INTERMED MACROECON THEORY

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Macroeconomics, seventh edition is organized around two central parts: A core and a set of two major extensions. The text’s flexible organization emphasizes an integrated view of macroeconomics, while enabling professors to focus on the theories, models, and applications that they deem central to their particular course.

The flowchart below quickly illustrates how the chapters are organized and fit within the book’s overall structure. For a more detailed explanation of the Organization, and for an extensive list of Alternative Course Outlines, see pages xiv–xv in the preface.

Flexible Organization

The Short Run The Goods Market Chapter 3 Financial Markets I Chapter 4

Goods and Financial Markets: The IS-LM Model Financial Markets II: The Extended IS-LM Model Chapter 6

Chapter 5

The Medium Run The Labor Market Chapter 7

The Phillips Curve, the Natural Rate of Unemployment, and Inflation Chapter 8

From the Short to the Medium Run: The IS-LM PC Model Chapter 9

The Long Run The Facts of Growth Chapter 10

Saving, Capital Accumulation, and Output Chapter 11 Technological Progress and Growth Chapter 12

Technological Progress: The Short, the Medium, and the Long Run Chapter 13

THE CORE

INTRODUCTION A Tour of the World Chapter 1 A Tour of the Book Chapter 2

EXTENSIONS

BACK TO POLICY Should Policy Makers Be Restrained? Chapter 21

Fiscal Policy: A Summing Up Chapter 22 Monetary Policy: A Summing Up Chapter 23

EPILOGUE The Story of Macroeconomics Chapter 24

EXPECTATIONS Financial Markets and Expectations Chapter 14

Expectations, Consumption, and Investment Chapter 15 Expectations, Output, and Policy Chapter 16

THE OPEN ECONOMY Openness in Goods and Financial Markets Chapter 17

The Goods Market in an Open Economy Chapter 18 Output, the Interest Rate, and the Exchange Rate Chapter 19

Exchange Rate Regimes Chapter 20

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Olivier Blanchard

MacroeconoMics Seventh Edition

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Library of Congress Cataloging-in-Publication Data

Names: Blanchard, Olivier (Olivier J.), author.|Johnson, David R., Title: Macroeconomics/Olivier Blanchard, International Monetary Fund, Massachusetts Institute of Technology, David R. Johnson, Wilfrid Laurier University. Description: Seventh edition.|Boston: Pearson, [2017] Identifiers: LCCN 2016001144|ISBN 9780133780581 (casebound) Subjects: LCSH: Macroeconomics. Classification: LCC HB172.5 .B573 2017|DDC 339—dc23 LC record available at http://lccn.loc.gov/2016001144

To Noelle

A citizen of France, Olivier Blanchard has spent most of his professional life in Cambridge, U.S.A. After obtaining his Ph.D. in economics at the Massachusetts Institute of Technology in 1977, he taught at Harvard University, returning to MIT in 1982.  He was chair of the economics department from 1998 to 2003. In 2008, he took a leave of absence to be the Economic Counsellor and Director of the Research Department of the International Monetary Fund. Since October 2015, he is the Fred Bergsten Senior Fellow at the Peterson Institute for International Economics, in Washington. He also remains Robert M. Solow Professor of Economics emeritus at MIT.

He has worked on a wide set of macroeconomic issues, from the role of monetary policy, to the nature of speculative bubbles, to the nature of the labor market and the determinants of unemployment, to transition in former communist countries, and to forces behind the recent global crisis. In the process, he has worked with numerous countries and international or- ganizations. He is the author of many books and articles, including a graduate level textbook with Stanley Fischer.

He is a past editor of the Quarterly Journal of Economics, of the NBER Macroeconom- ics Annual, and founding editor of the AEJ Macroeconomics. He is a fellow and past council member of the Econometric Society, a past vice president of the American Economic Associa- tion, and a member of the American Academy of Sciences.

About the Authors

iv

The Core

Introduction 1 Chapter 1 A Tour of the World 3 Chapter 2 A Tour of the Book 21

The Short Run 45 Chapter 3 The Goods Market 47 Chapter 4 Financial Markets I 67 Chapter 5 Goods and Financial Markets;

The IS-LM Model 89 Chapter 6 Financial Markets II: The Extended

IS-LM Model 111

The Medium Run 135 Chapter 7 The Labor Market 137 Chapter 8 The Phillips Curve, the Natural Rate

of Unemployment, and Inflation 157

Chapter 9 From the Short to the Medium Run: The IS-LM-PC Model 177

The Long Run 197 Chapter 10 The Facts of Growth 199 Chapter 11 Saving, Capital Accumulation,

and Output 217 Chapter 12 Technological Progress and

Growth 241 Chapter 13 Technological Progress:

The Short, the Medium, and the Long Run 263

exTensions

Expectations 283 Chapter 14 Financial Markets and

Expectations 285 Chapter 15 Expectations, Consumption, and

Investment 311 Chapter 16 Expectations, Output, and

Policy 331

The Open Economy 347 Chapter 17 Openness in Goods and Financial

Markets 349 Chapter 18 The Goods Market in an Open

Economy 369 Chapter 19 Output, the Interest Rate, and

the Exchange Rate 391 Chapter 20 Exchange Rate Regimes 411

Back to Policy 433 Chapter 21 Should Policy Makers Be

Restrained? 435 Chapter 22 Fiscal Policy:

A Summing Up 453 Chapter 23 Monetary Policy:

A Summing Up 477 Chapter 24 Epilogue: The Story

of Macroeconomics 497

Brief Contents

v

vi

Preface xiii

The Core

Introduction 1 Chapter 1 A Tour of the World 3

1-1 The Crisis 4

1-2 The United States 6 Low Interest Rates and the Zero Lower Bound  7  •  How Worrisome Is Low  Productivity Growth? 8

1-3 The Euro Area 9 Can European Unemployment Be   Reduced?  11  •  What Has the Euro  Done for Its Members?  12

1-4 China 13 1-5 Looking Ahead 15 Appendix: Where to Find the Numbers 18

Chapter 2 A Tour of the Book 21 2-1 Aggregate Output 22

GDP: Production and Income  22  •  Nominal and Real GDP  24  •  GDP: Level versus Growth Rate  26

2-2 The Unemployment Rate 27 Why Do Economists Care about  Unemployment?  29

2-3 The Inflation Rate 31 The GDP Deflator  31  •  The Consumer  Price Index  31  •  Why Do Economists  Care about Inflation? 33

2-4 Output, Unemployment, and the Inflation Rate: Okun’s Law and the Phillips Curve 33 Okun’s Law  34  •  The Phillips Curve  34

2-5 The Short Run, the Medium Run, and the Long Run 35

2-6 A Tour of the Book 36 The Core  36  •  Extensions  37  •  Back  to Policy  38  •  Epilogue  38

Appendix: The Construction of Real GDP and Chain-Type Indexes 42

The Short Run 45 Chapter 3 The Goods Market 47

3-1 The Composition of GDP 48

3-2 The Demand for Goods 50 Consumption (C)  50  •  Investment  ( I )  52  •  Government Spending (G)  52

3-3 The Determination of Equilibrium Output 53 Using Algebra  54  •  Using a  Graph  55  •  Using Words  57  •  How Long Does It Take for Output  to Adjust? 58

3-4 Investment Equals Saving: An Alternative Way of Thinking about Goods-Market Equilibrium 60

3-5 Is the Government Omnipotent? A Warning 62

Chapter 4 Financial Markets I 67 4-1 The Demand for Money 68

Deriving the Demand for Money  69

4-2 Determining the Interest Rate: I 71 Money Demand, Money Supply, and  the Equilibrium Interest Rate  71  •  Monetary Policy and Open Market  Operations  74  •  Choosing Money or  Choosing the Interest Rate?  76

4-3 Determining the Interest Rate: II 76 What Banks Do  76  •  The  Demand  and Supply for Central Bank   Money  78  •  The Federal Funds Market  and the Federal Funds Rate  79

4-4 The Liquidity Trap 80 Appendix: The Determination of the Interest Rate When People Hold Both Currency and Checkable Deposits 85

Chapter 5 Goods and Financial Markets; The IS-LM Model 89 5-1 The Goods Market and the

IS Relation 90

Contents

Contents vii

Investment, Sales, and the  Interest  Rate  90  •  Determining Output  91  •  Deriving the IS Curve  93  •  Shifts of  the IS Curve  93

5-2 Financial Markets and the LM Relation 94 Real Money, Real Income, and the   Interest Rate  94  •  Deriving the LM Curve  95

5-3 Putting the IS and the LM Relations Together 96 Fiscal Policy  96  •  Monetary Policy  98

5-4 Using a Policy Mix 99 5-5 How Does the IS-LM Model Fit the

Facts? 104

Chapter 6 Financial Markets II: The Extended IS-LM Model 111 6-1 Nominal versus Real Interest

Rates 112 Nominal and Real Interest Rates in the  United States since 1978  114  •  Nominal  and Real Interest Rates: The Zero Lower  Bound and Deflation 115

6-2 Risk and Risk Premia 116 6-3 The Role of Financial

Intermediaries 117 The Choice of Leverage  118  •  Leverage  and Lending  119

6-4 Extending the IS-LM 121 Financial Shocks and Policies  122

6-5 From a Housing Problem to a Financial Crisis 123 Housing Prices and Subprime   Mortgages  123  •  The Role of   Financial Intermediaries  125  •  Macroeconomic Implications  127  •  Policy  Responses  127

The Medium Run 135 Chapter 7 The Labor Market 137

7-1 A Tour of the Labor Market 138 The Large Flows of Workers  138

7-2 Movements in Unemployment 141 7-3 Wage Determination 143

Bargaining  144  •  Efficiency Wages  144  •  Wages, Prices, and Unemployment  146  •  The Expected Price Level  146  •  The Unemployment Rate  146  •  The Other Factors  147

7-4 Price Determination 147

7-5 The Natural Rate of Unemployment 148 The Wage-Setting Relation  148  •  The  Price-Setting Relation  149  •  Equilibrium  Real Wages and Unemployment  150

7-6 Where We Go from Here 151

Appendix: Wage- and Price-Setting Relations versus Labor Supply and Labor Demand 155

Chapter 8 The Phillips Curve, the Natural Rate of Unemployment, and Inflation 157 8-1 Inflation, Expected Inflation,

and Unemployment 158

8-2 The Phillips Curve and Its Mutations 160 The Early Incarnation  160  •  The   Apparent Trade-Off and Its   Disappearance  160

8-3 The Phillips Curve and the Natural Rate of Unemployment 163

8-4 A Summary and Many Warnings 165 Variations in the Natural Rate across  Countries  166  •  Variations in the  Natural Rate over Time  166  •  High  Inflation and the Phillips Curve  Relation  168  •  Deflation and the  Phillips Curve Relation  170

Appendix: Derivation of the Relation to a Relation between Inflation, Expected Inflation, and Unemployment 175

Chapter 9 From the Short to the Medium Run: The IS-LM-PC Model 177 9-1 The IS-LM-PC model 178 9-2 Dynamics and the Medium Run

Equilibrium 181 The Role of Expectations   Revisited  183  •  The Zero Lower Bound  and Debt Spirals  183

9-3 Fiscal Consolidation Revisited 186 9-4 The Effects of an Increase in the

Price of Oil 187 Effects on the Natural Rate of   Unemployment  189

9-5 Conclusions 192 The Short Run versus the Medium  Run  192  •  Shocks and Propagation  Mechanisms  192

viii Contents

The Long Run 197 Chapter 10 The Facts of Growth 199

10-1 Measuring the Standard of Living 200

10-2 Growth in Rich Countries since 1950 203 The Large Increase in the Standard  of Living since 1950  205  •  The   Convergence of Output per Person  206

10-3 A Broader Look across Time and Space 207 Looking across Two Millennia  207  •  Looking across Countries  207

10-4 Thinking about Growth: A Primer 209 The Aggregate Production Function  210  •  Returns to Scale and Returns to  Factors  210  •  Output per Worker and  Capital per Worker  211  •  The Sources  of Growth  211

Chapter 11 Saving, Capital Accumulation, and Output 217 11-1 Interactions between Output and

Capital 218 The Effects of Capital on Output  218  •  The Effects of Output on Capital  Accumulation  219  •  Output and  Investment  219  •  Investment  and Capital Accumulation  220

11-2 The Implications of Alternative Saving Rates 221 Dynamics of Capital and Output  221  •  The Saving Rate and Output  223  •  The Saving Rate and Consumption  227

11-3 Getting a Sense of Magnitudes 228 The Effects of the Saving Rate on  Steady-State Output  230  •  The  Dynamic Effects of an Increase in the  Saving Rate  231  •  The U.S. Saving  Rate and the Golden Rule  233

11-4 Physical versus Human Capital 234 Extending the Production Function  234  •  Human Capital, Physical Capital,  and Output  235  •  Endogenous  Growth  236

Appendix: The Cobb-Douglas Production Function and the Steady State 239

Chapter 12 Technological Progress and Growth 241 12-1 Technological Progress and the Rate

of Growth 242 Technological Progress and  the Production Function  242 

•  Interactions between Output and  Capital  244  •  Dynamics of Capital and  Output  246  •  The Effects of the Saving  Rate  247

12-2 The Determinants of Technological Progress 248 The Fertility of the Research  Process  249  •  The Appropriability  of Research Results  250  •  Management, Innovation,  and  Imitation  252

12-3 Institutions, Technological Progress, and Growth 252

12-4 The Facts of Growth Revisited 256 Capital Accumulation versus  Technological Progress in Rich  Countries since 1985  256  •  Capital  Accumulation versus Technological  Progress in China  257

Appendix: Constructing a Measure of Technological Progress 261

Chapter 13 Technological Progress: The Short, the Medium, and the Long Run 263 13-1 Productivity, Output, and

Unemployment in the Short Run 264 The Empirical Evidence  266

13-2 Productivity and the Natural Rate of Unemployment 267 Price Setting and Wage Setting  Revisited  267  •  The Natural Rate of  Unemployment  268  •  The Empirical  Evidence  269

13-3 Technological Progress, Churning, and Inequality 271 The Increase in Wage Inequality  272  •  The Causes of Increased Wage  Inequality  274  •  Inequality and the  Top 1%  277

exTensions

Expectations 283 Chapter 14 Financial Markets and

Expectations 285 14-1 Expected Present Discounted

Values 286 Computing Expected Present Discounted  Values  286  •  A  General Formula  287 

Contents ix

•  Using Present Values: Examples  288  •  Constant  Interest Rates  288  •  Constant Interest Rates and Payments  288  •  Constant Interest  Rates and Payments Forever  289  •  Zero Interest Rates  289  •  Nominal  versus Real Interest Rates and Present  Values  289

14-2 Bond Prices and Bond Yields 290 Bond Prices as Present Values  292  •  Arbitrage and Bond Prices  293  •  From Bond Prices to Bond Yields  294  •  Reintroducing Risk  295  •  Interpreting the Yield Curve  296

14-3 The Stock Market and Movements in Stock Prices 298 Stock Prices as Present Values  298  •  The Stock Market and Economic  Activity  301  •  A Monetary Expansion  and the Stock Market  301  •  An  Increase in Consumer Spending and  the Stock Market  302

14-4 Risk, Bubbles, Fads, and Asset Prices 304 Stock Prices and Risk  304  •  Asset  Prices, Fundamentals, and  Bubbles  304

Appendix: Deriving the Expected Present Discounted Value Using Real or Nominal Interest Rates 310

Chapter 15 Expectations, Consumption, and Investment 311 15-1 Consumption 312

The Very Foresighted Consumer  312  •  An Example  313  •  Toward  a More Realistic Description  314  •  Putting Things Together: Current  Income, Expectations, and  Consumption  317

15-2 Investment 318 Investment and Expectations of  Profit  318  •  Depreciation  319  •  The Present Value of Expected  Profits  319  •  The Investment  Decision  320  •  A Convenient  Special Case  320  •  Current versus  Expected Profit  322  •  Profit and  Sales  324

15-3 The Volatility of Consumption and Investment 326

Appendix: Derivation of the Expected Present Value of Profits under Static Expectations 330

Chapter 16 Expectations, Output, and Policy 331 16-1 Expectations and Decisions: Taking

Stock 332 Expectations, Consumption, and  Investment Decisions  332  •  Expectations and the IS Relation  332

16-2 Monetary Policy, Expectations, and Output 335 Monetary Policy Revisited  335

16-3 Deficit Reduction, Expectations, and Output 338 The Role of Expectations about the  Future  339  •  Back to the Current  Period  339

The Open Economy 347 Chapter 17 Openness in Goods and Financial

Markets 349 17-1 Openness in Goods Markets 350

Exports and Imports  350  •  The Choice  between Domestic Goods and Foreign  Goods  352  •  Nominal Exchange  Rates  352  •  From Nominal to Real  Exchange Rates  354  •  From Bilateral to  Multilateral Exchange Rates  357

17-2 Openness in Financial Markets 358 The Balance of Payments  359  •  The  Choice between Domestic and Foreign  Assets  361  •  Interest Rates and   Exchange Rates  363

17-3 Conclusions and a Look Ahead 365

Chapter 18 The Goods Market in an Open Economy 369 18-1 The IS Relation in the Open

Economy 370 The Demand for Domestic Goods  370  •  The Determinants of C, I, and G 370 •  The Determinants of Imports  371  •  The Determinants of Exports  371  •  Putting the Components  Together  371

18-2 Equilibrium Output and the Trade Balance 373

18-3 Increases in Demand—Domestic or Foreign 374 Increases in Domestic Demand  374  •  Increases in Foreign Demand  376  •  Fiscal Policy Revisited  377

x Contents

20-4 Choosing between Exchange Rate Regimes 422 Common Currency Areas  423  •  Hard Pegs, Currency Boards, and  Dollarization  425

Appendix 1: Deriving the IS relation under Fixed Exchange Rates 431 Appendix 2: The Real Exchange Rate and Domestic and Foreign Real Interest Rates 431

Back to Policy 433 Chapter 21 Should Policy Makers Be

Restrained? 435 21-1 Uncertainty and Policy 436

How Much Do Macroeconomists  Actually Know?  436  •  Should  Uncertainty Lead Policy Makers to  Do Less?  438  •  Uncertainty and  Restraints on Policy Makers  438

21-2 Expectations and Policy 439 Hostage Takings and Negotiations  440  •  Inflation and Unemployment  Revisited  440  •  Establishing  Credibility  441  •  Time Consistency  and Restraints on Policy Makers  443

21-3 Politics and Policy 443 Games between Policy Makers and  Voters  443  •  Games between Policy  Makers  445  •  Politics and Fiscal  Restraints  448

Chapter 22 Fiscal Policy: A Summing Up 453 22-1 What We Have Learned 454

22-2 The Government Budget Constraint: Deficits, Debt, Spending, and Taxes 455 The Arithmetic of Deficits and  Debt  455  •  Current versus Future  Taxes  457  •  The Evolution of the  Debt-to-GDP Ratio  459

22-3 Ricardian Equivalence, Cyclical Adjusted Deficits, and War Finance 462 Ricardian Equivalence  462  •  Deficits,  Output Stabilization, and the Cyclically  Adjusted Deficit  463  •  Wars and  Deficits  464

22-4 The Dangers of High Debt 466 High Debt, Default Risk, and Vicious  Cycles  466  •  Debt Default  468  •  Money Finance  468

18-4 Depreciation, the Trade Balance, and Output 379 Depreciation and the Trade Balance:  The Marshall-Lerner Condition  380  •  The Effects of a Real Depreciation  380  •  Combining Exchange Rate and Fiscal  Policies  381

18-5 Looking at Dynamics: The J-Curve 384

18-6 Saving, Investment, and the Current Account Balance 386

Appendix: Derivation of the Marshall- Lerner Condition 390

Chapter 19 Output, the Interest Rate, and the Exchange Rate 391 19-1 Equilibrium in the Goods

Market 392

19-2 Equilibrium in Financial Markets 393 Domestic Bonds versus Foreign  Bonds  393

19-3 Putting Goods and Financial Markets Together 397

19-4 The Effects of Policy in an Open Economy 399 The Effects of Monetary Policy in an  Open Economy  399  •  The Effects of  Fiscal Policy in an Open Economy  399

19-5 Fixed Exchange Rates 403 Pegs, Crawling Pegs, Bands, the  EMS, and the Euro  403  •  Monetary  Policy when the Exchange Rate Is  Fixed  404  •  Fiscal Policy when the  Exchange Rate Is Fixed  404

Appendix: Fixed Exchange Rates, Interest Rates, and Capital Mobility 409

Chapter 20 Exchange Rate Regimes 411 20-1 The Medium Run 412

The IS Relation under Fixed Exchange  Rates  413  •  Equilibrium in the Short  and the Medium Run  413  •  The Case  for and against a Devaluation  414

20-2 Exchange Rate Crises under Fixed Exchange Rates 416

20-3 Exchange Rate Movements under Flexible Exchange Rates 419 Exchange Rates and the Current  Account  420  •  Exchange Rates  and Current and Future Interest  Rates  421  •  Exchange Rate  Volatility  421

Contents xi

Chapter 23 Monetary Policy: A Summing Up 477 23-1 What We Have Learned 478

23-2 From Money Targeting to Inflation Targeting 479 Money Targeting  479  •  Inflation  Targeting  481  •  The Interest Rate  Rule  482

23-3 The Optimal Inflation Rate 483 The Costs of Inflation  483  •  The  Benefits of Inflation  486  •  The   Optimal Inflation Rate: The State of the   Debate  487

23-4 Unconventional Monetary Policy 488

23-5 Monetary Policy and Financial Stability 490 Liquidity Provision and Lender of Last Resort  490  •  Macroprudential  Tools  490

Chapter 24 Epilogue: The Story of Macroeconomics 497 24-1 Keynes and the Great

Depression 498

24-2 The Neoclassical Synthesis 498 Progress on All Fronts  499  •  Keynesians versus Monetarists  500

24-3 The Rational Expectations Critique 501 The Three Implications of Rational  Expectations  502  •  The Integration  of Rational Expectations  503

24-4 Developments in Macroeconomics up to the 2009 Crisis 504 New Classical Economics and Real  Business Cycle Theory  505  •  New  Keynesian Economics  505  •  New  Growth Theory  506  •  Toward an  Integration  507

24-5 First Lessons for Macroeconomics after the Crisis 508

Appendix 1 An Introduction to National Income and Product Accounts A-1

Appendix 2 A Math Refresher A-7

Appendix 3 An Introduction to Econometrics A-12

Glossary G-1

Index I-1

Credits C-1

xii

Real GDP, Technological Progress, and the Price of   Computers  27

Unemployment and Happiness  30

The Lehman Bankruptcy, Fears of Another Great Depression,  and Shifts in the Consumption Function  59

The Paradox of Saving  63

Semantic Traps: Money, Income, and Wealth  69

Who Holds U.S. Currency?  71

The Liquidity Trap in Action 81

Focus: The U.S. Recession of 2001  100

Deficit Reduction: Good or Bad for Investment?  103

Bank Runs  120

The Current Population Survey  140

Henry Ford and Efficiency Wages  145

Theory ahead of Facts: Milton Friedman  and Edmund Phelps  164

What Explains European Unemployment?  167

Changes in the U.S. Natural Rate of Unemployment since  1990  169

Okun’s Law across Time and Countries  180

Deflation in the Great Depression 185

Oil Price Increases: Why Were the 2000s  So Different from the 1970s?  191

The Construction of PPP Numbers  202

Does Money Lead to Happiness?  204

Capital Accumulation and Growth in France  in the Aftermath of World War II  224

Social Security, Saving, and Capital Accumulation  in the United States  229

The Diffusion of New Technology: Hybrid Corn  250

Management Practices: Another Dimension  of Technological Progress  252

The Importance of Institutions: North Korea  and South Korea  254

What Is behind Chinese Growth?  255

Job Destruction, Churning, and Earnings Losses  273

The Long View: Technology, Education, and Inequality  275

The Vocabulary of Bond Markets  292

The Yield Curve, the Zero Lower Bound, and Liftoff  297

Making (Some) Sense of (Apparent) Nonsense: Why the  Stock Market Moved Yesterday and Other Stories  303

Famous Bubbles: From Tulipmania in 17th-Century Holland to  Russia in 1994  305

The Increase in U.S. Housing Prices: Fundamentals  or Bubble?  306

Up Close and Personal: Learning from  Panel Data Sets  313

Do People Save Enough for Retirement?  316

Investment and the Stock Market  321

Profitability versus Cash Flow  324

Rational Expectations  337

Can a Budget Deficit Reduction Lead to an Output Expansion?  Ireland in the 1980s  341

Can Exports Exceed GDP?  352

GDP versus GNP: The Example of Kuwait  362

Buying Brazilian Bonds  364

The G20 and the 2009 Fiscal Stimulus  378

The Disappearance of Current Account Deficits in Euro  Periphery Countries: Good News or Bad News?  382

Sudden Stops, Safe Havens, and the Limits to the Interest   Parity Condition  394

Monetary Contraction and Fiscal Expansion:  The United States in the Early 1980s  402

German Reunification, Interest Rates, and the EMS  405

The Return of Britain to the Gold Standard:  Keynes versus Churchill  415

The 1992 EMS Crisis  418

The Euro: A Short History  425

Lessons from Argentina’s Currency Board  426

Was Alan Blinder Wrong in Speaking the Truth?  443

Euro Area Fiscal Rules: A Short History  446

Inflation Accounting and the Measurement of Deficits  456

How Countries Decreased Their Debt Ratios after  World War II  461

Deficits, Consumption, and Investment in the United States   during World War II  465

Money Financing and Hyperinflations  470

Should You Worry about U.S. Public Debt?  471

Money Illusion  485

LTV Ratios and Housing Price Increases  from 2000 to 2007  492

A Guide to Understanding Econometric Results  A-14

Focus Boxes

xiii

Preface

I had two main goals in writing this book:

■■ To make close contact with current macroeconomic events. What makes macroeconomics exciting is the light it sheds on what is happening around the world, from the major economic crisis which has engulfed the world since 2008, to monetary policy in the United States, to the problems of the Euro area, to growth in China. These events—and many more—are described in the book, not in footnotes, but in the text or in detailed boxes. Each box shows how you can use what you have learned to get an understanding of these events. My belief is that these boxes not only convey the “life” of macroeconomics, but also reinforce the lessons from the models, making them more concrete and easier to grasp.

■■ To provide an integrated view of macroeconomics. The book is built on one underlying model, a model that draws the implications of equilibrium conditions in three sets of markets: the goods market, the financial markets, and the labor market. Depending on the issue at hand, the parts of the model relevant to the issue are developed in more detail while the other parts are simplified or lurk in the background. But the underlying model is always the same. This way, you will see macroeconomics as a coherent whole, not a collection of models. And you will be able to make sense not only of past macroeconomic events, but also of those that unfold in the future.

New to this Edition The crisis that started in 2008, and is still lingering, forced macroeconomists to rethink much of macroeconomics. They clearly had understated the role of the financial sys- tem. They also had too optimistic a view of how the economy returned to equilibrium. Eight years later, I believe the main lessons have been absorbed, and this edition reflects the deep rethinking that has taken place. Nearly all chapters have been rewritten, and the main changes are as follows:

■■ A modified Chapter 5, and a modified presentation of the IS-LM. The traditional treatment of monetary policy assumed that the central bank chose the money sup- ply and then let the interest rate adjust. In fact, modern

central banks choose the interest rate and then let the money supply adjust. In terms of the IS-LM model used to describe the short run, the LM curve, instead of being upward sloping, should be treated as flat. This makes for a more realistic and a simpler model.

■■ A new Chapter 6. The chapter focuses on the role of the financial system in the economy. It extends the IS-LM model to allow for two interest rates, the interest rate set by monetary policy and the cost of borrowing for people or firms, with the state of the financial system determining the relation between the two.

■■ A new Chapter 9. The traditional aggregate supply- aggregate demand model was cumbersome and gave too optimistic a view of the return of output to potential. The model has been replaced by an IS-LM-PC model (where PC stands for Phillips curve), which gives a simpler and more accurate description of the role of monetary policy, and of output and inflation dynamics.

■■ The constraints on monetary policy, coming from the zero lower bound, and the constraints on fiscal policy, coming from the high levels of public debt, are recurring themes throughout the book.

■■ Many Focus boxes are new or extended. Among them: “Unemployment and Happiness” in Chapter 2; “The Liquidity Trap in Action” in Chapter 4; Bank Runs in Chapter 6; “Changes in the U.S. Natural Rate of Unem- ployment since 1990” in Chapter 8; “Okun’s Law” and “Deflation in the Great Depression” in Chapter 9; “The Construction of PPP Numbers” in Chapter 10; “The Long View: Technology, Education, and Inequality” in Chapter 13; “The Yield Curve, the Zero Lower Bound, and Lift-off” in Chapter 14; “The Disappearance of Current Account Deficits in Euro Periphery Countries: Good News or Bad News?” in Chapter 18; “Euro Area Fiscal Rules: A Short History” in Chapter 21; and “Money Financing and Hyperinflations” and “Should You Worry about U.S. Public Debt?” in Chapter 22.

■■ Figures and tables have been updated using the latest data available.

xiv Preface

In short, I see this edition as the first true post-crisis mac- roeconomics textbook. I hope it gives a clear guide not only to what has happened, and also to what may happen in the future.

Organization The book is organized around two central parts: A core, and a set of two major extensions. An introduction precedes the core. The two extensions are followed by a review of the role of policy. The book ends with an epilogue. A flowchart on the front endpaper makes it easy to see how the chapters are organized, and fit within the book’s overall structure.

■■ Chapters 1 and 2 introduce the basic facts and issues of macroeconomics. Chapter 1 focuses first on the cri- sis, and then takes a tour of the world, from the United States, to Europe, to China. Some instructors will prefer to cover Chapter 1 later, perhaps after Chapter 2, which introduces basic concepts, articulates the notions of short run, medium run, and long run, and gives the reader a quick tour of the book.

While Chapter 2 gives the basics of national income ac- counting, I have put a detailed treatment of national income accounts to Appendix 1 at the end of the book. This decreases the burden on the beginning reader, and allows for a more thorough treatment in the appendix.

■■ Chapters 3 through 13 constitute the core.

Chapters 3 through 6 focus on the short run. These four chapters characterize equilibrium in the goods market and in the financial markets, and they derive the basic model used to study short–run movements in output, the IS–LM model. Chapter 6 is new, and extends the basic IS-LM model to take into account the role of the financial system. It then uses it to describe what happened during the initial phase of the crisis.

Chapters 7 through 9 focus on the medium run. Chapter 7 focuses on equilibrium in the labor market and introduces the notion of the natural rate of unem- ployment. Chapter 8 derives and discusses the relation between unemployment and inflation, known as the Phillips curve. Chapter 9 develops the IS-LM-PC (PC for Phillips curve) model which takes into account equilib- rium in the goods market, in the financial markets, and in the labor market. It shows how this model can be used to understand movements in activity and movements in inflation, both in the short and in the medium run.

Chapters 10 through 13 focus on the long run. Chapter 10 describes the facts, showing the evolution of output across countries and over long periods of time. Chapters 11

and 12 develop a model of growth and describe how capital accumulation and technological progress deter- mine growth. Chapter 13 focuses on the effects of tech- nological progress on unemployment and on inequality, not only in the long run, but also in the short run and in the medium run.

■■ Chapters 14 through 20 cover the two major extensions.

Chapters 14 through 16 focus on the role of expectations in the short run and in the medium run. Expectations play a major role in most economic decisions, and, by implica- tion, play a major role in the determination of output.

Chapters 17 through 20 focus on the implications of openness of modern economies. Chapter 20 focuses on the implications of different exchange rate regimes, from flexible exchange rates, to fixed exchange rates, currency boards, and dollarization.

■■ Chapters 21 through 23 return to macroeconomic policy. Although most of the first 20 chapters constantly discuss macroeconomic policy in one form or another, the purpose of Chapters 21 through 23 is to tie the threads together. Chapter 21 looks at the role and the limits of macroeconomic policy in general. Chapters 22 and 23 review fiscal and monetary policy. Some instruc- tors may want to use parts of these chapters earlier. For example, it is easy to move forward the discussion of the government budget constraint in Chapter 22 or the discussion of inflation targeting in Chapter 23.

■■ Chapter 24 serves as an epilogue; it puts macroeco- nomics in historical perspective by showing the evolu- tion of macroeconomics in the last 70 years, discussing current directions of research, and the lessons of the crisis for macroeconomics.

Alternative Course Outlines Within the book’s broad organization, there is plenty of op- portunity for alternative course organizations. I have made the chapters shorter than is standard in textbooks, and, in my experience, most chapters can be covered in an hour and a half. A few (Chapters 5 and 9 for example) might require two lectures to sink in.

■■ Short courses. (15 lectures or less)

A short course can be organized around the two intro- ductory chapters and the core (Chapter 13 can be ex- cluded at no cost in continuity). Informal presentations of one or two of the extensions, based, for example, on Chapter 16 for expectations (which can be taught as a stand alone), and on Chapter 17 for the open economy, can then follow, for a total of 14 lectures.

Preface xv

A short course might leave out the study of growth (the long run). In this case, the course can be organ- ized around the introductory chapters and Chapters 3 through 9 in the core; this gives a total of 9 lectures, leaving enough time to cover, for example, Chapter 16 on expectations, Chapters 17 through 19 on the open economy, for a total of 13 lectures.

■■ Longer courses (20 to 25 lectures)

A full semester course gives more than enough time to cover the core, plus one or both of the two extensions, and the review of policy.

The extensions assume knowledge of the core, but are otherwise mostly self-contained. Given the choice, the order in which they are best taught is probably the order in which they are presented in the book. Having studied the role of expectations first helps students to under- stand the interest parity condition, and the nature of exchange rate crises.

Features I have made sure never to present a theoretical result with- out relating it to the real world. In addition to discussions of facts in the text itself, I have written a large number of Fo- cus boxes, which discuss particular macroeconomic events or facts, from the United States or from around the world.

I have tried to re-create some of the student–teacher in- teractions that take place in the classroom by the use of mar- gin notes, which run parallel to the text. The margin notes create a dialogue with the reader and, in so doing, smooth the more difficult passages and give a deeper understanding of the concepts and the results derived along the way.

For students who want to explore macroeconomics further, I have introduced the following two features:

■■ Short appendixes to some chapters, which expand on points made within the chapter.

