontal drilling. As a result, the supply elasticity of oil was low for many years. When that new technology was on full display, in particular during the doubling of U.S. oil production in the 2008 to 2015 time frame, supply elasticity increased markedly.

The final determinant of supply elasticity is the degree to which a firm is close to its production capacity combined with the degree to which it can easily and cheaply use inven- tories as a buffer. An industry that is always running at full capacity and can’t cheaply store their output will have very low supply elasticity. The clearest and most frequently observed example of this is in the gasoline-refining business. Refineries are always running at full capacity—24/7/365. The only exception to that is when they are down for maintenance, which they are during the required switch from winter blends to summer blends (in March) and back again (in October). You see the price at the pump rise in those months because there is no spare capacity in that business and the cost of storage is quite high.

Availability of Relevant Resources The easier it is for relevant resources to be developed or attracted into an industry, the greater will be the supply elasticity.

Time and Agility of Production The longer an industry has to adjust production, or the ease with which it can do so, the greater will be the supply elasticity.

Capacity and Inventories The farther away an industry is to its production capacity combined with the degree to which it can easily and cheaply use inventories as a buffer, the greater will be the elasticity of supply.

D E T E R M I N A N T S O F E L A S T I C I T Y O F S U P P L Y

gue46399_ch03_040-055.indd 48 16/03/17 11:38 AM

Consumer and Producer Surplus 49

Consumer and Producer Surplus

Consumer Surplus Most people think that when consumers buy goods, only the firm is better off for the exchange. They do not often acknowledge that consumers are also better off. It turns out that consum- ers often get much more value than they part with. Look back to “All about Demand” in Chapter 2 and recall that the demand curve represents the marginal utility of the good. This means that the amount each additional unit of the good is worth to the consumer can be read from the demand curve.

Figure 3.12 demonstrates how it is that consumers win in this exchange and provides a measure of the degree to which they win. The value the consumers place on each unit of the good is their marginal benefit for that unit. That is how much they would have paid for that unit. As a result the total value to the consumer is simply the sum of those marginal benefits for each unit and is the area under the demand curve from O to Q*. It looks like and is bounded by the letters OACQ*. The total amount of money they pay for these goods is the price, P*, times the amount they buy, Q*, so it looks like and is bounded by the letters OP*CQ*. The difference between the areas is the triangle that represents the value to the consumers minus the amount they pay the producer. Economists call that consumer surplus; it looks like and is bounded by the letters P*AC.

Producer Surplus Firms also benefit from exchange. In the Chapter 2 section “All about Supply” the supply curve is upward sloping because it is the marginal cost curve and marginal cost is increasing. Just as we added together marginal benefits to get the value to the consumers in Figure 3.12, we now add together marginal costs for each unit in Figure 3.13 to get the total variable cost to the producer (which is the difference between all its costs and those it needs to start up its business). As a result we can measure the total variable cost as the area under the supply curve from O to Q*, which looks like and is bounded by the letters OBCQ*. The amount consumers pay producers is the same OP*CQ* rectangle it was in Figure 3.12, . The dif- ference is what economists call producer surplus; it looks like and is bounded by the letters BP*C.

consumer surplus The value you get that is in excess of what you pay to get it.

producer surplus The money the firm gets that is in excess of its marginal costs.

Q/tQ*

P*

A

C

O

B

Consumer surplus =

Value to the consumer

Amount consumer pays producer

minus

Supply

Demand

=

FIGURE 3.12 Consumer surplus.

gue46399_ch03_040-055.indd 49 16/03/17 11:38 AM

50 Chapter 3 The Concept of Elasticity and Consumer and Producer Surplus

Producer surplus =

P

P* C

A

Variable cost to producer

Amount consumer pays producer

B

O Q* Q/t

= minus

Supply

Demand

FIGURE 3.13 Producer surplus.

Q/t

Supply

Demand

C

Q*O

B

P*

A

P

Consumer surplus

Producer surplus

FIGURE 3.14 Net benefit to society.

The net benefit to society, shown in Figure 3.14, is the consumer surplus plus the pro- ducer surplus. That is, if the market did not exist, consumers would lose their consumer surplus and the producers would lose their producer surplus. Because the market exists, both are better off.

Market Failure Reread the last sentence of the preceding paragraph. It seems to suggest that the market works perfectly and that there is never cause for government to intervene. Intuitively you know that is not true. A market can fail for a number of reasons: The actions of a consumer or producer can harm an innocent third party, a good may not be one for which a company can profit from selling even though society profits from its existence, the buyer may not be able to make a well-informed choice given the complexity of the decision, a buyer or a seller may have radi- cally different information about a good or service, or a buyer or seller may have too much power over the price. Each of these problems leads to market failure—the circumstance where the market outcome is not the economically efficient outcome. In the issue chapters to come, you will explore each of these types of market failures.

When market failure exists, economists use consumer and producer surplus to analyze the degree of the problem as well as to show how the problem can be solved through the proper application of taxes, regulations, or subsidies. Whether this is a tax discouraging the consump- tion or production of a good, a subsidy designed to encourage its production or consumption, or a regulation against monopoly pricing, economists are not always for or always against these mechanisms. Most economists favor policies that maximize the sum of producer and consumer surplus, however that occurs.

Categorizing Goods Broadly speaking, goods can be classified into four categories on the basis of the degree to which the consumption of the good can be restricted by a seller to only those who pay for it—called exclusivity, and the degree to which one person’s consumption reduces the value of the good for the next consumer—called rivalry. A slice of pizza has a high degree of both qualities; the pizza joint can easily prevent you from consuming their pizza if you do not pay for it, and once you have eaten a pizza, that particular pizza is not available to others. As a result, economists would label pizza as a purely private good. On the other hand, the army

market failure The circumstance where the market outcome is not the economically efficient outcome.

exclusivity The degree to which the consumption of the good can be restricted by a seller to only those who pay for it.

rivalry The degree to which one person’s consump- tion reduces the value of the good for the next consumer.

purely private good A good with the charac- teristics of both exclu- sivity and rivalry.

gue46399_ch03_040-055.indd 50 16/03/17 11:38 AM

Consumer and Producer Surplus 51

protects all citizens from foreign invasion regardless of how much they pay in taxes, and their success at doing so is not diminished at all by how many people they have to defend. Economists label national defense as a purely public good because it is one for which there is neither rivalry nor exclusivity.

In addition to those extremes, there are goods that have a high degree of one characteristic and a low degree of the other. Cable companies can easily exclude their consumers from get- ting HBO, but one consumer’s viewing of HBO does not affect another’s viewing. HBO is excludable, but there is no rivalry. Economists call such goods excludable public goods. Simi- larly, a city street is an example of a good for which it would be nearly impossible to prevent usage by citizens and one for which rivalry is common (think traffic jams).2 Such goods are what economists call congestible public goods.

There is another type of good for which you actually need other people consuming it for it to have any use to you. Economists call this type of good a network good. The first landline telephones were an early example of this type of good. Social media apps such as Facebook, Instagram, and Twitter, as well as the more nefarious ones like Yik-Yak, Tinder, and Kik all require other users to be active in order for the apps to have any value.

2While you may think license plates allow for exclusivity, they do not serve the entire function in that once you have a licensed car it is very difficult to charge you based on usage. As technology increases, GPS receivers and transmitters may make it pos- sible to charge drivers based on where and when they drive.

purely public good A good with neither of the characteristics of exclusivity or rivalry.

excludable public good A good with the char- acteristic of exclusivity but not of rivalry.

congestible public good A good with the charac- teristic of rivalry but not of exclusivity.

network good a type of good for which you need other people consuming it for it to have any use to you.

Kick It Up a Notch

DEADWEIGHT LOSS

When the market is not at equilibrium, the consumer surplus plus the producer surplus will not be as large. This triangle, ABC, is as big as it can be. If consumption is more than Q*, then consumers are paying more than they think a product is worth, or producers are not meeting their marginal costs, or both. If consumption is less than Q*, the consumers wish they could buy more (and they would get more consumer surplus), or firms wish they could sell more (and they would get more producer surplus), or both. If the triangle is smaller than ABC, then there is deadweight loss. This deadweight loss is the measure economists use to discuss the inefficiency of markets when a problem like air pollution exists or when government estab- lishes an impediment to a free floating price, such as the minimum wage.

To see how deadweight loss fits our supply and demand diagram, suppose that for some reason the price cannot be at P* but is instead at Pʹ (pronounced “P prime”). Figure 3.15 shows the impact of this when Pʹ is greater than P*, and Figure 3.16 shows the impact when Pʹ is less than P*. In either circumstance, the new quantity will be less than equilibrium because consumers will not be willing to buy more than Qʹ (pronounced “Q prime”) at the higher Pʹ in Figure 3.15 and producers will not be willing to sell more than Qʹ in Figure 3.16 at the lower Pʹ.

In Figure 3.15 the price is higher than P*. At that higher price, though producers will want to sell many more than the previous equilibrium quantity, consumers will want to buy fewer. Unless the consumers are compelled to buy things they do not want, they will buy only Qʹ.

Given that, we can find the consumer and producer surplus in this market and compare it to what it was in Figure 3.14. The area under the demand curve represents the value to the consumer of Qʹ goods and this is OAEQʹ. The price Pʹ times the quantity Qʹ is the amount of money consumers will pay to get Qʹ, and this is represented by the area OPʹEQʹ. The difference

deadweight loss The loss in societal welfare associated with production being too little or too great.

gue46399_ch03_040-055.indd 51 16/03/17 11:38 AM

52 Chapter 3 The Concept of Elasticity and Consumer and Producer Surplus

O

Demand

Supply A

B

P *

Pʹ

C

F

E

Q*Qʹ

P

Q/t

FIGURE 3.15 Deadweight loss with a price higher than P*.

O

Demand

Supply A

B

P *

Pʹ

C

F

E

Q*Qʹ

P

Q/t

FIGURE 3.16 Deadweight loss with a price lower than P*.

between these, PʹAE, is the consumer surplus. It costs the producer OBFQʹ in terms of variable costs to make these goods. The difference between the money consumers pay them and their costs, BPʹEF, is the producer surplus. The sum of consumer and producer surplus in this case is BAEF, but this is less than ABC, which is what this sum was in Figure 3.14. This means that the area FEC is lost as a result of being at Pʹ instead of P*, and this is what economists call the deadweight loss of being at Pʹ instead of P*.

In Figure 3.16 the price is lower than P*. At that lower price, though, producers will not want to sell as much as they did at the previous equilibrium and consumers will want to buy more. Unless producers are compelled to sell things they do not want to sell, they will produce only Qʹ. Again we can find the consumer and producer surplus in this market and compare it to what it was in Figure 3.14. The area under the demand curve still represents the value to the consumer of Qʹ goods and is still OAEQʹ. The price Pʹ times the quantity Qʹ is still the amount of money consumers will pay to get Qʹ, but this is now represented by the area OPʹFQʹ. The difference between these, the consumer surplus, is now PʹAEF. Whereas the costs of the producer, OBFQʹ, remain the same, the revenue has fallen so the producer surplus falls to BPʹF. The sum of consumer and producer surplus in this case is also BAEF, and this is still less than it was in Figure 3.14. The deadweight loss is again represented by the area FEC.

This chapter expanded on the supply and demand model by showing the importance of the responsiveness of quantity to changes in price and how the model can be used to show that market exchange results in mutually beneficial results for consumers and producers.

In discussing elasticity we began by introducing the formula, defining the terms elastic and inelastic, and exploring why demand for some goods may be elastic while others may be inelastic. We then considered how elasticity of demand is determined by the number of close substitutes and the time available to generate them.

To conclude the chapter, we discussed how we could use the supply and demand model to show that consumers and producers each benefit from a market transaction, and we showed how to measure the benefit each gets by defining consumer and producer surplus. Finally, we showed how we measure the inefficiency of being away from equilibrium by defining and illustrating the concept of deadweight loss.

Summary

gue46399_ch03_040-055.indd 52 16/03/17 11:38 AM

Summary 53

Key Terms congestible public good consumer surplus cross-price elasticity of

demand deadweight loss elastic elasticity excludable public good

exclusivity income elasticity of demand inelastic market failure network good perfectly elastic perfectly inelastic price elasticity of demand

price elasticity of supply

producer surplus purely private good purely public good rivalry total expenditure rule unitary elastic

1. The elasticity of demand is related to the slope of the demand curve a. and only the slope of the demand curve. b. but also the (price, quantity) position on the demand curve. c. but also the slope of the supply curve. d. and whether the good is normal or inferior.

2. Suppose a firm cannot figure out whether the demand for the good it sells is elastic or inelastic but discovers that every time it raises its price, its total revenue declines. Their a. demand is unit elastic. b. demand is elastic. c. demand is inelastic. d. demand is perfectly inelastic.

3. Suppose you observe that minor changes in supply seem to cause dramatic changes in price. You would conclude that a. demand is unit elastic. b. demand is elastic. c. demand is inelastic. d. demand is perfectly inelastic.

4. The fact that the demand for eggs is inelastic should not surprise you because a. they are a very cheap food. b. the demand for nearly all food products is inelastic. c. the supply of eggs is inelastic. d. they are so expensive.

5. Combined, the consumer surplus and producer surplus at equilibrium is a. lower than it would be at prices below equilibrium. b. lower than it would be at prices above equilibrium. c. typically negative. d. as big as it can get.

6. If supply and demand are lines, then at equilibrium both consumer and producer sur- plus are a. equal. b. shown as squares.

Quiz Yourself

Issues Chapters You Are Ready for Now

International Trade: Does It Jeopardize American Jobs?

The Line between Legal and Illegal Goods

Health Care Government-Provided

Health Insurance Farm Policy

Minimum Wage

gue46399_ch03_040-055.indd 53 16/03/17 11:38 AM

54 Chapter 3 The Concept of Elasticity and Consumer and Producer Surplus

c. shown as trapezoids. d. shown as triangles.

7. When looking at the impact of a change in trade policy, economists use consumer and producer surplus to look at the winners and losers. Free-trade economists insist that a. no one loses. b. everyone loses. c. there are winners and losers but that the gain to the winners is greater than the loss to

the losers. d. there are winners and losers but that the loss to the losers is greater than the gain to

the winners. 8. When a satellite television company gains a subscriber, there is no impact on existing

subscribers. That is, there is no rivalry in the consumption for their service. This is an example of a a. purely private good. b. purely public good. c. congestible public good. d. excludable public good.

9. Policy makers have considered putting computer chips in cars that would allow tax col- lectors to charge people on the basis of how often they drive during rush hours. These policy makers are dealing with the fact that public roads are a. purely private goods. b. purely public goods. c. congestible public goods. d. excludable public goods.

Short Answer Questions

1. Give an example of a good that you believe has perfectly inelastic demand for most people. Then explain why you believe that is the case.

2. Give an example of a good that you believe has inelastic demand (not perfectly inelastic) for most people. Then explain why you believe that is the case.

3. Give an example of something you hate to do, and imagine that you could pay someone else to do that thing for you. Explain why both you and the person you pay could end up better off.

4. Give an example of a situation where the government compels you to do something you do not want to do. Why might that be a reasonable requirement? When might it be unreasonable?

5. Suppose you hear the following: “They just increased taxes on cigarettes and on high- priced cigars.” Use the concept of elasticity to describe who will be hurt by those taxes. Is a change in the price of the good itself a change in the quantity supplied?

Think about This Suppose both gasoline supply and demand are highly inelastic. Knowing that a change in the expected price of gasoline will shift both supply and demand, explain how these combined facts can lead you to an understanding of wildly changing gasoline prices.

Talk about This Talk about your alternative choices for colleges. What schools did you consider? Was tuition a consideration? Does your college’s proximity to other schools imply anything about your school’s ability to raise revenue by raising tuition?

gue46399_ch03_040-055.indd 54 16/03/17 11:38 AM

Summary 55

Behind the Numbers Hirschman, Ira, Claire McKnight, and John Pucher, “Highway and Bridge Toll Elasticities,” Transportation 22 (May 1995). Food Demand and Nutrient Elasticities, www.ers.usda.gov/publications/tb1887/tb1887.pdf Schaller, Bruce, “Transportation Elasticities,” Transportation 26 (1999), pp. 283–297. Gasoline Elasticities: Hughes, Jonathan E., Christopher R. Knittel, and Daniel Sperling. Evidence of a Shift in the Short-Run Price Elasticity of Gasoline Demand (September 5, 2006). Available at SSRN: http://www.nber.org/papers/w12530

gue46399_ch03_040-055.indd 55 16/03/17 11:38 AM

56

C H A P T E R F O U R

Firm Production, Cost, and Revenue Learning Objectives

After reading this chapter you should be able to:

LO1 Demonstrate the relationship between produc- tion and costs and the relationship between sales and revenues.

LO2 Explain that models of production are based on the assumption that firms seek to maximize profit.

LO3 Demonstrate how profit maximization dictates that firms set production so that marginal cost equals marginal revenue.

Chapter Outline

Production

Costs

Revenue

Maximizing Profit

Summary

The business of business is making money, and the money business makes is called profit. How it makes that profit is by selling its goods for more than it costs to make them. For this chapter (and for most of this book) we make the simplifying assumption that nothing influ- ences business other than maximizing profit. Although this is an exaggeration, it is reasonably close to the truth, and accepting it as the truth simplifies our task considerably. Nothing about this chapter is simple, but you may be comforted by the knowledge that it could be more com- plicated (of course you may not be).

With the simplifying assumption of myopic profit maximization in place, we can break things down into the cost side and the revenue side. Cost is the expense that businesses must incur to produce goods for sale. Revenue is the money that comes into the firm from the sale of the goods.

It is important to understand why economists focus on costs that are incurred rather than simply those costs that must be paid. Accountants focus only on expenses that must be paid for a business to produce, but economists also consider the opportunity cost of choices. To fully understand the concepts of economic cost and accounting cost, consider an upstart business whose owner quits a $50,000 a year job and cashes in a $100,000 CD (earning 6 percent) to get it off the ground. An accountant would not consider the $50,000 of forgone job-related income or the $6,000 per year in forgone interest as costs of the business. An economist would. For the remainder of this chapter and all of the next, all costs refer to economic costs.

profit The money that a firm makes: revenue – cost.

cost The expense that must be incurred to produce goods and services for sale.

revenue The money that comes into the firm from the sale of goods and services.

economic cost All costs of a business: those that must be paid as well as those incurred in the form of forgone opportunities.

accounting cost Only those costs that must be explicitly paid by the owner of a business.

gue46399_ch04_056-067.indd 56 16/03/17 11:39 AM

Production 57

With that said, since profit is the difference between revenues and costs, we will be able to use what we have developed in these areas to find how much production our profit-maximizing firm will choose. We then explore the production process and the costs that it generates, move on to discuss the revenue side, and then put the two together to show how, under different cir- cumstances, firms choose their production levels. To pull all that off, we carry one example from the beginning of this explication to the end. Let’s assume that the industry we are talking about is the computer memory industry, the industry that makes the chips that enable com- puters to use and quickly access information. Let’s suppose that the production of computer memory requires three things: expensive machines, highly trained people, and very inexpensive plastic and metal from which the chips are made. To make things even easier, let’s assume that the plastic and metal used to make the chips are free.

So far we have had a section entitled “Kick It Up a Notch” in every chapter. The problem with this chapter is that material presented is already “kicked up” plenty. Complicating mat- ters further, some students need a verbal explanation, some need to “see” it in the form of a graph, while still others can only get their arms around a concrete numerical example. To deal with that, we go through each of them once using just words, once using graphical explana- tion, and then again with a numerical example.

Production

Just Words To get a handle on costs we need to know how much money it takes to produce goods. First we need to know what resources are necessary for production. Then we can construct an input– output relationship called a production function, and we will do this in the form of a graph. Our graph will show how many resources we need to produce various amounts of output. From that production function we can find out how much various amounts of production cost. From this resulting cost function we will be able to figure out how much each one costs on average and how much each additional one costs.

Of course, this is putting the cart before the horse. Before the firm decides how many to produce, it has to decide what to produce. In our example, the memory chip firm did not decide to make chips for the fun of it. Early computer designers decided that their computers would work better if they had a short-term place to store and quickly retrieve information. Chip-making companies came into existence to provide the computer industry with the parts to make short-term storage of data possible. For the remainder of this section and this chapter we assume that the firm is up and running and is simply trying to figure out how many chips to make at any given time.

To make any product, you typically have fixed and variable inputs. That is, you have resources that you cannot change and resources that you can. In our example, the plant and the equipment in the plant are called fixed inputs because they are not easily changed, added to, or subtracted from. On the other hand, the person power to operate those machines is eas- ily changed. You can hire and fire more easily and quickly than you can replace a machine. People and other resources that can be easily changed are called variable inputs.

The first step in our process of figuring out how many memory chips to make is to map out how many resources are needed to produce various numbers of these chips. Of course, without any personnel there is no production. If there are only a few workers, as at point B in Figure 4.1, production is not very great because workers are not able to specialize in particular parts of the production process. They waste time moving from one part of the process to another, and they take time to build momentum, working at each stage of production only to find that when they get good at it, it is time to move on to another stage.

production function A graph that shows how many resources are needed to produce vari- ous amounts of output.

cost function A graph that shows how much various amounts of production cost.

fixed inputs Resources that do not change.

variable inputs Resources that can be easily changed.

gue46399_ch04_056-067.indd 57 16/03/17 11:39 AM

58 Chapter 4 Firm Production, Cost, and Revenue

The addition of a few more workers solves that problem and production levels increase greatly. Workers divide the tasks in such a way that each can build momentum and does not have to switch jobs. This specialization is called the division of labor, and its impact is such that for a small increase in labor we can get a dramatic increase in output.

At some point, though, there are enough workers to get the job done, as at point D, and more workers do not add much to production. Some jobs, too, just cannot be easily divided. Although it is usually the case that having more workers increases output, workers find that the existing plant and equipment are too limiting for them to get the most out of new employees. As a result, output increases but not as fast as it had before. This phenomenon, referred to by economists as diminishing returns, is a central assumption of this chapter as well as the next.

Graphical Explanation Using the same ideas just presented, let’s walk through Figure 4.1. Point A begins at the origin because, as was pointed out in the preceding section, if you have no workers you have no out- put. Where there are too few workers to staff the plant, they have to waste time moving from one stage of production to the next, so the increase in production associated with the first group of workers is relatively low. That gives us point B. The curve is bowed to the right between points A and C because of the division of labor. That is, as you add the same number of workers, you get the benefits from those workers specializing and production increases at an increasing rate. Once you get to point C, though, there is not enough plant and equipment to accommodate more workers efficiently. The curve is then bowed to the left because of diminishing returns to the existing plant and equipment.

Numerical Example Now, let’s consider the same concept using the numbers that comprise Table 4.1. Continuing with the memory chips example, suppose the first column represents the groups of workers, the second column represents the total output produced, and the third column represents the extra output added with the inclusion of the group. Because memory chips cannot make them- selves, zero labor corresponds to zero output. Suppose that the first group of workers hired initially produces 100 units, but when a second group is added a total of 317 units is produced. That is, the second group adds 217 units to production. Suppose the third group adds some- what less, 183 units, so that the total becomes 500. If it takes 5 groups of workers to produce

division of labor Workers divide the tasks in such a way that each can build momen- tum and not have to switch jobs.

diminishing returns The notion that there exists a point where, because there are some fixed inputs like plant and equipment, the addition of resources increases production, but does so at a decreasing rate.

FIGURE 4.1 A production function.

Workers

O u

tp u

t

Production function

D

C

A

B

Labor Total Output

Extra Output of the Group

0 0 1 100 100 2 317 217 3 500 183 4 610 110 5 700 90 6 770 70 7 830 60 8 870 40 9 900 30 13 1,000

TABLE 4.1 Numerical example: production function.

gue46399_ch04_056-067.indd 58 16/03/17 11:39 AM

Costs 59

700, 9 to produce 900, and 13 to produce 1,000, then we have a story similar to what we saw in the graphical explanation. That is, as we added workers we got more production. The first group of workers was not very efficient because they could not specialize, whereas the second group was efficient because they could. In each case as more groups were added, efficiency waned because the workers were limited by the existing plant and equipment.

We have now explained production in terms of how a varying number of workers can be combined with a fixed amount of plant and equipment to make computer memory chips. We work next on how much it costs to hire those workers and pay for that machinery.

Costs

Just Words Once we know how many workers it takes to produce our memory chips, we can find out how much it costs to make those chips. The first thing to consider is that there are costs of production that we cannot change. In our example these fixed costs are the costs of the plant and equipment that we own. Costs that we can change, like the number of workers we hire for our plant, are called variable costs. The task now is to compare the number of memory chips we make against the costs of making those chips.

To accomplish this we need four cost concepts: marginal cost, average total cost, average variable cost, and average fixed cost.

Marginal cost (MC) is the increase in cost associated with a one-unit increase in produc- tion. Because total cost always rises, marginal cost is always positive. Because total cost rises quickly at low levels of output, marginal cost is high at low levels of output; however, total cost rises much more slowly at moderate levels of output, so marginal cost is much lower there. Last, because a rapid rise in total cost resumes at high levels of output, marginal cost is high in this range. Thus marginal cost starts high, decreases for a while, and then increases again.

Average total cost (ATC) is the per unit cost of production. Because this includes fixed cost, which can be very high, average total cost will be high at low levels of production. It will shrink as production gets more efficient and the fixed costs become spread over greater levels of output. As production rises to higher levels where marginal costs are increasing, these two effects will begin to counteract each other and the drop in average total costs will slow. Even- tually the increases in marginal cost will overwhelm the effect of spreading fixed costs over higher levels of output and average total cost will rise again.

The average variable cost (AVC) is dictated by the same changes in efficiency that gave us the marginal cost curve. Because it is an average, however, the movements are dampened; the highs are not as high and the lows are not as low.

Average fixed cost (AFC) falls continuously because the fixed costs of production are being spread over greater and greater levels of production. In addition, graphically, average fixed cost is the vertical distance between average total cost and average variable cost.

These cost concepts serve as the basis for much of what follows in this chapter, the next one, and our subsequent study of issues.

Looking back at Figure 4.1, you can see that at point A we will not have to pay anything to our workers (because we have no workers to pay), but we still have to pay fixed costs. As a result, point A in Figure 4.1 corresponds to point A in Figure 4.2. We have workers at point B whom we have to pay, and they are not all that productive. Remember that this is not their fault, because there are too few of them to allow specialization. Point B in Figure 4.2 is therefore higher than point A (because we have to pay them) but not much farther to the right (because they are not making that many chips).

fixed costs Costs of production that cannot be changed.

variable costs Costs of production that can be changed.

marginal cost (MC) The addition to cost as- sociated with one addi- tional unit of output.

average total cost (ATC) Total cost divided by output, the cost per unit of production.

average variable cost (AVC) Total variable cost divided by output, the average variable cost per unit of production.

average fixed cost (AFC) Total fixed cost divided by output, the average fixed cost per unit of production.

gue46399_ch04_056-067.indd 59 16/03/17 11:39 AM

60 Chapter 4 Firm Production, Cost, and Revenue

Point C in Figure 4.1 indicates that the workers were quite productive; so for the same amount of an increase in our costs we see a significant increase in production. Thus, point C in Figure  4.2 is also higher than point B but is significantly farther to the right. Point D in Figure  4.1 shows us where extra workers did not add much to production. Again they cost money, so point D in Figure 4.2 is higher than point C, but is not that much farther to the right. Connecting these points, we have a total cost function. Our graph shows how the function helps us understand and make decisions about the cost of production and the amount produced.

Thus far we have focused on finding the total cost of producing various amounts of output. When we get total revenue, we will be able to find the profit. Before we go there, though, we are going to need four other cost functions: marginal cost, the average variable cost, the average fixed cost, and the average total cost. In higher-level economics courses, students are required to derive these other cost functions from the total cost function. When you derive one function from another, you graphically manipulate the parent function (in this case total cost) to draw its descendants (in this case marginal cost, average variable cost, and average total cost).

Numerical Example Again we are dealing with concepts that may be easier to comprehend when there are numbers attached. Following the numerical example used in Table 4.1, consider Table 4.2 (on the next page). The first column represents output. The second, Total Variable Cost, is based on the $2,500 per unit of labor from Table 4.1 that is required to produce that output. The third, Total Fixed Cost, is the cost of plant and equipment and is unchanging. The fourth, Total Cost, is the sum of total variable cost and total fixed cost. The fifth, Marginal Cost, is the increase in total cost from each level of production. The sixth, Average Total Cost, is the per unit cost; the seventh, Average Variable Cost, is per unit variable cost; and the eighth, Average Fixed Cost, is per unit fixed cost.

These derivations take economics majors several class periods to understand. We’ll skip that but outline why Figure 4.3 looks the way it does. Starting with the easiest one, average fixed cost, it is constantly decreasing because the same costs are being spread over more and more output. Marginal cost, average total cost, and average variable cost all start high, decrease, and then increase. The manner in which they do that, though, is somewhat complicated.

Marginal cost is the increase in costs associated with a one-unit increase in production. That means it is the “rise over the run” in the total cost curve, which means it is the slope of the total cost curve. You can see in Figure 4.2 that total cost rises rapidly at the beginning, flattens out, and then rises rapidly again.

FIGURE 4.2 Total cost function.

To ta

l c o

st

Output

Total cost function

D

C

A

B

P

FIGURE 4.3 Marginal cost, average total cost, and average variable cost.

AFC

AVC

ATC

MC

P

Q/t

gue46399_ch04_056-067.indd 60 16/03/17 11:39 AM

Costs 61

Average total cost and average variable cost are both U-shaped because they start high and decrease. The difference between the two curves is average fixed costs. Because average fixed cost diminishes as production increases, the gap between the two curves diminishes. They are both cut from below by the marginal cost curve at their respective minimums. This happens when, because of diminishing returns, marginal costs increase to the point where, first, aver- age variable cost, then average total cost, starts to rise as well.

TABLE 4.2 Numerical example: cost functions.

Output

Total Variable Cost

Total Fixed Cost

Total Cost

Marginal Cost*

Average Total Cost

Average Variable Cost

Average Fixed Cost

0     0 8,500 8,500 100 2,500 8,500 11,000 25 110 25 85 200 3,800 8,500 12,300 13 62 19 43 300 4,800 8,500 13,300 10 44 16 28 400 6,000 8,500 14,500 12 36 15 21 500 7,500 8,500 16,000 15 32 15 17 600 9,500 8,500 18,000 20 30 16 14 700 12,500 8,500 21,000 30 30 18 12 800 17,000 8,500 25,500 45 32 21 10.6 900 22,500 8,500 31,000 55 34 25 9.4 1,000 32,500 8,500 41,000 100 41 32.5 8.5

*Change in total cost/change in output.

TABLE 4.2 Numerical example: cost functions.

Output

Total Variable Cost

Total Fixed Cost

Total Cost

Marginal Cost*

Average Total Cost

Average Variable Cost

Average Fixed Cost

0     0 8,500 8,500 100 2,500 8,500 11,000 25 110 25 85 200 3,800 8,500 12,300 13 62 19 43 300 4,800 8,500 13,300 10 44 16 28 400 6,000 8,500 14,500 12 36 15 21 500 7,500 8,500 16,000 15 32 15 17 600 9,500 8,500 18,000 20 30 16 14 700 12,500 8,500 21,000 30 30 18 12 800 17,000 8,500 25,500 45 32 21 10.6 900 22,500 8,500 31,000 55 34 25 9.4 1,000 32,500 8,500 41,000 100 41 32.5 8.5

*Change in total cost/change in output.

If you are inclined to replicate Figure 4.3 yourself (or are required to in your course) try the following:

1. Draw a sweeping check-shaped MC curve.

2. Draw a symmetrical U-shaped AVC curve that bottoms out on MC.

3. Draw an asymmetrical U-shaped ATC curve that also bottoms out on MC (a bit higher than the AVC curve bottoms out) where the vertical distance between ATC and AVC is longer on the left than it is on the right side of the diagram. (For the mathematically inclined among you, this is what you get if you have a cubic total cost function.)

D R A W I N G T H E A T C - A V C - M C D I A G R A M

MC

Step 1

P

Q

Step 2

AVC

MC

P

Q

Step 3

AVC

ATC

MC

P

Q

gue46399_ch04_056-067.indd 61 16/03/17 11:39 AM

62 Chapter 4 Firm Production, Cost, and Revenue

To see how each column in Table 4.2 is computed, let’s look at a production increase from 400 to 500. The variable costs associated with producing 400 are $6,000. Variable costs rise to $7,500 when output rises to 500. Fixed costs are $8,500 in both cases. That means that total cost is $14,500 ($6,000 + $8,500) for 400 and rises to $16,000 ($7,500 + $8,500) for 500. The increased cost for the increase of 100 units is $1,500, so each one increased cost by $15, so marginal cost is $15. Average total cost for 400 units is $36 ($14,500/400) and $32 ($16,000/500) for 500 units. The average fixed cost is $21 ($8,500/400) for 400 units and $17 ($8,500/500) for 500 units.

If you plot the last four columns against output, you will see that the curve for marginal cost is indeed check-shaped, that those for average total cost and average variable cost are both U-shaped, and that average fixed cost decreases steadily. You can also see that at 300 units of output marginal cost is at its minimum. Further, you can see that the curve depicting marginal cost cuts average variable cost at its minimum (at 500 units of out- put) and that the marginal cost curve cuts the average total cost curve at its minimum (at 700 units of output).

Revenue

Just Words The other side of any production decision is the amount of money that will come in from the sale of the goods. To get a handle on this revenue side we will need to know whether the business has competition and, if so, how much. For instance, if a business faces many other competitors that produce goods like the ones it produces, its behavior will be different from what it would be if it had the market to itself.

In some industries, like agriculture, the price that the firm receives remains unchanged regardless of how much it has to sell. In other industries, like those that supply electric power, the amount sold affects the price. To explore this difference let’s first assume our memory chip maker is one of many chip makers. Then we will see what happens when we assume that it is the only one.

If our chip-making firm has many competitors, the price is set in a market that it cannot control. The supply of and the demand for chips determine how much the firm can charge for its chips. To see the futility of trying to set its own price, imagine that it tried to have a price higher than the market price. If it did, computer makers could and would buy all their chips from our firm’s competitors. The firm could, of course, set a price lower than the market price. If it did, it would get to sell all it produced. On the other hand, it could do that at the market price. Because our firm wants to maximize profit and because it can always sell as much as it wants at or below the market price, it will always want to charge the market price.

Figure 4.4 shows how the market generates the price for the firm. This price also hap- pens to be the additional revenue the firm receives from the sale of each unit. To see why this marginal revenue (MR) is the same as the price, consider a thought experiment. If the market price is 5, how much will revenue be if our firm sells one? Answer: 5. How much will revenue be if it sells two? Answer: 10. The increase in revenue associated with any sale is therefore 5. This is true whether you let the price be 5, 10, or 600; the price is the marginal revenue.

If, on the other hand, we are the only ones selling computer chips, computer makers have to buy their memory chips from our firm. This situation is quite different from the case where there were many competitors. Instead of just taking a price given to it by the market, it is setting the price. Instead of being a small, insignificant part of the market, it is the market.

marginal revenue (MR) Additional revenue the firm receives from the sale of each unit.

gue46399_ch04_056-067.indd 62 16/03/17 11:39 AM

Revenue 63

TABLE 4.4 Numerical example: revenue when there are no competitors.

Q Price TR MR*

0 75 0 100 70 7,000 70 200 65 13,000 60 300 60 18,000 50 400 55 22,000 40 500 50 25,000 30 600 45 27,000 20 700 40 28,000 10 800 35 28,000 0 900 30 27,000 –10

1,000 25 25,000 –20

*Change in total revenue/change in output.

Unfortunately, to sell more, the firm has no recourse other than lowering the price it charges. For instance, if it is currently selling 1 million chips a week and it wants to increase its sales to 2 million a week, it must lower the price to everyone, even those who would have bought 1 million at the higher price. This means that in Figure 4.5 the marginal revenue is not graphed with a flat line; it falls as we increase sales.

Numerical Example Using the same numerical example that we have been using, suppose that our firm is one of many and has no control over price. Suppose further that the price in the market for memory is $45 per unit. This means that the total revenue (TR) increases by $45 for each unit sold and the marginal revenue is thus $45 for each unit sold. This is illustrated in Table 4.3.

If there are no competitors, then the market demand for memory is simply the demand for our firm’s memory. This means that our firm must lower its price to induce consumers to buy more memory. Another way of looking at precisely the same thing is to notice that a firm without competition can force the price higher by restricting its output. As before, total rev- enue is price times quantity, but because price does not remain the same, the marginal revenue falls. This is illustrated in Table 4.4.

P* P* = Marginal revenue

Output

Market for memory

Output

Our firm

P P S

D

FIGURE 4.4 Setting the price when there are many competitors.

P

MR

Output

D

Market for memory

FIGURE 4.5 Marginal revenue when we have no competitors.

TABLE 4.3 Numerical example: revenue when there are many competitors.

Q Price TR MR*

0 45 0 100 45 4,500 45 200 45 9,000 45 300 45 13,500 45 400 45 18,000 45 500 45 22,500 45 600 45 27,000 45 700 45 31,500 45 800 45 36,000 45 900 45 40,500 45

1,000 45 45,000 45

*Change in total revenue/change in output.

gue46399_ch04_056-067.indd 63 16/03/17 11:39 AM

64 Chapter 4 Firm Production, Cost, and Revenue

Maximizing Profit

Graphical Explanation As mentioned, the level of output for the business that will maximize profit very much depends on whether the business is in perfect competition—that is, one of many producing the same thing—or is a monopoly—that is, it has no competitors. Regardless of whether it has many competitors or it has the market to itself, we assume firms produce and sell the amount that will make them the most money possible. In economic terms this ends up mean- ing that every firm should produce an amount such that marginal revenue equals marginal cost (MR = MC). Recall the Chapter 1 concept of marginal analysis; this is our first oppor- tunity to see it at work.

This is not as difficult as it seems. Remember that marginal revenue is the amount the firm brings in from selling one more, and the marginal cost is the amount of money that it costs to produce one more. To illustrate, suppose you start by selling a fixed number, say, 10. If you sell an eleventh and you make money on that sale (MR > MC), you should do it again and sell at least one more. If you sell an eleventh and you lose money on that sale (MR < MC), you should reduce sales by at least one. Since marginal revenue is less than marginal cost for the eleventh chip, you should not have produced it. To maximize profit you could repeat this one-by-one process until you have found the production that makes the most money. On the other hand, you now know that it is only when marginal cost equals marginal revenue that you have exhausted the profit potential on the good you are trying to sell.

Of course it is possible that our entire business is a loser. In the age of word processors and cheap personal computers, the manual typewriter business would be a loser even if ours were the only firm in this industry. The exception to the rule that a firm should produce where marginal cost equals marginal revenue occurs when the best alternative is to do noth- ing; that is, sometimes the best decision is to shut down the business. This occurs when the amount that you sell a good for is not enough to cover the variable costs that went into the production of the good. The firm should shut down if the price is less than the average variable cost (P < AVC).

Numerical Example To illustrate profit maximization when there are many competitors, we need to combine the information in Tables 4.1 and 4.3; when there are no competitors, we need to combine the information in Tables 4.3 and 4.4. In either case we need to pick a quantity to maximize profit. This is done where marginal cost equals marginal revenue. Table 4.5 illustrates this for the case where there are many competitors, and Table 4.6 does it for the case where there are no competitors. In Table 4.5 we see that the firm that has many competitors has its profit

perfect competition A situation in a market where there are many firms producing the same good.

monopoly A situation in a market where there is only one firm producing the good.

A firm should produce an amount such that marginal revenue equals marginal cost (MR = MC).

A firm should shut down if the price is less than the average variable cost (P < AVC) at the quantity where mar- ginal revenue equals marginal cost.

T H E R U L E S O F P R O D U C T I O N

gue46399_ch04_056-067.indd 64 16/03/17 11:39 AM

Summary 65

maximized at $10,500, and this happens when the firm produces 800.1 In Table 4.6 we see that the firm that has no competitors has its profit maximized at $9,000, and this happens when it produces 600.

Q Price TR TC MR MC Profit

0 45 0 8,500 0 0 −8,500 100 45 4,500 11,000 45 25 −6,500 200 45 9,000 12,300 45 13 −3,300 300 45 13,500 13,300 45 10 200 400 45 18,000 14,500 45 12 3,500 500 45 22,500 16,000 45 15 6,500 600 45 27,000 18,000 45 20 9,000 700 45 31,500 21,000 45 30 10,500 800 45 36,000 25,500 45 45 10,500 900 45 40,500 31,000 45 55 9,500 1,000 45 45,000 41,000 45 100 4,000

TABLE 4.5 Numerical example: profit maximization when there are many competitors.

Q Price TR TC MR MC Profit

0 75 0 8,500 0 0 −8,500 100 70 7,000 11,000 70 25 −4,000 200 65 13,000 12,300 60 13 700 300 60 18,000 13,300 50 10 4,700 400 55 22,000 14,500 40 12 7,500 500 50 25,000 16,000 30 15 9,000 600 45 27,000 18,000 20 20 9,000 700 40 28,000 21,000 10 30 7,000 800 35 28,000 25,500 0 45 2,500 900 30 27,000 31,000 −10 55 −4,000 1,000 25 25,000 41,000 −20 100 −16,000

TABLE 4.6 Numerical example: profit maximization when there are no competitors.

Key Terms accounting cost average fixed cost (AFC) average total cost (ATC) average variable cost (AVC) cost cost function diminishing returns

division of labor economic cost fixed costs fixed inputs marginal cost (MC) marginal revenue (MR) monopoly

perfect competition production function profit revenue variable costs variable inputs

This chapter has illustrated production, costs, revenues, and profit maximization. For each concept and relationship, we considered both graphical explanations and numerical examples. We assumed that businesses choose production to maximize profit and that, as a result, they set it where marginal cost equals marginal revenue.

Summary

1In the next chapter we will see that firms with many competitors see their profits disappear because new firms enter, thereby increasing market supply and lowering the price.

gue46399_ch04_056-067.indd 65 16/03/17 11:39 AM

66 Chapter 4 Firm Production, Cost, and Revenue

1. When firms add workers and get more efficient, they are benefiting from a. the division of labor. b. diminishing returns. c. the law of large numbers. d. diminishing marginal utility.

2. When firms add workers and find that the additional workers add less to output than their predecessors did, they are experiencing a. the division of labor. b. diminishing returns. c. the law of large numbers. d. diminishing marginal utility.

3. Suppose a firm has $1,000,000 in fixed costs and variable costs equal to $100; for every unit they produce, a. their marginal costs are decreasing. b. their fixed costs are decreasing. c. their average costs are decreasing. d. the marginal costs are increasing.

4. The average total cost curve will be cut by the marginal cost curve from below as long as a. fixed costs are rising. b. average costs are decreasing. c. marginal costs eventually increase. d. marginal costs continually decrease.

5. Whether marginal revenue is constant or decreasing depends on a. whether the firm is benefiting from the division of labor. b. whether the firm is dealing with diminishing returns. c. how much the firm sells. d. whether the firm faces competition.

6. When a firm chooses to shut down, it is a. making a poor decision because it should always produce where marginal cost equals

marginal revenue. b. making a poor decision because it should always produce where average costs exceed

average revenue. c. making a good decision as long as the price it is getting is less than its average costs. d. making a good decision as long as the price it is getting is less than its average

variable costs. 7. The result that a firm should produce where MC = MR except when the shutdown con-

dition is met is based on the assumption that it is attempting to a. maximize profit. b. maximize market share. c. minimize marginal costs. d. minimize average costs.

Quiz Yourself

1. What key assumption for perfect competition would lead you to believe that fast food is not a perfectly competitive industry? Explain why.

2. Suppose your favorite sports team is losing by an insurmountable score. What does the shutdown condition suggest the team should do? Explain why.

Short Answer Questions

gue46399_ch04_056-067.indd 66 16/03/17 11:39 AM

Summary 67

3. Does raising the price always increase revenue for the firm raising the price? 4. If your college leadership sought your advice on setting tuition, why would it matter if

your college was the only college for miles?

Think about This Why is it that when a firm has no competition it typically must lower the price to all consum- ers in order to sell more? What would have to happen for it to be able to lower the price only to new consumers?

Talk about This We assume that the price to all consumers is the same. List the cases where the price to one person is different from the price to another. Why might a firm do this?

gue46399_ch04_056-067.indd 67 16/03/17 11:39 AM

68

C H A P T E R F I V E

Perfect Competition, Monopoly, and Economic versus Normal Profit Learning Objectives

After reading this chapter you should be able to:

LO1 Distinguish between perfect competition and monopoly and between normal and economic profit.

LO2 Demonstrate and explain why economic profit disappears under perfect competition but not under monopoly.

LO3 Illustrate why, under perfect competition, the supply curve from Chapter 2 is marginal cost.

Chapter Outline

From Perfect Competition to Monopoly

Supply under Perfect Competition

Summary

This chapter builds on Chapter 4 to describe firms in different competitive situations; it shows why, when there are many firms competing against one another, substantial profits are unsus- tainable; and it concludes by demonstrating why the supply curve from Chapter 2 was upward sloping.

Some firms, such as family farms, are among millions of firms in an industry, whereas other firms completely dominate their industry. In the middle of this continuum are numer- ous firms with definable sets of competitors. Some industries lend themselves to many competitors while others lend themselves to only a few; we explore examples along this continuum.

In Chapter 4 we operated under the assumption that firms were out to maximize profits. What we want to do now is to determine how well various-sized firms will manage. For instance, we may want to know why it is that family farmers cannot seem to make consis- tently high profits, whereas Microsoft can. We approach this by separating profit into two categories: the profit that is necessary for firms to stay in business and the profit that is above that level.

Last, we see that the supply curve laid out in Chapter 2 was indeed upward sloping for a reason. We will show that under perfect competition, an upward-sloping supply curve stems from the check-shaped marginal cost curve from Chapter 4.

gue46399_ch05_068-078.indd 68 16/03/17 11:39 AM

From Perfect Competition to Monopoly 69

From Perfect Competition to Monopoly

As we discussed in Chapter 4, the shape of the marginal revenue curve depends on whether there are many competitors or no competitors. Figure 5.1 lays out these extreme cases. On the left, the cost curves from Figure 4.3 are applied to the marginal revenue curve from the case where there are many competitors. On the right, we see the same for the case where there are no competitors. The amount they pick in each case is labeled Q*. The price they charge is labeled P*.

Perfect Competition The key difference between the cases just outlined is the number of competitors. When the number of competitors is large, the firm (e.g., a dairy farm) simply has to take the market price as given but can sell as many goods as it wants at that price. When there are no competitors, the firm (e.g., Microsoft) can set any price it wants but can sell only the number that consumers want to buy at that price. Of course, not every firm is faced with the stark either–or difference. Some firms (e.g., Exxon) have only a few competitors in markets of similar or identical prod- ucts, and other firms (e.g., McDonald’s) have many competitors in markets where each has its own signature brand.

When a firm faces a large number of competitors, such that no one firm can influence the price, when the good a firm sells is indistinguishable from those its competitor sells, when firms have good sales and cost forecasts, and when there is no legal or economic barrier to its entry into or exit from the market, then we have what economists call perfect competition. This may seem like an odd name given that the best examples of it are of sellers that do not really “compete” in the way noneconomists normally think of “competition.” Whether it is Midwestern grain farmers; Western ranchers; Florida or California vegetable growers; Wis- consin, New York, or California dairy operations; or Georgia peach growers, the common conception of competition does not seem to apply. As individuals, they do not advertise. A conversation with any of these farmers would reveal that their best friends are their neighbor farmers. When one farm’s equipment breaks down or a farmer has a significant health crisis at a critical planting or harvesting time, the neighborhood farmers come to help. That sounds more like cooperation than competition. So why do economists call this “perfect competition” when there does not seem to be any true competition? The reason this is “perfect” goes back to the first characteristic of perfect competition: No one firm has any control over price. No farmers, or any farm product, have any control over the price of their produce when they sell it on the wholesale market.1

P

QQ*

P* P* = MR

ATC AVC

MC

Many competitors

QQ*

P*

P

MR Demand

No competitors

ATC AVC

MC

FIGURE 5.1 Picking the quantity to maximize profit.

1 Though they may be able to charge any price they want at a local farmers’ market, they are not perfect competitors there. In that setting they are one of a few farmers selling that particular produce.

gue46399_ch05_068-078.indd 69 16/03/17 11:39 AM

70 Chapter 5 Perfect Competition, Monopoly, and Economic versus Normal Profit

Monopoly Monopolies exist at the other end of the spectrum, when we have markets in which there is only one firm. The important thing to know about the concept of monopoly is that the exis- tence of many firms does not necessarily mean the firms are in competition. For instance, Consolidated Edison was the exclusive provider of residential electrical power to New York City, and Commonwealth Edison still is the exclusive provider of residential electrical power to Chicago. There are hundreds of power companies in the United States, but very few of them compete with one another. They are not competitors because they cannot sell in another’s area. Another way of looking at this is to say that while there are many power companies, they are not competing in the same market. The reason is that it costs the companies too much to get the electricity to the consumer in the distant market. Just as a cement contractor in Little Rock, Arkansas, is not competing with a cement contractor in Miami for roadwork in south Florida because of transportation costs, electric companies do not compete with one another because they cannot access the same buyers. For monopoly, all that is necessary is that one firm and only one firm sells to the customers in a given market.

Some firms get their monopoly power because the law prevents others from entering the market. An example of a legal barrier to entry is a patent. For example, the manufacturer of Clarinex is the only firm that can produce and sell this drug. On the other hand, some firms get their monopoly power by attaining such a huge size that competing against them is impossible. The frustration that consumers have with monopolies is the lack of choice that results from there being only one seller. While many may understand and accept the lack of choice when the good being sold is a utility with very high fixed costs, and others may understand and ac- cept the need for patents and copyrights to motivate innovation, monopolies where the barriers to entry are simply associated with the size of the one monopolizing company often create anger and frustration. Consider the PC operating system business. Microsoft developed DOS in the early 1980s and various iterations of its Windows operating system after that. There have been at least two operating system genres (IBM’s OS2 and Linux) that were considerably more stable, more secure, and less glitchy than the Windows version against which they at- tempted to compete. Without question, had Microsoft not been the dominant firm when these competitors entered the market, either of these operating systems would have easily beaten Windows to become the preferred platform for personal computing. Because Microsoft had the leading position, it could maintain the position. Whether or not all of Microsoft’s tactics were legal has certainly been questioned, but its ability to keep people buying its products has not. It maintains a dominant position because it has a dominant position.

Monopolistic Competition One of the areas of middle ground is monopolistic competition, in which many firms sell slightly different products. In the fast-food market there are quite a few firms (McDonald’s,

monopolistic competition A situation in a market where there are many firms producing similar but not identical goods.

• A large number of competitors, so that no one firm can influence the price.

• The good a firm sells is indistinguishable from those its competitor sells.

• Firms have good sales and cost forecasts.

• There is no legal or economic barrier to entry into or exit from the market.

C H A R A C T E R I S T I C S O F P E R F E C T C O M P E T I T I O N

gue46399_ch05_068-078.indd 70 16/03/17 11:39 AM

From Perfect Competition to Monopoly 71

Wendy’s, Burger King, etc., in burgers; KFC, Taco Bell, etc., in various niches), but they do not sell exactly the same good. McDonald’s has a monopoly on the Big Mac and Happy Meal, but its competitors offer many close substitutes. This means that each firm has a monopoly on its particular menu, but the demand curve for the product is quite elastic. (Remember from Chapter 3 that the number of close substitutes determines elasticity.)

Oligopoly Another area of middle ground between perfect competition and monopoly is oligopolistic markets, in which there are very few discernible competitors. In the cell phone business, for example, there are major companies like AT&T, Sprint, and Verizon Wireless. In the soft drink business there are Coke and Pepsi. In some markets firms sell exactly the same thing, whereas in other markets firms sell close substitutes. In either case, firms are acting in oli- gopolistic ways and referred to as oligopolies.

Which Model Fits Reality Tables 5.1 and 5.2 summarize these market forms by providing examples and distinguishing characteristics of each type. That does not mean we will spend a great deal of time in the issues chapters worrying about market forms. Recall that in Chapter 2 we implicitly assumed that all markets were perfectly competitive. It turns out that very few markets meet the extreme criteria necessary to be labeled perfect competition. Most of the products that meet the criteria of perfect competition are agricultural; few products outside this area can make that claim. It may strike you, then, as somewhat curious that we will assume that most markets are perfectly competitive when we move into the issues. We do this because the supply and demand model is simple enough so that it can be used to explain and describe most markets where there are several competitors and the products are similar. You should understand that your instructor and I (the author) make this simplifying assumption reluctantly but knowingly.

Finally, you should be prepared for a high level of ambiguity in how particular markets fit into these forms. For instance, long-distance telephone service used to be a monopoly, became an oligopoly in the 1980s, and saw significant expansion in the number of companies offering service in the 1990s. Perhaps now it fits best under monopolistic competition. The personal

oligopolistic market A situation in a market where there are very few discernible competitors.

TABLE 5.1 Examples of different market forms. Perfect Competition

Monopolistic Competition Oligopoly Monopoly

Agricultural products Fast food Smartphones Operating systems Lumber Clothing Soft drinks Local residential

electric power

TABLE 5.2 Distinguishing characteristics between market forms.

Characteristic Perfect Competition

Monopolistic Competition Oligopoly Monopoly

Number of firms Many (often Several* Few* (usually One thousands or two to five) even millions)

Barriers to entry None Few Substantial Insurmountable, at least in the short run

Product Identical Similar but Similar or NA similarity not identical identical

*There is dispute about the line that separates monopolistic competition and oligopoly.

gue46399_ch05_068-078.indd 71 16/03/17 11:39 AM

72 Chapter 5 Perfect Competition, Monopoly, and Economic versus Normal Profit

computer business is similar in that there was only one firm, IBM, for many years, but today there are a dozen or more selling laptops and desktops. They all sell essentially the same thing but have a monopoly over their brand. The smartphone operating system industry is domi- nated by Apple and Google, with the device industry being dominated by HTC, Apple, and Samsung. Similarly, if you want to fly from New York to Los Angeles, you have a number of alternatives, perhaps not so many that it would be perfect competition but certainly enough to classify this service as monopolistic competition. On the other hand, if you want to fly directly from Indianapolis to Atlanta, you have two choices for nonstop flights (Southwest and Delta). If you want to fly directly from Syracuse to Detroit, you have only one choice (Delta). Where airline travel fits depends greatly on to where, and from where, you are traveling. In particular, it depends on who has a hub in the respective airports.

Further, there is no magic line that separates oligopoly from monopolistic competition. Economists who study these things will often look to something called a concentration ratio that measures the percentage of total market sales for the top firms (from 4 firms to 100 firms). So even though there are several tobacco companies selling cigarettes, one company, Philip Morris, holds nearly half the market, and the top four hold all but 1 percent of the market. Sev- eral equally competitive firms would suggest monopolistic competition, but these concentra- tion ratio data suggest that oligopoly may be a better fit. Table 5.3 presents 4-, 8-, and 50-firm concentration ratios for specific industries.

Another index that economists, particularly those in the antitrust division of the Depart- ment of Justice, use is the Herfindahl-Hirschman Index (HHI). Instead of just adding together the market shares of the largest firms, this adds the square of the market shares. What that does is distinguish a market where five firms have equal shares from one in which the big firm has a large proportion of sales and the others simply split the rest. If the market share is between 0 and 100 percent and there are N firms, the HHI ranges between 10,000/N and 10,000. A number between 1,000 and 1,800 is considered moderately concentrated while an index value greater than 1,800 is considered highly concentrated. The index value for break- fast cereals is above 2,500 and the one for cellular service is so high that the census bureau (that regularly published the statistics) must suppress the actual number to “protect the iden- tity of any business. . . .” Essentially the industry is so concentrated that reporting how much provides the largest businesses information on others.

concentration ratio A measure of the market power held by the top firms in an industry. For a specific number of firms (n), it is the per- centage of total sales in the industry accounted for by top n firms.

Herfindahl-Hirschman Index A measure of market concentration developed by adding the sum of squared market shares.

TABLE 5.3 Concentration ratios and Herfindahl-Hirschman indices for various industries, 2012.

Concentration Ratios

Industry Group 4 Largest Firms 8 Largest Firms 50 Largest Firms Herfindahl-Hirschman Index

Breakfast cereals 79.2 93.7 100.0 2,332.5 Ice cream 45.9 64.6 94.0 665.8 Beer 87.8 90.8 95.9 3,560.7 Wine 45.3 58.0 75.2 785.3 Clothing 10.3 15.0 38.3 54.0 Computers and peripherals 31.5 46.0 80.6 421.9 Furniture 23.7 30.9 52.8 233.7 Automobile manufacturing 60.2 88.7 99.7 1,177.90 Cellular service 89.1 95.2 98.8 *

*This industry is so concentrated that the Census Bureau cannot report exactly how concentrated it is because doing so would provide competing firms with sales information of their individual competitors.

Not published for service providers.

Source: United States Census Bureau, http://factfinder.census.gov/ ID: EC1251SSSZ6.

gue46399_ch05_068-078.indd 72 16/03/17 11:39 AM

Supply under Perfect Competition 73

Supply under Perfect Competition

Normal versus Economic Profit Let’s return to the example we used in Chapter 4: the business of selling memory chips. If we are one of many firms competing in this industry, it stands to reason that making money will be difficult. Because of our assumption of free entry into and exit from this market, any time there are abnormally large profits, other firms will want to start making memory chips. Remember that Chapter 2 presented evidence that an increase in the number of sellers will move the supply curve to the right, thus lowering market price. If that happens, our marginal revenue curve will fall. As a matter of fact, it will fall all the way to where profit is normal. Normal profit is the level of profit that business owners could get in their next best alternative investment. The next best alternative would be whatever investment an owner would choose if he or she decided to go out of business. Any profit above normal profit is called economic profit.

If business owners do not make their normal profit, they will quit the business and move into another. This means that we might think of normal profit as the salary the business owners pay themselves and, as such, part of the “cost of doing business.” If they make less than normal profit, then the salary they can pay themselves is too low to keep them in the industry. On the other hand, if profits are routinely more than that, others will want to enter the industry. This means that in the long run profit will shrink to normal levels.

When and Why Economic Profits Go to Zero Fortunately for our chip maker, although the firm cannot make long-run economic profits, it is not going to lose money for long either. When firms lose more money than their fixed costs, they shut down. In the short run firms will continue to produce when they lose less than their fixed costs, but as time passes these firms will also want to shut down. So, though our chip maker can make economic profit in the short run and lose money in the short run, the effect of free entry and exit in this market will cause the marginal revenue curve to settle at

normal profit The level of profit that business owners could get in their next best alternative investment.

economic profit Any profit above normal profit.