■■ A Further Readings section at the end of most chapters, indicating where to find more information, including a number of key Internet addresses.

Each chapter ends with three ways of making sure that the material in the chapter has been digested:

■■ A summary of the chapter’s main points. ■■ A list of key terms. ■■ A series of end-of-chapter exercises. “Quick Check” exer-

cises are easy. “Dig Deeper” exercises are a bit harder, and “Explore Further” typically require either access to the Internet or the use of a spreadsheet -program.

■■ A list of symbols on the back endpapers makes it easy to recall the meaning of the symbols used in the text.

MyEconLab

MyEconLab is a powerful assessment and tutorial system that works hand-in-hand with Macroeconomics. It includes comprehensive homework, quiz, test, and tutorial options, allowing students to test their knowledge and instructors to manage all assessment needs in one program. Students and instructors can register, create, and access all of their MyLab courses, regardless of discipline, from one conveni- ent online location: http://www.pearsonmylab.com.

Key innovations in the MyEconLab course for Macro- economics, seventh edition, include the following resources for students and instructors:

■■ MyEconLab Animation—The key figures in the seventh edition have been converted to digital figure animations where the figures from the textbook are presented in step-by-step animations with audio explanations of the action. The goal of this digital resource is to help students understand shifts in curves, movements along curves, and changes in equilibrium values. Having animated versions of a graph helps students who have difficulty interpreting the static version found in the printed text.

■■ MyEconLab Video—There are approximately 100 vid- eos featured in the new enhanced eText for the seventh edition. They provide real world explanations of key concepts with videos from the International Monetary Fund’s “World Economic Outlook” press conferences and interviews with author Olivier Blanchard. The videos include in depth market analysis and are accompanied by graded practice exercises to ensure mastery. These new videos are embedded in the eText and are accessible through MyEconLab

■■ Enhanced eText—The Pearson eText gives students access to their textbook anytime, anywhere. In addi- tion to notetaking, highlighting, and bookmarking, the Pearson eText offers interactive and sharing features. Students actively read and learn, through embedded and auto-graded practice, real-time data-graphs, anima- tions, author videos, and more. Instructors can share comments or highlights, and students can add their own, for a tight community of learners in any class.

■■ NEW: Math Review Exercises in MyEconLab. MyEconLab now offers a rich array of assignable and auto-graded exercises covering fundamental math con- cepts geared for macroeconomics students. Aimed at in- creasing student confidence and success, the new math skills review in Chapter R is accessible from the assign- ment manager and contains over 150 graphing, algebra, and calculus exercises for homework, quiz, and test use.

xvi Preface

■■ Practice. Algorithmically generated homework and study plan exercises with instant feedback ensure varied and productive practice that helps students improve their understanding and prepare for quizzes and tests. Exer- cises that require drawing figures encourage students to practice the language of economics.

■■ Learning Resources. Personalized learning aids such as Help Me Solve This Problem walkthroughs, Teach Me explanations of the underlying concept, and figure ani- mations provide on-demand help when students need it most.

■■ Study Plan. Customized study plans show students which sections to study next, give easy access to practice problems, and provide an automatically generated quiz to prove mastery of the course material.

■■ Current News Exercises. These exercises provide a turnkey approach to assign gradable news-based exercises in MyEconLab. Every week, Pearson scours the news, finds a current article appropriate for a macroeconomics course, creates an exercise based on this news article, and then automatically adds it to MyEconLab.

■■ MyEconLab Real-time data—Real-time data figures and  exercises allow students and in- structors to use the very latest data

from the Federal Reserve Bank of St. Louis’s FRED site. These figures and exercises communicate directly with the FRED® site and update as new data are available.

■■ Digital Interactives. Focused on a single core topic and organized in progressive levels, each interactive immerses students in an assignable and auto-graded activity. Digital Interactives are lecture tools for tradi- tional, online, and hybrid courses, many incorporating real-time data, data displays, and analysis tools for rich classroom discussions.

■■ Experiments in MyEconLab. Flexible, easy to assign, auto-graded, and available in Single and Multiplayer ver- sions, the Experiments in MyEconLab make learning fun and engaging.

■■ Learning Catalytics. Learning Catalytics™ is a “bring your own device” student engagement, assessment, and classroom intelligence system that lets learners use their smartphone, tablet, or laptop to participate in and stay engaged in lecture. It allows instructors to gener- ate classroom discussion, guides lectures, and promotes peer-to-peer learning with real-time analytics. Now stu- dents can use any device to interact in the classroom, engage with content and even draw and share graphs.

Instructors can divide classes into pairs or groups based on learners’ response patterns, and learners with greater proficiency help motivate other learners while allowing instructors time to provide individualized and focused attention to learners who will benefit from it.

■■ Reporting Dashboard. Faculty can view, analyze, and report learning outcomes clearly and easily using the Re- porting Dashboard. It is available via the Gradebook and fully mobile-ready. The Reporting Dashboard presents student performance data at the class, section, and pro- gram levels in an accessible, visual manner.

■■ LMS Integration. Faculty can link from any LMS plat- form to access assignments, rosters, and resources, and synchronize MyLab grades with your LMS gradebook. For students, a new direct, single sign-on provides easier access to all the personalized learning MyLab resources.

■■ Mobile Ready. Students and instructors can access multimedia resources and complete assessments from any mobile device.

For more information, visit http://www.myeconlab.com.

Supplements The book comes with a number of supplements that support teaching and learning.

■■ Instructor’s Manual. The Online Instructor’s Manual, prepared by LaTanya Brown-Robertson, discusses pedagog- ical choices, alternative ways of presenting the material, and ways of reinforcing students’ understanding. Chapters in the manual include six main sections: objectives, in the form of a motivating question; why the answer mat- ters; key tools, concepts, and assumptions; summary; and pedagogy. Many chapters also include sections focusing on extensions and observations. The Instructor’s Manual also includes the answers to all end-of-chapter questions and exercises. The Instructor’s Manual is available for down- load as Word files or as PDFs from the Instructor Resource Center at www.pearsonhighered.com/irc.

■■ Test Bank. The online test bank, updated by Liping Zheng is completely revised with additional new multi- ple–choice questions for each chapter. The Test Item File can be downloaded from the Instructor Resource Center at www.pearsonhighered.com/irc.

■■ Computerized Test Bank—The Computerized Test Item File is designed for use with the computerized Test- Gen package, which allows instructors to customize, save, and generate classroom tests. The test program permits instructors to edit, add, or delete questions from the test bank; edit existing graphics and create new

Preface xvii

graphics; analyze test results; and organize a database of tests and student results. This software allows for extensive flexibility and ease of use. It provides many options for organizing and displaying tests, along with search and sort features. The software and the Test Item File can be downloaded from the Instructor’s Resource Center at www.pearsonhighered.com/irc, and all ques- tions can be assigned via MyEconLab.

■■ PowerPoint Lecture Slides—These electronic slides, prepared by Jim Lee provide section lecture notes in- cluding tables, equations, and graphs for each chapter and can be downloaded from the Instructor’s Resource Center at www.pearsonhighered.com/irc.

Acknowledgments and Thanks This book owes much to many. I thank Adam Ashcraft, Peter Berger, Peter Benczur, Efe Cakarel, Francesco Furno, Harry Gakidis, Ava Hong, David Hwang, Kevin Nazemi, David Re- ichsfeld, Jianlong Tan, Stacy Tevlin, Gaurav Tewari, Corissa Thompson, John Simon, and Jeromin Zettelmeyer for their research assistance over the years. I thank the generations of students in 14.02 at MIT who have freely shared their reactions to the book over the years.

I have benefited from comments from many colleagues and friends. Among them are John Abell, Daron Acemoglu, Tobias Adrian, Chuangxin An, Roland Benabou, Samuel Bentolila, and Juan Jimeno (who have adapted the book for a Spanish edition); Francois Blanchard, Roger Brinner, Ricardo Caballero, Wendy Carlin, Martina Copelman, Henry Chappell, Ludwig Chincarini, and Daniel Cohen (who has adapted the book for a French edition); Larry Christiano, Bud Collier, Andres Conesa, Peter Diamond, Martin Eichenbaum, Gary Fethke, David Findlay, Francesco Giavazzi, and Alessia Amighini (who adapted the book first for an Italian edition, and then for a European edition); Andrew Healy, Steinar Holden, and Gerhard Illing (who has adapted the book for a German edition); Yannis Ioannides, Angelo Melino (who has adapted the book for a Canadian edition); P. N. Junankar, Sam Keeley, Bernd Kuemmel, Paul Krugman, Antoine Magnier, Peter Montiel, Bill Nordhaus, Tom Michl, Dick Oppermann, Athanasios Orphanides, and Daniel Pirez Enri (who has adapted the book for a Latin American edition); Michael Plouffe, Zoran Popovic, Jim Poterba, and Jeff Sheen (who has adapted the book for an Australasian edition); Ronald Schettkat, and Watanabe Shinichi (who has adapted the book for a Japanese edition); Francesco Sisci, Brian Simboli, Changyong Rhee, Julio Rotemberg, Robert Solow, Andre Watteyne (who kindly agreed to be the first reader of this edition), and Michael Woodford. Particular thanks go to David Johnson, who

coauthored the sixth edition while I was the chief econo- mist at the IMF and did not have enough time to do it alone, and wrote the end of chapter exercises for this edition, and to Francesco Giavazzi, with whom I worked closely in pre- paring this edition.

I have benefited from comments from many readers, reviewers, and class testers. Among them:

■■ John Abell, Randolph, Macon Woman’s College

■■ Carol Adams, Cabrillo College

■■ Gilad Aharonovitz, School of Economic Sciences

■■ Terence Alexander, Iowa State University

■■ Roger Aliaga-Diaz, Drexel University

■■ Robert Archibald, College of William & Mary

■■ John Baffoe-Bonnie, La Salle University

■■ Fatolla Bagheri, University of North Dakota

■■ Stephen Baker, Capital University

■■ Erol Balkan, Hamilton College

■■ Jennifer Ball, Washburn University

■■ Richard Ballman, Augustana College

■■ King Banaian, St. Cloud State University

■■ Charles Bean, London School of Economics and Political Science

■■ Scott Benson, Idaho State University

■■ Gerald Bialka, University of North Florida

■■ Robert Blecker, American University

■■ Scott Bloom, North Dakota State University

■■ Pim Borren, University of Canterbury, New Zealand

■■ LaTanya Brown-Robertson, Bowie State University

■■ James Butkiewicz, University of Delaware

■■ Colleen Callahan, American University

■■ Bruce Carpenter, Mansfield University

■■ Kyongwook Choi, Ohio University College

■■ Michael Cook, William Jewell College

■■ Nicole Crain, Lafayette College

■■ Rosemary Cunningham, Agnes Scott College

■■ Evren Damar, Pacific Lutheran University

■■ Dale DeBoer, University of Colorado at Colorado Springs

xviii Preface

■■ Adrian de Leon-Arias, Universidad de Guadalajara

■■ Brad DeLong, UC Berkeley

■■ Firat Demir, University of Oklahoma

■■ Wouter Denhaan, UC San Diego

■■ John Dodge, King College

■■ F. Trenery Dolbear, Brandeis University

■■ Patrick Dolenc, Keene State College

■■ Brian Donhauser, University of Washington

■■ Michael Donihue, Colby College

■■ Vincent Dropsy, California State University

■■ Justin Dubas, St. Norbert College

■■ Amitava Dutt, University of Notre Dame

■■ John Edgren, Eastern Michigan University

■■ Eric Elder, Northwestern College

■■ Sharon J. Erenburg, Eastern Michigan University

■■ Antonina Espiritu, Hawaii Pacific University

■■ J. Peter Federer, Clark University

■■ Rendigs Fels, Vanderbilt University

■■ John Flanders, Central Methodist University

■■ Marc Fox, Brooklyn College

■■ Yee-Tien (Ted) Fu, Stanford University

■■ Yee-Tien Fu, National Cheng-Chi University, Taiwan

■■ Scott Fullwiler, Wartburg College

■■ Julie Gallaway, University of Missouri–Rolla

■■ Bodhi Ganguli, Rutgers, The State University of NJ

■■ Fabio Ghironi, Boston College

■■ Alberto Gomez-Rivas, University of Houston–Downtown

■■ Fidel Gonzalez, Sam Houston State University

■■ Harvey Gram, Queen College, City University of New York

■■ Randy Grant, Linfield College

■■ Alan Gummerson, Florida International University

■■ Reza Hamzaee, Missouri Western State College

■■ Michael Hannan, Edinboro University

■■ Kenneth Harrison, Richard Stockton College

■■ Mark Hayford, Loyola University

■■ Thomas Havrilesky, Duke University

■■ George Heitmann, Muhlenberg College

■■ Ana Maria Herrera, Michigan State University

■■ Peter Hess, Davidson College

■■ Eric Hilt, Wellesley College

■■ John Holland, Monmouth College

■■ Mark Hopkins, Gettysburg College

■■ Takeo Hoshi, University of California, San Diego

■■ Ralph Husby, University of Illinois, Urbana–Champaign

■■ Yannis Ioannides, Tufts University

■■ Aaron Jackson, Bentley College

■■ Bonnie Johnson, California Lutheran University

■■ Louis Johnston, College of St. Benedict

■■ Barry Jones, SUNY Binghamton

■■ Fred Joutz, George Washington University

■■ Cem Karayalcin, Florida International University

■■ Okan Kavuncu, University of California

■■ Miles Kimball, University of Michigan

■■ Paul King, Denison University

■■ Michael Klein, Tufts University

■■ Mark Klinedinst, University of Southern Mississippi

■■ Shawn Knabb, Western Washington University

■■ Todd Knoop, Cornell College

■■ Paul Koch, Olivet Nazarene University

■■ Ng Beoy Kui, Nanyang Technical University, Singapore

■■ Leonard Lardaro, University of Rhode Island

■■ James Leady, University of Notre Dame

■■ Charles Leathers, University of Alabama

■■ Hsien-Feng Lee, National Taiwan University

■■ Jim Lee, Texas A&M University–Corpus Christi

■■ John Levendis, Loyola University New Orleans

■■ Frank Lichtenberg, Columbia University

■■ Mark Lieberman, Princeton University

■■ Shu Lin, Florida Atlantic University

■■ Maria Luengo-Prado, Northeastern University

Preface xix

■■ Mathias Lutz, University of Sussex

■■ Bernard Malamud, University of Nevada, Las Vegas

■■ Ken McCormick, University of Northern Iowa

■■ William McLean, Oklahoma State University

■■ B. Starr McMullen, Oregon State University

■■ Mikhail Melnik, Niagara University

■■ O. Mikhail, University of Central Florida

■■ Fabio Milani, University of California, Irvine

■■ Rose Milbourne, University of New South Wales

■■ Roger Morefield, University of Saint Thomas

■■ Shahriar Mostashari, Campbell University

■■ Eshragh Motahar, Union College

■■ Nick Noble, Miami University

■■ Ilan Noy, University of Hawaii

■■ John Olson, College of St. Benedict

■■ Brian O’Roark, Robert Morris University

■■ Jack Osman, San Francisco State University

■■ Emiliano Pagnotta, Northwestern University

■■ Biru Paksha Paul, SUNY Cortland

■■ Andrew Parkes, Mesa State College

■■ Allen Parkman, University of Mexico

■■ Jim Peach, New Mexico State University

■■ Gavin Peebles, National University of Singapore

■■ Michael Quinn, Bentley College

■■ Charles Revier, Colorado State University

■■ Jack Richards, Portland State University

■■ Raymond Ring, University of South Dakota

■■ Monica Robayo, University of North Florida

■■ Malcolm Robinson, Thomas Moore College

■■ Brian Rosario, University of California, Davis

■■ Kehar Sangha, Old Dominion University

■■ Ahmad Saranjam, Bridgewater State College

■■ Carol Scotese, Virginia Commonwealth University

■■ John Seater, North Carolina State University

■■ Peter Sephton, University of New Brunswick

■■ Ruth Shen, San Francisco State University

■■ Kwanho Shin, University of Kansas

■■ Tara Sinclair, The George Washington University

■■ Aaron Smallwood, University of Texas, Arlington

■■ David Sollars, Auburn University

■■ Liliana Stern, Auburn University

■■ Edward Stuart, Northeastern Illinois University

■■ Abdulhanid Sukaar, Cameron University

■■ Peter Summers, Texas Tech University

■■ Mark Thomas, University of Maryland Baltimore County

■■ Brian Trinque, The University of Texas at Austin

■■ Marie Truesdell, Marian College

■■ David Tufte, Southern Utah University

■■ Abdul Turay, Radford University

■■ Frederick Tyler, Fordham University

■■ Pinar Uysal, Boston College

■■ Evert Van Der Heide, Calvin College

■■ Kristin Van Gaasbeck, California State University, Sacramento

■■ Lee Van Scyoc, University of Wisconsin, Oshkosh

■■ Paul Wachtel, New York University Stern Business School

■■ Susheng Wang, Hong Kong University

■■ Donald Westerfield, Webster University

■■ Christopher Westley, Jacksonville State University

■■ David Wharton, Washington College

■■ Jonathan Willner, Oklahoma City University

■■ Mark Wohar, University of Nebraska, Omaha

■■ Steven Wood, University of California, Berkeley

■■ Michael Woodford, Princeton University

■■ Ip Wing Yu, University of Hong Kong

■■ Chi-Wa Yuen, Hong Kong University of Science and Technology

■■ Christian Zimmermann, University of Connecticut

■■ Liping Zheng, Drake University

They have helped us beyond the call of duty, and each has made a difference to the book.

xx Preface

I have many people to thank at Pearson Christina Masturzo, senior acquisitions editor; Nancy Freihofer, program manager; Diana Tetterton, editorial assistant; Heath- er Pagano, project manager; and Maggie Moylan, VP, product marketing.

Finally, I want to single out Steve Rigolosi, the editor for the first edition; Michael Elia, the editor to the second and third editions. Steve forced me to clarify. Michael forced me to simplify. Together, they have made all the difference to the

process and to the book. I thank them deeply. I thank John Ar- diti for his absolute reliability and his help, from the first edi- tion to this one. I have also benefited from often-stimulating suggestions from my daughters, Serena, Giulia, and Marie: I did not, however, follow all of them. At home, I continue to thank Noelle for preserving my sanity.

Olivier Blanchard Washington,

December 2015

1

Th e

C o

r e Introduction

The first two chapters of this book introduce you to the issues and the approach of macroeconomics.

Chapter 1

Chapter 1 takes you on a macroeconomic tour of the world. It starts with a look at the economic crisis that has shaped the world economy since the late 2000s. The tour then stops at each of the world’s major economic powers: the United States, the Euro area, and China.

Chapter 2

Chapter 2 takes you on a tour of the book. It defines the three central variables of macroeconomics: output, unemployment, and inflation. It then introduces the three time periods around which the book is organized: the short run, the medium run, and the long run.

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1

W A Tour of the World hat is macroeconomics? The best way to answer is not to give you a formal definition, but rather to take you on an economic tour of the world, to describe both the main economic evolutions and the issues that keep macroeconomists and macroeconomic policy makers awake at night.

At the time of this writing (the fall of 2015), policy makers are sleeping better than they did just a few years ago. In 2008, the world economy entered a major macroeconomic crisis, the deepest since the Great Depression. World output growth, which typically runs at 4 to 5% a year, was actually negative in 2009. Since then, growth has turned positive, and the world economy is slowly recovering. But the crisis has left a number of scars, and some worries remain.

My goal in this chapter is to give you a sense of these events and of some of the macroeco- nomic issues confronting different countries today. I shall start with an overview of the crisis, and then focus on the three main economic powers of the world: the United States, the Euro area, and China.

Section 1-1 looks at the crisis.

Section 1-2 looks at the United States.

Section 1-3 looks at the Euro area.

Section 1-4 looks at China.

Section 1-5 concludes and looks ahead.

Read this chapter as you would read an article in a newspaper. Do not worry about the exact meaning of the words or about understanding the arguments in detail: The words will be defined, and the arguments will be developed in later chapters. Think of this chapter as back- ground, intended to introduce you to the issues of macroeconomics. If you enjoy reading this chapter, you will probably enjoy reading this book. Indeed, once you have read it, come back to this chapter; see where you stand on the issues, and judge how much progress you have made in your study of macroeconomics.

MyEconLab Video

3

If you do not, please accept my apologies . . .

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4 Introduction The Core

1-1 The Crisis Figure 1-1 shows output growth rates for the world economy, for advanced economies, and for other economies, separately, since 2000. As you can see, from 2000 to 2007 the world economy had a sustained expansion. Annual average world output growth was 4.5%, with advanced economies (the group of 30 or so richest countries in the world) growing at 2.7% per year, and other economies (the other 150 or so countries in the world) growing at an even faster 6.6% per year.

In 2007 however, signs that the expansion might be coming to an end started to appear. U.S. housing prices, which had doubled since 2000, started declining. Economists started to worry. Optimists believed that, although lower housing prices might lead to lower housing construction and to lower spending by consumers, the Fed (the short name for the U.S. central bank, formally known as the Federal Reserve Board) could lower interest rates to stimulate demand and avoid a recession. Pessimists believed that the decrease in interest rates might not be enough to sustain demand and that the United States may go through a short recession.

Even the pessimists turned out not to be pessimistic enough. As housing prices con- tinued to decline, it became clear that the problems were deeper. Many of the mortgages that had been given out during the previous expansion were of poor quality. Many of the borrowers had taken too large a loan and were increasingly unable to make the monthly payments on their mortgages. And, with declining housing prices, the value of their mortgage often exceeded the price of the house, giving them an incentive to default. This was not the worst of it: The banks that had issued the mortgages had often bundled and packaged them together into new securities and then sold these securities to other banks and investors. These securities had often been repackaged into yet new securities, and so on. The result is that many banks, instead of holding the mortgages themselves, held these securities, which were so complex that their value was nearly impossible to assess.

This complexity and opaqueness turned a housing price decline into a major finan- cial crisis, a development that few economists had anticipated. Not knowing the quality of the assets that other banks had on their balance sheets, banks became reluctant to lend to each other for fear that the bank to which they lent might not be able to repay.

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2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Advanced economies

Other economies

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Figure 1-1

Output Growth Rates for the World Economy, for Advanced Economies, and for Emerging and Developing Economies, 2000–2014

Source: World Economic Outlook Database, July 2015. NGDP_RPCH.A.

MyEconLab Real-time data

“Banks” here actually means “banks and other financial in stitutions.” But this is too long to write and I do not want to go into these complications in Chapter 1.

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Chapter 1 A Tour of the World 5

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Figure 1-2

Stock Prices in the United States, the Euro Area, and Emerging Economies, 2007–2010

Source: Haver Analytics USA (S111ACD), Eurogroup (S023ACD), all emerging markets (S200ACD), all monthly averages.

Unable to borrow, and with assets of uncertain value, many banks found themselves in trouble. On September 15, 2008, a major bank, Lehman Brothers, went bankrupt. The effects were dramatic. Because the links between Lehman and other banks were so opaque, many other banks appeared at risk of going bankrupt as well. For a few weeks, it looked as if the whole financial system might collapse.

This financial crisis quickly turned into a major economic crisis. Stock prices collapsed. Figure 1-2 plots the evolution of three stock price indexes, for the United States, for the Euro area, and for emerging economies, from the beginning of 2007 to the end of 2010. The indexes are set equal to 1 in January 2007. Note how, by the end of 2008, stock prices had lost half or more of their value from their previous peak. Note also that, despite the fact that the crisis originated in the United States, European and emerging market stock prices decreased by as much as their U.S. counterparts; I shall return to this later.

Hit by the decrease in housing prices and the collapse in stock prices, and worried that this might be the beginning of another Great Depression, people sharply cut their consumption. Worried about sales and uncertain about the future, firms sharply cut back their investment. With housing prices dropping and many vacant homes on the market, very few new homes were built. Despite strong actions by the Fed, which cut interest rates all the way down to zero, and by the U.S. government, which cut taxes and increased spending, demand decreased, and so did output. In the third quarter of 2008, U.S. output growth turned negative and remained so in 2009.

One might have hoped that the crisis would remain largely contained in the United States. As Figures 1-1 and 1-2 both show, this was not the case. The U.S. crisis quickly became a world crisis. Other countries were affected through two channels. The first channel was trade. As U.S. consumers and firms cut spending, part of the decrease fell on imports of foreign goods. Looking at it from the viewpoint of countries exporting to the United States, their exports went down, and so, in turn, did their output. The second channel was financial. U.S. banks, badly needing funds in the United States, repatriated funds from other countries, creating problems for banks in those countries as well. As those banks got in trouble, lending came to a halt, leading to a decrease in spending and in output. Also, in a number of European countries, governments had accumulated high levels of debt and were now running large deficits. Investors began to worry about

I started my job as chief economist at the International Monetary Fund two weeks be- fore the Lehman bankruptcy. I faced a steep learning curve.

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6 Introduction The Core

whether debt could be repaid and asked for much higher interest rates. Confronted with those high interest rates, governments drastically reduced their deficits, through a com- bination of lower spending and higher taxes. This led in turn to a further decrease in demand, and in output. In Europe, the decline in output was so bad that this particular as- pect of the crisis acquired its own name, the Euro Crisis. In short, the U.S. recession turned into a world recession. By 2009, average growth in advanced economies was −3.4%, by far the lowest annual growth rate since the Great Depression. Growth in emerging and developing economies remained positive but was 3.5 percentage points lower than the 2000–2007 average.

Since then, thanks to strong monetary and fiscal policies and to the slow repair of the financial system, most economies have turned around. As you can see from Figure 1-1, growth in advanced countries turned positive in 2010 and has remained positive since. The recovery is however both unimpressive and uneven. In some advanced countries, most notably the United States, unemployment has nearly returned to its pre-crisis level. The Euro area however is still struggling. Growth is positive, but it is low, and unemploy- ment remains high. Growth in emerging and developing economies has also recovered, but, as you can see from Figure 1-1, it is lower than it was before the crisis and has steadily declined since 2010.

Having set the stage, let me now take you on a tour of the three main economic pow- ers in the world, the United States, the Euro area, and China.

1-2 The United States When economists look at a country, the first two questions they ask are: How big is the country from an economic point of view? And what is its standard of living? To answer the first, they look at output—the level of production of the country as a whole. To an- swer the second, they look at output per person. The answers, for the United States, are given in Figure 1-3: The United States is big, with an output of $17.4 trillion in 2014,

MyEconLab Video

The United States, 2014 Output: $17.4 trillion Population: 319.1 million Output per person: $54,592 Share of world output: 23%

Figure 1-3

The United States, 2014

Chapter 1 A Tour of the World 7

accounting for 23% of world output. This makes it the largest country in the world in economic terms. And the standard of living in the United States is high: Output per per- son is $54,600. It is not the country with the highest output per person in the world, but it is close to the top.

When economists want to dig deeper and look at the state of health of the country, they look at three basic variables:

■■ Output growth—the rate of change of output ■■ The unemployment rate—the proportion of workers in the economy who are not em-

ployed and are looking for a job ■■ The inflation rate—the rate at which the average price of goods in the economy is

increasing over time

Numbers for these three variables for the U.S. economy are given in Table 1-1. To put current numbers in perspective, the first column gives the average value of each of the three variables for the period 1990 up to 2007, the year before the crisis. The second col- umn shows numbers for the acute part of the crisis, the years 2008 and 2009. The third column shows the numbers from 2010 to 2014, and the last column gives the numbers for 2015 (or more accurately, the forecasts for 2015 as of the fall of 2015).

By looking at the numbers for 2015, you can see why economists are reasonably optimistic about the U.S. economy at this point. Growth in 2015 is forecast to be above 2.5%, just a bit below the 1990–2007 average. Unemployment, which increased during the crisis and its aftermath (it reached 10% during 2010), is decreasing and, at 5.4%, is now back to its 1990–2007 average. Inflation is low, substantially lower than the 1990– 2007 average. In short, the U.S. economy seems to be in decent shape, having largely left the effects of the crisis behind.

Not everything is fine however. To make sure demand was strong enough to sustain growth, the Fed has had to maintain interest rates very low, indeed, too low for comfort. And productivity growth appears to have slowed, implying mediocre growth in the fu- ture. Let’s look at both issues in turn.

Low Interest Rates and the Zero Lower Bound When the crisis started, the Fed tried to limit the decrease in spending by decreasing the interest rate it controls, the so-called federal funds rate. As you can see from Figure 1-4, on page 8 the federal funds rate went from 5.2% in July 2007 to nearly 0% (0.16% to be precise) in December 2008.

Why did the Fed stop at zero? Because the interest rate cannot be negative. If it were, then nobody would hold bonds, everybody would want to hold cash instead—because cash pays a zero interest rate. This constraint is known in macroeconomics as the zero lower bound, and this is the bound the Fed ran into in December 2008.

Output growth rate: annual rate of growth of output (GDP). Unemployment rate: average over the year. Inflation rate: annual rate of change of the price level (GDP deflator).

Source: IMF, World Economic Outlook, July 2015.

Percent 1990–2007 (average)

2008–2009 (average)

2010–2014 (average) 2015

Output growth rate 3.0 –1.5 2.2 2.5

Unemployment rate 5.4 7.5 8.0 5.4

Inflation rate 2.3 1.4 1.6 0.7

Table 1-1 Growth, Unemployment, and Inflation in the United States, 1990–2015

Can you guess some of the countries with a higher standard of living than the United States? Hint: Think of oil producers and financial centers. For answers, look for “Gross Domestic Prod- uct per capita, in current prices” at http://www.imf.org/external/ pubs/ft/weo/2015/01/weodata/ weoselgr.aspx

b

Because keeping cash in large sums is inconvenient and dangerous, people might be willing to hold some bonds even if those pay a small neg- ative interest rate. But there is a clear limit to how negative the interest rate can go before people find ways to switch to cash.

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8 Introduction The Core

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Figure 1-4

The U.S. Federal Funds Rate since 2000

Source: Haver Analytics.

MyEconLab Real-time data

As you will see later in the book, central banks like the Fed can use a few other tools to in- crease demand. These tools are known as “unconventional monetary policy.” But they do not work as well as the interest rate.

This sharp decrease in the interest rate, which made it cheaper for consumers to borrow, and for firms to invest, surely limited the fall in demand and the fall in output. But, as we saw earlier and you can see from Table 1-1, this was not enough to avoid a deep recession: U.S. growth was negative in both 2008 and 2009. To help the economy recover, the Fed then kept the interest rate close to zero, where it has remained until now (the fall of 2015). The Fed’s plan is to start increasing the interest rate soon, so when you read this book, it is likely that the rate will have increased, but it will still be very low by historical standards.

Why are low interest rates a potential issue? For two reasons: The first is that low interest rates limit the ability of the Fed to respond to further negative shocks. If the in- terest rate is at or close to zero, and demand further decreases, there is little the Fed can do to increase demand. The second is that low interest rates appear to lead to excessive risk taking by investors. Because the return from holding bonds is so low, investors are tempted to take too much risk to increase their returns. And too much risk taking can in turn give rise to financial crises of the type we just experienced. Surely, we do not want to experience another crisis like the one we just went through.

How Worrisome Is Low Productivity Growth? Although the Fed has to worry about maintaining enough demand to achieve growth in the short run, over longer periods of time, growth is determined by other factors, the main one being productivity growth: Without productivity growth, there just cannot be a sustained increase in income per person. And, here, the news is worrisome. Table 1-2 shows average U.S. productivity growth by decade since 1990 for the private sector as a whole and for the manufacturing sector. As you can see, productivity growth in the 2010s has so far been about half as high as it was in the 1990s.

How worrisome is this? Productivity growth varies a lot from year to year, and some economists believe that it may just be a few bad years and not much to worry about. Others believe that measurement issues make it difficult to measure output and that productivity growth may be underestimated. For example, how do you measure

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Chapter 1 A Tour of the World 9

the real value of a new smartphone relative to an older model? Its price may be higher, but it probably does many things that the older model could not do. Yet others believe that the United States has truly entered a period of lower productivity growth, that the major gains from the current IT innovations may already have been obtained, and that progress is likely to be less rapid, at least for some time.

One particular reason to worry is that this slowdown in productivity growth is hap- pening in the context of growing inequality. When productivity growth is high, most everybody is likely to benefit, even if inequality increases. The poor may benefit less than the rich, but they still see their standard of living increase. This is not the case today in the United States. Since 2000, the real earnings of workers with a high school educa- tion or less have actually decreased. If policy makers want to invert this trend, they need either to raise productivity growth or limit the rise of inequality, or both. These are two major challenges facing U.S. policy makers today.

1-3 The Euro Area In 1957, six European countries decided to form a common European market—an economic zone where people and goods could move freely. Since then, 22 more countries have joined, bringing the total to 28. This group is now known as the European Union, or EU for short.

In 1999, the EU decided to go a step further and started the process of replacing national currencies with one common currency, called the euro. Only 11 countries partici- pated at the start; since then, 8 more have joined. Some countries, in particular, the United Kingdom, have decided not to join, at least for the time being. The official name for the group of member countries is the Euro area. The transition took place in steps. On January 1, 1999, each of the 11 countries fixed the value of its currency to the euro. For example, 1 euro was set equal to 6.56 French francs, to 166 Spanish pesetas, and so on. From 1999 to 2002, prices were quoted both in national currency units and in euros, but the euro was not yet used as currency. This happened in 2002, when euro notes and coins replaced national currencies. Nineteen countries now belong to this common currency area.

Source: Haver Analytics.

Percent change; year on year (average) 1990s 2000s 2010–2014

Nonfarm Business Sector 2.0 2.6 1.2

Business Sector 2.1 2.6 1.2

Manufacturing 4.0 3.1 2.4

Table 1-2 Labor Productivity Growth, by Decade

IT stands for information technology.

b

Until a few years ago, the official name was the European Community, or EC. You may still encounter that name.

b

Percent 1990–2007 (average)

2008–2009 (average)

2010–2014 (average) 2015

Output growth rate 2.1 —2.0 0.7 1.5

Unemployment rate 9.4 8.6 11.1 11.1

Inflation rate 2.1 1.5 1.0 1.1

Output growth rate: annual rate of growth of output (GDP). Unemployment rate: average over the year. Inflation rate: annual rate of change of the price level (GDP deflator).

Source: IMF, World Economic Outlook, July 2015.

Table 1-3 Growth, Unemployment, and Inflation in the Euro Area, 1990–2015

The area also goes by the names of “Euro zone” or “Euroland.” The first sounds too technocratic, and the second reminds one of Disneyland. I shall avoid them.

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10 Introduction The Core

France Germany Italy Spain

2.8 3.9 2.1 1.4

63.9 81.1 60.0 46.5

$44,332 $47,604 $35,820 $30,272

2014 Output

($ trillions) Population (millions)

Output per Person

Finland

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Portugal

The Netherlands

Luxembourg

Austria

Greece

Italy

Malta Cyprus

Slovenia

Slovakia

Estonia

Latvia

Lithuania

France

Spain

Euro area, 2014 Output: $13.4 trillion Population: 334.5 million Output per person: $40,143 Share of world output: 17.4%

Figure 1-5

The Euro Area, 2014

Chapter 1 A Tour of the World 11

As you can see from Figure 1-5, the Euro area is also a strong economic power. Its output is nearly equal to that of the United States, and its standard of living is not far behind. (The EU as a whole has an output that exceeds that of the United States.) As the numbers in Table 1-3 show, however, it is not doing very well.

Just as in the United States, the acute phase of the crisis, 2008 and 2009, was char- acterized by negative growth. Whereas the United States recovered, growth in the Euro area remained anemic, close to zero over 2010 to 2014 (indeed two of these years again saw negative growth). Even in 2015, growth is forecast to be only 1.5%, less than in the United States, and less than the pre-crisis average. Unemployment, which increased from 2007 on, stands at a high 11.1%, nearly twice that of the United States. Inflation is low, below the target of the European Central Bank, the ECB.

The Euro area faces two main issues today. The first is how to reduce unemploy- ment. Second is whether and how it can function efficiently as a common currency area. We consider these two issues in turn.

Can European Unemployment Be Reduced? The high average unemployment rate for the Euro area, 11.1% in 2015, hides a lot of variations across Euro countries. At one end, Greece and Spain have unemployment rates of 25% and 23%, respectively. At the other, Germany’s unemployment rate is less than 5%. In the middle are countries like France and Italy, with unemployment rates of 10% and 12%, respectively. Thus, it is clear that how to reduce unemployment must be tailored to the specifics of each country.

To show the complexity of the issues, it is useful to look at a particular country with high unemployment. Figure 1-6, on page 12, shows the striking evolution of the Spanish unemployment rate since 1990. After a long boom starting in the mid 1990s, the unemployment rate had decreased from a high of nearly 25% in 1994 to 9% by 2007. But, with the crisis, unemployment exploded again, exceeding 25% in 2013. Only now, is it starting to decline, but it is still high. The graph suggests two conclusions:

■■ Much of the high unemployment rate today is a result of the crisis, and to the sud- den collapse in demand we discussed in the first section. A housing boom turned to

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12 Introduction The Core

housing bust, plus a sudden increase in interest rates, triggered the increase in un- employment from 2008 on. One can hope that, eventually, demand will pick up, and unemployment will decrease.

■■ How low can it get? Even at the peak of the boom however, the unemployment rate in Spain was around 9%, nearly twice the unemployment rate in the United States today. This suggests that more is at work than the crisis and the fall in demand. The fact that, for most of the last 20 years, unemployment has exceeded 10% points to problems in the labor market. The challenge is then to identify exactly what these problems are, in Spain, and in other European countries.

Some economists believe the main problem is that European states protect workers too much. To prevent workers from losing their jobs, they make it expensive for firms to lay off workers. One of the unintended results of this policy is to deter firms from hiring workers in the first place, and thus increasing unemployment. Also, to protect workers who become unemployed, European governments provide generous unemployment insurance. But, by doing so, they decrease the incentives for the unemployed to take jobs rapidly; this also increases unemployment. The solution, these economists argue, is to be less protective, to eliminate these labor market rigidities, and to adopt U.S.-style labor- market institutions. This is what the United Kingdom has largely done, and its unem- ployment rate is low.

Others are more skeptical. They point to the fact that unemployment is not high everywhere in Europe. Yet most countries provide protection and generous social in- surance to workers. This suggests that the problem may lay not so much with the de- gree of protection but with the way it is implemented. The challenge, those economists argue, is to understand what the low unemployment countries are doing right, and whether what they do right can be exported to other European countries. Resolving these questions is one of the major tasks facing European macroeconomists and policy makers today.

What Has the Euro Done for Its Members? Supporters of the euro point to its enormous symbolic importance. In light of the many past wars among European countries, what better proof of the permanent end to conflict than the adoption of a common currency? They also point to the economic advantages of having a common currency: no more changes in exchange rates for European firms to worry about; no more need to change currencies when crossing borders. Together with the removal of other obstacles to trade among European countries, the euro contributes, they argue, to the creation of a large economic power in the world. There is little question that the move to the euro was indeed one of the main economic events of the start of the twenty-first century.

Others worry, however, that the symbolism of the euro has come with substantial economic costs. Even before the crisis, they pointed out that a common currency means a common monetary policy, which means the same interest rate across the euro coun- tries. What if, they argued, one country plunges into recession while another is in the middle of an economic boom? The first country needs lower interest rates to increase spending and output; the second country needs higher interest rates to slow down its economy. If interest rates have to be the same in both countries, what will happen? Isn’t there the risk that one country will remain in recession for a long time or that the other will not be able to slow down its booming economy? And a common currency also means the loss of the exchange rate as an instrument of adjustment within the Euro area. What if, they argued, a country has a large trade deficit and needs to become more competitive? If it cannot adjust its exchange rate, it must adjust by decreasing prices relative to its competitors. This is likely to be a painful and long process.

Chapter 1 A Tour of the World 13

Until the Euro crisis, the debate had remained somewhat abstract. It no longer is. As a result of the crisis, a number of Euro members, from Ireland and Portugal, to Greece, have gone through deep recessions. If they had their own currency, they could have depreciated their currency vis-à-vis other Euro members to increase the demand for their exports. Because they shared a currency with their neighbors, this was not pos- sible. Thus, some economists conclude, some countries should drop out of the euro and recover control of their monetary policy and of their exchange rate. Others argue that such an exit would be both unwise because it would give up on the other advantages of being in the euro and be extremely disruptive, leading to even deeper problems for the country that exited. This issue is likely to remain a hot one for some time to come.

1-4 China China is in the news every day. It is increasingly seen as one of the major economic pow- ers in the world. Is the attention justified? A first look at the numbers in Figure 1-7 on page 14 suggests it may not be. True, the population of China is enormous, more than four times that of the United States. But its output, expressed in dollars by multiplying the number in yuans (the Chinese currency) by the dollar–yuan exchange rate, is still only 10.4 trillion dollars, about 60% of the United States. Output per person is about $7,600, only roughly 15% of output per person in the United States.

So why is so much attention paid to China? There are two main reasons: To under- stand the first, we need to go back to the number for output per person. When comparing output per person in a rich country like the United States and a relatively poor country like China, one must be careful. The reason is that many goods are cheaper in poor countries. For example, the price of an average restaurant meal in New York City is about 20 dollars; the price of an average restaurant meal in Beijing is about 25 yuans, or, at the current exchange rate, about 4 dollars. Put another way, the same income (ex- pressed in dollars) buys you much more in Beijing than in New York City. If we want to compare standards of living, we have to correct for these differences; measures which do so are called PPP (for purchasing power parity) measures. Using such a measure, output per person in China is estimated to be about $12,100, roughly one-fourth of the output per person in the United States. This gives a more accurate picture of the standard of living in China. It is obviously still much lower than that of the United States or other rich countries. But it is higher than suggested by the numbers in Figure 1-7.

Second, and more importantly, China has been growing very rapidly for more than three decades. This is shown in Table 1-4, which, like the previous tables for the United States and the Euro area, gives output growth, unemployment, and inflation for the peri- ods 1990–2007, 2008–2009, 2010–2014, and the forecast for 2015.

The first line of the table tells the basic story. Since 1990 (indeed, since 1980, if we were to extend the table back by another 10 years), China has grown at close to 10% a year. This represents a doubling of output every 7 years. Compare this number to the numbers for the United States and for Europe we saw previously, and you understand why the weight of the emerging economies in the world economy, China being the main one, is increasing so rapidly.

There are two other interesting aspects to Table 1-4. The first is how difficult it is to see the effects of the crisis in the data. Growth barely decreased during 2008 and 2009, and unemployment barely increased. The reason is not that China is closed to the rest of the world. Chinese exports slowed during the crisis. But the adverse effect on demand was nearly fully offset by a major fiscal expansion by the Chinese government, with, in partic- ular, a major increase in public investment. The result was sustained growth of demand and, in turn, of output.

The issue is less important when comparing two rich countries. Thus, this was not a major issue when compar- ing standards of living in the United States and the Euro area previously.b

14 Introduction The Core

The second is the decline in growth rates from 10% before the crisis to less than 9% after the crisis, and to the forecast 6.8% for 2015. This raises questions both about how China maintained such a high growth rate for so long, and whether it is now entering a period of lower growth.

A preliminary question is whether the numbers are for real. Could it be that Chinese growth was and is still overstated? After all, China is still officially a commu- nist country, and government officials may have incentives to overstate the economic performance of their sector or their province. Economists who have looked at this carefully conclude that this is probably not the case. The statistics are not as reliable as they are in richer countries, but there is no major bias. Output growth is indeed very high in China. So where has growth come from? It has come from two sources: The first was high accumulation of capital. The investment rate (the ratio of investment to output) in China is 48%, a very high number. For comparison, the investment rate in the United States is only 19%. More capital means higher productivity and higher output. The second is rapid technological progress. One of the strategies followed by the Chinese government has been to encourage foreign firms to relocate and produce in China. As foreign firms are typically much more productive than Chinese firms,

China, 2014 Output: $10.4 trillion Population: 1,368 million Output per person: $7,627 Share of world output: 13.5%

Figure 1-7

China, 2014

Source: World Economic Outlook, IMF.

Percent 1990–2007 (average)

2008–2009 (average)

2010–2014 (average) 2015

Output growth rate 10.2 9.4 8.6 6.8

Unemployment rate 3.3 4.3 4.1 4.1

Inflation rate 5.9 3.7 4.2 1.2

Table 1-4 Growth, Unemployment, and Inflation in China, 1990–2015

Output growth rate: annual rate of growth of output (GDP). Unemployment rate: average over the year. Inflation rate: annual rate of change of the price level (GDP deflator).

Source: IMF, World Economic Outlook, July 2015.

MyEconLab Real-time data

Chapter 1 A Tour of the World 15

this has increased productivity and output. Another aspect of the strategy has been to encourage joint ventures between foreign and Chinese firms. By making Chinese firms work with and learn from foreign firms, the productivity of the Chinese firms has increased dramatically.

When described in this way, achieving high productivity and high output growth appears easy and a recipe that every poor country could and should follow. In fact, things are less obvious. China is one of a number of countries that made the transition from central planning to a market economy. Most of the other countries, from Central Europe to Russia and the other former Soviet republics, experienced a large decrease in output at the time of transition. Most still have growth rates far below that of China. In many countries, widespread corruption and poor property rights make firms unwilling to invest. So why has China fared so much better? Some economists believe that this is the result of a slower transition: The first Chinese reforms took place in agriculture as early as 1980, and even today, many firms remain owned by the state. Others argue that the fact that the communist party has remained in control has actually helped the economic transition; tight political control has allowed for a better protection of property rights, at least for new firms, giving them incentives to invest. Getting the an- swers to these questions, and thus learning what other poor countries can take from the Chinese experience, can clearly make a huge difference, not only for China but for the rest of the world.

At the same time, the recent growth slowdown raises a new set of questions: Where does the slowdown come from? Should the Chinese government try to maintain high growth or accept the lower growth rate? Most economists and, indeed, the Chinese au- thorities themselves, believe that lower growth is now desirable, that the Chinese people will be better served if the investment rate decreases, allowing more of output to go to consumption. Achieving the transition from investment to consumption is the major challenge facing the Chinese authorities today.

1-5 Looking Ahead This concludes our whirlwind world tour. There are many other regions of the world and many other macroeconomic issues we could have looked at:

■■ India, another poor and large country, with a population of 1,270 million people, which, like China, is now growing very fast and becoming a world economic power.

■■ Japan, whose growth performance for the 40 years following World War II was so impressive that it was referred to as an economic miracle, but it has done very poorly in the last two decades. Since a stock market crash in the early 1990s, Japan has been in a prolonged slump, with average output growth under 1% per year.

■■ Latin America, which went from high inflation to low inflation in the 1990s, and then sustained strong growth. Recently however, its growth has slowed, as a result, in part, of a decline in the price of commodities.

■■ Central and Eastern Europe, which shifted from central planning to a market system in the early 1990s. In most countries, the shift was characterized by a sharp decline in output at the start of transition. Some countries, such as Poland, now have high growth rates; others, such as Bulgaria, are still struggling.

■■ Africa, which has suffered decades of economic stagnation, but where, contrary to common perceptions, growth has been high since 2000, averaging 5.5% per year and reflecting growth in most of the countries of the continent.

MyEconLab Video

Tight political control has also allowed for corruption to de- velop, and corruption can also threaten investment. China is now in the midst of a strong anti-corruption campaign.

b

There is a limit to how much you can absorb in this first chapter. Think about the issues to which you have been exposed:

■■ The big issues triggered by the crisis: What caused the crisis? Why did it transmit so fast from the United States to the rest of the world? In retrospect, what could and should have been done to prevent it? Were the monetary and fiscal responses appropriate? Why is the recovery so slow in Europe? How was China able to maintain high growth during the crisis?

■■ Can monetary and fiscal policies be used to avoid recessions? How much of an issue is the zero lower bound on interest rates? What are the pros and cons of joining a common currency area such as the Euro area? What measures could be taken in Europe to reduce persistently high unemployment?

■■ Why do growth rates differ so much across countries, even over long periods of time? Can other countries emulate China and grow at the same rate? Should China slow down?

The purpose of this book is to give you a way of thinking about these questions. As we develop the tools you need, I shall show you how to use them by returning to these questions and showing you the answers the tools suggest.

common currency area, 11European Union (EU), 9 Euro area, 9

Key Terms

Questions and Problems

QUICk ChECk MyEconLab Visit www.myeconlab.com to complete all Quick Check problems and get instant feedback. 1. Using the information in this chapter, label each of the following statements true, false, or uncertain. Explain briefly.

a. Output growth was negative in both advanced as well as emerging and developing countries in 2009.

b. World output growth recovered to its prerecession level after 2009.

c. Stock prices around the world fell between 2007 and 2010 and then recovered to their prerecession level.

d. The rate of unemployment in the United Kingdom is much lower than in much of the rest of Europe.

e. China’s seemingly high growth rate is a myth; it is a product solely of misleading official statistics.

f. The high rate of unemployment in Europe started when a group of major European countries adopted a common currency.

g. The Federal Reserve lowers interest rates when it wants to avoid recession and raises interest rates when it wants to slow the rate of growth in the economy.

h. Output per person is different in the Euro area, the United States, and China.

i. Interest rates in the United States were at or near zero from 2009 to 2015.

2. Macroeconomic policy in Europe Beware of simplistic answers to complicated macroeconomic

questions. Consider each of the following statements and comment on whether there is another side to the story.

a. There is a simple solution to the problem of high European unemployment: Reduce labor market rigidities.

b. What can be wrong about joining forces and adopting a common currency? Adoption of the euro is obviously good for Europe.

DIg DEEPEr MyEconLab Visit www.myeconlab.com to complete all Dig Deeper problems and get instant feedback. 3. Chinese economic growth is the outstanding feature of the world economic scene over the past two decades.

a. In 2014, U.S. output was $17.4 trillion, and Chinese output was $10.4 trillion. Suppose that from now on, the output of

16 Introduction The Core

MyEconLab Real-time data exercises are marked .

China grows at an annual rate of 6.5% per year, whereas the output of the United States grows at an annual rate of 2.2% per year. These are the values in each country for the period 2010–2014 as stated in the text. Using these assumptions and a spreadsheet, calculate and plot U.S. and Chinese out- put from 2014 over the next 100 years. How many years will it take for China to have a total level of output equal to that of the United States?

b. When China catches up with the United States in total out- put, will residents of China have the same standard of living as U.S. residents? Explain.

c. Another term for standard of living is output per person. How has China raised its output per person in the last two dec- ades? Are these methods applicable to the United States?

d. Do you think China’s experience in raising its standard of living (output per person) provides a model for developing countries to follow?

4. The rate of growth of output per person was identified as a major issue facing the United States as of the writing of this chapter. Go to the 2015 Economic Report of the President and find a table titled “Productivity and Related Data” (Table B-16). You can download this table as an Excel file.

a. Find the column with numbers that describe the level of output per hour worked of all persons in the nonfarm busi- ness sector. This value is presented as an index number equal to 100 in 2009. Calculate the percentage increase in output per hour worked from 2009 to 2010. What does that value mean?

b. Now use the spreadsheet to calculate the average percent increase in output per hour worked for the decades 1970– 1979, 1980–1989, 1990–1999, 2000–2009, and 2010– 2014. How does productivity growth in the last decade compare to the other decades?

c. You may be able to find a more recent Economic Report of the President. If so, update your estimate of the average

growth rate of output per hour worked to include years past 2014. Is there any evidence of an increase in productivity growth?

ExPlOrE FUrthEr 5. U.S. postwar recessions

This question looks at the recessions over the past 40 years. To work this problem, first obtain quarterly data on U.S. output growth for the period 1960 to the most recent date from the Web site www.bea.gov. Table 1.1.1 presents the percent change in real gross domestic product (GDP). This data can be downloaded to a spreadsheet. Plot the quarterly GDP growth rates from 1960:1 to the latest observations. Which, if any, quarters have negative growth? Using the definition of a recession as two or more consecu- tive quarters of negative growth, answer the following questions.

a. How many recessions has the U.S. economy undergone since 1960, quarter 2?

b. How many quarters has each recession lasted? c. In terms of length and magnitude, which two recessions

have been the most severe? 6. From Problem 5, write down the quarters in which the six traditional recessions started. Find the monthly series in the Federal Reserve Bank of St. Louis (FRED) database for the seasonally adjusted unemployment rate. Retrieve the monthly data series on the unemployment rate for the period 1969 to the end of the data. Make sure all data series are seasonally adjusted.

a. Look at each recession since 1969. What was the unem- ployment rate in the first month of the first quarter of nega- tive growth? What was the unemployment rate in the last month of the last quarter of negative growth? By how much did the unemployment rate increase?

b. Which recession had the largest increase in the rate of un- employment? Begin with the month before the quarter in which output first falls and measure to the highest level of the unemployment rate before the next recession.

■■ The best way to follow current economic events and issues is to read The Economist, a weekly magazine published in England.

The articles in The Economist are well informed, well written, witty, and opinionated. Make sure to read it regularly.

Further Reading

Chapter 1 A Tour of the World 17

18 Introduction The Core

APPEnDIx: Where to Find the numbers

Suppose you want to find the numbers for inflation in Germany over the past five years. Fifty years ago, the answer would have been to learn German, find a library with German publications, find the page where inflation numbers were given, write them down, and plot them by hand on a clean sheet of paper. Today, improvements in the collection of data, the development of computers and electronic databases, and access to the Internet make the task much easier. This appendix will help you find the numbers you are looking for, be it inflation in Malaysia last year, or consumption in the United States in 1959, or unemployment in Ireland in the 1980s. In most cases, the data can be down- loaded to spreadsheets for further treatment.

For a Quick Look at Current Numbers

■■ The best source for the most recent numbers on output, unem- ployment, inflation, exchange rates, interest rates, and stock prices for a large number of countries is the last four pages of The Economist, published each week (www.economist.com). The Web site, like many of the Web sites listed throughout the text, contains both information available free to anyone and information available only to subscribers.

■■ A good source for recent numbers about the U.S. economy is National Economic Trends, published monthly by the Federal Reserve Bank of Saint Louis. (https://research.stlouisfed. org/datatrends/net/)

For More Detail about the U.S. Economy

■■ A convenient database, with numbers often going back to the 1960s, for both the United States and other countries, is the Federal Reserve Economic Database (called FRED), main- tained by the Federal Reserve Bank of Saint Louis. Access is free, and much of the U.S. data used in this book comes from that database. (www.research.stlouisfed.org/fred2/)

■■ Once a year, the Economic Report of the President, written by the Council of Economic Advisers and published by the U.S. Government Printing Office in Washington, D.C., gives a description of current evolutions, as well as numbers for most major macroeconomic variables, often going back to the 1950s. (It contains two parts, a report on the economy, and a set of statistical tables. Both can be found at www.gpo .gov/erp/)

■■ A detailed presentation of the most recent numbers for national income accounts is given in the Survey of Current Business, published monthly by the U.S. Department of Commerce, Bureau of Economic Analysis (www.bea.gov). A user’s guide to the statistics published by the Bureau of Economic Analysis is given in the Survey of Current Business, April 1996.

■■ The standard reference for national income accounts is the National Income and Product Accounts of the United States.

Volume 1, 1929–1958, and Volume 2, 1959–1994, are published by the U.S. Department of Commerce, Bureau of Economic Analysis (www.bea.gov).

■■ For data on just about everything, including economic data, a precious source is the Statistical Abstract of the United States, published annually by the U.S. Department of Commerce, Bureau of the Census (http://www.census.gov/ library/publications/2011/compendia/statab/131ed.html).

Numbers for Other Countries

The Organization for Economic Cooperation and Development, OECD for short, located in Paris, France (www. oecd.org), is an organization that includes most of the rich countries in the world (Australia, Austria, Belgium, Canada, Chile, the Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Iceland, Israel, Italy, Japan, Korea, Luxembourg, Mexico, the Netherlands, New Zealand, Norway, Poland, Portugal, the Slovak Republic, Slovenia, Spain, Sweden, Switzerland, Turkey, the United Kingdom, and the United States). Together, these countries account for about 70% of the world’s output. One strength of the OECD data is that, for many variables, the OECD tries to make the variables comparable across member countries (or tells you when they are not compa- rable). The OECD issues three useful publications, all available on the OECD site.

■■ The first is the OECD Economic Outlook, published twice a year. In addition to describing current macroeconomic is- sues and evolutions, it includes a data appendix, with data for many macroeconomic variables. The data typically go back to the 1980s and are reported consistently, both across time and across countries.

■■ The second is the OECD Employment Outlook, published an- nually. It focuses more specifically on labor-market issues and numbers.

■■ Occasionally, the OECD puts together current and past data, and publishes a set of OECD Historical Statistics in which various years are grouped together.

The main strength of the publications of the International Monetary Fund (IMF for short, located in Washington, D.C.) is that they cover nearly all of the countries of the world. The IMF has 187 member countries and provides data on each of them (www.imf.org).

■■ A particularly useful IMF publication is the World Economic Outlook (WEO for short), which is published twice a year and which describes major economic events in the world and in specific member countries. Selected series associated with the Outlook are available in the WEO database, available on

Chapter 1 A Tour of the World 19

the IMF site (www.imf.org/external/data.htm). Most of the data shown in this chapter come from this database.

■■ Two other useful publications are the Global Financial Stability Report (GFSR for short), which focuses on financial developments, and the Fiscal Monitor, which focuses on fis- cal developments. All three publications are available on the IMF Web site (www.imf.org/external/index.htm).

The World Bank also maintains a large data base (data .worldbank.org/), with a wide set of indicators, from climate change to social protection.

Historical Statistics

■■ For long-term historical statistics for the United States, the basic reference is Historical Statistics of the United States, Colonial Times to 1970, Parts 1 and 2, published by the U.S. Department of Commerce, Bureau of the Census (www .census.gov/prod/www/statistical_abstract.html).

■■ For long-term historical statistics for several countries, a pre- cious data source is Angus Maddison’s Monitoring the World Economy, 1820–1992, Development Centre Studies, OECD, Paris, 1995. This study gives data going back to 1820 for 56 countries. Two even longer and broader sources are The World Economy: A Millenial Perspective, Development Studies, OECD, 2001, and The World Economy: Historical Statistics, Development Studies, OECD 2004, both also by Angus Maddison.

Current Macroeconomic Issues

A number of Web sites offer information and commentar- ies about the macroeconomic issues of the day. In addition to The Economist Web site, the site maintained by Nouriel Roubini (www.rgemonitor.com) offers an extensive set of links to articles and discussions on macroeconomic issues (by subscription). Another interesting site is vox.eu (www. voxeu.org), in which economists post blogs on current issues and events.

If you still have not found what you were looking for, a site maintained by Bill Goffe at the State University of New York (SUNY) (www.rfe.org), lists not only many more data sources, but also sources for economic information in general, from working papers, to data, to jokes, to jobs in economics, and to blogs.

And, finally, the site called Gapminder (http://www .gapminder.org/) has a number of visually striking animated graphs, many of them on issues related to macroeconomics.

Key Terms Organization for Economic Cooperation and

Development (OECD), 18 International Monetary Fund (IMF), 18

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21

The words output, unemployment, and inflation appear daily in newspapers and on the evening news. So when I used these words in Chapter 1, you knew roughly what we were talking about. It is now time to define these words more precisely, and this is what we do in the first three sections of this chapter.Section 2-1 looks at output. Section 2-2 looks at the unemployment rate.

Section 2-3 looks at the inflation rate.

Section 2-4 introduces two important relations between these three variables: Okun’s law and the Phillips curve.

Section 2-5 then introduces the three central concepts around which the book is organized:

■■ The short run: What happens to the economy from year to year

■■ The medium run: What happens to the economy over a decade or so

■■ The long run: What happens to the economy over a half century or longer

Building on these three concepts, Section 2-6 gives you a road map to the rest of the book.

2 A Tour of the Book

22 Introduction The Core

2-1 Aggregate Output Economists studying economic activity in the nineteenth century or during the Great Depression had no measure of aggregate activity (aggregate is the word macroeconomists use for total) on which to rely. They had to put together bits and pieces of information, such as the shipments of iron ore, or sales at some department stores, to try to infer what was happening to the economy as a whole.

It was not until the end of World War II that national income and product ac- counts (or national income accounts, for short) were put together. Measures of aggre- gate output have been published on a regular basis in the United States since October 1947. (You will find measures of aggregate output for earlier times, but these have been constructed retrospectively.)

Like any accounting system, the national income accounts first define concepts and then construct measures corresponding to these concepts. You need only to look at statistics from countries that have not yet developed such accounts to realize that preci- sion and consistency in such accounts are crucial. Without precision and consistency, numbers that should add up do not; trying to understand what is going on feels like trying to balance someone else’s checkbook. I shall not burden you with the details of national income accounting here. But because you will occasionally need to know the definition of a variable and how variables relate to each other, Appendix 1 at the end of the book gives you the basic accounting framework used in the United States (and, with minor variations, in most other countries) today. You will find it useful whenever you want to look at economic data on your own.

GDP: Production and Income The measure of aggregate output in the national income accounts is called the gross domestic product, or GDP, for short. To understand how GDP is constructed, it is best to work with a simple example. Consider an economy composed of just two firms:

■■ Firm 1 produces steel, employing workers and using machines to produce the steel. It sells the steel for $100 to Firm 2, which produces cars. Firm 1 pays its workers $80, leaving $20 in profit to the firm.

■■ Firm 2 buys the steel and uses it, together with workers and machines, to produce cars. Revenues from car sales are $200. Of the $200, $100 goes to pay for steel and $70 goes to workers in the firm, leaving $30 in profit to the firm.

We can summarize this information in a table:

Steel Company (Firm 1) Car Company (Firm 2)

Revenues from sales $100 Revenues from sales $200

Expenses $80 Expenses $170 Wages $80 Wages $70

Steel purchases $100

Profit $20 Profit $30

How would you define aggregate output in this economy? As the sum of the values of all goods produced in the economy—the sum of $100 from the production of steel and $200 from the production of cars, so $300? Or as just the value of cars, which is equal to $200?

Some thought suggests that the right answer must be $200. Why? Because steel is an intermediate good: It is used in the production of cars. Once we count the

Two economists, Simon Kuznets, from Harvard University, and Richard Stone, from Cambridge University, received the Nobel Prize for their contributions to the development of the national income and product accounts—a gigantic intellec- tual and empirical achievement.

c

You may come across another term, gross national product, or GNP. There is a subtle dif- ference between “domestic” and “national,” and thus be- tween GDP and GNP. We ex- amine the distinction in Chap- ter 18 and in Appendix 1 at the end of the book. For now, ignore it.

In reality, not only workers and machines are required for steel production, but so are iron ore, electricity, and so on. I ignore these to keep the ex- ample simple.

c

c

An intermediate good is a good used in the production of another good. Some goods can be both final goods and intermediate goods. Potatoes sold directly to consumers are final goods. Potatoes used to produce potato chips are in- termediate goods. Can you think of other examples? c

Chapter 2 A Tour of the Book 23

production of cars, we do not want to count the production of the goods that went into the production of these cars.

This motivates the first definition of GDP:

1. GDP Is the Value of the Final Goods and Services Produced in the Economy during a Given Period.

The important word here is final. We want to count only the production of final goods, not intermediate goods. Using our example, we can make this point in another way. Suppose the two firms merged, so that the sale of steel took place inside the new firm and was no longer recorded. The accounts of the new firm would be given by the following table:

Steel and Car Company

Revenues from sales $200 Expenses (wages) $150

Profit $50

All we would see would be one firm selling cars for $200, paying workers $80 + $70 = $150, and making $20 + $30 = $50 in profits. The $200 measure would remain unchanged—as it should. We do not want our measure of aggregate out- put to depend on whether firms decide to merge or not.

This first definition gives us one way to construct GDP: by recording and adding up the production of all final goods—and this is indeed roughly the way actual GDP numbers are put together. But it also suggests a second way of thinking about and constructing GDP.

2. GDP Is the Sum of Value Added in the Economy during a Given Period. The term value added means exactly what it suggests. The value added by a firm is defined as the value of its production minus the value of the intermediate goods used in production.

In our two-firms example, the steel company does not use intermediate goods. Its value added is simply equal to the value of the steel it produces, $100. The car company, however, uses steel as an intermediate good. Thus, the value added by the car compa- ny is equal to the value of the cars it produces minus the value of the steel it uses in production, $200 - $100 = $100. Total value added in the economy, or GDP, equals $100 + $100 = $200. (Note that aggregate value added would remain the same if the steel and car firms merged and became a single firm. In this case, we would not observe intermediate goods at all—because steel would be produced and then used to produce cars within the single firm—and the value added in the single firm would simply be equal to the value of cars, $200.)

This definition gives us a second way of thinking about GDP. Put together, the two definitions imply that the value of final goods and services—the first definition of GDP— can also be thought of as the sum of the value added by all the firms in the economy—the second definition of GDP.

So far, we have looked at GDP from the production side. The other way of looking at GDP is from the income side. Go back to our example and think about the revenues left to a firm after it has paid for its intermediate goods: Some of the revenues go to pay workers— this component is called labor income. The rest goes to the firm—that component is called capital income or profit income (the reason it is called capital income is that you can think of it as remuneration for the owners of the capital used in production).

Of the $100 of value added by the steel manufacturer, $80 goes to workers (labor income) and the remaining $20 goes to the firm (capital income). Of the $100 of value added by the car manufacturer, $70 goes to labor income and $30 to capital income. For the economy as a whole, labor income is equal to $150 1$80 + $702, capital income is equal to $50 1$20 + $302. Value added is equal to the sum of labor income and capital income is equal to $200 1$150 + $502.

MyEconLab Video

The labor share in the exam- ple is thus 75%. In advanced countries, the share of labor is indeed typically between 60 and 75%.b

24 Introduction The Core

This motivates the third definition of GDP.

3. GDP Is the Sum of Incomes in the Economy during a Given Period. To summarize: You can think about aggregate output— GDP—in three different but equivalent ways.

■■ From the production side: GDP equals the value of the final goods and services produced in the economy during a given period.

■■ Also from the production side: GDP is the sum of value added in the economy during a given period.

■■ From the income side: GDP is the sum of incomes in the economy during a given period.

Nominal and Real GDP U.S. GDP was $17,400 billion in 2014, compared to $543 billion in 1960. Was U.S. out- put really 32 times higher in 2014 than in 1960? Obviously not: Much of the increase reflected an increase in prices rather than an increase in quantities produced. This leads to the distinction between nominal GDP and real GDP.

Nominal GDP is the sum of the quantities of final goods produced times their current price. This definition makes clear that nominal GDP increases over time for two reasons:

■■ First, the production of most goods increases over time. ■■ Second, the price of most goods also increases over time.

If our goal is to measure production and its change over time, we need to eliminate the effect of increasing prices on our measure of GDP. That’s why real GDP is con- structed as the sum of the quantities of final goods times constant (rather than current) prices.

If the economy produced only one final good, say, a particular car model, construct- ing real GDP would be easy: We would use the price of the car in a given year and then use it to multiply the quantity of cars produced in each year. An example will help here. Consider an economy that only produces cars—and to avoid issues we shall tackle later, assume the same model is produced every year. Suppose the number and the price of cars in three successive years are given by:

Nominal GDP, which is equal to the quantity of cars times their price, goes up from $200,000 in 2008 to $288,000 in 2009—a 44% increase—and from $288,000 in 2009 to $338,000 in 2010—a 16% increase.

Year

Quantity of Cars

Price of Cars

Nominal GDP

Real GDP (in 2009 dollars)

2008 10 $20,000 $200,000 $240,000

2009 12 $24,000 $288,000 $288,000

2010 13 $26,000 $338,000 $312,000

■■ To construct real GDP, we need to multiply the number of cars in each year by a common price. Suppose we use the price of a car in 2009 as the common price. This approach gives us in effect real GDP in 2009 dollars.

■■ Using this approach, real GDP in 2008 (in 2009 dollars) equals 10 cars * $24,000 per car = $240,000. Real GDP in 2009 (in 2009 dollars) equals 12 cars * $24,000 per car = $288,000, the same as nominal GDP in 2005. Real GDP in 2010 (in 2009 dollars) is equal to 13 * $24,000 = $312,000.