A nearly perfect example of the importance of entry and exit in ex- plaining why and when economic profits go to zero is the crude oil industry and the experience from 2014 to 2016. Prior to mid-2014, hydraulic fracturing and horizontal drilling, though invented, hadn’t had a dramatic impact on world oil supplies. Because of that, OPEC countries had tight control over supplies and the market was largely oligopolistic (with OPEC operating like one enormously powerful firm and few other large producers). The benefits to them were high prices and enormous profits. Further, without the new technology, those high prices and profits could not generate profit-killing entry.

Starting in August of 2014, that technology created a boom in production levels. North Dakota’s production took off and once-idled

oil fields in Texas and Oklahoma resumed production. The result was a dramatic decline in crude prices. From $107 per barrel in mid- 2014, to below $30 per barrel in early 2016, the economic profit was completely wrung out of the industry. Economic losses replaced economic profits. Exit started to occur as firms ceased production from unprofitable wells.

When entry is possible, as it is now in oil, economic profits mo- tivate it. When production increases too much, economic losses motivate exit. When entry is impossible, economic profits can go on forever—a state of the world that OPEC nations can now only look back upon as their “good old days.”

A N E A R LY P E R F E C T E X A M P L E O F T H E I M P O R T A N C E O F E N T R Y A N D E X I T

gue46399_ch05_068-078.indd 73 16/03/17 11:39 AM

74 Chapter 5 Perfect Competition, Monopoly, and Economic versus Normal Profit

the minimum of the U-shaped average total cost. What this means in everyday English is that any short-run profit or loss will evaporate in the long run because new competitors will come in or old ones will leave. This will drive the price toward the minimum of average total cost where profit is normal.

Though profit also shrinks to its normal level under monopolistic competition, there is no mechanism for profits to shrink to normal levels under oligopoly or monopoly. This is because the mechanism that shrinks profit is entry. Because entry is almost insurmountable under monopoly and substantially difficult under oligopoly, new firms do not come in to put the pressure on the price to fall.

At this point we need to back off our discussion to define more explicitly what economists mean by short run and long run. To an economist the distinction between the two centers on the ability of a firm to change its fixed inputs. We have assumed all along that we cannot change things like plant and equipment, and this is true in what we call the short run. In the long run there is enough time to change plant and equipment. We can either buy more plant and more equipment, or we can sell what we have. The distinction is thus not one of time but of flexibility; in the long run we are more flexible and in the short run less flexible.

Why Supply Is Marginal Cost under Perfect Competition Showing that, under perfect competition, supply and marginal cost are interchangeable is important for several of the issues that follow, but it is also notoriously difficult. That is why we will go back to the three approaches used in Chapter 4. We’ll do the “Just Words,” and “Numerical Example” approaches first and end with the “Graphical Explanation.”

Just Words In order to see that, under perfect competition, supply and marginal cost are interchangeable, you need to recall two key facts from Chapter 4: (1) All profit-maximizing firms will choose to produce where marginal cost equals marginal revenue (as long as price is greater than average variable cost); and (2) under perfect competition price and marginal revenue are the same. With that in your head, imagine that a firm is trying to decide how much to produce. It will take the price that is given to it by the market (which is also the firm’s marginal revenue) and set produc- tion where that price equals its marginal cost. If the price rises or falls, it will do the calculation again. In every case, the quantity at which marginal revenue equals marginal cost is the same as the quantity at which price equals marginal cost. That means that in every case the relationship between quantity produced and the marginal cost of producing it (the marginal cost curve) is the same as the relationship between the quantity produced and the price at which it is sold (the supply curve). So, under perfect competition, supply and marginal cost are interchangeable.

Numerical Example Using the memory chips example again, you can see from Table 4.2 that the average variable cost reaches a minimum at $15 per unit at the quantity of 500 units. This is important because at any price below $15 the firm will choose not to produce. To see that, suppose the price were $12 per unit. Marginal cost equals marginal revenue ($12) at 400 units, but at 400 units the firm’s total revenue will be $4,800 ($12 × 400) while its total cost will be $14,500, and it will lose more money ($9,700 = $14,500 − $4,800) than it would if it simply shut down ($8,500).

At every price above $15 the firm either makes money or at least loses less than $8,500, and therefore it makes sense for the firm to produce where marginal cost equals marginal revenue. If the price were exactly $15, the firm would produce 500 units, have $7,500 ($15 × 500) in total revenue, $16,000 in total cost, and lose exactly its fixed costs. If the price were $20, the

short run The period of time where a firm cannot change things like plant and equipment.

long run The period of time where a firm can change things like plant and equipment.

gue46399_ch05_068-078.indd 74 16/03/17 11:39 AM

Supply under Perfect Competition 75

firm would produce 600 units, bringing $12,000 in revenue while costing $18,000, and the loss is $6,000. The firm would rather lose $6,000 than $8,500, so it produces 600 units.

As the price rises to $30, it produces 700 units, has both revenue and cost of $21,000, and breaks even. At a price of $45 it produces 800 units, has revenue of $36,000, costs of $25,500, and makes a profit. At a price of $55 it produces 900 units, has revenue of $49,500, costs of $31,000, and its profit increases. Finally, at a price of $100, it produces 1,000, has revenue of $100,000, costs of $41,000, and its profit increases further. Putting it all together, the firm’s supply curve is its marginal cost curve (out of the minimum of average variable cost) because it sets production by noting the price and using the marginal cost figure to set production. Therefore, the relationship between its marginal cost and its production (its marginal cost curve) is the same as the relationship between the price it will receive and its production (its supply curve).

Graphical Explanation Figure 5.2 shows our ATC-AVC-MC cost curve diagram with four potential marginal revenue curves. For each, if there is pressure on the price to change in the short run, this is indicated with a short arrow in the direction of the pressure. If there is long-run pressure, this is indi- cated with a long arrow. At the first price–marginal revenue, MR1, the loss is so big that firms want to leave in both the short and the long run. This will reduce the number of sellers and the market price will rise in both the short run and the long run. At MR2 the chip maker is losing money but not enough for it to close down. So, though the firm does not want to shut down in the short run, it will want to shut down rather than invest money in new equipment as the old equipment wears out. Therefore, the long-run pressure is for the price to rise. At MR4 our chip maker is making an economic profit. If this happens, others will want to join the chip-making industry and there will be short- and long-run pressure for the price to fall. It is only when the price is at MR3 that there is no pressure on the price.

Now to why under perfect competition a firm’s supply curve is its marginal cost curve out of the minimum of its average variable cost. In Figure 5.3 the arrows from Figure 5.2 have been taken away and the points where the firm will produce are indicated by a dot. These points appear where marginal cost crosses marginal revenue, a circumstance that will come about only if firms do not shut down.

MR1

MR2

MR3

MR4

MC

ATC

AVC

P

Q

FIGURE 5.2 In perfect competition the market price is under pressure to move to where economic profit is zero.

MR1

MR2

MR3

MR4

MC

ATC

AVC

P

Q

FIGURE 5.3 Points where MC = MR in perfect competition.

gue46399_ch05_068-078.indd 75 16/03/17 11:39 AM

76 Chapter 5 Perfect Competition, Monopoly, and Economic versus Normal Profit

This chapter built on the previous one in which costs and revenues were defined and illus- trated. We saw the distinction between perfect competition and monopoly and that they are the endpoints of a continuum. We said that most markets operate somewhere in the middle of this continuum. Further, we distinguished between normal and economic profit, and showed why economic profit disappears under perfect competition but not under monopoly. Last, we saw that under perfect competition, the supply curve from Chapter 2 is the part of the check- shaped marginal cost curve from Chapter 4 that is above average variable cost and is therefore upward sloping.

Summary

Key Terms concentration ratio economic profit Herfindahl-Hirschman

Index

long run monopolistic

competition 

normal profit oligopolistic market short run

Issues Chapters You Are Ready for Now

The Economics of Prescription Drugs

Ticket Brokers and Ticket Scalping

The Economics of K–12 Education

Energy Prices Unions Walmart: Always Low

Prices (and Low Wages)—Always

The Economic Impact of Casino and Sports Gambling

In our final manipulation of the figure we get one of the most important implications of perfect competition. Connecting the dots of Figure 5.3 makes clear the relationship between the price of the chips our firm is selling and the number of chips our firm is willing to produce. If that sounds familiar, it is because that is exactly the definition of supply. As a result we now know that sup- ply, under perfect competition, is marginal cost out of the minimum of average variable cost. This, of course, also demonstrates why the supply curve is upward sloping: Mar- ginal cost is increasing.

Although more difficult to show than it is worth, it is important to state that there is no supply curve under monopolistic competition, oligopoly, or monopoly. To understand the reason, note that Figure 5.4 generates the supply curve by finding the production levels with a variety of different prices. Recall from Figure 4.4 that these horizontal price lines also represent perfectly elastic demand curves for a particular firm’s output. This same derivation does not work for the other market forms because the elasticity of demand for a firm’s output is not perfectly elastic and demand curves of different elasticities result in different profit-maximizing firm output.

MC

Supply

ATC

AVC

P

Q

FIGURE 5.4 Derivation of supply: marginal cost out of the minimum of average variable cost.

gue46399_ch05_068-078.indd 76 16/03/17 11:39 AM

Summary 77

1. An industry in which there are many competitors with specific marketing niches is likely to be characterized by a. monopoly. b. oligopoly. c. monopolistic competition. d. perfect competition.

2. An industry in which there are a very limited number of large firms is likely to be char- acterized by a. monopoly. b. oligopoly. c. monopolistic competition. d. perfect competition.

3. Owing to its usefulness and relative simplicity, the supply and demand model is often used a. because nearly every major industry in the United States is governed by perfect

competition. b. because nearly every major industry in the United States is governed by monopoly. c. even though, strictly speaking, few industries in the United States are governed by

perfect competition. d. even though it has no connection to economic reality.

4. Whether a firm stays in business or shuts down depends heavily on the concept of a. economic profit. b. actual profit. c. market share. d. concentration ratios.

5. Economic theory would suggest that the profitability of an industry would be a. directly related to the number of firms competing in the industry. b. inversely related to the number of firms competing in the industry. c. unrelated to the number of firms competing in the industry. d. zero in the long run, regardless of market structure.

6. Under perfect competition, the supply curve is a. the marginal cost curve for all price quantity combinations. b. the marginal cost curve, but only that portion that is downward sloping. c. the marginal cost curve, but only that portion that is upward sloping. d. the marginal cost curve, but only that portion that is above the minimum of average

variable cost. 7. An indicator of the degree of competition in an industry is the concentration ratio. It measures

a. the percentage of sales in the industry by the largest firms. b. the percentage of profit in the industry by the smallest firms. c. the sales in the industry as a percentage of all consumption in the United States. d. the profitability of the industry.

8. Local telephone service was once an area in which consumers had no choices. Many young people today no longer use “landlines,” preferring instead to use their cell phones. This means that the market has moved toward a. monopoly. b. oligopoly. c. perfect competition. d. monopsony.

Quiz Yourself

gue46399_ch05_068-078.indd 77 16/03/17 11:39 AM

78 Chapter 5 Perfect Competition, Monopoly, and Economic versus Normal Profit

1. Imagine an owner of a firm is thinking about raising prices. Describe the consequences of doing so as a monopolist, oligopolist, monopolistic competitor, and perfect competitor.

2. What are the key differences between monopolistic competition and perfect competition? 3. Describe why there is pressure on the price to fall when P > ATC. Is there a long- and

short-run distinction in the answer? 4. Describe why there is pressure on the price to fall when P < ATC. Is there a long- and

short-run distinction in the answer?

Think about This One of the concerns about Walmart’s entry into the grocery business in the latter part of the 1990s was that it would set low prices, drive little stores out of business, and then raise prices to monopoly levels when it had no competition. That hasn’t happened, but that doesn’t mean it couldn’t happen. Under what conditions, and in what industries, might such a strategy work?

Talk about This List the monopolies that used to exist when you were growing up that are now facing increased competition. Compare that list to a list provided by your instructor (who is presumably older than you). What current monopolies are likely to be threatened with entry in the future?

Behind the Numbers Concentration ratios for largest 4, 8, and 50 firms in various industries— www.census.gov/econ/concentration.html

9. In a diagram of perfect competition, the marginal revenue line moves up and down when there is exit and entry, respectively, because a. the market demand for the good rises and falls when there is exit and entry,

respectively. b. the market demand for the good rises and falls when there is entry and exit,

respectively. c. the market supply for the good rises and falls when there is exit and entry,

respectively. d. the market supply for the good rises and falls when there is entry and exit,

respectively. 10. If MR > MC, then when an additional unit is sold, the firm’s

a. profit will be positive. b. profit will increase. c. profit will be negative. d. profit will decrease.

Short Answer Questions

gue46399_ch05_068-078.indd 78 16/03/17 11:39 AM

79

C H A P T E R S I X

Every Macroeconomic Word You Ever Heard: Gross Domestic Product, Inflation, Unemployment, Recession, and Depression Learning Objectives

After reading this chapter you should be able to:

LO1 Define the basic vocabulary of macro economics.

LO2 Describe how the economy is measured.

LO3 Describe how gross domestic product, our national measure of output, is calculated.

LO4 Calculate inflation using a price index.

LO5 Describe real gross domestic product as the inflation-adjusted value of economic activity and judge its use as the measure of the economy’s health.

LO6 Describe how unemployment is measured and enumerate the types of unemployment that economists recognize.

LO7 Define and apply the vocabulary of the business cycle.

Chapter Outline

Measuring the Economy

Real Gross Domestic Product and Why It Is Not Synonymous with Social Welfare

Measuring and Describing Unemployment

Productivity

Seasonal Adjustment

Business Cycles

Kick It Up a Notch: National Income and Product Accounting

Summary

gue46399_ch06_079-097.indd 79 16/03/17 11:39 AM

80 Chapter 6 Every Macroeconomic Word You Ever Heard: Gross Domestic Product, Inflation, Unemployment, Recession, and Depression

We shift gears now to talk about the economy as a whole rather than the consumption or pro- duction of specific goods. What we covered in Chapters 2 through 5 is called microeconomics, because it deals with individual markets and firms. The prefix micro, meaning small, applies here because of the narrow scope of microeconomics. The opposite prefix, macro, means large, so macroeconomics deals with the economy as a whole. When you read or hear “eco- nomic news” you more often than not get macroeconomic news. In that context you hear the same words over and over again. This chapter attempts to define and explain the vocabulary of macroeconomics.

We begin the chapter by examining the methods by which we measure the macroeconomy. In that process we define and explain gross domestic product, inflation, and how and why the gross domestic product is adjusted for inflation. We move from there to explain how un- employment is measured, and we finish with a discussion of the business cycle. You will see that all of these economic measures have flaws that economists recognize and study and that, though real gross domestic product is an accepted measure of the economy’s health, it is not a perfect measure of our nation’s overall health.

This is by far the most easily understood chapter of all the theory chapters, but you should make sure that you understand the terms and the concepts behind them thoroughly. Chapter 8 and the more macro-oriented issues chapters rely on them heavily.

Measuring the Economy

Measuring Nominal Output To keep tabs on how well or how poorly the economy is doing, we measure economic ac- tivity by adding up the dollar value of all of the goods and services produced for final sale in the United States in a year. The gross domestic product (GDP) is the primary measure of the health of the economy, and some important concepts within this definition need to be highlighted:

1. This measure is a dollar measure that is subject to price variability. 2. Only “final” sales are counted. 3. The goods that are studied must be goods produced within the United States.

The fact that the GDP is influenced by changes in prices must be dealt with at length, but this discussion must be delayed until we explore inflation at length. Moreover, besides infla- tion, two other fairly straightforward issues should be addressed. The first of these is the issue of double-counting intermediate sales; the second is how to count the production of multi- national companies.

To avoid the double-counting of certain economic activity, only final sales are counted. Suppose that you are talking about the production and sale of two loaves of bread. Suppose the first loaf is produced by a woman who grows and grinds the wheat, mixes the dough, bakes the loaf, and sells it all by herself. Suppose another loaf begins with a farmer who grows the wheat and sells it to a miller, who grinds it into flour and sells the flour to a baker, who mixes the dough, bakes the loaf, and sells the loaf to a retailer, who sells the loaf to a customer. If both loaves are of equal quality, then both should be sold for the same price: say, one dollar. Clearly both loaves contribute the same to the amount of bread available to society, so both should count the same when we measure economic activity. If you summed all sales along the way, however, the second loaf would count more than the first.

The other aspect of this measure is that it counts production only if it takes place within the borders of the United States. This means the Fords produced in Mexico are not counted in the U.S. GDP, but the Hondas produced in Ohio are.

microeconomics The part of the disci- pline of economics that deals with individual markets and firms.

macroeconomics The part of the disci- pline of economics that deals with the economy as a whole.

gross domestic product (GDP) The dollar value of all of the goods and serv- ices produced for final sale in the United States in a year.

gue46399_ch06_079-097.indd 80 16/03/17 11:39 AM

Measuring the Economy 81

The actual computation of the GDP is done in two distinct ways. One way is to count all those things for which people pay money. This is called the expenditures approach. The expen- ditures approach adds up all of the following: consumption, investment, government spending on goods and services, and exports; then it subtracts imports. The other approach, which counts all those ways in which people earn money, is called the income approach. This approach adds up employee compensation, interest, rents, profits, and depreciation and then subtracts income earned in other countries and indirect business taxes (such as sales taxes). Both approaches yield the same result because the money that the buyer “spends” is, by definition, the seller’s “income.” Therefore, adding up everyone’s income and everyone’s spending yields the same sum.

The sources that the government uses to compute this information are wide and varied. They are known as the National Income and Product Accounts, and compiling them is com- plicated and time-consuming. For instance, while the government knows quickly and reliably how much it spends on goods and services, nearly every other piece of information included in the GDP has to come from forms that businesses send to the government: tax forms, un- employment insurance forms, reports of sales and sales taxes, and other documentation. It is therefore obvious, but it warrants noting, that trying to produce the final GDP quickly is difficult. What actually happens is that government economists use sampling techniques to produce preliminary estimates that are repeatedly updated as more information is submitted. When all information is in, sometimes more than a year after the first preliminary estimate is made, a final GDP value is published.1

1 Even then, some components are estimates.

Measuring Prices and Inflation As we said in the previous section, measuring price changes is important. Whether price changes account for changes in the GDP or whether actual production changes account for those changes is vital to the question of whether we are better off in one period than we were

H O W D O E S I T C O U N T I N G D P ?

Issue How It Counts in GDP (C + I + G + X − M)

A product made in one year but sold a later year

GDP counts the value of the product made but not yet sold as an increase to business INVESTMENT (I), of which inventories are a part. So if it is made in December, investment goes up. When it is sold, investment drops but either CONSUMPTION (C) or EXPORTS (X) goes up. Typically a good goes into inventories at its wholesale value so when it is sold, the increase in consumption or exports is greater than the decrease in inventories.

A used car is sold The only part of a used car sale that counts is the markup from its purchase price from the previous owner to the sale to the next owner. That is the value the used car dealer created in cleaning and preparing the car for sale.

Stock sold in a stock market

Personal investment and business investment are two different things. It is only when a business uses the sale of (initial public offering) stock to raise money to buy equipment and inventory that there is any crossover.

How illegal drug sales are counted

The simple fact is they aren’t, and it isn’t because they shouldn’t be. Only recorded sales that are part of the system of business reporting to state and federal governments count.

gue46399_ch06_079-097.indd 81 16/03/17 11:39 AM

82 Chapter 6 Every Macroeconomic Word You Ever Heard: Gross Domestic Product, Inflation, Unemployment, Recession, and Depression

in a previous period. A GDP number that increases because prices rise is less desirable than a GDP that increases because people are actually buying products in greater quantities. For instance, let’s make the simplifying assumption that there is only one good in society, cheese, we produce 10 trillion tons of cheese in one year, and cheese is sold at a price of $1/ton. That is vastly better than if we produce only one ton of cheese and it is sold at a price of $10  trillion. Clearly, to discuss the value of production we have to discuss how we measure prices.

The way that government economists measure prices is intricate. Under their direction, employees of the Bureau of Labor Statistics (BLS) go shopping for a market basket of goods and services in an effort to see if the total cost of that market basket has changed in the cur- rent year from what it was in the previous year. To do this they have to establish what should go into that market basket through a process of figuring out what average people buy and in what quantities they buy it. This market basket then makes up a kind of “grocery list” of things that government employees go out and find prices on. With the rapid expansion of available products, the BLS has recently chosen to update the market basket every two years. Their old practice of updating the market basket only every 10 years led to significant problems.2

The “list” of items for which government employees go out every month to find prices is very specific, not only indicating what model number or UPC code to look for but also specifying stores in which the goods need to be located. Frequently, especially with electronic equipment, the item that the employee is supposed to find no longer exists or no longer exists at the specified store. In that case employees must use their best judgment to find a suitable substitute and record key attributes of the good.3

For each month for which the list is in effect, including the first month of the first year, called the base year, Bureau of Labor Statistics employees find the prices of everything on the list. When they finish, a national average is computed. The result constitutes the first key piece of information necessary to compute future inflation: It is the national average of the total cost of the market basket. It is called the price of the market basket in the base year. In succeeding months a revised national average is generated on the basis of new information on prices.

To use this information to measure any inflation that may have arisen in any given year, we have to go through three distinct steps: 1. We find the price of the market basket in the relevant years. 2. We compute a price index for the relevant years. 3. We compute the percentage of change in the relevant price indices.

After arriving at the price of the market basket in the base year, we also have to get the price of the market basket in any of the other years in question. For instance, if you ultimately wanted to know the inflation rate for 2015, you would need the price of the market basket in the base year, 1998, the price of the market basket at the beginning of 2015, and finally the price of the market basket at the beginning of 2016.

Next, a price index, which centers the price of the market basket around 100, is computed for the beginning of 2015 and 2016. For instance, the consumer price index (CPI) for 2015 is

CPI in 2015 = Price of the market basket in 2015 __________________________________________ Price of the market basket in the base year of 1998 × 100

market basket Goods that average people buy and the quantities they buy them in.

base year Year to which all other prices are compared.

price of the market basket in the base year National average of the total cost of the market basket.

price index A device that centers the price of the market basket around 100.

consumer price index (CPI) The price index based on what average consumers buy.

3 The BLS then constructs a “hedonic price” for these goods. A hedonic price is an educated guess at what the price of the original good would have been given its characteristics. The BLS constructs hedonic prices for clothes dryers, microwave ovens, refrigerators, camcorders, consumer audio products, DVD players, and college textbooks.

2 In 1996, the Boskin Commission established that measuring inflation the original way overstated the true inflation rate by 1.1 percentage points. In response to this criticism and in recognition of these problems, the Bureau of Labor Statistics corrected some of these flaws by going to a two-year cycle on market basket updates.

gue46399_ch06_079-097.indd 82 16/03/17 11:39 AM

Measuring the Economy 83

This formula can be interpreted to mean that in the base year the CPI is 100. At other times, as prices rise, the CPI will rise above 100. If prices eventually become twice what they were in the base year, the CPI will be 200.

The last step is to compute the percentage change in the price index. To do this, you take the CPI at the beginning of the year and the CPI at the beginning of the next year and plug them into the formula

Inflation during 2015 = CPI on January 1, 2016 − CPI on January 1, 2015 CPI on January 1, 2015

× 100%

As a practical matter the CPI is important for another reason. For economists it is important because it is used to generate not only an inflation rate, the percentage increase in the CPI, but also the cost-of-living adjustment, or COLA. This adjustment compensates people for the fact that changes in inflation also change the spending power of their income. For social security recipients and others on pensions that pay a COLA, as well as union members with contracts that are tied to a COLA, this represents the extra income they get each year to compensate them for inflation.4 Table 6.1 presents a historical picture of the CPI.

Problems Measuring Inflation We now have a measure of inflation that gives us helpful information on how the total price of a given market basket changes. For several reasons, however, it does not do a very good job in measuring the true impact of inflation. The first way in which the CPI can estimate inflation inaccurately derives from the two-year period between changes in the market basket. Specifically, large price decreases that occur in the first two years after the introduction of a product are ignored. For instance, the iPhone was originally marketed for $600 and two years after its introduction sold for less than $200 at Walmart. When the market basket updates were

inflation rate The percentage increase in the consumer price index.

cost-of-living adjustment (COLA) A device that compen- sates people for the fact that changes in inflation change the spending power of their income.

Year CPI Inflation Rate (%) Year CPI

Inflation Rate (%) Year CPI

Inflation Rate (%)

1920 19.4 1988 120.7 4.4 2002 181.8 2.5 1930 16.1 1989 126.3 4.6 2003 185.5 2.0 1940 14.1 1990 134.2 6.3 2004 191.7 3.3 1950 25.0 1991 138.2 3.0 2005 198.1 3.3 1960 29.8 1992 142.3 3.0 2006 203.1 2.5 1970 39.8 1993 146.3 2.8 2007 211.4 4.1 1980 86.4 12.4 1994 150.1 2.6 2008 211.4 0.0 1981 94.1 8.9 1995 153.9 2.5 2009 217.4 2.8 1982 97.7 3.8 1996 159.1 3.4 2010 220.5 1.4 1983 101.4 3.8 1997 161.8 1.7 2011 227.1 3.0 1984 105.5 4.0 1998 164.4 1.6 2012 231.1 1.8 1985 109.5 3.8 1999 168.8 2.7 2013 234.7 1.5 1986 110.8 1.2 2000 174.6 3.4 2014 236.3 0.7 1987 115.6 4.3 2001 177.4 1.6 2015 237.8 0.7

Note: CPI is year-end figure. Source: Bureau of Labor Statistics, www.bls.gov/cpi/home.htm (Series ID: CUSR000SA0)

TABLE 6.1 CPI and inflation in selected years, 1920–2015; base years 1982–1984.

4 Social Security uses the end of June CPI to compute the COLA. By law, Social Security checks to individuals cannot fall, which means that if prices fall, the Social Security Administration simply does not increase benefits until the CPI rises to above its previous higher level. Because the June 2008 to June 2009 CPI fell and because the June 2010 level did not rise to the June 2008 level, Social Security recipients received no COLA for two years. The same thing happened in 2015 when plummeting gasoline prices held the CPI down so much that overall inflation was zero.

gue46399_ch06_079-097.indd 83 16/03/17 11:39 AM

84 Chapter 6 Every Macroeconomic Word You Ever Heard: Gross Domestic Product, Inflation, Unemployment, Recession, and Depression

on a 10-year cycle, VCRs, personal computers, cell phones, DVD players, iPods, flat-screen TVs, and TiVo boxes/DVRs did not come into the market basket until several years after their introduction. In all of these cases large price decreases and significant quality improvements occurred long before their inclusion. Flat-screen TVs used to be priced at more than $10,000 and can be found now for less than $300. Though the CPI methodology will eventually pick up the final fall in prices once they are included, it will fail to pick up the initial drop in price.

The second way in which the CPI may assess inflation inaccurately relates to quality im- provements in electronics, which may occur so quickly that by the end of the final year of the market basket, the good that was originally included no longer exists. The best example of this is the personal computer. Recognizing this, in 2006 the BLS began to adjust for quality improvements in certain goods.

Third, people have significantly changed the places in which they buy goods. For instance, in the 1950s television sets were, by and large, purchased in department stores or small appli- ance stores. Although the personal service customers received during this period undoubtedly exceeded the level of service we now get at large discount stores or warehouse clubs, the price we pay when we make our purchases at discount stores is also much lower. Today we buy from stores where service is low but prices are also very low. If you remember, the government em- ployees who go looking at prices do so at the specific stores designated at the beginning of the life of the market basket. Because they change the store to match consumer behavior only when they change the market basket, they may fail to capture a significant source of price decreases. In this way, the BLS has lagged behind actual behavior regarding Internet shopping.

Fourth, when prices change dramatically people look for substitutes. Because the market basket is fixed for a two-year period, it is implicitly assumed that people mindlessly buy ex- actly the same amount of everything, every period, regardless of prices. This is surely a silly assumption for economists to make, given that much of Chapter 2 was devoted to how people react to price changes. For an example of how failing to account for substitution can overstate the effects of an increase in the price of one good, consider energy prices. In 2008, gasoline

An interesting aspect of inflation is that it creates its own set of winners and losers. People living on fixed incomes will be highly sensitive to inflation, and because people who borrow money are paying it back with dollars that are less valuable than  the money they borrowed, both they and the lending in- stitutions from whom they borrow will have a stake in the rate of inflation.

Anyone receiving a fixed amount of money per month or per year through an investment or having a fixed amount of cash that they must stretch over a long period of time will be unambiguously hurt by inflation. They will see their buying power drop incremen- tally over time. To see how important that is, suppose a 65-year-old new retiree sets up an annuity so that she gets $20,000 a year until she dies. If she lives 20 additional years and inflation is run- ning at 5 percent per year, the buying power of that money will be 62 percent lower. Even if inflation is running at a modest 2 percent per year, her buying power will be 33 percent lower. While good financial planners will account  for this when setting up such

annuities for their clients, retirees who forgo investment advice can get caught in this trap.

In the arena of borrowing and lending there are also winners and losers. Here the important question is not necessarily whether there is inflation but whether inflation is greater than was expected by the respective parties. If inflation is greater than was expected when the interest rate on the loan was established, then borrowers are winners because they are paying the loan back using less valu- able dollars than they anticipated. If borrowers are the winners, then lenders are clearly the losers in that they are receiving less valuable dollars in return. Of course, each “dollar” is still worth a dollar, but with inflation running above expectations, each dollar buys less than it was expected to be able to buy when the loan was set up.

On the other hand, if inflation runs less than was expected, the lender is the winner and the borrower is the loser. The borrower is paying the loan back with dollars that have more spending power than they were anticipated to have and the lender is receiving those more valuable dollars.

I N F L A T I O N ’ S W I N N E R S A N D L O S E R S

gue46399_ch06_079-097.indd 84 16/03/17 11:39 AM

Measuring the Economy 85

O T H E R P R I C E I N D I C E S

19 97

19 98

19 99

20 00

20 01

20 02

20 03

20 04

20 05

20 06

20 07

20 08

20 09

20 10

20 11

20 12

20 13

20 14

20 15

20.00%

15.00%

10.00%

5.00%

0.00%

–5.00%

–10.00%

–15.00%

–20.00%

–25.00%

A n

n u

al iz

e d

in fla

tio n

r at

e

Year

CPICore CPI Core PCE

FIGURE 6.1 CPI, core CPI, and core PCE.

Because inflation is damaging to an economy and extreme inflation can be very dangerous, the Federal Reserve Board keeps close tabs on it. As we will see in Chapters 8 and 12, the Fed, for short, adjusts short- term interest rates to keep inflation in check. If you look behind the numbers of the CPI you find that it is highly variable. That is why the Fed looks at two more stable price indices. Both are called the core rates because they eliminate the impact of highly volatile food and energy prices. The core CPI is based on the traditional CPI, while the core PCE strips out the costs

of food and energy from a different price index, called the Personal Consumption Expenditures deflator. You can see from Figure 6.1 that the core CPI and the core PCE are much more stable than the CPI itself. Because the Fed does not want to overreact to rapid changes in volatile sectors, it focuses its attention on these core measures.

Finally, there is also an index of input items for firms, called the Producer Price Index. It is often useful as a look ahead at what inflation will be in a few months as firms turn those inputs into goods that they sell.

prices climbed from $2 per gallon to more than $4.20 per gallon. Many people sold their SUVs and bought more fuel-efficient cars, or simply drove less.

In response to this criticism and in recognition of these problems, the Bureau of Labor Statistics began an effort to correct some of these flaws. First, as mentioned above, they make an explicit effort to account for the consumer electronics quality problem. Second, they now reestablish the market basket every 2 years rather than every 10 years. This allows for new goods to enter the market basket much more quickly and have at least a portion of the initial drops in price count. It also allows the BLS to account for substitution between goods when there are long-term changes in prices, such as the increase in gas prices that began in 1998 and culminated in $4.20 gasoline in 2008. This chain-based index represents progress as far as economists are concerned.

chain-based index A price index based on an annually adjusted market basket.

core CPI The consumer price index that has had the impact of food and energy costs removed.

core PCE The Personal Con- sumption Expenditures deflator that has had the impact of food and energy costs removed.

Personal Consumption Expenditures deflator A chain-based price index that adjusts for the substitution problem.

Producer Price Index A price index based on what firms buy.

gue46399_ch06_079-097.indd 85 16/03/17 11:39 AM

86 Chapter 6 Every Macroeconomic Word You Ever Heard: Gross Domestic Product, Inflation, Unemployment, Recession, and Depression

Still, these efforts have not solved the problem entirely. In a summary of the issues, David Lebow and Jeremy Rudd reported that the degree of error in the consumer price index has been cut to less than a percentage point. Though better than before, their 0.8 percentage point estimate for the overstatement is significant. Over the course of 30 years, tax brackets and CPI-adjusted benefits will be overadjusted by 27 percent.

Real Gross Domestic Product and Why It Is Not Synonymous with Social Welfare

Real Gross Domestic Product Having examined inflation and how it is measured, we can now come back to gross domestic product. As we said, one of the concerns with GDP measurement is that changes in prices can  affect the GDP just as easily as changes in output. To cleanse our GDP measure of the price changes, we use a price index called a GDP deflator (GDPDEF). This inflation-adjusted mea- sure of GDP is called the real gross domestic product (RGDP). Real GDP is computed by taking current production of goods and services and multiplying those by their previous year prices and then adding these up across different goods and services. The current production of new goods and services is then added to this figure. This process is different from that which creates the CPI in that the market basket changes from year to year so the choice of a base year is somewhat arbitrary. Still, it allows for a comparison of total production from one year to the next while eliminating the effects of inflation. Further, many economists feel more comfortable computing inflation using the GDP deflator approach (which is the annual percentage increase in the GDP deflator) than the CPI approach (which is the annual percentage increase in the CPI). Figure 6.2 shows the trajectory of real GDP since World War II using 2009 as the base year.

Problems with Real GDP Even with its adjustments, real GDP does not do everything right. Besides having the GDP deflator suffer from many of the problems that the CPI suffers from, real GDP has several other problems.

First, it does not give your mother or father much credit. When either one does things around the house—laundry, cooking, yard work, and the like—the value created in the process is not

GDP deflator (GDPDEF) The price index used to adjust GDP for infla- tion, including all goods rather than a market basket.

real gross domestic product (RGDP) An inflation-adjusted measure of GDP.

17,500

15,500

13,500

11,500

9,500

7,500

5,500

3,500

1,500

R G

D P

$ b

ill io

n s

(2 0

0 9

)

Year

19 4

7

19 5

0

19 5

3

19 5

6

19 5

9

19 6

2

19 6

5

19 6

8

19 7

1

19 7

4

19 7

7

19 8

0

19 8

3

19 8

6

19 8

9

19 9

2

19 9

5

19 9

8

2 0

0 1

2 0

10

2 0

13

20 0

4

2 0

0 7

FIGURE 6.2 Post–World War II real gross domestic product by quarter, billions of 2009 dollars.

Source: Bureau of Economic Analysis, www.bea.gov

gue46399_ch06_079-097.indd 86 16/03/17 11:39 AM

Measuring and Describing Unemployment 87

counted in GDP. It is not counted because it is not sold. Much work gets done and much value is created without sales. I, for instance, installed a large wooden fence around my backyard. Had I gotten a contractor to do it, it would have cost $8,000. Since I built it myself, it cost only $3,000 for supplies and the GDP missed as much as $5,000 of the value that was created.

Second, real GDP does not see that leisure is valuable. If we all worked ourselves to the bone and never took days off, we would cause GDP to rise, but we would be worse off for it. Clearly, in a fully employed society, people who retire voluntarily reduce GDP by the amount of work they would have done. Just as clearly, people retire voluntarily because they are happier fishing, golfing, lollygagging, or volunteering than working.

Third, what people buy is not considered important in the computation of GDP. The sub- stantial increase in government spending on homeland security that resulted from the terrorist attacks of 2001 and beyond was quite likely necessary given the threat, but we are not better off as a society for having to spend this money. We spend it in an attempt to re-create the old sense of security. Spending more money on something that used to require less does not make us better off.

Fourth, the population of the United States is always growing. If real GDP does not grow at the rate that the population does, then the per capita real GDP (the inflation-adjusted goods and services going to the average person) will fall.

Fifth, we can sacrifice environmental quality of life for economic gain, but again we would not necessarily be better off. There is untapped crude oil under the coral reefs off the coast of Florida and under the vast tundra of northern Alaska. As the summer of 2010 made clear, drilling for oil in environmentally sensitive areas comes at a cost. When the process of “fracking” opened up vast quantities of natural gas for use throughout western Pennsylvania in 2008–2011, GDP was clearly and positively affected. In 2012, President Obama rejected the path of the Keystone pipeline and was criticized by Republicans for doing so. Their argument was that he was con- straining GDP. In both cases, both sides are essentially correct. More drilling does increase GDP and reducing that new drilling does decrease GDP, but in both cases those concerned for the environment have a serious point. If the environmental concerns expressed turn out to be valid, this increase in GDP should be offset by the impact on the environment. No one in the govern- ment makes this adjustment. We would increase real GDP if we pumped this oil and gas, but the price of doing so would have to include its impact on the environment.

Sixth, just as the laundry and yard work your parents do does not count because the service does not get sold in a market, goods or services sold under the table do not get counted either. The illegal drugs that people buy do not get recorded anywhere. Similarly, if you mowed lawns or babysat as a teenager, it is unlikely you reported any of that income to the government. If you do not report the income on your taxes and your employer does not either, this economic activity does not appear as part of the GDP. This omission is especially important when it comes to the effect of higher tax rates. Studies reflect the obvious: When taxes are higher, people do more of their work under the table.

For all of these reasons, real GDP cannot be considered a perfect measure of social welfare. Still it remains the primary measure of the economic health of the country. Any attempt to account for the problems outlined above would subject the measure to value judgments about the intrinsic worth of certain goods for which there is little agreement. Therefore, economists generally accept real GDP for what it can tell us while remaining aware of its limitations.

Measuring and Describing Unemployment

Measuring Unemployment Losing one’s job is the most traumatic thing that a person can go through short of the loss of a loved one. Economists therefore consider the unemployment rate to be one of the most important indicators both of the economy and of well-being in general. When people who want and need to work cannot find suitable employment, they lose not only income but also self-esteem. The

gue46399_ch06_079-097.indd 87 16/03/17 11:39 AM

88 Chapter 6 Every Macroeconomic Word You Ever Heard: Gross Domestic Product, Inflation, Unemployment, Recession, and Depression

problem for economists is distinguishing in a meaningful way between stay-at-home parents who might work outside the home if they were paid $50,000 a year and unemployed auto workers who refuse to go from $20 an hour assembling cars to the minimum wage flipping burgers. At what point does the lack of a job go from being the economy’s fault for not gen- erating good jobs to being the person’s fault for not having realistic expectations? This is an important question, but it is nearly impossible to answer.

The government measures unemployment by conducting phone surveys. The first thing the people making the surveys do is to make sure they are speaking to a person age 16 or over. (This is because people under 16 are not counted, whether they are working or not.) Second, they ensure that the person they are talking to is not in the military. (Those in prison, in mental health facilities, and in the active duty military do not count.) Third, they ask if the person has done work for pay or worked more than 15 hours a week in a family business during the previ- ous week. If the answer to that question is yes, then the person is considered employed. If the answer to that question is no, then the person is asked if he or she looked for work during the week, that is, whether he or she filled out an application or made a job inquiry. If the answer to that question is yes, then the person is considered unemployed.

As mentioned previously, not everyone counts. For instance, the total U.S. population in 2013 was 317 million. Of those, 66 million were under the age of 16, 1.4 million were in the military, 2.2 million were incarcerated, and 1.8 million were institutionalized in mental health facilities (with about half of those being over 85 years old and in homes for the aged). As a result the civilian, noninstitutionalized population of working age was 246 million.

The percentage of the civilian, noninstitutionalized population that is either employed or searching for a job—called the labor force participation rate—increased substantially between the end of World War II and the turn of the century. Figure 6.3 shows that the rate increased from 59 percent after the war to 67.3 percent in 2000. While there were multiple causes, the biggest cause dwarfed all others: women. In 1948 the labor force participation rate for men in their prime working ages (25–54) was 98 percent, while it was only 34 percent for women. By April of 2000 when the aggregate number peaked, the rate had fallen to 91 percent for men but

58.0

59.0

60.0

61.0

62.0

63.0

64.0

65.0

66.0

67.0

68.0

19 4

8 19

5 0

19 5

2 19

5 4

19 5

6 19

5 8

19 6

0 19

6 2

19 6

4 19

6 6

19 6

8 19

7 0

19 7

2 19

7 4

19 7

6 19

7 8

19 8

0 19

8 2

19 8

4 19

8 6

19 8

8 19

9 0

19 9

2 19

9 4

19 9

6 19

9 8

2 0

0 0

2 0

0 2

2 0

0 4

2 0

0 6

2 0

0 8

2 0

10 2

0 12

2 0

14 2

0 15

FIGURE 6.3 Labor Force Participation Rate.

Source: http://www.bls.gov/cps/

labor force participation rate The percentage of the civilian, noninstitution- alized population that is either employed or searching for a job.

gue46399_ch06_079-097.indd 88 16/03/17 11:39 AM

Measuring and Describing Unemployment 89

had risen to 77 percent for women. At the end of 2015, the aggregate labor force participation rate was 62.6 percent, the rate for men ages 25–54 had fallen further to 88 percent and the rate for women in that age group had fallen to 74 percent.

From those surveys the government creates two numbers, the labor force and the unem- ployment rate. The labor force is generated by adding the employed to the unemployed. The unemployment rate is the unemployed divided by the labor force and should be interpreted as the percentage of people in the workforce who do not have jobs and are actively seeking them. Both of these numbers are announced on the first Friday of every month.

Problems Measuring Unemployment This measure of the unemployment rate has some flaws. First, it does not count as unemployed any people who are so discouraged that they stop looking for work. Second, it counts as un- employed those people who are (correctly or incorrectly) encouraged by positive economic news to look for work before there really is any work. Third, it fails to recognize the plight of workers who are working significantly below their skill level or those who would like to work full time but are stuck in part-time jobs. Those suffering from either of these last two problems are referred to as underemployed.

The first two flaws are important because they subject the unemployment rate to incorrect interpretation. For example, if there are 10 people, 8 who work and 2 who are looking, then the unemployment rate is 20 percent. If things turn bad, so that one of the two decides to stop looking, the unemployment rate falls to 11 percent (1/9). Thus, bad news in this case causes the unemployment rate to fall. This is called the discouraged-worker effect, a process that can be reversed. That is, good news causes people to look for work before there is any, and the unem- ployment rate rises back to 20 percent. This is called the encouraged-worker effect. Figure 6.4 offers a historical perspective on unemployment.

These two effects were prominent during the 2007–2009 recession and beyond. The clear- est examples of the discouraged-worker effect were in the January and February 2011 reports (for December and January unemployment, respectively). During that two-month period, three-quarters of a million people left the labor force, due in large part to the fact that their unemployment compensation had run out. The unemployed are required to look for work while they collect unemployment compensation. Once the benefits ran out, with no opportunities

labor force All those nonmilitary personnel who are over 16 and are employed or are unemployed and actively seeking employment.

unemployment rate The percentage of people in the workforce who do not have jobs and are actively seeking them.

underemployment The state of working significantly below skill level or working fewer hours than desired.

discouraged-worker effect Bad news induces peo- ple to stop looking for work, causing the unem- ployment rate to fall.

encouraged-worker effect Good news induces people to start looking for work, causing the unemployment rate to rise (until they succeed in finding work).

20.0

R at

e (%

)

Year

18.0

16.0

14.0

12.0

10.0

8.0

6.0

4.0

2.0

0.0

Civilian unemployment rate

Civilian UR plus discouraged workers

Civilian UR plus DW and underemployment

19 4

8

19 5

2

19 5

6

19 6

0

19 6

4

19 6

8

19 7

2

19 7

6

19 8

0

19 8

4

19 8

8

19 9

2

19 9

6

2 0

0 0

2 0

0 4

2 0

0 8

2 0

12

FIGURE 6.4 Post–World War II un- employment rates: the civilian unemployment rate (UR) and the rates as they would be if we include discouraged workers (DW) and the underemployed.

Source: Bureau of Labor Statis- tics, http://data.bls.gov/cgi-bin /srgate

Series: LNS12000000; LNS 14000000; LNS12032194; LNU05026645.

gue46399_ch06_079-097.indd 89 16/03/17 11:39 AM

90 Chapter 6 Every Macroeconomic Word You Ever Heard: Gross Domestic Product, Inflation, Unemployment, Recession, and Depression

out there, many unemployed simply gave up their search. When they did, the unemployment rate fell dramatically (from 9.6 percent to 9.0 percent).

Toward the end of a long employment dry spell, there is a predictable phenomenon where good news causes a significant increase in job seekers. In May 2003, as the economy started picking up after a slow “jobless” recovery, 500,000 people joined the labor force and only 250,000 got jobs. The result was, although this was a better-than-average month for new job creation, the unemployment rate rose from 6.1 percent to 6.3 percent.

Types of Unemployment Economists further divide the unemployed by reasons for unemployment. If people lose their jobs because of a temporary downturn in the economy, economists call them cyclically unemployed. The seasonally unemployed are those people who lose their jobs predictably every year at the same time, like lifeguards in Michigan.

A third type of unemployment is more problematic and permanent. If people lose their jobs because of a change in the economy that makes their particular skill obsolete (either because the industry ceases to exist or because it moves to another country), they are referred to as structurally unemployed. These are typically the most difficult people to re-employ because their wage expectations are higher than the positions that remain in the economy that they can fill.

Conversely, a fourth type of unemployment often results from good things in the economy. If things are going well and people get better jobs or at least are encouraged to go out and look for bet- ter jobs, they sometimes add to the unemployment rate. For instance, if people hear there are better jobs out there and quit their jobs to devote time to looking for them, they might be surveyed when they are unemployed. Still others may be part of a two-earner family where one gets a promotion that requires that the family move to another city and the spouse who does not get promoted quits to find work in the other city. During the time that such people are looking for work, they are categorized as frictionally unemployed. These people are unemployed for a short time, but they have skills that employers will want. It just takes time to find the appropriate job. Thus, this type of unemployment exists in any smoothly functioning economy as long as it takes time to find similar or better work.

Typically between a quarter and a third of unemployed people are laid off subject to re- call (cyclically unemployed), an equal number voluntarily leave their jobs (frictionally unem- ployed), and the remainder are let go involuntarily without being subject to recall (though not all of this latter group should be referred to as structurally unemployed).

Productivity

Measuring and Describing Productivity As described in Chapter 1, an economy can grow because more resources are available or be- cause the ability to turn those resources into output has improved. Productivity speaks to the latter source of growth. Labor force productivity is the total amount of output per worker hour, whereas total factor productivity, otherwise known as multifactor productivity, is the increase in output that cannot be explained by an increase in labor, capital, or materials. It is measured as the difference between actual output and what output would have been had inputs remained constant. For this reason it is called a “residual” and is named for the Nobel Prize–winning economist Robert Solow, who came up with the measure.

The annual changes are displayed in Figure 6.5 as dashed lines. Because those annual changes are so clearly volatile, the five-year moving average of those changes is displayed in solid lines and it is those that are more valuable to inspect. What is clear is that the rapid increase in productivity that occurred during the post–World War II period up to the late 1960s was dramatically higher

cyclical unemployment State that exists when people lose their jobs because of a tempo- rary downturn in the economy.

seasonal unemployment State that exists when people lose their jobs predictably every year at the same time.

structural unemployment State that exists when people lose their jobs because of a change in the economy that makes their particular skill obsolete.

frictional unemployment Short-term unemploy- ment during a transition to an equal or better job.

labor force productivity Output per labor hour.

Multifactor productivity/ Total factor productivity The increase in output that cannot be explained by an increase in labor, capital, or materials.

gue46399_ch06_079-097.indd 90 16/03/17 11:39 AM

Seasonal Adjustment 91

FIGURE 6.5 Annual Changes (AC) and Five-year Moving Averages (5 yr MA) of Labor Productivity and Multifactor Productivity. Sources: www.bls.gov/bls/productivity.htm; www.bls.gov/mfp/trends_in_multifactor_productivity.pdf

8.0

6.0

4.0

2.0

0.0

–2.0

LP AC (5 yr MA)Labor productivity Multifactor productivity MFP AC (5 yr MA)

19 48

19 50

19 52

19 54

19 58

19 60

19 62

19 64

19 66

19 68

19 70

19 72

1 9 7 4

19 76

1 9 7 8

19 80

19 82

19 84

19 86

19 88

19 90

19 92

19 94

19 96

19 98

20 00

20 02

20 04

19 56

20 06

20 08

20 10

20 12

20 14

than that which occurred during the 1980s and early 1990s. A brief spike in productivity occurred during the late 1990s and early 2000s when manufacturing firms began to utilize robotic produc- tion and many service-based firms began to substitute automation for human interactions (e.g., ATMs and phone-trees). During and after the Great Recession those productivity gains evaporated.

Seasonal Adjustment

Almost all economic data published by the U.S. government comes in two forms, season- ally adjusted and nonseasonally adjusted. Seasonal adjustment takes into account predict- able, calendar-based changes. For instance, in the run-up to the Christmas shopping season, employment increases. First it increases at those manufacturing facilities that produce goods and then through the wholesale and retail trade sector as those goods are transported for sale and ultimately sold. When the season ends there is typically a one-percentage point increase in the nonseasonally adjusted unemployment rate from December to January. The seasonal adjustment takes that into account. The good thing about seasonal adjustment is that it allows you to better understand what the change in the unemployment rate is telling you about the state of the economy. Without it, you may hear that the unemployment rate increased by half a percentage point from December to January and mistakenly view that as a troubling sign

gue46399_ch06_079-097.indd 91 16/03/17 11:39 AM

92 Chapter 6 Every Macroeconomic Word You Ever Heard: Gross Domestic Product, Inflation, Unemployment, Recession, and Depression

regarding the economy. If the typical increase is a full percentage point and the actual increase is less than that, that is actually a good sign.

The same thing is true regarding prices. Fresh fruits and vegetables are cheaper when they are in season and more expensive when they are out of season. When they are out of season, they must be imported from another country where they are in season or, at the very least, brought in from a warm-climate area like California or Florida. Gasoline prices are typically higher in March and October because that is when refineries are required to switch from pro- ducing winter formulations to summer ones or vice versa. The dip in refining capacity during that time creates temporary price spikes. Seasonal adjustment takes that into account.

Business Cycles

Over the years there has been such a regular pattern of ups and downs in the economy that economists have put a name to it: the business cycle. Figure 6.6 shows the general pattern of the economy over time. Though the general trend is up, you can see that the path is rarely a straight line. With real gross domestic product on one axis and time on the other, you can see that a busi- ness cycle has five main components. The trough is the lowest point in the business cycle. The recovery is the period of growth in RGDP from the trough to the previous peak, that is, the period where RGDP gets back to where it was before the recession began. The expansion is the period of growth in RGDP from the previous peak to the new peak. The peak is the period where the growth in RGDP slows and eventually stops. Traditionally, a recession has been defined as a pe- riod of at least two consecutive quarters when the RGDP falls. This definition has, at times, been ignored as the National Bureau for Economic Research’s Business Cycle Dating Committee has attempted a more commonsense approach to establishing the beginning and ending dates for recessions. The 2007–2009 recession, for instance, was determined to have begun in late 2007 despite there being a slightly positive first quarter and significantly positive second quarter of 2008. This was because the downturn clearly started in late 2007 and the first half of 2008 was aided by a stimulus package that provided rebate checks to millions of Americans. By the time those rebates worked their way through the system and the financial crisis of fall 2008 took hold, it was apparent to these economists that the recession began in late 2007.

Between 1950 and 2011 there were nine recessions that lasted an average of nine and a half months. Some economists have argued that absent a major precipitating event, such as the Sep- tember 11 terrorist attacks, the potential for a recession has been lessened by the globalization of the U.S. economy. Typically, a recession is accompanied by a steep rise in the unemployment rate, a moderation in the inflation rate, and a reduction in real gross domestic product in the range

of 2 percent to 3 percent. Many times in the last half-century economists wondered whether the business cycle had been “repealed” only to find that it had not. With the possible exception of the recession of 2007–2009, the worst recession since World War II occurred in the early 1980s. At that time the unemployment rate went from around 7 percent to nearly 11 percent and the inflation rate went from 13 percent to less than 4 percent. The recession that occurred in 1990 as a result of Iraq’s invasion of Kuwait had muted effects, in that it lasted only eight months. Its effect on un- employment, inflation, and output was not nearly as stark as that of the recession of 1981–1982.

business cycle Regular pattern of ups and downs in the economy.

trough The lowest point in the business cycle.

recovery The part of the growth period of the business cycle from the trough to the previous peak.

expansion The part of the growth period of the business cycle from the previous peak to the new peak.

peak The highest point in the business cycle.

recession The declining period of at least two consecutive quarters in the business cycle.

R G

D P

Time

Peak Recession

Trough

Recovery

Expansion

Peak

FIGURE 6.6 The business cycle.

gue46399_ch06_079-097.indd 92 16/03/17 11:39 AM

Business Cycles 93

The recession of 2001 began with the uncertainty of the 2000 presidential election and ended in November of 2001. At this writing, the length and depth of the recession that began in late 2007 has not yet been determined. However, it clearly ended the string of short and shallow recessions. Figure 6.7 shows the three business cycles from 1981 to 2008.

The potential for a recession has been lessened in some economists’ eyes by the globaliza- tion of the U.S. economy. Those who argue from this point of view suggest that with greater international trade, countries moving into recessions are bolstered by international demand for their products. Conversely, countries that are in strong recoveries have that impact damp- ened because purchases that were once domestic often are made from foreign sources.

On the other hand, other economists warned that the Asian–Russian–Latin American finan cial crisis of the late 1990s shows how one region’s economy can begin a domino effect that is destabilizing. Just as a string of dominoes is more stable when barriers are strategically placed between dominoes, economies may be more stable if the troubles in one country are insulated from the troubles in another. The health of the U.S. economy during the period did, in the end, stabilize the world economy.

Unfortunately, there were few corners of the globe that stood in the way of the 2007–2009 recession. Begun by declining demand in the United States and rapidly increasing world en- ergy prices, it got an unwelcome shot in the arm with the collapse of real estate markets around the world and the subsequent foreclosure-induced financial crisis of late 2008. Whether

From 1970 through the late 1990s, the predominant concern over prices was their propensity to rise too rapidly. Inflation concerns reached their peak in the late 1970s and early 1980s as prices were rising at or near 10 percent per year. Given that, why would it be a problem for prices to decline? The answer is actually somewhat simple. People delay buying big- ticket items when they are certain it will be cheaper if they are patient.

When inflation is running between 1 and 2 percent per year, it is not in anyone’s interest to not buy things in hopes that prices will decline, because they won’t. On the other hand, if prices are falling, then there is such a motivation. If consumers do not buy goods in anticipation of price declines, then the people who make those goods will see demand fall. They cut costs by cutting wages and benefits, or worse, by laying people off. When profits decline, the value of stocks declines. With less wealth, stockhold- ers spend less on consumer goods. The final straw is when housing prices start to fall. When that happens, people can easily owe more on their house than their house is worth. That results in a dramatic contraction in their willingness to maintain it and the elimination of their ability to borrow money against its equity (since they now have none).

From the late 1980s until 2003 Japan experi- enced a significant deflation in asset prices with the Japanese stock market, as measured by its principal index, the Nikkei 225, falling from nearly 40,000 to less than 8,000. Beginning in 2003 it recovered so that by early 2007 it was above 18,000. During that 13-year period, Japanese real estate values also plummeted. So, though Japan’s economy was once the envy of the Western world, its deflation-led eco- nomic slump lasted much longer than a typical re- cession. More recently, the bursting of the housing bubble in the United States in 2007, the demise of the commercial real estate market, and the dramatic drop in world oil prices from mid-2008 through 2009 caused many economists to worry that this same fate would strike the United States.

It was precisely this concern that kept the Federal Reserve focused on ensuring that the frag- ile recovery of 2010 and 2011 kept going. The Fed’s overriding fear was that a deflationary spiral would be nearly impossible to stop. This led the Fed to policies, like the much discussed second round of quantitative easing (dubbed QE2), that under normal circumstances would have been viewed as disas- trously inflationary. The goal of these policies was to prevent deflation.

deflation A general reduction in prices.

I F I N F L A T I O N I S B A D , H O W C A N D E F L A T I O N B E W O R S E ?

gue46399_ch06_079-097.indd 93 16/03/17 11:39 AM

94 Chapter 6 Every Macroeconomic Word You Ever Heard: Gross Domestic Product, Inflation, Unemployment, Recession, and Depression

globalization dampened or amplified the recession will be a matter for future macroeconomic historians to determine.

A phenomenon that has not visited the United States in nearly 60 years is depression. Although there is no formal economic distinction between a recession and a depression, there certainly is little doubt that we have not experienced a depression since the 1930s. Depressions are severe recessions usually characterized by any one of the following problems: financial panic and bank closures, unemployment rates exceeding 20 percent, prolonged retrenchment in RGDP on the magnitude of 10 percent or more, and significant deflation.

Lessening the likelihood of depression are the economic and social safety nets (e.g., unemployment insurance, welfare) that exist in most modern economies. The recessions that occur when people lack the confidence to buy things can be prevented from becoming de- pressions by governments that move to alter interest rates and government spending poli- cies. Further, as things worsen and unemployment rises, unemployment insurance and other policies exist now to lessen the effect. Thus people who are unemployed at the beginning of the 21st century have much more spending power than those unemployed at the beginning of the twentieth century. This in turn lessens the likelihood that a recession will turn into a depression.

depression Severe recession typically resulting in a financial panic and bank closures, unemploy- ment rates exceeding 20 percent, prolonged retrenchment in RGDP on the magnitude of 10 percent or more, and significant deflation.

Year

19 8

1

19 8

2

19 8

3

19 8

4

19 8

6

19 8

7

19 8

8

19 8

9

19 9

1

19 9

2

19 9

3

19 9

4

19 9

6

19 9

7

19 9

8

19 9

9

2 0

0 1

2 0

0 2

2 0

0 3

2 0

0 4

2 0

0 6

2 0

0 7

2 0

0 8

R G

D P

$ b

ill io

n s

(2 0

0 0

)

Peak

Peak

Peak

Recovery

Recovery

Recovery

Expansions

Recessions

Trough

Trough

Trough

11,500

12,500

10,500

9,500

8,500

7,500

6,500

5,500

4,500

FIGURE 6.7 An example of three business cycles: 1981 to 2008.

Source: Bureau of Economic Analysis, www.bea.gov

NATIONAL INCOME AND PRODUCT ACCOUNTING

All the data described in this chapter come from multiple sources and can be accessed from a variety of government and academic web pages. Whether from tax reports, sales tax records, surveys, or reports firms are required to supply the government, the data are collected, analyzed, and published. As we saw early in this chapter we can get to GDP using the expenditures approach or the income approach. The formulas are complicated and needlessly tedious for a book such as this, but you can get an idea of what is needed for GDP from the table below. You should also note that for a variety of statistical and methodological reasons the numbers don’t add up to be precisely equal, so a “statistical discrepancy” is always present.

Kick It Up a Notch

gue46399_ch06_079-097.indd 94 16/03/17 11:39 AM

Summary 95

Alternative Calculations for Gross Domestic Product in Billions, 2014.

Expenditures Approach Amount Income Approach Amount

Personal consumption 12061.4 Employee compensation 9434.7 Gross private investment 2937.2 All profits 4489.4 Government consumption and

investment expenditures 3162.5 Indirect business taxes 1169.5 Net exports −545.2

Depreciation 2784.2 Statistical discrepancy −261.8

Gross domestic product 17615.9 Gross domestic product 17,616*

Expenditures Approach: Table 1.1.5; Income Approach: Table 1.10. * Rounding error Source: Bureau of Economic Analysis, www.bea.gov

This chapter presented the basic vocabulary of the macroeconomy and explored many of the measures of it—measures that are not without flaw. We saw that the measure of output is gross domestic product, that prices and inflation are measured using a price index, and that the most frequently referred to price index is the CPI. Moreover, we discussed why GDP is adjusted for inflation to create real GDP and that this, though also flawed, is a key measure of economic health. Further, the chapter explained how unemployment is measured, that this measure is subject to some concern, and that economists divide the unemployed into types depending on how they got that way. We concluded by discussing the language of the business cycle.

Summary

Key Terms base year business cycle chain-based index consumer price index (CPI)  core CPI core PCE cost-of-living adjustment

(COLA) cyclical unemployment deflation depression discouraged-worker effect  encouraged-worker effect expansion frictional unemployment

GDP deflator (GDPDEF)

gross domestic product (GDP)

inflation rate labor force labor force participation rate labor force productivity macroeconomics market basket microeconomics multifactor productivity peak Personal Consumption

Expenditures deflator

price index price of the market basket in

the base year Producer Price Index real gross domestic product

(RGDP) recession recovery seasonal unemployment structural unemployment total factor productivity trough underemployment unemployment rate

Quiz Yourself 1. In measuring gross domestic product, goods produced by foreign firms in the United States are a. counted, and so are goods produced by American firms in foreign countries. b. counted, but goods produced by American firms in foreign countries are not counted. c. not counted, but goods produced by American firms in foreign countries are counted. d. not counted, and goods produced by American firms in foreign countries are also

not counted.

gue46399_ch06_079-097.indd 95 16/03/17 11:39 AM

96 Chapter 6 Every Macroeconomic Word You Ever Heard: Gross Domestic Product, Inflation, Unemployment, Recession, and Depression

2. Gross domestic product is counted using two methods: one that counts all the ways people money and another that counts all the ways people

money. a. earn, spend b. spend, save c. earn, save d. loan, borrow

3. Inflation is measured using in a price index. a. the absolute increase b. a multiyear weighted average increase c. the percentage year-to-year increase d. logarithm-adjusted absolute increase

4. In early 2005, inflation increased unexpectedly because of an increase in oil prices. This helped a. borrowers. b. lenders. c. people on fixed incomes. d. workers.

5. The consumer price index (CPI) is a heavily criticized measure of inflation because a. the government does nothing to fix its known deficiencies. b. it consistently understates the increase in the cost of living. c. it consistently overstates the increase in the cost of living. d. the government constantly makes adjustments in it without warrant.

6. One problem with using real gross domestic product as a measure of social welfare is that a. it fails to count home production. b. it fails to count services, a growing part of the economy. c. it double, triple, and sometimes quadruple counts goods that are produced in stages. d. it fails to account for imports, a growing part of the economy.

7. In 2005, General Motors announced a 20 percent reduction in its staffing levels and the closure of many assembly plants. Those laid off as a result would likely be classified as a. seasonally unemployed. b. cyclically unemployed. c. frictionally unemployed. d. structurally unemployed.

8. On a graph of real gross domestic product over time, recessions appear as a. relatively short and shallow drops on an otherwise increasing path. b. long, sharp declines on an otherwise increasing path. c. the dips on a path that increases and decreases equally. d. the periods where the rate of growth, while still positive, slows.

9. Of these, economists consider this the worst: a. inflation of 5 percent. b. recession. c. deflation of 5 percent. d. depression.

gue46399_ch06_079-097.indd 96 16/03/17 11:39 AM

Summary 97

Short Answer Questions

1. Explain why an economist would focus on real GDP rather than nominal GDP. 2. Suppose you walked into an unemployment office and found the following people: a laid-

off mall Santa Claus, an unemployed auto-industry worker (who is subject to callback by their company), a woman who lost her job at a manufacturer because the company relo- cated to Mexico, and a nurse who just moved to town because his wife recently started a new job. Assign the following labels to the people above: cyclically unemployed, friction- ally unemployed, structurally unemployed, and seasonally unemployed. Then, explain your assignment of the terms to each person.

Think about This Economists have argued for many years that the CPI overstates the cost of living. The degree of that overstatement has been the subject for significant economic research. Part of the prob- lem in resolving the agreed-upon problems is that any correction has the effect of reducing Social Security checks and increasing taxes. Should economic measures be subject to political debate?

Talk about This Economist Joseph Schumpeter once argued that people are too often lulled into an unpro- ductively comfortable state when they have continuous employment. His conclusion was that recessions (more accurately, depressions, in his era) were good because they forced people to be creative and entrepreneurial. He labeled this “creative destruction.” Do you agree with the premise of his argument? Do you agree with his conclusion?

For More Insight See Hausman, Jerry. “Sources of Bias and Solutions to Bias in the Consumer Price Index.” Journal of Economic Perspectives 17, no. 1, pp. 23–44. Lebow, David E., and Jeremy B. Rudd. “Measurement Error in the Consumer Price Index: Where Do We Stand?” Journal of Economic Literature XLI, pp. 159–201. “Measuring the Economy”—www.bea.gov/national/pdf/nipa_primer.pdf

Behind the Numbers U.S. Gross Domestic Product and Recessions—www.bea.gov Unemployment rate—www.bls.gov/cps

gue46399_ch06_079-097.indd 97 16/03/17 11:39 AM

98

C H A P T E R S E V E N

Interest Rates and Present Value Learning Objectives

After reading this chapter you should be able to:

LO1 Describe what interest rates are and differentiate nominal from real interest rates.

LO2 Describe the use of present value calculations in determining the value of a payment stream.

LO3 Apply the tool of present value when thinking about economic decisions where the costs and benefits of decisions happen at different times.

Chapter Outline

Interest Rates

Present Value

Future Value

Kick It Up a Notch: Risk and Reward

Summary

Many economic decisions take place over time. That is, the time at which the benefits of a given decision are gained is different from the time the costs are incurred. For instance, when you save money, you put off the ability to buy something now so that you have even more money to spend in the future. When you borrow, you get to consume a good before you have sufficient means to pay for it. Thus we agree to give up a single sum now for a larger amount that we will receive later, or we agree to pay a certain amount per month over a series of months rather than pay a single sum now. In this market, as in any market, there is a price and there is a quantity, and there is a buyer and there is a seller. In this chapter we explore borrow- ing, lending, investing, and saving decisions.

We begin by exploring interest rates, the price of money, and how they are determined. We look at the importance of anticipated inflation in this decision so as to draw a distinction between nominal and real interest rates, a distinction that is important to economists.

We conclude by looking at financial decisions. We will see that any particular decision to borrow, save, lend, or invest depends on what economists call present value. We will examine scenarios in which we save or borrow a sum of money now in order to get a larger sum of money later. We will also provide more complicated examples in which the payments we make or receive are spread over time.

gue46399_ch07_098-106.indd 98 16/03/17 11:40 AM

Interest Rates 99

Interest Rates

The Market for Money When people lend or borrow money, we call the price at which they do this the interest rate. A useful way to think of this market for money is to imagine yourself renting a moving van. When you rent such a vehicle, the owner is letting you use it for a predetermined period of time at a predetermined price. Now, instead of renting a van, think about renting money. The owner of the money is letting you use the money for a period of time at a predetermined price. The period of time is typically denoted per year and so the price is an annual interest rate. This means that when you are borrowing money to buy a car or home or seeking money from investors, you must pay interest.

Of course you could be on the other side and be the owner of money that you put in a bank or use to buy a bond. You are now “renting” the money to someone else. In all cases the rate of interest is an important component in your transaction. In this market that we are discussing, the seller is the one with money and the buyer is the one seeking the money.

Figure 7.1 depicts a market like one we saw in Chapters 2 and 3. Here, though, the price is the interest rate and the quantity is the amount that the lender/saver extends to the borrower. The supply curve is upward sloping because the lender/saver will be motivated to lend more if he or she can get a higher return, and the demand curve is downward sloping because at higher interest rates the borrower will view borrowing as less advantageous. As in any other market, an equilibrium interest rate and amount borrowed or lent will result.

The equilibrium interest rate will depend on a number of factors. For instance, the inter- est rate for people with good credit histories is typically lower than it is for people with poor ones. The bank interest rate for car loans is usually higher than the interest rate for home loans. Credit card interest rates are very high. The reason for this is the degree of risk. A lender can- not assume that a borrower will pay every loan back in full. Lenders are taking a risk and part of what goes into their decisions is the likelihood that the borrowers will pay back the loans and the consequences if they do not. Credit cards are typically not secured by anything, and, as a result, credit card interest rates are higher than home loans. If a buyer defaults on a home loan, the lender can take possession and ultimately sell the house.

Nominal Interest Rates versus Real Interest Rates When the interest rate for a certificate of deposit (CD) or car loan is advertised publicly, that is referred to by economists as the nominal interest rate. Though this is the rate of in- terest referred to in Figure 7.1, it is not as interesting to economists as what they refer to as the real interest rate. The real interest rate is the rate of interest after inflation expectations

have been taken into account. Inflation, which was explained in Chapter 6, is the increase in prices in percentage terms. Inflation matters for our discussion of interest rates because both borrowers and lenders consider the benefits and costs of their decisions in terms of the consumption gained and lost. Since the borrower is presumably going to take the money to buy something now and pay the money back later to a lender who will then buy something with the money, the change in prices is important. Let’s consider a concrete example.

Suppose you agree to lend a friend $500 if he agrees to pay you back next year with 10 percent interest. This

interest rate The percentage, usu- ally expressed in annual terms, of a balance that is paid by a borrower to a lender that is in addition to the original amount borrowed or lent.

nominal interest rate The advertised rate of interest.

real interest rate The rate of interest after inflation expectations are accounted for; the compensation for wait- ing to consume.

FIGURE 7.1 The market for money.

r*

$*

Demand

Money borrowed /saved ($)

In te

re st

r at

e r

Supply

gue46399_ch07_098-106.indd 99 16/03/17 11:40 AM

100 Chapter 7 Interest Rates and Present Value

means that next year you will get $550. Suppose that both of you will end up buying iPads with the money and that today it costs exactly $500. If the price of these devices goes up to $600 by the time you get your money, then you have lost out. He got his iPad and you did not have enough for one even after waiting a year to get it. On the other hand, if iPads increased only to $525, then you could afford one when you got your money and would have $25 extra for waiting the year to get it. What this means is that inflation matters in this borrowing/ lending decision. This is especially true if we know what the rate of inflation will be.

Although no one knows for sure what inflation will be in the coming year, people are able to use recent experience as a guide. As a result borrowers and lenders form inflation expectations. If you require $25 compensation for waiting a year to buy your iPad and you expect the price to increase by $25, then you will require $550 be paid to you. The first $25 compensates you for the higher prices that will exist when you go to buy yours, and the second $25 compensates you for waiting the year to buy it.

What this means for economists is that the nominal interest rate is equal to the sum of infla- tion expectations and the real interest rate.1

Present Value

It is easy to see that $100 is more than $50. It is much more difficult to compare $50 today against $100 six years from now. To put dollar values on an even playing field, we compare monies using a concept called present value. Using an appropriate interest rate, though, you can compare money paid at two different times. We say that two amounts paid apart from one another in time are equal in present value if the money paid now could be invested at an appropriate interest rate and generate an amount that turns out to be equal to a higher amount that is paid later.

Simple Calculations The math required to fully understand present value is somewhat complicated and is displayed below:

Present value = Payment

________ (1 + r)n

where

payment = payment to be received in the future r = interest rate n = number of years before payment is received

Fortunately, the concept and its conclusions are not as complicated as the math. The idea is that the payment in the future needs to be deflated by a factor equal to 1 plus the interest rate for every year that is to pass before the payment is made. If the interest rate is 10 percent and 10 years are to pass, then the payment is deflated 10 times by 1.10.

To use a particular example, consider what $200 paid 10 years from now is worth in present value if the interest rate is 10 percent. To compute this we need to multiply 1.1 by itself 10 times. The result is 2.5937, so the present value is $200/2.5937, or approximately $77.11. This means that if you had $77.11 today, and you invested it at 10 percent interest for 10 years, you would have $200. Stated differently, if 10 years from now you were going to receive $200 and wanted to borrow against it and the going rate was 10 percent, you could borrow only $77.31.

present value The interest-adjusted value of future payment streams.

1 There is a mathematical cross-product term as well, but it is very small when the inflation and real interest rates are low.

gue46399_ch07_098-106.indd 100 16/03/17 11:40 AM

Present Value 101

As mentioned, the factor 2.5937 was computed by multiplying 1.1 by itself 10 times (a pro- cess called compounding). Table 7.1 provides factors for several different interest rates for sev- eral different periods. The interest rate appears at the top, and the left column indicates the number of years between the time when the borrower gets the money and the time he or she pays it back. The body of the table displays how much money the borrower will have to pay back for every dollar borrowed. For instance, every dollar you borrow on a 20 percent credit card that you fail to pay back within five years costs you $2.49, the original dollar plus $1.49 interest.

Mortgages, Car Payments, and Other Multipayment Examples We can use this concept to calculate how much house or car we can afford. Here, instead of borrowing a single sum and paying it off with a single payment, we are borrowing a single sum and paying it off in small increments. Of course we could think of situations where we save in small increments to generate a single sum, like saving for a vacation, or situations where we save in small increments to generate other increments, like saving for retirement and getting a monthly check in retirement. These are simply extensions of the same principle.

For each of these examples there is a wonderfully elegant formula that would allow us to plug in various numbers and get results. These formulas, while interesting to those who study financial management issues, are not necessary for us to understand how we might use the present value idea in these other contexts.

For that, let’s turn to Table 7.2, where we will try to evaluate whether a particular business deal is a good idea. Suppose that an investment of $100 each year for five years will, starting in the sixth year, return a payout of $100 a year that will continue for the next seven years.

Though the total of benefits is greater than the total of costs, whether this is a good business deal depends on the interest rate. If the interest rate is 5 percent, the present value of benefits is larger than the present value of costs. At 8 percent and 10 percent the present value of benefits is less than the present value of costs. That means that a business whose goal was to maximize profit would go ahead with the investment if interest rates were 5 percent and not if the inter- est rate was 8 or 10 percent. The interest rate where the present value of costs and benefits are equal is called the internal rate of return. In this case it is about 5.8 percent. Generally, when the interest rate that must be paid is less than the internal rate of return, then the present value of benefits exceeds the present value of costs.

All mortgages and car payments are similarly calculated, though these are somewhat more simple because there is only one up arrow, the value of the house or car loan, and the multiple down arrows, the payments that are required. To give you some perspective on how much you would have to make in monthly payments on a variety of loans, consider Table 7.3, a very abbreviated set of present value factors. Again at the top are the various yearly interest rates and in the left column are the various loan durations. Thus a $1,000 computer purchased on a 20 percent interest credit card will cost the buyer $26.49 every month for five years. This translates into $1,589.63 in total payments over the five-year loan.

internal rate of return The interest rate where the present value of costs and benefits is equal.

Interest Rate (%)

Year 20 10 5 2 1

30 237.38 17.45 4.32 1.81 1.35 10 6.19 2.59 1.63 1.22 1.10 5 2.49 1.61 1.28 1.10 1.05 1 1.20 1.10 1.05 1.02 1.01

TABLE 7.1 The amount payable for every dollar borrowed for several interest rates and several loan durations.

gue46399_ch07_098-106.indd 101 16/03/17 11:40 AM

102 Chapter 7 Interest Rates and Present Value

We can use Table 7.3 to figure out what typical monthly payments will be on purchases that you might make in the coming years. We just saw that if you purchase a $1,000 computer using a typical credit card, you will have to pay $26.49 per month for five years to pay off the loan. If you buy a $30,000 car with a five-year payoff period and get a 10 percent interest bank loan, you will have monthly payments of $637.50 (30 × $21.25). If you buy the same car during a financing promotion when the car company loans you the cost of the car at only 2 percent interest, your payments will be only $525.90 (30 × $17.53) per month. Last, if you purchase a $100,000 home with a 30-year mortgage at 5 percent interest, it will cost you $537 (100 × 5.37) per month.

Future Value

The present value formula can be algebraically rearranged to become a future value formula. Future value is the interest-adjusted value of past payments. Using the same variables from the present value formula,

Future value = Payment × (1 + r)n

This calculation is useful when you are looking to save an amount now for an expense that will occur at a later time. If, for instance, you had $10,000 and wanted to save it to give to your newborn daughter upon her high school graduation, you might put it in an 18-year certificate of deposit earning 4 percent. If you plug in those numbers (n = 18, r = .04), you will find that she could cash it in for $20,258.17.

future value The interest-adjusted value of past payments.

TABLE 7.2 Present value of costs and benefits at alternative interest rates.

Year Cost Benefit PV Cost @5%

PV Benefit @5%

PV Cost @8%

PV Benefit @8%

PV Cost @10%

PV Benefit @10%

1 100 100.00 100.00 100.00 2 100 95.24 92.59 90.91 3 100 90.70 85.73 82.64 4 100 86.38 79.38 75.13 5 100 82.27 73.50 68.30 6 100 78.35 68.06 62.09 7 100 74.62 63.02 56.45 8 100 71.07 58.35 51.32 9 100 67.68 54.03 46.65 10 100 64.46 50.02 42.41 11 100 61.39 46.32 38.55 12 100 58.47 42.89 35.05

500 700 454.59 476.04 431.20 382.69 416.98 332.52

Interest Rate (%)

Year 20 10 5 2 1

30 16.71 8.78 5.37 3.70 3.22 10 19.33 13.22 10.61 9.20 8.76 5 26.49 21.25 18.87 17.53 17.09 1 92.63 87.92 85.61 84.24 83.79

TABLE 7.3 Monthly payments required on a $1,000 loan for various interest rates and various loan durations.

gue46399_ch07_098-106.indd 102 16/03/17 11:40 AM

Future Value 103

Spreadsheet programs, such as Microsoft’s Excel®, allow for quick and easy processing of complicated financial calculations. For in- stance, the PMT function allows users to calculate the payment that, when made over several periods, will pay off a loan. The PV function allows users to calculate how much they can borrow to buy a home or car when they can afford a particular payment. The FV function allows users to know how much money they will have when they retire or when they are ready to put a child through school if they

were to save a particular amount per pay period. The IRR function allows users to calculate the internal rate of return on an investment that takes the form of a flow of uneven payments. The RATE function allows users to calculate the rate of return they are earning on an investment that promises to pay a particular amount in the future should the user save either a fixed amount now or follow a regular savings plan.

Function Form of the Function Example Problem Example Solution

Payment (PMT)

@PMT (r,N,PV,FV) How much would you have to pay per month on a four-year $30,000 car loan when the bank charges you 5%?

@PMT (.05/12,4*12,30000)

How much would you have to save per month if you wanted to have $20,000 for a car five years from now if you could earn 3% interest?

@PMT (.03/12,5*12,0,20000)

Present Value (PV)

@PV (r,N,PMT,FV) How much could you borrow if you could afford $500 per month payments on a house on a 30-year 4% mortgage?

@PV (.04/12,30*12,500)

How much could you borrow at 7% if you were going to receive $10,000 in two years and use that money to pay all of your loan at that time?

@PV (.07,2,0,10000)

Future Value (FV)

@FV (r,N,PMT,PV) How much would you have in an account in 20 years if you saved $1,000 per month and earned 1% on those savings?

@FV (.01/12,20*12,1000)

How much would you have in an account in 15 years if you put $15,000 into an account that earned 9%?

@FV (.09,15,0,15000)

Internal Rate of Return (IRR)

@IRR (range on the sheet)

What is the internal rate of return for an investment that costs $100 the first year, $50 the second, but earns $200 in the third year and $40 in the fourth?

–100

@irr(C1:C4)

200 40

–50

C

@Rate (N,PMT,PV,FV) What is the internal rate of return for an investment that costs $10,000 but returns $4,000 for three years?

@Rate (4,4000, −10000)

What is the internal rate of return for an investment that costs $1,000 per year but returns $15,000 after 10 years?

@Rate (10, −1000,0,15000)

S P R E A D S H E E T S M A K E C O M P L I C A T E D C A L C U L A T I O N S Q U I C K A N D E A S Y

gue46399_ch07_098-106.indd 103 16/03/17 11:40 AM

104 Chapter 7 Interest Rates and Present Value

Both present value and future value calculations are central to problems in business, the discipline of finance in particular. They require a calculator with a yx key or a spreadsheet pro- gram to make the exponential calculations. Before calculators and computers were common, car dealers and real estate agents used a shortcut, called the Rule of 72, which allowed them to estimate these calculations in their head relatively quickly. Note from the preceding calcula- tion that the $10,000 CD roughly doubled when saved at 4 percent for 18 years. The Rule of 72 allows you to estimate the time it would take for an investment to double by dividing 72 by the annual interest rate (72/4 = 18).

Rule of 72 A shortcut that allows you to estimate the time it would take for an investment to double by dividing 72 by the annual interest rate.

RISK AND REWARD

Investing is risky business. Some investments do not pay off as expected. Economists look at risk as the possibility that the investor will not get those anticipated payoffs. There are two basic types of risk, the default risk, where the borrower doesn’t pay the debts, and market risk, where the market value of a stock or bond changes in an unanticipated manner. To compensate the investor, a greater reward is offered. Economists call that greater reward the risk premium. Because longer-term predictions are often less accurate than shorter-term ones, there is also a relationship between the reward an investor receives and the length of time the investor must wait to get that reward. Economists call that relationship between reward and the time you have to wait to get it the yield curve. A sample yield curve for loaning money to the federal govern- ment is shown in Figure 7.2.

risk The possibility that the investor will not get anticipated payoffs.

default risk The risk to the investor that the borrower will not pay.

market risk The risk that the market value of an asset will change in an unantici- pated manner.

risk premium The reward investors receive for taking greater risk.

yield curve The relationship between reward and the time until the reward is received.

Kick It Up a Notch

0

0.5

1.5

2.0

2.5

3.0

1.0

2 0

16 2

0 17

2 0

18 2

0 19

2 0

2 0

2 0

2 1

2 0

2 2

2 0

2 3

2 0

2 4

2 0

2 5

2 0

2 6

2 0

2 7

2 0

2 8

2 0

2 9

2 0

3 0

2 0

3 1

2 0

3 2

2 0

3 3

2 0

3 4

2 0

3 5

2 0

3 6

2 0

3 7

2 0

3 8

2 0

3 9

2 0

4 0

2 0

4 1

2 0

4 2

2 0

4 3

2 0

4 4

2 0

4 5

FIGURE 7.2 Yield curve for U.S. treasuries, January 2016, with maturities to 2046.

This chapter introduced the concept of interest rates and showed that the market for money is no different conceptually from the market for any other good. The interest rate was explained as the price of borrowing money. The difference between real and nominal interest rates was explained, highlighting the notion that real interest rates account for anticipated inflation. These concepts were expanded to explain present value and future value and how those concepts can be used to evaluate economic decisions where payments are made or received over a span of time.

Summary

gue46399_ch07_098-106.indd 104 16/03/17 11:40 AM

Summary 105

Key Terms default risk future value interest rate internal rate of return

market risk nominal interest rate present value real interest rate

risk risk premium Rule of 72 yield curve

Issues Chapters You Are Ready for Now

The Economics of Crime The Economics of K–12

Education

College and University Education: Why Is It So Expensive?

Social Security

Personal Income Taxes The Stock Market and

Crashes

Quiz Yourself 1. When evaluating a business decision, an economist will often resort to the use of present value because a. the profits may not be large enough to warrant the time and attention of the investor. b. the investment occurs in one time period and the profits in another. c. the investment is often in one currency and the profits in another. d. the investment is often under one set of managers and the profits under another.

2. In the market for loanable dollars, an increase in the profitability of investments overall will be revealed in a. an increase in the supply of loanable dollars. b. an increase in the demand for loanable dollars. c. a decrease in the supply of loanable dollars. d. a decrease in the demand for loanable dollars.

3. When evaluating whether or not to make an investment, one should focus on the __________ because doing so takes into account anticipated inflation. a. nominal interest rate b. real interest rate c. exchange rate d. junk bond rate

4. Suppose your grandmother told you (today) that she had set aside an amount of money in a savings account bearing 3 percent interest that was sufficient to give you a $5,000 graduation present in exactly four years. How much would she have had to set aside? a. $5,000 b. $5,000 × (1.03)4 c. $5,000/(1.03)4 d. $5,000/(1 + 0.034)

5. Using an interest rate of 5 percent, which figure has the largest present value? a. $5,000 b. $5,050 to be received two years from now c. $5,075 to be received three years from now d. $5,500 to be received 10 years from now

6. Using an interest rate of 5 percent, which figure has the smallest present value? a. $5,000 b. $5,050 to be received two years from now c. $5,075 to be received three years from now d. $5,500 to be received 10 years from now

gue46399_ch07_098-106.indd 105 16/03/17 11:40 AM

106 Chapter 7 Interest Rates and Present Value

7. The present value of a $1,000 payment received two years from now at 5 percent annual interest will be less than $900 because of a. taxes. b. compounding. c. withholding. d. double jeopardy.

8. A 60-month car loan (where no down payment was made) with a 6 percent interest rate and a monthly payment of $500 would allow the borrower to buy a a. $35,500 car. b. $30,000 car. c. $25,863 car. d. $28,200 car.

Short Answer Questions

1. Why is the present value of money to be paid in the future less than the amount to be paid, but the future value of money invested now and withdrawn later is greater than the original investment?

2. Why is it that $400 per month paid over five years will not be enough to buy a $24,000 car?

3. Why is there usually a positive relationship between the time a bond will mature (how long the investor has to wait to get her money) and the interest rate on that bond?

Think about This The amount of principal paid in the early stages of a mortgage is relatively modest. On a $100,000 loan, at 6 percent for 360 months, the first payment is almost exactly $600 with $500 going for interest and $100 going toward principal. Before 2008’s financial meltdown, many new homebuyers were getting “interest-only” mortgages. (They paid $500 per month for the first five years and then $644 per month thereafter.) Do you think this was a good idea?

Talk about This College students and young people generally get themselves into credit problems because they do not fully understand the consequences of borrowing and overestimate their ability to pay loans back. Should your college censor campus bulletin boards and remove credit card offers from mail you receive in residence halls? Bankruptcy laws prevent people from defaulting on student loans, which means even if you do declare bankruptcy on your credit card debt, you cannot get out from money you owe in student loans. Were you aware of this when you took out a student loan, and would that impact your decision to take out a student loan?

gue46399_ch07_098-106.indd 106 16/03/17 11:40 AM

107

C H A P T E R E I G H T

Aggregate Demand and Aggregate Supply Learning Objectives

After reading this chapter you should be able to:

LO1 Apply and manipulate the aggregate supply and aggregate demand model of macroeconomics.

LO2 Explain why the aggregate demand curve is downward sloping and why there is controversy over the shape of the aggregate supply curve.

LO3 List the variables that shift these curves and understand how the shifting translates into price and output impacts.

LO4 Discriminate between demand-pull and cost-push inflation.

LO5 Summarize what is meant by supply-side economics.

Chapter Outline

Aggregate Demand

Aggregate Supply

Shifts in Aggregate Demand and Aggregate Supply

Causes of Inflation

How the Government Can Influence (but Probably Not Control) the Economy

Summary

Now that we have laid out the language of macroeconomics and some of the measurement issues, it is time that we turn our attention to modeling the macroeconomy. Just as we used the supply and demand model in Chapter 2 to help us understand what would happen in a particu- lar industry if certain variables changed, we use the aggregate supply and aggregate demand model to help us understand how other variables affect the economy as a whole.

Remember that models are not perfect. They rest on simplifying assumptions that allow us to boil down the essentials of what we are looking at in a way that clarifies the big picture. In microeconomics, supply and demand is a well-understood and relatively well-accepted framework with which to look at particular industries. Regrettably, in macroeconomics no such comparable model exists.

The closest we come to finding a workable model that is relatively easy to use and that is flex- ible enough to encompass a variety of differing viewpoints is the aggregate supply and aggregate demand model. It also has the virtue of mirroring the supply and demand model that we studied in Chapter 2, so the concepts are less foreign than they would be with a completely new model.

The reason for caution with regard to macro models is that, unlike microeconomic models, where there is only one market, many interrelated goods and services are combined.

gue46399_ch08_107-118.indd 107 16/03/17 11:40 AM

108 Chapter 8 Aggregate Demand and Aggregate Supply

Whereas we can readily list five important things that influence the price of apples, we would need more than five pages to list the important things that affect the economy as a whole. The macro economy is just much bigger and much more complex than any particular market. With this caution in mind we proceed in this chapter with the aggregate supply– aggregate demand model knowing that, although not perfect, it is reasonably suited to the purpose at hand.

Following the method of presentation in Chapter 2, we explain this model by first exam- ining aggregate demand and aggregate supply individually. Then we look at them together, as part of one model. Just as in Chapter 2, where we then looked at why supply and demand might change, we examine why aggregate supply and aggregate demand might change and what happens when they do. Last, we use the aggregate supply–aggregate demand model to explain, albeit very briefly, supply-side economics.

Aggregate Demand

Definition Aggregate demand (AD) is a measure of the amount of goods and services that will be pur- chased at various prices. It shows the quantities of real domestic output that domestic consum- ers, businesses, governments, and foreign buyers collectively will desire to purchase at each possible price level. As a practical matter we map this on a graph (Figure 8.1) with our mea- sure of real goods and services sold, real gross domestic product (RGDP), on the horizontal axis and our measure of all prices, the price index (PI), on the vertical axis.

Just as in Chapter 2, when we asserted that the demand curve was downward sloping and then discussed why this makes sense, we do the same now. As shown in Figure 8.1, the aggre- gate demand curve does, in fact, relate all prices to real output in a negative or inverse manner. This makes sense for three reasons: the real-balances effect, the foreign purchases effect, and the interest rate effect.

Why Aggregate Demand Is Downward Sloping The real-balances effect is the idea that any wealth that you may have in the form of cash or securities becomes less valuable as prices rise. Also, if you have less ability to buy real goods and services when prices are higher, then the two are negatively related.

The second reason why the aggregate demand curve is downward sloping is the foreign purchases effect. The argument here is that as prices rise in the United States, Americans will be more willing to buy imports and less willing to buy American-made goods. Foreigners will also be less willing to buy U.S. goods, thus reducing our exports to them. If you remember the

expenditures approach from Chapter 6, you will recall that any increase in imports reduces U.S. GDP.

The interest rate effect is that higher prices lead to in- flation. This in turn leads to less borrowing and a lowering of RGDP. The definition of aggregate demand will help explain the significance of interest rates as they relate to the downward-sloping nature of the aggregate demand curve. Recall from Chapter 6 that, using the expenditure approach, aggregate demand is calculated by adding total consumption, business investment, government spending on goods and services, and exports and then subtracting imports from that sum. Two of those items, consumption

aggregate demand (AD) The amounts of real domestic output that domestic consumers, businesses, governments, and foreign buyers col- lectively will desire to purchase at each possible price level.

foreign purchases effect When domestic prices are high relative to their imported alternatives, we will export less to for- eign buyers and we will import more from for- eign producers. There- fore, higher prices lead to less domestic output.

real-balances effect Because higher prices reduce real spending power, prices and output are negatively related.

interest rate effect Higher prices lead to inflation, which leads to less borrowing and a lowering of RGDP.

PI

RGDP

AD

FIGURE 8.1 Aggregate demand.

gue46399_ch08_107-118.indd 108 16/03/17 11:40 AM

Aggregate Supply 109

and business investment, are interest-sensitive. When people buy homes, cars, home furnishings, or any good expected to last longer than three years (what economists call durable goods), they often do it by borrowing the money. When interest rates are high, the payments people can expect to make on the consumption of these goods will be higher than they are when interest rates are lower. When businesses borrow money to build a new plant or buy new equipment, the payments they must make to their creditors are also determined by the interest rate. Any time the interest rate rises, the volume of both large-dollar-item consumption and business investment will fall because the interest rates have caused costs to be greater. Recall from Chapter 7 that inflation increases in- terest rates, so if prices rise, inflation rises; if inflation rises, interest rates rise; if interest rates rise, consumption and investment fall; if consumption and investment fall, then RGDP falls.

Aggregate Supply Definition Aggregate supply (AS) is a measure of the level of real domestic output available at each possi- ble price level. The accommodations for differing viewpoints take place in the aggregate sup- ply curve. The differing viewpoints hinge on what is called full employment. Most economists say that full employment exists when cyclical unemployment is zero, so that there are still unemployed people at “full employment.” Specifically, the so-called structurally unemployed, the people whose industry has moved or no longer exists, are without work. In addition, the frictionally unemployed, those who quit because they are looking for better jobs or because their spouse found a better job in a new location, are out of work during what is referred to as “full employment.” These differences of opinion are displayed in the various ranges of the aggregate supply curve shown in Figure 8.2.

Competing Views of the Shape of Aggregate Supply We have a serious divergence of opinion among macroeconomists on several important defi- nitions. The following questions separate the two main camps of economists: What constitutes full employment and how are voluntary unemployment and involuntary unemployment de- fined? While what follows may seem like “airing out dirty laundry in public,” it also serves as an excellent “teachable moment” in your general education curriculum. Profound differences of opinion exist in all disciplines, and one of the most profound differences of opinion in mac- roeconomics centers on these issues. Accepting that there is not a single right answer to every question is an important step in becoming an educated person. So, given that caution. . . .

Classical economists believe in the ability of all markets to generate good outcomes with- out government involvement. They believe that if minimum-wage jobs are available and un- employed steel workers choose not to take them, they are not involuntarily unemployed, just

deluded about their prospects. As a result, they believe that cyclical unemployment is zero and therefore we will, by definition, always be at full employment be- cause changes in the labor market will ensure that each person who wants a job will have one. If people are not willing to work for the market equilibrium wage, then they do not count anyway—at least within the defini- tion of full employment held by classical economists.

Keynesian economists take the opposite view. These economists, followers of the early 20th-century econo- mist John Maynard Keynes, argue that there are always more people willing to work than there are jobs available

aggregate supply (AS) The level of real domestic output available at each possible price level.

PI

RGDP

Keynesian range

Classical range

Intermediate range

AS FIGURE 8.2 The aggregate supply curve.

gue46399_ch08_107-118.indd 109 16/03/17 11:40 AM

110 Chapter 8 Aggregate Demand and Aggregate Supply

and that, as a practical matter, we have never actually reached full employment. To Keynesians the concept of full employment is irrelevant. Thus, however many people are employed, Keynesians argue there could always be more and increases in aggregate demand are needed to employ them.

To depict these differing views on a graph, classical economists believe that the aggregate supply curve is vertical all the time. They believe that prices and wages will constantly equili- brate all markets, so increases in aggregate demand will only bid up prices, and the underlying real gross domestic product will remain unchanged. As an example, recall the memory chip– making firm we studied in Chapters 4 and 5. Suppose it has many competitors that are identi- cal to it. If aggregate demand increases, leading to an increase in demand for computers and therefore memory chips, our firm will want to expand output. Classical economists argue that since all markets are at full employment to begin with, our firm will have to raise the wage it pays to attract more employees to produce those extra chips. Whether or not the firm succeeds in luring away the workers from the competition, total industry output will remain the same, since the total number of workers will not have changed. The only thing that will change if the classical economists are right is that prices will rise.

On the other hand, Keynesian economists believe that prices and wages are rigid and that unemployment results from that fact. The only way to employ these people, so the Keynesians’ argument goes, is to increase aggregate demand. Moreover, since prices do not change, the aggregate supply curve should be thought of as horizontal. Again, using our chip maker as an example, if there are many unemployed workers available for hire into the chip-making business, then increasing output to meet increased demand does not require that wages rise.

A reasonable middle ground between these two models is that some industries are at full employment while other industries are not. If this is the case, an increase in aggregate demand may simply bid up prices in some industries and simply increase output in others. Thus, in the aggregate, real GDP rises a little and prices rise a little. If some industries, like computer chip makers, are at full employment and others, like steel, are not, then an increase in aggregate demand that increases demand for these two products will cause only inflation in the chip industry and only an increase in output in the steel industry.

The aggregate supply curve and the differences among economists are shown in Figure 8.2. As you can see, the vertical portion corresponds to what classical economists believe and is so indicated because any increase in aggregate demand will simply increase prices and not out- put. Similarly, the horizontal region corresponds to what Keynesian economists believe and is labeled as such because any increase in aggregate demand will simply increase output and not prices. The middle ground, labeled the intermediate range, connects the two ideological extremes and does so on the assumption that the classical economists may be right for some industries and the Keynesians for others.

You should understand that the representation of aggregate supply in Figure 8.2 is not one that most economists would embrace as perfect. For our purposes, though, it allows us to deal with the differences of opinion among the major schools of thought within macroeconomics in a way that is as uncomplicated as it can be. (This is not to say that you will necessarily find it to be uncomplicated.)

Shifts in Aggregate Demand and Aggregate Supply

Variables That Shift Aggregate Demand Just as we saw in Chapter 2, where there were factors that shifted demand, there are factors that will shift aggregate demand. If you look at the elements of aggregate demand, you will find clues to what these might be. Anything that affects people’s willingness to consume,

gue46399_ch08_107-118.indd 110 16/03/17 11:40 AM

Shifts in Aggregate Demand and Aggregate Supply 111

government’s desire or need to spend money on goods and services, a business’s desire to in- vest in new plant and equipment, or net exports (exports minus imports) will affect aggregate demand.

For instance, taxes on personal or business income will affect consumption and investment, respectively. With higher tax rates, consumers have less take-home income to spend on things. With higher business or corporate tax rates, prospective business ventures are not as attractive as they might otherwise be. Thus any increase in personal or business taxes will lower aggregate demand, shifting it to the left on the graph, and any decrease will raise it, shifting it to the right on the graph.

Any increase in interest rates will have a similar effect. As we saw in Figure 7.1 and as we described in the previous discussion on the interest rate effect, increases in interest costs diminish individuals’ and businesses’ willingness to borrow money. The result is that aggregate demand decreases and moves to the left on the graph.

Any increase in business and consumer confidence will be followed by an increase in, and a movement to the right in, aggregate demand. This result occurs because as consum- ers become more confident in their own financial situation, they are more willing to take on

There is something vaguely unpatriotic about saying there are prob- lems with a “strong dollar.” Nevertheless, it is true. As an example take the euro (€)–dollar ($) relationship and apply it to the hypo- thetical case where a German and an American are car shopping. Suppose each person is looking to buy a midsized sedan and each is comparing a German-made car with an American-made alterna- tive. Each, after extensive research, has decided they are of equal quality and overall appeal and that each will simply buy whichever one is cheaper.

Keeping in mind that the euro was created in the 1990s to replace various European currencies and its value was originally pegged to equal one U.S. dollar, then if they are of equal value, the exchange rate is 1–1 (one euro equals one U.S. dollar). That would mean that if each of the cars was equally priced in both the United States and Germany, both cars would cost $30,000 in the United States and both cars would cost 30,000€ in Germany.

Now suppose that American dealers of German cars must buy those cars from Germany for 25,000€ and that German dealers of American cars must buy those cars from the United States for $25,000. That means that American dealers pay $25,000 to a bank to get 25,000€ and German dealers pay 25,000€ to a bank to get $25,000.

If the dollar gets substantially stronger so that the exchange rate moves to 1.00–0.75 (one euro equals 75 cents), then German dealers of American cars would have to pay 33,333€ to a bank to get $25,000 to buy the car from America. To maintain the 5,000€ margin they had been making at the old exchange rate, they would have to raise the price of American cars in Germany to 38,333€. The American dealer of German cars would now need only $18,750 to

get the 25,000€ and could therefore maintain the $5,000 margin by charging a price of $23,750 for German cars. Thus, the American is now more likely to buy the imported (German) car and the German is more likely to buy the domestic (German) car. Thus, a stronger dollar increases imports and decreases exports in the United States.

Before the United States, as well as the rest of the world, plunged into a deep recession in 2007–2009, the dollar was very weak rela- tive to the euro ($1 equaled around 0.64 euros). This was one rea- son why, until fall 2008, it seemed possible the United States might avoid a recession. American exports were rising at such a rapid pace that it seemed possible that the United States might avoid the deep recession that had already begun in Europe. When the financial crisis of fall 2008 arrived, that hope faded. Though the crisis began with American banks buckling under the weight of massive home foreclo- sures, the United States was still seen as a safer place to ride out the recession. Foreign investors sought out dollars to invest in United States government bonds. This resulted in a rapid strengthening of the dollar relative to the euro. In the course of 80 days between August and November, the dollar rose to being worth 0.81 euros, a nearly 25 percent appreciation. While this may have been good for American morale, it was not at all helpful to American exporters.

As the recoveries in Europe and the United States plodded along through the first half of the next decade, the value of the dollar con- tinued to fluctuate relative to the euro. It fell to as low as $1 equaling 0.68 euros only to rise to $1 equaling 0.81 euros during the first crisis over Greek debt. As the U.S. tightened its monetary stimulus between 2014 and 2016, the Europeans were doing the opposite such that the euro fell in value to near par with the dollar. That, in turn, dampened American exports to Europe.

W H Y A S T R O N G D O L L A R I S N ’ T N E C E S S A R I L Y G O O D

gue46399_ch08_107-118.indd 111 16/03/17 11:40 AM

112 Chapter 8 Aggregate Demand and Aggregate Supply

debt to buy durable goods. As businesses have more confidence in their ability to sell their products, they will invest more in their productive capacity. Any reduction in that confidence will, of course, have the opposite effect. It will lessen aggregate demand and move the curve to the left on the graph.

The effect of foreign exchange rates on aggregate demand is complicated by the fact that though exchange rates are widely published, the fashion in which they are published is often confusing. The Japanese yen typically is expressed in terms of how many yen it takes to buy a U.S. dollar, whereas the British pound typically is expressed in terms of how many dollars it takes to buy the pound. It is as if you went into one bakery looking to buy a dozen donuts and they quoted prices in terms of the number of donuts you can buy for a dollar and another bakery quoted prices in terms of the money you needed to buy a single donut. With a bit of arithmetic you can do the comparison; it just takes a minute. This aside, we can say that if the dollar becomes stronger, exports will fall and imports will rise. Thus a strong dollar reduces aggregate demand, moving it to the left on the graph. Of course, a weaker dollar has the opposite impact. Aggregate demand increases and moves the curve to the right on the graph.

The only variable that impacts aggregate demand directly, one that needs little explanation, is government spending. Because government spending on goods and services is a direct part of the addition that makes up aggregate demand, the impact is direct. An increase in govern- ment spending causes an increase in aggregate demand, and a decrease in government spend- ing causes a decrease in aggregate demand. Therefore, an increase in government spending will move the aggregate demand curve to the right and a decrease in government spending will move the curve to the left.

These impacts are summarized in Table 8.1. The effect of an increase in aggregate demand is shown in Figure 8.3, and the effect of a decrease in aggregate demand is shown in Figure 8.4.

Recall, if you will, the Chapter 2 admonition against trying to memorize Table 8.1 as it ap- plies to Figures 8.3 and 8.4. Here, as it was in Chapter 2’s discussion of supply and demand determinants and curve shifts, the advice is to use these tables and figures as a cross-check against your own intuition and understanding. For example, if you were faced with the problem of analyzing a tax increase, you would understand that taxes take money out of the hands of consumers and business and thereby reduce the ability of these groups to buy goods and ser- vices. That decreases aggregate demand. An aggregate demand decrease is depicted as leftward movement of aggregate demand. Were you to follow that intuition and understanding, you could check your conclusion against Table 8.1 and Figure 8.4.

Variable Part of Aggregate Demand Affected

Effect of an Increase in Variable on the Movement of Aggregate Demand

Effect of a Decrease in the Variable on the Movement of Aggregate Demand

Taxes Consumption Investment

Decreases AD so curve moves left

Increases AD so curve moves right

Interest rates Consumption Investment

Decreases AD so curve moves left

Increases AD so curve moves right

Confidence Consumption Investment

Increases AD so curve moves right

Decreases AD so curve moves left

Strength of the dollar

Exports and imports

Decreases AD so curve moves left

Increases AD so curve moves right

Government spending

Government spending

Increases AD so curve moves right

Decreases AD so curve moves left

TABLE 8.1 Determinants of aggregate demand.

gue46399_ch08_107-118.indd 112 16/03/17 11:40 AM

Shifts in Aggregate Demand and Aggregate Supply 113

Variables That Shift Aggregate Supply Just as there are factors that will change aggregate demand, there are important factors that will change aggregate supply. These are factors that are important to business. Any change that increases business costs will be important in terms of aggregate supply. Other factors that matter are government regulations and factors affecting productivity.

Any factor that will increase costs of production will hurt aggregate supply. That is, an in- crease in labor costs or other input costs will decrease aggregate supply and shift the curve to the left, whereas a decrease in those costs will increase aggregate supply and move the curve to the right. Along with any or all other costs of doing business, interest rates also impact the aggregate supply curve in that they affect borrowing costs on lines of credit used to keep cash- flow problems at a minimum.

Similarly, if government regulations increase costs of production in some way, then ag- gregate supply will decrease and the curve will shift to the left. Deregulation will have the op- posite impact because firms can eliminate costs of complying with regulations. Last, if firms become more productive perhaps through the use of better technology, then aggregate supply will increase and the curve will shift to the right.

Table 8.2 summarizes these impacts; Figures 8.5 and 8.6 summarize the impacts of these shifts on an aggregate supply–aggregate demand diagram. Figure 8.5 shows the impact of an increase in aggregate supply, and Figure 8.6 shows a decrease in aggregate supply.

Now apply the admonition against memorization to Table 8.2 as it applies to Figures 8.5 and 8.6. For example, if you were faced with the problem of analyzing a productivity increase, you would understand that productivity increases enhance the ability of firms to produce goods and services. That increases aggregate supply. An aggregate supply

Variable

Effect of an Increase in the Variable on the Movement of Aggregate Supply

Effect of a Decrease in the Variable on the Movement of Aggregate Supply

Input prices Decreases AS so curve moves left

Increases AS so curve moves right

Productivity Increases AS so curve moves right

Decreases AS so curve moves left

Government regulation Decreases AS so curve moves left

Increases AS so curve moves right

TABLE 8.2 Determinants of aggregate supply.

PI

AD

PIʹ

PI*

ADʹ

AS

RGDPRGDPʹ RGDP*

FIGURE 8.4 Aggregate demand decreases, causing it to move to the left on the graph.

PI

PIʹ

ADʹ

PI*

AD

AS

RGDPRGDP* RGDPʹ

FIGURE 8.3 Aggregate demand increases, causing it to move to the right on the graph.

gue46399_ch08_107-118.indd 113 16/03/17 11:40 AM

114 Chapter 8 Aggregate Demand and Aggregate Supply

increase is depicted as a movement down and to the right for aggregate supply. Were you to follow that intuition and understanding, you could check your conclusion against Table 8.2 and Figure 8.5.

Causes of Inflation

As can be seen in Figures 8.3 and 8.6, increases in prices can result from demand-side impacts or supply-side impacts. Anything that causes the aggregate demand curve to move to the right increases prices. Economists refer to the inflation caused for this reason as demand-pull inflation. Anything that causes the aggregate supply curve to move to the left also increases prices. Economists refer to the inflation caused for this reason as cost-push inflation.

Many of the things that move the aggregate demand curve to the right are things that government manipulates. If government spending is increased or taxes are decreased, aggre- gate demand is increased and demand-pull inflation occurs. In addition, monetary policy— government decisions about the money supply—purposefully influences interest rates. If the impact of that policy is the lowering of the rates, then the aggregate demand increases as a result of the increase in interest-sensitive consumption and investment.

During the 1960s, when President Lyndon Johnson was simultaneously carrying on the Vietnam War and attempting to wage a war on poverty, there was a substantial concern of demand-pull inflation. Government spending was increasing rapidly, and though taxes during this period also increased, inflation increased from 1 percent in 1965 to 6 percent in 1970.

Input costs are important influences on the aggregate supply curve. For example, an in- crease in wages that comes about because of either market actions or legislation will move the aggregate supply curve to the left, thereby increasing prices. Increases in such things as oil prices will have a similar effect on the aggregate supply curve.

The inflation of the late 1970s was largely attributable to increases in oil prices. Oil, a significant input to production throughout the economy, increased from $5.21 per barrel in 1973 to $35.15 per barrel in 1981. This, in turn, contributed to inflation rising from 3 percent in 1972 to 18 percent in the first quarter of 1980. Similarly, the short spike in inflation during 2007 through early 2008 was due, in large part, to the tripling of world oil prices during the same period. The impact of the revolutions in the Middle East during early 2011, from Tunisia, Egypt, Libya, and elsewhere, caused many to be concerned that oil-related inflation would choke off the slow recoveries taking place in the United States and Europe.

demand-pull inflation Inflation caused by an increase in aggregate demand.

cost-push inflation Inflation caused by a decrease in aggregate supply.

PI

PIʹ

AD

PI*

ASʹ AS

RGDPRGDP* RGDPʹ

FIGURE 8.5 Aggregate supply increases causing it to move to the right on the graph.

PI

PIʹ

AD

PI*

ASʹ AS

RGDPRGDP*RGDPʹ

FIGURE 8.6 Aggregate supply decreases causing it to move to the left on the graph.

gue46399_ch08_107-118.indd 114 16/03/17 11:40 AM

How the Government Can Influence (but Probably Not Control) the Economy 115

How the Government Can Influence (but Probably Not Control) the Economy

In looking at the determinants of aggregate demand and the determinants of aggregate supply, it is clear that government can influence the economy in a number of ways. Taxes, interest rates, the strength of the dollar, and government spending make up four of the five determi- nants of aggregate demand outlined in Table 8.1, and these are quite clearly areas where the government can exert influence. Input prices and government regulation show up as deter- minants of aggregate supply in Table 8.2. The latter is quite obviously under the control of government, and there are aspects of the former in which influence is possible.

Demand-Side Macroeconomics While Chapters 9 and 10 offer more detail on how government policy makers can influ- ence the economy via the demand side, it is worth mentioning here as well. By raising or lowering taxes or by raising or lowering spending, Congress and the president can influence aggregate demand and thereby influence prices and output. Similarly, by raising or lowering target interest rates, the Federal Reserve can influence aggregate demand. To a lesser extent, governments—through their ability to buy or sell world currencies—can influence the value of their own currency. These are the means by which government can steer an economy out of a recession. The rapid reductions in interest rates that occurred between January 2001 and summer 2003, the cut of short-term interest rates to nearly zero in late 2008, the large-scale purchase of mortgage-backed securities by the Federal Reserve in 2008 and again from 2010 into 2013, the tax rebate checks generated in 2001, 2003, and 2008, as well as the Obama-era stimulus plan were all attempts to jump-start the economy on the demand side.

Supply-Side Macroeconomics During the late 1970s a new way of thinking about government’s ability to influence the economy began to arise. Basically, the new way of thinking involved policy actions that would influence the aggregate supply curve. We have already seen that government spend- ing and interest rate policy influence the aggregate demand curve. Figures 8.3 and 8.4 show that any movement in the aggregate demand curve will either increase RGDP but also in- crease inflation, or decrease RGDP but also decrease inflation. Movements in the aggregate supply curve to the right have only good consequences: Inflation is reduced and RGDP is increased.

Supply-side economics involves influencing the aggregate supply curve by lowering input costs, reducing regulation, and increasing incentives for hard work and innovation. Though advocates of supply-side economics usually advocate for changes in the tax code, such changes are not necessary. Only some of the actions the Reagan administration (1981–1989) took are properly understood as supply-side actions: Tax cuts aimed at businesses (the in- vestment tax credit and accelerated depreciation schedules), tax code changes that signifi- cantly reduced marginal tax rates, attempts at deregulation and lax enforcement of existing regulations, and vetoing of increases in the minimum wage are clearly supply-side policies. These policies, advocates suggest, increased the incentive to innovate, take risks, and work hard by increasing after-tax rewards or by removing impediments. On the other hand, de- tractors argue, the large part of the tax cuts to individuals that resulted from higher standard deductions, and the even larger defense buildup, are properly thought of as typical aggregate demand-side policy.

The biggest supply-side impact in the 1980s was that the price of a barrel of oil fell from $40 to less than $10. More recently, the tax cuts proposed by President Bush in

supply-side economics Government policy intended to influence the economy through aggregate supply by lowering input costs and reducing regulation.

gue46399_ch08_107-118.indd 115 16/03/17 11:40 AM

116 Chapter 8 Aggregate Demand and Aggregate Supply

2003 to eliminate the taxation of corporate dividends are properly thought of as supply- side economics. The argument he was making was that eliminating the double taxation of corporate dividends would stimulate businesses to invest in productivity increasing assets. Whether or not his logic was on target or flawed, the 2003 tax cut did not eliminate double taxation, though it did reduce the top tax rates on capital gains, an objective of supply-side economists. These tax cuts were a major point of difference between President Obama and Senator McCain during the 2008 campaign and between him and Governor Romney during the 2012 campaign. When Republicans won significant electoral victories in 2010, Obama agreed to extend those cuts through 2012—all because he believed that allowing taxes to rise at that time would have negative supply and demand–side impacts. When the president won reelection in 2012, he had his way with tax rate increases for certain high- income earners.

This chapter introduced the aggregate demand and aggregate supply model that we will use when discussing the macroeconomy and macroeconomic issues. We first examined aggregate demand and aggregate supply in isolation, explaining why aggregate demand is downward sloping. We also looked at the shape of the aggregate supply curve in the context of the differ- ences between classical and Keynesian views of both aggregate supply and full employment. When they were combined as one, we were able to show what happens when certain macro- economic variables change. In that way we used them to explain the concepts of cost-push and demand-pull inflation and of supply-side economics.

Summary

Key Terms aggregate demand (AD) aggregate supply (AS) cost-push inflation

demand-pull inflation foreign purchases effect interest rate effect

real-balances effect supply-side economics

1. Any event that creates a “crisis in confidence” is likely to lead to a. higher aggregate prices. b. higher aggregate output. c. lower aggregate prices. d. inflation.

2. Use the aggregate supply–aggregate demand model to determine which of the following will lead to higher prices. a. A tax increase b. A fall in world oil prices c. An increase in interest rates d. An increase in government spending

Quiz Yourself

Issues Chapters You Are Ready for Now

Fiscal Policy Monetary Policy

Federal Deficits, Surpluses, and the National Debt

The Housing Bubble

Is Economic Stagnation the New Normal?

gue46399_ch08_107-118.indd 116 16/03/17 11:40 AM

Summary 117

3. Use the aggregate supply–aggregate demand model to determine which of the following will lead to higher aggregate output. a. A tax increase b. A spike in world oil prices c. A cut in interest rates d. A cut in government spending

4. Congress and the president have control of the tax system and government spending. As a result, their policies will directly impact a. aggregate supply. b. aggregate demand. c. residual demand. d. the demand for loanable dollars.

5. The Federal Reserve has indirect control over short-term interest rates, and, as a result, their ability to control economic activity is through a. aggregate supply. b. aggregate demand. c. residual demand. d. the exchange rate.

6. An economist worrying about the economic impact of environmental regulations would model that impact with a a. decrease in aggregate supply. b. increase in aggregate supply. c. decrease in aggregate demand. d. increase in aggregate demand.

7. Disagreements about the shape of the aggregate supply curve focus on the degree of ___________ in the economy. a. unemployment b. inflation c. fraud d. confidence

8. The use of a backward L–shaped aggregate supply curve allows us to _______________ in a way that other shapes would not. a. consider various levels of prices b. consider different macroeconomic points of view c. deal with shifting curves d. create an equilibrium

Short Answer Questions

1. Of the reasons that the aggregate demand curve and the demand curve are downward sloping, each has one labeled the “real balance effect.” How are they different?

2. If we want our president to “do something” about the economy, what do we usually have in mind? How can we use the aggregate demand–aggregate supply model to show that what we have in mind will work?

3. Suppose a president says: “We are in a crisis and on the verge of another Great Depres- sion. We need to increase government spending to give the economy a boost.” What determinant of aggregate demand is the president counting on to keep us out of that depression? What determinant of aggregate demand is the president hoping you do not respond to?

gue46399_ch08_107-118.indd 117 16/03/17 11:40 AM

118 Chapter 8 Aggregate Demand and Aggregate Supply

4. Explain the chain of events that connect an overall price increase to a decrease in aggre- gate demand using the interest rate effect.

5. Define aggregate demand. Then, list and explain the intuitive reasons why aggregate demand is downward sloping.

6. Discuss the shape of the aggregate supply curve by listing and explaining the reasons behind the various ranges.

7. List and explain the three ways that the Federal Reserve controls the money supply (i.e., tools of the monetary authority).

Think about This President Harry Truman once lamented that he wanted a “one-handed economist” because we economists have a tendency to say “on the one hand . . . but on the other hand. . . .” Economists have never made very good presidential aides because we respect the uncertainty of things; we rarely give straight answers because there are rarely simple, straight answers to give. Macro- economics generally, and the aggregate supply–aggregate demand model specifically, embrace that uncertainty. If you were a political leader, would you want a “one-handed” economist?

Talk about This The aggregate supply–aggregate demand model can be useful in predicting macroeconomic consequences of policy actions (like tax cuts, government spending increases, regulatory ac- tions, interest rate adjustments). It does not tell you about the distributional aspects of policy actions. For instance, a regulatory requirement that all employers offer health insurance would shift the aggregate supply curve to the left, increasing prices and decreasing real GDP. Does that make it a bad idea? Would the impact of such a regulation on health care availability counteract these macroeconomic consequences in your mind?

gue46399_ch08_107-118.indd 118 16/03/17 11:40 AM

C H A P T E R N I N E

119

Fiscal Policy Learning Objectives

After reading this chapter you should be able to:

LO1 Describe and model discretionary and nondiscretionary fiscal policy using an aggregate supply and aggregate demand diagram.