Two lessons to remember:

i. GDP is the measure of ag- gregate output, which we can look at from the pro- duction side (aggregate pro- duction), or the income side (aggregate income); and

ii. Aggregate production and aggregate income are al- ways equal.

c

Warning! People often use nom- inal to denote small amounts. Economists use nominal for variables expressed in current prices. And they surely do not refer to small amounts: The numbers typically run in the bil- lions or trillions of dollars.

c

You may wonder why I chose these three particular years. Explanation given when I look at the actual numbers for the United States.

c

Chapter 2 A Tour of the Book 25

So real GDP goes up from $240,000 in 2008 to $288,000 in 2009—a 20% increase—and from $288,000 in 2009 to $312,000 in 2010—an 8% increase.

■■ How different would our results have been if we had decided to construct real GDP using the price of a car in, say, 2010 rather than 2009? Obviously, the level of real GDP in each year would be different (because the prices are not the same in 2010 as in 2009); but its rate of change from year to year would be the same as shown.

The problem when constructing real GDP in practice is that there is obviously more than one final good. Real GDP must be defined as a weighted average of the output of all final goods, and this brings us to what the weights should be.

The relative prices of the goods would appear to be the natural weights. If one good costs twice as much per unit as another, then that good should count for twice as much as the other in the construction of real output. But this raises the question: What if, as is typically the case, relative prices change over time? Should we choose the relative prices of a particular year as weights, or should we change the weights over time? More discussion of these issues, and of the way real GDP is constructed in the United States, is left to the appendix to this chapter. Here, what you should know is that the measure of real GDP in the U.S. national income accounts uses weights that reflect relative prices and which change over time. The measure is called real GDP in chained (2009) dollars. We use 2009 because, as in our example, at this point in time 2009 is the year when, by construction, real GDP is equal to nominal GDP. It is our best measure of the output of the U.S. economy, and its evolution shows how U.S. output has increased over time.

Figure 2-1 plots the evolution of both nominal GDP and real GDP since 1960. By construction, the two are equal in 2009. The figure shows that real GDP in 2014 was about 5.1 times its level of 1960—a considerable increase, but clearly much less than the 32-fold increase in nominal GDP over the same period. The difference between the two results comes from the increase in prices over the period.

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Nominal and Real U.S. GDP, 1960–2014

From 1960 to 2014, nominal GDP increased by a factor of 32. Real GDP increased by a factor of about 5.

Source: Series GDPCA, GDPA: Federal Reserve Economic Data (FRED) http://research.stlouisfed. org/fred2/.

MyEconLab Animation MyEconLab Real-time data

To be sure, compute real GDP in 2010 dollars, and compute the rate of growth from 2008 to 2009, and from 2009 to 2010.

b

The year used to construct prices, at this point the year 2009, is called the base year. The base year is changed from time to time, and by the time you read this book, it may have changed again.

b

Suppose real GDP was meas- ured in 2000 dollars rather than 2009 dollars. Where would the nominal GDP and real GDP lines on the graph intersect?

b

26 Introduction The Core

The terms nominal GDP and real GDP each have many synonyms, and you are likely to encounter them in your readings:

■■ Nominal GDP is also called dollar GDP or GDP in current dollars. ■■ Real GDP is also called: GDP in terms of goods, GDP in constant dollars, GDP

adjusted for inflation, or GDP in chained (2009) dollars or GDP in 2009 dollars —if the year in which real GDP is set equal to nominal GDP is 2009, as is the case in the United States at this time.

In the chapters that follow, unless I indicate otherwise,

■■ GDP will refer to real GDP and Yt will denote real GDP in year t. ■■ Nominal GDP, and variables measured in current dollars, will be denoted by a dollar

sign in front of them—for example, $Yt for nominal GDP in year t.

GDP: Level versus Growth Rate We have focused so far on the level of real GDP. This is an important number that gives the economic size of a country. A country with twice the GDP of another country is eco- nomically twice as big as the other country. Equally important is the level of real GDP per person, the ratio of real GDP to the population of the country. It gives us the aver- age standard of living of the country.

In assessing the performance of the economy from year to year, economists focus, however, on the rate of growth of real GDP, often called just GDP growth. Periods of positive GDP growth are called expansions. Periods of negative GDP growth are called recessions.

The evolution of GDP growth in the United States since 1960 is given in Figure 2-2. GDP growth in year t is constructed as 1Yt - Yt - 12 / Yt - 1 and expressed as a percentage. The figure shows how the U.S. economy has gone through a series of expansions, inter- rupted by short recessions. Again, you can see the effects of the recent crisis: zero growth in 2008, and a large negative growth rate in 2009.

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Growth Rate of U.S. GDP, 1960–2014

Since 1960, the U.S. economy has gone through a series of expansions, interrupted by short recessions. The 2008– 2009 recession was the most severe recession in the period from 1960 to 2014.

Source: Calculated using series GDPCA in Figure 2-1.

MyEconLab Real-time data

Warning: One must be care- ful about how one does the comparison: Recall the dis- cussion in Chapter 1 about the standard of living in China. This is discussed further in Chapter 10.

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Chapter 2 A Tour of the Book 27

2-2 The Unemployment Rate Because it is a measure of aggregate activity, GDP is obviously the most important mac- roeconomic variable. But two other variables, unemployment and inflation, tell us about other important aspects of how an economy is performing. This section focuses on the unemployment rate.

We start with two definitions: Employment is the number of people who have a job. Unemployment is the number of people who do not have a job but are looking for one. The labor force is the sum of employment and unemployment:

L = N + U labor force = employment + unemployment

The unemployment rate is the ratio of the number of people who are unemployed to the number of people in the labor force:

u = U L

unemployment rate = unemployment / labor force

Real GDP, Technological Progress, and the Price of Computers

A tough problem in computing real GDP is how to deal with changes in quality of existing goods. One of the most difficult cases is computers. It would clearly be absurd to assume that a personal computer in 2015 is the same good as a personal computer produced, say 20 years ago: The 2015 version can clearly do much more than the 1995 version. But how much more? How do we measure it? How do we take into account the improvements in internal speed, the size of the random access memory (RAM) or of the hard disk, faster access to the Internet, and so on?

The approach used by economists to adjust for these im- provements is to look at the market for computers and how it values computers with different characteristics in a given year. Example: Suppose the evidence from prices of differ- ent models on the market shows that people are willing to pay 10% more for a computer with a speed of 4 GHz (4,000 megahertz) rather than 3 GHz. The first edition of this book, published in 1996, compared two computers, with speeds of 50 and 16 megahertz, respectively. This change is a good indi- cation of technological progress. (A further indication of the complexity of technological progress is that, for the past few years, progress has not been made not so much by increasing the speed of processors, but rather by using multicore proces- sors. We shall leave this aspect aside here, but people in charge of national income accounts cannot; they have to take this change into account as well.) Suppose new computers this year have a speed of 4 GHz compared to a speed of 3 GHz for new computers last year. And suppose the dollar price of new

computers this year is the same as the dollar price of new computers last year. Then economists in charge of computing the adjusted price of computers will conclude that new com- puters are in fact 10% cheaper than last year.

This approach, which treats goods as providing a col- lection of characteristics—for computers, speed, memory, and so on—each with an implicit price, is called hedonic pricing (“hedone” means “pleasure” in Greek). It is used by the Department of Commerce—which constructs real GDP—to estimate changes in the price of complex and fast changing goods, such as automobiles and computers. Using this approach, the Department of Commerce estimates for example, that, for a given price, the quality of new laptops has increased on average by 18% a year since 1995. Put another way, a typical laptop in 2015 delivers 1.1821 = 32 times the computing services a typical laptop delivered in 1995. (Interestingly, in light of the discussion of slowing U.S. productivity growth in Chapter 1, the rate of improvement of quality has decreased substantially in the recent past, down closer to 10%.)

Not only do laptops deliver more services, they have become cheaper as well: Their dollar price has declined by about 7% a year since 1995. Putting this together with the information in the previous paragraph, this implies that their quality–adjusted price has fallen at an average rate of 18% + 7% = 25% per year. Put another way, a dollar spent on a laptop today buys 1.2521 = 108 times more computing services than a dollar spent on a laptop in 1995.

Fo C

u s

28 Introduction The Core

Constructing the unemployment rate is less obvious than you might have thought. The cartoon notwithstanding, determining whether somebody is employed is relatively straightforward. Determining whether somebody is unemployed is more difficult. Recall from the definition that, to be classified as unemployed, a person must meet two condi- tions: that he or she does not have a job, and he or she is looking for one; this second condition is harder to assess.

Until the 1940s in the United States, and until more recently in most other countries, the only available source of data on unemployment was the number of people registered at unemployment offices, and so only those workers who were registered in unemployment offices were counted as unemployed. This system led to a poor measure of unemployment. How many of those looking for jobs actually registered at the unemployment office varied both across countries and across time. Those who had no incentive to register—for example, those who had exhausted their unemployment benefits—were unlikely to take the time to come to the unemploy- ment office, so they were not counted. Countries with less generous benefit systems were likely to have fewer unemployed registering, and therefore smaller measured unemployment rates.

Today, most rich countries rely on large surveys of households to compute the un- employment rate. In the United States, this survey is called the Current Population Survey (CPS). It relies on interviews of 60,000 households every month. The survey classifies a person as employed if he or she has a job at the time of the interview; it classi- fies a person as unemployed if he or she does not have a job and has been looking for a job in the last four weeks. Most other countries use a similar definition of unemployment. In the United States, estimates based on the CPS show that, in July 2015, an average of 148.9 million people were employed, and 8.3 million people were unemployed, so the unem- ployment rate was 8.3/(148.9 + 8.3) = 5.3%.

Note that only those looking for a job are counted as unemployed; those who do not have a job and are not looking for one are counted as not in the labor force. When unemployment is high, some of the unemployed give up looking for a job and there- fore are no longer counted as unemployed. These people are known as discouraged workers. Take an extreme example: If all workers without a job gave up looking for one, the unemployment rate would go to zero. This would make the unemployment rate a poor indicator of what is actually happening in the labor market. This example is too extreme; in practice, when the economy slows down, we typically observe both an increase in unemployment and an increase in the number of people who drop out of

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The 60,000 households are chosen as a representative sample of the whole U.S. pop- ulation. Thus, the sample pro- vides good estimates of what is happening for the population as a whole.

c

Chapter 2 A Tour of the Book 29

the labor force. Equivalently, a higher unemployment rate is typically associated with a lower participation rate, defined as the ratio of the labor force to the total population of working age.

Figure 2-3 shows the evolution of unemployment in the United States since 1960. Since 1960, the U.S. unemployment rate has fluctuated between 3 and 10%, going up during recessions and down during expansions. Again, you can see the effect of the recent crisis, with the unemployment rate reaching a peak at nearly 10% in 2010, the highest such rate since the 1980s.

Why Do Economists Care about Unemployment? Economists care about unemployment for two reasons. First, they care about un- employment because of its direct effect on the welfare of the unemployed. Although unemployment benefits are more generous today than they were during the Great Depression, unemployment is still often associated with financial and psychological suffering. How much suffering depends on the nature of unemployment. One image of unemployment is that of a stagnant pool, of people remaining unemployed for long periods of time. In normal times, in the United States, this image is not right: Every month, many people become unemployed, and many of the unemployed find jobs. When unemployment increases, however, We're at 5.3% now, so not increasing the image be- comes more accurate. Not only are more people unemployed, but also many of them are unemployed for a long time. For example, the mean duration of unemployment, which was 16 weeks on average during 2000–2007, increased to 40 weeks in 2011; it has de- creased since, but at the time of writing, remains at a relatively high 30 weeks. In short, when the unemployment increases, not only does unemployment become both more widespread, but it also becomes more painful for those who are unemployed.

Second, economists also care about the unemployment rate because it provides a signal that the economy may not be using some of its resources. When unemployment is high, many workers who want to work do not find jobs; the economy is clearly not using

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U.S. Unemployment Rate, 1960–2014

Since 1960, the U.S. unem- ployment rate has fluctuated between 3 and 10%, going down during expansions and going up during recessions. The effect of the recent crisis is highly visible, with the unem- ployment rate reaching close to 10% in 2010, the highest such rate since the early 1980s.

Source: Organization for Economic Co-operation and Development, Unemployment Rate: Aged 15-64: All Persons for the United States© [LRUN64TTUSA156N], retrieved from FRED, Federal Reserve Bank of St. Louis https://research.stlouisfed.org/ fred2/series/LRUN64TTUSA156N/, January 13, 2016.

MyEconLab Real-time data

During the crisis, as the U.S. unemployment rate in- creased, the participation rate decreased from 66% to 63%. But, surprisingly, as unem- ployment has decreased, the participation rate has not re- covered. Why this is so is not fully understood. One hypoth- esis is the recession was so deep that some workers, who lost their job, have permanently given up on trying to become employed.

b

30 Introduction The Core

its human resources efficiently. What about when unemployment is low? Can very low unemployment also be a problem? The answer is yes. Like an engine running at too high a speed, an economy in which unemployment is very low may be overusing its resources and run into labor shortages. How low is “too low”? This is a difficult question, a ques- tion we will take up at more length later in the book. The question came up in 2000 in the United States. At the end of 2000, some economists worried that the unemployment rate, 4% at the time, was indeed too low. So, although they did not advocate triggering a

unemployment and Happiness Fo

C u

s How painful is unemployment? To answer the question, one needs information about particular individuals, and how their happiness varies as they become unemployed. This information is available from the German Socio-Economic Panel survey. The survey has followed about 11,000 house- holds each year since 1984, asking each member of the household a number of questions about their employment status, their income, and their happiness. The specific ques- tion in the survey about happiness is the following: “How satisfied are you at present with your life as a whole?’’, with the answer rated from 0 (“completely dissatisfied”) to 10 (“completely satisfied”).

The effect of unemployment on happiness defined in this way is shown in Figure 1. The figure plots the average life satis- faction for those individuals who were unemployed during one year, and employed in the four years before and in the four years after. Year 0 is the year of unemployment. Years -1 to -4 are the years before unemployment, years 1 to 4 the years after.

The figure suggests three conclusions. The first and main one is indeed that becoming unemployed leads to a large decrease in happiness. To give you a sense of scale, other studies suggest that this decrease in happiness is close to the decrease triggered by a divorce or a separation. The second

is that happiness declines before the actual unemployment spell. This suggests that either workers know they are more likely to become unemployed, or that they like their job less and less. The third is that happiness does not fully recover even four years after the unemployment spell. This suggests that unemployment may do some permanent damage, either because of the experience of unemployment itself, or be- cause the new job is not as satisfying as the old one.

In thinking about how to deal with unemployment, it is essential to understand the channels through which un- employment decreases happiness. One important finding in this respect is that the decrease in happiness does not depend very much on the generosity of unemployment benefits. In other words, unemployment affects happiness not so much through financial channels than through psychologi- cal channels. To cite George Akerlof, a Nobel Prize winner, “A person without a job loses not just his income but often the sense that he is fulfilling the duties expected of him as a human being.”

b The material in this box, and in particular the figure, comes in part from “Unemployment and happiness,” by Rainer Winkelmann, IZA world of labor, 2014: 94, pp 1–9.

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It is probably because of statements like this that economics is known as the “dismal science.”

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Chapter 2 A Tour of the Book 31

recession, they favored lower (but positive) output growth for some time, so as to allow the unemployment rate to increase to a somewhat higher level. It turned out that they got more than they had asked for: a recession rather than a slowdown.

2-3 The Inflation Rate Inflation is a sustained rise in the general level of prices—the price level. The infla- tion rate is the rate at which the price level increases. (Symmetrically, deflation is a sustained decline in the price level. It corresponds to a negative inflation rate.)

The practical issue is how to define the price level so the inflation rate can be mea- sured. Macroeconomists typically look at two measures of the price level, at two price indexes: the GDP deflator and the Consumer Price Index.

The GDP Deflator We saw how increases in nominal GDP can come either from an increase in real GDP, or from an increase in prices. Put another way, if we see nominal GDP increase faster than real GDP, the difference must come from an increase in prices.

This remark motivates the definition of the GDP deflator. The GDP deflator in year t, Pt, is defined as the ratio of nominal GDP to real GDP in year t:

Pt = Nominal GDPt

Real GDPt =

$Yt Yt

Note that, in the year in which, by construction, real GDP is equal to nominal GDP (2009 at this point in the United States), this definition implies that the price level is equal to 1. This is worth emphasizing: The GDP deflator is called an index number. Its level is chosen arbitrarily—here it is equal to 1 in 2009—and has no economic interpre- tation. But its rate of change, 1Pt - Pt -12>Pt - 1 (which we shall denote by pt in the rest of the book), has a clear economic interpretation: It gives the rate at which the general level of prices increases over time—the rate of inflation.

One advantage to defining the price level as the GDP deflator is that it implies a sim- ple relation between nominal GDP, real GDP, and the GDP deflator. To see this, reorganize the previous equation to get:

$Yt = Pt Yt

Nominal GDP is equal to the GDP deflator times real GDP. Or, putting it in terms of rates of change: The rate of growth of nominal GDP is equal to the rate of inflation plus the rate of growth of real GDP.

The Consumer Price Index The GDP deflator gives the average price of output—the final goods produced in the economy. But consumers care about the average price of consumption—the goods they consume. The two prices need not be the same: The set of goods produced in the economy is not the same as the set of goods purchased by consumers, for two reasons:

■■ Some of the goods in GDP are sold not to consumers but to firms (machine tools, for example), to the government, or to foreigners.

■■ Some of the goods bought by consumers are not produced domestically but are imported from abroad.

Deflation is rare, but it happens. The United States experienced sustained de- flation in the 1930s during the Great Depression (see the Focus Box in Chapter 9). Japan has had deflation, off and on, since the late 1990s. More recently, the Euro area has had short spells of deflation.

b

Index numbers are often set equal to 100 (in the base year) rather than to 1. If you look at the Economic Report of the President (see Chapter  1) you will see that the GDP deflator, reported in Table B3 is equal to 100 for 2009 (the base year), 102.5 in 2010, and so on.

b

Compute the GDP deflator and the associated rate of inflation from 2008 to 2009 and from 2009 to 2010 in our car example in Section 2-1, when real GDP is constructed using the 2009 price of cars as the common price.b

For a refresher for going from levels to rates of change, see Appendix 2, Proposition 7.

b

32 Introduction The Core

To measure the average price of consumption, or, equivalently, the cost of living, macroeconomists look at another index, the Consumer Price Index, or CPI. The CPI has been in existence in the United States since 1917 and is published monthly (in contrast, numbers for GDP and the GDP deflator are only constructed and published quarterly).

The CPI gives the cost in dollars of a specific list of goods and services over time. The list, which is based on a detailed study of consumer spending, attempts to represent the consumption basket of a typical urban consumer and is updated every two years.

Each month, Bureau of Labor Statistics (BLS) employees visit stores to find out what has happened to the price of the goods on the list; prices are collected for 211 items in 38 cities. These prices are then used to construct the CPI.

Like the GDP deflator (the price level associated with aggregate output, GDP), the CPI is an index. It is set equal to 100 in the period chosen as the base period and so its level has no particular significance. The current base period is 1982 to 1984, so the av- erage for the period 1982 to 1984 is equal to 100. In 2014, the CPI was 236.7; thus, it cost more than twice as much in dollars to purchase the same consumption basket than in 1982–1984.

You may wonder how the rate of inflation differs depending on whether the GDP de- flator or the CPI is used to measure it. The answer is given in Figure 2-4, which plots the two inflation rates since 1960 for the United States. The figure yields two conclusions:

■■ The CPI and the GDP deflator move together most of the time. In most years, the two inflation rates differ by less than 1%.

■■ But there are clear exceptions. In 1979 and 1980, the increase in the CPI was sig- nificantly larger than the increase in the GDP deflator. The reason is not hard to find. Recall that the GDP deflator is the price of goods produced in the United States, whereas the CPI is the price of goods consumed in the United States. That means when the price of imported goods increases relative to the price of goods produced in the United States, the CPI increases faster than the GDP deflator. This is precisely what happened in 1979 and 1980. The price of oil doubled. And although the United States is a producer of oil, it produces less than it consumes: It was and still is an oil importer. The result was a large increase in the CPI compared to the GDP deflator.

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Source: Calculated using series USAGDPDEFAISMEI, CPALTT01USA659N Federal Reserve Economic Data (FRED) http://research.stlouisfed.org/fred2/.

MyEconLab Real-time data

Do not ask why such a strange base period was chosen. Nobody seems to remember.

Do not confuse the CPI with the PPI, or producer price in- dex, which is an index of pric- es of domestically produced goods in manufacturing, mining, agriculture, fishing, forestry, and electric utility industries.

c

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You may wonder why the effect of the 50% decrease in the price of oil in the sec- ond half of 2014 does not similarly show up as a larger decline of the CPI relative to the GDP deflator. The reason is that, although CPI inflation was indeed negative during the second half of 2014, this was offset by positive inflation in the first half of the year, and so does not show up in annual data. c

MyEconLab Video

Chapter 2 A Tour of the Book 33

In what follows, we shall typically assume that the two indexes move together so we do not need to distinguish between them. We shall simply talk about the price level and denote it by Pt , without indicating whether we have the CPI or the GDP deflator in mind.

Why Do Economists Care about Inflation? If a higher inflation rate meant just a faster but proportional increase in all prices and wages—a case called pure inflation—inflation would be only a minor inconvenience be- cause relative prices would be unaffected.

Take, for example, the workers’ real wage—the wage measured in terms of goods rather than in dollars. In an economy with 10% inflation, prices would, by definition, increase by 10% a year. But wages in dollars would also increase by 10% a year, so real wages would be unaffected by inflation. Inflation would not be entirely irrelevant; people would have to keep track of the increase in prices and wages when making decisions. But this would be a small burden, hardly justifying making control of the inflation rate one of the major goals of macroeconomic policy.

So why do economists care about inflation? Precisely because there is no such thing as pure inflation:

■■ During periods of inflation, not all prices and wages rise proportionately. Because they don’t, inflation affects income distribution. For example, retirees in some coun- tries receive payments that do not keep up with the price level, so they lose in rela- tion to other groups when inflation is high. This is not the case in the United States, where Social Security benefits automatically rise with the CPI, protecting retirees from inflation. But during the very high inflation that took place in Russia in the 1990s, retirement pensions did not keep up with inflation, and many retirees were pushed to near starvation.

■■ Inflation leads to other distortions. Variations in relative prices also lead to more uncertainty, making it harder for firms to make decisions about the future, such as investment decisions. Some prices, which are fixed by law or by regulation, lag behind the others, leading to changes in relative prices. Taxation interacts with inflation to create more distortions. If tax brackets are not adjusted for inflation, for example, people move into higher and higher tax brackets as their nominal income increases, even if their real income remains the same.

If inflation is so bad, does this imply that deflation (negative inflation) is good? The answer is no. First, high deflation (a large negative rate of inflation) would

create many of the same problems as high inflation, from distortions to increased uncertainty. Second, as we shall see later in the book, even a low rate of deflation limits the ability of monetary policy to affect output. So what is the “best” rate of inflation? Most macroeconomists believe that the best rate of inflation is a low and stable rate of inflation, somewhere between 1 and 4%.

2-4 Output, Unemployment, and the Inflation Rate: Okun’s Law and the Phillips Curve We have looked separately at the three main dimensions of aggregate economic activ- ity: output growth, the unemployment rate, and the inflation rate. Clearly they are not independent, and much of this book will be spent looking at the relations among them in detail. But it is useful to have a first look now.

This is known as bracket creep. In the United States, the tax brackets are adjusted automatically for inflation: If inflation is 5%, all tax brack- ets also go up by 5%—in other words, there is no bracket creep. By contrast, in Italy, where inflation averaged 17% a year in the second half of the 1970s, bracket creep led to a rise of almost 9 percentage points in the rate of income taxation.b

Newspapers sometimes con- fuse deflation and recession. They may happen together but they are not the same. Deflation is a decrease in the price level. A recession is a decrease in real output.

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We shall look at the pros and cons of different rates of infla- tion in Chapter 23.

b

34 Introduction The Core

Okun’s Law Intuition suggests that if output growth is high, unemployment will decrease, and this is indeed true. This relation was first examined by U.S. economist Arthur Okun and for this reason has become known as Okun’s law. Figure 2-5 plots the change in the unemploy- ment rate on the vertical axis against the rate of growth of output on the horizontal axis for the United States since 1960. It also draws the line that best fits the cloud of points in the figure. Looking at the figure and the line suggests two conclusions:

■■ The line is downward sloping and fits the cloud of points quite well. Put in econom- ic terms: There is a tight relation between the two variables: Higher output growth leads to a decrease in unemployment. The slope of the line is -0.4. This implies that, on average, an increase in the growth rate of 1% decreases the unemployment rate by roughly -0.4%. This is why unemployment goes up in recessions and down in expansions. This relation has a simple but important implication: The key to decreas- ing unemployment is a high enough rate of growth.

■■ This line crosses the horizontal axis at the point where output growth is roughly equal to 3%. In economic terms: It takes a growth rate of about 3% to keep unem- ployment constant. This is for two reasons. The first is that population, and thus the labor force, increases over time, so employment must grow over time just to keep the unemployment rate constant. The second is that output per worker is also increas- ing with time, which implies that output growth is higher than employment growth. Suppose, for example, that the labor force grows at 1% and that output per worker grows at 2%. Then output growth must be equal to 3%11% + 2%2 just to keep the unemployment rate constant.

The Phillips Curve Okun’s law implies that, with strong enough growth, one can decrease the unemploy- ment rate to very low levels. But intuition suggests that, when unemployment becomes very low, the economy is likely to overheat, and that this will lead to upward pressure on inflation. And, to a large extent, this is true. This relation was first explored in 1958 by a New Zealand economist, A. W. Phillips, and has become known as the Phillips curve. Phillips plotted the rate of inflation against the unemployment rate. Since then, the Phillips curve has been redefined as a relation between the change in the rate of inflation and the unemployment rate. Figure 2-6 plots the change in the inflation rate (measured

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Output growth that is higher than usual is associated with a reduction in the unemploy- ment rate; output growth that is lower than usual is associ- ated with an increase in the unemployment rate.

Source: Series GDPCA,GDPA: Federal Reserve Economic Data (FRED) http://research.stlouisfed. org/fred2/.

MyEconLab Animation MyEconLab Real-time data

In recent years, the growth rate at which the unemployment rate remains constant has been lower, around 2.5%. This reflects again the decrease in productivity growth (the rate of growth of output per worker), discussed in Chapter 1.

Arthur Okun was an adviser to President John F. Kennedy in the 1960s. Okun’s law is, of course, not a law, but an empirical regularity.

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c

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It should probably be known as the Phillips relation, but it is too late to change that. c

Chapter 2 A Tour of the Book 35

using the CPI) on the vertical axis against the unemployment rate on the horizontal axis, together with the line that fits the cloud of points best, for the United States since 1960. Looking at the figure again suggests two conclusions:

■■ The line is downward sloping, although the fit is not as good as it was for Okun’s law: Higher unemployment leads, on average, to a decrease in inflation; lower unemploy- ment leads to an increase in inflation. But this is only true on average. Sometimes, high unemployment is associated with an increase in inflation.

■■ The line crosses the horizontal axis at the point where the unemployment rate is roughly equal to 6%. When unemployment has been below 6%, inflation has typically increased, suggesting that the economy was overheating, operating above its poten- tial. When unemployment has been above 6%, inflation has typically decreased, sug- gesting that the economy was operating below potential. But, again here, the relation is not tight enough that the unemployment rate at which the economy overheats can be pinned down precisely. This explains why some economists believe that we should try to maintain a lower unemployment rate, say 4 or 5%, and others believe that it may be dangerous, leading to overheating and increasing inflation.

Clearly, a successful economy is an economy that combines high output growth, low unemployment, and low inflation. Can all these objectives be achieved simultaneously? Is low unemployment compatible with low and stable inflation? Do policy makers have the tools to sustain growth, to achieve low unemployment while maintaining low infla- tion? These are the questions we shall take up as we go through the book. The next two sections give you the road map.

2-5 The Short Run, the Medium Run, and the Long Run What determines the level of aggregate output in an economy? Consider three answers:

■■ Reading newspapers suggests a first answer: Movements in output come from move- ments in the demand for goods. You probably have read news stories that begin like this: “Production and sales of automobiles were higher last month due to a surge in consumer confidence, which drove consumers to showrooms in record numbers.” Stories like these highlight the role demand plays in determining aggregate output;

As we shall see later in Chapter  8, the Phillips curve relation has evolved over time, in ways which cannot be captured in Figure 2-6. This explains why the fit is not as good as, say, for Okun’s law.

b

–6

–4

–2

0

2

4

6

3 4 5 6 7 8 9 10 11

C ha

ng e

in th

e in

fla tio

n ra

te (p

er ce

nt ag

e po

in ts

)

Unemployment (percent)

Figure 2-6

Changes in the Inflation Rate versus the Unemployment Rate in the United States, 1960–2014

A low unemployment rate leads to an increase in the inflation rate, a high unemployment rate to a decrease in the inflation rate.

Source: Series GDPCA,GDPA: Federal Reserve Economic Data (FRED) http://research.stlouisfed. org/fred2/.

MyEconLab Animation MyEconLab Real-time data

36 Introduction The Core

they point to factors that affect demand, ranging from consumer confidence to gov- ernment spending to interest rates.

■■ But, surely, no amount of Indian consumers rushing to Indian showrooms can in- crease India’s output to the level of output in the United States. This suggests a sec- ond answer: What matters when it comes to aggregate output is the supply side— how much the economy can produce. How much can be produced depends on how advanced the technology of the country is, how much capital it is using, and the size and the skills of its labor force. These factors—not consumer confidence—are the fundamental determinants of a country’s level of output.

■■ The previous argument can be taken one step further: Neither technology, nor capi- tal, nor skills are given. The technological sophistication of a country depends on its ability to innovate and introduce new technologies. The size of its capital stock depends on how much people have saved. The skills of workers depend on the qual- ity of the country’s education system. Other factors are also important: If firms are to operate efficiently, for example, they need a clear system of laws under which to operate and an honest government to enforce those laws. This suggests a third an- swer: The true determinants of output are factors like a country’s education system, its saving rate, and the quality of its government. If we want to understand what determines the level of output, we must look at these factors.

You might be wondering at this point, which of the three answers is right? The fact is that all three are right. But each applies over a different time frame:

■■ In the short run, say, a few years, the first answer is the right one. Year-to-year movements in output are primarily driven by movements in demand. Changes in demand, perhaps as a result of changes in consumer confidence or other factors, can lead to a decrease in output (a recession) or an increase in output (an expansion).

■■ In the medium run, say, a decade, the second answer is the right one. Over the medium run, the economy tends to return to the level of output determined by supply factors: the capital stock, the level of technology, and the size of the labor force. And, over a decade or so, these factors move sufficiently slowly that we can take them as given.

■■ In the long run, say, a few decades or more, the third answer is the right one. To understand why China has been able to achieve such a high growth rate since 1980, we must understand why both the capital stock and the level of technology in China are increasing so fast. To do so, we must look at factors like the education system, the saving rate, and the role of the government.

This way of thinking about the determinants of output underlies macroeconomics, and it underlies the organization of this book.

2-6 A Tour of the Book The book is organized in three parts: A core; two extensions; and, finally, a comprehen- sive look at the role of macroeconomic policy. This organization is shown in Figure 2-7. We now describe it in more detail.

The Core The core is composed of three parts—the short run, the medium run, and the long run.

■■ Chapters 3 to 6 look at how output is determined in the short run. To focus on the role of demand, we assume that firms are willing to supply any quantity at a given price. In other words, we ignore supply constraints. Chapter 3 shows

MyEconLab Video

Chapter 2 A Tour of the Book 37

how the demand for goods determines output. Chapter 4 shows how monetary policy determines the interest rate. Chapter 5 puts the two together, by allowing demand to depend on the interest rate, and then showing the role of monetary and fiscal policy in determining output. Chapter 6 extends the model by intro- ducing a richer financial system, and using it to explain what happened during the recent crisis.

■■ Chapters 7 to 9 develop the supply side and look at how output is determined in the medium run. Chapter 7 introduces the labor market. Chapter 8 builds on it to derive the relation between inflation and unemployment. Chapter 9 puts all the parts to- gether, and shows the determination of output, unemployment, and inflation both in the short and the medium run.

■■ Chapters 10 to 13 focus on the long run. Chapter 10 introduces the relevant facts by looking at the growth of output both across countries and over long periods of time. Chapters 11 and 12 discuss how both capital accumulation and technological progress determine growth. Chapter 13 looks at the interaction among technologi- cal progress, wages, unemployment, and inequality.

Extensions The core chapters give you a way of thinking about how output (and unemployment, and inflation) is determined over the short, medium, and long run. However, they leave out several elements, which are explored in two extensions:

■■ Expectations play an essential role in macroeconomics. Nearly all the economic decisions people and firms make depend on their expectations about future income, future profits, future interest rates, and so on. Fiscal and monetary policies affect economic activity not only through their direct effects, but also through their effects on people’s and firms’ expectations. Although we touch on these issues in the core, Chapters 14 to 16 offer a more detailed treatment and draw the implications for fis- cal and monetary policy.

■■ The core chapters treat the economy as closed, ignoring its interactions with the rest of the world. But the fact is, economies are increasingly open, trading goods and services and financial assets with one another. As a result, countries are becoming

ExtensionThe Short Run Chapters 3 to 6

The Medium Run Chapters 7 to 9

The Long Run Chapters 10 to 13

The Open Economy Chapters 17 to 20

Expectations Chapters 14 to 16

Introduction A Tour of the World (Chapter 1) A Tour of the Book (Chapter 2)

Epilogue Chapter 24

Back to Policy Chapters 21 to 23

The Core

Extension

Figure 2-7

The Organization of the Book

38 Introduction The Core

more and more interdependent. The nature of this interdependence and the impli- cations for fiscal and monetary policy are the topics of Chapters 17 to 20.

Back to Policy Monetary policy and fiscal policy are discussed in nearly every chapter of this book. But once the core and the extensions have been covered, it is useful to go back and put things together in order to assess the role of policy.

■■ Chapter 21 focuses on general issues of policy, whether macroeconomists know enough about how the economy works to use policy as a stabilization tool at all, and whether policy makers can be trusted to do what is right.

■■ Chapters 22 and 23 return to the role of fiscal and monetary policies.

Epilogue Macroeconomics is not a fixed body of knowledge. It evolves over time. The final chapter, Chapter 24, looks at the history of macroeconomics and how macroeconomists have come to believe what they believe today. From the outside, macroeconomics sometimes looks like a field divided among schools—“Keynesians,” “monetarists,” “new classicals,” “supply-siders,” and so on—hurling arguments at each other. The actual process of re- search is more orderly and more productive than this image suggests. We identify what we see as the main differences among macroeconomists, the set of propositions that define the core of macroeconomics today, and the challenges posed to macroeconomists by the crisis.

increases. Macroeconomists look at two measures of the price level. The first is the GDP deflator, which is the average price of the goods produced in the economy. The second is the Consumer Price Index (CPI), which is the average price of goods consumed in the economy.

■■ Inflation leads to changes in income distribution, to distor- tions, and to increased uncertainty.

■■ There are two important relations among output, unem- ployment, and inflation. The first, called Okun’s law, is a relation between output growth and the change in unem- ployment: High output growth typically leads to a decrease in the unemployment rate. The second, called the Phillips curve, is a relation between unemployment and inflation: A low unemployment rate typically leads to an increase in the inflation rate.

■■ Macroeconomists distinguish between the short run (a few years), the medium run (a decade), and the long run (a few decades or more). They think of output as being determined by demand in the short run. They think of output as being determined by the level of technology, the capital stock, and the labor force in the medium run. Finally, they think of out- put as being determined by factors like education, research, saving, and the quality of government in the long run.

■■ We can think of GDP, the measure of aggregate output, in three equivalent ways: (1) GDP is the value of the final goods and services produced in the economy during a given period; (2) GDP is the sum of value added in the economy during a given period; and (3) GDP is the sum of incomes in the economy during a given period.

■■ Nominal GDP is the sum of the quantities of final goods pro- duced times their current prices. This implies that changes in nominal GDP reflect both changes in quantities and changes in prices. Real GDP is a measure of output. Changes in real GDP reflect changes in quantities only.

■■ A person is classified as unemployed if he or she does not have a job and is looking for one. The unemployment rate is the ratio of the number of people unemployed to the number of people in the labor force. The labor force is the sum of those employed and those unemployed.

■■ Economists care about unemployment because of the hu- man cost it represents. They also look at unemployment because it sends a signal about how efficiently the economy is using its resources. High unemployment indicates that the country is not using its resources efficiently.

■■ Inflation is a rise in the general level of prices—the price level. The inflation rate is the rate at which the price level

Summary

Chapter 2 A Tour of the Book 39

Key Terms

national income and product accounts, 22 aggregate output, 22 gross domestic product (GDP), 22 gross national product (GNP), 22 intermediate good, 22 final good, 23 value added, 23 nominal GDP, 24 real GDP, 24 real GDP in chained (2009) dollars, 25 dollar GDP, GDP in current dollars, 26 GDP in terms of goods, GDP in constant dollars, GDP adjusted

for inflation, GDP in chained 2009 dollars, GDP in 2009 dollars, 26

real GDP per person, 26 GDP growth, 26 expansions, 26 recessions, 26 hedonic pricing, 27 employment, 27

unemployment, 27 labor force, 27 unemployment rate, 27 Current Population Survey (CPS), 28 not in the labor force, 28 discouraged workers, 28 participation rate, 29 inflation, 31 price level, 31 inflation rate, 31 deflation, 31 GDP deflator, 31 index number, 31 cost of living, 32 Consumer Price Index (CPI), 32 Okun’s law, 34 Phillips curve, 34 short run, 36 medium run, 36 long run, 36

Questions and Problems

QuICk ChECk MyEconLab Visit www.myeconlab.com to complete all Quick Check problems and get instant feedback. 1. Using the information in this chapter, label each of the following statements true, false, or uncertain. Explain briefly.

a. U.S. GDP was 32 times higher in 2014 than it was in 1960. b. When the unemployment rate is high, the participation

rate is also likely to be high. c. The rate of unemployment tends to fall during expansions

and rise during recessions. d. If the Japanese CPI is currently at 108 and the U.S. CPI is at

104, then the Japanese rate of inflation is higher than the U.S. rate of inflation.

e. The rate of inflation computed using the CPI is a better index of inflation than the rate of inflation computed using the GDP deflator.

f. Okun’s law shows that when output growth is lower than normal, the unemployment rate tends to rise.

g. Periods of negative GDP growth are called recessions. h. When the economy is functioning normally, the unemploy-

ment rate is zero. i. The Phillips curve is a relation between the level of prices

and the level of unemployment.

2. Suppose you are measuring annual U.S. GDP by adding up the final value of all goods and services produced in the economy. Determine the effect on GDP of each of the following transactions.

a. A seafood restaurant buys $100 worth of fish from a f isherman.

b. A family spends $100 on a fish dinner at a seafood restaurant.

c. Delta Air Lines buys a new jet from Boeing for $200 million.

d. The Greek national airline buys a new jet from Boeing for $200 million.

e. Delta Air Lines sells one of its jets to Jennifer Lawrence for $100 million.

3. During a given year, the following activities occur: i. A silver mining company pays its workers $200,000 to

mine 75 pounds of silver. The silver is then sold to a jew- elry manufacturer for $300,000.

ii. The jewelry manufacturer pays its workers $250,000 to make silver necklaces, which the manufacturer sells directly to consumers for $1,000,000.

a. Using the production-of-final-goods approach, what is GDP in this economy?

b. What is the value added at each stage of production? Using the value-added approach, what is GDP?

c. What are the total wages and profits earned? Using the income approach, what is GDP?

4. An economy produces three goods: cars, computers, and oranges. Quantities and prices per unit for years 2009 and 2010 are as follows:

2009 2010

Quantity Price Quantity Price

Cars 10 $2000 12 $3000 Computers 4 $1000 6 $500 Oranges 1000 $1 1000 $1

40 Introduction The Core

a. What is nominal GDP in 2009 and in 2010? By what percentage does nominal GDP change from 2009 to 2010?

b. Using the prices for 2009 as the set of common prices, what is real GDP in 2009 and in 2009? By what percent- age does real GDP change from 2009 to 2010?

c. Using the prices for 2010 as the set of common prices, what is real GDP in 2009 and in 2010? By what percent- age does real GDP change from 2009 to 2010?

d. Why are the two output growth rates constructed in (b) and (c) different? Which one is correct? Explain your answer.

5. Consider the economy described in Problem 4. a. Use the prices for 2009 as the set of common prices to com-

pute real GDP in 2009 and in 2010. Compute the GDP deflator for 2009 and for 2010, and compute the rate of inflation from 2009 to 2010.

b. Use the prices for 2010 as the set of common prices to compute real GDP in 2009 and in 2010. Compute the GDP deflator for 2009 and for 2010 and compute the rate of inflation from 2009 to 2010.

c. Why are the two rates of inflation different? Which one is correct? Explain your answer.

6. Consider the economy described in Problem 4. a. Construct real GDP for years 2009 and 2010 by using the

average price of each good over the two years. b. By what percentage does real GDP change from 2009 to

2010? c. What is the GDP deflator in 2009 and 2010? Using the GDP

deflator, what is the rate of inflation from 2009 to 2010? d. Is this an attractive solution to the problems pointed out in

Problems 4 and 5 (i.e., two different growth rates and two different inflation rates, depending on which set of prices is used)? (The answer is yes and is the basis for the construc- tion of chained-type deflators. See the appendix to this chapter for more discussion.)

7. The Consumer Price Index The Consumer Price Index represents the average price of goods

that households consume. Many thousands of goods are included in such an index. Here consumers are represented as buying only food (pizza) and gas as their basket of goods. Here is a representa- tion of the kind of data the Bureau of Economic Analysis collects to construct a consumer price index. In the base year, 2008, both the prices of goods purchased and the quantity of goods purchased are collected. In subsequent years, only prices are collected. Each year, the agency collects the price of that good and constructs an index of prices that represents two exactly equivalent concepts. How much more money does it take to buy the same basket of goods in the cur- rent year than in the base year? How much the purchasing power of money has declined, measured in baskets of goods, in the current year, from the base year?

The data: In an average week in 2008, the Bureau of Economic Analysis surveys many consumers and determines that the average consumer purchases 2 pizzas and 6 gallons of gas in a week. The price per pizza and per gallon in subsequent years are found below. Prices change over time.

Year Price of Pizzas Price of Gas

2008 $10 $3

2009 $11 $3.30

2010 $11.55 $3.47

2011 $11.55 $3.50

2012 $11.55 $2.50

2013 $11.55 $3.47

a. What is the cost of the consumer price basket in 2008? b. What is the cost of the consumer price basket in 2009 and

in subsequent years? c. Represent the cost of the consumer price basket as an index

number in the year 2008 to 2013. Set the value of the in- dex number equal to 100 in 2008.

d. Calculate the annual rate of inflation using the percent change in the value of the index number between each year from 2009 through 2013. You would find it helpful to fill in the table below

Year Consumer Price Index

2008 = 100 Inflation rate

2008 100

2009

2010

2011

2012

2013

e. Is there a year where inflation is negative? Why does this happen?

f. What is the source of inflation in the year 2011? How is that different than inflation in the years 2009 and 2010?

g. I have 100 dollars in 2008. How many baskets of goods can I buy with $100 in 2008? If I have$100 in 2013, how many baskets can I buy with that money in 2013? What is the percentage decline in the purchasing power of my money? How does the percentage decline in the purchas- ing power of money relate to the change in the value of the price index between 2008 and 2013?

h. From 2009 to 2011, the price of a pizza remains the same. The price of gas rises. How might consumers respond to such a change? In 2012, the price of gas falls. What are the implications of such changes in relative prices for the construction of the Consumer Price Index?

i. Suppose the Bureau of Economic Analysis determines that in 2013, the average consumer buys 2 pizzas and 7 gal- lons of gas in a week. Use a spreadsheet to calculate the Consumer Price Index set equal to 100 in 2013 and mov- ing back in time, using the 2013 basket in the years from 2008 to 2013. Fill in the table below:

Chapter 2 A Tour of the Book 41

Year Consumer Price Index

2013 = 100 Inflation rate

2008

2009

2010

2011

2012

2013 100

Why are the inflation rates (slightly) different in part d. and part i?

8. Using macroeconomic relations: a. Okun’s law stated that when output growth is higher than

usual, the unemployment rate tends to fall. Explain why usual output growth is positive.

b. In which year, a year where output growth is 2% or a year where output growth is –2%, will the unemployment rate rise more?

c. The Phillips curve is a relation between the change in the inflation rate and the level of the unemployment rate. Using the Phillips curve, is the unemployment rate zero when the rate of inflation is neither rising nor falling?

d. The Phillips curve is often portrayed as a line with a negative slope. In the text, the slope is about –0.5. In your opinion, is this a “better” economy if the line has a large slope, say –0.8, or a smaller slope, say –0.2?

DIG DEEPER MyEconLab Visit www.myeconlab.com to complete all Dig Deeper problems and get instant feedback.

9. Hedonic pricing As the first Focus box in this chapter explains, it is difficult to

measure the true increase in prices of goods whose characteristics change over time. For such goods, part of any price increase can be attributed to an increase in quality. Hedonic pricing offers a method to compute the quality-adjusted increase in prices.

a. Consider the case of a routine medical check-up. Name some reasons you might want to use hedonic pricing to measure the change in the price of this service.

Now consider the case of a medical check-up for a pregnant woman. Suppose that a new ultrasound method is introduced. In the first year that this method is available, half of doctors offer the new method, and half offer the old method. A check-up using the new method costs 10% more than a check-up using the old method.

b. In percentage terms, how much of a quality increase does the new method represent over the old method? (Hint: Consider the fact that some women choose to see a doctor offering the new method when they could have chosen to see a doctor offering the old method.)

Now, in addition, suppose that in the first year the new ultrasound method is available, the price of check-ups using the new method is 15% higher than the price of check-ups in the previous year (when everyone used the old method).

c. How much of the higher price for check-ups using the new method (as compared to check-ups in the previous year) reflects a true price increase of check-ups and how much rep- resents a quality increase? In other words, how much higher is the quality-adjusted price of check-ups using the new method as compared to the price of check-ups in the previous year?

In many cases, the kind of information we used in parts (b) and (c) is not available. For example, suppose that in the year the new ultra- sound method is introduced, all doctors adopt the new method, so the old method is no longer used. In addition, continue to assume that the price of check-ups in the year the new method is introduced is 15% higher than the price of check-ups in the previous year (when everyone used the old method). Thus, we observe a 15% price increase in check- ups, but we realize that the quality of check-ups has increased.

d. Under these assumptions, what information required to compute the quality-adjusted price increase of check-ups is lacking? Even without this information, can we say any- thing about the quality-adjusted price increase of check- ups? Is it more than 15%? less than 15%? Explain.

10. Measured and true GDP Suppose that instead of cooking dinner for an hour, you decide to work an extra hour, earning an additional $12. You then purchase some (takeout) Chinese food, which costs you $10.

a. By how much does measured GDP increase? b. Do you think the increase in measured GDP accurately

reflects the effect on output of your decision to work? Explain.

ExPlORE FuRThER 11. Comparing the recessions of 2001 and 2009. One very easy source for data is the Federal Reserve Bank of St. Louis FRED database. The series that measures real GDP is GDPC1, real GDP in each quarter of the year expressed at a seasonally adjusted annual rate (denoted SAAR). The monthly series for the unemployment rate is UNRATE. You can download these series in a variety of ways from this database.

a. Look at the data on quarterly real GDP growth from 1999 through 2001 and then from 2007 through 2009. Which recession has larger negative values for GDP growth, the recession centered on 2000 or the recession centered on 2008?

b. The unemployment rate is series UNRATE. Is the unem- ployment rate higher in the 2001 recession or the 2009 recession?

c. The National Bureau of Economic Research (NBER), which dates recessions, identified a recession beginning in March 2001 and ending in November 2001. The equivalent dates for the next, longer recession were December 2007 end- ing June 2009. In other words, according to the NBER, the economy began a recovery in November 2001 and in June 2009. Given your answers to parts (a) and (b), do you think the labor market recovered as quickly as GDP? Explain.

For more on NBER recession dating, visit www.nber.org. This site provides a history of recession dates and some discussion of their methodology.

42 Introduction The Core

Further Readings ■■ If you want to learn more about the definition and the con-

struction of the many economic indicators that are regularly reported on the news—from the help-wanted index to the retail sales index—two easy-to-read references are: The Guide to Economic Indicators, by Norman Frumkin, 3rd edition, M.E. Sharpe, 4th edition, New York, 2005. The Economist Guide to Economic Indicators, by the staff of The Economist, 6th edition, Bloomberg, New York, 2007.

■■ In 1995, the U.S. Senate set up a commission to study the construction of the CPI and make recommendations about potential changes. The commission concluded that the rate of inflation computed using the CPI was on average about 1% too high. If this conclusion is correct, this implies in particu- lar that real wages (nominal wages divided by the CPI) have grown 1% more per year than is currently being reported. For more on the conclusions of the commission and some of the exchanges that followed, read Consumer Prices, the Consumer

Price Index, and the Cost of Living, by Michael Boskin et al., Journal of Economic Perspectives, 1998, 12(1): pp. 3–26.

■■ For a short history of the construction of the National Income Accounts, read GDP: One of the Great Inventions of the 20th Century, Survey of Current Business, January 2000, 1–9. (http://www.bea.gov/scb/pdf/BEAWIDE/2000/0100od.pdf).

■■ For a discussion of some of the problems involved in meas- uring activity, read Katherine Abraham, “What We Don’t Know Could Hurt Us; Some Reflections on the Measurement of Economic Activity,” Journal of Economic Perspectives, 2005, 19(3): pp. 3–18.

■■ To see why it is hard to measure the price level and output correctly, read “Viagra and the Wealth of Nations” by Paul Krugman, 1998 (www.pkarchive.org/theory/viagra.html). (Paul Krugman is a Nobel Prize winner, and a columnist at the New York Times. His columns are opinionated, insightful, and fun to read.)

The example we used in the chapter had only one final good— cars—so constructing real GDP was easy. But how do we con- struct real GDP when there is more than one final good? This appendix gives the answer.

To understand how real GDP in an economy with many final goods is constructed, all you need to do is look at an econ- omy where there are just two final goods. What works for two goods works just as well for millions of goods.

Suppose that an economy produces two final goods, say wine and potatoes:

■■ In year 0, it produces 10 pounds of potatoes at a price of $1 a pound, and 5 bottles of wine at a price of $2 a bottle.

■■ In year 1, it produces 15 pounds of potatoes at a price of $1 a pound, and 5 bottles of wine at a price of $3 a bottle.

■■ Nominal GDP in year 0 is therefore equal to $20. Nominal GDP in year 1 is equal to $30.

This information is summarized in the following table.

Nominal GDP in Year 0 and in Year 1.

Year 0 Quantity $ Price $ Value

Potatoes (pounds) 10 1 10 Wine (bottles), Nominal GDP

5 2 10 20

Year 1 Quantity $ Price $ Value

Potatoes (pounds) 15 1 15 Wine (bottles), Nominal GDP

5 3 15 30

APPENDIx: The Construction of Real GDP and Chain-Type Indexes

The rate of growth of nominal GDP from year 0 to year 1 is equal to 1$30 - $202>1$202 = 50%. But what is the rate of growth of real GDP?

Answering this question requires constructing real GDP for each of the two years. The basic idea behind constructing real GDP is to evaluate the quantities in each year using the same set of prices.

Suppose we choose, for example, the prices in year 0. Year 0 is then called the base year. In this case, the computation is as follows:

■■ Real GDP in year 0 is the sum of the quantity in year 0 times the price in year 0 for both goods: 110 * $12 + 15 * $22 = $20.

■■ Real GDP in year 1 is the sum of the quantity in year 1 times the price in year 0 for both goods: 115 * $12 + 15 * $22 = $25.

■■ The rate of growth of real GDP from year 0 to year 1 is then 1$25 - $202>1$202, or 25%.

This answer raises however an obvious issue: Instead of us- ing year 0 as the base year, we could have used year 1, or any other year. If, for example, we had used year 1 as the base year, then:

■■ Real GDP in year 0 would be equal to 110 * $1 + 5 * $32 = $25.

■■ Real GDP in year 1 would be equal to 115 * $1 + 5 * $32 = $30.

■■ The rate of growth of real GDP from year 0 to year 1 would be equal to $5/$25, or 20%.

The answer using year 1 as the base year would therefore be different from the answer using year 0 as the base year. So if

Chapter 2 A Tour of the Book 43

book is written, the arbitrary year is 2009. Given that the constructed rate of change from 2009 to 2010 by the BEA is 2.5%, the index for 2010 equals 11 + 2.5%2 = 1.025. The index for 2010 is then obtained by multiplying the index for 2009 by the rate of change from 2009 to 2010, and so on. (You will find the value of this index—multiplied by 100—in the second column of Table B3 in the Economic Report of the President. Check that it is 100 in 2009 and 102.6 in 2010, and so on.)

■■ Multiplying this index by nominal GDP in 2009 to derive real GDP in chained (2009) dollars. As the index is 1 in 2009, this implies that real GDP in 2009 equals nominal GDP in 2009.

Chained refers to the chaining of rates of change de- scribed previously. (2009) refers to the year where, by con- struction, real GDP is equal to nominal GDP. (You will find the value of real GDP in chained (2009) dollars in the first column of Table B2 of the Economic Report of the President.)

This index is more complicated to construct than the indexes used before 1995. (To make sure you understand the steps, construct real GDP in chained (year 0) dollars for year 1 in our example.) But it is clearly better conceptually: The prices used to evaluate real GDP in two adjacent years are the right prices, namely the average prices for those two years. And, because the rate of change from one year to the next is constructed using the prices in those two years rather than the set of prices in an arbitrary base year, history will not be rewritten every five years—as it used to be when, under the previous method for constructing real GDP, the base year was changed every five years.

(For more details, go to http://www.bea.gov/scb/pdf/national/ nipa/1995/0795od.pdf.)

Key Term base year, 42

the choice of the base year affects the constructed percentage rate of change in output, which base year should one choose?

Until the mid-1990s in the United States—and still in most countries today—the practice was to choose a base year and change it infrequently, say, every five years or so. For example, in the United States, 1987 was the base year used from December 1991 to December 1995. That is, measures of real GDP published, for example, in 1994 for both 1994 and for all earlier years were constructed using 1987 prices. In December 1995, national in- come accounts shifted to 1992 as a base year; measures of real GDP for all earlier years were recalculated using 1992 prices.

This practice was logically unappealing. Every time the base year was changed and a new set of prices was used, all past real GDP numbers—and all past real GDP growth rates—were recom- puted: Economic history was, in effect, rewritten every five years! Starting in December 1995, the U.S. Bureau of Economic Analysis (BEA)—the government office that produces the GDP numbers— shifted to a new method that does not suffer from this problem.

The method requires four steps:

■■ Constructing the rate of change of real GDP from year t to year t + 1 in two different ways. First using the prices from year t as the set of common prices; second, using the prices from year t + 1 as the set of common prices. For example, the rate of change of GDP from 2006 to 2007 is computed by: (1) Constructing real GDP for 2006 and real GDP for 2007

using 2006 prices as the set of common prices, and computing a first measure of the rate of growth of GDP from 2006 to 2007.

(2) Constructing real GDP for 2006 and real GDP for 2007 using 2007 prices as the set of common prices, and computing a second measure of the rate of growth of GDP from 2006 to 2007.

■■ Constructing the rate of change of real GDP as the average of these two rates of change.

■■ Constructing an index for the level of real GDP by linking—or chaining—the constructed rates of change for each year. The index is set equal to 1 in some arbitrary year. At the time this

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45

Chapter 6

Chapter 6 extends the model by introducing a richer financial system and uses it to explain what happened during the recent crisis.

Chapter 4

Chapter 4 looks at equilibrium in financial markets and the determination of the interest rate. It shows how monetary policy affects the interest rate.

Chapter 3

Chapter 3 looks at equilibrium in the goods market and the determination of output. It focuses on the interaction among demand, production, and income. It shows how fiscal policy affects output.

The Short Run In the short run, demand determines output. Many factors affect demand, from consumer confidence to the state of the financial system, to fiscal and monetary policy. Th

e C

o r

e

Chapter 5

Chapter 5 looks at the goods market and financial markets together. It shows what determines output and the interest rate in the short run. It looks at the role of fiscal and monetary policy.

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47

3

When economists think about year-to-year movements in economic activity, they focus on the interactions among production, income, and demand:■■ Changes in the demand for goods lead to changes in production.■■ Changes in production lead to changes in income. ■■ Changes in income lead to changes in the demand for goods.

Nothing makes the point better than this cartoon:

The Goods Market

To le

s ©

1 99

1 Th

e W

as hi

ng to

n Po

st . R

ep rin

te d

w ith

p er

m is

si on

o f U

ni ve

rs al

U cl

ic k.

A ll

rig ht

s re

se rv

ed .

48 The Short Run The Core

This chapter looks at these interactions and their implications.

Section 3-1 looks at the composition of GDP and the different sources of the demand for goods.

Section 3-2 looks at the determinants of the demand for goods.

Section 3-3 shows how equilibrium output is determined by the condition that the production of goods must be equal to the demand for goods.

Section 3-4 gives an alternative way of thinking about the equilibrium, based on the equality of investment and saving.

Section 3-5 takes a first pass at the effects of fiscal policy on equilibrium output.

3-1 The Composition of GDP The purchase of a machine by a firm, the decision to go to a restaurant by a consumer, and the purchase of combat airplanes by the federal government are clearly different decisions and depend on different factors. So, if we want to understand what determines the demand for goods, it makes sense to decompose aggregate output (GDP) from the point of view of the different goods being produced, and from the point of view of the dif- ferent buyers for these goods.

The decomposition of GDP typically used by macroeconomists is shown in Table 3-1 (a more detailed version, with precise definitions, appears in Appendix 1 at the end of the book).

■■ First comes consumption (which we will denote by the letter C when we use algebra throughout this book). These are the goods and services purchased by con- sumers, ranging from food to airline tickets, to new cars, and so on. Consumption is by far the largest component of GDP. In 2014, it accounted for 68% of GDP.

■■ Second comes investment 1I2, sometimes called fixed investment to distinguish it from inventory investment (which we will discuss later). Investment is the sum of nonresidential investment, the purchase by firms of new plants or new ma- chines (from turbines to computers), and residential investment, the purchase by people of new houses or apartments.

Table 3-1 The Composition of U.S. GDP, 2014

Billions of Dollars Percent of GDP

GDP (Y ) 17,348 100.0

1 Consumption (C) 11,865 68.3

2 Investment (I) 2,782 16.0

Nonresidential 2,233 12.9

Residential 549 3.1

3 Government spending (G) 3,152 18.1

4 Net exports -530 -3.1

Exports (X ) 2,341 13.5

Imports (IM ) -2,871 -16.6

5 Inventory investment 77 0.4

Source: Survey of Current Business, July 2015, Table 1-1-5

The terms output and produc- tion are synonymous. There is no rule for using one or the other. Use the one that sounds better.

c

Warning! To most people, the term investment refers to the purchase of assets like gold or shares of General Motors. Economists use investment to refer to the purchase of new capital goods, such as (new) machines, (new) buildings, or (new) houses. When econo- mists refer to the purchase of gold, or shares of General Motors, or other financial as- sets, they use the term finan- cial investment.

c

MyEconLab Real-time data

Chapter 3 The Goods Market 49

Nonresidential investment and residential investment, and the decisions behind them, have more in common than might first appear. Firms buy machines or plants to produce output in the future. People buy houses or apartments to get housing services in the future. In both cases, the decision to buy depends on the services these goods will yield in the future, so it makes sense to treat them together. Together, nonresidential and residential investment accounted for 16% of GDP in 2014.

■■ Third comes government spending 1G2. This represents the purchases of goods and services by the federal, state, and local governments. The goods range from airplanes to office equipment. The services include services provided by govern- ment employees: In effect, the national income accounts treat the government as buying the services provided by government employees—and then providing these services to the public, free of charge.

Note that G does not include government transfers, like Medicare or Social Security payments, nor interest payments on the government debt. Although these are clearly government expenditures, they are not purchases of goods and services. That is why the number for government spending on goods and services in Table 3-1, 18.1% of GDP, is smaller than the number for total government spending including transfers and interest payments. That number, in 2014, was approximately 33% of GDP when transfers and interest payments of federal, state, and local governments are combined.

■■ The sum of lines 1, 2, and 3 gives the purchases of goods and services by U.S. consum- ers, U.S. firms, and the U.S. government. To determine the purchases of U.S. goods and services, two more steps are needed:

First, we must add exports 1X2, the purchases of U.S. goods and services by foreigners.

Second, we must subtract imports 1IM 2 the purchases of foreign goods and services by U.S. consumers, U.S. firms, and the U.S. government.

The difference between exports and imports is called net exports 1X - IM2, or the trade balance. If exports exceed imports, the country is said to run a trade surplus. If exports are less than imports, the country is said to run a trade deficit. In 2014, U.S. exports accounted for 13.5% of GDP. U.S. imports were equal to 16.6% of GDP, so the United States was running a trade deficit equal to 3.1% of GDP.

■■ So far we have looked at various sources of purchases (sales) of U.S. goods and services in 2014. To determine U.S. production in 2014, we need to take one last step:

In any given year, production and sales need not be equal. Some of the goods produced in a given year are not sold in that year but in later years. And some of the goods sold in a given year may have been produced in a previous year. The difference between goods produced and goods sold in a given year—the difference between production and sales, in other words—is called inventory investment.

If production exceeds sales and firms accumulate inventories as a result, then inventory investment is said to be positive. If production is less than sales and firms’ inventories fall, then inventory investment is said to be negative. Inventory investment is typically small—positive in some years and negative in others. In 2014, inventory in- vestment was positive, equal to just $77 billion. Put another way, production was higher than sales by an amount equal to $77 billion.

We now have what we need to develop our first model of output determination.

Exports 7 imports 3 trade surplus

Imports 7 exports 3 trade deficit

b

Although it is called ‘inventory investment’, the word invest- ment is slightly misleading. In contrast to fixed investment, which represents decisions by firms, inventory investment is partly involuntary, reflect- ing the fact that firms did not anticipate sales accurately in making production plans.b

Make sure you understand each of these three equivalent ways of stating the relations among production, sales, and inventory investment:

Inventory investment = production - sales

Production = sales + inventory investment

Sales = Production - inventory investment

b

50 The Short Run The Core

3-2 The Demand for Goods Denote the total demand for goods by Z. Using the decomposition of GDP we saw in Section 3-1, we can write Z as

Z K C + I + G + X - IM

This equation is an identity (which is why it is written using the symbol “ K ” rather than an equals sign). It defines Z as the sum of consumption, plus investment, plus government spending, plus exports, minus imports.

We now need to think about the determinants of Z. To make the task easier, let’s first make a number of simplifications:

■■ Assume that all firms produce the same good, which can then be used by consum- ers for consumption, by firms for investment, or by the government. With this (big) simplification, we need to look at only one market—the market for “the” good—and think about what determines supply and demand in that market.

■■ Assume that firms are willing to supply any amount of the good at a given price level P. This assumption allows us to focus on the role demand plays in the determination of output. As we shall see, this assumption is valid only in the short run. When we move to the study of the medium run (starting in Chapter 7), we shall abandon it. But for the moment, it will simplify our discussion.

■■ Assume that the economy is closed—that it does not trade with the rest of the world: Both exports and imports are zero. This assumption clearly goes against the facts: Modern economies trade with the rest of the world. Later on (starting in Chapter 17), we will abandon this assumption as well and look at what happens when the econ- omy is open. But, for the moment, this assumption will also simplify our discussion because we won’t have to think about what determines exports and imports.

Under the assumption that the economy is closed, X = IM = 0, so the demand for goods Z is simply the sum of consumption, investment, and government spending:

Z K C + I + G

Let’s discuss each of these three components in turn.

Consumption (C) Consumption decisions depend on many factors. But the main one is surely income, or, more precisely, disposable income 1YD2, the income that remains once consumers have received transfers from the government and paid their taxes. When their disposable income goes up, people buy more goods; when it goes down, they buy fewer goods.

We can then write:

C = C1YD2 1+2

(3.1)

This is a formal way of stating that consumption C is a function of disposable income YD . The function C1YD2 is called the consumption function. The positive sign below YD reflects the fact that when disposable income increases, so does consumption. Economists call such an equation a behavioral equation to indicate that the equation captures some aspect of behavior—in this case, the behavior of consumers.

We will use functions in this book as a way of representing relations between vari- ables. What you need to know about functions—which is very little—is described in Appendix 2 at the end of the book. This appendix develops the mathematics you need to go through this book. Not to worry: We shall always describe a function in words when we introduce it for the first time.

Recall that inventory invest- ment is not part of demand. c

A model nearly always starts with “Assume” (or “Suppose”). This is an indication that real- ity is about to be simplified to focus on the issue at hand.

c

Chapter 3 The Goods Market 51

It is often useful to be more specific about the form of the function. Here is such a case. It is reasonable to assume that the relation between consumption and disposable income is given by the simpler relation:

C = c0 + c1YD (3.2)

In other words, it is reasonable to assume that the function is a linear relation. The relation between consumption and disposable income is then characterized by two parameters, c0 and c1:

■■ The parameter c1 is called the propensity to consume. (It is also called the mar- ginal propensity to consume. I will drop the word marginal for simplicity.) It gives the effect an additional dollar of disposable income has on consumption. If c1 is equal to 0.6, then an additional dollar of disposable income increases consumption by $1 * 0.6 = 60 cents.

A natural restriction on c1 is that it be positive: An increase in disposable income is likely to lead to an increase in consumption. Another natural restriction is that c1 be less than 1: People are likely to consume only part of any increase in disposable income and save the rest.

■■ The parameter c0 has a literal interpretation. It is what people would consume if their disposable income in the current year were equal to zero: If YD equals zero in equation (3.2), C = c0. If we use this interpretation, a natural restriction is that, if current income were equal to zero, consumption would still be positive: With or without income, people still need to eat! This implies that c0 is positive. How can people have positive consumption if their income is equal to zero? Answer: They dis- save. They consume either by selling some of their assets or by borrowing.

■■ The parameter c0 has a less literal and more frequently used interpretation. Changes in c0 reflect changes in consumption for a given level of disposable income. Increases in c0 reflect an increase in consumption given income, decreases in c0 a decrease. There are many reasons why people may decide to consume more or less, given their disposable income. They may, for example, find it easier or more difficult to borrow, or may become more or less optimistic about the future. An example of a decrease in c0 is given in the Focus Box, “The Lehman Bankruptcy, Fears of Another Great Depression, and Shifts in the Consumption Function.”

The relation between consumption and disposable income shown in equation (3.2) is drawn in Figure 3-1. Because it is a linear relation, it is represented by a straight line.

Disposable Income,YD

Consumption Function C 5 c0 1 c1YD

Slope 5 c1C on

su m

pt io

n, C

c0

Figure 3-1

Consumption and Disposable Income

Consumption increases with disposable income but less than one for one. A lower value of c0 will shift the entire line down.

MyEconLab Animation

Think about your own con- sumption behavior. What are your values of c0 and c1?

b

52 The Short Run The Core

Its intercept with the vertical axis is c0; its slope is c1. Because c1 is less than 1, the slope of the line is less than 1: Equivalently, the line is flatter than a 45-degree line. If the value of c0 increases, then the line shifts up by the same amount. (A refresher on graphs, slopes, and intercepts is given in Appendix 2.)

Next we need to define disposable income YD . Disposable income is given by

YD K Y - T

where Y is income and T is taxes paid minus government transfers received by consum- ers. For short, we will refer to T simply as taxes—but remember that it is equal to taxes minus transfers. Note that the equation is an identity, indicated by “K”.

Replacing YD in equation (3.2) gives

C = c0 + c11Y - T2 (3.3) Equation (3.3) tells us that consumption C is a function of income Y and taxes T.

Higher income increases consumption, but less than one for one. Higher taxes decrease consumption, also less than one for one.

Investment (I) Models have two types of variables. Some variables depend on other variables in the model and are therefore explained within the model. Variables like these are called endogenous variables. This was the case for consumption given previously. Other vari- ables are not explained within the model but are instead taken as given. Variables like these are called exogenous variables. This is how we will treat investment here. We will take investment as given and write:

I = I (3.4)

Putting a bar on investment is a simple typographical way to remind us that we take investment as given.