LO2 Distinguish between aggregate demand and aggregate supply shocks.

LO3 Acknowledge and enumerate the problems associated with discretionary fiscal policy.

LO4 Describe nondiscretionary fiscal policy as the mainstay of our current macroeconomic system.

Chapter Outline

Nondiscretionary and Discretionary Fiscal Policy

Using Fiscal Policy to Counteract “Shocks”

Evaluating Fiscal Policy

The Obama Stimulus Plan

Kick It Up a Notch: Aggregate Supply Shocks

Summary

When you want government to “do something” about the economy, you are typically referring to fiscal policy, which was considered a vital tool in macroeconomics at one time. Fiscal policy is the purposeful movements in government spending or tax policy designed to direct an economy. In the United States, fiscal policy is deter-

mined by the Congress and the president.

Fiscal policy is not simply one idea; it is really two. Dis- cretionary fiscal policy consists of actions taken at the time of a problem to alter the economy of the moment. Nondiscretionary fiscal policy is that set of policies that are built into the system to stabilize the economy when growth is either too fast or too slow.

Discretionary and nondis- cretionary fiscal policy are de- scribed first. Then we consider the benefits of nondiscretionary fiscal policy and explain why

some argue that discretionary fiscal policy cannot claim similar benefits. We use that discussion to examine why policy makers had abandoned discretionary fiscal policy for many years. We finish by discussing the two Bush tax cuts, and specifically the child-credit rebates, in the context of reviving discretionary fiscal policy.

Nondiscretionary and Discretionary Fiscal Policy

How They Work The difference between nondiscretionary and discretion- ary fiscal policy is that one is automatic and the other is not. Nondiscretionary fiscal policy, for example, in- cludes government policies that stimulate the economy when it needs stimulus and dampen it when it needs to be dampened. Under discretionary fiscal policy, Congress and the president agree on a course of action to stimulate or dampen the economy at a specific time.

Nondiscretionary fiscal policy is at work every day as a result of policies enacted years ago. Every time you get a raise, move to a better job, or make a killing in the stock market, the government takes a portion of

fiscal policy The purposeful move- ments in government spending or tax policy designed to direct an economy.

discretionary fiscal policy Government spend- ing and tax changes enacted at the time of the problem to alter the economy.

nondiscretionary fiscal policy A set of policies that are built into the system to stabilize the economy.

gue46399_ch09_119_130.indd 119 16/03/17 11:41 AM

120 Chapter 9 Fiscal Policy

your improved income in taxes. The effect on your as- sets becomes more pronounced as you advance in the tax brackets, because when you make more money you pay a higher percentage of that income in taxes. If you happened to have been a welfare recipient and you have found a job, the effect is even greater. Not only is the government now not providing you with money, but also is withholding taxes from your pay. In both cases, the effect of nondiscretionary fiscal policy is dampening the increase in your income.

Of course, nondiscretionary fiscal policy can have the opposite effect as well. If you lose your job, get demoted, or lose a lot of money in the market, your tax burden falls. If you lose your job and go back on welfare, the effect is again magnified. The government is not taking money from you but is giving money to you. This stimu- lates the economy somewhat, and it thus has the effect of helping to counteract the loss you incurred.

Because our progressive income tax system in- creases the percentage that you pay in taxes as you make more money and because federal and state pro- grams are in place that offer economic assistance when you need it, nondiscretionary fiscal policy is constantly working to stabilize the economy. No one has to use any discretion—that is, make any decisions—to make it work. Therefore, it is called nondiscretionary fiscal policy. Because the actions are built into the system, nondiscretionary fiscal policy is often referred to as a built-in stabilizer.

With discretionary fiscal policy, on the other hand, action is required by Congress and the president. When each decides that the economy is in need of a specific ac- tion that will properly stimulate or dampen it, the usual actions that they consider involve changes in taxes or spending policies. Historically, fiscal policy has been used to stimulate an economy in recession but rarely to dampen an economy that is running too hot.1

The specific policy actions used in the past were tax cuts and funding of public works projects to give jobs to people who were unemployed. In the middle 1970s, for example, President Gerald Ford sought to provide each taxpayer with a tax rebate of $50. During the Great De- pression many unemployed workers found jobs in gov- ernment programs that built roads, dams, and bridges.

During his 2008 campaign, President Barack Obama promised a middle-class tax cut while promising to re- peal tax cuts passed during the prior administration that

went primarily to those wealthy Americans earning more than $250,000. President Obama’s election in the midst of the financial crisis of fall 2008 was quickly followed by the worst holiday shopping period in 40 years. In this context, the incoming Obama administration spent considerable time during the transition contemplating a fiscal stimulus package. What emerged was a package that included tax cuts for individuals, an extension of and an increase in unemployment benefits, aid to state and local governments both to account for the expected in- creases in Medicaid enrollment and to forestall the need for significant state and local budget cuts, spending on a series of projects that were priorities for Democrats, and spending on what were called “shovel-ready” infrastruc- ture projects.

The individual tax cuts were structured differently from the 2001, 2003, and 2008 rebates in that they were implemented through short-term changes to withholding tables. The Bush rebates came first with paper checks, then with a combination of paper checks and direct de- posits to banks. With each rebate there was a period of time from the passage of the package to the time when the money was in the hands of the consumer. The econ- omists advising President Obama were convinced that there were two significant problems with the Bush-era rebates. They took too long to get into taxpayers’ hands and too much of the money was saved rather than spent. They believed that by changing withholding tables they could speed up the process as well as induce more spend- ing by giving average taxpayers smaller amounts per week rather than a large amount at once.

Using Aggregate Supply and Aggregate Demand to Model Fiscal Policy Our aggregate supply and aggregate demand model is a useful tool for examining the effect of both forms of fiscal policy. Both discretionary and nondiscretion- ary fiscal policy work to move the aggregate demand curve. Figure 9.1 shows the effect of expansionary fiscal policy and Figure 9.2 shows the effect of contraction- ary fiscal policy. Expansionary fiscal policy options, such as increased government spending and decreases in taxes, are reflected in an aggregate demand curve that moves to the right. Contractionary fiscal policy options, including decreased government spending and increases in taxes, are seen in an aggregate demand curve that moves to the left.

It should be noted that there is considerable debate over whether any fiscal policy will have a real impact

1A one-year 10 percent surtax was added to income taxes in the Lyndon Johnson administration. Some justified this action as an effort to combat inflation.

gue46399_ch09_119_130.indd 120 16/03/17 11:41 AM

Using Fiscal Policy to Counteract “Shocks” 121

on the economy. A useful but relatively simplistic way of thinking about this argument is to frame it in terms of where on the aggregate supply curve the economy lies. Those who believe that we are on the vertical portion of the curve argue that any expansionary fiscal policy will be completely ineffective. It will merely create inflation without bolstering output.

It is worth mentioning that the money necessary to engage in expansionary fiscal policy does not come out of thin air. The increased government spending and the reduced tax revenue generate a shortfall that must be made up with either borrowing or printing the requisite money. Economists do not consider the latter option a good one in that inflation is nearly always the result. Thus deficits financed through borrowing money tend to be the result of expansionary fiscal policy.

Using Fiscal Policy to Counteract “Shocks”

Aggregate Demand Shocks Neither expansionary nor contractionary actions happen in a vacuum. They happen because the economy moves unexpectedly to make RGDP much higher or much lower than policy makers think is healthy. Figures 9.3 and 9.4

show the impact of these shocks, or unexpected moves. In each we suppose that aggregate de- mand is what moves unexpect-

edly, and in each we start with it at AD1. Because of a shock it unexpectedly moves to AD2. If a slump in ag- gregate demand causes a recession, like Figure 9.3, then

shock Any unanticipated economic event.

FIGURE 9.1 Expansionary fiscal policy.

PI

PIʹ

ADʹ

PI*

AD

AS

RGDPRGDPʹRGDP*

FIGURE 9.2 Contractionary fiscal policy.

PI

PIʹ

AD

PI*

ADʹ

AS

RGDPRGDPʹ RGDP*

FIGURE 9.3 A negative aggregate demand shock.

Pl

Pl*

Shock

AS

RGDPRGDP*

AD1

AD2

FIGURE 9.4 A positive aggregate demand shock.

Pl

Pl*

Shock AS

RGDPRGDP*

AD 1

AD2

gue46399_ch09_119_130.indd 121 16/03/17 11:41 AM

122 Chapter 9 Fiscal Policy

the aggregate demand curve moves from AD1 to AD2. When people lose their jobs, welfare spending will have to rise and tax revenue will fall. As Figure 9.5 shows, this nondiscretionary fiscal policy moves the aggregate demand curve partially back to AD3. Expansionary dis- cretionary fiscal policy (either increases in government spending or decreases in taxes) can move aggregate demand all the way back to AD1.

If a jump in aggregate demand causes an overheated economy, like Figure 9.4, then the aggregate demand curve moves from AD1 to AD2. When people get bet- ter jobs or raises, welfare spending will fall and tax revenue will rise. As Figure 9.6 shows, this nondiscre- tionary fiscal policy moves the aggregate demand curve partially back to AD3. Contractionary discretionary fis- cal policy (either decreases in government spending or

increases in taxes) can move aggregate demand all the way back to AD1.

Nondiscretionary fiscal policy (NDFP) moves it back toward AD1 to AD3, and discretionary fiscal pol- icy (DFP) can move it all the way back to AD1 again. In theory, whether the economy experiences a positive demand shock or a negative one, the government can use both discretionary and nondiscretionary fiscal policy to return us to a healthy economy.

We need to ask at this point how it is that aggregate demand can move unexpectedly. There are a number of reasons and each involves the reaction of people to their predictions of the future. If people’s positive view of the health of the economy spurs them to buy new cars or fur- nishings, an aggregate demand curve will move to the right. If the opposite happens and people decide to delay buying these expensive items because of negative feel-

ings about the economy, the ag- gregate demand curve will move to the left. Tracking the “feeling” that people have about the econ- omy is not easy and therefore large, unexpected swings can

upset the economy. Economists call these swings aggregate demand shocks.

Aggregate Supply Shocks Along with aggregate demand shocks, we must also deal with the problem of aggregate supply shocks. Usu-

ally an aggregate supply shock involves an important natural re- source. It should come as no sur- prise that recent supply shocks have all involved the price of oil.

During the 1973 Arab–Israeli war, for example, the price of oil climbed dramatically. During the Iran–Iraq war, the price of oil fell dramatically as both sides increased pro- duction to pay for war material. The tripling of world oil prices from 2007 to mid-2008 and the dramatic plummet- ing of those prices from summer 2008 through early 2009 each had dramatic aggregate supply impacts.

Even more recently, the early 2011 uprisings through- out the Middle East illustrated the uncertainty effect of these supply shocks. Crude oil prices, which were below $80 per barrel in January 2011, rose above $100 per bar- rel with the Libyan uprising, even though Libya itself is a relatively minor producer of oil (3 percent of world production).

Whether drastic changes are positive or negative, pol- icy makers are frequently called upon to do something to

aggregate demand shock An unexpected event that causes aggregate demand to increase or decrease.

FIGURE 9.5 Nondiscretionary and discretionary fiscal policy as it combats a recession.

PI

PI*

AD1 AD3AD2

NDFP

DFP

Shock

AS

RGDPRGDP*

FIGURE 9.6 Nondiscretionary and discretionary fiscal policy as it combats an overheated economy.

PI

PI*

AD1

AD3

AD2

NDFP

DFP

Shock

AS

RGDP

aggregate supply shock An unexpected event that causes aggregate supply to increase or decrease.

gue46399_ch09_119_130.indd 122 16/03/17 11:41 AM

Evaluating Fiscal Policy 123

counter that aggregate supply shock, and, because they very frequently have little control over the events that cause those shocks, they may wish to use discretionary fiscal policy to mitigate the economic impact.

Evaluating Fiscal Policy

Nondiscretionary Fiscal Policy Nondiscretionary fiscal policy serves to get output mov- ing back toward the desired level, RGDP*, but it works much better when the shock is to aggregate demand rather than to aggregate supply. In addition, even though previous Congresses and presidents developed tax and spending policies to get the country out of a recession, such discretionary fiscal policy just does not work as well as does nondiscretionary policy.

Since the Great Depression of the 1930s, the U.S. economy has successfully avoided the sorts of boom and bust cycles that plagued the 19th century. The degree to which the built-in stabilizing effect of a welfare state and a progressive tax system generated this state of affairs is debated by economic historians. The two most significant post–World War II recessions, the one in 1982 and the one that extended from late 2007 to mid-2009, were far less onerous than any of the financial panics of the 1800s.

Discretionary Fiscal Policy You might think that discretionary fiscal policy would work as well. If you did, you would be wrong, but you would be in good company. By the 1950s and 1960s, most economists were confident that discretionary fis- cal policy would essentially eliminate the instability of recessions. By 1980 most economists had given up on discretionary fiscal policy. Coincidentally or not, during the 20 years that followed, the United States experienced half the usual number of recessions.

What transformed economists from overconfident dis- cretionary fiscal policy champions in the 1960s to ardent detractors in the 1980s was the very poor performance of these policies during the 1970s. The preceding aggregate demand and aggregate supply analysis is nice to look at, and the nondiscretionary fiscal policy part does work as advertised, but discretionary fiscal policy was more of a fantasy of economists. In the 1950s and 1960s, econo- mists were confident that Congress could know exactly how much stimulus or dampening would be necessary to get the economy back to a desired level of RGDP. Con- gress would then pass a bill that the president would sign

to implement that policy. As a practical matter, it just did not work in the ways economists predicted it would.

The reasons discretionary fiscal policy does not work as well as advertised (or perhaps at all) are threefold. First, the failures can be attributed to lags in recognizing, administering, and operating fiscal policy. Second, the failures can result from political motivations overwhelm- ing economic reason, and third, there can be immediate counter-effects with both aggregate demand and aggre- gate supply, which partially or completely eliminate the positive intent of the policies.

On the issue of the lags, the first of these is the recognition lag, which means that the econ- omy in general, and RGDP in particular, is measured with a considerable lag. The second, the administrative lag, results because it takes time for Con- gress and the president to agree on a course of action. The third, the operational lag, results be- cause it takes quite awhile for the full impact of a government program or tax change to have its effect on the economy.

The recognition lag results from the fact that gross do- mestic product is not easily and immediately measured. Quarterly GDP is first estimated using reasonably good predictors that are available soon after the end of the quarter. Later, more data are brought to bear and GDP is reestimated. Only after many months is a final GDP fig- ure given. Thus we do not know for sure whether we are in a recession until months after it begins. Similarly, we do not know when we are out of a recession until months after it ends. The problem this creates was highlighted by the 2007–2009 recession. It was late fall 2008 before the National Bureau of Economic Research Business Cycle Dating Committee identified fall 2007 as the beginning of the recession. While it was clear by late summer 2008 that the economy was slowing dramatically, it was a full year after the recession began before it was universally acknowledged. At the end of the 2001 recession, the economy was growing so slowly that it took until sum- mer 2003 for economists to declare the recession had actually ended in the fall of 2001. This meant that by the time they had declared a recession had started, it was almost over and by the time they had declared it over, it had actually been over for a year and a half. The reces- sion of 2007–2009 was not declared to have ended in

recognition lag The time it takes to measure the state of the economy.

administrative lag The time it takes for Congress and the president to agree on a course of action.

operational lag The time it takes for the full impact of a govern- ment program or tax change to have its effect on the economy.

gue46399_ch09_119_130.indd 123 16/03/17 11:41 AM

124 Chapter 9 Fiscal Policy

June 2009 until September 2010. The stimulus package had not yet spent more than 10 percent of the allocated funds by that time.

The administrative lag results from the inherent inef- ficiency of American democracy. We have two legisla- tive bodies that must first agree with each other and then must agree with the president. The president, the House, or the Senate can delay or derail fiscal policy. Even if they choose to work on a given problem, Congress never solves a problem without disagreements. They may agree, for example, that we are in a recession but will not be able to decide whether to engage in discretionary fiscal policy through tax cuts or through spending programs. Even when they agree on that, they may argue over the kinds of tax cuts to make, who should get them, what kinds of spending programs would be appropriate, and the con- gressional districts that should be benefited. By the time they finally agree, of course, more time has passed.

This is quite well illustrated by the political wrangling over the 2008 financial system rescue plan and the 2009 stimulus package. Both presidential candidates were in agreement that the Troubled Asset Relief Program (TARP) was necessary, but it took nearly a month for the plan to pass. Even with significant majorities in both houses and two and a half months from his election to his swearing in, it took President Obama five additional weeks to get a stimulus plan through Congress. Much of the disagreement surrounded the size and composition of the package. Conservative economists and members of Congress were concerned about the budget deficit impli- cations of the package. Liberal economists and members of Congress were concerned that the package would be of insufficient size to have the desired impact. These are perfectly legitimate differences of opinion, but the debate took time.

The operational lag offers the final roadblock to ef- fective discretionary fiscal policy. Even supposing that Congress and the president agree on time that a policy is needed and they agree on the type of policy, it takes months, if not years, for discretionary fiscal policy to have its desired effects.

If the discretionary fiscal policy takes the form of increases in highway construction, a program that in- creases the numbers of jobs available, federal contracts usually do not pay the entire amount up front. Contrac- tors are paid in the stages of building, and it takes quite awhile to go from the beginning of a large construction project to its end. To avoid this delay, the Obama stimu- lus package hoped to include mostly “shovel-ready” in- frastructure plans. The idea was to take plans that had

already gone through the design phase. In so doing, the hope was to get these projects started the moment funds became available. It bears repeating that when the reces- sion of 2007–2009 ended in June 2009, less than 10 per- cent of the stimulus funds from the bill that had passed that February had been spent.

As for the tax aspects of fiscal policy, the vast major- ity of the money going to taxpayers went to them well after it was needed. The 2001, 2003, and 2008 summer rebate checks and the change to withholding tables in 2009 are evidence that tax cuts can make their way into the economy somewhat more quickly. In the pre-2009 cases, the laws generating the rebates were passed at least six months before the money was fully in the hands of consumers. The downside to these relatively quick tax cuts is that their impacts are often muted by those who use the extra money to save or to pay down existing debt.

The Political Problems with Fiscal Policy Another argument against discretionary fiscal policy is that even if it worked, vote-obsessed politicians would not use it properly. Aside from the bias toward expan- sionary fiscal policy alluded to in the introduction, there is the question of who will be affected by any changes in taxation or spending policies. In addition, there is the complication caused by politicians too concerned with re- election. They seek to expand the economy in presidential election years only to act responsibly after the election.

The first of these issues raises questions of political motivation. Whether large-scale, federally funded build- ing projects are needed is one question; where they will go is quite another. For instance, whether the revamped Boston mass transit system, referred to by many as the “big dig,” was motivated by purely engineering reasons or because influential members of Congress lived in the area is debatable. Similarly, critics have charged that political influence alone was behind the placement of a majority of highway demonstration projects in the early 1990s in West Virginia. While these are examples of Democrats engaging in steering tax dollars, Republicans too have engaged in such practices. Between 1995 and 2001, the GOP majority leader and the chair of the Sen- ate Appropriations Committee made certain that dispro- portionate dollars were spent in their home states. The infamous “bridge to nowhere” in Alaska provides an excellent example of politically motivated infrastructure projects. Noted economist James Buchanan and others have suggested that all federal spending, but in particular that spending that is done in the name of fiscal policy, is susceptible to this kind of problem.

gue46399_ch09_119_130.indd 124 16/03/17 11:41 AM

Evaluating Fiscal Policy 125

There is also the problem of the political business cycle. It is suggested that politicians, particularly presi-

dents, will add new spending and tax policies to their pre- election-year budgets to boost the economy in time for their own or their party’s reelection.

Table 9.1 suggests that this might be the case, given that the average of growth rates in the fourth year of presi- dential terms of office is slightly higher than that of first- year growth rates.

Criticism from the Right and Left There were many economists, mainly on the conserva- tive end of the spectrum, who advised against a fiscal stimulus of any kind and then were only too happy to say “I told you so” when, by their calculations, the impact of the 2009 stimulus package was less than the Obama ad- ministration had predicted. John Cogan, John Taylor, and others argued that the impact was, if anything, small and temporary, and quite possibly negative. They argued that the only way to truly stimulate consumption and invest- ment is to make long-term structural changes to tax rates in ways that consumers and businesses can confidently predict that their future after-tax income will be higher.

Liberal (and Nobel Prize–winning) economist Paul Krugman was just as derisive of the stimulus package as

political business cycle Politically motivated fiscal policy used for short-term gain just prior to elections.

these conservative economists, yet his point of attack was that it was predictably too small to have any of its desired impacts. While dismissing the conservative economists’ estimation of the importance of, as he called it, “the con- fidence fairy,” he and others argued as early as December 2008 that policy makers were understating what was nec- essary by a factor of at least two. Since that time Krugman repeatedly pointed to the fact that total government spend- ing declined in 2010 and 2011 because state and local governments were cutting back on spending by more than the federal government was increasing spending.

The Rise, Fall, and Rebirth of Discretionary Fiscal Policy In the 1970s it became apparent to policy makers that discretionary fiscal policy was not up to the task of sta- bilizing the economy. The lags were just too important to ignore, and the recessions of the 1970s had been too short for these recessions to be recognized, laws to be passed, and money spent in time to have any effect on them.

Despite the preceding cautions about the effectiveness of discretionary fiscal policy, its arguments have been used to bolster particular programs. President Clinton used the discretionary fiscal policy argument in 1993 to bolster a $16 billion investment program. Critics defeated his proposal, suggesting that we were already out of the recession and its size was too small to have any impact.

President First Year Second Year Third Year Fourth Year

Truman −0.5 8.7 8.1 4.1 Eisenhower I 4.7 −0.6 7.1 2.1 Eisenhower II 2.1 −0.7 6.9 2.6 Kennedy/Johnson 2.6 6.1 4.4 5.8 Johnson 6.5 6.6 2.7 4.9 Nixon I 3.1 0.2 3.3 5.2 Nixon II/Ford 5.6 −0.5 −0.2 5.4 Carter 4.6 5.6 3.2 −0.2 Reagan I 2.6 −1.9 4.6 7.3 Reagan II 4.2 3.5 3.5 4.2 Bush GHW 3.7 1.9 −0.1 3.6 Clinton I 2.7 4.0 2.7 3.8 Clinton II 4.5 4.5 4.7 4.1 Bush GW I 1.0 1.8 2.8 3.8 Bush GW II 3.3 2.7 1.8 −0.3 Obama I −2.8 2.5 1.6 2.2 Obama II 1.5 2.4 2.4 Average 2.9 2.8 3.5 3.7

Source: Bureau of Economic Analysis, www.bea.gov

TABLE 9.1 Real growth rates by presidential terms.

gue46399_ch09_119_130.indd 125 16/03/17 11:41 AM

126 Chapter 9 Fiscal Policy

An odd coincidence happened on the way to the grave for discretionary fiscal policy. When the 2001 Bush tax cut passed in May of that year, it was not known then that we were already in a recession. In addition, instead of implementing the tax cut prospectively, it was made ret- roactive to the beginning of the year, and instead of hav- ing taxpayers wait until they filed their tax forms in 2002 to claim their money, rebate checks were sent out in an- ticipation of those cuts. These checks started arriving in August and September of that year and were nearly fully dispersed when the terrorist attacks of September 11 oc- curred. Together with a series of interest rate cuts, these tax cuts had the fortunate coincidence of stimulating the economy at precisely the time the stimulus was needed.

When the economy had not picked up much steam through early 2003, President Bush proposed another tax cut. What he proposed was not at all what passed, but what did pass was remarkably similar to what had passed in 2001. Again, rebate checks began arriving in taxpayers’ mailboxes in late summer 2003.

The Obama Stimulus Plan

The clearest sign that discretionary fiscal policy was back as a policy tool under active consideration came with the election of Barack Obama as president of the United States. Prior to that, it had been more than 30 years since policy makers actively sought to increase aggregate de- mand through increases in government spending rather than through tax rebates.

As shown in Table 9.2, the plan itself had four basic elements. The first was to shore up the state-run un- employment, welfare, and Medicaid systems. Though the money had to be appropriated through an act of

Congress, this is best labeled as nondiscretionary fiscal policy as it is a regular part of the federal government’s response to economic difficulty. The second element in the plan is not as readily categorized because though it was “discretionary” in that the federal government could have chosen to let states ride out the recession on their own, it was intended to allow states to make it through the 2009 and 2010 fiscal years without having to cut budgets and raise taxes. In essence, this portion was designed to allow states—that often are constitution- ally prevented from borrowing—to engage in their own form of nondiscretionary fiscal policy. The remainder was clearly discretionary as it was motivated by a desire to speed a recovery rather than to simply mitigate the impact of it. It remains to be seen whether the stimulus package passed in 2009 was too large, too small, solved the problem, or created other problems. It also remains to be seen, after the 2010 political season when “stimu- lus” became a dirty word to many across the political spectrum, whether discretionary fiscal policy goes back into the hole it was in between 1980 and 2000.

Stimulus Plan Element Amount in $ Millions

Nondiscretionary $135,832 fiscal policy: Unemployment, welfare, Medicaid Aid to states 53,600 Discretionary fiscal policy: 301,135 Tax cuts Discretionary fiscal policy: 300,047 Spending increases

Source: www.recovery.gov/Transparency/fundingoverview/Pages/fundingbreakdown.aspx

TABLE 9.2 The Obama stimulus plan as originally enacted.

The question of whether the Obama stimulus package worked or not depends entirely on what you assume the counterfactual to be. Recall that a “counterfactual” to a policy is a story associated with what the result would have most likely been had there been no change in policy. Had there been no stimulus package of any kind, had there been no assistance to states to cover higher unemploy- ment and Medicaid claims, had there been no extension of Bush- era tax rates, had there been no “Making Work Pay” credit, had

there been no money for shovel-ready projects, Cash-for-Clunkers, or for alternative energy development, what would have been the result? The judged effectiveness of the stimulus package as a whole, therefore, depends on how you create the counterfactual.

There are, generally speaking, two branches of counterfactu- als: Keynesian ones and Ricardian equivalence ones. Keynesian counterfactuals assume that the $787 billion stimulus was all new money being spent and was not displacing any money that would

D I D T H E O B A M A S T I M U L U S W O R K ?

gue46399_ch09_119_130.indd 126 16/03/17 11:41 AM

The Obama Stimulus Plan 127

have been spent elsewhere, by someone, even perhaps by another level of government. Ricardian equivalence counterfactuals assume that people foresee that current and temporary increases in the defi- cit will ultimately necessitate future tax increases or spending cuts to pay for it, or that federal grants received by states are offset by reductions in what states would have otherwise borrowed. In this way, currently higher deficits and the private and other level govern- ment reactions to those deficits completely wipe out any effect of the policy.

For instance, if you assume that people only bought the cars they did because of the Cash-for-Clunkers program so that all spending on those cars, including the subsidy, was induced by the program, you would, by the evidence, be wrong. In fact, most of the cars purchased during that period were by people who happened to be in the market for a new car anyway and had a “clunker” to trade in. Similarly, if you assume that states would have chosen not to borrow money to provide for Medicaid cover- age for those people who were forced on to the program because of their lost jobs, you would count the extra money provided to the states for that purpose by the federal government as extra money that was spent that wouldn’t have been. That is probably wrong in some states and correct in others.

However, sometimes the money spent as part of the stimulus was clearly new money that resulted from the stimulus. Even the most strident anti-stimulus economists acknowledge that unem- ployment benefits were extended and made more generous using federal money and that money was available only through the stimu- lus. The fact that almost all that money was spent by relatively poor recipients has a stimulatory impact. Some economists would still

quibble with this as stimulus because they would argue that those who were unemployed and receiving long-term benefits were less likely to accept the reality of lesser jobs at lower wages and that the benefits merely extended their ability to convince or even de- lude themselves that their old jobs would reappear at their old wage levels.

The stimulus plan’s supporters point to the relatively short period of economic distress in the United States relative to ongo- ing challenges in Europe where there was relatively little appe- tite for stimulus. They argue that the United States emerged from the Great Recession to rates of growth that were, while slow, generally more brisk than were European nations’. Detractors simply point to the very slow recovery in real GDP and very slow drop in unemployment in the United States. They point to invest- ments in companies that ultimately went bankrupt or to shovel- ready projects that had little infrastructure-enhancing purpose. They point to large decreases in the percentage of the population working or seeking work, the primary driver for reduced rates of unemployment.

There is no consensus on this topic. Noble Prize winners are on both sides of the debate. If the measure to be used to judge its overall effectiveness is the median estimate of its ultimate im- pact, then the impact was modestly effective. Several economists have prepared estimates of the impact of the stimulus. A simple summary of the studies done on the topic is included below. Given that the term stimulus became a political “dirty word” shortly after the package’s passage, it appears that academic economists have a greater appetite for discretionary fiscal policy than does the public.

Study Authors Conclusions

“Did the Stimulus Stimulate? Real Time Estimates of the Effects of the American Recovery and Reinvestment Act”

James Feyrer, Bruce Sacerdote Significantly positive

“Does State Fiscal Relief during Recessions Increase Em- ployment? Evidence from the American Recovery and Reinvestment Act”

Gabriel Chodorow-Reich, Laura Feiveson, Zachary Liscow, and William Gui Woolston

Significantly positive

“Estimated Impact of the American Recovery and Rein- vestment Act on Employment and Economic Output from January 2011 through March 2011”

Benjamin Page and Felix Reichling

Mostly Positive

“Targeted Transfers and the Fiscal Response to the Great Recession”

Hyunseung Oh and Ricardo Reis

Mildly Positive

“The American Recovery and Reinvestment Act: Public Sector Jobs Saved, Private Sector Jobs Forestalled”

Timothy Conley and Bill Dupor No Impact

“An Empirical Analysis of the Revival of Fiscal Activism in the 2000s”

John B. Taylor No Impact

A more detailed summary of these and other papers can be found at www.washingtonpost.com under the title “Did the Stimulus Work? A Review of the Nine Best Studies on the Subject.” It was authored by Dylan Matthews.

gue46399_ch09_119_130.indd 127 16/03/17 11:41 AM

128 Chapter 9 Fiscal Policy

AGGREGATE SUPPLY SHOCKSKick It Up a Notch

In both Figures 9.7 and 9.8 we start out with AS1 crossing AD1 so that prices are at PI* and output is at RGDP*. A hypothetical shock moves aggregate supply to AS2. If the supply shock is negative and it raises input prices sub- stantially, as in Figure 9.7, people will lose their jobs as RGDP falls. Nondiscretionary fiscal policy will kick in at this point, though, because the loss of jobs will mean an increase in welfare spending and a decrease in taxes. This will cause aggregate demand to shift to the right to AD2. If the president and Congress then decide to go further with discretionary fiscal policy in an effort to get out- put back to RGDP*, they will have to cut taxes or raise

spending to do so. The problem is that the shock itself and the nondiscretionary fiscal policy that was imple- mented have already created high inflation. Discretion- ary fiscal policy can only serve to worsen the problem. On the other hand, if the supply shock is that input prices have fallen, as depicted in Figure 9.8, output increases. Nondiscretionary fiscal policy is such that taxes go up and welfare spending goes down. When this happens, aggre- gate demand falls to AD2. In this case there is no need for discretionary fiscal policy because, even though there is a shock, it is only for the good. Both the shock and the nondiscretionary fiscal policy also serve to calm inflation.

PI

PI*

AD1

AD3

AS1AS2

AD2

NDFP

DFP

Shock

RGDPRGDP*

FIGURE 9.7 Nondiscretionary and discretionary fiscal policy in the wake of a negative aggregate supply shock.

FIGURE 9.8 Nondiscretionary fiscal policy in the wake of a positive aggregate supply shock.

PI

PI*

AD1

AS1

AS2

AD2

NDFP

Shock

RGDPRGDP*

Summary You now understand the difference between discretion- ary and nondiscretionary fiscal policy and know how to model them using an aggregate supply and aggregate demand diagram. You understand that different policies are used to counteract aggregate demand and aggregate

supply shocks. You also now understand that though there are considerable problems associated with discre- tionary fiscal policy, it has seen a recent revival. Still, nondiscretionary fiscal policy remains a mainstay of our current macroeconomic system.

Key Terms administrative lag aggregate demand shock aggregate supply shock discretionary fiscal policy

fiscal policy nondiscretionary fiscal policy operational lag political business cycle

recognition lag shock

gue46399_ch09_119_130.indd 128 16/03/17 11:41 AM

1. The existence of the federal income tax and the welfare system serve as the primary elements of a. discretionary fiscal policy. b. nondiscretionary fiscal policy. c. monetary policy. d. exchange rate policy.

2. Adjustments to tax and spending policies serve as primary elements of a. discretionary fiscal policy. b. nondiscretionary fiscal policy. c. monetary policy. d. exchange rate policy.

3. Discretionary fiscal policy is the purview of a. Congress only. b. the president only. c. Congress and the president collectively

through law. d. the Federal Reserve.

4. Nondiscretionary fiscal policy has its impact by a. magnifying the economic ups and downs

already occurring. b. purposefully adjusting interest rates. c. congress focusing its constant attention. d. dampening the economic ups and downs

already occurring. 5. The aggregate demand–aggregate supply model

examines the impact of discretionary fiscal policy and nondiscretionary fiscal policy by focusing on movements of a. interest rates. b. aggregate supply. c. aggregate demand. d. regulatory policies.

6. One typical response to a recession for those interested in discretionary fiscal policy is to a. raise taxes and cut spending. b. lower taxes and cut spending. c. raise taxes and increase spending. d. lower taxes and increase spending.

7. One typical response to an overheated economy for those interested in discretionary fiscal policy is to a. raise taxes and cut spending. b. lower taxes and cut spending. c. raise taxes and increase spending. d. lower taxes and increase spending.

Quiz Yourself 8. Discretionary fiscal policy as a tool for making things better is a. universally applauded as being helpful. b. universally derided for never being effective. c. considered by many to be effective but subject

to several concerns over timing and motive. d. inconsistent with the aggregate demand–

aggregate supply model. 9. The oil price increases of 2002–2005 are an exam-

ple of a a. positive aggregate demand shock. b. negative aggregate demand shock. c. positive aggregate supply shock. d. negative aggregate supply shock.

Short Answer Questions 1. Which lag described in this chapter is the concept of

“shovel-ready” intended to combat. 2. Explain how the built-in economic stabilizers work

in the U.S. economy. 3. Assign the correct label to the corresponding events/

policy actions that occurred during the 2007–2011 time period. Events/policy actions: TARP, the 2009 stimu- lus package, the 2010 extension of the Bush tax cuts, the reduction in taxes most Americans paid because they had less income than they would have had. Label: discretionary fiscal policy, nondiscretionary fiscal policy.

Think about This Concerns over the recognition, administrative, and op- erational lags as well as the concern that discretionary fiscal policy is subject to political biases have caused some economists to believe Congress and the president should do nothing in the face of a recession. Even if they are correct, is it realistic to expect the public to embrace elected officials who do nothing?

Talk about This The third and fourth years of presidential terms have higher average rates of real growth than the first and second years. Do you think this is a coincidence or is it a reflection of political reality that politicians are more concerned about reelection than about creating long-run economic growth?

Summary 129

gue46399_ch09_119_130.indd 129 20/03/17 12:27 PM

130 Chapter 9 Fiscal Policy

For More Insight See Journal of Economic Perspectives 14, no. 3 (Summer

2000). See articles written by Alberto Alesina, John B. Taylor, Alan Auerbach, and Daniel Feenberg, and Douglas Elmendorf and Louise Sheiner.

Any textbook entitled Intermediate Macroeconomics will have a chapter on fiscal policy.

Behind the Numbers Gross domestic product. U.S. Bureau of Economic Analysis; gross domestic

product; historical data—www.bea.gov Early estimates of GD. U.S. Bureau of Economic Analysis; news release—

www.bea.gov/newsreleases/rels.htm

gue46399_ch09_119_130.indd 130 16/03/17 11:41 AM

C H A P T E R T E N

131

Monetary Policy Learning Objectives

After reading this chapter you should be able to:

LO1 Describe the role of the Federal Reserve of the United States.

LO2 Define macroeconomic stability as the Fed’s primary goal while noting that controlling inflation has typically been the means by which it has measured its success.

LO3 Integrate an understanding of the tools of monetary policy with their application utilizing an aggregate supply– aggregate demand model.

LO4 Describe the recent history of monetary policy and the Federal Reserve’s role in the 2007–2009 recession.

Chapter Outline

Goals, Tools, and a Model of Monetary Policy

Central Bank Independence

Modern Monetary Policy

Summary

Throughout the 2007–2009 recession and beyond, the role of the Federal Reserve—usually called the Fed— in shaping the economy of the United States has grown from mysterious yet important to absolutely central, with politicians, the media, and, on some days, ordi- nary Americans glued to its actions. No more impor- tant aspect of our daily lives is run by people with as little accountability as those who are its executive offi- cers. The Federal Reserve began in 1913 as a response to the boom and bust nature of the financial world of the late 19th and early 20th centuries. It has become a government institution every bit as important in the lives of people as the three branches of government we learn about in school. In a matter of a couple of hours, one person, the chairman of the Federal Re- serve Board, can influence stock prices by 5 percent, cause mortgage interest rates to rise or fall by a full percentage point, and set in place a course of action that will raise or lower the unemployment rate by a point or more. The chairman can do this, moreover, without the approval of or even consultation with any elected person. Fortunately, the chairmen appointed by presidents and confirmed by the Senate have all been

people of impeccable character. Even if their wisdom has been clouded at some points, a hint of corruption in this area of government would be devastating to world financial markets in particular and, by extension, to the whole world economy.

We will use the context of the 2007–2009 reces- sion, and the very slow recovery from it, to explore the goals of monetary policy and then move to discuss the tools the Federal Reserve has to meet those goals. We will begin the discussion of those tools by first focus- ing on the traditional and ordinary tools of monetary policy and then discuss the extraordinary ones that were first employed in 2008 as the Federal Reserve at- tempted to stabilize first the financial markets and later the overall economy. As we move through the chap- ter, we will consider why the Fed exists and why its independence from political winds is important. Next we review some of the history of the pre-2008 use of monetary policy and then move to an examination of Fed policy during and after the 2007–2009 recession. We conclude by describing the process by which the Fed is likely to unwind those policies and return to its traditional function.

gue46399_ch10_131-144.indd 131 16/03/17 11:41 AM

132 Chapter 10 Monetary Policy

the late 1970s, targeting the federal funds rate proved to be impossible. Keeping the rate down required a continuous increase in the supply of money. As more money chased limited goods, those increases created even greater infla- tion. This caused interest rates to rise rather than fall. In October 1979, as the rate of inflation continued to rise, the Fed formally gave up on the federal funds rate as its target and shifted to targeting M2. M2 is what is known as a monetary aggregate. M2 is a broader measure of money because it includes cash, checking accounts, sav- ings accounts, and small certificates of deposit (CDs). M1 includes only cash and checking accounts.1 By the summer of 1982, inflation had subsided just as M2 be-

came unstable and too difficult to target. In response the Fed reverted to targeting the federal funds rate.

The European Central Bank currently targets inflation rather than a monetary aggregate or interest rate. Inflation target- ing is relatively new as a con- cept and involves publishing a desired range of a specified inflationary measure and then using the tools of monetary policy to bring that measure of inflation into that desired range. Many argue that from the time Benjamin Bernanke took over as Fed chair in 2006 to the begin- ning of the financial crisis in the fall of 2007, the Fed engaged in de facto inflation targeting. The Fed made clear through its regu- lar announcements that it was closely monitoring the core PCE deflator described in Chapter 6.

Whatever is targeted, the mechanism by which the Fed

keeps day-to-day tabs on the target is open-market operations. Open-market operations result when the Fed buys and sells government debt. The Fed owns approxi- mately half a trillion dollars of the national debt, and it sells a portion of that reserve of bonds when it wants to get money out of the system. It buys bonds when it wants to add to the money that is in circulation.

Goals, Tools, and a Model of Monetary Policy

The Federal Reserve has never had a “tool” that would directly impact the economy. Its goals have to be met using an intermediate target with the hope and expecta- tion that the end result of hitting the intermediate target will be satisfaction of the ultimate goal. What follows then is a description of the goals of monetary policy, the tools of monetary policy that until 2008 were considered adequate to the task of meeting those goals, and a model that explains why the tools work under typical circum- stances. We proceed to an explanation of why those tools failed in 2008 and then to a discussion of the extraordi- nary tools that the Federal Reserve, under Chairman Ben Bernanke, created to deal with the 2007–2009 recession and the tenuous recovery in 2010 and 2011.

Goals of Monetary Policy The most important historical role for monetary policy and its implementing institution, the Federal Reserve, has been to prevent boom and bust cycles by regulat- ing banks and other financial institutions. While the role of dampening the boom and bust cycle remains an important part of the job, the mechanism has changed dramatically. At first the Fed simply ensured the finan- cial soundness of institutions. Now it also directly ma- nipulates interest rates to change the borrowing habits of banks, businesses, and consumers. In this way it seeks to maintain low levels of inflation and sustainable levels of real GDP growth.

Traditional and Ordinary Tools of Monetary Policy For the better part of the last 50 years, the Federal Re- serve and other similar central banks around the world have been conducting monetary policy by picking an intermediate target variable and utilizing the basic tools at their disposal to hit that target. If the target variable was outside the desired range, the Fed used its tools to nudge the variable back within the range. At times the Fed has had to abandon its target because the policies necessary to stay within the desired range had undesir- able effects.

In the 1970s the target was the federal funds rate—the rate at which banks borrow from one another to meet reserve require- ments. As inflation heated up in

federal funds rate The rate at which banks borrow from one another to meet reserve requirements.

M2 M1 + saving accounts + small CDs.

monetary aggregate A measure of the quan- tity of money in the economy.

M1 Cash + coin + checking accounts.

inflation targeting A policy whereby a central bank publishes a desired range of a specified inflationary measure and then uses the tools of monetary policy to bring that measure of inflation into that desired range.

open-market operations The buying and sell- ing of bonds, which, respectively, increases or decreases the money supply, thereby influ- encing interest rates.

1In 2006 the Fed abandoned its use of M3 as a useful measure as it was becoming unstable and therefore an unreliable measure.

gue46399_ch10_131-144.indd 132 16/03/17 11:41 AM

Goals, Tools, and a Model of Monetary Policy 133

Banks can also borrow directly from the Fed rather than borrowing from each other. Banks with sufficient creditworthiness can borrow unlimited amounts from

the Fed at the primary credit rate. The primary credit rate or discount rate is typically one percentage point higher than the federal funds rate. Banks with lesser credit ratings face higher rates.2

The last way that the Federal Reserve can impact interest rates is by altering the proportion that the bank can lend from the de- posits it takes in. The reserve

ratio, at 10 percent in 2011, requires that a specific per- centage of every dollar deposited be placed in a Federal Reserve bank. If the ratio is lowered, the bank has more money to lend, whereas if the ratio is raised, the bank has less money to lend.

Modeling Monetary Policy The way monetary policy is supposed to work is through what is called the monetary transmission mechanism. The Federal Reserve can use any of its tools to impact the left panels of Figures 10.1 and 10.2. That is, through

an increase or decrease in the supply of loanable funds, it can have a decisive impact on short-term interest rates. The only real question is whether the causation arrow that connects the left and right panels of these two dia- grams is operating.

Let’s begin by showing that each of the Fed’s tools can impact interest rates. If the Federal Reserve uses open market operations to buy bonds, it increases the amount of money that banks and other financial institutions can loan. This increases the supply of loanable funds in Figure 10.1 and decreases the interest rate in this market. The Fed can just as easily have an opposite desire and want to increase interest rates. The left panel of Figure 10.2 shows what happens when the Fed sells bonds in an effort to increase interest rates. The increase in interest rates is accomplished when the Fed reduces the supply of loanable funds.

2Prior to 2003 the Federal Reserve utilized another key interest rate to sig- nal its intentions, the discount rate. This was the interest rate at which the Fed itself loaned money to banks, usually buying a portion of a bank’s loan portfolio. The discount rate was below the federal funds rate, but banks were reticent to use this service too often because it brought with it the potential for extra scrutiny from auditors.

FIGURE 10.1 Expansionary monetary policy: buying bonds, lowering the discount rate, or lowering the reserve ratio.

RGDPLoanable funds

r

S

Sʹ

D

rʹ

Price level AS

AD1

AD2

Interest rates

One of the lessons that economists routinely teach students in courses designed for economics and business majors is the notion of “money creation.” The banking system can create more “money” than physically exists in the form of coin and cash. This was implied in our definitions of the monetary aggregates (M1, M2, etc.) because if money were only currency, then there would be no need to add checkable accounts and CDs.

The banking system creates money by a series of loans. To see how, let’s assume that there are several people (John, Paul, George, Ringo, Simon, Randy, and Paula) and several banks (1st  National, 2nd National, 3rd National, and 4th National [the Midwest is home to an actual bank called “Fifth-Third”]). Suppose

John makes a $1,000 deposit at 1st National, and that bank loans Paul $900 (10 percent, or $100, must be held as part of the re- quired reserve). Suppose Paul buys something from George, who deposits that $900 at 2nd National. Then suppose that Ringo borrows $810 (again 10 percent, or $90, must be held at the Fed) from 2nd National to buy something from Simon, who deposits that money in 3rd National. If Randy borrows $729 (10  percent, or $81, must be held at the Fed) from 3rd National to buy some- thing from Paula and Paula deposits that money in 4th National and . . . You get the point—this could go on forever. In the end there are deposits totaling $10,000 ($1,000 + $900 + $810 + $729 + . . .) that resulted from that initial $1,000.

M O N E Y C R E A T I O N

primary credit rate or discount rate The rate at which banks with excellent credit can borrow from the Federal Reserve.

reserve ratio The percentage of every dollar deposited in a checking account that a bank must maintain at a Federal Reserve branch.

gue46399_ch10_131-144.indd 133 16/03/17 11:41 AM

134 Chapter 10 Monetary Policy

rise as a result of increases in investment and interest- sensitive consumption. This is shown in the right panel of Fig ure  10.1. An identical but opposite story can be told concerning a tightening of the money supply. Less is available for banks to lend, a circumstance that allows them to raise the interest rates they charge to ordinary borrowers. Raising such rates causes a reduction in in- vestment and interest-sensitive consumption. This in turn causes aggregate demand to fall, as is shown in the right panel of Figure 10.2.

The Monetary Transmission Mechanism Now we get to the question of whether changing short-term interest rates impacts the overall econ- omy in the desired fashion. That is, does the change in the left panel of Figure 10.1 cause the change in the right panel of Figure 10.1, and does the same

work for Figure  10.2? The process by which the use of a monetary policy tool impacts the overall economy is called the monetary transmission mechanism.

Economists disagree about the effectiveness of mon- etary policy, especially its effectiveness in the long run and in circumstances of extreme economic uncertainty. Let’s take the first of these two concerns. Whereas there is some doubt among economists about whether the Fed has the ability to alter short-term economic outcomes in normal economic circumstances, the doubt is much more widely held concerning its long-term ability to in- crease output through sustained increases in the money supply. The underlying reason for the skepticism is that sustained increases in the money supply will be factored in by investors, who will anticipate that substantial infla- tion will result from such a policy. Thus, though it may look as if the Fed could use the logic from Figure 10.1 to continuously foster long-run rapid growth, not many economists believe the Fed has this power. As a result, Figures 10.1 and 10.2 should be taken as relevant only in the short term.

The reason conventional monetary policy is less effective in times of extreme economic uncertainty than Figures 10.1 and 10.2 suggest is that borrowers’ confidence is so shaken by actual unemployment, the threat of unemployment, or slack demand that any small modifications to borrowing costs are trivial compared to these underlying problems. This was certainly the case during the Great Depression, but you don’t have to go back that far for a clear example of what economists call

Because the federal funds rate is determined by mar- ket forces between banks and is not determined directly by the Fed, the way the Fed can influence that rate is by increasing or decreasing the supply of generally available funds for loans. Its rationale is that this action will indi- rectly influence the federal funds rate. There is enough linkage between the quantity of money that is generally available for loans and the interest rate that banks charge each other so that this seems to work fairly well.

As we noted, the Federal Reserve can impact interest rates by changing the reserve ratio. If the ratio is lowered, the bank has more money to lend and the supply of loan- able funds moves to the right, as it does in the left panel of Figure 10.1. If the ratio is raised, the bank has less money to lend and the supply of loanable funds moves to the left, as is indicated in the left panel of Figure 10.2.

As you saw in Chapter 8, one of the determinants of ag- gregate demand is interest rates. The influence of interest rates stems from the fact that investors want to borrow more to buy plant and equipment when interest rates are lower. In addition, consumers are more willing to buy expensive durable goods like cars and home furnishings when interest rates are lower. For the person who pays cash, the lower interest rate effect is indirect in that buyers sacrifice less interest income when they take money out of savings to buy something. The person who buys a car and gets a shiny new payment book with the shiny new car is more likely to buy that car and more likely to buy a nicer, more expensive car because of the lower interest rate.

A loosening of the money supply or a lowering of the federal funds or discount rate allows banks to make more loans. These are loans that they can make only if they lower interest rates to ordinary borrowers. The lowering of interest rates causes the aggregate demand curve to

FIGURE 10.2 Contractionary monetary policy: selling bonds, raising the discount rate, or raising the reserve ratio.

RGDPLoanable funds

rʹ

S

Sʹ

D

r

Price level AS

AD1

AD2

Interest rates

monetary transmission The process by which the use of a monetary policy tool impacts the overall economy.

gue46399_ch10_131-144.indd 134 16/03/17 11:41 AM

Goals, Tools, and a Model of Monetary Policy 135

Reserve paid a modest interest rate on these deposits, the risk-adjusted profits the banks could earn by depositing their excess reserves with the Federal Reserve were suf- ficient to have them do that rather than loaning it to busi- nesses and consumers.

The Additional Tools of Monetary Policy Created in 2008 The Federal Reserve recognized before many the poten- tial severity of the 2008 financial crisis, and well before it became evident to others, the Fed began contemplating other tools it might use to fight a global slowdown. First, it created a new discount window for investment banks, and second, it began buying corporate paper, effectively lending money directly to nonbank corporations. Finally, it contemplated buying longer-term debt such as 30-year treasuries and mortgage-backed securities from banks and other institutions in a frantic attempt to lower long-term interest rates and halt the slide of the housing market.

Investment banks were a creation of post–Great Depression policies that sought to separate commer- cial banks, which took deposits and made loans from those deposits, from investment banks, which simply served as intermediaries to large financial transac- tions. These investment banks were capitalized with their own equity and their own borrowing and did not take deposits. The discount window that was created for investment banks allowed these entities to borrow money from the Fed in much the same way that com- mercial banks do through the discount rate or primary credit rate facility. The effort was for naught as the fi- nancial crisis of 2008 sent one, Lehman Brothers, into liquidation and threatened the health of the remaining two, Morgan Stanley and Goldman Sachs. In the end, the Federal Reserve needed both entities to become commercial banks so that they could assist the Fed in saving other commercial banks.

a liquidity trap. A liquidity trap exists when even zero or near zero interest rates do not stimu- late borrowing.

With a global economic slow- down under way in 2008 and 2009, firms had more than adequate capital to produce the significantly reduced volume of goods and services consumers were ready to purchase. As a result, the reduction in interest rates that might have motivated them to borrow money to buy new capital in 2006 and 2007 did not motivate them in the slightest. Furthermore, consumers who might have been persuaded to borrow money to buy cars, homes, or home furnishings were more concerned about the likelihood that they would keep their jobs. Moreover, the bursting of the housing bubble, which reduced home prices by an average of more than 20 percent, gave many pause when it came to taking on more debt.

The supply side of the liquidity trap can be demon- strated with the help of the data on required and excess reserves of banks (see Figure 10.3). As previously de- scribed, large banks are compelled to hold 10 percent of their deposits in the form of required reserves at the Federal Reserve. They can loan the other 90 percent as they see fit. During normal economic times, that is ex- actly what they do. With the quite obvious and notable exception of September of 2001, bank reserves were what were required. Upward of 95 percent of their reserves were required while the remainder were simply viewed as a cushion against unusual daily activity. The excess reserves were loaned overnight in the federal funds mar- ket. In late 2008, as the financial crisis hit in full force, the proportion of reserves that were considered “excess” went from 5 percent of the total to 90 percent of the total, and this occurred over a short three-month window. That these proportions did not revert to normal through mid- 2013 suggests that, at least from the banks’ perspective, the liquidity trap was in full effect. Because the Federal

liquidity trap A situation where zero or near zero interest rates do not stimulate borrowing.

Imagine a world without money. While you may think that would be utopian, it would actually be a pain in the neck. Money allows us to exchange the goods or services we have to offer so that we may get the goods or services we want. Without it we would have to barter. Money allows us to avoid this by serving as a medium of exchange.

Money also holds its value. Suppose the good you had to offer was subject to spoilage. If you could not find someone who had a good you wanted and wanted what you had to offer within a short period of time, your good would be worthless. With money you can sell your goods and hold on to the cash until such time that you find the goods you want to buy.

T H E R O L E O F M O N E Y

gue46399_ch10_131-144.indd 135 16/03/17 11:41 AM

136 Chapter 10 Monetary Policy

FIGURE 10.3 Proportion of bank reserves held by banks that are required and excess.

Source: Board of Governors of the Federal Reserve System, www.federalreserve.gov/econresdata/statisticsdata.htm

100

80

70

60

50

40

30

20

10

0

90

Required reserves Excess reserves

2 0

0 0

-0 1

2 0

0 0

-0 5

2 0

0 0

-0 9

2 0

0 1-

0 1

2 0

0 1-

0 5

2 0

0 1-

0 9

2 0

0 2

-0 5

2 0

0 2

-0 9

2 0

0 2

-0 1

2 0

0 3

-0 5

2 0

0 3-

0 9

2 0

0 3

-0 1

2 0

0 4-

0 5

2 0

0 4-

0 9

2 0

0 4

-0 1

2 0

0 5

-0 5

2 0

0 5

-0 9

2 0

0 5

-0 1

2 0

0 6

-0 5

2 0

0 6

-0 9

2 0

0 6

-0 1

2 0

0 7-

0 5

2 0

0 7-

0 9

2 0

0 7-

0 1

2 0

0 8

-0 5

2 0

0 8

-0 9

2 0

0 8

-0 1

2 0

0 9

-0 5

2 0

0 9

-0 9

2 0

0 9

-0 1

2 0

10 -0

5 2

0 10

-0 9

2 0

10 -0

1

2 0

11 -0

5 2

0 11

-0 9

2 0

11 -0

1

2 0

12 -0

5 2

0 12

-0 9

2 0

12 -0

1

2 0

13 -0

5 2

0 13

-0 9

2 0

13 -0

1

2 0

14 -0

5 2

0 14

-0 9

2 0

14 -0

1

2 0

15 -0

5 2

0 15

-0 9

2 0

15 -0

1

Additionally, the Fed began buying corporate paper when even well-capitalized and well-run corporations were having difficulty finding buyers for their short-term debt. Corporate paper is the name given to short-term

debt offered by large corpora- tions. These corporations rou- tinely borrow billions of dollars for inventory- building purposes

or to deal with uneven sales knowing that they will eas- ily be able to pay off the debt with the proceeds of future sales. Without this market, many corporations could not operate. Because the financial system was not working properly in the fall of 2008, the Fed stepped in to make these loans possible.

At times during this 2008– 2013 period, the Federal Re- serve began buying long-term debt in a process called quan- titative easing. This process referred to making much more money available to the economy through the purchase of 20- and

30-year U.S. treasuries and mortgage-backed securities. A mortgage-backed security is a financial asset that is the aggre- gation of mortgages where the holder of the security is paid from the combined mortgage payments of homeowners. This

was done to directly impact long-term interest rates to stimulate business investment and to re-ignite the hous- ing market.

For perspective on the relative importance of the traditional tools and the new tools of monetary policy, consider Figure 10.4. The traditional security hold- ings of short-term treasuries, the result of open-market operations and the lending to financial institutions via the discount window, constituted the entirety of the $860 billion Federal Reserve holdings. In very late 2008, the Federal Reserve began its still tradi- tional loaning of large amounts to financial institu- tions, but when that was insufficient to prevent the panic in the financial markets, it followed up only a

corporate paper Short-term debt offered by large corporations.

quantitative easing The process by which the Federal Reserve buys long-term securi- ties in order to decrease long-term interest rates to directly stimulate business investment and housing markets.

mortgage-backed security Financial asset that is the aggregation of mortgages where the holder of the security is paid from the combined mortgage payments of homeowners.

gue46399_ch10_131-144.indd 136 16/03/17 11:41 AM

Central Bank Independence 137

FIGURE 10.4 Federal Reserve holdings 2007–2015.

Source: Board of Governors of the Federal Reserve System, www.federalreserve.gov/econresdata/statisticsdata.htm F

e d

e ra

l R e

se rv

e h

o ld

in g

s (m

ill io

n s

o f

d o

lla rs

)

35,00,000

45,00,000

40,00,000

50,00,000

30,00,000

25,00,000

20,00,000

15,00,000

10,00,000

500,000

0

Liquidity to key credit markets

Federal agency debt mortgage-backed securities purchases

Lending to financial institutions

Traditional security holdings Long-term treasury purchases

1/3 /2

00 7

1/3 /2

00 8

1/3 /2

00 9

1/3 /2

01 0

1/3 /2

01 1

1/3 /2

01 2

1/3 /2

01 3

1/3 /2

01 4

1/3 /2

01 5

matter of weeks later with nontraditional purchases of short-term commercial paper. Beginning in 2009, the Federal Reserve tried to overcome the liquidity trap by embracing the nontraditional tools fully. From early 2009 through 2013, it was buying both long-term trea- suries and mortgage-back securities in such volume that by March 2013, the total Federal Reserve hold- ings had nearly tripled. In order to avoid the percep- tion that this was simply flooding credit markets with cheap money, “operation twist” was employed during 2011 and 2012 in which the Federal Reserve sold tra- ditional short-term securities while using the proceeds to purchase long-term treasuries. This can be seen clearly in that the bottom two portions of Figure 10.4 total roughly the same amount ($1.6 trillion) from mid- 2011 through all of 2012 while the total holdings held steady at $2.75  trillion. The pause was broken in late 2012 when the Fed restarted the purchase of mortgage- backed securities in order to keep the economy from sliding back into recession.

Central Bank Independence

The Fed’s power over the economy is substantial because it can do what it thinks is best without fear of being con- tradicted. Its independence from political control gives it awesome power and awesome responsibility to use that power judiciously. The Fed is so independent that it can slow growth or even put the nation into a recession in an effort to stamp out inflation. Economists generally agree that the Fed must be free from political control in order to take the necessary action to fight inflation. Experience across nations in the latter half of the 20th century pro- vides rather powerful evidence that this is true.

Long-run economic growth requires that the financial markets have faith that money invested in a country will not lose value as a result of excessive inflation. When people are concerned about inflation, interest rates in- crease. Higher interest rates make investments more ex- pensive. Since growth occurs only when investments in the future take place, long-term growth depends on the

gue46399_ch10_131-144.indd 137 16/03/17 11:41 AM

138 Chapter 10 Monetary Policy

individual private bank. With its authorizing of the printing of money during and after the Civil War, prices fluctuated so fast that three significant financial panics in the span of 60 years convinced Congress to create the Federal Reserve. If Congress became sufficiently motivated, it could return to the business of controlling the supply of money and, indi- rectly, interest rates. Under ordinary circumstances, the con- tinuous consultations between Federal Reserve Chairman Bernanke, Treasury Secretary Paulson, and then New York Federal Reserve Bank Chairman and Obama Treasury Sec- retary designate Geithner that occurred in the fall of 2008 would have raised concerns about the degree to which this independence might have been compromised. Clearly, the circumstances were anything but ordinary at the time.

Modern Monetary Policy

The Last 30 Years The history of monetary policy in the second half of the 20th century is one of increasing importance and self- confidence, and its effect on interest rates can be seen in Figure 10.5. In the late 1970s the Fed attempted to

existence of a believable monetary authority. Monetary authority, by the way, is the general name for institutions like the Federal Reserve. While a politically controlled monetary authority could generate that faith if it never wavered from potentially unpopular policies, experi- ence tells us this does not happen. We know this because those countries with a history of independent monetary authorities have experienced lower inflation rates, lower interest rates, and higher real growth rates than countries without that history of independence. The United States, Germany, Switzerland, Japan, Canada, and the Nether- lands are examples of countries with such independence, whereas Spain and Italy are examples of countries with- out it. For the stability we enjoy, we are willing to accept the risk of having an independent monetary authority.

It is worth a small historical interlude to note that Congress could, by simply passing a law, regain complete control over the Federal Reserve. Article I, Section 8, of the U.S. Constitution gives the Congress control over the power to coin money. It never took the role of monetary policy very seriously, however; and before the Civil War paper money was usually a banknote, typically backed by gold, of an

FIGURE 10.5 Key interest rates from 1955 to 2015.

Source: Board of Governors of the Federal Reserve System, www.federalreserve.gov/econresdata/statisticsdata.htm

18

16

14

12

10

In te

re st

r at

e

8

6

4

Year

2

0

Fed funds 1-year 10-year 20-year 30-year

19 55

19 59

19 63

19 67 19

71 19

75 19

79 19

83 19

87 19

91 19

95 19

99 20

03 20

07 20

11 20

15

gue46399_ch10_131-144.indd 138 16/03/17 11:41 AM

Modern Monetary Policy 139

combat the oil-price shocks and a stagnating economy with increases in the money supply. Unfortunately, these efforts served only to add to inflation. In 1981 the Fed changed course with a high-stakes war on inflation. It sent interest rates soaring. Its grip on M2 was such that the federal funds rate went to nearly 20 percent while the discount rate went to 13 percent. By most measures the resulting recession of 1981–1982 was the worst in post– World War II history. The unemployment rate peaked higher, real GDP fell more, and the reduction in inflation was greater than in any of the other post-1946 recessions. It also had the distinction of being the only recession caused intentionally by the Fed.

Since that time the Fed has had a little better luck and has learned from its mistakes. For one thing, since the recession of 1982 it has not had to fight a signifi- cant inflation battle. In part this has been because it has been vigilant about not contributing to inflation. After 1984 the highest inflation rate has been 5 per- cent. Not having to wring out double-digit inflation but only having to keep it under control has made the Fed’s job a little easier. In 1988, 1995, and again in 1999 and 2000, the Fed preemptively kept inflation in check by quickly increasing interest rates to slow an economy on the verge of creating inflation. It also worked to pre- vent a recession in 1994 by quickly pushing interest rates down.

Its response to the 1990 recession was slow, but it was probably forgivably slow. In the months leading up to Iraq’s invasion of Kuwait, real GDP growth was slow, inflation was picking up, and consumer indebtedness was starting to peak. On top of that, the Fed was deter- mined to wait for the outcome of a budget deal. At the time, the federal deficit was more than $250 billion, it was headed toward $400 billion, and the Fed wanted to hold President Bush’s (George Herbert Walker) and the Democratic leadership in Congress’s collective feet to the fire and force them to act.

Unfortunately, Saddam Hussein’s Iraq did not wait for the completion of the budget deal. After the invasion of Kuwait, gasoline prices increased sharply, and these circumstances precipitated an equally sharp decline in consumer confidence. Had the Fed acted immediately, it might have had better success keeping the United States out of the 1990–1991 recession, but its focus was on the deficit. It was also wary of duplicating the mistakes of the late 1970s by trying to battle cost-push inflation (inflation caused by movements in aggregate supply to the left) with increases in the money supply.

Whether explicitly or by chance, the Fed simply let the recession happen. It appeared to decide that there was little it could or should do to prevent it. Fortu- nately, however, the 1990–1991 recession was one of the shortest and the least disruptive recessions on re- cord. Inflation never became a significant problem in part because consumer credit card debt was so high. Thus, except for a short spike in gas prices, inflation was negligible during this period. Unemployment rose but it came nowhere near 1982’s modern record of 11 percent. During the first 18 months of the recovery, from June 1992 through the end of 1993, the econ- omy was so weak, however, that it was unclear at the time whether it was a recovery or just an extension of the recession. In 1992 and 1993 the Fed stepped in with a significant reduction in interest rates, and by the last quarter of 1994 the economy was humming along nicely.

From 1994 on, the Fed kept a vigilant eye on inflation. Where necessary, as in 1995, the Fed let its guard down enough to prevent a slowdown from becoming a reces- sion. By 1998 Fed governors were feeling rather proud of themselves. Unemployment was at a 30-year low, in- flation was nowhere in sight, and longtime Fed chairman Alan Greenspan had successfully kept the stock market in check by offering advice against “irrational exuber- ance.” In 1998 the economy was doing fine. It was in no need of increases or decreases in interest rates. Then the Asian financial crisis hit.

The Asian financial crisis resulted from a series of bad loans made in the Pacific Rim nations of Thailand, Malaysia, South Korea, and Indonesia, and from failed attempts by these countries to hold their foreign ex- change rates constant.

The Fed’s response to the crisis was guarded at first. It wanted to prevent the crisis from spreading but did not want its action to have the effect of importing the crisis to the United States. Stock prices in the United States did fall 20 percent in three months, and many econo- mists began to predict that a recession would occur in the United States within a year. The Fed lowered inter- est rates a full percentage point, enough of an action to increase U.S. demand for imported goods. This helped to stabilize Asia. In turn, the dollar got so strong relative to Asian currencies that the relative price of imports pur- chased by Americans fell enough to offset any domestic price increases.

The recession of 2001 served as another example of monetary policy, its uses and its limitations. Beginning

gue46399_ch10_131-144.indd 139 16/03/17 11:41 AM

140 Chapter 10 Monetary Policy

2002 and picked up considerable steam through 2003 and 2004. In response, the Fed raised interest rates to more normal historical levels in 10 steps through mid- 2005. As mentioned repeatedly through this chapter, the Federal Reserve’s response to the financial crisis of 2008 was swift, if not entirely effective. It lowered short-term interest rates to nearly zero in an attempt to forestall, or at least dampen, the impact of the recession.

Economists will debate whether these interest rate changes had the desired impact, but consider this: Be- tween June 2003 and June 2004, and again in 2008 and 2009, the Fed was pretty much out of bullets. The Fed can’t make businesses borrow money to invest in new plant and equipment and can’t make consumers borrow to buy expensive consumer durables. Once the interest rate has been driven to nearly zero, these deci- sions to borrow money are determined by the confi- dence that the borrower has in his or her ability to pay the money back.

Also worth noting was the Federal Reserve’s dif- ficulty in “talking down” skyrocketing home prices and questionable home lending practices in 2005. Fed increases in short-term interest rates during 2005 had little impact on mortgage rates, which remained low during that year.

with the ambiguous nature of the 2000 presidential elec- tion, the recession of 2001 was met with 12 separate cuts in interest rates by the Federal Reserve. By 2003 the federal funds rate was at its lowest level in more than 40 years. For a time, in the spring of 2003, 30-year fixed mortgage interest rates were below 5 percent for the first time ever.

As can be seen from Figure 10.6, the crowning pe- riod of this aggressive monetary policy was between 1999 and 2006. The Federal Reserve Board’s Open- Market Committee aggressively moved their federal funds rate target to combat economic circumstances. In mid-1999 the Fed aggressively raised interest rates six separate times to combat what Greenspan termed the “irrational exuberance” of the stock markets. These actions had little impact themselves in stemming the overheated stock market. The tech-stock bubble burst on its own in 2000, prompting the Fed to begin to lower interest rates.

The Fed was in the process of easing credit condi- tions in 2001 when the attacks of September 11, 2001, occurred. When stock markets opened the following Monday, it was with a Federal Reserve announcement that it was aggressively moving interest rates lower. With 13 rate cuts in a period of two-and-one-half years, the sluggish economy slowly rebounded through

In the late 1980s and through the decade of the 1990s, criticism started to be heard from the left and right that the Fed was overly concerned about the reappearance of inflation and not sufficiently concerned about the average person. Whether it has admitted it in public or not, since the late 1970s and early 1980s the Fed had considered inflation public enemy number one. This had been true whether inflation was really a problem, as it was in 1979 and 1980; had the possibility of being a problem, as in 1988, 1995, and 1999– 2000; or was just a theoretical threat on the distant horizon.

Only when the country or the world was in trouble and inflation was less than 3 percent, as in the United States in 1993 and 2001 and the world in 1994, has the Federal Reserve relaxed its vigilance against inflation. In being focused on inflation it has cut recoveries short or starved them of sufficient cash to really get going.

In late 2002–early 2003, and again in late 2008 and 2009, a new public enemy number one had begun to come into view: deflation. Recall from Chapter 6 that deflation is the opposite

of inflation but is no less of a concern. Deflation has the ef- fect of encouraging people not to buy now. This is because they know that if they wait, they will save money. This can be self- perpetuating in that by not buying, consumers force businesses to cut prices. This causes profits to fall and layoffs to occur, and buy- ing diminishes even further. Even moderate deflation is worse than inflation in this regard. The Japanese experience with deflation in the late 1980s and 1990s offered very slow growth and stagnant employment. The Fed understood this potential quite well in 2003 when it again began to consider further interest rate cuts. It also understood this well when it drove short-term interest rates to zero in the fall of 2008. We will not know for some time whether it real- ized the threat too late. The deflation of 2008 was confined mostly to housing (20 percent), energy (60 percent), and to some producer commodities such as corn (40 percent), soybeans (40 percent), and raw metal prices (20 percent to 50  percent). Core PCE did not de- crease during the period.

P U B L I C E N E M Y # 1 : I N F L A T I O N O R D E F L A T I O N ?

gue46399_ch10_131-144.indd 140 16/03/17 11:41 AM

Modern Monetary Policy 141

FIGURE 10.6 Aggressive monetary policy between 1999 and 2015.

Source: Board of Governors of the Federal Reserve System, www.federalreserve.gov/fomc/fundsrate.htm

7

6

5

4

R at

e

3

2

1

0

Se p-

99

Se p-

98

M ar

-9 9

M ar

-0 0

M ar

-0 1

M ar

-0 2

M ar

-0 3

Se p-

00

Se p-

01

Se p-

02

M ar

-0 4

Se p-

03

M ar

-0 5

Se p-

04

M ar

-0 6

Se p-

05

M ar

-0 7

Se p-

06

M ar

-0 8

Se p-

07

M ar

-0 9

Se p-

08

M ar

-10

Se p-

09

M ar

-11

Se p-

10

M ar

-12

Se p-

11

M ar

-13

Se p-

12

M ar

-14

Se p-

13

M ar

-15

Se p-

14

Se p-

15

FIGURE 10.7 Selected yield curves on federal funds and U.S. debt.

Source: Board of Governors of the Federal Reserve System, www.federalreserve.gov/econresdata/statisticsdata.htm

In te

re st

r at

e

18

16

14

12

10

8

6

4

2

0

Maturity

1-yearFed funds 10-year

19931981 2000 2002

20-year 30-year

Though Figure 10.5 makes it look like short- and long- term interest rates move in lockstep, they do not. Though they typically move together, it’s useful to remember Chapter 7’s definition of the yield curve. Figure 10.7

notes yield curves from different periods of recent his- tory. What appears is that at times the yield curve is up- ward sloping (the usual case), while at other times it is flat, and at still other times it is downward sloping.

gue46399_ch10_131-144.indd 141 16/03/17 11:41 AM

142 Chapter 10 Monetary Policy

At no time in world history have central banks engaged in such sus- tained efforts to keep interest rates so low for so long. As can be seen in Figure 10.8, the U.S. Federal Reserve was hardly alone in its massive purchases of financial assets. Both the Federal Reserve and the Bank of England quintupled the size of their respective port- folios. The European Central Bank started along the path the Fed was on and abandoned the effort at the same time the Fed doubled- down. The Bank of Japan, late to the show, tripled its holdings in the span of three years.

In the case of the U.S. Federal Reserve, it purchased nearly $2  trillion in mortgage-backed securities and nearly $2 trillion in long-term treasuries in three separate stages. The result is that $3.7 trillion is now in the economy with most of it in bank reserves (typically held at the Fed as excess reserves) and in the hands of investors. In late 2014 the Fed stopped pushing new money into the system and in late 2015 it began the long process of pulling it out.

The toe in the water was the December increase in the targeted Fed Funds rate. Recalling Figure 10.3, because nearly every bank has its own high level of excess reserves, few have any need to borrow in that market so the impact is likely muted.

Still, the real work of removing that money has to be done even- tually, and it appears that the way it will be done is simply through the process of lettering the instruments that were purchased ma- ture. When the mortgages that make up a mortgage-backed secu- rity mature, the Fed can simply not use the money to purchase a replacement security. When the long-term treasuries reach maturity, the same thing can occur. That could be a two-decade process. In the interim it can alter the interest rate that it pays on deposits that banks make at the Federal Reserve. By increasing the rate paid to banks on excess reserves, it can constrain commercial and con- sumer loans, and by decreasing the rate paid to banks on those ex- cess reserves, it can do the opposite.

W A S T H E U N I T E D S T A T E S A L O N E I N T H I S ? C A N I T B E U N D O N E ?

600

500

400

300

200

100

0

Euro zone Bank of Japan Bank of England US Fed. Res

20 07

.1

20 07

.5

20 07

.9

20 08

.1

20 08

.5

20 08

.9

20 09

.1

20 09

.5

20 09

.9

20 10

.1

20 10

.5

20 10

.9

20 11

.1

20 11

.5

20 11.

9

20 12

.1

20 12

.5

20 12

.9

20 13

.1

20 13

.5

20 13

.9

20 14

.1

20 14

.5

20 14

.9

20 15

.1

20 15

.5

20 15

.9

20 15

.11

FIGURE 10.8 Central Bank assets relative to 2007 (=100).

gue46399_ch10_131-144.indd 142 16/03/17 11:41 AM

Summary 143

Key Terms corporate paper federal funds rate inflation targeting liquidity trap M1

M2 monetary aggregate monetary transmission mortgage-backed security open-market operations

primary credit rate or discount rate

quantitative easing reserve ratio

1. The Constitution of the United States grants to Con- gress the power of monetary policy in Article 1, Section 8. Since 1913, Congress has a. jealously guarded this power. b. granted this power to the president. c. delegated this power to the Federal Reserve. d. ignored this power.

2. When engaging in monetary policy, the impact of ex pansionary policy on an aggregate demand– aggregate supply model is to a. increase aggregate demand. b. increase aggregate supply. c. decrease aggregate demand. d. decrease aggregate supply.

3. The most precise tool of monetary policy is a. the adjustment of the federal funds target. b. the adjustment of the discount rate. c. the adjustment of the reserve requirement. d. the use of open-market operations.

4. Federal Reserve independence is a. completely fictitious. b. totally complete. c. subject to Congress’s desire to keep it independent. d. subject to the Supreme Court’s desire to keep it

independent. 5. The “creation” of money is

a. entirely the purview of Congress. b. entirely the purview of the Federal Reserve. c. formally the purview of the Federal Reserve,

constitutionally the purview of Congress,

but banks have a practical means of creating money.

d. entirely subject to the whims of the banking system.

6. During 1999 through 2006, the Federal Reserve a. was passive and simply let things happen. b. reacted actively to quell potentially inflationary

expansions but did nothing to deal with the recession.

c. reacted actively to deal with the recession but did nothing to quell potentially inflationary expansions.

d. reacted actively to deal with the recession and to quell potentially inflationary expansions.

7. The ability of the Federal Reserve to control interest rates is a. limited almost entirely to short-term rates. b. limited almost entirely to long-term rates. c. limited almost entirely to intermediate-term

rates. d. unlimited.

8. Which of the following tools would have likely had the impact of raising short-term interest rates the most? a. Cutting the federal funds target by one-quarter

point b. Buying $1 million in bonds c. Raising the reserve requirement from 8 percent

to 15 percent d. Raising personal income tax rates by 1 percent-

age point each

Quiz Yourself

Summary With your newfound wealth of knowledge, you now under- stand the role of the Federal Reserve of the United States and its primary goal to maintain macroeconomic stability. You see that the Fed’s own apparent measure of success in meeting this goal has been the ability to control infla- tion. You know the tools of monetary policy, understand

how they work, and are able to apply that knowledge to an aggregate supply–aggregate demand model. You know the recent history of monetary policy and know how it has shaped the Federal Reserve’s current fixation with infla- tion. Finally, you understand the debate among economists over whether inflation or deflation is a greater concern.

gue46399_ch10_131-144.indd 143 16/03/17 11:41 AM

144 Chapter 10 Monetary Policy

Short Answer Questions 1. Explain how open-market operations work. 2. Explain the difference between the discount rate and

the federal funds rate. 3. Explain how lowering the reserve ratio affects the

economy. 4. Explain how the 2010–2013 quantitative easing

through the Federal Reserve purchase of mortgage- backed securities is different in style from what it usually does.

Think about This Because the chairs of the Federal Reserve Board can have an enormous impact on policy decisions of the Fed and thereby the economy, their selection has been the subject of great political interest. Politically motivated monetary policy could be ruinous economic policy. Previous Fed chairs have understood that their functional independence from congressional interference depends on the apolitical nature of their decisions. What would the economic consequences be if this balance was upset by a president who nominated a Fed chair dedicated to protecting the president’s political party?

Talk about This Presidents tend to nominate Fed chairs on the basis of advice from those working daily in the financial markets.

Who should have an impact on the choice of the Fed chair? Specifically, Fed policy can favor financial inter- ests or the interests of workers. Should unions or others with a claim to represent workers have an impact on the selection of the Fed chair?

For More Insight See Colander, David, “The Stories We Tell: A Reconsid-

eration of AS/AD Analysis,” Journal of Economic Perspectives 9, no. 3 (Summer 1995), pp. 169–188.

Ramo, Joshua Cooper, “The Three Marketeers,” Time, February 15, 1999, pp. 34–42.

Steiger, Douglas, James H. Stock, and Mark W. Watson, “The NAIRU, Unemployment and Monetary Policy,” Journal of Economic Perspectives 11, no. 1 (Winter 1997), pp. 33–50.

Behind the Numbers Consumer price index and historical U.S. inflation rates.

Bureau of Labor Statistics—www.bls.gov/cpi U.S. interest rates 1955–2015.

Federal Reserve Board; statistics: releases and his- torical data— www.federalreserve.gov/econresdata/statisticsdata.htm

gue46399_ch10_131-144.indd 144 16/03/17 11:41 AM

C H A P T E R E L E V E N

145

Federal Spending Learning Objectives

After reading this chapter you should be able to:

LO1 Describe the process that goes into creating the federal budget of the United States.

LO2 Show that mandatory spending—the portion of the budget that is devoted to spending on items for which no annual vote is taken—has steadily increased because of various entitlement programs and interest on the national debt.

LO3 Summarize how 30 percent of the federal budget is al- located almost equally to domestic spending and defense, with a relatively small amount going for foreign aid and for dues to international organizations such as the United Nations.

LO4 Explain how to use marginal analysis when looking at federal spending.

LO5 Distinguish between current-services and baseline budgeting.

LO6 Conclude that the idea of opportunity cost is at the heart of federal spending.

Chapter Outline

A Primer on the Constitution and Spending Money

Using Our Understanding of Opportunity Cost

Using Our Understanding of Marginal Analysis

Budgeting for the Future

Summary

The federal government of the United States of America spends more than $4 trillion each year on everything from welfare to national defense. This chapter focuses at- tention on how the government spends that money, a per- fect example of how, in public policy, we use the concept of opportunity cost that was introduced in Chapter 1.

We start with a brief primer on what the Consti- tution requires before money can be spent. We then discuss the difference between mandatory and discre- tionary spending and how the balance between the two has shifted over the years. Next we lay out where the money was budgeted in the 2014 fiscal year, how that budget reflects on our priorities, and how the shift in distribution over the years reflects a shift in priori- ties. We focus our attention, in particular, on health, Social Security, and defense spending, which make up

the bulk of the federal budget. We use the Chapter 1 notion of marginal analysis to discuss both the size of federal spending and the distribution of it among vari- ous programs. Finally, we describe baseline and cur- rent-services budgeting and use Medicare and defense to discuss the differences.

As can be seen in Figure 11.1, federal spending as a percentage of GDP stayed between 18 percent and 22 percent for 22 years. After peaking in 1952 as a re- sult of the Korean War, this measure trended up from 16 percent in 1955 to a peak at 23.5 percent in 1982 as spending on social programs increased. The Reagan years saw a slow decline only to rebound in the George Herbert Walker Bush years as billions were spent in a bailout of failed savings and loan associations. Since that time the size of the federal government,

gue46399_ch11_145-154.indd 145 16/03/17 11:41 AM

146 Chapter 11 Federal Spending

The Congress often uses that budget as a blueprint upon which it bases a budget plan of its own. It uses its version as it debates and negotiates with the executive branch of government. When both sides reach agreement on a final budget, Congress passes appropriations bills to actually spend the money that has been budgeted.

All of this work must be completed by October 1 be- cause the government’s fiscal year starts then and goes to September 30 of the following year. (So the 2017 fiscal year began October 1, 2016, and ended September 30, 2017.) When these bills are passed and signed by the president, they become law and money can be spent. Otherwise, money cannot be spent.

Shenanigans This process has a myriad of places for shenanigans. Chief among these are actions taken by the various subcommittee and committee chairs and in the House– Senate conferences. The chairs of the appropriations subcommittees and the chairs of the full committees can and do influence how much gets spent and where it gets spent. Whereas spending on social insurance programs like Medicaid, Medicare, and Social Secu- rity cannot be easily altered, highway spending and defense spending are prime targets for spending on items of local rather than national interest. The chair of a subcommittee like the one on highway spending

measured as a percentage of GDP, fell to its lowest point in 25 years only to rise again in the wake of the September 11, 2001, attacks, and the subsequent wars in Afghanistan and Iraq. The $750 billion Troubled Asset Relief Program (TARP) passed in October 2008 and the $787 billion Obama stimulus law passed in February 2009 greatly altered this figure. After the Great Recession peak of 25.2  percent, federal spend- ing as a percentage of GDP is projected to stabilize at around 22 percent.

A Primer on the Constitution and Spending Money

What the Constitution Says According to the Constitution of the United States of America, “No money shall be drawn from the treasury, but in consequence of appropriations made by law.” This means that unless Congress passes an appropria- tions bill and the president either signs it or has a veto overturned, no money can be spent. The president and Congress thus must reach either an agreement or a com- promise on spending priorities so that Congress will pass an appropriation bill that the president will sign.

Under normal procedures, the president sends a pro- posed budget to Congress in late winter or early spring.

19 47

19 51

19 55

19 59

19 63

19 67

19 71

19 75

19 79

19 83

19 87

19 91

19 95

19 99

20 03

20 07

20 11

20 15

20 19

F e

d e

ra l s

p e

n d

in g

/G D

P

30.0

25.0

20.0

15.0

10.0

5.0

0.0

Year

Federal spending/GDP 2014–2018 est.

FIGURE 11.1 Federal spending as a percentage of GDP. Source: The Office of Management and Budget, www.whitehouse.gov/omb/budget/Historicals

gue46399_ch11_145-154.indd 146 16/03/17 11:41 AM

A Primer on the Constitution and Spending Money 147

review. Promises to quell this type of spending are rarely kept.

Dealing with Disagreements The appropriations process seldom moves smoothly, and the process is particularly rough when the political party in control of the White House is not in control of Congress. Disagreements abound when this is the case, and rarely can one party “have its way” with the budget. While the Obama administration was elected to office with large majorities in both the House of Repre- sentatives and Senate, Senate budget rules required that Obama garner 60 votes for his stimulus package. He could do that only with Republican votes. Even then, he was in a considerably more advantageous position than Presidents Clinton and Bush. Neither could count on his own party to back his budget priorities, and both dealt with periods when Congress was in the hands of the other party. It has been a truly rare circumstance in recent American history where a president had suffi- cient political party and ideological majorities in Con- gress to get his way. Thus the usual case for much of the late 20th century featured long and protracted budget debates.

When Congress either does not pass appropriations bills that are acceptable to the president or passes bills the president does not want, there are only four choices:

1. Congress can give in. 2. The president can give in. 3. The government can shut down. 4. Congress can pass a continuing resolution and the

president can sign it.

If either side gives in, a bill gets passed. Shutting down the government becomes a battle of chicken until the sides reach compromises. A continuing resolution con- stitutes an agreement to disagree that lets the government continue functioning.

Specifically, a continuing resolution is a bill passed by Congress and signed by the president that allows the government to spend money temporarily in a fashion identical to the previous year. This usually happens when

Congress does not meet the Oc- tober 1 deadline. More often than not, it is for only a few of the 13 appropriations bills and for only a few weeks, but in 2013, almost the entire budget was passed as a continuing resolution.

can fund the building of bridges and highways in his or her district much more easily than anyone else can. As with roads and bridges, defense is also an area where the powerful chairs of the subcommittees and the full committees work to ensure that federal money is spent in their districts. Recent history is replete with examples of weapons systems that are not wanted by the military but that are being built anyway because the production facilities are in districts or states of powerful members of Congress.

Even worse, members of the conference committees, who are charged with putting together good compromise bills, have been known to spend significant time mak- ing sure money is included for their states or districts and less time making sure the bill is a good one for the country. Members of Congress who have seniority over other members are the ones who are assigned to such committees. Such appointments are considered rewards for years of service. The most egregious products of the conferences are usually found in parts of the final bill that were not in the original House or Senate version of the bill. These are items that conference members knew they could not get passed in their own houses. Knowing they  were going to end up on a conference committee, they just waited and made the inclusion of the item they wanted passed a condition of their support for the bill in conference.

Another element of budgetary shenanigans comes when members of Congress agree to support spending programs in each other’s districts. This vote trading, called logrolling among economists, increases spend- ing in ways that raise eyebrows. A senator from Ver- mont got his colleagues to declare Lake Champlain a Great Lake so that it would qualify for an environmen-

tal program. The emergency spending legislation approved after the attacks of September 11, 2001, included billions for wholly unrelated items. The infamous Alaskan “bridge to nowhere” was tucked into

emergency spending following Hurricane Katrina by then Alaska Senator Ted Stevens. The 2013 Hurricane Sandy relief bill included $33 billion in spending en- tirely unrelated to the storm. Bridges, roads, univer- sity studies, and memorials to obscure local celebrities tend to grow on spending bills in direct proportion to the need to move the legislation quickly as members of Congress take advantage of the situation and agree to spending that would otherwise require extensive

logrolling The trading of votes used to generate sufficient support for projects that are not in the general interest of the country.

continuing resolution A bill passed by Con- gress and signed by the president that allows the government to tempo- rarily spend money in a fashion identical to the previous year.

gue46399_ch11_145-154.indd 147 16/03/17 11:41 AM

148 Chapter 11 Federal Spending

spending. You can see that the broadest of its distinctions is the difference between mandatory and discretionary spending. Mandatory spending delineates those items for which a previously passed law requires that money be

spent, while discretionary spend- ing is subject to annual appropri- ations decisions. For instance, current law states that people are entitled to certain benefits that must be paid without regard to any other budget details. Future laws could overturn those now in existence, but the benefits that are currently provided through Social Security, Medicare, Med- icaid, and welfare are so firmly entrenched in our society that in reality the money spent on them is untouchable. These four areas of the budget are often referred to as entitlement spending be-

cause the people for whom they are intended are entitled to the money they receive based on their poverty or age. Entitlement spending is a subset of mandatory spending, which also includes interest on the national debt.

The appropriations for defense, student loans, the courts, and so on, occur annually. While these budgets rarely change drastically from the previous year, a failure to pass an appropriations bill can significantly affect the operations in these areas.

On the discretionary side of the budget there are three main components: defense, international policy and foreign aid, and everything else (broken out in Table 11.1). The most misunderstood and controversial of these is international policy. Of the $46 billion spent

Using Our Understanding of Opportunity Cost

The federal budget of the United States is an object lesson in opportunity cost. Whenever money is spent in one area, it cannot be spent in another. Although more money can be spent in all areas, this also has an opportunity cost. When money is taken from taxpayers, their ability to enjoy pri- vate consumption is reduced. Deficit spending is also not without opportunity cost. Interest payments add up into the future and money for private investment is reduced.

Some economists argue that the opportunity cost of government deficit spending is such that for every dol- lar the federal government borrows and spends, a dollar is removed from private investment. If these economists are correct, this phenomenon, called crowding out, is an example of opportunity cost at work: Government cannot just spend money and make everyone better off. In the

process, someone is being made worse off. Other economists suggest that crowding out is less than complete, which means that for every dollar of govern- ment spending something less

than a dollar of private spending is lost. In either case there is an opportunity cost to the money spent.

The remainder of this section describes the choices that must be made by Congress and the president when setting out a spending plan.

Mandatory versus Discretionary Spending Although the actual budget proposal of the president runs to more than 1,000 pages and is incredibly detailed and precise, Figure 11.2 offers its basic distribution of

crowding out The opportunity cost of government deficit spending such that private investment is reduced.

mandatory spending Budget items for which a previously passed law requires that money be spent.

discretionary spending Budget items for which an annual appropriations bill must be passed so that money can be spent.

entitlement A program where if people meet certain income or demo- graphic criteria they are automatically eligible to receive benefits.

TABLE 11.1 Nondefense domestic discretionary spending, Fiscal Year 2016.

Income Security, $528, 13%

Medicaid and SCHIP, $407, 10%

Medicare, $595, 15%

Social Security, $929, 24%

Discretionary domestic, $628,

16%

International A�airs and Aid,

$46, 1%

Defense and Homeland Security,

$604, 15% Interest, $240, 6%

FIGURE 11.2 Fiscal Year 2016 spending (in billions) and percentage of federal budget.

Category of Domestic Discretionary Spending

2016 Spending ($ billions)

Science and space 30.8 Natural resources/environment 42.6 Agriculture 25.6 Transportation 92.4 Education and training 113.9 Veterans 178.2 Justice 64.4

gue46399_ch11_145-154.indd 148 16/03/17 11:41 AM

Using Our Understanding of Opportunity Cost 149

future Congresses and presidents as less and less of the budget can be devoted to other priorities.

Where the Money Goes As you can see from Figure 11.2, defense, Social Security, Medicare, Medicaid, and net interest take up $2.8 trillion of the $4 trillion spent each year. The rest is either in the form of other welfare programs such as Temporary Assis- tance for Needy Families (TANF) or food stamps, or it is spent in the relatively smaller amounts listed in Table 11.1. The biggest of these areas of spending are under the De- partment of Education and its education and training pro- grams. Of the $114 billion spent on education and training, $39 billion is spent on student loans, grants, and the federal work–study program. The remainder is spent as a supple- ment to state and local spending on primary and secondary education. With the wars in Iraq and Afghanistan, spend- ing on veterans’ benefits has increased to $178 billion. In 2016, transportation spending was budgeted at $92 billion with $64 billion for the federal justice system.

Figure 11.4 indicates that the mix of spending has dra- matically changed over the years. Half or more of the fed- eral budget once was devoted to national defense; today the amount is less than 16 percent. While Social Security once took up only 15 percent of the budget, today it is ap- proximately 23 percent. Net interest paid increased from less than 10 percent to more than 15 percent only to fall to 9 percent as a result of the surpluses of the late 1990s

in this area, $14 billion is spent to maintain the State Department and its embassies in other countries and to pay our dues to the UN and other international organiza- tions. The remaining $32 billion goes to other countries in foreign aid.

As you can see from Figure 11.3, the proportion of the budget devoted to discretionary spending has decreased from over 65 percent to just over 30 percent, while the proportion devoted to mandatory spending has skyrocketed. This led President Clinton in 1993 to decry the fact that under projections valid at the time, by 2010 Congress would convene each year to debate less than 10 percent of the annual budget. This troublesome trend was halted in the late 1990s, but was on track to resume before the financial crisis of 2008 and coincident reces- sion began. The massive increase in discretionary spend- ing that resulted from the 2009 stimulus plan briefly interrupted this trend. However, aging baby boomers will soon balloon Social Security and Medicare spend- ing, and the massive deficits of 2009 through 2014 and likely beyond will surely increase interest obligations such that President Clinton’s prediction may come true, a few years after he thought it would.

This brings us back to the inescapable notion of op- portunity cost. Every time a new entitlement program comes on board, such as the prescription drug coverage for Medicare recipients, it not only costs money now and in the future but also reduces the amount of flexibility of

FIGURE 11.3 Mandatory and discretionary spending as a percentage of total federal spending, 1962–2021. Source: The Office of Management and Budget, www.whitehouse.gov/omb/budget/Historicals

80%

70%

60%

50%

40%

30%

20%

10%

0%

Discretionary

Discretionary est. 2016–2021

Mandatory

Mandatory est. 2016–2021

Year

P e

rc e

n ta

g e

o f

fe d

e ra

l s p

e n

d in

g

19 62

19 65

19 68

19 71

19 74

19 77

19 80

19 83

19 86

19 89

19 92

19 95

19 98

20 01

20 04

20 07

20 10

20 13

20 16

20 19

gue46399_ch11_145-154.indd 149 16/03/17 11:41 AM

150 Chapter 11 Federal Spending

Federal Reserve has used its power to buy this debt to temporarily reduce the interest rate.

An area of spending that has increased remarkably since 1970 is federal spending in support of health care. As seen in Figure 11.5, adjusted for inflation, federal

and early 2000s and the historically low interest rates of 2001 through 2004. As deficits grew during 2005–2007 and then exploded during and after the 2007–2009 re- cession, it is once again more than 10 percent. The only reason it has not already exceeded that amount is that the

19 62

19 65

19 68 19

71 19

74 19

77 19

80 19

83 19

86 19

89 19

92 19

95 19

98 20

01 20

04 20

07 20

10 20

13 20

16 20

19

Year

50

P e

rc e

n ta

g e

o f

fe d

e ra

l s p

e n

d in

g

40

45

35

30

20

25

10

15

5

0

Social Security Net interest

Soc. Sec. 2016–2021 est. Net int. 2016–2021 est. Means tested entitlements National defense

Nat. def. 2016–2021 est.M.T.E 2016–2021 est.

FIGURE 11.4 Composition of federal spending. Source: The Office of Management and Budget, www.whitehouse.gov/omb/budget/Historicals

600

700

400

500

200

300

100

0

Total

Total 2016–2021 est.

Medicaid

Medicaid 2016–2021 est.

Medicare

Medicare 2016–2021 est.

Year

R e

al $

b ill

io n

s

19 62

19 65

19 68 19

71 19

74 19

77 19

80 19

83 19

86 19

89 19

92 19

95 19

98 20

01

20 04

20 07

20 10

20 13

20 16

20 19

FIGURE 11.5 Real health spending by the federal government, 1962–2021 billions of 2000 dollars. Source: The Office of Management and Budget, www.whitehouse.gov/omb/budget/Historicals

gue46399_ch11_145-154.indd 150 16/03/17 11:41 AM

Budgeting for the Future 151

marginal analysis compares the marginal benefit of an action with its marginal cost. In particular, that marginal cost is its opportunity cost.

The Size of the Federal Government In judging the proper size of the federal government, an economist using marginal analysis would attempt to decide if the benefits resulting from additional tax money would outweigh the benefits that would other- wise accrue to private citizens if they were not taxed that amount. A government that purports to be “of, by and for the people” should seek to take only that money needed to fund programs whose marginal benefit is greater than or equal to their marginal cost. Thus it is not enough to say that we are getting $4 trillion in value for our $4 trillion; we need to be able to say that we are getting a dollar’s worth of value for the last dollar of those $4 trillion dollars.

The Distribution of Federal Spending Just as government should seek to maximize the net benefit to society by picking the optimal size of gov- ernment, it should ensure that the distribution of spend- ing between various priorities is optimal as well. Once the optimal size is established, the opportunity cost of money spent by one program is that it cannot be spent by another. For instance, the choice to build an aircraft car- rier could come at the cost of expanding student grants and loans to cover several thousand more college stu- dents. Thus money spent on a program with only modest evidence of success could be viewed as wasteful, even if it is spent with good intentions and does no harm, because the money could be spent elsewhere to greater effect.

Budgeting for the Future

Baseline versus Current-Services Budgeting The yearly budget debate in Washington is replete with claims about who is making what cuts. For instance, dur- ing the debate over the 1996 budget, Republicans sug- gested that spending on Medicare increases yearly at a rate of 9 percent rather than the 14 percent requested by President Clinton. Since another aspect of their program was a broad-based tax cut, they were accused of “cut- ting Medicare to pay for a tax cut for the rich.” This kind of debate is annoying because politicians often redefine simple words such as “cut” or simple phrases such as

spending on health care has risen 1,000 percent over that time. This is because Medicare and Medicaid spending has risen dramatically. When these programs were intro- duced in the late 1960s, spending on both was trivial. In the 2016 federal budget more than $407 billion was spent on Medicaid and the State Children’s Health Insurance Programs, and $595 billion on Medicare. Together this is more than is spent on any program other than Social Security.

Again we are faced with the fact that there are always trade-offs. The trade-offs that we have made until now have clearly been in favor of entitlements. Social Secu- rity, Medicare, Medicaid, and various welfare programs have driven the budget for many years. The combined budget for all non-defense domestic spending, which in- cludes everything from the federal judiciary to student loans, is exceeded by just one program, Social Security. The choice that we have made to ensure that elderly peo- ple and persons who are disabled have steady and reli- able incomes comes at a cost.

Another choice that we have made is to exercise our military power in other parts of the world. Though some would argue that we had no real choice being the world’s only superpower, it does, nonetheless, absorb resources and have an opportunity cost. As can be seen from Table 11.2, we spend a higher percentage of our GDP on military expenditures than our allies.

Using Our Understanding of Marginal Analysis

Federal spending is a prime arena to utilize marginal anal- ysis. We can use this form of thinking to discuss whether the federal government spends too little or too much and whether the distribution of spending on various spend- ing priorities is appropriate. Recall from Chapter 1 that

TABLE 11.2 International comparisons of defense spending as a percentage of GDP, 2014.

Source: The World Bank, http://data.worldbank.org/indicator/MS.MIL.XPND.GD.ZS

Country Defense Spending/GDP

United States 3.5 United Kingdom 2.0 France 2.2 Germany 1.2 Japan 1.0

gue46399_ch11_145-154.indd 151 16/03/17 11:41 AM

152 Chapter 11 Federal Spending

to ensure that government services are available to everyone who is eligible to receive them. There is no guarantee that baseline budgeting will provide enough money. A reasonable question to ask in budgeting is one that Democrats tend to ask: “How much will it cost to perform services this year in a manner identical to last year?” This is referred to as current-services budgeting. Current-services budg et ing takes into account such things as overall inflation, inflation in the specific sec-

tor, and an increase in the num- ber of people being served. If you want to guarantee enough money to provide identical ser- vices in the future, then merely starting with the previous year’s baselines may not work. This

has been particularly true in the health care field because new, more effective treatments become available. Thus the question is whether the new spending required to meet the old standard of care will be sufficient to meet the new standard.

Using current-services budgeting, President Clinton criticized Republicans in 1995 for their plan to “cut Medicare.” Republicans countered, using baseline budgeting, that there was no cut at all. By using jar- gon with technical definitions to further their own posi- tions, each party was telling the truth. In this case the truth depended on the standard that had been set. If the agreed-upon standard had been baseline budgeting, then the Republicans were right; if it had been current- services, then the Democrats were right. Because a standard had not been set, they were both right and they were both wrong.

“broad-based” to suit their argument. It is indisputable that Democrats wanted more money for Medicare and Republicans, less. Moreover, Republicans wanted a re- duction in taxes in rough proportion to taxes paid, and Democrats did not.

Had each side used straightforward and agreed- upon definitions, the debate would have been easier to understand. For instance, Democrats often define a broad-based tax cut as one that goes to everyone equally, whereas Republicans define it as one that goes proportionally to those who pay income taxes. Republicans argue that most of a tax cut should go to those making the most money since they pay the most taxes. (See Chap ter 41 on personal income tax.) Democrats, on the other hand, define broad-based tax cuts as those that are given to everyone in similar amounts.

The language problem on spending cuts is equally exasperating. The problem is that when you formulate a budget and you compare it to other years’ budgets, there is an open question as to how the comparison should be done. If you simply look at last year’s bud- geted figure and compare it to this year’s budgeted fig-

ure, you are engaging in what is referred to as baseline budget- ing. If you are budgeting more than you did last year, that is an increase; if you are budgeting less, that is a decrease. This is

a commonsense approach and it is one that Republicans typically take.

This approach, however, misses an important point that is vital to interests Democrats support. They wish

Summary You now understand the process that goes into creating the federal budget of the United States. You know that in percentage terms a large and increasing part of the bud- get is devoted to spending on items for which no annual vote is taken. You now see that this mandatory spend- ing goes mostly to Social Security, Medicare, Medic- aid, various welfare programs, and the costs of interest on the debt. You understand that the rest goes almost equally to spending on domestic concerns and spending

on defense. You see that a relatively small amount goes for foreign aid and other obligations to international or- ganizations such as the United Nations. You understand the difference between current-services and baseline budgeting and why this difference is at the heart of many political debates. Most important, you now understand that the idea of opportunity cost—choices have conse- quences, and money spent in one area cannot be spent in another—is at the heart of budgeting.

baseline budgeting Using last year’s budgeted figure to set this year’s budgeted figure.

current-services budgeting Using an estimate of the costs of providing the same level of services next year as last.

gue46399_ch11_145-154.indd 152 16/03/17 11:41 AM

Key Terms baseline budgeting continuing resolution crowding out

current-services budgeting discretionary spending entitlement

logrolling mandatory spending

1. Federal spending is typically percent of GDP. a. less than 10 b. between 18 and 22 c. between 25 and 30 d. more than 30

2. The FY 2016 federal budget was around a. $4 million. b. $4 billion. c. $4 trillion. d. $4 quadrillion.

3. Disagreements between the Congress and the presi- dent about the federal budget occur frequently. When they cannot agree on a budget but want to keep the government running, they a. use the president’s budget. b. use Congress’s budget. c. use a budget created by an independent budget

commission. d. pass a continuing resolution.

4. Mandatory spending implies spending that is a. required by a previously passed set of laws. b. required by the U.S. Constitution. c. needed more than discretionary spending. d. off-limits for any cuts at any time.

5. The largest single item in federal spending is a. international aid. b. welfare. c. interest on the debt. d. Social Security.

6. Total federal spending on health care, after adjusting for inflation, has been a. growing. b. relatively constant. c. declining slowly. d. declining rapidly.

7. In determining whether the federal government is the right size, an economist would determine whether a. the first dollar spent produced $1 worth of

social good.

Quiz Yourself b. the average dollar spent produced $1 worth of

social good. c. the last dollar spent produced $1 worth of

social good. d. an amount of social good was created equal to

the amount spent. 8. In determining whether the distribution of federal

spending among various agencies was correct, an economist would want to make sure a. that each agency manager got what (s)he

thought was needed in that area. b. that the last dollar spent in each area produced

the same amount of social good. c. that the average dollar spent in each area

produced the same amount of social good. d. that the total amount of money spent in each

agency produced the same level of social good. 9. If a program’s cost rises only with inflation and in-

creases in those that qualify for the program, this represents a. an increase in spending using baseline

budgeting. b. a decrease in spending using current-services

budgeting. c. no increase or decrease in spending using

current-services budgeting. d. a and c are both correct.

Short Answer Questions 1. Explain how mandatory spending comes about

relative to discretionary spending. Then assign the following programs to each: interest payments on the debt, national defense, Social Security, food stamps.

2. In order of magnitude, rank the following spending from greatest to smallest: Social Security, national defense, Medicare, federal support for education, space exploration, and foreign aid.

3. Explain what would transpire for new government expenditures to crowd out other economic activity.

Summary 153

gue46399_ch11_145-154.indd 153 16/03/17 11:41 AM

154 Chapter 11 Federal Spending

For More Insight See Lee, Ronald, and Jonathan Skinner, “Will Aging Baby

Boomers Bust the Federal Budget?” Journal of Eco- nomic Perspectives 13, no. 1 (Winter 1999).

Lynch, Thomas, Public Budgeting in the United States (Englewood Cliffs, NJ: Prentice Hall, 1979).

Behind the Numbers Historical data.

Federal spending. Mandatory and discretionary spending. Composition of federal spending. Federal government health spending. Budget of the United States Government; historical

tables—www.whitehouse.gov/omb/budget/Historicals World Bank; data and statistics—http://data.worldbank.org

4. One political party believes government spending is too high; another party thinks it is too low. Which party will argue for current-services budgeting as a practice for setting government budgets? Explain why.

Think about This The Medicare prescription drug benefit passed dur- ing 2003 comes at a significant long-term cost (at least $720  billion over 10 years). Consider the opportunity cost of this spending in terms of tax cuts, deficit reduc- tion, or spending on other priorities. Would you have committed the federal government to this spending?

Talk about This When Congress and the president do not agree on a spend- ing package and cannot agree on a continuing resolution, the government shuts down all but emergency services. What, in your mind, should be considered under the um- brella of “emergency”?

gue46399_ch11_145-154.indd 154 16/03/17 11:41 AM

C H A P T E R T W E L V E

155

Federal Deficits, Surpluses, and the National Debt Learning Objectives

After reading this chapter you should be able to:

LO1 Explain how economists look at the federal budget deficits and surpluses and the national debt.

LO2 Associate significant deficits as resulting from wars and se- vere recessions/depressions.

LO3 Conclude that economists are interested less in raw num- bers than in more sophisticated measures of the burdens that deficits and debt place on us.

LO4 Compare the U.S. national debt-to-GDP ratio relative to U.S. history and to other countries.

LO5 Explain that the federal government owns much of the debt and list what agencies own that debt.

LO6 Summarize the different positions taken by economists on the issue of a balanced-budget amendment to the U.S. Constitution.

LO7 Conclude that the deficit and debt picture has changed substantially since 1990 and articulate why deficit projections are so often wrong.

Chapter Outline

Surpluses, Deficits, and the Debt: Definitions and History

How Economists See the Deficit and the Debt

Who Owns the Debt?

A Balanced-Budget Amendment

Projections

Summary

This chapter could have had a simpler title: “Deficits and the National Debt.” That is, except for a brief period in recent history, from 1998 to 2001, the federal govern- ment has spent more than it has taken in. The purpose of this chapter is to discuss the history of the deficits, those few surpluses, and the national debt of the U.S. federal government. (Particular attention will be paid to the debts coming out of the 2007–2009 recession and the budgets of President Obama.) After a brief history of these, we discuss the main causes of deficits and debt through time. We examine how economists look at the federal

debt and how they compare the current state of affairs with other countries and U.S. history. When we discover who actually owns the federal debt, you will be surprised to see that a significant portion of it is owned by the fed- eral government itself. We discuss whether a balanced- budget amendment to the U.S. Constitution makes sense as economic policy, and we conclude by looking at the rosy projections of surpluses and the national debt made by the Office of Management and Budget and the Con- gressional Budget Office and comparing them with much less rosy projections made by others.

gue46399_ch12_155-167.indd 155 16/03/17 11:42 AM

156 Chapter 12 Federal Deficits, Surpluses, and the National Debt

Confederation, before the Constitution was ratified, the country had a considerable debt (more than $75 million) from the American Revolutionary War and no money to pay it off. In fact, because the Continental Congress had no power to tax during the war, almost all of the money necessary to fight and win it was borrowed. In the first 58 years of constitutional government in the United States, from 1791 to 1849, there were more years of surplus (36) than deficit (23), and over that time the country ran a net surplus of $60 million. As a matter of fact, in 1836 the debt had all been repaid and President Andrew Jackson got Congress to give states money. Congress missed the mark and gave away $37,000 too much. The only alterna- tive to giving the money to the states—investing in the private sector—was considered inappropriate.

The American Civil War ended notions that the coun- try would ever again go without a national debt. Two billion dollars was borrowed to fight that war, and even though in the 35 years after the war there were more years with a surplus (21) than a deficit (14), the debt remained at $2 billion by 1900. As a matter of fact, in the first 30 years of the 20th century, there were almost as many years of surplus (13) as deficit (17). The debt during that period grew because the deficits during the two-year U.S. involvement in World War I were twice the size of the combined surplus in the other years. The longest uninterrupted period of debt reduction began just after World War I and lasted until 1930, the first full year of the Great Depression. Surpluses ruled for 11 consecu- tive years. In general, U.S. economic history prior to the Great Depression can be summarized as one in which the expenses of wars created the debt and steady efforts were made to eliminate the debt when the wars ended.

Since 1930, however, deficits have been more the rule than the exception. During the 86 years from 1930 to 2015, there were only 12 years with surpluses (three years in the 1940s, three in the 1950s, two in the 1960s, two in the 1990s, and two in the 2000s), whereas there were 74 with deficits. Also during that time the national debt grew from $50 billion to $18.1 trillion. Adjusting the deficits and sur- pluses for inflation, we can compare the relative size of the various years, and this is shown in Figure 12.1.

Figure 12.1 also portrays an important division be- tween the total budget and the off-budget surpluses and deficits. Recall that the total budget is the combination of the on- and off-budget numbers. In recent times, espe- cially after changes in Social Security in 1982 that saw a hefty increase in taxes in anticipation of the large num- ber of retirements among baby boomers, the off-budget surplus has been substantial. In all but 12 of the 82 years

Surpluses, Deficits, and the Debt: Definitions and History

Definitions Defining budget deficit, budget surplus, or national debt ought to be simple, but because of the way the federal

government does its accounting, the definitions are not as simple as they could be. For instance, you would think that if you did the math, a surplus would result when the total amount of tax rev- enue that came in was greater than the total amount that you spent. If spending exceeded the revenue, the result would be a deficit, and the debt would be the sum of the deficits minus the sum of the surpluses.

The problem is the usual definitions are not quite right, and it is because the deficit or surplus for a year is the combi- nation of what are referred to as the off- and on-budget deficits and surpluses. Social Security, Medicare, and other parts of the budget that have trust funds at- tached to them complicate the matter because they are con- sidered off-budget. The part of the federal budget that operates from year to year without a trust

fund is on-budget. So, in 1998, when revenues exceeded expenditures and there was a $60 billion surplus for the total budget, we still added to our national debt because of a deficit in the on-budget part of the equation. When- ever we have an on-budget deficit, we have more debt. Since the off-budget part of the system had a greater surplus than the on-budget part had a deficit, the total budget was in net surplus, yet our debt grew.

History The annual budget of the United States is never actually balanced. The closest we ever came to a strictly balanced budget was a $3,800 deficit in 1835. Why is the budget not ever balanced? Congress passes the budget before it knows exactly how much money is going to come in. When the United States operated under the Articles of

budget deficit The amount by which expenditures exceed revenues.

budget surplus The amount by which revenues exceed expenditures.

national debt The total amount owed by the federal government.

off-budget Parts of the budget designated by Congress as separate from the normal budget. Programs that operate with their own revenue sources and have trust funds; Social Security, Medicare, and the Postal Service are examples.

on-budget Parts of the budget that rely entirely or mostly on general revenue.

gue46399_ch12_155-167.indd 156 16/03/17 11:42 AM

Surpluses, Deficits, and the Debt: Definitions and History 157

depicted in Figure 12.1, the off-budget part of the sys- tem was in surplus, and nine of these were from the late 1970s and early 1980s, before Social Security taxes were raised substantially. This continues to be the case with the surpluses in the Social Security system. These off- budget surpluses masked the severity of budget deficits in the late 1980s and created the illusion of surpluses in the late 1990s. It was only in fiscal years 1999 and 2000 that the on-budget side was showing a surplus. Deficits surged after the Bush-era tax cuts and spending increases resulting from the terrorist attacks of September 11, 2001, and the subsequent wars in Iraq and Afghanistan. The deficits were slated to hover in the $400 billion per year range when, in 2008, the recession and financial collapse took place.

Figure 12.2 displays the trend in deficits as a per- centage of GDP. On the left side of the graph, the large annual deficits were for the expenses of war, just as 19th- century deficits were. In addition to all of the other upheaval caused by the Great Depression and World War II, budget deficits, measured in 1996 dollars in Figure 12.1 and measured as a percentage of GDP in Figure 12.2, peaked at more than $400 billion a year, or nearly a third of GDP.

The deficits of the 1980s and 1990s were caused by a confluence of events. In 1981 President Ronald Reagan took office on a platform dedicated to decreas- ing the size of the federal government and to lessening the threat of communism. Part of this meant that he worked to reduce federal income taxes. Tax rates were slashed and important deductions and exemptions were indexed1 for inflation to prevent bracket creep2 from rais- ing taxes later. The part of the equation that focused on quelling communism resulted in an increase in federal spending on national defense from $157 billion in 1980 to $303  billion in 1988. All of this might have meant a budget with historically typical deficits had President Reagan been successful in convincing Congress to cut or even substantially slow the rate of increase in domes- tic spending. Though the rate of increase in spending on those programs that were on-budget did slow, they did

400

200

0

Year

–400

–600

–800

–200

–1,000

–1,200

O�-budget O�-budget est.Total Total est.

19 43

19 47

1 9 5 1

19 55

19 59

19 63

19 67

1 9 7 1

19 75

19 79

19 83

19 87

1 9 9 1

19 95

19 99

20 03

20 07

20 11

20 15

20 19

FIGURE 12.1 The total and off-budget deficits and surpluses since 1940, in billions of 1996 dollars.

Source: The Office of Management and Budget, www.whitehouse.gov/omb/budget/Historicals

1Recall from Chapter 6 that indexing is adjusting a dollar amount for inflation. It is called indexing because an index, in this case the consumer price index, is used to perform the adjustment. 2When inflation occurs and incomes rise exactly in line with inflation, then, unless the tax brackets are adjusted for inflation, people pay a higher per- centage of that income in taxes even though the real spending power of their income has remained unchanged. This is called bracket creep.

gue46399_ch12_155-167.indd 157 16/03/17 11:42 AM

158 Chapter 12 Federal Deficits, Surpluses, and the National Debt

not slow enough. In addition, spending on Social Security and Medicare increased substantially faster than before. While revenues grew quickly despite the cut in income taxes, this growth was insufficient to keep pace with the spending increases. With spending growing in nearly all sectors of the budget and revenues not keeping pace, the deficits during this period were inflation-adjusted, larger than the deficits it took to win World War I but smaller than the deficits it took to win World War II.

Despite incurring the huge deficits, many argue in President Reagan’s defense that the victory over the

Soviet Union in the Cold War and the peace dividend (money that was freed up for other spending priorities when the Cold War was over) that en- sued was worth the investment.

To back up this position, they claim that the inflation- adjusted military budget in 2000 was smaller than at any other point since World War II and about half of its 1980s peak. If you accept the proposition that the Rea- gan defense buildup caused, or at least contributed to, a more rapid ending of the Cold War, then those respon- sible for allowing the deficits of the 1980s are no more to be criticized than those responsible for the deficits from either of the two world wars.

The dramatic turnaround in the deficit picture that occurred between 1996 and 2001 resulted from a nearly 50 percent increase in taxable income. About a third of that increase resulted from a skyrocketing stock market. From 1991 to 2000 taxable capital gains income increased from

just over $100 billion to more than $630 billion. As a re- sult, a deficit that had been approaching $300 billion in 1992 turned into a $236 billion surplus in 2000.

Beginning in 2000, things began to unravel. In March, the stock market reached its peak (12,000 on the Dow Jones and 5,000 on the NASDAQ) and began a two-and-a-half year decline (7,500 on the Dow and 1,200 on the NASDAQ). Taxable capital gains income was cut by more than half in that time. In November of 2000 we had an election where it took a month of court battles to decide who won the presidency. By the time George W. Bush took office, the economy was in recession and unemployment was on the rise. He delivered on a prom- ised tax cut in the spring of 2001 that further diminished revenues. The attacks of September 11 resulted in vast increases in government spending for reconstruction as well as military and domestic security. More tax cuts, undisciplined federal spending unrelated to defense, and the wars in Afghanistan and Iraq further swelled the def- icit such that by 2005 the total budget deficit was more than $239 billion.

In 2006 and 2007, the lack of progress in Iraq forced President Bush to choose between withdrawing or increas- ing forces. His surge strategy, combined with a weakening housing market, caused deficits to rise again. The 2008 tax cuts and weakening economy in early 2008 further exacerbated the deficit, resulting in predictions of $500 to $600 billion deficits that would greet a new president. Then, of course, the bottom dropped out of the financial sector in the fall of 2008. This created four strains on the deficit. First, the weakened state of the economy caused

Year

–35 –30

–25 –20 –15 –10 –5

0

5

10

D e

fic it/

G D

P (%

)

Deficit/GDP Estimated

19 40

19 44

19 52

19 48

19 56

19 60

19 64

19 68

1 9 7 2

1 9 7 6

19 80

19 84

19 88

19 92

20 00

19 96

20 04

20 12

20 16

20 20

20 08

FIGURE 12.2 Deficits as a percentage of GDP: 1940–2021.