We take investment as given to keep our model simple. But the assumption is not in- nocuous. It implies that, when we later look at the effects of changes in production, we will assume that investment does not respond to changes in production. It is not hard to see that this implication may be a bad description of reality: Firms that experience an increase in production might well decide they need more machines and increase their investment as a result. For now, though, we will leave this mechanism out of the model. In Chapter 5 we will introduce a more realistic treatment of investment.

Government Spending (G) The third component of demand in our model is government spending, G. Together with taxes T, G describes fiscal policy—the choice of taxes and spending by the government. Just as we just did for investment, we will take G and T as exogenous. But the reason why we assume G and T are exogenous is different from the reason we assumed investment is exogenous. It is based on two distinct arguments:

■■ First, governments do not behave with the same regularity as consumers or firms, so there is no reliable rule we could write for G or T corresponding to the rule we wrote, for example, for consumption. (This argument is not airtight, though. Even if gov- ernments do not follow simple behavioral rules as consumers do, a good part of their behavior is predictable. We will look at these issues later, in particular in Chapters 22 and 23. Until then, I shall set them aside.)

■■ Second, and more importantly, one of the tasks of macroeconomists is to think about the implications of alternative spending and tax decisions. We want to be able to say, “If the government was to choose these values for G and T, this is what would

MyEconLab Video

In the United States, the two major taxes paid by individuals are income taxes and Social Security contributions. The main government transfers are Social Security benefits, Medi- care (health care for retirees), and Medicaid (health care for the poor). In 2014, taxes and social contributions paid by individuals were $2,900 billion, and government transfers to individuals were $2,500 billion.

c

Endogenous variables: explained within the model Exogenous variables: taken as given

c

Recall: Taxes means taxes minus government transfers.

c

Chapter 3 The Goods Market 53

happen.” The approach in this book will typically treat G and T as variables chosen by the government and will not try to explain them within the model.

3-3 The Determination of Equilibrium Output Let’s put together the pieces we have introduced so far.

Assuming that exports and imports are both zero, the demand for goods is the sum of consumption, investment, and government spending:

Z K C + I + G Replacing C and I from equations (3.3) and (3.4), we get

Z = c0 + c11Y - T2 + I + G (3.5) The demand for goods Z depends on income Y, taxes T, investment I and government

spending G. Let’s now turn to equilibrium in the goods market, and the relation between pro-

duction and demand. If firms hold inventories, then production need not be equal to demand: For example, firms can satisfy an increase in demand by drawing upon their inventories—by having negative inventory investment. They can respond to a decrease in demand by continuing to produce and accumulating inventories—by having positive inventory investment. Let’s first ignore this complication, though, and begin by assum- ing that firms do not hold inventories. In this case, inventory investment is always equal to zero, and equilibrium in the goods market requires that production Y be equal to the demand for goods Z:

Y = Z (3.6)

This equation is called an equilibrium condition. Models include three types of equations: identities, behavioral equations, and equilibrium conditions. You now have seen examples of each: The equation defining disposable income is an identity, the con- sumption function is a behavioral equation, and the condition that production equals demand is an equilibrium condition.

Replacing demand Z in (3.6) by its expression from equation (3.5) gives

Y = c0 + c11Y - T2 + IQ + G (3.7) Equation (3.7) represents algebraically what we stated informally at the beginning

of this chapter:

In equilibrium, production, Y (the left side of the equation), is equal to demand (the right side). Demand in turn depends on income, Y, which is itself equal to production.

Note that we are using the same symbol Y for production and income. This is no ac- cident! As you saw in Chapter 2, we can look at GDP either from the production side or from the income side. Production and income are identically equal.

Having constructed a model, we can solve it to look at what determines the level of output—how output changes in response to, say, a change in government spending. Solving a model means not only solving it algebraically but also understanding why the results are what they are. In this book, solving a model will also mean characterizing the results using graphs—sometimes skipping the algebra altogether—and describing the results and the mechanisms in words. Macroeconomists always use these three tools:

1. Algebra to make sure that the logic is correct, 2. Graphs to build the intuition, and 3. Words to explain the results.

Make it a habit to do the same.

MyEconLab Video

Because we will (nearly al- ways) take G and T as exog- enous, I won’t use a bar to denote their values. This will keep the notation lighter.

b

Think of an economy that produces only haircuts. There cannot be inventories of hair- cuts—haircuts produced but not sold?—so production must always be equal to demand.

b

There are three types of equations:

Identities Behavioral equations Equilibrium conditions

b

Can you relate this statement to the cartoon at the start of the chapter?

b

54 The Short Run The Core

Using Algebra Rewrite the equilibrium equation (3.7):

Y = c0 + c1Y - c1T + IQ + G

Move c1Y to the left side and reorganize the right side:

11 - c12Y = c0 + IQ + G - c1T Divide both sides by 11 - c12:

Y = 1

1 - c1 3c0 + IQ + G - c1T 4 (3.8)

Equation (3.8) characterizes equilibrium output, the level of output such that produc- tion equals demand. Let’s look at both terms on the right, beginning with the term in brackets.

■■ The term 3c0 + IQ + G - c1T4 is that part of the demand for goods that does not de- pend on output. For this reason, it is called autonomous spending.

Can we be sure that autonomous spending is positive? We cannot, but it is very likely to be. The first two terms in brackets, c0 and IQ, are positive. What about the last two, G - c1T? Suppose the government is running a balanced budget—taxes equal government spending. If T = G, and the propensity to consume 1c12 is less than 1 (as we have assumed), then 1G - c1T2 is positive and so is autonomous spending. Only if the government were running a very large budget surplus—if taxes were much larger than government spending—could autonomous spending be negative. We can safely ignore that case here.

■■ Turn to the first term, 1>11 - c12. Because the propensity to consume 1c12 is be- tween zero and 1, 1>11 - c12 is a number greater than one. For this reason, this number, which multiplies autonomous spending, is called the multiplier. The closer c1 is to 1, the larger the multiplier. If T = G, then

1G - c1T2 = 1T - c1T2 = 11 - c12T 7 0 What does the multiplier imply? Suppose that, for a given level of income, consum-

ers decide to consume more. More precisely, assume that c0 in equation (3.3) increases by $1 billion. Equation (3.8) tells us that output will increase by more than $1 billion. For example, if c1 equals 0.6, the multiplier equals 1>11 - 0.62 = 1>0.4 = 2.5. so that output increases by 2.5 * $1 billion = $2.5 billion.

We have looked at an increase in consumption, but equation (3.8) makes it clear that any change in autonomous spending—from a change in investment, to a change in government spending, to a change in taxes—will have the same qualitative effect: It will change output by more than its direct effect on autono- mous spending.

Where does the multiplier effect come from? Looking back at equation (3.7) gives us the clue: An increase in c0 increases demand. The increase in demand then leads to an increase in production. The increase in production leads to an equivalent increase in income (remember the two are identically equal). The increase in income further increases consumption, which further increases demand, and so on. The best way to describe this mechanism is to represent the equilibrium using a graph. Let’s do that.

Autonomous means independent—in this case, independent of output.

c

Chapter 3 The Goods Market 55

Using a Graph Let’s characterize the equilibrium graphically.

■■ First, plot production as a function of income. In Figure 3-2, measure production on the vertical axis. Measure income on

the horizontal axis. Plotting production as a function of income is straightforward: Recall that production and income are identically equal. Thus, the relation between them is the 45-degree line, the line with a slope equal to 1.

■■ Second, plot demand as a function of income. The relation between demand and income is given by equation (3.5). Let’s

rewrite it here for convenience, regrouping the terms for autonomous spending together in the term in parentheses:

Z = 1c0 + IQ + G - c1T2 + c1Y (3.9) Demand depends on autonomous spending and on income—via its effect on con-

sumption. The relation between demand and income is drawn as ZZ in the graph. The intercept with the vertical axis—the value of demand when income is equal to zero— equals autonomous spending. The slope of the line is the propensity to consume, c1: When income increases by 1, demand increases by c1. Under the restriction that c1 is positive but less than 1, the line is upward sloping but has a slope of less than 1.

■■ In equilibrium, production equals demand. Equilibrium output, Y, therefore occurs at the intersection of the 45-degree

line and the demand function. This is at point A. To the left of A, demand exceeds production; to the right of A, production exceeds demand. Only at A are demand and production equal. Suppose that the economy is at the initial equilibrium, represented by point A in the

graph, with production equal to Y.

Y

A

ZZ

Demand

Income, Y

D em

an d

Z, P

ro du

ct io

n Y

Y

Equilibrium Point: Y 5 Z

Slope 5 c1

Autonomous Spending

Slope 5 1Production

458

Figure 3-2

Equilibrium in the Goods Market

Equilibrium output is deter- mined by the condition that production is equal to demand.

MyEconLab Animation

56 The Short Run The Core

Now suppose c0 increases by $1 billion. At the initial level of income (the level of disposable income associated with point A since T is unchanged in this example), consumers increase their consumption by $1 billion. This makes use of the second interpretation of the value of c0. What happens is shown in Figure 3-3, which builds on Figure 3-2.

Equation (3.9) tells us that, for any value of income, if c0 is higher by $1 billion, demand is higher by $1 billion. Before the increase in c0, the relation between demand and income was given by the line ZZ. After the increase in c0 by $1 billion, the relation between demand and income is given by the line ZZœ, which is parallel to ZZ but higher by $1 billion. In other words, the demand curve shifts up by $1 billion. The new equilibrium is at the intersection of the 45-degree line and the new demand relation, at point Aœ.

Equilibrium output increases from Y to Yœ. The increase in output, 1Y′ - Y2, which we can measure either on the horizontal or the vertical axis, is larger than the initial in- crease in consumption of $1 billion. This is the multiplier effect.

With the help of the graph, it becomes easier to tell how and why the economy moves from A to Aœ. The initial increase in consumption leads to an increase in demand of $1 billion. At the initial level of income, Y, the level of demand is shown by point B: Demand is $1 billion higher. To satisfy this higher level of demand, firms increase pro- duction by $1 billion. This increase in production of $1 billion implies that income in- creases by $1 billion (recall: income = production), so the economy moves to point C. (In other words, both production and income are higher by $1 billion.) But this is not the end of the story. The increase in income leads to a further increase in demand. Demand is now shown by point D. Point D leads to a higher level of production, and so on, until the economy is at Aœ, where production and demand are again equal. This is therefore the new equilibrium.

We can pursue this line of explanation a bit more, which will give us another way to think about the multiplier.

■■ The first–round increase in demand, shown by the distance AB in Figure 3-3— equals $1 billion.

Y

A

B C

D E

ZZ

ZZ

Income, Y

D em

an d

Z, P

ro du

ct io

n Y

Y

Y

Y

A

458

$1 billion

Figure 3-3

The Effects of an Increase in Autonomous Spending on Output

An increase in autonomous spending has a more than one-for-one effect on equilib- rium output.

MyEconLab Animation

Look at the vertical axis. The distance between Y and Yœ on the vertical axis is larger than the distance between A and B—which is equal to $1 billion.

c

Chapter 3 The Goods Market 57

■■ This first-round increase in demand leads to an equal increase in production, or $1 billion, which is also shown by the distance AB.

■■ This first-round increase in production leads to an equal increase in income, shown by the distance BC, also equal to $1 billion.

■■ The second-round increase in demand, shown by the distance CD, equals $1 billion (the increase in income in the first round) times the propensity to consume, c1— hence, $c1 billion.

■■ This second-round increase in demand leads to an equal increase in production, also shown by the distance CD, and thus an equal increase in income, shown by the distance DE.

■■ The third-round increase in demand equals $c1 billion (the increase in income in the second round), times c1, the marginal propensity to consume; it is equal to $c1 * c1 = $c1 2 billion, and so on.

Following this logic, the total increase in production after, say, n + 1 rounds equals $1 billion times the sum:

1 + c1 + c12 + g + c1n

Such a sum is called a geometric series. Geometric series will frequently appear in this book. A refresher is given in Appendix 2 at the end of the book. One property of geo- metric series is that, when c1 is less than one (as it is here) and as n gets larger and larger, the sum keeps increasing but approaches a limit. That limit is 1>11 - c12, making the eventual increase in output $1>11 - c12 billion.

The expression 1>11 - c12 should be familiar: It is the multiplier, derived another way. This gives us an equivalent, but more intuitive way of thinking about the multi- plier. We can think of the original increase in demand as triggering successive increases in production, with each increase in production leading to an increase in income, which leads to an increase in demand, which leads to a further increase in production, which leads p and so on. The multiplier is the sum of all these successive increases in production.

Using Words How can we summarize our findings in words?

Production depends on demand, which depends on income, which is itself equal to production. An increase in demand, such as an increase in government spending, leads to an increase in production and a corresponding increase in income. This increase in in- come leads to a further increase in demand, which leads to a further increase in produc- tion, and so on. The end result is an increase in output that is larger than the initial shift in demand, by a factor equal to the multiplier.

The size of the multiplier is directly related to the value of the propensity to con- sume: The higher the propensity to consume, the higher the multiplier. What is the value of the propensity to consume in the United States today? To answer this ques- tion, and more generally to estimate behavioral equations and their parameters, economists use econometrics, the set of statistical methods used in economics. To give you a sense of what econometrics is and how it is used, read Appendix 3 at the end of this book. This appendix gives you a quick introduction, along with an application estimating the propensity to consume. A reasonable estimate of the propensity to con- sume in the United States today is around 0.6 (the regressions in Appendix 3 yield two estimates, 0.5 and 0.8). In other words, an additional dollar of disposable income leads on average to an increase in consumption of 60 cents. This implies that the multiplier is equal to 1>11 - c12 = 1>11 - 0.62 = 2.5.

MyEconLab Video

Trick question: Think about the multiplier as the result of these successive rounds. What would happen in each successive round if c1, the propensity to consume, was larger than one?

b

The empirical evidence sug- gests that multipliers are typi- cally smaller than that. This is because the simple model de- veloped in this chapter leaves out a number of important mechanisms, for example, the reaction of monetary policy to changes in spending, or the fact that some of the demand falls on foreign goods. We shall come back to the issue as we go through the book.b

58 The Short Run The Core

How Long Does It Take for Output to Adjust? Let’s return to our example one last time. Suppose that c0 increases by $1 billion. We know that output will increase by an amount equal to the multiplier 1>11 - c12 times $1 billion. But how long will it take for output to reach this higher value?

Under the assumptions we have made so far, the answer is: Right away! In writ- ing the equilibrium condition (3.6), I have assumed that production is always equal to demand. In other words, I have assumed that production responds to demand instan- taneously. In writing the consumption function (3.2) as I did, I have assumed that con- sumption responds to changes in disposable income instantaneously. Under these two assumptions, the economy goes instantaneously from point A to point Aœ in Figure 3-3: The increase in demand leads to an immediate increase in production, the increase in income associated with the increase in production leads to an immediate increase in de- mand, and so on. There is nothing wrong in thinking about the adjustment in terms of successive rounds as we did previously, even though the equations indicate that all these rounds happen at once.

This instantaneous adjustment isn’t really plausible: A firm that faces an increase in demand might well decide to wait before adjusting its production, meanwhile draw- ing down its inventories to satisfy demand. A worker who gets a pay raise might not adjust her consumption right away. These delays imply that the adjustment of output will take time.

Formally describing this adjustment of output over time—that is, writing the equa- tions for what economists call the dynamics of adjustment, and solving this more com- plicated model—would be too hard to do here. But it is easy to do it informally in words:

■■ Suppose, for example, that firms make decisions about their production levels at the beginning of each quarter. Once their decisions are made, production cannot be ad- justed for the rest of the quarter. If purchases by consumers are higher than produc- tion, firms draw down their inventories to satisfy the purchases. On the other hand, if purchases are lower than production, firms accumulate inventories.

■■ Now suppose consumers decide to spend more, that they increase c0. During the quarter in which this happens, demand increases, but production—because we as- sumed it was set at the beginning of the quarter—doesn’t yet change. Therefore, income doesn’t change either.

■■ Having observed an increase in demand, firms are likely to set a higher level of pro- duction in the following quarter. This increase in production leads to a correspond- ing increase in income and a further increase in demand. If purchases still exceed production, firms further increase production in the following quarter, and so on.

■■ In short, in response to an increase in consumer spending, output does not jump to the new equilibrium, but rather increases over time from Y to Yœ.

How long this adjustment takes depends on how and when firms revise their production schedule. If firms adjust their production schedules more fre- quently in response to past increases in purchases, the adjustment will occur faster.

We will often do in this book what I just did here. After we have looked at changes in equilibrium output, we will then describe informally how the economy moves from one equilibrium to the other. This will not only make the description of what happens in the economy feel more realistic, but it will often reinforce your intuition about why the equi- librium changes.

We have focused in this section on increases in demand. But the mechanism, of course, works both ways: Decreases in demand lead to decreases in output. The recent re- cession was the result of two of the four components of autonomous spending dropping

In the model we saw previ- ously, we ruled out this pos- sibility by assuming firms did not hold inventories, and so could not rely on drawing down inventories to satisfy an increase demand.

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Chapter 3 The Goods Market 59

The Lehman Bankruptcy, Fears of Another Great Depression, and Shifts in the Consumption Function

Why would consumers decrease consumption if their dispos- able income has not changed? Or, in terms of equation (3.2), why might c0 decrease—leading in turn to a decrease in demand, output, and so on?

One of the first reasons that come to mind is that, even if their current income has not changed, they start worrying about the future and decide to save more. This is precisely what happened at the start of the crisis, in late 2008 and early 2009. The basic facts are shown in Figure 1 below. The figure plots, from the first quarter of 2008 to the third quarter of 2009, the behavior of three variables, disposable income, total consumption, and consumption of durables— the part of consumption that falls on goods such as cars, computers, and so on (Appendix 1 at the end of the book gives a more precise definition). To make things visually simple, all three variables are normalized to equal 1 in the first quarter of 2008.

Note two things about the figure. First, despite the fact that the crisis led to a large fall in GDP, during that period, disposable income did not initially move much. It even in- creased in the first quarter of 2008. But consumption was unchanged from the first to the second quarter of 2008 and then fell before disposable income fell. It fell by 3 percentage points in 2009 relative to 2008, more than the decrease in disposable income. In terms of the Figure 1, the distance between the line for disposable income and the line for con- sumption increased. Second, during the third and especially the fourth quarters of 2008, the consumption of durables

dropped sharply. By the fourth quarter of 2008, it was down 10% relative to the first quarter, before recovering in early 2009 and decreasing again later.

Why did consumption, and especially, consumption of durables, decrease at the end of 2008 despite relatively small changes in disposable income? A number of factors were at play, but the main one was the psychological fallout of the financial crisis. Recall from Chapter 1, that, on September 15, 2008, Lehman Brothers, a very large bank, went bank- rupt, and that, in the ensuing weeks, it appeared that many more banks might follow suit and the financial system might collapse. For most people, the main sign of trouble was what they read in newspapers: Even though they still had their job and received their monthly income checks, the events reminded them of the stories of the Great Depression and the pain that came with it. One way to see this is to look at the Google Trends series that gives the number of searches for “Great Depression,” from January 2008 to September 2009, and is plotted in Figure 2. The series is normalized so its aver- age value is 1 over the two years. Note how sharply the series peaked in October 2008 and then slowly decreased over the course of 2009, as it became clear that, while the crisis was a serious one, policy makers were going to do whatever they could do to avoid a repeat of the Great Depression.

If you felt that the economy might go into another Great Depression, what would you do? Worried that you might become unemployed or that your income might decline in the future, you would probably cut consumption, even if

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Source: Calculated using series DPIC96, PCECC96, PCDGCC96: Federal Reserve Economic Data (FRED) http://research.stlouisfed.org/fred2/.

60 The Short Run The Core

your disposable income had not yet changed. And, given the uncertainty about what was going on, you might also delay the purchases you could afford to delay; for example, the purchase of a new car or a new TV. As Figure 1 in this box shows, this is exactly what consumers did in late 2008:

Total consumption decreased, and consumption of durables collapsed. In 2009, as the smoke slowly cleared and the worse scenarios became increasingly unlikely, consumption of durables picked up. But by then, many other factors were contributing to the crisis.

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by a large amount at the same time. To remind you, the expression for autonomous spending is 3c0 + I + G - c1T4. The Focus box “The Lehman Bankruptcy, Fears of Another Great Depression, and Shifts in the Consumption Function” shows how, when the crisis started, worries about the future led consumers to cut their spending despite the fact that their disposable income had not yet declined; that is, c0 decreased sharply. As house prices fell, building new homes became much less desirable. New homes are part of autonomous investment spending, so I also fell sharply. As autonomous spending decreased, the total demand for goods fell, and so did output. We shall return at many points in the book to the factors and the mechanisms behind the crisis and steadily en- rich our story line. But this effect on autonomous spending will remain a central element of the story.

3-4 Investment Equals Saving: An Alternative Way of Thinking about Goods-Market Equilibrium Thus far, we have been thinking of equilibrium in the goods market in terms of the equality of the production and the demand for goods. An alternative—but, it turns out, equivalent—way of thinking about equilibrium focuses instead on investment and sav- ing. This is how John Maynard Keynes first articulated this model in 1936, in The General Theory of Employment, Interest and Money.

Chapter 3 The Goods Market 61

Let’s start by looking at saving. Saving is the sum of private saving and public saving.

■■ By definition, private saving 1S2, (i.e. saving by consumers) is equal to their dispos- able income minus their consumption:

S K YD - C

Using the definition of disposable income, we can rewrite private saving as income minus taxes minus consumption:

S K Y - T - C

■■ By definition, public saving 1T - G2 is equal to taxes (net of transfers) minus government spending. If taxes exceed government spending, the government is running a budget surplus, so public saving is positive. If taxes are less than government spending, the government is running a budget deficit, so public saving is negative.

■■ Now return to the equation for equilibrium in the goods market that we derived previously. Production must be equal to demand, which, in turn, is the sum of con- sumption, investment, and government spending:

Y = C + I + G

Subtract taxes (T) from both sides and move consumption to the left side:

Y - T - C = I + G - T

The left side of this equation is simply private saving 1S2, so S = I + G - T

Or, equivalently,

I = S + 1T - G2 (3.10) On the left is investment. On the right is saving, the sum of private saving and public saving.

Equation (3.10) gives us another way of thinking about equilibrium in the goods market: It says that equilibrium in the goods market requires that investment equal saving—the sum of private and public saving. This way of looking at equilibrium explains why the equilibrium condition for the goods market is called the IS relation, which stands for “Investment equals Saving”: What firms want to invest must be equal to what people and the government want to save.

To understand equation (3.10), imagine an economy with only one person who has to decide how much to consume, invest, and save—a “Robinson Crusoe” economy, for example. For Robinson Crusoe, the saving and the investment decisions are one and the same: What he invests (say, by keeping rabbits for breeding rather than having them for dinner), he automatically saves. In a modern economy, however, investment decisions are made by firms, whereas saving decisions are made by consumers and the govern- ment. In equilibrium, equation (3.10) tells us, all these decisions have to be consistent: Investment must equal saving.

To summarize: There are two equivalent ways of stating the condition for equilib- rium in the goods market:

Production = Demand Investment = Saving

MyEconLab Video

Private saving is also done by firms, who do not distribute all of their profits and use those retained earnings to finance investment. For simplicity, we ignore saving by firms here. But the bottom line, namely the equality of investment and sav- ing in equation (3.10), does not depend on this simplification.

b

Public saving 7 0 3 Budget surplusb

62 The Short Run The Core

We characterized the equilibrium using the first condition, equation (3.6). We now do the same using the second condition, equation (3.10). The results will be the same, but the derivation will give you another way of thinking about the equilibrium.

■■ Note first that consumption and saving decisions are one and the same: Given their disposable income, once consumers have chosen consumption, their saving is de- termined, and vice versa. The way we specified consumption behavior implies that private saving is given by:

S = Y - T - C = Y - T - c0 - c11Y - T2

Rearranging, we get

S = -c0 + 11 - c121Y - T2 (3.11) ■■ In the same way that we called c1 the propensity to consume, we can call 11 - c12

the propensity to save. The propensity to save tells us how much of an additional unit of income people save. The assumption we made previously—that the propen- sity to consume 1c12 is between zero and one implies that the propensity to save 11 - c12 is also between zero and one. Private saving increases with disposable income, but by less than one dollar for each additional dollar of disposable income.

In equilibrium, investment must be equal to saving, the sum of private and pub- lic saving. Replacing private saving in equation (3.10) by its expression,

I = -c0 + 11 - c121Y - T2 + 1T - G2 Solving for output,

Y = 1

1 - c1 3c0 + I + G - c1T4 (3.12)

Equation (3.12) is exactly the same as equation (3.8). This should come as no sur- prise. We are looking at the same equilibrium condition, just in a different way. This alternative way will prove useful in various applications later in the book. The Focus box “The Paradox of Saving” looks at such an application, which was first emphasized by Keynes and is often called the paradox of saving.

3-5 Is the Government Omnipotent? A Warning Equation (3.8) implies that the government, by choosing the level of spending 1G2 or the level of taxes 1T2, can choose the level of output it wants. If it wants output to be higher by, say, $1 billion, all it needs to do is to increase G by $11 - c12 billion. This increase in government spending, in theory, will lead to an output increase of $11 - c12 billion times the multiplier 1>11 - c12, or $1 billion.

Can governments really achieve the level of output they want? Obviously not: If they could, and it was as easy as it sounds in the previous paragraph, why would the U.S. gov- ernment have allowed growth to stall in 2008 and output to actually fall in 2009? Why wouldn’t the government increase the growth rate now, so as to decrease unemployment more rapidly? There are many aspects of reality that we have not yet incorporated in our model, and all of them complicate the government’s task. We shall introduce them in due time. But it is useful to list them briefly here:

■■ Changing government spending or taxes is not easy. Getting the U.S. Congress to pass bills always takes time, often becoming a president’s nightmare (Chapters 21 and 22).

For a glimpse at the longer list, go to Section 22-1, “What You Have Learned,” in Chapter 22.

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Chapter 3 The Goods Market 63

■■ We have assumed that investment remained constant. But investment is also likely to respond in a variety of ways. So are imports: Some of the increased demand by consumers and firms will not be for domestic goods but for foreign goods. The exchange rate may change. All these responses are likely to be associated with com- plex, dynamic effects, making it hard for governments to assess the effects of their policies with much certainty (Chapters 5 and 9, and 18 to 20).

■■ Expectations are likely to matter. For example, the reaction of consumers to a tax cut is likely to depend on whether they think of the tax cut as transitory or permanent. The more they perceive the tax cut as permanent, the larger will be their consump- tion response. Similarly, the reaction of consumers to an increase in spending is likely to depend on when they think the government will raise taxes to pay for the spending (Chapters 14 to 16).

■■ Achieving a given level of output can come with unpleasant side effects. Trying to achieve too high a level of output can, for example, lead to increasing inflation and, for that reason, be unsustainable in the medium run (Chapter 9).

■■ Cutting taxes or increasing government spending, as attractive as it may seem in the short run, can lead to large budget deficits and an accumulation of public debt. A large debt has adverse effects in the long run. This is a hot issue in almost every advanced country in the world (Chapters 9, 11, 16, and 22).

The Paradox of Saving

As we grow up, we are told about the virtues of thrift. Those who spend all their income are condemned to end up poor. Those who save are promised a happy life. Similarly, govern- ments tell us, an economy that saves is an economy that will grow strong and prosper! The model we have seen in this chapter, however, tells a different and surprising story.

Suppose that, at a given level of disposable income, con- sumers decide to save more. In other words, suppose con- sumers decrease c0, therefore decreasing consumption and increasing saving at a given level of disposable income. What happens to output and to saving?

Equation (3.12) makes it clear that equilibrium output decreases: As people save more at their initial level of income, they decrease their consumption. But this decreased con- sumption decreases demand, which decreases production.

Can we tell what happens to saving? Let’s return to the equation for private saving, equation (3.11) (recall that we assume no change in public saving, so saving and private saving move together):

S = −c0 + 11 − c1 2 1Y − T 2 On the one hand, -c0 is higher (less negative): Consumers

are saving more at any level of income; this tends to increase saving. But, on the other hand, their income Y is lower: This decreases saving. The net effect would seem to be ambiguous. In fact, we can tell which way it goes:

To see how, go back to equation (3.10), the equilibrium condition that investment and saving must be equal:

I = S + 1T − G 2 By assumption, investment does not change: I = IQ. Nor

do T or G. So the equilibrium condition tells us that in

equilibrium, private saving S cannot change either. Although people want to save more at a given level of income, their income decreases by an amount such that their saving is unchanged.

This means that as people attempt to save more, the result is both a decline in output and unchanged saving. This sur- prising pair of results is known as the paradox of saving (or the paradox of thrift). Note that the same result would obtain if we looked at public rather than private saving: A decrease in the budget deficit would also lead to a lower output and unchanged overall (public and private) saving. And note that, if we extended our model to allow investment to decrease with output (we shall do this in Chapter 5) rather than assum- ing it is constant, the result would be even more dramatic: An attempt to save more, either by consumers or by the govern- ment, would lead to lower output, lower investment, and by implication lower saving!

So should you forget the old wisdom? Should the govern- ment tell people to be less thrifty? No. The results of this simple model are of much relevance in the short run. The desire of consumers to save more is an important factor in many of the U.S. recessions, including, as we saw in the previous Focus box, the recent crisis. But—as we will see later when we look at the medium run and the long run— other mechanisms come into play over time, and an in- crease in the saving rate is likely to lead over time to higher saving and higher income. A warning remains, however: Policies that encourage saving might be good in the medium run and in the long run, but they can lead to a reduction in demand and in output, and perhaps even a recession, in the short run.

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In short, the proposition that, by using fiscal policy, the government can affect de- mand and output in the short run is an important and correct proposition. But as we refine our analysis, we will see that the role of the government in general, and the suc- cessful use of fiscal policy in particular, become increasingly difficult: Governments will never again have it so good as they have had in this chapter.

Summary What you should remember about the components of GDP:

■■ GDP is the sum of consumption, investment, government spending, inventory investment, and exports minus imports.

■■ Consumption 1C2 is the purchase of goods and services by con- sumers. Consumption is the largest component of demand.

■■ Investment 1I) is the sum of nonresidential investment—the purchase of new plants and new machines by firms—and of residential investment—the purchase of new houses or apartments by people.

■■ Government spending 1G2 is the purchase of goods and ser- vices by federal, state, and local governments.

■■ Exports 1X2 are purchases of U.S. goods by foreigners. Imports 1IM2 are purchases of foreign goods by U.S. con- sumers, U.S. firms, and the U.S. government.

■■ Inventory investment is the difference between production and purchases. It can be positive or negative.

What you should remember about our first model of output determination:

■■ In the short run, demand determines production. Production is equal to income. Income in turn affects demand.

■■ The consumption function shows how consumption de- pends on disposable income. The propensity to consume describes how much consumption increases for a given in- crease in disposable income.

■■ Equilibrium output is the level of output at which produc- tion equals demand. In equilibrium, output equals autono- mous spending times the multiplier. Autonomous spending is that part of demand that does not depend on income. The multiplier is equal to 1>11 - c12, where c1 is the propensity to consume.

■■ Increases in consumer confidence, investment demand, gov- ernment spending, or decreases in taxes all increase equilib- rium output in the short run.

■■ An alternative way of stating the goods-market equilibrium condition is that investment must be equal to saving—the sum of private and public saving. For this reason, the equi- librium condition is called the IS relation (I for investment, S for saving).

Key Terms consumption 1C2, 48 investment 1I2, 48 fixed investment, 48 nonresidential investment, 48 residential investment, 48 government spending 1G2, 49 government transfers, 49 exports 1X2, 49 imports 1IM2, 49 net exports 1X - IM2, 49 trade balance, 49 trade surplus, 49 trade deficit, 49 inventory investment, 49 identity, 50 disposable income 1YD2, 50 consumption function, 50 behavioral equation, 50 linear relation, 51 parameter, 51 propensity to consume 1c12, 51

endogenous variables, 52 exogenous variables, 52 fiscal policy, 52 equilibrium, 53 equilibrium in the goods market, 53 equilibrium condition, 53 autonomous spending, 54 balanced budget, 54 multiplier, 54 geometric series, 57 econometrics, 57 dynamics, 58 private saving 1S2, 61 public saving 1T - G2, 61 budget surplus, 61 budget deficit, 61 saving, 61 IS relation, 61 propensity to save, 62 paradox of saving, 63

64 The Short Run The Core

QuICk ChECk MyEconLab Visit www.myeconlab.com to complete all Quick Check problems and get instant feedback. 1. Using the information in this chapter, label each of the following statements true, false, or uncertain. Explain briefly.

a. The largest component of GDP is consumption. b. Government spending, including transfers, was equal to

18.1% of GDP in 2014. c. The propensity to consume has to be positive, but other-

wise it can take on any positive value. d. One factor in the 2009 recession was a drop in the value

of the parameter c0. e. Fiscal policy describes the choice of government spend-

ing and taxes and is treated as exogenous in our goods market model.

f. The equilibrium condition for the goods market states that consumption equals output.

g. An increase of one unit in government spending leads to an increase of one unit in equilibrium output.

h. An increase in the propensity to consume leads to a de- crease in output.

2. Suppose that the economy is characterized by the following behavioral equations:

C = 160 + 0.6YD I = 150

G = 150

T = 100

Solve for the following variables. a. Equilibrium GDP (Y) b. Disposable income (YD) c. Consumption spending (C)

3. Use the economy described in Problem 2. a. Solve for equilibrium output. Compute total demand. Is it

equal to production? Explain. b. Assume that G is now equal to 110. Solve for equilibrium

output. Compute total demand. Is it equal to production? Explain.

c. Assume that G is equal to 110, so output is given by your an- swer to part b. Compute private plus public saving. Is the sum of private and public saving equal to investment? Explain.

DIG DEEPER MyEconLab Visit www.myeconlab.com to complete all Dig Deeper problems and get instant feedback. 4. The balanced budget multiplier

For both political and macroeconomic reasons, governments are often reluctant to run budget deficits. Here, we examine whether policy changes in G and T that maintain a balanced budget are macroeconomically neutral. Put another way, we examine whether it is possible to affect output through changes in G and T so that the government budget remains balanced.