Source: The Office of Management and Budget, www.whitehouse.gov/omb/budget/Historicals

peace dividend Money that was freed up for other spending priorities when the Cold War was over.

gue46399_ch12_155-167.indd 158 16/03/17 11:42 AM

How Economists See the Deficit and the Debt 159

tax revenues to slow. Second, that weakening resulted in increases in unemployment compensation, Medicaid, and other welfare spending. Third, the financial collapse re- sulted in the appropriation of $750 billion to the Troubled Asset Relief Program (TARP) in an attempt to prevent a global depression. Finally, a month after President Obama was sworn in, he signed a $787 billion stimulus package. Though not all of the money was spent in FY2009, defi- cits surged past $1 trillion for that year and stayed above that level until FY2012. The lack of agreement between President Obama and Republicans in Congress resulted in no significant deficit reduction. The tax increases on high-income taxpayers and the sequester (automatic budget cuts) of 2013 combined with a modestly growing economy had the effect of reducing trillion dollar per year deficits by 30 to 50 percent between 2013 and 2016.

How Economists See the Deficit and the Debt

As you know by now, economists see things differently from the way many other people see them. Nothing is more emblematic of that different viewpoint than the way economists look at deficits and the national debt. When noneconomists see that we have spent more than we have paid in taxes, they see it as a problem. Only a minority of economists believe that the current U.S. national debt rep- resents a significant threat to current or future economic health. This differs substantially from the position most economists took in the early 1990s when the deficit was large and growing and the debt and its interest obligations were becoming rapidly burdensome. We next examine why economists hold differing views on this matter.

Operating and Capital Budgets To see things from an economist’s perspective, consider first that the debt is made up of a series of budget defi- cits over time. The next thing to realize about the budget

is that, again from an econo- mist’s viewpoint, it is figured all wrong. It should be divided between operating and capital budgets. Things that are big, expensive, and will last several years ought not be accounted for in the same way as federal purchases of toilet paper. High- ways, dams, and buildings are certainly going to be around for

a while, and it makes little economic sense to account for them as though they are going to disappear at the end of the year.

Away from government, what businesses normally do with such large investments is to create a capital budget. An investment in an asset with a long life simply has to be able to generate profits over the years that are more than sufficient to make payments on the asset. The ex- penses of the business that go to pay for items that are used up soon after they are paid for, like labor, paper, and phone calls, go into an operating budget. As long as the revenue of the firm is sufficient to cover the operat- ing budget and make the appropriate payments on the capital previously purchased, the business is fine, even if it is carrying a large debt. If big corporations did their accounting the way the federal government does, they would rarely show a profit. When they did show a profit, it would be a great deal smaller than usual.

One problem with separating a capital budget from an operating budget is trying to figure out what spending is an investment that should go into the capital budget and what spending is not. Liberal politicians tend to argue that nearly all social spending should be included in the capital budget. Conservatives, on the other hand, usually say that nearly all military spending should be included in the capital budget. Each would label its spending rec- ommendations as investments in the future and the oth- er’s as spending on today. This distinction is important because getting the budget to balance is harder as more goes into the operating side. Moreover, balancing the operating budget is more a political shell game than an exercise grounded in fundamental economic principles.

Cyclical and Structural Deficits Another way in which economists look at the defi- cit differently from other people is that we divide it between its structural and cyclical components. In Chapter 6 we broke unemployment into three parts— frictional, cyclical, and structural. We can do a similar thing here. The part of the deficit that is attributable to

the economy’s not being at full employment is called the cyclical deficit, and the part of the defi- cit that would remain even if we were at full employment is called a structural deficit. If the deficit is large because the econ- omy is not doing well, then the whole economy is the issue, not the deficit. If the deficit is large

operating budget That part of the fed- eral budget devoted to spending on goods and services that will be used in the current year.

capital budget That part of the fed- eral budget devoted to spending on goods that will last several years.

cyclical deficit That part of the deficit attributable to the econ- omy’s not being at full employment.

structural deficit That part of the deficit that would remain even if the economy were at full employment.

gue46399_ch12_155-167.indd 159 16/03/17 11:42 AM

160 Chapter 12 Federal Deficits, Surpluses, and the National Debt

even when the economy is doing relatively well, then the deficit is a problem. Economists who think deficits can

be used to stimulate a lacklus- ter economy consider that part of the deficit attributable to the “stimulus package” useful and label it functional finance.

The Debt as a Percentage of GDP There are other reasons why most economists did not view the national debt (as it stood during the pre-2008 periods) as all that troubling. Among these was that, as a percentage of national income, the national debt was not anywhere near as high as it had been. If you look at Figure 12.3, you will see that the ratio of na- tional debt to the GDP was greater than 1 after World War II and, while it increased to near .70 in the 1990s, it fell sharply when in the late 1990s deficits turned into surpluses. Of course, that lasted only a short time as burgeoning deficits resumed bringing the debt-to- GDP ratio back near the 70  percent level. With the global economic downturn and the subsequent TARP and stimulus plans all occurring in relatively short order, the debt shot up to near 100 percent of GDP by 2011. Current projections suggest a debt level above 100 percent of GDP will exist through 2020.

Gross domestic product measures what we can afford as a nation, and Figure 12.3 shows that we were in a

position that was similar to the average of our recent history; yet with the debt above 100 percent of GDP, a level not seen in quite some time, and with Medicare and Social Security spending certain to rise much faster than their funding sources, more economists are con- cerned about the debt picture going forward.

International Comparisons There is an even more compelling argument that the state of the national debt has changed markedly in the last five years. Though the relevant measure of debt dif- fers among countries,3 what is clear is that government debts have increased throughout the developed world. As can be seen in Table 12.1, the U.S. debt-to-GDP ratio was well within the norms of the rest of the world for the period between 1970 and 2005. Though still nowhere near the levels of Italy and Japan, this debt-to-GDP ratio that had been significantly better than Canada’s and Germany’s, and only somewhat worse than that of the United Kingdom, is now noticeably worse than any of those countries. The country that has really begun to tread close to its ability to manage its debt is Japan. Once held up as an example of fiscal rectitude, Japan,

functional finance That part of the budget attributable to programs designed to get an econ- omy out of a recession.

3OECD and World Bank definitions of public sector debt differ. The OECD discontinued its published series. World Bank Gross PS includes all public sector debt (including state/provincial/local). World Bank-Central includes only the central government debt. These numbers differ greatly in more federal systems (e.g., U.S. and Canada) and less in centralized systems (e.g., the U.K.).

19 40

19 44

19 48

19 52

19 56

19 60

19 64

19 68

19 72

19 76

19 80

19 84

19 88

19 92

19 96

20 00

20 04

20 08

20 12

20 16

20 20

140

120

100

80

60

40

Year

20

0

D e

b t/

G D

P (%

)

Publicly held debt

Publically held debt (est.)Total debt (est.)

Total debt

FIGURE 12.3 Debt as a percentage of GDP: 1940–2021.

Source: The Office of Management and Budget, www.whitehouse.gov/omb/budget/Historicals

gue46399_ch12_155-167.indd 160 16/03/17 11:42 AM

Who Owns the Debt? 161

has seen its national debt balloon from 10.6 percent of GDP in 1970 to more than 244 percent in 2015.

Generational Accounting Some economists look at the deficit and surplus in a completely different fashion. These economists, led by Alan Auerbach and Laurence Kotlikoff, argue that, in- stead of looking at the deficit as a meaningful number, we should look at the “net tax rate” that the current policies imply for future generations. To understand their argument, recall the discussion of present value from Chapter  7. These economists and others argue that if you look at the difference between the pres- ent value of what people of different generations pay in taxes and the transfers that they get in government benefits, you can compute a net tax rate. They claim that this number has been getting steadily worse for younger generations and that future generations will face a terrible tax burden because of the deficits of the 1980s and 1990s and the entitlement crises of Social Security and Medicare.

Who Owns the Debt?

The question of who owns the bonds that a nation sells to finance its debt is an important aspect of any na- tion’s debt. Although this may seem like an irrelevant issue, you may be surprised to know that the U.S. gov- ernment owes itself more than a quarter of the debt.

That is what separates the “Total” and “Public” debts in Figure 12.3 and is the point of Figure 12.4. There are two ways in which the federal government lends itself money:

1. The Federal Reserve uses federal debt for purposes of open-market operations.

2. The federal trust funds invest their money by lending it to other parts of the federal government.

As you may see in the issues chapter on monetary policy, the Federal Reserve of the United States (the Fed) has three options for moving the economy: open- market operations, changing key interest rates, and changing the reserve ratio. Open-market operations are activities that result in the Fed buying or selling bonds. To get money into the economy, it buys bonds, and to remove money from the system, it sells bonds. Since the role of the Federal Reserve is to keep inflation on an even keel, it must steadily increase the money supply to keep pace with the growth in the economy. Doing so requires that the Fed constantly buy bonds. In this way the federal government owes itself a growing amount of money. If you think that is silly, consider that when the federal government borrows money from itself it also pays itself interest, and, as a matter of fact, in the early 1990s it was borrowing money from itself to pay interest to itself.

The government also owes itself money through the various trust funds it maintains for Social Security, Medicare, highways, airports, and other smaller parts

TABLE 12.1 International comparisons of debt-to-GDP ratios. Sources: www.oecd.org; databank.worldbank.org

Year Canada U.S. U.K. Germany Italy Japan

OECD

World Bank Gross PS

World Bank Gross Central OECD

World Bank Gross PS

World Bank Gross Central OECD

World Bank Gross PS

World Bank Gross Central OECD

World Bank Gross PS

World Bank Gross Central OECD

World Bank Gross PS

World Bank Gross Central OECD

World Bank Gross PS

World Bank Gross Central

1970 54.1 44.5 78.0 17.5 38.1 10.6

1975 44.9 42.8 62.1 23.1 57.4 20.2

1980 45.6 39.8 54.5 30.2 58.0 47.9

1985 66.3 53.5 59.4 41.6 82.1 64.2

1990 74.5 66.6 33.0 41.5 103.7 68.6

1995 100.3 131.2 74.9 74.2 83.1 70.0 52.7 49.0 46.8 57.2 125.5 87.1

2000 82.1 108.1 56.1 55.2 61.5 53.0 45.6 42.3 41.3 60.4 58.9 37.7 121.6 105.1 101.9 136.7 136.5 101.0

2005 70.3 94.5 42.9 62.4 78.5 56.3 46.5 43.7 42.4 71.1 66.9 40.8 120.5 101.9 96.8 177.3 182.1 143.6

2010 84.4 105.3 49.5 92.8 116.0 85.6 81.3 79.7 77.9 79.9 81.0 51.6 131.3 115.3 108.5 198.4 212.5 174.6

2015 113.1 47.1 124.4 97.0 94.3 92.8 71.9 45.9 134.6 129.4 244.4 207.0

gue46399_ch12_155-167.indd 161 16/03/17 11:42 AM

162 Chapter 12 Federal Deficits, Surpluses, and the National Debt

19 40

0 10 20 30 40 50 60 70 80 90

19 44

19 48

19 52

19 56

19 60

19 64

19 68

19 72

Year

P e

rc e

n ta

g e

f e

d e

ra l d

e b

t

19 76

19 80

19 84

19 88

19 92

19 96

20 00

20 04

20 08

20 12

20 16

20 20

Trust funds Federal Reserve Public (non-Fed)

FIGURE 12.4 Who owns our debt? Percentage of the debt held by the public, trust funds, and the Federal Reserve.

Source: The Office of Management and Budget, www.whitehouse.gov/omb/budget/Historicals

of the government entities. By law, these trust funds are allowed to invest their money in federal bonds only. Given that these bonds are the safest investment on the planet, this makes sense, but the bonds also return among the lowest interest rates available. In any event, when these programs bring in more money than they spend, the excess is lent to other parts of the government and is money that the government will not have to borrow on the open market.

From Figure 12.4 we see that the amount of federal debt that is held by the public tends to fall unless the deficit and debt are rising quickly. When these are rising quickly, the Federal Reserve is reluctant to buy a great amount of debt in a short period of time because injecting large quanti- ties of new money in the system can create inflation. Any time large deficits are rung up, they have to be sold to the public, and the overall proportion held by the public rises. When the deficit is not large or we have a surplus, the per- centage held by the public will fall. It is conceivable that if we ran many years of large surpluses, the bulk of the debt would be owed to the government itself.

On a more dreary note, we should remember that the portion of the debt that the Medicare system owns began to be sold to the public beginning in 2010. That was when the expenses of the hospital portion of Medicare first exceeded the tax payments that fund it. That debt was transferred to the Treasury and then sold to the public. Though the effect was slight at the time, as the process continues, we can expect that the portion of the debt held by the public will rise. Because of the way we do the accounting now, the national debt will not rise, but the amount that is important, the amount held by the public, will.

Externally Held Debt A concern that has arisen from time to time is the degree to which our national debt is owed to foreigners. At points in American history our national debt has been owed to citizens of other nations. While we could consider this flattering, in that these non-Americans view the United States as a safe place for their savings, it can also be a problem if too much of our debt is owed to foreigners.

Figure 12.5 demonstrates that, in large measure, the Japanese and Chinese have loaned us much of the money we have used to go on the federal spending and tax cut spree of the 2000s. Our debt to citizens of Japan has more than doubled since 2000 while our debt to Chinese citizens has increased 14-fold. Of the nearly $18 trillion in debt, 59 percent is owed to real people and of that 58 percent is owed to non-U.S. entities.

This presents a problem for the future in that even- tually these investors will want their money back in the form of goods and services. Foreigners are no different than the rest of us: They save in order to buy something later. When one U.S. citizen owes another U.S. citizen money, the future state of the economy is not necessarily threatened. On the other hand, when the U.S. taxpayer owes money to foreign investors, part of the taxes that we pay in the future will go to pay them interest rather than to pay for schools, defense, or our criminal justice system.

A Balanced-Budget Amendment

One of the important debates of the final quarter of the 20th century was whether we need an amendment to the U.S. Constitution requiring a balanced federal budget.

gue46399_ch12_155-167.indd 162 16/03/17 11:42 AM

A Balanced-Budget Amendment 163

Year

Japan Mainland China United Kingdom Caribbean banking centers

All others OPEC

2000

2,500

3,000

3,500

2,000

1,500

1,000

500

A m

o u

n t

o f

U .S

. T re

as u

ry (b

ill io

n s)

0 2001 2002 2003 2004 2005 2006 2007 2009 2010 2011 2012 2013 20142008

FIGURE 12.5 U.S. debt owed to foreign entitites.

Source: www.treasury.gov/resource-center/data-chart-center/tic/Documents/mfhhis01.txt

Economists are on both sides of this issue, but the major- ity believe it is not a good idea. Those who are opposed reason that an inflexible amendment could cause reces- sions to turn into depressions because the provisions of the amendment would mandate tax increases and spend- ing cuts at precisely the time when just the opposite would be needed. Those in favor of the amendment argue that the politicians’ performance in the latter half of the 20th century is evidence of Congress’s inability to show the discipline necessary to bring budgets into balance. Balancing the federal budget, it is argued, is necessary to generate low interest rates, which bring about long-term, investment-led growth.

Opponents of balanced budgets and of a constitu- tional amendment that makes them mandatory offer their best argument against a balanced-budget amend- ment by appealing to the aggregate supply–aggregate demand model that was explained in Chapter 8. The left panel of Figure 12.6 depicts this model and what would happen if we entered a recession. If aggregate demand were to shrink from AD1 to AD2 and a balanced-budget

amendment were not required, two things would happen: (1) People would make less money and therefore pay less in taxes, and (2) people would require more assistance from government and spending would have to rise. This would happen without any new laws having to be passed. This nondiscretionary fiscal policy is built into the sys- tem and is called a built-in stabilizer. This stabilizer would result in aggregate demand’s getting a boost back in the direction it came from, perhaps AD3. If a balanced- budget amendment were in place, we would be without the built-in stabilizer and the movement back to AD3 would not happen. A recession would thus be worse than it would be if it were to come along now.

Of course the opposite could happen, and the right side of Figure 12.6 depicts that eventuality. Because spending on welfare programs and unemployment ben- efits would fall and tax revenues would rise, an increase in aggregate demand would result in surpluses. With- out a balanced-budget requirement (that might force the money to be spent or taxes cut), aggregate demand would fall back to AD3. With such a requirement, aggregate

gue46399_ch12_155-167.indd 163 16/03/17 11:42 AM

164 Chapter 12 Federal Deficits, Surpluses, and the National Debt

demand would not bounce back and the economic boom would be more extensive than otherwise. What

this means is a balanced-budget amendment would be procyclical because good times would be even better and bad times even worse than they would be without such a

requirement. This “boom or bust” phenomenon was part of the economic landscape of the 19th century. Avoiding that outcome has been one of the successes of the eco- nomics profession in the post–World War II era.

The best argument for mandating a balanced budget in some way, however, is that an elimination of federal borrowing would go a long way to reducing interest rates. The results of the 1990s support the idea that reducing the deficit can create a virtuous cycle in which lower defi- cits create lower interest rates. With lower interest rates the economy grows, tax revenues increase, the deficit de- creases even more, and so on. While this occurred without a balanced-budget amendment in the late 1990s, the 1960s through the early 1990s was a period of extensive borrow- ing with little fiscal discipline by either political party.

In the 1990s both the Republican and Democratic par- ties claimed that reducing the federal deficit was impor- tant. Both parties, under President Bush (George Herbert Walker) with a Democratic Congress and President Clin- ton with a mostly Republican Congress, attempted to re- duce the deficit. Each did it with means consistent with their own party’s philosophy. They were successful be- cause a reduction in the demand for loanable funds by the federal government translated into lower interest rates. In particular, mortgage interest rates were lower during this

period than they had been in 30 years. Lower interest rates meant more business investment as well. What ensued was the most dramatic drop in the deficit and the longest peacetime expansion since the end of World War II.

Both proponents and opponents of such an amend- ment point to the behavior of the states during the 1990s and early 2000s. Opponents note that the fiscal crises the states experienced between 2002 and 2006, and again in 2009, were a direct result of the constitutional require- ments to have balanced budgets. Though the constitu- tions of the states are varied in this regard, they generally suggest that they can spend no more than the revenue for that year plus their built-up reserve. This essentially requires that they have a cyclically balanced budget, one that is in balance over the business cycle. An annual balanced-budget requirement would not let a state cre- ate or utilize a reserve. What occurred in many states, though, was that the shortfall in revenues lasted longer than the reserve. Many states raided their state employee pension funds and delayed payments to local school dis- tricts and state universities, forcing them to borrow to meet their needs, all in an effort to have a “balanced bud- get.” Opponents argue that governments will resort to these and other “smoke and mirror” tactics when forced to render any balanced-budget amendment meaningless.

The arguments relating to a balanced budget amend- ment were rendered moot when, in 2008, the federal government borrowed hundreds of billions of dollars for the spring 2008 stimulus and especially after the fall 2008 TARP plan required the federal government to bor- row nearly a trillion dollars to save the financial system from meltdown.

procyclical Situation that renders good times better and bad times worse.

AD2 AD3

AD1

AS

RGDP

P ri

ce le

ve l

AD2

AD3 AD1

AS

RGDP

P ri

ce le

ve l

FIGURE 12.6 Built-in stabilizers at work.

gue46399_ch12_155-167.indd 164 16/03/17 11:42 AM

Projections 165

The initial Obama budget, curiously if not ironically named “A New Era of Responsibility,” called for annual deficits of more than $1 trillion for 2009 and 2010 and deficits above $700 billion for many years after that. It has turned out that the deficit picture was somewhat worse than that with trillion dollar deficits extending into 2012. It is important to understand, though, that the ma- jority of economists would acknowledge that imposing a balanced budget in this period would have seriously di- minished the government’s ability to stabilize the econ- omy. Economists, even those among a group that might be called deficit “hawks,” were not upset by the record deficits of 2009 and 2010. The fear of these economists is that without a serious reduction in the deficit over the course of the next few years, when the large Medicare and Social Security bills due to retiring baby boom- ers come due, there will be little ability of the federal government to make good on those promises, even with borrowed money.

Economists are all over the map in terms of how and when these deficits should be closed. Some, like Paul Krugman, believe that the real concern is down the road and that tax increases (especially on the wealthy) will be enough to close the deficit to manageable levels. Others, like John Taylor, believe that it should not only be sooner rather than later but should be accomplished with entitle- ment reform. Still, almost no economist of any reputa- tion believes that a balanced budget requirement would have been helpful during the 2008–2011 period.

Projections

In the movie Major League, a 1989 baseball comedy, the character played by real-life Milwaukee Brewers announcer Bob Uecker suggests that a pitch that ends up in the stands was “juuuuuust a bit outside.” In terms of projecting the deficit/surplus picture, the Congres- sional Budget Office and the Office of Management and Budget have similarly missed the target. In 1990 both were projecting “deficits as far as the eye could see.” In 1995 they each projected a shrinking deficit. Five  years later they projected that “we would be debt free by 2010.” Two years after that, it was deficits now, surpluses later.

Figure 12.7 illustrates the rapidly changing projections, but the year 2005, in particular, illustrates the degree of misestimation. In 2000, the prediction for 2005 was that there would be a surplus approaching $402 billion. The year actually came to a close with a deficit of more than $400 billion. As a result, the estimates produced in 2000 missed the mark by $800 billion (or one-third the size of the federal government).

How could they get it so wrong, so often, and still be given any credibility? In an April 2003 report, the Congres- sional Budget Office makes a pretty good case that it wasn’t their fault. They argue that taking into account the things that occurred during this period, they did a pretty good job in short-term projections. They also argue that longer-term projections are given more weight than they are due.

–1,500

–1,000

–500

0

500

1,000

Year

1985 Outlook

2000 Outlook

1995 Outlook

2010 Outlook2005 Outlook

1990 Outlook

Actual2015 Outlook

19 85

19 87

19 89

1 9 9 1

19 93

19 95

19 97

19 99

20 01

20 03

20 05

20 07

20 09

20 11

20 13

20 15

20 23

20 25

20 21

20 19

20 17

FIGURE 12.7 Deficit and surplus projections of the past.

Source: “The Budget and Economic Outlook: An Update,” 1985–2015, Congressional Budget Office, www.cbo.gov

gue46399_ch12_155-167.indd 165 16/03/17 11:42 AM

166 Chapter 12 Federal Deficits, Surpluses, and the National Debt

Consider these factors: No one foresaw that the economy would grow at twice the projected rates in the late 1990s. No one projected that the stock markets would grow as quickly as they did during this period such that taxable capital gains income would increase 700 percent. No one projected that the 2000 presiden- tial election would insert so much uncertainty into the economy and push it into a recession in 2001. They had no way of knowing in 1995 that George W. Bush would take over as president and get a tax cut enacted

in 2001 and 2003. They certainly could not have taken into account in 2000 that Al-Qaeda would attack the United States or that we would respond by going to war in Afghanistan and Iraq in 2002 and 2003. Finally, few saw the economy of 2008 and 2009 “falling off a cliff,” as Berkshire Hathaway chairman Warren Buffett described it. Still, the “outlook” lines on the graph are all upward sloping, meaning that the OMB and CBO are always projecting a better future when the reality is that there are ups and downs.

Summary You now understand how economists look at federal budget deficits and surpluses and the national debt. You know that deficits have been more often than not caused by wars and that economists are less interested in the raw numbers of the debt and deficits than in more sophisticated measures of them. You now are aware of U.S. economic history and that comparisons with other countries indicate that the United States had a relatively moderate national debt-to-GDP ratio, but that the defi- cits of the period from 2008 to 2012 have raised debt

concerns dramatically. You know that the federal gov- ernment actually owns much of the debt, and you should understand why economists are mostly against an amendment to the U.S. Constitution that would mandate that it maintain a balanced budget. Finally, you now see that the deficit–surplus picture changed substantially between 1996 and 2001 and changed again as a result of the 2001 recession, the September 11, 2001, terrorist attacks, the wars in Afghanistan and Iraq, and the reces- sion of 2007–2009.

Key Terms budget deficit budget surplus capital budget cyclical deficit

functional finance national debt off-budget on-budget

operating budget peace dividend procyclical structural deficit

Quiz Yourself 1. In 2015 the national debt was approximately

a. $18 million. b. $18 billion. c. $18 trillion. d. $18 quadrillion.

2. The off-budget–on-budget distinction a. is important because two large programs, Social

Security and Medicare, largely run off-budget. b. is a historical fiction. c. deals with long-lasting products of government

(like roads and bridges). d. is important because defense is run off-budget.

3. The U.S. budget a. is required to be balanced.

b. is never truly balanced, but historically surpluses are more common than deficits.

c. is never truly balanced, but historically surpluses are less common than deficits.

d. is typically balanced except in time of war. 4. The $400 billion deficits of 2005 were

a. accurately forecast by the Office of Management and Budget in 2000.

b. accurately forecast by the Office of Management and Budget in 2002.

c. accurately forecast by the Office of Management and Budget in 2003.

d. much higher than any previous Office of Management and Budget forecast.

gue46399_ch12_155-167.indd 166 16/03/17 11:42 AM

Summary 167

5. The portion of the national debt owed to citizens of other countries a. is economically irrelevant however big it is. b. is economically important, but it has been

falling in recent years. c. is economically important and it has been rising

in recent years. d. is practically inconsequential because it is so

small. 6. When looking at a balanced-budget amendment to

the U.S. Constitution, economists a. are universally opposed to it. b. are universally in favor of it. c. are of two minds with opponents concerned

about its procyclical nature. d. are of two minds with proponents excited about

its procyclical nature. 7. By way of international comparison, recent U.S.

deficits have increased the ratio of debt to GDP a. such that the United States has the highest ratio

in the industrialized world. b. but every other industrialized nation’s ratio is

much worse. c. but the United States ratio is still lower than that

of Germany, Canada, and Japan. d. such that only Japan’s ratio is worse.

Short Answer Questions 1. If you ranked eras in terms of times in which the na-

tional debt was the biggest, what measures could you use and why? How would the measures differ when ranking the deficits of the 1940s, 1980s, and 2010s?

2. Why might you distinguish between borrowing to rebuild roads and bridges and borrowing to increase food stamp allocations?

3. Suppose the deficit were to be $300 billion during nor- mal times, but increases to $500 billion because we are in a recession, then increases again to $600 billion be- cause the government attempts to stimulate the econ- omy. Which of these amounts are the structural deficit and the cyclical deficit and which amount represents functional finance?

4. Explain why to whom a country owes its money matters in terms of the true burden a national debt will have on future generations.

5. Explain why what deficit spending buys matters in terms of the true burden a national debt will have on future generations.

Think about This The United States and China have had foreign policy dis- putes in the past. The most problematic situation could arise over the status of Taiwan. Does owing Chinese investors nearly $1 trillion make this problem more or less likely to come to a head? Does economic interdepen- dence promote peace?

Talk about This What is the opportunity cost of running a high deficit? How might this opportunity cost depend on the shape of the supply curve for loanable funds? What does it tell you about the supply curve for loanable funds when in- terest rates remained low even while the United States went from a $200 billion surplus to a $1.5 trillion deficit over 15 years?

For More Insight See Journal of Economic Perspectives 10, no. 1 (Winter

1996). See articles by Alan J. Auerbach, Ronald Lee, Jonathan Skinner, and Douglas Bernheim.

Ronald, Lee, and Jonathan Skinner, “Will Aging Baby Boomers Bust the Federal Budget?” Journal of Eco- nomic Perspectives 13, no. 1 (Winter 1999).

Behind the Numbers Total United States off-budget, on-budget and total deficit,

surplus, debt, debt sources 1940–2012. Budget of the United States Government, historical tables—

www.whitehouse.gov/omb/budget/Historicals U.S. GDP 1940–2006.

Bureau of Economic Analysis—www.bea.gov International comparisons of gross debt-to-GDP ratios.

Statistical Abstract of the United States; comparative international statistics—www.oecd.org

CBO projections. Congressional Budget Office; The Budget and Economic

Outlook: an update, multiple years—www.cbo.gov

gue46399_ch12_155-167.indd 167 16/03/17 11:42 AM

C H A P T E R T H I R T E E N

168

The Housing Bubble

In this chapter you will learn about the U.S. housing mar- ket, mortgages, and lending practices. Specifically, you will learn how, fundamentally, housing prices are deter- mined, and how housing prices are determined in a hot, bubble market. Finally, you will learn how the bursting of such a bubble in 2006 and 2007 was only the first wave of housing foreclosures and how the combination set off the worst economic spiral in at least 27 years.

How Much Is a House Really Worth?

As you can see from Figure 13.1, between 1997 and mid- 2006 housing prices in many major urban areas rose much faster than overall inflation (as measured by core PCE) and much faster than housing prices in other areas. This housing price index, created by economists Karl Case and Robert Shiller, has a base year of 2000 and measures the increase in prices in major metropolitan areas. While the price of all goods consumers buy (excluding food and energy) increased about 13 percent between 2000 and 2006, and while home prices in Dallas and Cleveland increased a mere 25 percent, home prices in Miami and Los Angeles had almost tripled. Starting in mid-2006, the housing market in many metropolitan areas collapsed.

Learning Objectives

After reading this chapter you should be able to:

LO1 List the fundamental determinants of housing prices.

LO2 Compare and contrast the components of a traditional mortgage, an interest-only mortgage, and a negative amortization mortgage.

LO3 Discuss how a bubble can be created in a market based on unrealistic expectations.

LO4 Summarize the consequences of a burst housing bubble on the U.S. economy.

Chapter Outline

How Much Is a House Really Worth?

Mortgages

How to Make a Bubble

Pop Goes the Bubble!

The Effect on the Overall Economy

Summary

Home prices in Phoenix dropped 41 percent, while those in Las Vegas and Miami dropped 39 percent and 38 per- cent, respectively. To understand why this happened, we need to remember some fundamentals from the definition of opportunity cost, from supply and demand, and from interest rates and present value.

The key ingredients in what a house is fundamentally worth pertain to the opportunity cost of the land upon which the home sits, the cost of labor and materials in the community, the characteristics of the home itself, and the income of the likely potential buyers.

Referring back to Figure 13.1, the reason Dallas’s home prices never increased at the rate of those in other areas is that buildable land is abundant in north-central Texas. The area is flat, with relatively few alternative uses. Unlike Los Angeles, San Francisco, or Miami, Dallas has almost no physical barriers to expansion. This means that the supply of buildable land is quite elastic. That doesn’t mean land is created, but rather land use is changed from ranching to residential use and this can be done very easily. So even if there is a significant increase in the demand for homes, the price of an existing house can, therefore, not increase beyond that of the alternative of building a new one. While building farther away from the city center (and there are actually two city centers because Ft. Worth is practically

gue46399_ch13_168-176.indd 168 16/03/17 11:42 AM

How Much Is a House Really Worth? 169

the cities are not randomly distributed geographically. California has 17 of the top 20 least affordable cities and the Midwest is home to 15 of the top 20 most affordable.

Population growth also figures into the equation. The city of Detroit is the only city in the world to have gone from a population exceeding 2 million to a population of less than 1 million. This means that for every new home that is built, more than one home will go vacant. In grow- ing areas, new neighborhoods spring up constantly. The Atlanta metropolitan area has seen an increase in home prices based almost entirely on its increase in population.

Though the housing bubble of the early 2000s burst later in the decade, the result of the last few years has been a slow increase in home prices in those cities that experienced it. The cities of Los Angeles, Miami, and Washington, D.C., have each experienced significant re- coveries from their lows. After increasing to 275 percent, 280 percent, and 250 percent of their January 2000 level, respectively, when the bust ended houses were priced at only 160 percent, 139 percent, and 175 percent of their 2000 levels. The recovery from 2010 to 2015 allowed for each to regain about half their respective losses.

next door) can be inconvenient, resulting from the longer commute, most home buyers would gladly drive 10 to 20  minutes longer per day if they can save tens of thou- sands of dollars on the price of the home.

The supply of buildable land in Los Angeles, San Francisco, and Miami is quite inelastic because there are oceans, beaches, environmental regulations, and either swamps or mountains that render some land unsuitable for residential building. An increase in demand for homes in these cities will inevitably result in higher prices.

The next biggest factors in explaining home prices are demand-side factors such as the characteristics of the home and the income of the buyers. That a home with all modern amenities will sell for more than an older one in need of repair is obvious. Similarly obvious is that the income of a community’s potential buyers matters as well. The Department of Housing and Urban Development estimated median family income in San Francisco and Washington D.C. is substantially higher (nearly $100,000) than median family income in Dallas and Cleveland (about $60,000). Table 13.1 ranks cities on housing affordability using the ratio of median housing prices to median income. Clearly,

FIGURE 13.1 Case-Shiller indices.

Source: Federal Reserve Bank of St. Louis, http://research.stlouisfed.org/fred2

Phoenix Miami Dallas

Los Angeles Las Vegas Composite-10

Washington Cleveland Core PCE

0.00

50.00

100.00

150.00

200.00

250.00

300.00

C as

e -S

h ill

e r

h o

m e

p ri

ce in

d e

x (J

an 2

0 0

9 =

1 0

0 )

Ja n-

97

Ja n-

98

Ja n-

99

Ja n-

00

Ja n-

01

Ja n-

02

Ja n-

03

Ja n-

04

Ja n-

05

Ja n-

06

Ja n-

07

Ja n-

08

Ja n-

09

Ja n-

10 Ja

n- 11

Ja n-

12

Ja n-

13

Ja n-

14

Ja n-

15

gue46399_ch13_168-176.indd 169 16/03/17 11:42 AM

170 Chapter 13 The Housing Bubble

Mortgages

As we learned in Chapter 7’s review of present value and interest rates, the mathematics of amortization are relatively straightforward. In determining a car payment or a mortgage payment, you find the monthly payment that will pay off the debt, at a particular interest rate, over a particular period of time. A mortgage, besides being a formal piece of paper, is a payment scheme de- signed to bring the original debt to zero over a period of time. In the good old days, when your grandparents bought a home, mortgages were all structured the same. The home buyer would be required to pay 20 percent of the value of the home, and the bank would loan the remaining 80 percent. On top of that, your grandparents were compelled to provide verifiable documentation of their income, assets, and debts. Even if they had the 20 percent to put down on the home, if their mortgage payment, their estimated annual property taxes, and home owners insurance were more than 30 percent of the verifiable income, your grandparents’ banker would have been reluctant to lend them the money. They would have counseled your grandparents to buy a smaller home. A final aspect of “old-fashioned” mortgages was that your grandparents’ banker would have held the mortgage.

This meant that if your grandparents defaulted on their mortgage, their hometown bank would take the loss.

To understand how your grandparents’ mortgage would work, look at Table 13.2. In a traditional mortgage the pay- ment lasts for 30 years. Though home prices have risen substantially from the time they bought their first home and interest rates have fluctuated between 4.5 percent and 12 percent during that time, to be clear, let’s do an apples-to- apples comparison as we compare the old-fashioned mort- gage with the newer ones. Let’s assume a loan of $250,000, for 30 years, at 5 percent interest. A financial calculator or a spreadsheet program can help you compute the payment to be $1,342 per month. That is $1,342 the first month, the last month, and every month in between.

Now let’s turn to the evolutionary and revolutionary changes that have occurred in the mortgage market. The first significant change came in 1968 when Congress spun off the Federal National Mortgage Association (more com-

monly known as Fannie Mae) and authorized it as a government- sponsored enterprise to buy home mortgages from banks and other financial institutions that wrote them. It would securitize them; that is, it bundled those mortgages

TABLE 13.1 Most affordable and least affordable places to live.

Sources: National Association of Home Builders, www.nahb.com

Least Affordable Most Affordable

1 San Francisco–San Mateo–Redwood City, CA 1 Glens Falls, NY 2 Los Angeles–Long Beach–Glendale, CA 2 Sandusky, OH 3 Santa Ana–Anaheim–Irvine, CA 3 Syracuse, NY 4 Santa Cruz–Watsonville, CA 4 Kokomo, IN 5 Salinas, CA 5 Springfield, OH 6 San Jose–Sunnyvale–Santa Clara, CA 6 Rockford, IL 7 Napa, CA 7 Lima, OH 8 Santa Rosa–Petaluma, CA 8 Monroe, MI 9 New York–White Plains–Wayne, NY–NJ 9 Elizabethtown, KY

10 San Diego–Carlsbad–San Marcos, CA 10 Binghamton, NY 11 San Luis Obispo–Paso Robles, CA 11 Utica–Rome, NY 12 Oxnard–Thousand Oaks–Ventura, CA 12 Mansfield, OH 13 Oakland–Fremont–Hayward, CA 13 Battle Creek, IM 14 Santa Barbara–Santa Maria–Goleta, CA 14 Fairbanks, AK 15 Honolulu, HI 15 Lansing–East Lansing, MI 16 Riverside–San Bernardino–Ontario, CA 16 Springfield, IL 17 Stockton, CA 17 Youngstown–Warren–Boardman, OH–PA 18 Fresno, CA 18 Cumberland, MD–WV 19 Modesto, CA 19 Salisbury, MD 20 Bend, OR 20 Harrisburg–Carlisle, PA

securitize The process of bundling nonfinancial assets (typically mortgages) together and then resell- ing them as either shares or as financial instru- ments to investors.

gue46399_ch13_168-176.indd 170 16/03/17 11:42 AM

171

TA B

LE 1

3. 2

Tr ad

iti on

al , z

er o-

in te

re st

, a nd

n eg

at iv

e am

or tiz

at io

n m

or tg

ag es

, 3 0

ye ar

s, 5

p er

ce nt

.

Tr ad

iti on

al M

or tg

ag e

In te

re st

-O nl

y, 5

Y ea

rs In

te re

st -O

nl y,

1 0

Y ea

rs N

eg at

iv e-

A m

or tiz

at io

n, 5

Y ea

rs

Pa ym

en t

N um

be r

Pa ym

en t

In te

re st

B al

an ce

Pa ym

en t

In te

re st

B al

an ce

Pa ym

en t

In te

re st

B al

an ce

Pa ym

en t

In te

re st

B al

an ce

0

$2 50

,0 00

$2 50

,0 00

$2 50

,0 00

$2 50

,0 00

1

$1 ,3

42 $1

,0 42

2 49

,7 00

$1 ,0

42 $1

,0 42

2 50

,0 00

$1 ,0

42 $1

,0 42

2 50

,0 00

$ 5

21 $1

,0 42

2 50

,5 21

2

1 ,3

42 1

,0 40

2 49

,3 98

1 ,0

42 1

,0 42

2 50

,0 00

1 ,0

42 1

,0 42

2 50

,0 00

5

22 1

,0 44

2 51

,0 43

3

1 ,3

42 1

,0 39

2 49

,0 95

1 ,0

42 1

,0 42

2 50

,0 00

1 ,0

42 1

,0 42

2 50

,0 00

5

23 1

,0 46

2 51

,5 66

4

1 ,3

42 1

,0 38

2 48

,7 91

1 ,0

42 1

,0 42

2 50

,0 00

1 ,0

42 1

,0 42

2 50

,0 00

5

24 1

,0 48

2 52

,0 90

. .

. .

. .

. .

. .

. .

. .

. .

. .

. .

. .

. .

. .

. .

. .

. .

. .

. .

. .

. 5

7 1

,3 42

9

63 2

30 ,7

19 1

,0 42

1 ,0

42 2

50 ,0

00 1

,0 42

1 ,0

42 2

50 ,0

00

5 85

1 ,1

70 2

81 ,4

87 5

8 1

,3 42

9

61 2

30 ,3

38 1

,0 42

1 ,0

42 2

50 ,0

00 1

,0 42

1 ,0

42 2

50 ,0

00

5 86

1 ,1

73 2

82 ,0

74 5

9 1

,3 42

9

60 2

29 ,9

56 1

,0 42

1 ,0

42 2

50 ,0

00 1

,0 42

1 ,0

42 2

50 ,0

00

5 88

1 ,1

75 2

82 ,6

61 6

0 1

,3 42

9

58 2

29 ,5

72 1

,0 42

1 ,0

42 2

50 ,0

00 1

,0 42

1 ,0

42 2

50 ,0

00

5 89

1 ,1

78 2

83 ,2

50 6

1 1

,3 42

9

57 2

29 ,1

86 1

,4 61

1 ,0

42 2

49 ,5

80 1

,0 42

1 ,0

42 2

50 ,0

00 1

,6 56

1 ,1

80 2

82 ,7

75 6

2 1

,3 42

9

55 2

28 ,7

99 1

,4 61

1 ,0

40 2

49 ,1

59 1

,0 42

1 ,0

42 2

50 ,0

00 1

,6 56

1 ,1

78 2

82 ,2

97 6

3 1

,3 42

9

53 2

28 ,4

10 1

,4 61

1 ,0

38 2

48 ,7

35 1

,0 42

1 ,0

42 2

50 ,0

00 1

,6 56

1 ,1

76 2

81 ,8

17 6

4 1

,3 42

9

52 2

28 ,0

20 1

,4 61

1 ,0

36 2

48 ,3

10 1

,0 42

1 ,0

42 2

50 ,0

00 1

,6 56

1 ,1

74 2

81 ,3

36 .

. .

. .

. .

. .

. .

. .

. .

. .

. .

. .

. .

. .

. .

. .

. .

. .

. .

. .

. .

11 7

1 ,3

42

8 55

2 04

,8 27

1 ,4

61

9 32

2 23

,0 53

1 ,0

42 1

,0 42

2 50

,0 00

1 ,6

56 1

,0 56

2 52

,7 20

11 8

1 ,3

42

8 53

2 04

,3 38

1 ,4

61

9 29

2 22

,5 21

1 ,0

42 1

,0 42

2 50

,0 00

1 ,6

56 1

,0 53

2 52

,1 17

11 9

1 ,3

42

8 51

2 03

,8 48

1 ,4

61

9 27

2 21

,9 87

1 ,0

42 1

,0 42

2 50

,0 00

1 ,6

56 1

,0 50

2 51

,5 12

12 0

1 ,3

42

8 49

2 03

,3 55

1 ,4

61

9 25

2 21

,4 50

1 ,0

42 1

,0 42

2 50

,0 00

1 ,6

56 1

,0 48

2 50

,9 04

12 1

1 ,3

42

8 47

2 02

,8 60

1 ,4

61

9 23

2 20

,9 12

1 ,6

50 1

,0 42

2 49

,3 92

1 ,6

56 1

,0 45

2 50

,2 93

12 2

1 ,3

42

8 45

2 02

,3 64

1 ,4

61

9 20

2 20

,3 71

1 ,6

50 1

,0 39

2 48

,7 81

1 ,6

56 1

,0 43

2 49

,6 80

12 3

1 ,3

42

8 43

2 01

,8 65

1 ,4

61

9 18

2 19

,8 27

1 ,6

50 1

,0 37

2 48

,1 68

1 ,6

56 1

,0 40

2 49

,0 65

. .

. .

. .

. .

. .

. .

. .

. .

. .

. .

. .

. .

. .

. .

. .

. .

. .

. .

. .

. 35

8 1

,3 42

17 2,

66 7

1 ,4

61

18

2

,9 05

1 ,6

50

20

3

,2 79

1 ,6

56

21

3

,2 91

35 9

1 ,3

42

11

1, 33

6 1

,4 61

12

1 ,4

55 1

,6 50

14

1 ,6

43 1

,6 56

14

1 ,6

49 36

0 1

,3 42

6

0

1 ,4

61

6

0

1 ,6

50

7

0

1 ,6

56

7

0

gue46399_ch13_168-176.indd 171 16/03/17 11:42 AM

172 Chapter 13 The Housing Bubble

mortgage converts to a standard type and the balance is paid off over the remaining years.

Now let’s compare the tradi tional mortgages to the interest-only mortgages and negative-amortization mort- gages. Again, comparing apples to apples, suppose the home owner is borrowing $250,000, for 30 years, at 5 per- cent interest. Looking at Table 13.2 you see that an interest- only mortgage saves the buyer $300 per month for however long the interest-only period lasts, but the payment increases substantially once the mortgage converts to a traditional version. Because with most negative-amortization mort- gages, the borrower gets to choose how much to pay during the initial payment period, let’s assume they take an option of paying half the interest they owe each month. As a result the outstanding balance rises, so the payment rises, albeit very slowly until the point were it converts to a traditional mortgage, and then the payment nearly triples.

These interest-only and negative-amortization mort- gages were popular with home buyers because they al- lowed someone of modest means to get into a home they might otherwise not be able to afford. What is unclear is  the degree to which borrowers adequately understood the terms of these mortgages. They may have simply not read their documentation, or they may have been convinced that regardless of how high their mortgage payments rose, the ever-increasing value of their home would allow them to take out a second mortgage with a home equity line of credit. Of the interest-only and negative-amortization mortgages issued during 2006 and 2007, approximately half came with built-in home equity lines of credit.

How to Make a Bubble

As NASDAQ investors of the late 1990s discovered, bubbles are created by the expectation of higher prices causing people to buy assets based on that expectation rather than fundamentals. When you are told to “buy now before the price goes up” and you do, you only add to the volume of the bubble. People buy on the expectation that prices will rise faster than their ability to afford those same assets later so they become convinced to buy now. What really gets a bubble going is borrowed money. If you had to put 20 percent down on a home, the increased price would affect your ability to react to that expecta- tion. With the ability to put nothing down, and pay only half the interest, the buyer’s ability to continue fueling the bubble is sustained, not diminished.

As NASDAQ bubble-riders remember, bubbles are fun when they go up. Why? Suppose you bought that $250,000 home in Miami in January 2002. Suppose you

together and then sold shares of itself to investors. In so doing, it spread the geographic risk of mortgages that re- sulted from banks holding a significant portion of the portfolios in local markets. This reduced the risk to any one bank of going bankrupt as a result of a local economic downturn. In so doing, this reduced the risk to investors and thereby reduced home mortgage interest rates. Its sister or- ganization, the Federal Home Loan Mortgage Corporation (commonly known as Freddie Mac), was founded in 1970 and did much the same thing except that it focused on sell- ing these bundled mortgage-backed securities to other in- vestors. Neither the principal nor the profits of either entity was explicitly guaranteed by the federal government, but investors believed there to be an implicit understanding that should these entities have difficulty, the federal government would back them.

Beginning in the late 1980s, mortgages began to spring up where the buyer would have to put down only 5 percent or 10 percent. Though they would have to pay for an insurance policy (that would pay the bank in case of default), this opened up home buying as an option for millions of Americans. In the early part of this decade,

zero-down mortgages became common. Only paperwork costs would be charged when the house was sold.

Beginning in 2002, interest- only mortgages and even negative-amortization mortgages began to spring up. An interest- only mortgage, as the name sug- gests, has the buyer paying only interest for the first few (typically 5 or 10) years of a mortgage and then paying off the balance over the remainder of the mortgage. A negative-amortization mortgage does much the same thing, except that buyers get to choose how much they want their payment to be in the first few years of the mortgage. These pick-a-pay mortgages (also known as pay option adjustable rate mortgages) would typically have the buyer paying about half the interest accrued each month on the mort- gage so the outstanding balance on the mortgage would rise over time. After a few years, the

interest-only mortgage A mortgage that allows the buyer to pay only the interest portion of the typical payment for the first few years of a mortgage. The mortgage would reset to a tradi- tional mortgage after that period, typically at a higher payment.

negative-amortization mortgage A mortgage that allows the buyer to pay less than the interest portion of the typical payment for the first few years of a mortgage. The mortgage would reset to a traditional mort- gage after that period, typically at a higher payment.

pick-a-pay mortgage A variety of negative amortization mortgage that allows the buyer to choose a payment for the first few years of a mortgage.

gue46399_ch13_168-176.indd 172 16/03/17 11:42 AM

Pop Goes the Bubble! 173

borrower might better under- stand the features of a mortgage (such as the tripling of the re- quired payment after year 5).

Some in the financial system began to openly worry about the impact of a collapse of the mortgage market. This fear created an instrument that, perversely, only added to the bubble. By the middle of the decade, it became more difficult to sell the securitized mortgages because of the growing fear of foreclosures. The same entities that bought the mortgages, securitized them, and then sold them to investors, now offered to sell the investors credit default swaps. In this case, the credit default swap acted like an insurance policy that promised to pay the holder of the se- curitized mortgage should the borrowers fail to pay their debts. This satisfied the investors’ concern for security and kept the bubble going. The problem was that these insur- ance policies were not regulated like typical insurance policies. A typical home owners or auto insurance com- pany is compelled to have sufficient capital to pay claims and is often required to carry reinsurance. Though credit default swaps are, most certainly, insurance policies, those that sold them were not regulated as if they were. Though some in Congress and others in regulatory bodies began to question these practices, the underlying feel-good story of record rates of home ownership and increasing home owner wealth (at least paper wealth) overwhelmed these voices of concern. This was the now infamous AIG’s most profitable line of business for several years prior to its needed bailout by the Federal Reserve.

Pop Goes the Bubble!

What the feel-good story relies upon heavily is the fiction that home prices only go up. Home prices can fall. Imag- ine this story somewhat differently. Suppose the price of the home falls from $250,000 to $200,000 because the home was only 1,500 square feet to begin with, had few amenities, and was in a relatively unattractive neighborhood. That is, suppose the fundamentals start to take over and the specula- tive demand to buy a house at any price goes away, meaning that the only reason its price exceeded what was rational for its location was a bubble mentality (like NASDAQ in 1999 and 2000). Now the poor home owner, who paid $250,000 for a home that is worth only $200,000, must pay $1,656 per month because he or she owes $283,250.

What are the options? Not many. First, if the home owners sell the home they are in, they will owe $83,250 plus real estate fees of approximately $12,000 more, and

put nothing down and took out a negative-amortization mortgage. In Miami, from January 2002 to January 2007, the average home more than doubled in value. So you may owe $283,250 on the house you bought for $250,000, but who cares? It’s now worth $500,000. Having trouble making the payments that have now in- creased from $589 per month to $1,656? No problem. You now have $216,750 in equity in that home and since you signed up for a home equity line of credit when you signed up for the mortgage, you can use your home like an ATM. You can even buy an SUV and take a vacation!

While that explains the demand side of the housing bubble, bubbles require calamitous mistakes on both the demand side and the supply side. So you may be asking why banks would lend money to these borrowers. This takes us back to the first of the evolutionary changes in the mortgage market: securitization. While your grand- parents’ mortgage was owned by their local bank, these mortgages were immediately sold. It was no longer part of the local banker’s job to counsel home buyers against borrowing more than they could afford. Remember that old 30 percent rule? The banker no longer cared that you could not afford the payment because the banker was going to sell the mortgage within days of writing the mortgage. If you defaulted on the mortgage, it was someone else’s problem. In addition, about half of negative-amortization mortgages were “liar loans” in that the bankers who wrote the mortgages purposefully did not verify the income or assets of the borrower. They merely consulted the credit agencies. If your credit was good enough that they could sell your mortgage to Fannie Mae or Freddie Mac, they wrote the mortgage and sold it within days.1

There is one other aspect of the modern mortgage mar- ket that may have contributed to the mess, and that is the noticeable absence of the intimidation involved in the clos- ing process. Your grandparents sat across the table from a banker who went through each piece of paper associated with the mortgage. Your grand parents paid very close at- tention, in part because they were afraid that if they didn’t, somehow the mortgage would not go through. Today, a click here or a phone call there, and you can be approved by a mortgage company with no local interests whatso- ever. That means that you get a package of papers that you simply have to take down to a notary public (a designation of a person that certifies that the person signing is indeed the named party) and sign where the “sign here” tabs are located. This eliminates one of the places where a

1They may still take your payment every month, but they are only servicing it. They send that payment to the true owner.

credit default swap Insurance on a mortgage-backed security.

gue46399_ch13_168-176.indd 173 16/03/17 11:42 AM

174 Chapter 13 The Housing Bubble

taxes would be well above 30 percent of their income in the “bubble” cities. One estimate in 2008 suggested that 1 in 6 households in the United States was above this 30  percent guideline and that 1 in 20 was paying more than half of its income in housing costs. Given that, it is no wonder that home prices stopped rising in 2006.

The shakeout after the collapse in housing has had a notable impact on the ability of the median-income fam- ily to afford the median home in these markets. At the peak of housing prices in 2006, with a 6 percent mortgage a median family would have to spend 43 percent of their income on housing in Las Vegas. In 2015, that was down to 32 percent. There are three basic reasons housing was more affordable in 2015 than 2006: prevailing mortgage interest rates were 4 percent rather than 6 percent, hous- ing prices were lower by about 20 percent, and median incomes were at least near their 2006 level.

The Effect on the Overall Economy

At the beginning, the bursting of the housing bubble had a modest impact slowing the rate of growth of the overall economy in 2006 and 2007 by about 1 percent. By late 2007 and into 2008, as foreclosures ballooned, the im- pact snowballed. It was not until the fall of 2008 that the true impact of the crisis came to light. In order to avoid a massive financial meltdown, the Treasury Department took ownership of both Fannie Mae and Freddie Mac, the Federal Reserve took a significant ownership stake in the insurance giant AIG, and Congress passed the Troubled Assets Relief Program (TARP) to save the nation’s largest banks from the consequences of their ill-advised practices.

they will have no home. If they do not have that in savings, they will have to negotiate some other noncollateralized loan to pay off that amount before they can buy another home. Their only option to get out from under the massive debt is bankruptcy. This is a very bad option because they not only lose the home in which they live but they become unable to buy another home for years to come. Of course, they also eliminate their ability to buy cars, furniture, or anything else on time as well. Their ability to go on vacation is quashed by their inability to qualify for credit cards, and their ability to pay off their existing credit card debt is elimi- nated because they no longer have equity in their home.

People who used this form of negative-amortization loan to purchase a home did so either because they be- lieved their income in a few years would be sufficient to cover the increased mortgage payment, or they believed that housing prices would continue to rise, or they believed that a combination of the two would cause everything to turn out in the end. Unfortunately, it didn’t “turn out in the end” for many borrowers. Beginning in 2006 foreclo- sures and near foreclosures (homes more than 30 days in arrears) began to skyrocket. In 2007, foreclosures were up 51 percent, and in 2008 they were up 82 percent. In Nevada in early 2009, 1 in 14 homes was in some sort of foreclosure process. In one month alone, November 2008, 1 in 76 homes in Nevada received foreclosure paperwork. The hardest hit states were California, Nevada, and Flor- ida. It is not hard to see why. Consider Table 13.3 and the ability of the median family, with median income, to buy the median house in those locations we examined in Figure 13.1. Even if they chose a conventional mortgage, their 2006 mortgage payments, insurance, and property

Median Family Income1

Median Sale Price of an Existing Single- Family Home2

Approximate Annual Mortgage Payments (30 years)

Approximate Home Owners Insurance*

Approximate Property Tax*

Total Annual Housing Costs

Home Costs as a Percentage of Income

2006 2015 2006 2015 2006 (6)% 2015 (4)% 2006 2015 2006 2015 2006 2015 2006 2015 Phoenix $64.0 $64.2 $218.8 $257.4 $12.5 $18.5 $2.0 $2.0 $4.0 $4.0 $18.5 $24.5 38.2% 29.0% Los Angeles 63.0 59.8 506.8 589.2 29.0 42.4 2.0 2.0 4.0 4.0 35.0 48.4 80.9 55.6 Washington 109.2 97.2 388.6 430.8 22.3 31.0 2.0 2.0 4.0 4.0 28.3 37.0 38.1 25.9 Miami 49.9 49.2 290.0 365.5 16.6 26.3 2.0 2.0 4.0 4.0 22.6 32.3 65.6 45.3 Las Vegas 59.2 63.9 221.5 297.7 12.7 21.4 2.0 2.0 4.0 4.0 18.7 27.4 42.9 31.6 Cleveland 66.1 62.1 132.0 130.0 7.6 9.4 2.0 2.0 4.0 4.0 13.6 15.4 24.7 20.5 Dallas 70.4 65.0 210.0 150.9 12.0 10.9 2.0 2.0 4.0 4.0 18.0 16.9 25.9 25.6

TABLE 13.3 Measuring housing affordability in major cities.

*Author estimate. 1Source: HUD estimated from Home Mortgage Disclosure Act reports 2Source: National Association of Realtors

gue46399_ch13_168-176.indd 174 16/03/17 11:42 AM

Summary 175

that the recovery in housing, if it has occurred at all, has been very slow. One issue that slowed the process of the housing mar- ket finding its “bottom” was the difficulty in selling homes for which more was owed than the home was worth. Part of that

problem is that with securitization it is a difficult, time- consuming, and lawyer-filled process to engage in what is called a short sale. A short sale involves a buyer and a seller agreeing to a price and the mortgage company agreeing to write off the difference between the price of the home and what is owed on the mortgage. Until all such “underwater” homes are sold we will continue to live with one in seven homes in Nevada, for instance, being vacant.

It will be left to Chapter 14 to review the effectiveness of TARP and the 2009 stimulus package as well as the Federal Reserve’s attempt to stabilize markets by buying long-term treasuries and mortgage-backed securities.

From September 2008 through the end of that year, credit markets were almost entirely frozen. This meant that institutions that were otherwise healthy could not access credit markets in a normal and necessary fash- ion. As the news of that fall was almost entirely bad, consumers simply stopped buying anything that was not absolutely necessary. Depending on the automaker, car purchases fell between 40 percent and 67 percent, and by December, GM and Chrysler required TARP funds to survive. The year culminated with the worst Christmas shopping season in more than 40 years.

The final post-mortem has not been written on what the ultimate impact of the housing bubble was. It cer- tainly caused the steepest decline in economic activity since the Great Depression. It certainly led to relatively modest government deficits obliterating all post–World War II deficit records (whether in real or nominal terms) and states having to cut billions from their own bud- gets. Because of the timing of many of the ARMs, the ultimate bottom of the housing market did not occur until 2011 or 2012. A look back at Figure 13.1 shows

short sale A sale of a home where the amount owed is more than the sale price and in which the seller seeks to have the remaining balance forgiven.

Summary You now understand the fundamental elements that determine housing prices, how homes are typically fi- nanced, and that new types of mortgages are replacing traditional 20 percent-down, constant-payment mortgages.

You also understand that unrealistic expectations in hous- ing prices can create spiraling price increases and that such bubbles inevitably burst and can have a significant economic impact.

Key Terms credit default swap interest-only mortgage

negative-amortization mortgage pick-a-pay mortgage

securitize short sale

Quiz Yourself 1. The type of mortgage that allows you to make the

lowest possible payment is called a a. zero-down mortgage. b. a traditional constant-payment, 20 percent-down

mortgage. c. an interest-only mortgage. d. a negative-amortization mortgage.

2. In which type of mortgage do you build equity the fastest? a. zero-down mortgage. b. a traditional constant-payment, 20 percent-down

mortgage.

c. an interest-only mortgage. d. a negative-amortization mortgage.

3. In which type of mortgage do you neither build nor lose equity? a. zero-down mortgage. b. a traditional constant-payment, 20 percent-down

mortgage. c. an interest-only mortgage. d. a negative-amortization mortgage.

gue46399_ch13_168-176.indd 175 16/03/17 11:42 AM

176 Chapter 13 The Housing Bubble

get your hands on the fourth edition’s web chapter on this subject, you can see that I thought it was one, but because prices were stabilizing when I wrote it, I wasn’t sure.) The same thing was true with the stock market in 1929 and 2000. Fast-forward 30 years and imagine your- self in a position of trying to manage your retirement savings. How are you going to tell if your portfolio is really worth what your 401(k) statements say or whether it is a bubble all over again?

Talk about This We are in a post–housing bubble world in which millions of families owe substantially more money on their homes than they can sell them for. Recent changes to bankruptcy laws make it more difficult to declare bankruptcy, which leaves many fully employed, hard working people trapped in their homes with no means of financial escape. As we reconsider financial regulation, should we treat negative- amortization mortgages and interest-only mortgages like cocaine: banned to prevent you from making a lifetime mistake?

4. Fundamentally, housing prices are a function of the home’s a. location and amenities. b. amenities only. c. location only. d. interest rates only.

5. A housing bubble occurs when _______________ drive(s) prices more than fundamental factors. a. the price of gasoline b. a home’s expected future price

c. interest rate changes d. property tax increases

6. A bursting of a housing bubble could create more problems than the NASDAQ crash in 2000 because the housing bubble involves a. assets, and NASDAQ was about debts. b. risky forms of debt. c. more people. d. fewer people.

Short Answer Questions 1. Explain how mortgage securitization makes it easier

to borrow money to buy a house but harder to deal with when a house is sold for a loss.

2. Explain why securitization contributed to the prob- lem of people buying homes using mortgages for which they did not know all the details (such as the negative-amortization mortgages referred to in the text).

3. Explain why the Federal Reserve felt it necessary to bail out AIG and what result it was attempting to avoid.

4. Explain the role of the credit default swap and why the attempt to make things safer for investors made things worse for everyone.

Think about This Bubbles are a great deal easier to identify after they burst. Believe it or not there were many who did not be- lieve that the housing market was in a bubble until well into 2008 when it was obvious to everyone. (If you can

gue46399_ch13_168-176.indd 176 16/03/17 11:42 AM

C H A P T E R F O U R T E E N

177

The Recession of 2007–2009: Causes and Policy Responses Learning Objectives

After reading this chapter you should be able to:

LO1 Describe the housing crisis and overall consumer indebted- ness as the cause of the 2007–2009 recession.

LO2 Enumerate the consequences of the recession including a record drop in housing prices, a significant increase in the unemployment rate, a substantial drop in real gross domestic product, and a long string of job losses.

LO3 Describe and model the discretionary and nondiscre tionary fiscal policy, monetary policy, and TARP program to combat the recession.

LO4 Enumerate and describe the components of the fiscal stimulus package passed in the early days of the Obama administration.

Chapter Outline

Before It Began

Late 2007: The Recession Begins as Do the Initial Policy Reactions

The Bottom Falls Out in Fall 2008

The Obama Stimulus Package

Extraordinary Monetary Stimulus

Summary

The recession of 2007–2009 was one of the most, if not the most, severe recessions in post–World War II history. In terms of peak unemployment, it was the second worst since the Great Depression. In terms of the drop in real GDP and in terms of how long it took for real GDP to recover to its prerecession peak, it was the worst. It began in the fall of 2007 looking very much like the short and shallow recessions of 1991 and 2001. Then in the fall of 2008 the bottom fell out as the bursting of the housing bubble and the decima- tion of the financial sector set off a series of events whose consequences are not yet fully understood.

This chapter will begin with a look at economic ac- tivity in 2005 and 2007, discuss the most significant cause of the recession—the bursting housing bubble— the attempts in early 2008 to make it another short and shallow one, the financial sector meltdown of the fall

of 2008, and the policy responses from the Federal Re- serve, the Congress, and Presidents Bush and Obama. The chapter will conclude with a summary of the debate surrounding whether these policies were effective in ei- ther shortening or mitigating the impact of the recession.

Before It Began

As can be seen in Figure 14.1, real economic growth was progressing at about the 20-year average (2.7 percent annually) until the final quarter of 2007. As you can see in Figure 14.2, this was despite gasoline prices that had nearly doubled from their early 2005 levels. What was providing the steam behind this growth? Housing.

While a full discussion of how the housing bubble was created (and subsequently how it burst) can be found

gue46399_ch14_177-185.indd 177 16/03/17 11:42 AM

178 Chapter 14 The Recession of 2007–2009: Causes and Policy Responses

rate of appreciation in homes averaged 14.2 percent. At that annual increase in prices, it was erroneously thought, even if the borrower defaulted on the loan, the bank would lose no money because they could unload the house for more than the loan value.

This housing price escalation fueled two distinct housing booms: home building and home equity lines of credit. As you can see in Figure 14.4, housing starts, though fluctuating with the weather, steadily

in Chapter 13, we’ll provide a much briefer version here. As can be seen from Figure 14.3, the price of homes (as measured by the Case-Shiller Home Price Index Composite-10) was also increasing at an astonishing rate. While this may have made buying a home difficult under normal circumstances, these were anything but nor- mal circumstances. Lenders were eager to make loans of almost any amount to people wanting to buy a home. This was because between early 2000 and late 2005, the annual

G D

P (b

ill io

n s,

2 0

0 0

)

11,700.0

11,600.0

11,500.0

11,400.0

11,300.0

11,200.0

11,100.0

11,000.0

10,900.0

10,800.0

20 05

.1

20 05

.2

20 05

.3

20 05

.4

20 06

.1

20 06

.2

20 06

.3

20 06

.4

20 07

.1

20 07

.2

20 07

.3

GDP in billions of chained 2000 dollars RGDP at long-run expected growth

FIGURE 14.1 Real GDP (billions, 2000) 2005.1–2007.3.

Source: Bureau of Economic Analysis, www.bea.gov/national/xls/gdplev.xls

P ri

ce o

f g

as o

lin e

in c

e n

ts

350

330

310

290

270

250

230

210

190

150

170

1/3 /2

00 5

3/ 3/

20 05

5/ 3/

20 05

7/ 3/

20 05

9/ 3/

20 05

11/ 3/

20 05

1/3 /2

00 6

3/ 3/

20 06

5/ 3/

20 06

7/ 3/

20 06

9/ 3/

20 06

11/ 3/

20 06

1/3 /2

00 7

3/ 3/

20 07

5/ 3/

20 07

7/ 3/

20 07

9/ 3/

20 07

FIGURE 14.2 Average price of gasoline in cents.

Source: http://tonto.eia.doe.gov/oog/info/twip/twipmgvwall.xls

gue46399_ch14_177-185.indd 178 16/03/17 11:42 AM

Before It Began 179

increased between 2001 and 2007, and as you can see in Figure  14.5, nonrevolving credit, which includes home mortgages, home equity lines of credit, and car loans, increased at a 7.1 percent annual clip. Credit card debt increased at a 5.2 percent rate.

During this period the most significant policy con- cern of the Federal Reserve was the increase in infla- tion that was resulting from rapidly increasing energy prices and overall increases in demand. As you can see

from Figure 14.6, the Federal Reserve increased its tar- geted federal funds rate 14 times between June 2004 and June 2006 from 1 percent to 5.25 percent. At one point in January 2006 the concern over inflation was so great the Fed increased the federal funds rate 1.25 per- centage points in one step. Given that the vast majority of increases and decreases in the federal funds rate have been limited to one-quarter of a point changes, this was considered a very aggressive action to quell inflation.

240.00

220.00

200.00

180.00

160.00

140.00

120.00

100.00

Ja n-

00

Ju l-0

0

Ja n-

01

Ju l-0

1

Ja n-

02

Ju l-0

2

Ja n-

03

Ju l-0

3

Ja n-

04

Ju l-0

4

Ja n-

05

Ju l-0

5

Ja n-

06

Ju l-0

6

Ja n-

07

Ju l-0

7

FIGURE 14.3 Case-Shiller Price Index (Composite-10).

Source: www.macromarkets.com/csi_housing/sp_caseshiller.asp

500

450

400

350

300

250

20 07

.3

Year.Quarter

H o

u si

n g

s ta

rt s

in t

h o

u sa

n d

s

20 01

.1

20 01

.3

20 02

.1

20 02

.3

20 03

.1

20 03

.3

20 04

.1

20 04

.3

20 05

.1

20 05

.3

20 06

.1

20 06

.3

20 07

.1

FIGURE 14.4 Single family housing starts.

Source: U.S. Department of Commerce, www.census.gov/const/www/newresconstindex.html

gue46399_ch14_177-185.indd 179 16/03/17 11:42 AM

180 Chapter 14 The Recession of 2007–2009: Causes and Policy Responses

Late 2007: The Recession Begins as Do the Initial Policy Reactions

We know now that the National Bureau of Economic Research Business Cycle Dating Committee has pinned the beginning of the recession as late fall 2007. It was evident to policy makers that a slowdown was about to occur in late 2007. As can be seen in Figure 14.7, the

Federal Reserve began cutting its federal funds rate in September 2007 and didn’t stop cutting the rate until it was at zero in December 2008.

The Bush administration began lobbying in early 2008 for a stimulus package. Its preferred mechanism was to make its tax cuts of 2003 permanent as well as to provide tax rebates to taxpayers. It failed in securing the former but succeeded in garnering the latter. By early spring

D e

b t

in $

m ill

io n

s

1,800,000

1,600,000

1,400,000

1,200,000

1,000,000

800,000

600,000

Revolving credit Nonrevolving credit

20 00

.0 1

20 00

.0 7

20 01

.0 1

20 01

.0 7

20 02

.0 1

20 02

.0 7

20 03

.0 1

20 03

.0 7

20 04

.0 1

20 04

.0 7

20 05

.0 1

20 05

.0 7

20 06

.0 1

20 06

.0 7

20 07

.0 1

20 07

.0 7

FIGURE 14.5 Revolving and nonrevolving household debt.

Source: Board of Governors of the Federal Reserve System, www.federalreserve.gov/releases/g19/hist

6

4

5

3

2

1

0

Ju n-

07

Date

R at

e

Ju n-

03

Se p-

03

De c-

03

Ju n-

04

Se p-

04

De c-

04

M ar

-0 4

Ju n-

05

Se p-

05

De c-

05

M ar

-0 5

Ju n-

06

Se p-

06

De c-

06

M ar

-0 7

M ar

-0 6

FIGURE 14.6 The federal funds rate.

Source: Board of Governors of the Federal Reserve System, www.federalreserve.gov/fomc/fundsrate.htm

gue46399_ch14_177-185.indd 180 16/03/17 11:42 AM

The Bottom Falls Out in Fall 2008 181

2008 the rebate plan was enacted and by early summer, millions of Americans received $600 per individual, $1,200 per married couple. For most this money was deposited directly into their checking accounts by early summer. For the rest, rebate checks were mailed before summer was out. If you look at Figure 14.8, you can see that this $158 billion package had a significant short-run impact. Economic growth in the third quarter of 2008 was consistent with a healthy economy, but the economy was not at all healthy. Oil prices were rising to $145 per barrel and home foreclosures were increasing rapidly.

The Bottom Falls Out in Fall 2008

In the late summer and early fall 2008, a crisis of confi- dence in the financial sector threatened to freeze capital markets in a way not seen since the Great Depression of the 1930s. During the summer the rating agencies, Moody’s and Standard and Poor’s, were downgrading mortgage‐backed securities and the companies that held them in significant amounts. The Federal Reserve created several loan programs to assist various bank and non‐ bank entities to cope with the difficult credit markets.

6

4

5

3

2

1

0

1/3 /2

00 9

9/ 3/

20 07

10 /3

/2 00

7

11/ 3/

20 07

1/3 /2

00 8

2/ 3/

20 08

3/ 3/

20 08

12 /3

/2 00

7

5/ 3/

20 08

6/ 3/

20 08

7/ 3/

20 08

4/ 3/

20 08

9/ 3/

20 08

10 /3

/2 00

8

11/ 3/

20 08

12 /3

/2 00

8

8/ 3/

20 08

FIGURE 14.7 Federal funds rate September 2007–December 2008.

Source: Board of Governors of the Federal Reserve System, www.federalreserve.gov/releases/h15/data.htm R

G D

P $

b ill

io n

s (2

0 0

0 )

Year

11,750.0

11,700.0

11,650.0

11,600.0

11,550.0

11,500.0

11,450.0

11,400.0 2007.3 2007.4 2008.1 2008.2 2008.3 2008.4

FIGURE 14.8 Real GDP 2007.2 to 2008.3.

Source: Bureau of Economic Analysis, www.bea.gov/national

gue46399_ch14_177-185.indd 181 16/03/17 11:42 AM

182 Chapter 14 The Recession of 2007–2009: Causes and Policy Responses

On September 7, 2008, the Treasury Department placed Fannie Mae and Freddie Mac in conservatorship, because it realized that these government-supported en- tities were essentially bankrupt. Within a week Lehman Brothers filed for bankruptcy, and two days later, the Fed lent the insurance giant AIG $85 billion (which ultimately became $182.5 billion). Two weeks later, then Treasury Secretary Paulson and Federal Reserve Chair- person Bernanke went to Congress seeking $700 billion for their planned Troubled Asset Relief Program. Two weeks after that, Wachovia teetered on the edge of bank- ruptcy and was purchased by Wells Fargo.

Within the span of two months, from Labor Day week- end to election day 2008, the financial system was on the verge of collapse. The terrible news, repeated on a daily basis, produced such a crisis of confidence that Christmas 2008 was the worst holiday shopping season in 40 years. As can be seen in Figure 14.9, a fair unemployment picture through mid-2008 turned sharply worse, and as can be seen in Figure 14.10, job losses mounted rapidly during the fall of 2008 with more than 2 million jobs lost in the third and fourth quarters of 2008. Particularly disturbing was that the number, including those working part time when they would like to be working full time, almost doubled.

The Obama Stimulus Package

Even before President Obama took the oath of of- fice, he was deeply involved in negotiations with the incoming Congress to produce a stimulus package. While President Bush had engaged fiscal policy in the form of tax rebates, as the Obama plan emerged, it was not confined to tax changes but included significant spending.

As you can see in Figure 14.11, the aggregate demand– aggregate supply model can be used to model both the recession as well as the built-in and discretionary policy reactions. As the initial crisis of consumer confidence took hold, aggregate demand contracted markedly. As unemployment rose, the welfare state kicked into high gear with substantial increases in unemployment insur- ance, food stamps, and Medicaid spending. This non- discretionary fiscal policy (NDFP) dampened the initial impact of the decrease in demand. A stimulus package passed by Congress and signed by the president is, by definition, discretionary and as you read in Chapter 9 is called discretionary fiscal policy (DFP). Whether or not the Obama plan has had or will have the desired impact will be known only with the passage of time.

16

12

14

10

8

6

2

4

Unemployment rate UR + DW UR + DW + Under

20 06

.0 1

20 06

.0 3

20 06

.0 5

20 06

.0 7

20 06

.0 9

20 06

.11

20 07

.0 1

20 07

.0 3

20 07

.0 5

20 07

.0 7

20 07

.0 9

20 07

.11

20 08

.0 1

20 08

.0 3

20 08

.0 5

20 08

.0 7

20 08

.0 9

20 08

.11

20 09

.0 1

FIGURE 14.9 Unemployment rates 2006–2009.

Source: Bureau of Labor Statistics, http://data.bls.gov/cgi-bin/srgate (LNS12032194; LNU05026645; LNS12000000; LNS14000000)

gue46399_ch14_177-185.indd 182 16/03/17 11:42 AM

Extraordinary Monetary Stimulus 183

The stimulus package passed by Congress and signed by the president was entirely discretionary since they had to pass a law to make it happen. Still, as you read in Chapter 9, a portion of the spending was to shore up the nondiscretionary fiscal policy spending on welfare and unemployment insurance that is typically run through the states. The details of the Obama stimu- lus plan can be seen in Figure 14.12. As you can see, a roughly equal portion went to tax cuts (38 percent) and spending programs (39 percent) with the remainder going to shore up Medicaid, welfare, and unemploy- ment programs.

You can also see in Figure 14.12 that the bulk of the tax cuts went to individuals, with some additional tax cuts going to energy-conservation programs. For instance, in 2009, the purchase of energy-efficient appliances was given preferential treatment. About half of the aid to in- dividuals came in the form of money to states to help them provide Medicaid, given the anticipated increase in enrollment caused by the recession. About a quarter of the individual aid went to increase unemployment benefits by $25 per week and to extend benefits beyond the already approved 26 weeks. The final portion of the spending was broken into many pieces for many different priorities of the new administration.

Extraordinary Monetary Stimulus

At the same time the Obama administration was attempt- ing a fiscal stimulus, the Federal Reserve was engaging in the most expansive monetary stimulus in its history. When the fiscal stimulus ended, the monetary stimulus continued. For a detailed look at the monetary stimulus of this period, it would be worthwhile to read (or reread) Chapter 10’s discussion of the “The Additional Tools of Monetary Policy Created during 2008” and to exam- ine Figure 10.4. The short version is this: The Federal Reserve’s portfolio of assets nearly tripled between 2008 and 2013, and that tripling meant that there was available to the banking system three times more money in 2013

400

0

200

–200

–400

–600

–800

Year.Month

N e

t ch

an g

e in

jo b

s (0

0 0

)

20 06

.0 1

20 06

.0 4

20 06

.0 7

20 06

.10

20 07

.0 1

20 08

.0 1

20 09

.0 1

20 08

.0 4

20 08

.0 7

20 08

.10

20 07

.0 4

20 07

.0 7

20 07

.10

FIGURE 14.10 Net change in employment (2009).

Source: Bureau of Labor Statistics, http://data.bls.gov/cgi-bin/srgate (LNS12000000)

Pl

Pl*

Shock

NDFP

AS

RGDPRGDP*

AD1

AD2

AD3 DFP

FIGURE 14.11 Modeling the impact of nondiscre- tionary fiscal policy and the Obama stimulus package (discretionary fiscal policy).

gue46399_ch14_177-185.indd 183 16/03/17 11:42 AM

184 Chapter 14 The Recession of 2007–2009: Causes and Policy Responses

than there was in 2008. Moreover, the stimulus contin- ued through 2013 as the Federal Reserve was purchasing $40 billion in mortgage-backed securities and another $40 billion in long-term treasuries each and every month.

This dramatic increase in loanable money kept interest rates extraordinarily low for the whole period. In 2012 and 2013, home mortgage interest rates were below 3 per- cent for those with good credit. That allowed those who

refinanced their mortgages to lower payments or shorten the terms on those mortgages, or in many cases, both.

Whether this monetary stimulus was effective is also open for debate and will likely not be settled among econ- omists until the stimulus has been reversed. As the textbox at the end of Chapter 10 indicates, there were significant risks associated with this policy, that, at this writing in the spring of 2013, have neither been proven nor disproven.

Spending Total, $311,339, 39%

Total Stimulus Package (millions, %)

Aid Total, $178,140, 23%

Tax Cuts Total, $301,135, 38%

Individual Tax Cuts, $232,426, 77%

Bus and Manu Tax Cuts,

$8,000, 3%

Energy Tax Cuts, $19,963, 7%

Other, $40,582, 13%

Tax Cuts (millions, %)

Individual Aid (millions, %)

Unemployment/ Welfare,

$45,788, 26%

Health Insurance Subsidy,

$24,749, 14%

Medicaid to States,

$90,044, 50%

Computerizing Medical Records,

$17,559, 10%

Other, $19,219, 6% Outdoors, Indian

Reservations, Arts, $10,950, 4%

Commerce, Science and Justice, $15,920, 5%

Farming and Food,

$26,466, 9%

Environment and Energy,

$50,825, 16%

Aid to States, $53,600, 17%

Transportation and Housing, $61,795, 20%

Labor, Health, Education,

Volunteering, and Social Security, $72,564, 23%

Spending Total (millions, %)

FIGURE 14.12 The Obama stimulus plan in detail.

Source: www.cbo.gov

Summary The recession of 2007–2009 was set off by a confluence of events surrounding the bursting of the housing bubble. The housing bubble resulted in dramatic losses in the

financial sector and a tightening of credit. This tighten- ing was despite repeated attempts by the Federal Reserve, the Bush administration, and the Obama administration

gue46399_ch14_177-185.indd 184 16/03/17 11:42 AM

Summary 185

Quiz Yourself 1. Which of the following was not likely a contributing

factor to the recession of 2007–2009? a. The bursting of the housing bubble b. The 2008 tax rebates c. The failure of major financial service

companies d. The drop in oil prices from $150 to $40 per

barrel in late 2008 2. In the years prior to the recession the economy was

growing a. at about its typical rate. b. at a rate much slower than typical. c. at a rate much faster than typical.

3. Gasoline prices in late 2007 through mid-2008. a. spiked b. increased relatively slowly c. remained constant d. plunged

4. The Federal Reserve’s response to the recession of 2007–2008 was a. clearly effective in shortening the recession. b. quick but not obviously effective in shortening

the recession. c. slow and subject to criticism for being rather timid. d. procyclical in that it had precisely the opposite

impact as intended. 5. The Obama administration’s stimulus package was

a. almost entirely made up of tax cuts. b. almost entirely made up of spending on

“shovel-ready” projects. c. a balance between tax cuts, spending on

projects, and shoring up the unemployment and welfare systems.

d. almost entirely spent on welfare programs.

6. The job losses during this recession were a. typical of a short recession. b. nonexistent. c. significant and rapid.

Short Answer Questions 1. Explain each of the following in terms of whether

they were discretionary fiscal policy, nondiscretion- ary fiscal policy, or monetary policy: TARP, the AIG bailout, the 2009 stimulus package, the rapid increase in unemployment compensation spend- ing, the rapid reductions in state sales, and income tax revenues resulting from people having lower incomes.

2. How was “quantitative easing” different from what the Federal Reserve normally does?

3. Which lag described in Chapter 9 did the concept of “shovel-ready” intend to combat?

Think about This Nobel Prize–winning economist Paul Krugman repeat- edly warned through 2008 and 2009 that it was far worse for Congress to be too timid than too aggressive. In ret- rospect, was he correct? What would have been the result of a $1.5 trillion stimulus package?

Talk about This What lessons would you draw from the recession of 2007–2009? What could have realistically been at- tempted in the middle of the housing boom to forestall the bust that came after?

to revive the financial sector. The resulting loss of jobs and shrinking of GDP made this recession quite likely the worst since World War II. The attempts by the Federal

Reserve to shore up the financial sector and by the Obama administration to stimulate the economy were breathtak- ing in their magnitude, though uncertain in their impact.

gue46399_ch14_177-185.indd 185 16/03/17 11:42 AM

C H A P T E R F I F T E E N

186

Is Economic Stagnation the New Normal? Learning Objectives

After reading this chapter you should be able to:

LO1 Describe the historical rates of per capita real GDP growth from 1950 to 2015.

LO2 Enumerate the sources of economic growth and explain why some of those sources cannot be repeated and why others may be repeated.

LO3 Describe the causes and consequences of slowing economic growth and describe the debate as to whether a shrinking middle class is best labeled a cause or a consequence.

LO4 Describe and model the alternative suggestions for jump- starting economic growth.

Chapter Outline

Periods of Robust Economic Growth

Sources of Growth

Causes and Consequences of Slowing Growth

What Can Be Done to Jump-Start Growth, or Is This the New Normal?

Summary

In the United States and around the globe there is a de- pressing concern expressed among economists that the era of sustained, standard-of-living-enhancing economic growth is coming to an end. For decades the U.S. econ- omy grew at a healthy and steady pace. While interrupted by recessions, that pace was considered sustainable. Whether measured in terms of real GDP growth, or per capita real GDP growth, Table 15.1 shows that during the

period from 1950 to 2000, economic growth was pretty constant. The annualized rate of growth in per capita real GDP was approximately 2 percent.

Since 2000, however, the “new normal” is a phrase that has crept into the economic lexicon to both describe and accustom people to the unpleasant realization that growth can no longer be expected to increase standards of living across the board. The outlook for economic growth pro- duced by the Organization for Economic Cooperation and Development (OECD) across the world’s richer countries shows just how slow growth is projected to be. The United States is the leader in terms of projected 2017 economic growth at a paltry 2.39 percent. The United Kingdom, Germany, and Canada are also clustered between 2 percent and 2.33 percent. France, Italy, and Japan are predicted to grow at rates of 1.62, 1.40, and 0.53 percent, respectively. This chapter puts these slow growth numbers in historical context, offers an explanation for why they are so low, and concludes with how this state of affairs could easily become the “new normal.”

TABLE 15.1 Real growth in the United States.

Decade Annualized Growth in Real GDP

Annualized Growth in Per Capita Real GDP

1950s 3.33 1.74 1960s 4.24 3.06 1970s 3.19 2.23 1980s 3.14 2.23 1990s 3.03 1.90 2000s 1.40 0.71 2010s 1.69 0.77

gue46399_ch15_186-192.indd 186 16/03/17 11:43 AM

Causes and Consequences of Slowing Growth 187

increased from 36 percent to 77 percent. All those extra workers clearly boosted overall economic output.

Technological growth also played an important role in increasing economic output. The use of carbon-based energy to power manufacturing and electric lighting to elongate the production day produced incredible gains. As a result of these technological innovations, labor productivity increased at a rapid pace for much of this period. Looking back at Chapter 6’s statistics on pro- ductivity, the five-year moving average of labor produc- tivity exceeded 2 percent (for all but a select few years) during the period from 1950 to 1975. Though it slowed dramatically, to below 2 percent for most of the period from 1975 to 2000, it once again rose rapidly in the pre–Great Recession 2000s as robotic- and computer- assisted manufacturing once again boosted production.1

Workers also became more productive, in part, be- cause of increases in worker educational attainment. Though explored more deeply in Chapters 36 and 37, it is worth noting here that the percentage of Americans ages 25 to 64 with at least a high school diploma in- creased from 45 percent just after World War II to around 85 percent by 1980. That figure stabilized until 2000 when it increased further to in excess of 90 percent by 2015. The college completion rate for that same popula- tion increased from under 5 percent prior to World War II to more than 30 percent in 2015.

Another source of growth during the period was glo- balization. International trade created new markets for U.S. goods while also creating new goods for American mar- kets. Of course, globalization also contributed to job losses, particularly for manufacturing workers, but economists are consistent that the impact on output was positive.

Causes and Consequences of Slowing Growth

Causes Slowing economic growth, on both a real GDP basis and a real per capita GDP basis, has several causes and con- sequences. In terms of causes, the two most significant of these have been the slowing of production-related technological improvements and the general reversal of the increases to the Labor Force Participation Rate. De- mographic changes have also occurred that are teeing up slower growth. The population is not only growing at a slower rate; it is aging. The lingering consequences of the

Periods of Robust Economic Growth

Estimates of real GDP growth for the pre–Civil War era vary, but they clearly show that the United States grew at rather modest rates (on a per capita basis). A startling statistic generated by economic historians suggests that between 1300 and 1750 per capita real economic growth was essentially zero. Another suggests that growth between the Revolutionary War and the Civil War was not much better at 1 percent. Pre–Industrial Revolution growth was limited by modest improvements in tools and animal-based energy (i.e., mules, horses, and oxen pulling plows). Though the cotton gin created a 50-fold increase in the amount of lint that could be separated from seed on a cotton plant, it was still operated by a hand crank with the energy of a slave. What ignited the years of growth after the Civil War was the use of carbon-based energy (i.e., oil, natural gas, and coal), which fueled the Industrial Revolution’s assembly-line manufacture of goods. Electric lighting added to this productivity by opening up the entire day for produc- tion. This torrential rate of growth created not only cars, airplanes, and useful home appliances; it created middle- class jobs for those who produced those goods. Those jobs created incomes that were then used to purchase those goods. The virtuous cycle of growth enabling more growth made it such that from the end of the U.S. Civil War to the beginning of the Great Depression, annual growth in real per capita GDP averaged 1.75 percent.

Toward the end of the pre–World War II portion of the Industrial Revolution, political change and economic growth also brought about unionization of employees, the substantial raising of wages, the dramatic improve- ment in working conditions, the ending of child-labor practices, a minimum wage, and the standardization of the 40-hour workweek. Laws protecting workers’ rights to organize, collectively bargain, and strike were passed. That growth and those laws created a broad U.S. middle class. Though conservative, pro-business economists would give more of the credit to growth and liberal, pro-labor economists would give more credit to labor- friendly laws, it is clear that the combination created a large, healthy, and stable middle class.

Sources of Growth

From 1950 to 2007 per capita real GDP growth averaged 2.16 percent. That latter growth had several “mothers.” During the 1950s through the 1990s the Labor Force Par- ticipation Rate for women of prime working age (25–54)

1Multifactor productivity, though notably slower overall, showed essentially the same pattern and timing.

gue46399_ch15_186-192.indd 187 16/03/17 11:43 AM

188 Chapter 15 Is Economic Stagnation the New Normal?

Great Recession are also not to be discounted. Tighter credit standards and greater financial regulations have made it more challenging for small businesses to operate and grow. We will take each of these, in turn.

Though technological improvements have been dramatic since 2000, few of the inventions of the last 15 years have been particularly important to production. The cell phone and its offspring, the smartphone, have enabled us to do things as we walk from one place to another or as we wait in line somewhere, but we don’t do much of anything that is productive with those devices. While some of us may write or respond to work-related e-mail, most of us are reading for entertainment (e.g., a book in our Kindle app), participating in social media (e.g., Facebook, Pinterest), or playing a mind-numbing game (e.g., Candy Crush). The smartphone, the tablet, and all the applications to which we are addicted do not increase the productivity of the workforce in the way that the electric light did. The DVR, the smart TV, and the proliferation of streaming media outlets that feed them may increase the joy associated with our leisure time, but they do not add to production.

The bump in labor productivity of the 1990s and early 2000s was due to the application of computer technol- ogy to manufacturing, agriculture, retail, wholesale, and service providers. Auto companies now use robotic spot welders thereby increasing the consistency of those welds. Sawmills use laser imaging and computerized cutting programs to increase the amount of lumber that can be produced from each log. Hyper-accurate GPS- driven planters have increased yields in farm fields. Self- scanning checkouts have sprung up allowing one cashier to monitor several lanes at once. Interconnected supply- chain management software has allowed Walmart and others to order goods, load trucks, and restock shelves with greater efficiency. Banking and payment processing efficiency has increased dramatically because of com- puterized processes and electronic transfers.

On the other hand, Netflix, Facebook, Twitter, Pinter- est, Candy Crush, and the myriad simulation game apps do absolutely nothing positive for production.

Another significant cause related to slowing growth is the significant decline in the Labor Force Participa- tion Rate. Whereas men in their prime working ages used to participate at rates nearing 98 percent, that rate has fallen to 88 percent. Though still high, consider this: The percentage of men NOT working or look- ing for work while in their prime working years is six times higher than it was in the 1950s. Women in this age group, who constituted one of the “mothers” of earlier

growth, have also departed the labor force albeit at a much slower rate. At 36 percent in 1950, the rate for women ages 25 to 54 peaked at 77.3 percent in 2000. By 2015 the rate had fallen to 73.4 percent. Young people have also left the labor force. In the early 1950s, ap- proximately 60 percent of those between the ages of 16 and 24 were in the labor force. That number increased to a peak of 69 percent in the middle 1980s but dropped to 55 percent by 2015.

Another major cause of declining real GDP growth is the slowing increase in the population. This is one reason to focus on the per capita statistic. From 1950 to 1964, the U.S. population grew at between 1.4 per- cent and 2.2 percent per year, largely due to the post- war baby boom. The birth control pill slowed that rate such that it ranged between 0.8 percent and 1 percent from 1966 to 2009. The slowing since 2010 to less than 0.75 percent is attributable to out-migration of South and Central Americans and to a continued slowing of births.

A related cause is the changing demographic mix of the population. The percentage of the U.S. population under the age of 25 and over the age of 65 has changed dramatically over time. In 1970 46 percent of the popu- lation was under the age of 25 and 9.8 percent was over the age of 65. By 2010, 33 percent of the population was under 25 while 13 percent was over 65. That is, the popu- lation in 2010 in their peak earning years was 54 percent. That number is now falling. By 2014 it had fallen to 53.6 percent and is projected to continue falling to under 50 percent by 2040.

The Great Recession was not just an economic prob- lem for those who suffered through it; it created myriad problems that lingered far longer than the recession. Chapter 13 described the extraordinary measures un- dertaken by the Federal Reserve. Those artificially low interest rates should have caused an increase in business investment. The reality is that business investment did not revive, and that is likely because of the higher stan- dards that banks applied to commercial and industrial loans. Those higher standards are at least somewhat at- tributable to new financial regulations imposed on banks shortly after the Great Recession.

Consequences One of the elements that is a cause to some, a conse- quence to others, and to still others both a cause and a consequence, is the declining middle class (a subject explored in some depth in Chapter 31, “Income and Wealth Inequality: What’s Fair?”). The longer-term

gue46399_ch15_186-192.indd 188 16/03/17 11:43 AM

What Can Be Done to Jump-Start Growth, or Is This the New Normal? 189

consequences relate to the overall social and economic health and welfare of the American population. In par- ticular, with incomes growing more slowly than that projected by the Medicare and Social Security Trustees, the financial viability of those programs could be called into question.

The percentage of Americans in the middle class has seen a recent and troubling decline. The Pew Charitable Trust defines the middle class as those households with in- comes between 67 percent and 200 percent of the median household income by household size. For 2014, a three-per- son household with income between $42,000 and $126,000 would qualify as being in the middle class. As Table 15.2 shows, the middle class has been shrinking since the 1970s, but much of that shrinkage was because those near the top boundary of the definition had their incomes rise pushing them into the “upper-middle” category. Now it is shrinking because households nearest the bottom boundary of the def- inition are having their incomes fall into the “lower-middle” category and those at the bottom of the “lower-middle” cat- egory are falling into the “lowest” category.

Though a shrinking middle class can be viewed as merely a consequence of a slowly growing economy, it can also be viewed as a cause of that slowly growing economy. That perspective, that the distribution of in- come is contributing to the lack of income, is typically held by economists on the left. Their view is that because people in the lower and middle classes use most of their income for the purpose of bolstering their consumption and because those at the top of the income distribution use their income for the purpose of making more income for themselves, there is a macroeconomic impact to the change in distribution. Those in the bottom 80 percent use their income to buy things produced, typically, by those in the bottom 80 percent. When they buy, their spending is someone else’s income and their income is generated by someone else’s purchases of the goods and services they produce. At the very least the money in the hands of the highest-income individuals is spent or invested much more slowly than money in the hands of

those not in the highest strata. In this way, the conse- quence can also be a cause.

Where economists generally agree, because it is sim- ply math, is that when growth runs at 1 percent per capita rather than 2 percent per capita, the average newborn child today can count on having about half as much income when they retire. That is because growth is mathemati- cally exponential. It isn’t just 65 years of 1 percent lost for a 65 percent difference, it is 1.0165, or a 191 percent difference. The result is that everybody simply has a whole lot less. There are fewer opportunities, fewer jobs, lower pay, and lower tax revenue. This means that com- mitments that were made years ago, such as Social Secu- rity and Medicare, will become increasingly difficult to keep. It also means that new promises, perhaps to offer government-subsidized child care or to provide universal paid family leave, not only can’t be kept; they can’t even be responsibly considered. A society with twice as much income can do many more things for its citizenry. Growth not only helps those who earn the money; it also helps those who depend on government because government depends on revenue growth to support social programs.

One startling statistic that jolts and depresses at the same time is one that relates to suicide. According to the Centers for Disease Control and Prevention, between 2000 and 2014 the suicide rate for those between the ages of 45 and 64 increased from 13.5 to 19.2 per 100,000. This in- crease has been more pronounced among whites than other ethnicities. Already twice the rate for whites as for African Americans, the suicide rate for whites increased from 11.3 per 100,000 to 14.7. When growth is slow and good-paying jobs are hard to come by, depression can lead to suicide.

What Can Be Done to Jump-Start Growth, or Is This the New Normal?

Just as the cause of the slow-growth predicament is subject to debate, the conclusions economists draw are also subject to debate. There are essentially

Year Lowest Lower Middle Middle Upper Middle Highest

1971 16 9 61 10 4 1981 17 9 59 12 3 1991 18 9 56 12 5 2001 18 9 54 11 7 2011 20 9 51 12 8 2015 20 9 50 12 9

TABLE 15.2 Pew Charitable Trust income classes.

Source: http://www.pewsocialtrends.org/2015/12/09/the-american-middle-class-is-losing-ground/

gue46399_ch15_186-192.indd 189 16/03/17 11:43 AM

190 Chapter 15 Is Economic Stagnation the New Normal?

two camps: “get used to it, this is the new normal” and “we can do better.” Within the “we can do better” camp there are also two camps with two vastly differ- ent solution sets. Liberals suggest a massive increase in stimulus to jump-start aggregate demand. Conser- vatives suggest an equally massive change to the regu- latory system and tax structure.

Chief among the “new normal” group of economists is Robert Gordon. In his book, The Rise and Fall of American Growth, Gordon makes the case that the sources of economic growth of the post–Civil War pe- riod through 2000 have all but evaporated. Specifically, there isn’t a large new workforce sitting by waiting to be tapped. Women entering the workforce in great numbers can only happen once. There is no significant portion of the day to be turned to productive use like there was when electric lighting allowed for round-the- clock manufacturing. The conversion to carbon-based energy from human or animal energy happened, and its benefits can’t be repeated. Even if we can convert completely to non-carbon-based energy sources, that will not increase output. Such a conversion may save the planet from climate change, but it will not increase production because electrically powered equipment does not run any better just because the source of that electricity has changed.

A group Gordon labels “techno-optimists” disagrees with his assertions that the days of robust growth are behind us. They point to driverless cars and trucks as an example of productivity enhancements that are only a few years away from having a dramatic impact. If all the labor devoted to over-the-road trucking were to be re- placed with driverless vehicles, that labor could be used to produce other goods and services. Further into the fu- ture, it is not hard to imagine that artificially intelligent robots could engage in home production in much the same way that current robots have increased productivity in factories. People might be able to engage in produc- tive activities rather than cooking, cleaning, shopping, or doing laundry. These techno-optimists imagine a world in which technology increases growth at once-again robust rates.

Back in the real world where we do our own cooking and cleaning, conservative and liberal economists debate what can be done to get the United States back on track. Liberals typically advocate for policies that increase ag- gregate demand while conservatives look to aggregate supply increasing actions. Figures 15.1 and 15.2 show these alternatives.

Liberals/Democrats would use the Chapter 8 levers of middle-class tax cuts and increases to government spending to shift aggregate demand rightward. It is argued that that would stimulate the virtuous cycle. Greater demand would foster more business invest- ment and more jobs (both to produce the greater number of goods and services and to increase the jobs associated with building new businesses). That would create more income and even greater middle-class de- mand. An abrupt rightward shift in aggregate demand would generate faster future rightward shifts in ag- gregate demand. This assertion is based on the notion

AD

ADʹ

ASPI

PIʹ

PI*

RGDPRGDP* RGDPʹ

FIGURE 15.1 Growth through increases in aggregate demand.

AD

ASʹ

ASPI

PIʹ

PI*

RGDPRGDP* RGDPʹ

FIGURE 15.2 Growth through increases in aggregate supply.

gue46399_ch15_186-192.indd 190 16/03/17 11:43 AM

Summary 191

shores, so companies simply leave those profits over- seas because stockholders are better off when they do. Lowering the corporate income tax would also keep U.S. companies from wanting to sell themselves to smaller foreign companies. This shell game, called inversion, reduces corporate income tax obligations dramatically thereby increasing share prices for stock- holders. Conservatives would also simplify the tax code to remove most of the tax breaks associated with favored types of behavior. These economists argue that deductions and credits for everything from college expenses to energy-efficient windows creates a level of needless complication in the personal income tax system and discourages productive activity in favor of tax-reducing activity.

that there is a level of growth that must be achieved to be self-sustaining. That is because consumer con- fidence is bolstered by increasing growth, and that increased consumer confidence is itself a cause of economic growth.

Conservatives/Republicans would argue that a re- duction in the U.S. corporate income tax rate and a reform and simplification of the U.S. personal income tax system would generate aggregate supply increases. The U.S. corporate income tax (considering both state and federal tax systems) places one of the highest busi- ness tax burdens on U.S. companies. It also motivates companies with large international divisions to locate and hide those profits in foreign countries. Profits are only taxed in the United States when they reach U.S.

Summary The rapid slowing of U.S. real economic growth from 2 percent per capita to less than 1 percent per capita is a significant problem not only for the near term but also the long term. Caused by both demographic shifts and a decline in productivity-enhancing technological im- provements, the decline in growth has led to a decline in the U.S. middle class and to reduced expectations for

the future. If the “new normal” ends up being the correct description of this slow growth, economic opportunities for today’s generation of young people will likely lead to many more of them living below their parent’s economic station for the first time in more than 150 years. Perhaps even more depressing is that there is no consensus solu- tion to this quandary.

Quiz Yourself 1. Per capita real economic growth during the pre–

Revolutionary War era was a. negative. b. zero. c. 1 percent. d. 2 percent.

2. Per capita real economic growth during the Indus- trial Revolution through the mid-1970s was a. negative. b. zero. c. 1 percent. d. 2 percent.

3. The impact of slowing economic growth over a long period of time is a. negligible. b. the lost growth times the number of years. c. substantial because of the exponential aspect

of growth.

4. The large increase in the Labor Force Participa- tion Rate that occurred between 1950 and 2000 was because a. women’s participation in the labor force

doubled. b. men’s participation in the labor force increased. c. the proportion of the population over 65 increased. d. young people’s participation in the labor force

doubled. 5. The large increase in the Labor Force Participation

Rate is ________ source of growth. a. a duplicatable b. an unduplicatable

6. What source of rapid (1950–1975) growth is not duplicable? a. Electrification of lighting b. Increases in education c. Increases in productivity

gue46399_ch15_186-192.indd 191 16/03/17 11:43 AM

192 Chapter 15 Is Economic Stagnation the New Normal?

1. Why is it that some believe that slowing growth is a cause of a declining middle class and others believe the causality is reversed? Could it be both?

7. One issue that some call a consequence and others call a cause of slowing growth is a. a slowing rate of increase in the population. b. a change in the demographic mix of people to

nonworking populations. c. a declining middle class. d. an increase in the Labor Force Participation

Rate among women. 8. To counter the slowing rate of economic growth,

liberal economists would recommend a. taxation and spending policies that decrease

aggregate demand. b. taxation and spending policies that increase

aggregate demand. c. corporate and personal income tax policies that

decrease aggregate supply. d. corporate and personal income tax policies that

increase aggregate supply. 9. To counter the slowing rate of economic growth,

conservative economists would recommend a. taxation and spending policies that decrease

aggregate demand. b. taxation and spending policies that increase

aggregate demand. c. corporate and personal income tax policies that

decrease aggregate supply. d. corporate and personal income tax policies that

increase aggregate supply.

Short Answer Questions

2. Why would a cut in the rate of growth from 2 per- cent to 1 percent have more than a 10 percent impact if it lasted 10 years?

Think about This Part of the reason that the economy is slowing is that both men and women in their prime working years are decreasing their Labor Force Participation Rate. This could be because more couples are choosing to sacrifice income for the benefits associated with having one stay at home during the period when their children are young. If this is the case, is it a problem? Is it merely a conse- quence of a choice that individuals are making?

Talk about This Bernie Sanders and Donald Trump both tapped into a 2016 electorate troubled by the same thing: a slow- ing economy pinching the middle class (or a pinching middle class slowing the economy). Both targeted trade deals, but neither noted any of the causes cited by econo- mists (left and right). What is your explanation for why?

For More Insight See Gordon, Robert, The Rise and Fall of American Growth

(Princeton University Press).

Behind the Numbers Pew Charitable Trust—http://www.pewsocialtrends.org

/2015/12/09/the-american-middle-class-is-losing -ground/

gue46399_ch15_186-192.indd 192 16/03/17 11:43 AM

193

Is the (Fiscal) Sky Falling?: An Examination of Unfunded Social Security, Medicare, and State and Local Pension Liabilities Learning Objectives

After reading this chapter you should be able to:

LO1 Describe the source of the problem of the largest fiscal chal- lenges facing the federal and state and local governments as those associated with Social Security, Medicare, and pensions for state and local government employees.

LO2 Compare and contrast defined benefit and defined contribution pension plans and explain why defined ben- efit plans can be unfunded or underfunded but defined contribution plans cannot.

LO3 Describe the scope and degree of underfunding of each of the sources of fiscal problems.

LO4 List and evaluate the likelihood of each of the scenarios in which the underfunding of Social Security, Medicare, and pensions for state and local government employees presents smaller problems than expected.

Chapter Outline

What Is the Source of the Problem?

How Big Is the Social Security and Medicare Problem?

How Big Is the State and Local Pension Problem?

Is It Possible That the Fiscal Sky Isn’t About to Fall?

Summary

The story of “Chicken Little” is one in which the lead character claims that “the sky is falling” though the only thing that fell was an acorn. This chapter examines whether the fiscal sky is falling and uses the concept of present value to consider the question of whether the promises made by politicians of the past with re- gard to Social Security, Medicare, and defined benefit pensions to employees of state and local governments can be kept.

What Is the Source of the Problem?

As you may go on to read in Chapters 25 and 40, Medicare Part A and Social Security are funded through a system of payroll taxes. Working 40 quarters and paying taxes en- titles people to subsidized hospital care as well as a pen- sion based on the highest 35 years of earnings. For many employees of state and local governments, a system simi- lar to Social Security, albeit one in which instead of both

C H A P T E R S I X T E E N

gue46399_ch16_193-200.indd 193 16/03/17 12:43 PM

194 Chapter 16 Is the (Fiscal) Sky Falling?: An Examination of Unfunded Social Security, Medicare, and State and Local Pension Liabilities

spend their careers with one private employer and be- cause a large number of public employees do stay with their original employer, it is now the norm for employees in the private sector to have defined contribution plans and for public employees to have defined benefit plans.

Defined benefit plans, because they involve employers investing money on the behalf of employees, require either a degree of trust or a degree of regulation. Employee Retire- ment Income Security Act of 1974 (ERISA) provides regula- tion for defined benefit plans offered by private employers. The rules require that the funds in the accounts meet the

actuarial requirements to keep them fully funded. This simply means that, accounting for ex- pected returns on investments, life expectancy of pensioners, and so forth, the assets of the investments

must be able to meet the liabilities, which to the fund are the pension payments to retirees. They also must make pay- ments to the Pension Guaranty Trust Corporation, which operates as a public insurance company in cases where the pension fund cannot meets its obligations and the company that is supposed to pay in goes bankrupt. This guarantees pensioners that their defined benefit plans will pay pensions if the company that sponsored them does not survive.

Another thing that ERISA requires private companies to do is that when they offer health benefits to retirees, those funds also have to be fully funded. So if a private company, for whatever reason, wants to guarantee its employees that when they retire the company’s health insurance will follow them until they get to Medicare eligibility, they have to put enough aside to pay for that.

How Big Is the Social Security and Medicare Problem?

It is important to understand that ERISA applies most stringently to private pensions, and the public pensions, namely Social Security and state and local pensions, do not have to be fully funded. This is the crux of the prob- lem. Social Security is, in present value terms, under- funded by more than $12 trillion dollars, state pension funds are underfunded by $3 trillion, and local govern- ment pension funds are underfunded by more than one- half trillion. On top of that, though it is not a pension fund, Medicare is underfunded by another $4 trillion.

Let’s begin at the federal level. The Social Security and Medicare system had one gigantic, and perhaps even fatal, operational assumption: Current employees could pay for current retirees. This assumption was necessary so that

Employee Retirement Income Security Act of 1974 (ERISA) A regulatory system for defined benefit plans.

employers and employees paying equal shares, states and local governments make most of the investments, provides pension benefits, typically based on the last three to five years of salary.

All three systems are either entitlements or defined benefit programs in that if you participate for the re- quired period of time, you get a benefit according to a

set of rules and a formula. For instance, defined benefits plans frequently have a rule defin- ing retirement eligibility that is structured around the variable years-of-service + age. When this number exceeds a particular

level (often  85), the person is eligible to retire. This is why a teacher who began teaching in a school district at age 25 can retire at full benefits at 55.

This plan differs from a defined contribution program. In a defined contribution pro- gram, those enrolled, as well as their employer, contribute to an account according to a formula (which can be 100  percent em- ployee, 100  percent employer, or some mix), and the investment of that account is under the con-

trol of the employee. Under defined contribution systems, retirees only get what their account accumulates.

Under a defined benefit program, because you pay ac- cording to a formula and you receive benefits according to a formula, there is the possibility that the formula will be wrong (on either side), resulting in a surplus (more than enough has been collected to pay the promised benefits) or a deficit (not enough has been collected and invested to pay the benefits). As is probably obvious, politicians would love the former because they can increase benefit payouts, but the latter is more likely. It is the latter that has occurred and now plagues the public pension system. Because you only get to reap what you sow in a defined contribution plan, there are no surpluses or deficits in those programs.

Defined benefit programs used to dominate the world of employee retirement systems, but they quickly fell by the wayside as fewer and fewer workers spent their entire careers with one firm. This is important because under most defined contribution plans there is a mini- mum years-of-service requirement and people who work 15 years with three different employers would usually get nothing or at least substantially less in aggregate pensions than they would if they worked 45  years with one employer. Because significantly fewer employees

defined contribution program A pension plan in which those enrolled, as well as their employer, con- tribute to an account according to a formula, and the investment of that account is under the control of the employee.

defined benefit program A pension plan that defines eligibility for retirement and benefits according to a set of rules and a formula.

gue46399_ch16_193-200.indd 194 16/03/17 12:43 PM

How Big Is the Social Security and Medicare Problem? 195

people could begin collecting benefits when the programs passed. Otherwise, the programs would have been col- lecting taxes and providing nearly no benefits for several years. Unfortunately for both systems, that mechanism requires that the number of babies born in a year remain roughly stable or grow at a steady rate so that eventually the ratio of workers per retiree can remain roughly con- stant. With the dearth of babies born between 1931 and 1945, due first to the scarcity of food during the Great De- pression, which made many women at least temporarily infertile, and, second, World War  II, which made young men temporarily scarce, and the subsequent baby boom of the postwar era, that assumption did not hold.

The result was that in 1982 analysts anticipated that beginning in 2008, as the first baby boomers became eligible for early-retirement Social Security benefits, and extending until around 2040, both Social Security and Medicare would have insufficient funds to pay for the anticipated benefits. In that year a compromise was worked out that significantly raised payroll taxes in order to create the Social Security and Medicare trust funds and raised the full-benefit retirement age from 65 to 67.

As of 2011, those accounts remain seriously under- funded. As can be seen in Figure 16.1, the annual deficits in these programs alone will, very soon, reach very high lev- els. Because these deficits will occur mostly in the future,

there are two reasonable ways of looking at them. The first, presented in Figure 16.1 displays them by discounting using the present value methodology of Chapter 7. Using an inter- est rate associated with long-term U.S. treasuries, 2.8 per- cent,1 the annual deficits are discounted and plotted below. The area between the 0-line and the Social Security line is the degree of the problem with regard to that program going out 75 years.2 It is $36 trillion. Similarly, between the 0-line and the Medicare line is the degree of the deficit in that pro- gram, which is $10 trillion. For perspective, at this writing the sum of those two numbers is nearly three times GDP. That means that the total liabilities of the United States are more than $64 trillion (the sum of the national debt and the unfunded liabilities of Social Security and Medicare).

To compound the problem, there will be a decreasing percentage of the population working to pay that enormous bill. As can be seen in Figure 16.2, the dependency ratio, the ratio of the population dependent on others to support them to the population supporting them, will rise from around 25 percent currently to more than 38  percent in the next 20 years and to nearly 44 percent within the next 75 years.

1 The zero-coupon bond yield at this chapter’s writing (March 2016). 2 This is the length of time the Social Security and Medicare trustees are required to consider and report upon.

0

2 0

15

2 0

19

2 0

2 3

2 0

2 7

2 0

3 1

2 0

3 5

2 0

3 9

2 0

4 3

2 0

4 7

2 0

5 1

2 0

5 5

2 0

5 9

2 0

6 3

2 0

6 7

2 0

7 1

2 0

75

2 0

79

2 0

8 3

2 0

8 7

2 0

8 9

–1200

–1000

–800

–600

–400

–200

200

Social Security Medicare

FIGURE 16.1 The present value of the annual Social Security and Medicare deficits: 2015–2090.

Source: www.ssa.gov/oact/TR/2012/tr2015.pdf

gue46399_ch16_193-200.indd 195 16/03/17 12:43 PM

196 Chapter 16 Is the (Fiscal) Sky Falling?: An Examination of Unfunded Social Security, Medicare, and State and Local Pension Liabilities

0.45 2

0 10

2 0

15

2 0

2 0

2 0

2 5

2 0

3 0

2 0

3 5

2 0

4 0

2 0

4 5

2 0

5 0

2 0

5 5

2 0

6 0

2 0

6 5

2 0

70

2 0

7 5

2 0

8 0

2 0

8 5

2 0

9 0

0.20

0.25

0.30

0.35

0.40

D e

p e

n d

e n

cy r

at io

(p o

p u

la tio

n o

ve r

6 5

/p o

p u

la tio

n 2

0 –

6 4

) FIGURE 16.2 The dependency ratio: 2010–2090.

Source: www.ssa.gov/oact/TR/2012/tr2015.pdf

The other way of looking at the size of these problems is to consider that the earning capacity of the next generations will be greater than the earning capacity of today’s genera- tion, and through immigration and birth, the U.S. popula- tion continues to grow, making it somewhat likely that the problem could present less of a burden than these figures imply. In Figure 16.3 we see that we could pay for these deficits with an amount of money equal to around 1 percent of payroll over the next decade. Though, by this measure, these deficits as a percentage of payroll rise to 5 percent in

rapid order between 2020 and 2035, they only grow by an- other 1.5 percentage points in the ensuing 40 years.

How Big Is the State and Local Pension Problem?

State and local governments provide their own pensions in addition to Social Security. They do so, by and large, using defined benefit plans. The tumult in Wisconsin in 2011

0

–6

–5

–4

–2

–1

S o

ci al

S e

cu ri

ty a

n d

M e

d ic

ar e

d e

fic it

as a

p e

rc e

n ta

g e

o f

ta xa

b le

p ay

ro ll

–3

2 0

10

2 0

15

2 0

2 0

2 0

2 5

2 0

3 0

2 0

3 5

2 0

4 0

2 0

4 5

2 0

5 0

2 0

5 5

2 0

6 0

2 0

6 5

2 0

7 0

2 0

7 5

2 0

8 0

2 0

8 5

2 0

9 0

FIGURE 16.3 Social Security and Medicare deficits as a percentage of projected payroll.

Source: www.ssa.gov/oact/TR/2012/tr2015.pdf

gue46399_ch16_193-200.indd 196 16/03/17 12:43 PM

How Big Is the State and Local Pension Problem? 197

each state by looking at 2010 pension liability data in Table 16.1. Produced by economists Robert Novy-Marx and Joshua Rauh, their methodology began by looking at the liabilities that these states acknowledge and the assets they claimed, but then made adjustments to the discount rate that these states use to establish those liabilities. Find- ing those discount rates unreasonably high, they instead chose to use what they determined to be a more reasonable rate—the rate that you would get on U.S. Treasury bonds.3 What they found was that in 2010 states had roughly $3 trillion in unfunded liabilities in their state-funded pension plans. When they updated the aggregate number using 2013 data, they found that the problem was growing and that the gap was as much as $3.3 trillion.

was in large part due to conflicts between its Republican governor and the public employees. The budget standoff in Illinois in 2015 and 2016 was a direct result of the unfunded pension liability problem there. The Republican governor and the Democratic state legislature could not agree on a budget because of, among other things, the pension issue. That standoff was made substantially worse when the Illinois Supreme Court ruled that Illinois public pensions were “inviolate”—meaning they could not be lower than promised—and that this extended to everyone currently or previously working for state or local government in Illinois. The consequences of that standoff included little things, like cancelling spring break at Chicago State Uni- versity in 2016 and closing interstate rest areas for unpaid sewer bills; and really big things, like failing to honor state scholarships at public universities across the state and fur- loughs to several employees of those institutions.

How big is the problem of state pensions? You can see the degree to which these unfunded liabilities will affect

TABLE 16.1 State pension liabilities, 2010.

Source: Robert Novy-Marx and Joshua Rauh, “Public Pension Promises: How Big Are They and What Are They Worth?” Journal of Finance, 2011.

State Name Liabilities, Stated

Liabilities, Treasury Rate

Pension Assets State Name

Liabilities, Stated

Liabilities, Treasury Rate

Pension Assets

Alabama 42.0 61.8 21.4 Montana 9.1 12.4 5.3 Alaska 15.3 21.7 12.4 Nebraska 8.4 11.6 5.5 Arizona 43.6 73.5 24.8 Nevada 25.4 36.3 18.8 Arkansas 21.5 30.4 14.6 New Hampshire 8.5 12.5 4.3 California 518.1 699.7 329.6 New Jersey 132.8 191.2 67.2 Colorado 57.3 86.2 28.8 New Mexico 28.8 39.8 15.9 Connecticut 45.3 69.1 20.1 New York 239.8 325.7 192.8 Delaware 7.6 10.9 5.8 North Carolina 74.9 101.8 64.0 Florida 136.4 186.3 96.5 North Dakota 4.4 6.3 2.7 Georgia 75.8 110.1 53.1 Ohio 197.5 281.4 114.7 Hawaii 17.5 24.2 8.1 Oklahoma 33.6 45.9 15.8 Idaho 11.7 16.6 8.7 Oregon 57.5 80.7 42.9 Illinois 151.0 233.0 65.7 Pennsylvania 110.6 164.5 64.3 Indiana 37.3 49.8 19.6 Rhode Island 13.9 20.5 6.6 Iowa 26.0 35.0 18.0 South Carolina 42.4 63.5 20.3 Kansas 21.3 30.3 10.2 South Dakota 7.4 10.3 5.6 Kentucky 45.2 63.4 21.1 Tennessee 36.7 49.6 26.4 Louisiana 36.8 54.8 18.4 Texas 191.2 268.4 126.1 Maine 14.4 20.1 8.3 Utah 22.6 31.2 14.7 Maryland 52.7 72.1 28.6 Vermont 4.0 5.7 2.4 Massachusetts 59.7 86.9 32.7 Virginia 69.1 89.6 41.3 Michigan 73.2 103.1 39.5 Washington 62.3 86.4 43.5 Minnesota 60.6 91.0 35.9 West Virginia 13.7 18.3 7.2 Mississippi 31.4 44.2 15.5 Wisconsin 79.7 114.6 58.4 Missouri 53.5 75.2 33.1 Wyoming 7.0 9.8 4.4

3 The technical reasons for this consideration are beyond the scope of this text; however, from Chapter 7 you understand that higher rates of discount mean that liabilities far off into the future will have a smaller present value. The authors argue that the discount rates on the liabilities are overstated for political purposes to mask the actual size of the problem.

gue46399_ch16_193-200.indd 197 16/03/17 12:43 PM

198 Chapter 16 Is the (Fiscal) Sky Falling?: An Examination of Unfunded Social Security, Medicare, and State and Local Pension Liabilities

To put a bow on this, imagine a household in Chicago wanted to pay off its share of all unfunded Social Security, Medicare, and pension liabilities (completely ignoring the other portions of the national debt); they would have to come up with more than $215,000, of which one-third would be their state and local liabilities. If this fiscal “sky is falling” prediction is accurate, the fiscal sky will fall in the next 20 to 25 years. That is the period in which the Medicare problem will hit its present-value peak, the state and local pension problem will peak, and the Social Security problem will still be increasing.