Start from equation (3.8).

a. By how much does Y increase when G increases by one unit? b. By how much does Y decrease when T increases by one unit? c. Why are your answers to parts and b different?

Suppose that the economy starts with a balanced budget: G = T. If the increase in G is equal to the increase in T, then the budget remains in balance. Let us now compute the balanced budget multiplier.

d. Suppose that G and T increase by one unit each. Using your answers to parts and b what is the change in equilibrium GDP? Are balanced budget changes in G and T macroeco- nomically neutral?

e. How does the specific value of the propensity to consume affect your answer to part a? Why?

5. Automatic stabilizers In this chapter we have assumed that the fiscal policy variables

G and T are independent of the level of income. In the real world, however, this is not the case. Taxes typically depend on the level of in- come and so tend to be higher when income is higher. In this problem, we examine how this automatic response of taxes can help reduce the impact of changes in autonomous spending on output.

Consider the following behavioral equations:

C = c0 + c1YD T = t0 + t1Y

YD = Y - T

G and I are both constant. Assume that t1 is between 0 and 1. a. Solve for equilibrium output. b. What is the multiplier? Does the economy respond more to

changes in autonomous spending when t1 is 0 or when t1 is positive? Explain.

c. Why is fiscal policy in this case called an automatic stabilizer?

6. Balanced budget versus automatic stabilizers It is often argued that a balanced budget amendment would

actually be destabilizing. To understand this argument, consider the economy in Problem 5.

a. Solve for equilibrium output. b. Solve for taxes in equilibrium.

Suppose that the government starts with a balanced budget and that there is a drop in c0.

c. What happens to Y? What happens to taxes? d. Suppose that the government cuts spending in order to keep

the budget balanced. What will be the effect on Y? Does the cut in spending required to balance the budget counteract or reinforce the effect of the drop in c0 on output? (Don’t do the algebra. Use your intuition and give the answer in words.)

7. Taxes and transfers Recall that we define taxes, T, as net of transfers. In other words,

T = Taxes - Transfer Payments a. Suppose that the government increases transfer payments

to private households, but these transfer payments are not financed by tax increases. Instead, the government

Questions and Problems

Chapter 3 The Goods Market 65

66 The Short Run The Core

Specifically, assume that consumer confidence 1c02 falls. What will happen to output?

b. As a result of the effect on output you determined in part a, what will happen to investment? What will happen to pub- lic saving? What will happen to private saving? Explain. (Hint: Consider the saving-equals-investment characteri- zation of equilibrium.) What is the effect on consumption?

c. Suppose that consumers had decided to increase con- sumption expenditure, so that c0 had increased. What would have been the effect on output, investment, and pri- vate saving in this case? Explain. What would have been the effect on consumption?

d. Comment on the following logic: “When output is too low, what is needed is an increase in demand for goods and ser- vices. Investment is one component of demand, and sav- ing equals investment. Therefore, if the government could just convince households to attempt to save more, then investment, and output, would increase.”

Output is not the only variable that affects investment. As we develop our model of the economy, we will revisit the paradox of saving in future chapter problems.

10. Using fiscal policy in this first (and simplest model) to avoid the recession of 2009:

GDP in 2009 was roughly $15,000 billion. You learned in Chapter 1 that GDP fell by approximately 3 percentage points in 2009.

a. How many billion dollars is 3 percentage points of $15,000 billion?

b. If the propensity to consume were 0.5, by how much would government spending have to have increased to prevent a decrease in output?

c. If the propensity to consume were 0.5, by how much would taxes have to have been cut to prevent any decrease in output?

d. Suppose Congress had chosen to both increase govern- ment spending and raise taxes by the same amount in 2009. What increase in government spending and taxes would have been required to prevent the decline in output in 2009?

11. The “exit strategy” problem In fighting the recession associated with the crisis, taxes were

cut and government spending was increased. The result was a large government deficit. To reduce that deficit, taxes must be increased or government spending must be cut. This is the “exit strategy” from the large deficit.

a. How will reducing the deficit in either way affect the equi- librium level of output in the short run?

b. Which will change equilibrium output more: (i) cutting G by $100 billion (ii) raising T by $100 billion?

c. How does your answer to part b depend on the value of the marginal propensity to consume?

d. You hear the argument that a reduction in the deficit will increase consumer and business confidence and thus re- duce the decline in output that would otherwise occur with deficit reduction. Is this argument valid?

borrows to pay for the transfer payments. Show in a dia- gram (similar to Figure 3-2) how this policy affects equilib- rium output. Explain.

b. Suppose instead that the government pays for the increase in transfer payments with an equivalent increase in taxes. How does the increase in transfer payments affect equilib- rium output in this case?

c. Now suppose that the population includes two kinds of people: those with high propensity to consume and those with low propensity to consume. Suppose the transfer pol- icy increases taxes on those with low propensity to con- sume to pay for transfers to people with high propensity to consume. How does this policy affect equilibrium output?

d. How do you think the propensity to consume might vary across individuals according to income? In other words, how do you think the propensity to consume compares for people with high income and people with low income? Explain. Given your answer, do you think tax cuts will be more effective at stimulating output when they are directed toward high-income or toward low-income taxpayers?

8. Investment and income This problem examines the implications of allowing investment

to depend on output. Chapter 5 carries this analysis much further and introduces an essential relation—the effect of the interest rate on investment—not examined in this problem.

a. Suppose the economy is characterized by the following b ehavioral equations:

C = c0 + c1YD YD = Y - T

I = b0 + b1Y Government spending and taxes are constant. Note that investment now increases with output. (Chapter 5 discusses the reasons for this relation.) Solve for equilib- rium output.

b. What is the value of the multiplier? How does the relation between investment and output affect the value of the multiplier? For the multiplier to be positive, what condition must 1c1 + b12 satisfy? Explain your answers.

c. What would happen if 1c1 + b12 7 1? (Trick question. Think about what happens in each round of spending).

d. Suppose that the parameter b0, sometimes called business confidence, increases. How will equilibrium output be af- fected? Will investment change by more or less than the change in b0? Why? What will happen to national saving?

ExPloRE FuRthER 9. The paradox of saving revisited

You should be able to complete this question without doing any algebra, although you may find making a diagram helpful for part a. For this problem, you do not need to calculate the magnitudes of changes in economic variables—only the direction of change.

a. Consider the economy described in Problem 8. Suppose that consumers decide to consume less (and therefore to save more) for any given amount of disposable income.

67

4

Financial markets are intimidating. They involve a maze of institutions, from banks, to money market funds, mutual funds, investment funds, and hedge funds. Trading involves bonds, stocks, and other financial claims with exotic names, such as swaps and options. The financial pages of newspapers quote interest rates on many government bonds, on many corporate bonds, on short-term bonds, on long-term bonds, and it is easy to get confused. But financial markets play an essential role in the economy. They determine the cost of funds for firms, for households, for the government, and in turn affect their spending decisions. To understand their role we must proceed in steps.

In this chapter, we focus on the role of the central bank in affecting these interest rates. To do so, we drastically simplify reality and think of the economy as having only two financial assets, namely money, which does not pay interest, and bonds, which do. This will allow us to understand how the interest rate on bonds is determined, and the role of the central bank (in the United States, the Fed, short for Federal Reserve Bank) in this determination.

In the next chapter, Chapter 5, we shall combine the model of the goods market we deve- loped in the previous chapter with the model of financial markets we develop in this chapter, and have another look at equilibrium output. Having done so however, we shall return to financial markets in Chapter 6, allowing for more financial assets and more interest rates, and focusing on the role of banks and other financial institutions. This will give us a richer model, and allow us to better understand what happened in the recent crisis.

The chapter has four sections:

Section 4-1 looks at the demand for money.

Section 4-2 assumes that the central bank directly controls the supply of money and shows how the interest rate is determined by the condition that the demand for money be equal to the supply of money.

Section 4-3 introduces banks as suppliers of money, revisits the determination of the interest rate, and describes the role of the central bank in that context.

Section 4-4 looks at the constraint on monetary policy coming from the fact that the interest rate on bonds cannot be negative, a constraint that has played an important role in the crisis.

Financial Markets I

68 The Short Run The Core

4-1 The Demand for Money This section looks at the determinants of the demand for money. A warning before we start: Words such as money or wealth have specific meanings in economics, often not the same meanings as in everyday conversation. The purpose of the Focus box “Semantic Traps: Money, Income, and Wealth” is to help you avoid some of these traps. Read it carefully, and refer back to it once in a while.

Suppose, as a result of having steadily saved part of your income in the past, your financial wealth today is $50,000. You may intend to keep saving in the future and in- crease your wealth further, but its value today is given. Suppose also that you only have the choice between two assets, money and bonds:

■■ Money, which you can use for transactions, pays no interest. In the real world, as we already mentioned, there are two types of money: currency, coins and bills, and checkable deposits, the bank deposits on which you can write checks or use a debit card. The distinction between the two will be important when we look at the supply of money. For the moment, however, the distinction does not matter and we can ignore it. Just think currency.

■■ Bonds pay a positive interest rate, i, but they cannot be used for transactions. In the real world, there are many types of bonds and other financial assets, each associated with a specific interest rate. For the time being, we also ignore this aspect of reality and assume that there is just one type of bond and that it pays, i, the rate of interest.

Assume that buying or selling bonds implies some cost; for example, a phone call to your broker and the payment of a transaction fee. How much of your $50,000 should you hold in money, and how much in bonds? On the one hand, holding all your wealth in the form of money is clearly very convenient. You won’t ever need to call a broker or pay transaction fees. But it also means you will receive no interest income. On the other hand, if you hold all your wealth in the form of bonds, you will earn interest on the full amount, but you will have to call your broker frequently — whenever you need money to take the subway, pay for a cup of coffee, and so on. This is a rather inconvenient way of going through life.

Therefore, it is clear that you should hold both money and bonds. But in what pro- portions? This will depend mainly on two variables:

■■ Your level of transactions. You will want to have enough money on hand to avoid having to sell bonds whenever you need money. Say, for example, that you typi- cally spend $3,000 a month. In this case, you might want to have, on average, say, two months worth of spending on hand, or $6,000 in money, and the rest, $50,000 - $6,000 = $44,000, in bonds. If, instead, you typically spend $4,000 a month, you might want to have, say, $8,000 in money and only $42,000 in bonds.

■■ The interest rate on bonds. The only reason to hold any of your wealth in bonds is that they pay interest. The higher the interest rate, the more you will be willing to deal with the hassle and costs associated with buying and selling bonds. If the inter- est rate is very high, you might even decide to squeeze your money holdings to an average of only two weeks’ worth of spending, or $1,500 (assuming your monthly spending is $3,000). This way, you will be able to keep, on average, $48,500 in bonds and earn more interest as a result.

Let’s make this last point more concrete. Most of you probably do not hold bonds; my guess is that few of you have a broker. However, some of you hold bonds indirectly if you have a money market account with a financial institution. Money market funds (the full name is money market mutual funds) pool together the funds of many people. The funds are then used to buy bonds — typically government bonds. Money market

Make sure you see the differ- ence between the decision about how much to save (a decision that determines how your wealth changes over time) and the decision about how to allocate a given stock of wealth between money and bonds.

c

You may want to pay by credit card and avoid carrying cur- rency. But you still have to have money in your checking ac- count when you pay the credit card company.

c

Chapter 4 Financial Markets I 69

Semantic Traps: Money, Income, and Wealth

In everyday conversation, we use “money” to denote many different things. We use it as a synonym for income: “mak- ing money.” We use it as a synonym for wealth: “She has a lot of money.” In economics, you must be more careful. Here is a basic guide to some terms and their precise meanings in economics.

Money is what can be used to pay for transactions. Money is currency and checkable deposits at banks. Income is what you earn from working plus what you receive in interest and dividends. It is a flow — something expressed in units of time: weekly income, monthly income, or yearly income, for example. J. Paul Getty was once asked what his income was. Getty answered: “$1,000.” He meant but did not say: $1,000 per minute!

Saving is that part of after-tax income that you do not spend. It is also a flow. If you save 10% of your income, and your income is $3,000 per month, then you save $300 per month. Savings (plural) is sometimes used as a synonym for wealth — the value of what you have accumulated over time. To avoid confusion, I shall not use the term savings in this book.

Your financial wealth, or wealth for short, is the value of all your financial assets minus all your financial liabilities. In contrast to income or saving, which are flow variables, financial wealth is a stock variable. It is the value of wealth at a given moment in time.

At a given moment in time, you cannot change the total amount of your financial wealth. It can only change over

time as you save or dissave, or as the value of your assets and liabilities change. But you can change the composition of your wealth; you can, for example, decide to repay part of your mortgage by writing a check against your checking account. This leads to a decrease in your liabilities (a smaller mortgage) and a corresponding decrease in your assets (a smaller checking account balance); but, at that moment, it does not change your wealth.

Financial assets that can be used directly to buy goods are called money. Money includes currency and checkable de- posits — deposits against which you can write checks. Money is also a stock. Someone who is wealthy might have only small money holdings — say, $1,000,000 in stocks but only $500 in a checking account. It is also possible for a person to have a large income but only small money holdings — say, a monthly income of $10,000 but only $1,000 in his checking account.

Investment is a term economists reserve for the pur- chase of new capital goods, from machines to plants to office buildings. When you want to talk about the purchase of shares or other financial assets, you should refer them as a financial investment.

Learn how to be economically correct:

Do not say “Mary is making a lot of money”; say “Mary has a high income.”

Do not say “Joe has a lot of money”; say “Joe is very wealthy.”

Fo c

u S

funds pay an interest rate close to but slightly below the interest rate on the bonds they hold — the difference coming from the administrative costs of running the funds and from their profit margins.

When the interest rate on these funds reached 14% per year in the early 1980s (a  very high interest rate by today’s standards), people who had previously kept all of their wealth in their checking accounts (which paid little or no interest) realized how much interest they could earn by moving some of it into money market accounts in- stead. Now that interest rates are much lower, people are less careful about putting as much as they can in money market funds. Put another way, for a given level of transac- tions, people now keep more of their wealth in money than they did in the early 1980s.

Deriving the Demand for Money Let’s go from this discussion to an equation describing the demand for money.

Denote the amount of money people want to hold — their demand for money — by Md (the superscript d stands for demand). The demand for money in the economy as a whole is just the sum of all the individual demands for money by the people and firms in the economy. Therefore, it depends on the overall level of transactions in the economy and on the interest rate. The overall level of transactions in the economy is hard to measure, but it is likely to be roughly proportional to nominal income (income

70 The Short Run The Core

measured in dollars). If nominal income were to increase by 10%, it is reasonable to think that the dollar value of transactions in the economy would also increase by roughly 10%. So we can write the relation between the demand for money, nominal income, and the interest rate as:

Md = $Y L1i2 (4.1) 1-2 where $Y denotes nominal income. Read this equation in the following way: The demand for money Md is equal to nominal income $Y times a decreasing function of the interest rate i, with the function denoted by L1i2. The minus sign under i in L1i2 captures the fact that the interest rate has a negative effect on money demand: An in- crease in the interest rate decreases the demand for money, as people put more of their wealth into bonds.

Equation (4.1) summarizes what we have discussed so far:

■■ First, the demand for money increases in proportion to nominal income. If nomi- nal income doubles, increasing from $Y to $2Y, then the demand for money also doubles, increasing from $Y L1i2 to $2Y L1i2.

■■ Second, the demand for money depends negatively on the interest rate. This is captured by the function L1i2 and the negative sign underneath: An increase in the interest rate decreases the demand for money.

The relation between the demand for money, nominal income, and the interest rate implied by equation (4.1) is shown in Figure 4-1. The interest rate, i, is measured on the vertical axis. Money, M, is measured on the horizontal axis.

The relation between the demand for money and the interest rate for a given level of nominal income $Y is represented by the Md curve. The curve is downward sloping: The lower the interest rate (the lower i), the higher the amount of money people want to hold (the higher M).

Revisit Chapter 2’s example of an economy composed of a steel company and a car company. Calculate the total value of transactions in that economy. If the steel and the car companies doubled in size, what would happen to transactions and to GDP?

c

What matters here is nominal income — income in dollars, not real income. If real income does not change but prices double, leading to a doubling of nominal income, people will need to hold twice as much money to buy the same con- sumption basket.

c

M

Md

(for nominal income $Y )

Md (for $Y $Y )

Money, M

In te

re st

r at

e, i i

M

Figure 4-1

The Demand for Money

For a given level of nominal income, a lower interest rate increases the demand for money. At a given interest rate, an increase in nominal income shifts the demand for money to the right.

MyEconLab Animation

Chapter 4 Financial Markets I 71

For a given interest rate, an increase in nominal income increases the demand for money. In other words, an increase in nominal income shifts the demand for money to the right, from Md to Md′. For example, at interest rate i, an increase in nominal income from $Y to $Y′ increases the demand for money from M to M′.

4-2 Determining the Interest Rate: I Having looked at the demand for money, we now look at the supply of money and then at the equilibrium.

In the real world, there are two types of money: checkable deposits, which are sup- plied by banks, and currency, which is supplied by the central bank. In this section, we shall assume that the only money in the economy is currency, central bank money. This is clearly not realistic, but it will make the basic mechanisms most transparent. We shall reintroduce checkable deposits, and look at the role banks play in the next section.

Money Demand, Money Supply, and the Equilibrium Interest Rate Suppose the central bank decides to supply an amount of money equal to M, so

Ms = M

The superscript s stands for supply. (Let’s disregard, for the moment, the issue of how exactly the central bank supplies this amount of money. We shall return to it in a few paragraphs.)

Who Holds u.S. currency?

According to household surveys, in 2006, the average U.S. household held $1,600 in currency (dollar bills and coins). Multiplying by the number of households in the U.S. economy at the time (about 110 million), this implies that the total amount of currency held by U.S. households was around $170 billion.

According to the Federal Reserve Board, however — which issues the dollar bills and therefore knows how much is in cir- culation — the amount of currency in circulation was actu- ally a much higher $750 billion. Here lies the puzzle: If it was not held by households, where was all this currency?

Clearly some currency was held by firms rather than by households. And some was held by those involved in the underground economy or in illegal activities. When deal- ing with drugs, dollar bills (and, in the future, bitcoin?), not checks, are the way to settle accounts. Surveys of firms and IRS estimates of the underground economy suggest, however, that this can only account for another $80 billion at the most. This leaves $500 billion, or 66% of the total, unaccounted for. So where was it? The answer: Abroad, held by foreigners.

A few countries, Ecuador and El Salvador among them, have actually adopted the dollar as their own currency. So people in these countries use dollar bills for transactions. But these countries are just too small to explain the puzzle.

In a number of countries that have suffered from high inflation in the past, people have learned that their domestic currency may quickly become worthless and they see dollars as a safe and convenient asset. This is, for example, the case of Argentina and of Russia. Estimates by the U.S. Treasury suggest that Argentina holds more than $50 billion in dollar bills, Russia more than $80 billion — so together, close to the holdings of U.S. households.

In yet other countries, people who have emigrated to the United States bring home U.S. dollar bills; or tourists pay some transactions in dollars, and the dollar bills stay in the country. This is, for example, the case for Mexico or Thailand.

The fact that foreigners hold such a high proportion of the dollar bills in circulation has two main macroeconomic implications. First, the rest of the world, by being willing to hold U.S. currency, is making in effect an interest-free loan to the United States of $500 billion. Second, while we shall think of money demand (which includes both currency and checkable deposits) as being determined by the interest rate and the level of transactions in the country, it is clear that U.S. money demand also depends on other factors. Can you guess, for example, what would happen to U.S. money de- mand if the degree of civil unrest increased in the rest of the world?

Fo c

u S

Throughout this section, the term money means central bank money, or currency.b

72 The Short Run The Core

Equilibrium in financial markets requires that money supply be equal to money de- mand, that Ms = Md. Then, using Ms = M, and equation (4.1) for money demand, the equilibrium condition is

Money supply = Money demand M = $Y L1i2 (4.2)

This equation tells us that the interest rate i must be such that, given their income $Y, people are willing to hold an amount of money equal to the existing money supply M.

This equilibrium condition is represented graphically in Figure 4-2. As in Figure 4-1, money is measured on the horizontal axis, and the interest rate is measured on the verti- cal axis. The demand for money, Md, drawn for a given level of nominal income, $Y, is downward sloping: A higher interest rate implies a lower demand for money. The sup- ply of money is drawn as the vertical line denoted Ms : The money supply equals M and is independent of the interest rate. Equilibrium occurs at point A, and the equilibrium interest rate is given by i.

Now that we have characterized the equilibrium, we can look at how changes in nominal income or changes in the money supply by the central bank affect the equilib- rium interest rate.

■■ Figure 4-3 shows the effects of an increase in nominal income on the interest rate. The figure replicates Figure 4-2, and the initial equilibrium is at point A. An

increase in nominal income from $Y to Y′ increases the level of transactions, which increases the demand for money at any interest rate. The money demand curve shifts to the right, from Md to Md′. The equilibrium moves from A up to A′, and the equilibrium interest rate increases from i to i′.

In words: For a given money supply, an increase in nominal income leads to an increase in the interest rate. The reason: At the initial interest rate, the demand for

M

Money Demand Md

Money Supply Ms

Money, M

A

In te

re st

r at

e, i

i

Figure 4-2

The Determination of the Interest Rate

The interest rate must be such that the supply of money (which is independent of the interest rate) is equal to the demand for money (which does depend on the interest rate).

MyEconLab Animation

Chapter 4 Financial Markets I 73

money exceeds the supply. The increase in the interest rate decreases the amount of money people want to hold and reestablishes equilibrium.

■■ Figure 4-4 shows the effects of an increase in the money supply on the interest rate. The initial equilibrium is at point A, with interest rate i. An increase in the

money supply, from Ms = M to Ms′ = M′, leads to a shift of the money supply curve to the right, from Ms to Ms′. The equilibrium moves from A down to A′; the interest rate decreases from i to i′.

M

A

A

Md

Ms

Md

($Y > $Y )

Money, M

In te

re st

r at

e, i i

i

Figure 4-3

The Effects of an Increase in Nominal Income on the Interest Rate

Given the money supply, an increase in nominal income leads to an increase in the interest rate.

MyEconLab Animation

M

A

A

Md

MsMs

Money, M

In te

re st

r at

e, i i

M

i

Figure 4-4

The Effects of an Increase in the Money Supply on the Interest Rate

An increase in the supply of money leads to a decrease in the interest rate.

MyEconLab Animation

74 The Short Run The Core

Assets

Bonds

Liabilities

Money (currency)

Central Bank Balance Sheet

The Effects of an Expansionary Open Market Operation

Assets

Change in money stock: 1$1 million

Change in bond holdings: 1$1 million

Liabilities

Figure 4-5

The Balance Sheet of the Central Bank and the Effects of an Expansionary Open Market Operation

The assets of the central bank are the bonds it holds. The lia- bilities are the stock of money in the economy. An open mar- ket operation in which the central bank buys bonds and issues money increases both assets and liabilities by the same amount.

The balance sheet of a bank (or firm, or individual) is a list of its assets and liabilities at a point in time. The assets are the sum of what the bank owns and what is owed to the bank by others. The liabilities are what the bank owes to others. It goes without saying that Figure 4-5 gives a much simplified version of an actual central bank balance sheet, but it will do for our purposes.

b

In words: an increase in the supply of money by the central bank leads to a decrease in the interest rate. The decrease in the interest rate increases the demand for money so it equals the now larger money supply.

Monetary Policy and Open Market Operations We can get a better understanding of the results in Figures 4-3 and 4-4 by looking more closely at how the central bank actually changes the money supply, and what happens when it does so.

In modern economies, the way central banks typically change the supply of money is by buying or selling bonds in the bond market. If a central bank wants to in- crease the amount of money in the economy, it buys bonds and pays for them by creat- ing money. If it wants to decrease the amount of money in the economy, it sells bonds and removes from circulation the money it receives in exchange for the bonds. These actions are called open market operations because they take place in the “open market” for bonds.

The Balance Sheet of the Central Bank To understand what open market operations do, it is useful to start with the balance sheet of the central bank, given in Figure 4-5. The assets of the central bank are the bonds it holds in its portfolio. Its liabilities are the stock of money in the economy. Open market operations lead to equal changes in assets and liabilities.

If the central bank buys, say, $1 million worth of bonds, the amount of bonds it holds is higher by $1 million, and so is the amount of money in the economy. Such an operation is called an expansionary open market operation, because the central bank increases (expands) the supply of money.

If the central bank sells $1 million worth of bonds, both the amount of bonds held by the central bank and the amount of money in the economy are lower by $1 million. Such an operation is called a contractionary open market operation, because the central bank decreases (contracts) the supply of money.

Bond Prices and Bond Yields We have focused so far on the interest rate on bonds. In fact, what is determined in bond markets are not interest rates, but bond prices. The two are however directly related. Understanding the relation between the two will prove useful both here and later in this book.

Chapter 4 Financial Markets I 75

■■ Suppose the bonds in our economy are one-year bonds — bonds that promise a pay- ment of a given number of dollars, say $100, a year from now. In the United States, bonds issued by the government promising payment in a year or less are called Treasury bills or T-bills. Let the price of a bond today be $PB, where the subscript B stands for “bond.” If you buy the bond today and hold it for a year, the rate of return on holding the bond for a year is 1$100 - $PB2>$PB. Therefore, the interest rate on the bond is given by

i = $100 - $PB

$PB

If $PB is $99, the interest rate equals $1>$99 = 0.010, or 1.0% per year. If $PB is $90, the interest rate is $1>$90 = 11.1% per year. The higher the price of the bond, the lower the interest rate.

■■ If we are given the interest rate, we can figure out the price of the bond using the same formula. Reorganizing the formula above, the price today of a one-year bond paying $100 a year from today is given by

$PB = 100

1 + i

The price of the bond today is equal to the final payment divided by 1 plus the in- terest rate. If the interest rate is positive, the price of the bond is less than the final payment. The higher the interest rate, the lower the price today. You may read or hear that “bond markets went up today.” This means that the prices of bonds went up, and therefore that interest rates went down.

Back to Open Market Operations We are now ready to return to the effects of an open market operation and its effect on equilibrium in the money market.

Consider first an expansionary open market operation, in which the central bank buys bonds in the bond market and pays for them by creating money. As the central bank buys bonds, the demand for bonds goes up, increasing their price. Conversely, the interest rate on bonds goes down. Note that by buying the bonds in exchange for money that it created, the central bank has increased the money supply.

Consider instead a contractionary open market operation, in which the central bank decreases the supply of money. This leads to a decrease in their price. Conversely, the in- terest rate goes up. Note that by selling the bonds in exchange for money previously held by households, the central bank has reduced the money supply.

This way of describing how monetary policy affects interest rates is more intuitive. By buying or selling bonds in exchange for money, the central bank affects the price of bonds, and by implication, the interest rate on bonds.

Let’s summarize what we have learned in the first two sections:

■■ The interest rate is determined by the equality of the supply of money and the de- mand for money.

■■ By changing the supply of money, the central bank can affect the interest rate. ■■ The central bank changes the supply of money through open market operations,

which are purchases or sales of bonds for money. ■■ Open market operations in which the central bank increases the money supply by

buying bonds lead to an increase in the price of bonds and a decrease in the interest rate. In Figure 4-2, the purchase of bonds by the central bank shifts the money sup- ply to the right.

The interest rate is what you get for the bond a year from now ($100) minus what you pay for the bond today ($PB), divided by the price of the bond today, ($PB).b

76 The Short Run The Core

■■ Open market operations in which the central bank decreases the money supply by selling bonds lead to a decrease in the price of bonds and an increase in the interest rate. In Figure 4-2, the purchase of bonds by the central bank shifts the money sup- ply to the left.

Choosing Money or Choosing the Interest Rate? Let me take up one more issue before moving on. I have described the central bank as choosing the money supply and letting the interest rate be determined at the point where money supply equals money demand. Instead, I could have described the central bank as choosing the interest rate and then adjusting the money supply so as to achieve the interest rate it has chosen.

To see this, return to Figure 4-4. Figure 4-4 showed the effect of a decision by the central bank to increase the money supply from Ms to Ms′, causing the interest rate to fall from i to i′. However, we could have described the figure in terms of the central bank decision to lower the interest rate from i to i′ by increasing the money supply from Ms to Ms′.

Why is it useful to think about the central bank as choosing the interest rate? Because this is what modern central banks, including the Fed, typically do. They typically think about the interest rate they want to achieve, and then move the money supply so as to achieve it. This is why, when you listen to the news, you do not hear: “The Fed decided to decrease the money supply today.” Instead you hear: “The Fed decided to increase the interest rate today.” The way the Fed did it was by increasing the money supply appropriately.

4-3 Determining the Interest Rate: II We took a shortcut in Section 4-2 in assuming that all money in the economy consisted of currency supplied by the central bank. In the real world, money includes not only currency but also checkable deposits. Checkable deposits are supplied not by the cen- tral bank but by (private) banks. In this section, we reintroduce checkable deposits and examine how this changes our conclusions. Let me give you the bottom line: Even, in this more complicated case, by changing the amount of central bank money, the central bank can and does control the interest rate.

To understand what determines the interest rate in an economy with both currency and checkable deposits, we must first look at what banks do.

What Banks Do Modern economies are characterized by the existence of many types of financial in- termediaries — institutions that receive funds from people and firms and use these funds to buy financial assets or to make loans to other people and firms. The assets of these institutions are the financial assets they own and the loans they have made. Their liabilities are what they owe to the people and firms from whom they have received funds.

Banks are one type of financial intermediary. What makes banks special — and the reason we focus on banks here rather than on financial intermediaries in general — is that their liabilities are money: People can pay for transactions by writ- ing checks up to the amount of their account balance. Let’s look more closely at what they do.

The balance sheet of banks is shown in the bottom half of Figure 4-6, Figure 4-6b.

Suppose nominal income increases, as in Figure 4-3, and that the central bank wants to keep the interest rate unchanged. How does it need to adjust the money supply? c

Banks have other types of liabilities in addition to check- able deposits, and they are en- gaged in more activities than just holding bonds or making loans. Ignore these complica- tions for the moment. We con- sider them in Chapter 6.

c

Chapter 4 Financial Markets I 77

■■ Banks receive funds from people and firms who either deposit funds directly or have funds sent to their checking accounts (via direct deposit of their paychecks, for example). At any point in time, people and firms can write checks, use a debit card, or withdraw funds, up to the full amount of their account balances. The liabilities of the banks are therefore equal to the value of these checkable deposits.

■■ Banks keep as reserves some of the funds they receive. They are held partly in cash and partly in an account the banks have at the central bank, which they can draw on when they need to. Banks hold reserves for three reasons:

On any given day, some depositors withdraw cash from their checking accounts, whereas others deposit cash into their accounts. There is no reason for the inflows and outflows of cash to be equal, so the bank must keep some cash on hand.

In the same way, on any given day, people with accounts at the bank write checks to people with accounts at other banks, and people with accounts at other banks write checks to people with accounts at the bank. What the bank, as a result of these transactions, owes the other banks can be larger or smaller than what the other banks owe to it. For this reason also, the bank needs to keep reserves.

The first two reasons imply that the banks would want to keep some reserves even if they were not required to do so. But, in addition, banks are typically subject to reserve requirements, which require them to hold reserves in some proportion of their checkable deposits. In the United States, reserve requirements are set by the Fed. In the U.S. banks are required to hold at least 10% of the value of the checkable deposits. They can use the rest to make loans or buy bonds.

■■ Loans represent roughly 70% of banks’ non reserve assets. Bonds account for the rest, 30%. The distinction between bonds and loans is unimportant for our purposes in this chapter — which is to understand how the money supply is de- termined. For this reason, to keep the discussion simple, we will assume in this chapter that banks do not make loans, that they hold only reserves and bonds as assets.

Figure 4-6a returns to the balance sheet of the central bank, in an economy in which there are banks. It is similar to the balance sheet of the central bank we saw in Figure 4-5. The asset side is the same as before: The assets of the central bank are the bonds it holds. The liabilities of the central bank are the money it has issued, central bank money. The new feature, relative to Figure 4-5, is that not all of central bank money is held as currency by the public. Some of it is held as reserves by banks.

MyEconLab Video

(a)

Banks

Assets

Reserves Loans Bonds

Liabilities

Checkable deposits

(b)

Central Bank

Assets

Bonds Central Bank Money 5 Reserves 1 Currency

Liabilities Figure 4-6

The Balance Sheet of Banks, and the Balance Sheet of the Central Bank Revisited

The distinction between loans and bonds is important for other purposes, from the possi- bility of “bank runs” to the role of federal deposit insurance. More on this in Chapter 6.b

78 The Short Run The Core

The Demand and Supply for Central Bank Money So how do we think about the equilibrium in this more realistic setting? Very much in the same way as before, in terms of the demand and the supply of central bank money.

■■ The demand for central bank money is now equal to the demand for currency by people plus the demand for reserves by banks.

■■ The supply of central bank money is under the direct control of the central bank. ■■ The equilibrium interest rate is such that the demand and the supply for central

bank money are equal.

The Demand for Central Bank Money The demand for central bank money now has two components. The first is the demand for currency by people, the second is the demand for reserves by banks. To make the alge- bra simple, I shall assume in the text that people only want to hold money in the form of checkable deposits, and do not hold any currency. The more general case, where people hold both currency and checkable deposits, is treated in the appendix to this chapter. It involves more algebra but yields the same basic conclusions.

In this case, the demand for central bank money is simply the demand for reserves by banks. This demand in turn depends on the demand for checkable deposits by people. So let’s start there. Under our assumption that people hold no currency, the demand for checkable deposits in turn is just equal to the demand for money by people. So, to describe the demand for checkable deposits, we can use the same equation as we used before (equation (4.1)):

Md = $Y L1i2 (4.3) 1-2 People want to hold more checkable deposits the higher their level of transactions and the lower the interest rate on bonds.

Now turn to the demand for reserves by banks. The larger the amount of checkable deposits, the larger the amount of reserves the banks must hold, both for precaution- ary and for regulatory reasons. Let u (the Greek lowercase letter theta) be the reserve ratio, the amount of reserves banks hold per dollar of checkable deposits. Then, using equation (4.3), the demand for reserves by banks, call it Hd, is given by:

Hd = uMd = u$Y L1i2 (4.4) The first equality reflects the fact that the demand for reserves is proportional to the

demand for checkable deposits. The second equality reflects the fact that the demand for checkable deposits depends on nominal income and on the interest rate. So, the demand for central bank money, equivalent the demand for reserves by banks, is equal to u times the demand for money by people.