Is It Possible That the Fiscal Sky Isn’t About to Fall?

It is at least plausible that the preceding overstates the actual problem that Americans will face. Optimists point to a number of factors that could make these problems

These same scholars duplicated this analysis for county and municipal pensions. Using a comprehensive (but not universal) list of cities and counties and their pension plans, they performed similar calculations for those local gov- ernments. What they found, as shown in Table 16.2, was that for those counties and cities they could include in their database, there was $383 billion in unfunded liabilities on pensions, and if that was extrapolated to the remain- ing population of local governments, they have a total of $574 billion in unfunded pension liabilities. Some of those cities had laughably large unfunded liabilities. For instance, the city of Chicago had so many outstanding liabilities that if every household in the city contributed $40,000 to the city, it would still be insufficient to entirely eliminate the gap. Even worse, because the state of Illinois had not con- tributed anywhere near enough money to its pension funds for state employees (such as teachers, college professors, state highway patrol, prison guards), it would take almost an additional $30,000 to cover those liabilities.

TABLE 16.2 County and municipal pension liabilities, 2010.

Source: Robert Novy-Marx (University of Rochester and NBER) and Joshua Rauth (Kellogg School of Management and NBER), www.kellogg.northwestern.edu/faculty/rauh /research/nmrlocal20101011.pdf

Name (Number of Plans)

Liabilities, Stated Basis, June 2009 ($B)

Liabilities, Treasury Rate

Net Pension Assets ($B)

Unfunded Liability ($B)

Unfunded Liability/ Revenue

Unfunded Liability per Household ($)

Chicago 46.3 66.6 21.8 44.8 763% 41,966 New York City 155.8 214.8 92.6 122.2 276 38,886 San Francisco 16.3 22.6 11.9 8.7 306 34,940 Boston 7.4 11.0 3.6 7.5 430 30,901 Detroit 8.1 11.0 4.6 6.4 402 18,643 Los Angeles 34.6 49.3 23.2 26.1 378 18,193 Philadelphia 9.0 13.0 3.4 9.7 290 16,690 Cincinnati 2.2 3.2 1.2 2.0 321 15,681 Baltimore 4.4 6.4 2.7 3.7 260 15,420 Milwaukee 4.4 6.7 3.3 3.4 687 14,853 Fairfax County 8.3 11.1 5.5 5.6 169 14,415 Hartford 1.2 1.6 0.9 0.7 249 14,333 St. Paul 1.5 2.2 0.8 1.4 464 13,686 Jacksonville 4.1 6.0 2.0 4.0 278 12,994 Dallas 7.4 10.8 4.6 6.3 298 12,856 Contra Costa County 6.3 8.7 3.7 5.0 425 12,771 Santa Barbara County 2.3 3.3 1.4 1.8 329 11,995 Kern County 4.2 5.6 2.0 3.6 612 11,919 San Jose 5.4 7.5 3.4 4.1 321 11,391 Houston 11.1 16.4 7.2 9.1 356 10,804 Nashville Davidson 2.9 4.1 1.8 2.3 151 10,048 Arlington County 1.5 2.0 1.2 0.8 103 10,000

gue46399_ch16_193-200.indd 198 16/03/17 12:43 PM

Summary 199

substantially smaller in scope. First, the analysis is predi- cated on the ability of the authors of the Social Secu- rity and Medicare trustees’ reports to predict wages, life expectancy, GDP, interest rates, and other economic variables 20, 30, 50, 75 years in advance. Additionally, there are any number of changes that could make the next 20 years only slightly uncomfortable with regard to these underfunded programs. Incomes could grow at a more rapid, but still historically reasonable, rate, or the programs’ benefits could be curtailed.

Aside from the possibility that the forecasts are just wrong, consider the most likely and most important source for potential optimism. Taxable incomes could grow at the rate they did in the 1980s and 1990s and do so for a sustained period. Similarly, productivity and/ or technological increases could be sufficient to raise real GDP growth expectations from the 2.5 percent to 3.5 percent they have been to 3.5 percent to 4.5 percent. A one percentage point increase in growth would make the U.S. real GDP 28 percent higher in 25 years than it is now projected to be at that time, and that would be more than enough to make the funding of those particular pro- grams substantially less onerous.

Second, programmatic changes could be made, especially to Social Security, that could take the larg- est part of the long-term problem off the table. For instance, some combination of tax increases (either eliminating the maximum taxable earnings for So- cial Security, increasing tax rates 1 percent across the board on both employers and employees, or extending

Social Security taxes to unearned income) or benefits changes (eliminating the option for taking benefits at 62, raising the retirement age to 70, using price infla- tion rather than wage inflation to adjust benefits for the cost of living) could be enacted. If these were en- acted in the next five years, most of the problem in Social Security could be eliminated.

Whether state and local governments can break the promises they have already made to their teachers, firefighters, police, and other workers is another story. There would certainly be political and even legal chal- lenges to such changes. As governors around the coun- try were seeing between 2011 and 2016, it is politically difficult to require public workers to contribute (more) to their pensions; so, though there could be a political solution that would require higher contribution levels by the workers themselves, if that does not occur soon, such a solution will not be enough to solve the state and local pension problem. That would leave state and local governments needing to cut benefits to current retirees (which would ignite an even more furious political and legal challenge) or to seek a bailout from higher levels of government.

The biggest challenge to optimists has to be Medi- care. Its problems were almost completely ignored within the Obama administration’s health care plan. That plan’s focus was on expanding eligibility and not on realistic cost control. Second, Medicare’s fiscal challenges will be front and center earlier than the other programs.

Summary Whether or not you believe the “sky is falling” on fiscal issues relating to Social Security, Medicare, and the pen- sions systems for state and local government workers, you should now understand the source of the problem. Com- bined, various levels of government have underfunded their programs for retirees by trillions of dollars. You understand that the Medicare challenge will occur first,

followed shortly thereafter by the state and local pension challenge. The Social Security shortfall will not become acute until the late 2030s but remains the largest fiscal challenge. You understand that because these liabilities will occur so far in the future that the rate at which you dis- count them and the rate at which the economy will grow can significantly alter the estimated scope of the problem.

Key Terms defined benefit program defined contribution program ERISA

gue46399_ch16_193-200.indd 199 16/03/17 12:43 PM

200 Chapter 16 Is the (Fiscal) Sky Falling?: An Examination of Unfunded Social Security, Medicare, and State and Local Pension Liabilities

Quiz Yourself 1. In terms of magnitude, which of the following has

the greatest fiscal shortfall? a. State pension funds b. Local pension funds c. Medicare d. Social Security

2. In terms of when these fiscal shortfalls are likely to require significant changes to budgets or program rules, which of the following is likely to occur first? a. State pension funds b. Local pension funds c. Medicare d. Social Security

3. Using a higher rate of discount a. makes no difference when calculating the pres-

ent value of future liabilities. b. raises the present value of future liabilities. c. lowers the present value of future liabilities.

4. The dependency ratio in the United States is a. growing. b. steady. c. falling rapidly. d. falling slowly.

5. State and local pensions for government employees are usually a. defined benefit plans. b. defined contribution plans. c. entitlements. d. determined year to year.

6. Deficits cannot occur in a. defined benefit plans. b. defined contribution plans. c. entitlement budgets. d. state and local budgets.

Short Answer Questions 1. Why does the discount rate matter when evaluat-

ing the future liabilities of defined benefit pension plans?

2. Why does it matter whether you have a defined con- tribution plan or a defined benefit plan in terms of

whether there is a degree of underfunding that your boss might not be telling you about?

3. Why would a schoolteacher be a better candidate for a defined benefit pension than a computer programmer?

4. Why would the Pension Guaranty Trust or some- thing like it be necessary in defined benefit plans?

5. Is Social Security closer to a defined benefit plan or a defined contribution plan?

Think about This When you go into the voting booth, which type of politi- cian appeals to you: the optimistic sort that seeks to as- sure you that brighter days are ahead or the pessimistic sort that seeks to warn you of impending disaster? Are voters the source of the problem?

Talk about This Suppose nothing is done about state and local pension issues and state and local governments face a choice of either paying their retired teachers what they were promised in terms of pensions or paying current teach- ers enough to ensure an adequate education for children. (Suppose for the purpose of this discussion, you are con- vinced at the state level if you impose a tax increase, too many citizens will leave to go to another state, rendering the tax rate increase ineffective.)

Behind the Numbers Social Security and Medicare— www.ssa.gov/oact/TR/2010/tr2010.pdf State and local pensions— http://www.pewtrusts.org/en/projects/public-sector

-retirement-systems Novy-Marx, Robert, and Joshua Rauh, “Public Pension

Promises: How Big Are They and What Are They Worth?” Journal of Finance, 62, pp. 2123–2167.

Novy-Marx, Robert (University of Rochester and NBER), and Joshua Rauth (Kellogg School of Man- agement and NBER)—www.kellogg.northwestern .edu/faculty/rauh/research/nmrlocal20101011.pdf

gue46399_ch16_193-200.indd 200 16/03/17 12:43 PM

C H A P T E R S E V E N T E E N

201

International Trade: Does It Jeopardize American Jobs? Learning Objectives

After reading this chapter you should be able to:

LO1 Name the principal trading partners of the United States and the goods that are most often traded.

LO2 Illustrate how international trade benefits both trade partners.

LO3 Define the principles of absolute and comparative advantage and utilize these definitions to prove the benefits from trade.

LO4 Compare and evaluate the reasons given for limiting trade and illustrate the mechanisms for doing so.

LO5 Conclude that limiting trade protects some industries and jobs, but at a very high cost.

LO6 Enumerate attempts to use trade as a diplomatic weapon and evaluate the success of those attempts.

Chapter Outline

What We Trade and with Whom

The Benefits of International Trade

Trade Barriers

Trade as a Diplomatic Weapon

Kick It Up a Notch: Costs of Protectionism

Summary

One of the more important economic developments of the last 35 years is the increased globalization of our economy. Whereas the world used to be made up of more than 150 countries whose economies were mostly independent of one another, nearly all of the economies of the nations of the world now depend heavily on one another.

As you can see from Figure 17.1, exports make up approximately 14% of the U.S. economy while imports make up more than 17%. Though there was a significant decline in both as a consequence of the global recession in 2009, there has also been a general recovery in both. One thing that does appear to have happened is that both have stabilized after more than 30 years of consistent growth. The increasing importance of the international sector has led some to worry about whether this trend is a good one. Are American jobs being unfairly taken by

workers from other countries? If so, is this trend toward globalization avoidable?

We address these questions first by explaining why economists generally believe that international trade is good for both parties. Then we discuss the reasons for limiting international trade, distinguishing between rea- sons that economists embrace and those that they do not. Next we discuss the methods by which trade is limited. To wrap up, we consider whether trade can be used as a tool in political or diplomatic disagreements.

What We Trade and with Whom

Trade in the United States is not only growing; it is also encompassing a diverse area of goods and services, as seen in Table 17.1. We trade in the obvious goods and

gue46399_ch17_201-212.indd 201 16/03/17 12:44 PM

202 Chapter 17 International Trade: Does It Jeopardize American Jobs?

exporting others. Similarly, though we export and import computers, this also shows the degree to which many products are made all over the globe.

If you open up any computer, you will find compo- nents that were made in a variety of places. The memory comes from one country, the hard drive from another, and the CPU from still another. Your computer may have been assembled in the United States, but it was made

the not so obvious goods. We import TVs, computers, and other electronics, as well as cars and oil. We export industrial equipment and airplanes. You probably would have guessed this. We simultaneously export and import large quantities of automobiles, computers (electrical equipment), and services. While that may sound some- what odd, it is not as strange as it may sound. There are myriad types of cars, and we are importing some and

TABLE 17.1 U.S. exports and imports of goods and services.

Sources: International Trade Administration, www.trade.gov; TradeStats Express (TM), http://tse.export.gov

Exports Imports  

Transportation equipment 273.6 Computer and electronic products 365.8 Computer and electronic products 209.1 Oil & gas 263.2 Chemicals 200.2 Transportation equipment 355.7 Machinery, except electrical 152.6 Chemicals 205.7 Petroleum & coal products 116.9 Machinery, except electrical 160.8 Primary metal mfg. 64.0 Miscellaneous manufactured commodities 111.4 Miscellaneous manufactured commodities 81.9 Primary metal mfg. 101.2 Agricultural products 72.9 Petroleum & coal products 82.0 Food manufactures 70.7 Electrical equipment, appliances & components 99.8 Electrical equipment, appliances & components 60.6 Apparel manufacturing products 86.6 Special classification provisions, NESOI 43.8 Fabricated metal products, NESOI 66.2 Services 710.6 Services 447.4 Total 2343.2 Total 2851.5

FIGURE 17.1 Increasing importance of international trade.

Source: United States Census Bureau, www.census.gov/foreign-trade/statistics/index.html

20

0

2

4

6

8

10

12

14

16

18

Year

P e

rc e

n ta

g e

o f

G D

P

Exports/GDP Imports/GDP

19 60

19 64

19 68

19 72

19 76

19 80

19 84

19 88

19 92

19 96

20 00

20 04

20 08

20 12

gue46399_ch17_201-212.indd 202 16/03/17 12:44 PM

What We Trade and with Whom 203

from components that could have been produced in 10 other countries. You can see that it is difficult to decide where it was really made. In part this is one reason why the trade deficit we have with China is so high. China is the final assembly point for significant consumer elec- tronics, and it is the final assembly point that gets credit (in our trade data) for their export to us.

There is one good on the list of exports that also may intrigue you—“petroleum and coal products.” In this in- dustrial group is coal and the United States is a signifi- cant exporter of coal. It also includes refined products, so any oil imported to the United States as crude oil into the refineries around Houston, Texas, and is then sold in Mexico, would show up as an export of a petroleum product of the United States. Recent legislation has also allowed for the exportation of crude oil.

The final item in Table 17.1 that also might also seem out of place is the trade in services. It is hard to imagine that we would import babysitting and lawn-mowing ser- vices, but it is much more plausible in areas of financial services and, specifically, in insurance. An American insurance company can easily sell life insurance to Canadians, and vice versa. Services make up a large and

rapidly growing area of trade, and it is one area where the United States has a substantial trade surplus.

Table 17.2 may also surprise you in that few Americans realize how important Canada is as a U.S. trading partner. In trade it is roughly equal in importance to all of Europe. Figure 17.2 shows the degree to which these deficits continue to burgeon.

FIGURE 17.2 Trade balances with selected partners.

Source: United States Census Bureau, www.census.gov/foreign-trade

50

Tr ad

e b

al an

ce ($

b ill

io n

s)

19901985 1995 2000 Year

2004 2012 20152009

–100

–150

–200

–50

0

–350

–450

–300

–250

Canada

Mexico

Japan

China

Middle East

European Union

Africa

TABLE 17.2 U.S. exports, imports, and trade balances of goods with selected countries and regions of the world, 2015.

Source: United States Census Bureau, www.census.gov/foreign-trade

Country Exports ($ billions)

Imports ($ billions)

Balance ($ billions)

Canada 280.3 295.2 −14.9 Mexico 236.4 294.7 −58.4 Japan 62.5 131.1 −68.6 China 116.2 481.9 −365.7 OPEC 72.8 66.2 6.6 Europe 320.6 490.6 −170.0 Africa 26.9 25.4 1.5 World 1504.9 2241.1 −736.2

gue46399_ch17_201-212.indd 203 16/03/17 12:44 PM

204 Chapter 17 International Trade: Does It Jeopardize American Jobs?

their individual production of two goods. We will sup- pose that the two countries are the United States and Brazil and the two goods are apples and coffee.

In Table 17.3 we will suppose that the United States is better at producing apples than it is at producing coffee and Brazil is better at producing coffee than it is at producing apples. We will assume that a single unit of labor is capable of producing two units of coffee in Brazil but only one unit of apples. In the United States that situation is reversed. A unit of labor produces two units of apples but only one of coffee. Clearly, since a unit of labor in the United States can produce more apples than a unit of labor in Brazil, the United States has the absolute advantage in apples. Similarly, it is clear that Brazil has an absolute advantage in coffee.

To analyze comparative advantage we need to mea- sure what is given up when the two countries allocate a unit of labor. For instance, when Americans produce an additional unit of coffee, they are giving up two apples. When Brazilians produce an additional unit of coffee, they are giving up only one-half a unit of apples. Brazilians therefore have the lower opportunity cost of producing coffee. Similarly, when Americans produce an additional unit of apples they give up one-half a unit of coffee, and when Brazilians do so they give up two units of coffee. As a result Americans have a lower op- portunity cost for apples. What this means is that in addi- tion to having an absolute advantage in coffee, Brazilians also have a comparative advantage in coffee. Similarly, Americans have a comparative advantage as well as an absolute advantage in apples.

These advantages need not be in line. Consider Table  17.4, which shows where the Americans are as- sumed to have an absolute advantage in the production of both goods. A single unit of American labor can pro- duce more apples and more coffee than a single unit of Brazilian labor. As a result, Americans have an absolute advantage in the production of both goods. Comparative advantage is another story. The opportunity cost of an additional unit of coffee to Americans is two-thirds of a unit of apples. For Brazilians the opportunity cost of an additional unit of coffee is only half a unit of apples. Thus Brazilians have the lower opportunity cost of pro- ducing coffee and therefore have a comparative advan- tage in coffee. In apple production the Americans have an opportunity cost of one and a half units of coffee while the Brazilian opportunity cost is two units of coffee. Americans therefore have the lower opportunity cost of apples production and, as a result, the comparative ad- vantage in apples.

The Benefits of International Trade

Comparative and Absolute Advantage To illustrate the benefits of trade it is useful to distin- guish between two kinds of “advantages” that people can have. Consider a brain surgeon and her secretary. Suppose that the surgeon worked her way through school by typing papers and that she types faster than her cur- rent secretary. If she is better at both typing and surgery, would it be better for her to do both and fire her secre- tary? The answer is no; she will be better off having her slow-typing secretary do the typing. Making the decision relies on the notion of opportunity cost that we discussed in Chapter 1.

To review, opportunity cost is what you give up by mak- ing the choices that you do. In the case of the secretary and the surgeon, if the surgeon does her own typing, she must give up at least some of her lucrative surgeries. On the other

hand, if she delegates the typing, she will pay the secretary only a small fraction of the money she would earn doing extra surgeries. In this case she has an absolute advantage in both surgery and typing, because she is better at both things than the competition. Her secretary has a comparative advantage at typing because the secretary has a lower opportunity

cost of doing the typing than does the surgeon. As a simple example of how this applies to interna-

tional trade, consider Tables 17.3 and 17.4. We can il- lustrate comparative and absolute advantage and the benefits from trade for each of two countries by relating

absolute advantage The ability to produce a good better, faster, or more quickly than a competitor.

comparative advantage The ability to produce a good at a lower opportunity cost of the resources used.

TABLE 17.3 Production: Absolute and comparative advan- tage are the same.

Coffee Apples

United States 1 2 Brazil 2 1

TABLE 17.4 Production: Absolute and comparative advantage are not the same.

Coffee Apples

United States 3 2 Brazil 2 1

gue46399_ch17_201-212.indd 204 16/03/17 12:44 PM

The Benefits of International Trade 205

apples and produce 60 units. The Brazilians will ship 30 units of coffee to the United States in exchange for 30 units of apples, and in the end each will be able to consume 30 units of each and be better off with trade than without it.

Trade is also beneficial when one country has the absolute advantage in both goods. Turning back to Table  17.4 we can show that there are gains from trade here as well. Prior to trade the Brazilian situation is un- changed from the preceding example, but the American situation is such that 12 Americans are producing 36 units of coffee and 18 Americans are producing 36 units of apples. Again if both focus more on the good for which they have a comparative advantage, coffee for Brazilians and apples for Americans, and the terms of trade adjust appropriately, then the Americans will again ship apples to Brazil for coffee, and both will be better off.

Production Possibilities Frontier Analysis We can show the gains using our Chapter 1 production possibilities frontier as well. Recall that a production possibilities frontier shows the output combinations that a country can accomplish on its own. If we assume either of the scenarios presented above, then the production possibilities frontiers for the two countries, shown in Figure 17.3, would have different slopes. The Brazilian

Demonstrating the Gains from Trade In either case the gains from trade can be illustrated. Start- ing with the situation where the gains from trade are more obvious, look back at Table 17.3. If Americans focus their production on apples and Brazilians on coffee, then for every unit of labor that Americans move to apples and Brazilians move to coffee, there is a worldwide increase in total production of one unit of apples and one unit of coffee.

To see that each is better off with trade than without it, suppose there is a total of 30 units of labor in each country and each prefers apples and coffee in equal amounts. Before trade there will be 10 Americans pro- ducing 20  units of apples and 20 Americans producing 20 units of coffee. Similarly there will be 10 Brazilians

producing 20 units of coffee and 20 Brazilians producing 20 units of apples.

To see that trade makes both better off, we need to know how the terms of trade, the amount of one good required to get the other, between the two countries

will come out. If we suppose that it comes to one unit of apples for one unit of coffee, then we have our an- swer. The Brazilians will produce only coffee and make a total of 60 units, and the Americans will produce only

terms of trade The amount of a good one country must give up to obtain another good from the other country, usually ex- pressed as a ratio.

FIGURE 17.3 Increased consumption possibilities with trade.

Production possibilities frontier

United States

A p

p le

s

Co�ee

Production possibilities frontier

Brazil

A p

p le

s

Co�ee

A p

p le

s

Co�ee

Consumption possibilities frontier

gue46399_ch17_201-212.indd 205 16/03/17 12:44 PM

206 Chapter 17 International Trade: Does It Jeopardize American Jobs?

production possibilities frontier would be flatter and the United States’ steeper.

If we again assume the one-for-one terms of trade, per- fect specialization would improve the situation for both the Americans and the Brazilians, in that the Americans would now have to give up only one unit of coffee to get a unit of apples instead of the two they had to give up before. The Brazilians would benefit, too. They would have to give up only one unit of apples instead of two to get a unit of coffee.

This is specifically illustrated in the bottom panel of Figure 17.3, which uses the production possibili- ties frontier of both to create a new line that shows the consumption possibilities with trade. We saw in Chapter 1 that a production possibilities frontier farther away from the origin implies that more production is possible. You can see that the consumption possibilities with trade are greater for both the Brazilians and the Americans than their individual production possibilities without trade. When the Brazilians concentrate on coffee and the Americans concentrate on apples, and they trade, each country is better off. Each produces what it produces best and trades for what it does not produce particularly well.

Supply and Demand Analysis We can demonstrate the same general conclusion, that Americans are better off because of trade than without

it, using supply and demand. Using Figure 17.4, suppose there is a market for domestically produced coffee (from Hawaii perhaps). In a world without trade, the market price of coffee is Pdomestic and the amount that the domes- tic industry produces is Q’d. If there is trade and there is a lower world price of coffee, domestic producers re- duce the amount they produce to Q’s. The domestic pro- ducer surplus falls by PdomesticPworldCF. This shows up as lower profits in the domestic coffee business and losses to domestic coffee workers from having to look for other work. The consumer surplus to domestic coffee consum- ers rises by PdomesticPworldCE. In the end, the gain to con- sumers is larger than the loss to producers.

Whom Does Trade Harm? Even though we have seen that both countries are clearly better off than before, there still are people who would not necessarily like the development of trade. Specifically, American coffee makers and Brazilian apple growers would not necessarily find the idea of trade good. Inter- national trade would cause workers in these industries to lose their jobs because the competition would drive their employers out of business. This simple model assumes that the unemployed could find new work in the expand- ing industries in their respective countries or in other in- dustries generally. This assumption, however, while not

FIGURE 17.4 Gains from trade.

P P

A

B

Qs Qd Qd Q/t Q/t

Pdomestic

Pworld Pworld

S

C

EF

S

DD

Domestic market World market

gue46399_ch17_201-212.indd 206 16/03/17 12:44 PM

Trade Barriers 207

bad in the long run, ignores the pain of people losing their jobs and needing to attain new skills. In addition, these displaced workers are likely to get jobs at wages below those they were previously earning.

A relatively recent phenomenon is the development of outsourcing. The term is generally understood by econo- mists to narrowly apply to a firm’s use of foreign contrac- tors to perform services that were previously performed within the firm. So, if a computer peripheral company that used to have a technical support line in the United States now contracts to have this service provided by a foreign company, this would be outsourcing. The popular press often refers to anything that used to be done domestically that is now done off-shore as outsourcing. Economists refer to this as off-shoring. An example here would be a manufacturer, like Ford, that used to assemble all of its F-150 pickup truck line in the United States, moving a portion of that operation to Mexico. In either case, the same issue arises. Domestic workers are required to find new jobs.

It is important to note, though, that in a typical non- recession year 30 million of approximately 140 million jobs are eliminated and about 31 million new jobs are created. While some of the 30 million jobs that are eliminated are eliminated because companies engage in outsourcing or off-shoring, more jobs are created than are lost.

Trade Barriers

Reasons for Limiting Trade Because it is possible that with free trade some businesses go under and some workers lose their jobs, it is useful to summarize some of the questionable and some of the good reasons to limit trade. The questionable reasons begin with protecting jobs within the industries that are being affected by better or cheaper imports. The good rea- sons are as numerous as they are narrow. We may choose not to trade with other countries in certain goods because those goods may be important to our national security or national identity. Producing such goods at home is there- fore important in and of itself. We may choose not to trade with countries that gain their comparative advantage through lax worker safety rules, lax environmental laws, or because they allow businesses to employ child labor.

Though there are clearly short-run costs to free trade, when people lose their jobs to foreign competition and need retraining to get new ones, the long-term benefits usually outweigh these. When labor unions argue against

free trade, it is often because the industry that they rep- resent has lost its comparative advantage to other coun- tries. Though this comparative advantage is sometimes lost because of labor or environmental protections, it is usually because the other country has come up with a better or more cost-effective method of producing the good. Protecting an industry in such circumstances is not beneficial for two reasons:

1. For capitalism to work, not only must success be rewarded, but failure must be punished. If companies see that the government will prevent international competition, they will become lax, and they will not produce the best goods for the lowest prices.

2. If other countries see that we protect our firms from competition, they will certainly feel free to do the same. Instead of everyone benefiting from trade, we will return to the days before trade and lose consump- tion possibilities. We will lose our ability to export our goods to countries where our products are better and cheaper than domestic goods.

The preceding points notwithstanding, there are still good and legitimate reasons for limiting trade even when other countries produce better or cheaper goods. If, for instance, a country other than the United States produced the best and cheapest combat aircraft and it also happened to be a potential wartime enemy of the United States, the United States would be seriously mis- guided to shut down its own combat aircraft industry and buy planes from the other country. For national se- curity reasons, guaranteed access to war material is im- portant for countries.

Countries also limit trade for reasons that are similar to national defense. If a nation’s identity is tied to a particular commodity the way the Japanese identity is tied to rice, for example, it makes sense for the government to limit imports of the commodity so that its domestic producers can survive. Though there is enough productive capacity in the south-central United States to supply the entire rice consumption needs of Japan, and though the Japanese con- tinue to pay more than five times the world market price for rice to maintain a domestic industry, this economi- cally inefficient trade restriction can be justified on two grounds. First, Japan without a rice industry is not Japan; and second, in case of a naval war in the Pacific, it is hard to imagine the United States or any other country devot- ing significant naval resources to protect rice shipments to Japan. It is not a coincidence that as the Cold War waned, the Japanese began to allow at least limited rice imports.

gue46399_ch17_201-212.indd 207 16/03/17 12:44 PM

208 Chapter 17 International Trade: Does It Jeopardize American Jobs?

A final reason for limiting trade is that other countries may get their comparative advantage by using production processes that indirectly harm other countries or that other countries find offensive. If a country lowers its production costs, for example, by polluting in a way that would not be allowed in the United States, the United States might rea- sonably decide not to let that country sell its products here. This is especially true if the pollution ultimately causes health problems here. The United States might not want to allow the importation of chemicals and other environmen- tally onerous products from Mexico if, as a by-product of their manufacture, they pollute the Rio Grande.

In addition to environmental objections, countries may find certain labor practices so immoral that they do not allow importation of goods from countries that engage in them. For instance, it is against U.S. law to import any good made with slave labor or with prison labor. Additionally, the United States will not knowingly allow the importation of goods made with forced or in- dentured child labor, and the U.S. government requires that its contractors certify that no child labor was used in the production of its goods.1 Several countries allow children as young as eight to work in factories several hours a day. For example, if you own a soccer ball, it was probably made outside the United States, and the production involved at least one child who would not be allowed to work in the United States. The garment industry joins sporting goods in utilizing child labor and engaging in other labor practices that are not legal in the United States. Child labor has existed in nearly every country at some point, and its use is attributable al- most entirely to high rates of poverty. In addition, some economists argue that laws outlawing child labor are not necessarily good for the children involved if their only alternative is abject poverty. Despite this, many see the issue less in economic terms and more in moral ones.

Other reasons for limiting trade have appeal to only a limited number of economists. The first of these, the infant-industry argument, says that trade protection is required to give an industry in a country time to get on its feet. In theory, there may be an argument for tempo- rary shelter from competition, but in practice, it often happens that trade is permanently limited.

The second of these limited- appeal arguments is the anti- dumping argument. Dumping occurs when international

competitors charge less than their cost in order to drive out competition. The argument is that competitors do this to gain a monopoly in the long run. The problem with this argument is ascertaining the true mar- ginal cost of the international competitor. Inefficient domestic producers’ assertions of dumping often hinge on the notion that since they cannot produce at such low costs, it must be impossible. The crux of the dumping argument is the attempt at generating a monopoly, and there are few if any industries in which such a strategy has prevailed.

Methods of Limiting Trade Once a nation has decided to limit trade, it must choose a method. There are three main methods for limiting trade: A country can put a tax on imported goods, limit the quantity of a good that can be imported, or put regula- tions on goods that are imported to make it more difficult for the goods to be imported.

The most widely used method for limiting trade is the use of a tax on imports, called a tariff. Figure 17.5 shows that if a country wants to limit the amount of a good imported to Qlimit, a tax can be put on the good that is sufficient to move the supply curve to where it intersects the demand curve at that output. With such a tariff the price increases to Plimit, where domestic producers have a better chance of competing. In ad- dition, the government gets CPlimit AB in tax revenue

that it can use to retrain work- ers or to provide other sorts of compensation.

The second method of limit- ing trade, a quota, places a legal restriction on the quantity of a

dumping The exporting of goods below cost to drive com- petitors out of business.

FIGURE 17.5 The effect of tariffs and quotas.

Qlimit Q*

Plimit

P

P*

C

D

Q/t

F

A

B

E

S Sʹ

Tari�

1See Executive Order 99-06-12, Executive Order on Child Labor, www.fedworld.gov.

tariff A tax on imports.

quota A legal restriction on the amount of a good coming into the country.

gue46399_ch17_201-212.indd 208 16/03/17 12:44 PM

Trade as a Diplomatic Weapon 209

good coming into the country. Also shown in Figure 17.5, this method is popular in that it has the effect of rais- ing the price that domestic producers can charge to Plimit. The main difference between a quota and a tar- iff is that with a quota the government of the import- ing country receives no tax revenue. Importers get to raise their prices and they get to keep the extra money as profit. Even though it appears this method would seem to be much worse than a tariff for the importing country, quotas sometimes provide politi- cal advantages. Often it is less of a diplomatic prob- lem for a country to impose a quota on the imports of another country. Also, as has happened before in the automobile business, it is sometimes possible to  get an exporting country to agree to limit its exports vol- untarily. While this operates exactly like a quota, the exporting country retains the power to end the action rather than ceding that power to the importing coun- try. In the early 1980s Japan willingly limited exports of cars to the United States when congressional action was threatened.

The final method by which a country can limit the imports of another country utilizes a recognized right of a country to inspect goods coming in. If you do not want a particular good coming into the country, you can set up rules for its import that effectively make the importation too costly. This method is ef- fective, it is nearly impossible to get around, and it becomes apparent only when the rules become silly. The method is seen mostly with the importation of agricultural products. Although it is perfectly legiti- mate for a country to want to inspect a shipment to look for certain diseases, bugs, or parasites, countries will sometimes use such inspection as an excuse to limit imports. Because the goods themselves are usu- ally perishable, this can raise the cost to prohibitive levels and effectively prevent any attempts to break into a new market.

Many examples of these nontariff barriers exist. Some are perfectly logical; others are dubious. An

outbreak of mad cow disease began to affect English herds in 1999, resulting in a ban on English beef sold in Europe. A concern over the potential

of allergic reactions in genetically altered corn re- sulted in a similar European ban on Starlink corn. The European ban on milk from cows that had been given bovine growth hormone (BGH) and the Japa- nese ban on American apples in the 1980s appear to

be examples of the use of nontariff barriers for strictly protectionist reasons.

Trade as a Diplomatic Weapon

There are countless examples in the last 50 years of international trade being used to make a diplomatic point or to solve a diplomatic problem. Since the late 1950s, the United States has imposed trade sanctions against Cuba to destabilize Fidel Castro. In 1979, in response to Iran’s refusal to free American diplomats being held hostage in its embassy, the United States made it illegal to trade with Iran. In 1980, in response to the Soviet invasion of Afghanistan, the United States imposed a grain embargo, making it illegal to sell wheat to Russia. In the middle 1980s, in response to a series of terrorist acts by the Libyan government and its surrogates, the United States declared it illegal to buy Libyan oil. In the early 1990s, after Iraq invaded Kuwait, the United Nations imposed economic sanc- tions against Iraq in hopes that Iraq would retreat. Iraq did not retreat, the Gulf War was fought, and afterward, further economic sanctions were used in attempts to pressure Iraq into giving up its weapons of mass de- struction. This too failed.2 In 2012 and 2013, both Iran and North Korea were sanctioned by the United States and other allies for refusal to give up nuclear weapons. Neither budged.

Manipulating trade simply has not been particularly effective as a method of influencing diplomacy. Cas- tro has outlasted nine U.S. presidents; the Iranians did not buckle to such pressure; the Soviets, the Libyans, and the Iraqis followed their lead. The main reason that cutting off trade has not worked as a diplomatic tool is that it has been impossible to implement adequately. There have always been other avenues that the countries in question could use for trade. The Iranians had never sold much oil to the United States, and they found few problems selling their output to other countries. Argentinean and Australian farmers were only too happy to sell their grain to the Soviets, and the Libyans and the Iraqis had few problems breaking the sanctions imposed on them because many other countries felt free to break them. In theory, the limiting of trade appears to be a powerful diplomatic tool. In reality, it has not been very effective.

2Recently released interrogations of Saddam Hussein show that he failed to com- ply with these UN directives because Iraq had no such weapons after 1995, but that he wanted the Iranians to believe Iraq was stronger militarily than it was.

nontariff barriers Barriers to trade result- ing from regulatory actions.

gue46399_ch17_201-212.indd 209 16/03/17 12:44 PM

210 Chapter 17 International Trade: Does It Jeopardize American Jobs?

COSTS OF PROTECTIONISM

Reasons and mechanisms for limiting trade are available, but their use incurs substantial economic costs. We can examine those costs using Figure 17.5 and our consumer and producer surplus analysis from Chapter 3. Whatever the mechanism is for limiting trade, if the price of the imported good increases to Plimit and the quantity is re- duced to Qlimit, then there are winners and losers from the protectionist measures. The losers are consumers because their consumer surplus falls by P*Plimit AE. Do- mestic producers are winners because they get a higher price, and foreign producers are losers because their sales are limited. The net gain to producers from a quota, or alternatively the net gain to producers plus the tariff

revenue to the government, is CPlimit AB − BFE. In any event there is a net loss to society from the protectionist measures of ABE.

In practice this loss can be very substantial. Table 17.5 illustrates the net loss to the United States from trade protection in certain industries. It also demonstrates the net loss per job that the protectionist measures save. This table clearly shows the efficiency costs to American consumers from tariffs and quotas. We pay a few dollars more for many goods, but these figures add up to more than $32 billion to save 191,664 jobs. At $169,000 per job saved, trade protectionism is one of the worst jobs programs in place.

absolute advantage comparative advantage dumping

nontariff barriers quota

tariff terms of trade

Key Terms

Kick It Up a Notch

TABLE 17.5 Total cost of trade protectionism.

Source: Gary Hufbauer and Kimberly Elliott, Measuring the Costs of Protection in the United States. Washington, D.C.: Institute for International Economics, 1994.

Industry Total Cost to Consumers ($ millions) Jobs Saved

Cost per Job Saved ($)

Food and beverage $ 2,947 6,035 $ 488,000 Textiles and light industry 26,443 179,102 148,000 Chemical products 484 514 942,000 Machinery 542 1,556 348,000 Miscellaneous 1,895 4,457 425,000 Total 32,311 191,664 169,000

Summary You now understand that the United States trades in many goods and with many partners and that we have a mas- sive trade deficit, but that both we and our trading part- ners benefit from our international trade. You are now able to use the principles of absolute and comparative advantage as well as a production possibilities frontier to

demonstrate why that is the case. You know the reasons for limiting trade and alternative mechanisms for doing so and that limiting trade comes at a very high cost. Last, you now see that the use of trade as a diplomatic weapon has been largely a failure.

gue46399_ch17_201-212.indd 210 16/03/17 12:44 PM

Summary 211

Quiz Yourself 1. America’s most significant trading partner is

a. Saudi Arabia. b. Canada. c. China. d. Japan.

2. In 2015, which country had the largest trade surplus with the United States? a. Saudi Arabia b. Canada c. China d. Japan

3. Theoretically speaking, all trade is based on a. comparative advantage. b. absolute advantage. c. numerical advantage. d. political advantage.

4. The trends in U.S. international trade are such that a. imports are increasing and exports are decreasing. b. imports are decreasing and exports are

increasing. c. both imports and exports are decreasing. d. both imports and exports are increasing.

5. Using simple linear production possibilities fron- tiers in a simple two-good, two-country model, comparative advantage is evident when a. one country can make more of both goods than

the other. b. the slopes of the two production possibilities

frontiers are identical. c. the slopes of the two production possibilities

frontiers are different. d. one country is incapable of producing one good.

6. Using simple linear production possibilities fron- tiers in a simple two-good, two-country model, ab- solute advantage is evident when a. one country can make more of a good than the

other country can. b. the slopes of the two production possibilities

frontiers are identical. c. the slopes of the two production possibilities

frontiers are different. d. one country is incapable of producing one good.

7. Of the following justifications for limiting trade, which one would economists be least likely to endorse? Some goods should not be imported because a. they are important for national defense

(e.g., tanks, fighter airplanes).

b. they are important for national identity (e.g., television programs).

c. their production employs many people (e.g., cars).

d. other countries use child labor to gain a com- parative advantage (e.g., clothing).

8. When choosing to limit trade, a country can impose a tax on imported goods. This is called a. an estate tax. b. a tariff. c. a quota. d. a capital gains tax.

9. Economists are concerned about nontariff (regula- tory) barriers when they are used to prevent imports when a good a. is produced via questionable means (e.g., ban-

ning milk produced from cows injected with bovine growth hormone).

b. is produced via more efficient use of labor. c. may spread disease (e.g., banning beef from

countries that have experienced mad cow disease).

d. violates local standards for decency.

Short Answer Questions 1. Use the concept of comparative and absolute advan-

tage to illustrate why a fast-typing business execu- tive might dictate letters on a digital audio recorder for her secretary to type rather than type them herself.

2. List some reasons why the United States might im- port and export cars, airplanes, chemicals, and pe- troleum products.

3. Construct an argument against “energy indepen- dence” as a policy goal for the United States using the notion of comparative advantage.

4. Explain why a tariff on imported oil would be better than an import quota as a means by which to achieve energy independence.

Think about This Today’s transportation infrastructure makes international trade more efficient than intra-U.S. trade was 100 years ago. What this means is that it is easier today for a shirt made in China to get to California than it was for a shirt made in Georgia to make it to Missouri in 1900. The U.S. Constitu- tion has always banned states from regulating trade between states. This amounted to a within United States free-trade

gue46399_ch17_201-212.indd 211 20/03/17 12:29 PM

212 Chapter 17 International Trade: Does It Jeopardize American Jobs?

Journal of Economic Perspectives 9, no. 3 (Summer 1995). See articles by J. David Richardson and Adrian Wood, pp. 57–80.

Krugman, Paul R. “Is Free Trade Passe?” Journal of Economic Perspectives 1, no. 2 (Fall 1987), pp. 131–144. Any text with a title like International Economics.

Behind the Numbers Country comparisons—

www.census.gov/foreign-trade/balance/index.html Industry comparisons—

www.trade.gov

agreement. Can we use the experience of the United States between 1900 and 2000 to predict what would happen in world trade if there was free trade across the globe?

Talk about This Simple trade theory suggests that a country should not import and export the same good. It should either import the good or export the good, but not both. Reality is that intraindustry trade is common. What might explain this?

For More Insight See Journal of Economic Perspectives 12, no. 4 (Fall 1998). See

articles by Dani Rodrik; Maurice Obstfeld; and Robert C. Feenstra and Jeffrey G. Williamson, pp. 3–72.

gue46399_ch17_201-212.indd 212 16/03/17 12:44 PM

C H A P T E R E I G H T E E N

213

International Finance and Exchange Rates Learning Objectives

After reading this chapter you should be able to:

LO1 Describe the importance of international financial transactions in the global economy.

LO2 Discuss how foreign exchange markets work to facilitate trade.

LO3 List the determinants of foreign exchange rates.

LO4 Analyze how alternative foreign exchange systems operate.

Chapter Outline

International Financial Transactions

Foreign Exchange Markets

Alternative Foreign Exchange Systems

Determinants of Exchange Rates

Summary

If you have studied the chapter “International Trade: Does It Jeopardize American Jobs?,” you know that globalization is one of the central historical facts of the late 20th and early 21st centuries. In the United States alone, as a percentage of GDP, exports have more than doubled and imports have more than tripled. Since 1970, U.S. investment abroad as a percentage of GDP has increased 10-fold and foreign investment in the United States as a percentage of GDP has increased 15-fold. What the previous two sentences imply is that a massive accumulation of trade deficits has resulted in the transition of the United States from the world’s largest creditor nation to the world’s largest debtor na- tion. In addition to discussing the financial implica- tions of increasing trade, increasing American trade deficits, and increasing globalization, this chapter dis- cusses the exchange of the world’s currencies.

International Financial Transactions

In order for international trade to occur, international cur- rencies have to be transacted to allow for that trade. There is almost no barter left in the world. Because of that, there

is no guarantee that the value of what is imported will equal the value of what is exported. There is also no guar- antee that the amount of money Americans invest abroad will equal the amount of money others invest in America. To understand international finance, you have to begin with three basic accounting concepts: balance of trade, current account balances, and capital account balances.

When Americans buy iPads, though the iPad is made by an American-owned company, Apple, it is assembled in China, with components manufactured in several coun- tries. We will wait to talk about currency exchanges until the next section, but we know that the Chinese company needs yuan, the currency of China, in order to pay its employees. Ignoring that detail for the moment, suppose that there is American currency, say $100,000,000, that has left the United States. Whoever ends up with that $100,000,000 can buy things that are made in the United States: They can buy financial assets, like U.S. govern- ment debt; they can buy physical assets that remain in the United States, like land, buildings, or manufacturing fa- cilities; or they can simply hold on to the cash. This latter option is rarely chosen unless the holder lives in a country where the dollar is a better form of money than the home currency, or the holder is engaged in an internationally

gue46399_ch18_213-221.indd 213 16/03/17 11:55 AM

214 Chapter 18 International Finance and Exchange Rates

illegal activity where holding cash makes them less trace- able. In short, that $100,000,000 has to return to the United States somehow. The “how” is the key question.

Table 18.1 lays out the balance of payments, the accounting system for how money moves between countries to facilitate the purchase of goods, ser- vices, financial instruments, and physical investments. What “balances” with the balance of payments is the current ac- count and the capital account. The current account represents the impacts of trade, short- term investment payments, and American payments of foreign taxes, foreign payments of American taxes, and the net transfer of private money. This latter item is most often seen when migrant workers send

money home to their families who live outside the United States. As you can see, mostly because of the enormous trade deficit, there is a massive current ac- count deficit of $470 billion.

Over time the current account and the balance of trade mirror one another quite closely. Figure 18.1 maps both as a percentage of GDP from 1960 to 2010. For all but one of the last 33 years, the balance of each has

been negative. The exploding trade deficits of the 1990s and the 2000s can be seen as trade and current account deficits that had reached previous records in the middle 1980s and grew to in excess of 5 percent of GDP from

2003 to 2008. Both of these def- icits fell rapidly during the re- cession as Americans cut import demand signficantly.

The capital account repre- sents the changes in holding of longer-term financial and

balance of payments The accounting system for how money moves between countries to facilitate the purchase of goods, services, financial instruments, and physical investments.

current account The portion of the balance of payments ac- counting that represents the impacts of trade, short-term investment payments, and American payments of foreign taxes, foreign payments of American taxes, and the net transfer of private money.

Major Accounting Item Sub Accounting Item Sub Accounting Component Component Amount

Sub Accounting Balance Balance

Current Account Balance of trade Exports 3,306,574 −389,526 −277,636

Imports 3,696,100

Balance of short-term investment income

Income to the United States 816,445 231,076

Payments from the United States

585,369

Net Transfers (taxes, private payments) −119,186

Capital Account Change in the ownership of assets

U.S.-owned assets abroad 792,145 185,276 277,636

Foreign-owned assets in the United States

977,421

Financial derivatives net −54,372

Statistical discrepancy & net derivatives 146,732

TABLE 18.1 Balance of payments, United States, 2012 ($ millions).

Source: Bureau of Economic Analysis, www.bea.gov/international

2.00

0.00

–2.00 –1.00

1.00

–6.00 –5.00 –4.00 –3.00

–7.00

P e

rc e

n ta

g e

o f

G D

P (%

)

Current account (surplus/deficit)/GDP

Balance of trade/GDP

19 60

19 84

19 75 19

78 1 9

8 1 19

72 19

69 19

66 19

63 19

87 19

90 19

93 19

96 19

99 20

08 2 0

1 1 20

14 20

05 20

02

FIGURE 18.1 Current Account and Balance of Trade as a Percentage of GDP (1960–2014).

Source: Bureau of Economic Analysis, www.bea.gov/international

capital account Represents the changes in holding of longer- term financial and physical assets by citizens of one country in another country.

gue46399_ch18_213-221.indd 214 16/03/17 11:55 AM

Foreign Exchange Markets 215

so at a local store, the $500 goes several places. The first place it goes is to the store owner, who uses some of it to pay employees and other business expenses, and some to pay Apple. The rest is profit. Apple Inc. contracted with a company in China (Foxconn) to assemble the iPad from parts made all over the world and here is where the issue of foreign exchange comes up. Those in China want to be paid in their own currency called the yuan (to say “yuan,” say “u-wan,” which is also known by its other name, the “renminbi”).

Let’s look at this U.S. dollar-for-yuan exchange. Figure 18.3 looks like any ordinary supply and demand diagram except that the labels are more confusing. The confusion stems from the fact that in a typical market you are exchanging a form of currency for a good or a service. Here you are exchanging a form of currency for another form of currency. In this particular case the demand for yuan is also the supply of U.S. dollars, and the demand for U.S. dollars is really the supply of yuan. The price is confusing. Typically the price is quoted in terms of dollars per unit of the good. Here it is U.S. dollars per unit of yuan. It could just as easily be yuan per unit of U.S. dollars. For this reason we have renamed the curves using somewhat roundabout language.

The vertical axis of Figure 18.3 is labeled “Yuan to U.S. dollar” because it is the number of U.S. dollars that must be given up to get a quantity of yuan. The horizontal axis is the amount in yuan exchanged. What would normally be called a demand curve is the “curve that represents the willingness of those who have U.S. dollars to trade them for yuan.” It is downward sloping because people would be less willing to trade their U.S.

physical assets by citizens of one country in another country. The most significant elements of this are the amount of foreign investment in the United States and the amount of investment by Americans in other coun- tries. Recall that when iPads are sold, the holders of dol- lars have to do something with the money. For the most part, they buy U.S. financial and physical assets. The balance of the capital account, plus or minus a statistical discrepancy, is the opposite of the balance of the current account.

As can be seen in Figure 18.2, the globalization of asset holding has grown markedly. From less than a percentage point of GDP for much of the 1960s to 10 to 15 times those levels today, the international ownership of finan- cial and physical assets is quite clearly a sign of the times. Figures 18.1 and 18.2 are directly related in that the level of the current account deficit line in Figure 18.1 is the difference between the two lines in Figure 18.2.

The other feature of Figure 18.2 that is worth noting is that though the economy recovered from the Great Recession, the financial turmoil it caused continues to be reflected in these international transactions with ex- traordinary fluctuations in the annual changes in invest- ment positions.

Foreign Exchange Markets

To understand the importance and the complexity of dealing with foreign exchange, consider the simple act of buying a low-end iPad. When you plunk down $500 or

18.00

14.00

10.00 12.00

16.00

2.00 4.00 6.00 8.00

–4.00 –2.00

0.00

A n

n u

al in

ve st

m e

n t

as a

% o

f G

D P

U.S.-owned assets abroad Foreign-owned assets in the United States

19 60

19 84

19 75

19 78

19 81

19 72

19 69

19 66

19 63

19 87

19 90

19 93

19 96

19 99

20 08 20

11 20

14 20

05 20

02

FIGURE 18.2 Foreign purchases of U.S. assets and U.S. pur- chases of foreign assets as a percentage of GDP (1960–2014).

Source: Bureau of Economic Analysis, www.bea.gov/international

A curve that represents the willingness of those who have U.S. dollars to trade them for yuan

A curve that represents the willingness of those who have yuan to trade them for U.S. dollars

Equilibrium exchange rate

Quantity of yuan

Price of yuan in U.S. dollars

FIGURE 18.3 Yuan to U.S. dollar.

gue46399_ch18_213-221.indd 215 16/03/17 11:55 AM

216 Chapter 18 International Finance and Exchange Rates

dollars for yuan if they had to give up more U.S. dollars to do it. What would normally be called a supply curve is the “curve that represents the willingness of those who have yuan to trade them for U.S. dollars.” It is upward sloping because people would be more willing to trade their yuan for U.S. dollars if they could get more dollars from them.

Going back to our iPad example, this simple pur- chase involves a number of different currencies that must be exchanged because the components are pro- duced throughout Asia. If currency exchange is as easy as going to the bank with a $20 bill and asking for 20 $1

bills, then foreign exchange is not an obstacle to trade. In most of the Western world, it is a relatively simple proposi- tion for a corporation to get the

currencies it needs. There are foreign exchange markets in all large cities that have stock markets. If you need a special permit to exchange currency, however, the transaction is far more cumbersome. Moreover, if that special permit is given only to those who support the ruling party, the ease of trading ranges from difficult to nearly impossible. Who gets hurt by such obstacles to trade? Lots of people. With too many barriers your iPad either will not be manufactured or will cost much more. You will be forced to choose to pay more or to do without it. The store owner will lose profit and the store salesperson will lose commissions. The distribu- tor, Apple, and the Chinese worker will be hurt too; one will not make a sale; the other will not have a job.

In most places in the world, exchange rates are like any freely traded asset. The price, or in this case the exchange rate, changes over time. A look at Figure 18.4

foreign exchange The conversion of the currency of one coun- try for the currency of another.

1.70

U.S. dollar per euro

U.S. dollar per British pound

Japanese yen per U.S. dollar

Chinese Yuan per U.S. dollar

140

130

120

110

100

90

80

70

Ye n

/D o

lla r

Y u

an /D

o lla

r

D o

lla rs

/E u

ro D

o lla

rs /B

ri tis

h P

o u

n d

8.50

8.00

7.50

7.00

6.50

6.00

1.60 1.50 1.40 1.30 1.20 1.10

1.00 0.90 0.80

1.00

1.20

1.40

1.60

1.80

2.00

2.20

1/3 /2

00 0

1/3 /2

00 1

1/3 /2

00 2

1/3 /2

00 3

1/3 /2

00 4

1/3 /2

00 5

1/3 /2

00 6

1/3 /2

00 7

1/3 /2

00 8

1/3 /2

00 9

1/3 /2

01 0

1/ 3/

20 11

1/3 /2

01 2

1/3 /2

01 3

1/3 /2

01 4

1/3 /2

01 5

1/3 /2

01 6

1/3 /2

00 0

1/3 /2

00 1

1/3 /2

00 2

1/3 /2

00 3

1/3 /2

00 4

1/3 /2

00 5

1/3 /2

00 6

1/3 /2

00 7

1/3 /2

00 8

1/3 /2

00 9

1/3 /2

01 0

1/3 /2

01 1

1/3 /2

01 2

1/3 /2

01 3

1/3 /2

01 4

1/3 /2

01 5

1/3 /2

01 6

1/3 /2

00 0

1/3 /2

00 1

1/3 /2

00 2

1/3 /2

00 3

1/3 /2

00 4

1/3 /2

00 5

1/3 /2

00 6

1/3 /2

00 7

1/3 /2

00 8

1/3 /2

00 9

1/3 /2

01 0

1/3 /2

01 1

1/3 /2

01 2

1/3 /2

01 3

1/3 /2

01 4

1/3 /2

01 5

1/3 /2

01 6

1/3 /2

00 0

1/3 /2

00 1

1/3 /2

00 2

1/3 /2

00 3

1/3 /2

00 4

1/3 /2

00 5

1/3 /2

00 6

1/3 /2

00 7

1/3 /2

00 8

1/3 /2

00 9

1/3 /2

01 0

1/ 3/

20 11

1/3 /2

01 2

1/3 /2

01 3

1/3 /2

01 4

1/3 /2

01 5

1/3 /2

01 6

FIGURE 18.4 Exchange rates between the dollar and four major currencies.

Source: Board of Governors of the Federal Reserve System, www.federalreserve.gov/releases/h10/hist

gue46399_ch18_213-221.indd 216 16/03/17 11:55 AM

Alternative Foreign Exchange Systems 217

shows the exchange rate between the dollar and other key currencies around the world. As the previous sec- tion suggested, any exchange rate between any two currencies can be expressed either as the amount of country A’s currency you need to buy one unit of coun- try B’s currency, or vice versa. They are commonly expressed in both ways, as they are in Table 18.2, but there are times when a conventional method of expres- sion dominates. For instance, the yen–dollar exchange rate is almost always expressed in terms of the number of yen it takes to get a dollar, whereas the dollar–pound exchange rate is typically expressed the other way. There is no functional difference, as one is always the reciprocal of the other.

A strengthening of the dollar relative to the currency in each graph is shown as a decrease in the dollar per other currency line and an increase in the other currency per dollar line. So between July 2008 and November 2008 the dollar strengthened relative to the euro and pound and weakened relative to the yen.

It is important to note that the Chinese government does not let its currency move at the whim of market forces. It was not until 2005 that the Chinese let their currency move, and even then it was only slowly, and not nearly as fast as free market forces would have had it move.

In 2010 China began a slow process of letting the yuan float with other currencies in a managed way. In 2015 and early 2016, the yuan actually began decreasing in value as the slowdown in the Chinese manufacturing economy began to impact exchange rates.

Alternative Foreign Exchange Systems

Throughout modern history, currencies have been ex- changed in order to facilitate trade. During that time there have been three models for setting those exchange rates. As suggested by Figure 18.4, most exchange rates are determined by market forces. An increase in the de- mand for a currency will strengthen it relative to another currency. While this is the system that dominates today, it has not always been that way and as intimated above with reference to the Chinese yuan, market forces can be controlled by governments.

Though we have already dis- cussed the market, let’s quickly review the role of the market in determining exchange rates. In a floating exchange rate system, there is no government control

floating exchange rate system Foreign exchange rate system where there is no government control over exchange rates.

TABLE 18.2 Exchange rates between several currencies and the U.S. dollar, February 3, 2016.

Source: http://www.x-rates.com/table/?from=USD&amount=1

Foreign Currency

Amount of Currency Needed to Get $1

Amount of U.S. Dollars Needed to Get One Unit of the Currency

Argentine Peso 14.145009 0.070696 Australian Dollar 1.396831 0.715906 Bahraini Dinar 0.377095 2.651852 Botswana Pula 11.482067 0.087092 Brazilian Real 3.894941 0.256743 British Pound 0.685333 1.459145 Bruneian Dollar 1.414138 0.707144 Bulgarian Lev 1.76236 0.567421 Canadian Dollar 1.378635 0.725355 Chilean Peso 704.795996 0.001419 Chinese Yuan Renminbi 6.575946 0.152069 Colombian Peso 3373.5 0.000296 Croatian Kuna 6.91826 0.144545 Czech Koruna 24.383567 0.041011 Danish Krone 6.734442 0.14849 Emirati Dirham 3.673 0.272257 Euro 0.902379 1.108182 Hong Kong Dollar 7.794381 0.128298 Hungarian Forint 281.001131 0.003559 Icelandic Krona 129.49 0.007723 Indian Rupee 67.828047 0.014743 Indonesian Rupiah 13735.33119 0.000073 Iranian Rial 29950 0.000033 Israeli Shekel 3.938317 0.253916 Japanese Yen 118.041073 0.008472 Kazakhstani Tenge 370 0.002703 Kuwaiti Dinar 0.30165 3.3151 Latvian Lat 0.634192 1.57681 Libyan Dinar 1.36 0.735294 Lithuanian Litas 3.115733 0.320952 Malaysian Ringgit 4.174 0.239578 Mauritian Rupee 36.055 0.027735 Mexican Peso 18.169871 0.055036 Nepalese Rupee 108.991944 0.009175 New Zealand Dollar 1.502725 0.665458 Norwegian Krone 8.57476 0.116621 Omani Rial 0.3845 2.60078 Pakistani Rupee 104.85 0.009537 Philippine Peso 47.875 0.020888 Polish Zloty 3.989091 0.250684 Qatari Riyal 3.6409 0.274657 Romanian New Leu 4.07219 0.245568 Russian Ruble 76.709769 0.013036 Saudi Arabian Riyal 3.74962 0.266694

(Continued )

gue46399_ch18_213-221.indd 217 16/03/17 11:55 AM