Equilibrium in the Market for Central Bank Money Just as before, the supply of central bank money — equivalently the supply of reserves by the central bank — is under the control of the central bank. Let H denote the supply of central bank money. And just as before, the central bank can change the amount of H through open market operations. The equilibrium condition is that the supply of central bank money be equal to the demand for central bank money:

H = Hd (4.5)

MyEconLab Video

The use of the letter H comes from the fact that central bank money is sometimes called high-powered money, to reflect its role in determining the equilibrium interest rate. Yet another name for central bank money is also the mone- tary base.

c

Chapter 4 Financial Markets I 79

Or, using equation (4.4):

H = u$Y L1i2 (4.6) We can represent the equilibrium condition, equation (4.6), graphically, and we do

this in Figure 4-7. The figure looks the same as Figure 4-2, but with central bank money rather than money on the horizontal axis. The interest rate is measured on the vertical axis. The demand for central bank money, Hd, is drawn for a given level of nominal in- come. A higher interest rate implies a lower demand for central bank money as demand for checkable deposits by people, and thus the demand for reserves by banks goes down. The supply of money is fixed and is represented by a vertical line at H. Equilibrium is at point A, with interest rate i.

The effects of either changes in nominal income or changes in the supply of cen- tral bank money are qualitatively the same as in the previous section. In particular, an increase in the supply of central bank money leads to a shift in the vertical supply line to the right. This leads to a lower interest rate. As before, an increase in central bank money leads to a decrease in the interest rate. Conversely, a decrease in central bank money leads to an increase in the interest rate. So, the basic conclusion is the same as in Section 4-2: By controlling the supply of central bank money, the central bank can deter- mine the interest rate on bonds.

The Federal Funds Market and the Federal Funds Rate You may wonder whether there is an actual market in which the demand and the sup- ply of reserves determine the interest rate. And, indeed, in the United States, there is an actual market for bank reserves, where the interest rate adjusts to balance the supply and demand for reserves. This market is called the federal funds market. The interest rate determined in this market is called the federal funds rate. Because the Fed can in effect choose the federal funds rate it wants by changing the supply of central bank money, H,

H

A

Central Bank Money, H

Demand for Central Bank Money

Supply of Central Bank Money

In te

re st

r at

e, i

i

Hd

Figure 4-7

Equilibrium in the Market for Central Bank Money and the Determination of the Interest Rate

The equilibrium interest rate is such that the supply of cen- tral bank money is equal to the demand for central bank money.

MyEconLab Animation

80 The Short Run The Core

the federal funds rate is typically thought of as the main indicator of U.S. monetary pol- icy. This is why so much attention is focused on it, and why changes in the federal funds rate typically make front page news.

4-4 The Liquidity Trap The main conclusion from the first three sections was that the central bank can, by choosing the supply of central bank money, choose the interest rate that it wants. If it wants to increase the interest rate, it decreases the amount of central bank money. If it wants to decrease the interest rate, it increases the amount of central bank money. This section shows that this conclusion comes with an important caveat: The interest rate cannot go below zero, a constraint known as the zero lower bound. When the interest rate is down to zero, monetary policy cannot decrease it further. Monetary policy no lon- ger works, and the economy is said to be in a liquidity trap.

Ten years ago, the zero lower bound was seen as a minor issue. Most economists believe that central banks would not want to have negative interest rates in any case, so the con- straint would be unlikely to bind. The crisis however, has changed those perceptions. Many central banks decreased interest rates to zero and would have liked to go down even further. But the zero lower bound stood in the way, and turned out to be a serious constraint on policy.

Let’s look at the argument more closely. When we derived the demand for money in Section 4-1, we did not ask what happens when the interest rate becomes equal to zero. Now we must ask the question. The answer: Once people hold enough money for trans- action purposes, they are then indifferent between holding the rest of their financial wealth in the form of money or in the form of bonds. The reason they are indifferent is that both money and bonds pay the same interest rate, namely zero. Thus, the demand for money is as shown in Figure 4-8:

■■ As the interest rate decreases, people want to hold more money (and thus fewer bonds): The demand for money increases.

In te

re st

r at

e, i

A

Money, M

O CB

MSMd MS MS

i

Figure 4-8

Money Demand, Money Supply, and the Liquidity Trap

When the interest rate is equal to zero, and once people have enough money for transaction purposes, they become indif- ferent between holding money and holding bonds. The de- mand for money becomes horizontal. This implies that, when the interest rate is equal to zero, further increases in the money supply have no ef- fect on the interest rate, which remains equal to zero.

MyEconLab Animation

If you look at Figure 4-1, you will see that I avoided the issue by not drawing the de- mand for money for interest rates close to zero.

In fact, because of the incon- venience and the dangers of holding currency in very large amounts, people and firms are willing to hold some bonds even when the interest rate is a bit negative. We shall ignore this complication here.

The concept of a liquidity trap (i.e., a situation in which in- creasing the amount of money [“liquidity”] does not have an effect on the interest rate [the liquidity is “trapped”]), was developed by Keynes in the 1930s, although the expres- sion itself came later. c

c

c

Chapter 4 Financial Markets I 81

Fo c

u S

The Liquidity Trap in Action

You saw in Chapter 1 how, when the financial crisis began, the Fed decreased the federal funds rate from 5% in mid 2007 to 0% by the end of 2008, when it hit the zero lower bound. Seven years later, at the time of writing (the fall of 2015), the federal funds rate is still equal to zero, although it is forecast to increase in the near future.

During that time, despite having reached the zero lower bound, the Fed has continued to increase the money supply through open market operations in which it bought bonds in exchange for money. The analysis in the text suggests that, despite an unchanged interest rate, we should have seen an increase in checkable deposits by households, and

an increase in reserves by banks. And, indeed, as Figure 1 shows, this is exactly what has happened. Checkable deposits of both households and firms which were decreasing before 2007, reflecting the increasing use of credit cards, increased from 740 billion dollars in 2007 to 880 billion in 2008, and 2,020 billion in 2014. Bank reserves and vault cash (the cash that banks keep on hand) increased from 76 billion dollars in 2007 to 910 billion in 2008 (a more than 12-fold increase), and to 2,450 billion in 2014. In other words, the very large increase in the supply of central bank money was absorbed by households and by banks with no change in the interest rate, which remained equal to zero.

0

500

1,000

1,500

2,000

2,500

3,000

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Vault cash plus reserves at the FRB

Checkable deposits

U S

D (b

ill io

ns )

Figure 1 Checkable Deposits and Bank Reserves, 2005–2014.

Source: Flow of Funds.

MyEconLab Real-time data

■■ As the interest rate becomes equal to zero, people want to hold an amount of money at least equal to the distance, OB. This is what they need for transaction purposes. But they are willing to hold even more money (and therefore hold fewer bonds) because they are indifferent between money and bonds. Therefore, the demand for money becomes horizontal beyond point B.

Now consider the effects of an increase in the money supply. (Let’s ignore banks for the time being, and assume, as in Section 4-2, that all money is currency, so we can use the same diagram as in Figure 4-2 extended to allow for the horizontal portion of money demand. We shall come back to banks and bank money later.)

■■ Consider the case where the money supply is Ms, so the interest rate consistent with financial market equilibrium is positive and equal to i. (This is the case we con- sidered in Section 4-2.) Starting from that equilibrium, an increase in the money supply — a shift of the Ms line to the right — leads to a decrease in the interest rate.

MEL Video

82 The Short Run The Core

■■ When money includes both currency and checkable depos- its, we can think of the interest rate as being determined by the condition that the supply of central bank money be equal to the demand for central bank money.

■■ The supply of central bank money is under the control of the central bank. In the special case where people hold only checkable deposits, the demand for central bank money is equal to the demand for reserves by banks, which is itself equal to the overall demand for money times the reserve ra- tio chosen by banks.

■■ The market for bank reserves is called the federal funds mar- ket. The interest rate determined in that market is called the federal funds rate.

■■ The interest rate chosen by the central bank cannot go below zero. When the interest rate is equal to zero, people and banks are indifferent to holding money or bonds. An increase in the money supply leads to an increase in money demand, an increase in reserves by banks, and no change in the interest rate. This case is known as the liquidity trap. In the liquidity trap monetary policy no longer affects the interest rate.

■■ The demand for money depends positively on the level of transactions in the economy and negatively on the interest rate.

■■ The interest rate is determined by the equilibrium condi- tion that the supply of money be equal to the demand for money.

■■ For a given supply of money, an increase in income leads to an increase in the demand for money and an increase in the interest rate. An increase in the supply of money for a given income leads to a decrease in the interest rate.

■■ The way the central bank changes the supply of money is through open market operations.

■■ Expansionary open market operations, in which the central bank increases the money supply by buying bonds, lead to an increase in the price of bonds and a decrease in the interest rate.

■■ Contractionary open market operations, in which the cen- tral bank decreases the money supply by selling bonds, lead to a decrease in the price of bonds and an increase in the interest rate.

Summary

■■ Now consider the case where the money supply is Ms′, so the equilibrium is at point B; or the case where the money supply is Ms″, so the equilibrium is given by point C. In either case, the initial interest rate is zero. And, in either case, an increase in the money supply has no effect on the interest rate. Think of it this way:

Suppose the central bank increases the money supply. It does so through an open market operation in which it buys bonds and pays for them by creating money. As the interest rate is zero, people are indifferent to how much money or bonds they hold, so they are willing to hold fewer bonds and more money at the same interest rate, namely zero. The money supply increases, but with no effect on the interest rate — which remains equal to zero.

What happens when we reintroduce checkable deposits and a role for banks, along the lines of Section 4-3? Everything we just said still applies to the demand for money by people: If the interest rate is zero, they are indifferent to whether they hold money or bonds: Both pay zero interest. But, now a similar argument also applies to banks and their decision whether to hold reserves or buy bonds. If the interest rate is equal to zero, they will also be indifferent as to whether to hold reserves and to buy bonds: Both pay zero interest. Thus, when the interest rate is down to zero, and the central bank increases the money supply, we are likely to see an increase in check- able deposits and an increase in bank reserves, with the interest rate remaining at zero. As the Focus box “The Liquidity Trap in Action” shows, this is exactly what we saw during the crisis. As the Fed decreased the interest rate to zero, and continued to expand the money supply, both checkable deposits by people and reserves by banks steadily increased.

You may ask why the Fed con- tinued to increase the money supply despite the fact that the federal funds rate was down to zero. We shall see the reason in Chapter 6: In effect, in an economy with more than one type of bond, open market operations can affect relative interest rates on other bonds and affect the economy. c

Chapter 4 Financial Markets I 83

Key Terms Federal Reserve Bank (Fed), 67 currency, 68 checkable deposits, 68 bonds, 68 money market funds, 68 money, 69 income, 69 flow, 69 saving, 69 savings, 69 financial wealth, 69 stock, 69 investment, 69 financial investment, 69

open market operation, 73 expansionary open market operation, 74 contractionary open market operation, 74 Treasury bill (T-bill), 74 financial intermediaries, 76 (bank) reserves, 77 central bank money, 77 reserve ratio, 78 high-powered money, 78 monetary base, 78 federal funds market, 79 federal funds rate, 79 zero lower bound, 80 liquidity trap, 80

Questions and Problems

Quick check MyEconLab Visit www.myeconlab.com to complete all Quick Check problems and get instant feedback. 1. Using the information in this chapter, label each of the following statements true, false, or uncertain. Explain briefly.

a. Income and financial wealth are both examples of stock variables.

b. The term investment, as used by economists, refers to the purchase of bonds and shares of stock.

c. The demand for money does not depend on the interest rate because only bonds earn interest.

d. A large proportion of U.S. currency appears to be held out- side the United States.

e. The central bank can increase the supply of money by sell- ing bonds in the market for bonds.

f. The Federal Reserve can determine the money supply, but it cannot change interest rates.

g. Bond prices and interest rates always move in opposite directions.

h. An increase in income (GDP) will always be accompanied by an increase in interest rates when the money supply is not increased.

2. Suppose that a person’s yearly income is $60,000. Also suppose that this person’s money demand function is given by

Md = $Y10.35 - i2 a. What is this person’s demand for money when the interest

rate is 5%? 10%? b. Explain how the interest rate affects money demand. c. Suppose that the interest rate is 10%. In percentage terms,

what happens to this person’s demand for money if the yearly income is reduced by 50%?

d. Suppose that the interest rate is 5%. In percentage terms, what happens to this person’s demand for money if the yearly income is reduced by 50%?

e. Summarize the effect of income on money demand. In percentage terms, how does this effect depend on the in- terest rate?

3. Consider a bond that promises to pay $100 in one year. a. What is the interest rate on the bond if its price today is

$75? $85? $95? b. What is the relation between the price of the bond and the

interest rate? c. If the interest rate is 8%, what is the price of the bond

today?

4. Suppose that money demand is given by

Md = $Y(0.25 - i) where $Y is $100. Also, suppose that the supply of money is $20.

a. What is the equilibrium interest rate? b. If the Federal Reserve Bank wants to increase the equilib-

rium interest rate i by 10 percentage points from its value in part (a), at what level should it set the supply of money?

Dig DeepeR MyEconLab Visit www.myeconlab.com to complete all Dig Deeper problems and get instant feedback.

5. Suppose that a person’s wealth is $50,000 and that her yearly income is $60,000. Also suppose that her money demand function is given by

Md = $Y10.35 - i2 a. Derive the demand for bonds. Suppose the interest rate in-

creases by 10 percentage points. What is the effect on her demand for bonds?

b. What are the effects of an increase in wealth on her demand for money and her demand for bonds? Explain in words.

c. What are the effects of an increase in income on her de- mand for money and her demand for bonds? Explain in words.

84 The Short Run The Core

d. What is the effect on the interest rate if central bank money is increased to $300 billion?

e. If the overall money supply increases to $3,000 billion, what will be the effect on i? [Hint: Use what you discovered in part (c).]

9. Choosing the quantity of money or the interest rate Suppose that money demand is given by

Md = $Y10.25 - i2 where $Y is $100.

a. If the Federal Reserve Bank sets an interest rate target of 5%, what is the money supply the Federal Reserve must create?

b. If the Federal Reserve Bank wants to increase i from 5 to 10%, what is the new level of the money supply the Federal Reserve must set?

c. What is the effect on the Federal Reserve’s balance sheet of the increase in the interest rate from 5 to 10%?

10. Monetary policy in a liquidity trap Suppose that money demand is given by

Md = $Y10.25 - i2 as long as interest rates are positive. The questions below then refer to situations where the interest rate is zero.

a. What is the demand for money when interest rates are zero and $Y = 80?

b. If $Y = 80, what is the smallest value of the money supply at which the interest rate is zero?

c. Once the interest rate is zero, can the central bank con- tinue to increase the money supply?

d. The United States experienced a long period of zero inter- est rates after 2009. Can you find evidence in the text that the money supply continued to increase over this period?

e. Go to the database at the Federal Reserve Bank of St. Louis known as FRED. Find the series BOGMBASE (the monetary base) and look at its behavior from 2010 to 2015. What happened to the monetary base? What happened to the federal funds rate in the same period?

exploRe FuRtheR 11. Current monetary policy

Go to the Web site for the Federal Reserve Board of Governors (www.federalreserve.gov) and download the most recent monetary policy press release of the Federal Open Market Committee (FOMC). Make sure you get the most recent FOMC press release and not simply the most recent Fed press release.

a. What is the current stance of monetary policy? (Note that policy will be described in terms of increasing or decreas- ing the federal funds rate as opposed to increasing or de- creasing the money supply or the monetary base.)

b. Find a press release where the federal funds rate was actu- ally changed by the FOMC. How did the Federal Reserve explain the need for that change in monetary policy?

d. Consider the statement “When people earn more money, they obviously will hold more bonds.” What is wrong with this statement?

6. The demand for bonds In this chapter, you learned that an increase in the interest rate

makes bonds more attractive, so it leads people to hold more of their wealth in bonds as opposed to money. However, you also learned that an increase in the interest rate reduces the price of bonds.

How can an increase in the interest rate make bonds more attractive and reduce their price?

7. ATMs and credit cards This problem examines the effect of the introduction of ATMs

and credit cards on money demand. For simplicity, let’s examine a person’s demand for money over a period of four days.

Suppose that before ATMs and credit cards, this person goes to the bank once at the beginning of each four-day period and with- draws from her savings account all the money she needs for four days. Assume that she needs $4 per day.

a. How much does this person withdraw each time she goes to the bank? Compute this person’s money holdings for days 1 through 4 (in the morning, before she needs any of the money she withdraws).

b. What is the amount of money this person holds, on average?

Suppose now that with the advent of ATMs, this person withdraws money once every two days.

c. Recompute your answer to part (a). d. Recompute your answer to part (b).

Finally, with the advent of credit cards, this person pays for all her purchases using her card. She withdraws no money until the fourth day, when she withdraws the whole amount necessary to pay for her credit card purchases over the previous four days.

e. Recompute your answer to part a. f. Recompute your answer to part b. g. Based on your previous answers, what do you think

has been the effect of ATMs and credit cards on money demand?

8. Money and the banking system I described a monetary system that included simple banks in

Section 4-3. Assume the following: i. The public holds no currency. ii. The ratio of reserves to deposits is 0.1. iii. The demand for money is given by

Md = $Y10.8 - 4i2 Initially, the monetary base is $100 billion, and nominal income is $5 trillion.

a. What is the demand for central bank money? b. Find the equilibrium interest rate by setting the demand

for central bank money equal to the supply of central bank money.

c. What is the overall supply of money? Is it equal to the overall demand for money at the interest rate you found in part (b)?

Chapter 4 Financial Markets I 85

APPEnDIx: The Determination of the Interest Rate When People Hold Both Currency and Checkable Deposits

In Section 4-3, we made the simplifying assumption that people only held checkable deposits and did not hold any currency. We now relax this assumption and derive the equilibrium interest rate under the assumption that people hold both checkable de- posits and currency.

The easiest way to think about how the interest rate in this economy is determined is still by thinking in terms of the supply and the demand for central bank money:

■■ The demand for central bank money is equal to the demand for currency by people plus the demand for reserves by banks.

■■ The supply of central bank money is under the direct control of the central bank.

■■ The equilibrium interest rate is such that the demand and the supply for central bank money are equal.

Figure 4A-1 shows the structure of the demand and the supply of central bank money in more detail. (Ignore the equa- tions for the time being. Just look at the boxes.) Start on the left side. The demand for money by people is for both checkable de- posits and currency. Because banks have to hold reserves against checkable deposits, the demand for checkable deposits leads to a demand for reserves by banks. Consequently, the demand for central bank money is equal to the demand for reserves by banks plus the demand for currency. Go to the right side: The supply of central bank money is determined by the central bank. Look at the equal sign: The interest rate must be such that the demand and the supply of central bank money are equal.

We now go through each of the boxes in Figure 4-A1 and ask:

■■ What determines the demand for checkable deposits and the demand for currency?

■■ What determines the demand for reserves by banks? ■■ What determines the demand for central bank money? ■■ How does the condition that the demand for and the supply

of central bank money be equal determine the interest rate?

The Demand for Money When people can hold both currency and checkable deposits, the demand for money involves two decisions. First, people must decide how much money to hold. Second, they must decide how much of this money to hold in currency and how much to hold in checkable deposits.

It is reasonable to assume that the overall demand for money (currency plus checkable deposits) is given by the same factors as before. People will hold more money the higher the level of transactions and the lower the interest rate on bonds. So we can assume that overall money demand is given by the same equation as before (equation (4.1)):

Md = $Y L1i2 (4.A1) 1-2

That brings us to the second decision. How do people de- cide how much to hold in currency, and how much in checkable deposits? Currency is more convenient for small transactions (it is also more convenient for illegal transactions). Checks are more convenient for large transactions. Holding money in your checking account is safer than holding cash.

Let’s assume people hold a fixed proportion of their money in currency — call this proportion c — and, by implication, hold a fixed proportion 11 - c2 in checkable-deposits. Call the de- mand for currency CUd (CU for currency, and d for demand). Call the demand for checkable deposits Dd (D for deposits, and d for demand). The two demands are given by

CUd = cMd (4.A2) Dd = 11 - c2M d (4.A3) Equation (4.A2) shows the first component of the demand for central bank money — the demand for currency by the public. Equation (4.A3) shows the demand for checkable deposits.

Finally you can visit the Fed’s Web site and find various statements explaining the Fed’s current policy on interest rates. These statements set the stage for the analysis in Chapter 5. Some parts

of this statement should make more complete sense at the end Chapter 5.

Further Readings ■■ While we shall return to many aspects of the financial sys-

tem throughout the book, you may want to dig deeper and read a textbook on money and banking. Here are four of them: Money, Banking, and Financial Markets, by Laurence Ball (Worth, 2011); Money, Banking, and Financial Markets, by Stephen Cecchetti and Kermit Schoenholtz (McGraw-Hill/ Irwin, 2015); Money, the Financial System and the Economy,

by R. Glenn Hubbard (Addison-Wesley, 2013); The Econom- ics of Money, Banking, and the Financial System, by Frederic Mishkin, (Pearson, 2012).

■■ The Fed maintains a useful Web site, which contains not only data on financial markets but also information on what the Fed does, on recent testimonies by the Fed Chairperson, and so on (http://www.federalreserve.gov).

86 The Short Run The Core

We now have a description of the first box, “Demand for Money,” on the left side of Figure 4-A1: Equation (4.A1) shows the overall demand for money. Equations (4.A2) and (4.A3) show the demand for checkable deposits and the demand for currency, respectively.

The demand for checkable deposits leads to a demand by banks for reserves, the second component of the demand for central bank money. Let u (the Greek lowercase letter theta) be the reserve ratio, the amount of reserves banks hold per dollar of checkable deposits. Let R denote the reserves of banks. Let D denote the dollar amount of checkable deposits. Then, by the definition of u, the following relation holds between R and D:

R = uD (4.A4)

We saw previously that, in the United States today, the reserve ratio is roughly equal to 10%. Thus, u is roughly equal to 0.1.

If people want to hold Dd in deposits, then, from equation (4.A4), banks must hold uDd in reserves. Combining equations (4.A2) and (4.A4), the second component of the demand for cen- tral bank money — the demand for reserves by banks — is given by

Rd = u11 - c2Md (4.A5)

We now have the equation corresponding to the second box, “Demand for Reserves by Banks,” on the left side of Figure 4-A1.

The Demand for Central Bank Money Call Hd the demand for central bank money. This demand is equal to the sum of the demand for currency and the demand for reserves:

Hd = CUd + Rd (4.A6)

Replace CUd and Rd by their expressions from equations (4.A2) and (4.A5) to get

Hd = cMd + u11 - c2Md = [c + u11 - c2]Md

Finally, replace the overall demand for money, Md, by its expression from equation (4.A1) to get:

Hd = [c + u11 - c2]$Y L1i2 (4.A7) This gives us the equation corresponding to the third

box, “Demand for Central Bank Money,” on the left side of Figure 4-A1.

Demand for money

Demand for checkable deposits

Demand for reserves by banks

Demand for Central Bank

Money

Supply of Central Bank

Money Demand for

currency

5

Demand for money Md 5 $Y L(i )

Demand for checkable deposits

Dd 5 (12c) Md

Demand for reserves by banks Rd 5 (12c) Md

Demand for Central Bank

Money Hd 5 CUd 1 Rd 5 [c 1 (12c)] Md 5

[c 1 (12c)] $Y L(i )

Supply of Central Bank

Money

H

Demand for currency

CUd 5 c Md 5

Figure 4-A1

Determinants of the Demand and the Supply of Central Bank Money

MyEconLab Animation

Chapter 4 Financial Markets I 87

equation would be exactly the same as equation (4.2) in Section 4-2 (with the letter H replacing the letter M on the left side, but H and M both stand for the supply of central bank money). In this case, people would hold only currency, and banks would play no role in the supply of money. We would be back to the case we looked at in Section 4-2.

Assume instead that people did not hold currency at all, but held only checkable deposits, so c = 0. Then, the term in brackets would be equal to u, and the equation would be exactly the same as equation (4.6) in Section 4-3.

Leaving aside these two extreme cases, note that the de- mand for central bank money is, as it was in Section 4-2, pro- portional to the overall demand for money, with the factor of proportionality being [c + u11 - c2] rather than just u. Thus, the implications are very much the same as before. A decrease in central bank money leads to an increase in the interest rate, an increase in central bank money leads to a decrease in the interest rate.

The Determination of the Interest Rate We are now ready to characterize the equilibrium. Let H be the supply of central bank money; H is directly controlled by the central bank; just like in the previous section, the central bank can change the amount of H through open market operations. The equilibrium condition is that the supply of central bank money be equal to the demand for central bank money:

H = Hd (4.A8)

Or, using equation (4.9):

H = [c + u11 - c2]$YL1i2 (4.A9) The supply of central bank money (the left side of equation

(4.A9)) is equal to the demand for central bank money (the right side of equation (4.A9)), which is equal to the term in brackets times the overall demand for money.

Look at the term in brackets more closely:

Suppose that people held only currency, so c = 1. Then, the term in brackets would be equal to 1, and the

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89

I

5 Goods and Financial Markets; The IS-LM Model n Chapter 3, we looked at the goods market. In Chapter 4, we looked at financial markets. We now look at goods and financial markets together. By the end of this chapter you will have a framework to think about how output and the interest rate are determined in the short run.

In developing this framework, we follow a path first traced by two economists, John Hicks and Alvin Hansen in the late 1930s and the early 1940s. When the economist John Maynard Keynes published his General Theory in 1936, there was much agreement that his book was both fundamental and nearly impenetrable. (Try to read it, and you will agree.) There were (and still are) many debates about what Keynes “really meant.” In 1937, John Hicks summarized what he saw as one of Keynes’s main contributions: the joint description of goods and financial markets. His analysis was later extended by Alvin Hansen. Hicks and Hansen called their formalization the IS-LM model.

Macroeconomics has made substantial progress since the early 1940s. This is why the IS-LM model is treated in this and the next chapter rather than in Chapter 24 of this book. (If you had taken this course 40 years ago, you would be nearly done!) But to most economists, the IS-LM model still represents an essential building block—one that, despite its simplicity, captures much of what happens in the economy in the short run. This is why the IS-LM model is still taught and used today.

This chapter develops the basic version of the IS-LM model. It has five sections:

Section 5-1 looks at equilibrium in the goods market and derives the IS relation.

Section 5-2 looks at equilibrium in financial markets and derives the LM relation.

Sections 5-3 and 5-4 put the IS and the LM relations together and use the resulting IS-LM model to study the effects of fiscal and monetary policy—first separately, then together.

Section 5-5 introduces dynamics and explores how the IS-LM model captures what happens in the economy in the short run.

The version of the IS-LM presented in this book is a bit dif- ferent (and, you will be happy to know, simpler) than the model developed by Hicks and Han- sen. This reflects a change in the way central banks now conduct monetary policy, with a shift in focus from control- ling the money stock in the past to con- trolling the interest rate today. More in Section 5-2.b

90 The Short Run The Core

5-1 The Goods Market and the IS Relation Let’s first summarize what we learned in Chapter 3:

■■ We characterized equilibrium in the goods market as the condition that production, Y, be equal to the demand for goods, Z. We called this condition the IS relation.

■■ We defined demand as the sum of consumption, investment, and government spending. We assumed that consumption was a function of disposable income (income minus taxes), and took investment spending, government spending, and taxes as given:

Z = C1Y - T2 + IQ + G (In Chapter 3, we assumed, to simplify the algebra, that the relation between con- sumption, C, and disposable income, Y - T, was linear. Here, we shall not make this assumption but use the more general form C = C1Y - T2 instead.)

■■ The equilibrium condition was thus given by

Y = C1Y - T2 + IQ + G ■■ Using this equilibrium condition, we then looked at the factors that moved equilib-

rium output. We looked in particular at the effects of changes in government spend- ing and of shifts in consumption demand.

The main simplification of this first model was that the interest rate did not affect the demand for goods. Our first task in this chapter is to abandon this simplification and introduce the interest rate in our model of equilibrium in the goods market. For the time being, we focus only on the effect of the interest rate on investment and leave a discus- sion of its effects on the other components of demand until later.

Investment, Sales, and the Interest Rate In Chapter 3, investment was assumed to be constant. This was for simplicity. Investment is in fact far from constant and depends primarily on two factors:

■■ The level of sales. Consider a firm facing an increase in sales and needing to increase production. To do so, it may need to buy additional machines or build an additional plant. In other words, it needs to invest. A firm facing low sales will feel no such need and will spend little, if anything, on investment.

■■ The interest rate. Consider a firm deciding whether or not to buy a new machine. Suppose that to buy the new machine, the firm must borrow. The higher the interest rate, the less attractive it is to borrow and buy the machine. (For the moment, and to keep things simple, we make two simplifications. First, we assume that all firms can borrow at the same interest rate—namely, the interest rate on bonds as determined in Chapter 4. In fact, many firms borrow from banks, possibly at a different rate. We also leave aside the distinction between the nominal interest rate—the interest rate in terms of dollars—and the real interest rate—the interest rate in terms of goods. We return to both issues in Chapter 6.) At a high enough interest rate, the additional profits from using the new machine will not cover interest payments, and the new machine will not be worth buying.

To capture these two effects, we write the investment relation as follows:

I = I1Y, i2 1+ , -2 (5.1)

c

Much more on the effects of interest rates on both con- sumption and investment in Chapter 15.

The argument still holds if the  firm uses its own funds: The higher the interest rate, the more attractive it is to lend the funds rather than to use them to buy the new machine.

c

Chapter 5 Goods and Financial Markets; The IS-LM Model 91

Equation (5.1) states that investment I depends on production Y and the interest rate i. (We continue to assume that inventory investment is equal to zero, so sales and production are always equal. As a result, Y denotes both sales and production.) The posi- tive sign under Y indicates that an increase in production (equivalently, an increase in sales) leads to an increase in investment. The negative sign under the interest rate i indi- cates that an increase in the interest rate leads to a decrease in investment.

Determining Output Taking into account the investment relation (5.1), the condition for equilibrium in the goods market becomes

Y = C1Y - T2 + I1Y, i2 + G (5.2) Production (the left side of the equation) must be equal to the demand for goods (the

right side). Equation (5.2) is our expanded IS relation. We can now look at what happens to output when the interest rate changes.

Start with Figure 5-1. Measure the demand for goods on the vertical axis. Measure output on the horizontal axis. For a given value of the interest rate i, demand is an in- creasing function of output, for two reasons:

■■ An increase in output leads to an increase in income and thus to an increase in dis- posable income. The increase in disposable income leads to an increase in consump- tion. We studied this relation in Chapter 3.

■■ An increase in output also leads to an increase in investment. This is the relation between investment and production that we have introduced in this chapter.

In short, an increase in output leads, through its effects on both consumption and investment, to an increase in the demand for goods. This relation between demand and output, for a given interest rate, is represented by the upward-sloping curve ZZ. Note two characteristics of ZZ in Figure 5-1:

■■ Because we have not assumed that the consumption and investment relations in equation (5.2) are linear, ZZ is in general a curve rather than a line. Thus, we have drawn it as a curve in Figure 5-1. All the arguments that follow would apply if we

b

An increase in output leads to an increase in investment. An increase in the interest rate leads to a decrease in investment.

45°

ZZ

Demand

Output, Y

D em

an d,

Z

Y

A

Figure 5-1

Equilibrium in the Goods Market

The demand for goods is an increasing function of output. Equilibrium requires that the demand for goods be equal to output.

MyEconLab Animation

92 The Short Run The Core

(a)

A

45°

ZZ

(for i )

ZZ

(for i > i )

D em

an d,

Z

A

(b)

Y

A

IS curve

Output, Y

In te

re st

r at

e, i

Y

A

Y Output, Y

Y

i

i

Figure 5-2

The IS Curve

(a) An increase in the interest rate decreases the demand for goods at any level of out- put, leading to a decrease in the equilibrium level of output. (b) Equilibrium in the goods market implies that an in- crease in the interest rate leads to a decrease in out- put. The IS curve is therefore downward sloping.

MyEconLab Animation

assumed that the consumption and investment relations were linear and that ZZ were a straight line.

■■ We have drawn ZZ so that it is flatter than the 45-degree line. Put another way, we have assumed that an increase in output leads to a less than one-for-one increase in demand. In Chapter 3, where investment was constant, this restriction natu- rally followed from the assumption that consumers spend only part of their ad- ditional income on consumption. But now that we allow investment to respond to production, this restriction may no longer hold. When output increases, the sum of the increase in consumption and the increase in investment could exceed the initial increase in output. Although this is a theoretical possibility, the empirical evidence suggests that it is not the case in reality. That’s why we shall assume the response of demand to output is less than one-for-one and draw ZZ flatter than the 45-degree line.

cMake sure you understand why the two statements mean the same thing.

Chapter 5 Goods and Financial Markets; The IS-LM Model 93

Equilibrium in the goods market is reached at the point where the demand for goods equals output; that is, at point A, the intersection of ZZ and the 45-degree line. The equi- librium level of output is given by Y.

So far, what we have done is extend, in straightforward fashion, the analysis of Chapter 3. But we are now ready to derive the IS curve.

Deriving the IS Curve We have drawn the demand relation, ZZ, in Figure 5-1 for a given value of the interest rate. Let’s now derive in Figure 5-2 what happens if the interest rate changes.

Suppose that, in Figure 5-2(a), the demand curve is given by ZZ, and the initial equilibrium is at point A. Suppose now that the interest rate increases from its initial value i to a new higher value i′. At any level of output, the higher interest rate leads to lower investment and lower demand. The demand curve ZZ shifts down to ZZ′: At a given level of output, demand is lower. The new equilibrium is at the intersection of the lower demand curve ZZ′ and the 45-degree line, at point A′. The equilibrium level of output is now equal to Y′.

In words: The increase in the interest rate decreases investment. The decrease in investment leads to a decrease in output, which further decreases consumption and in- vestment, through the multiplier effect.

Using Figure 5-2(a), we can find the equilibrium value of output associated with any value of the interest rate. The resulting relation between equilibrium output and the interest rate is drawn in Figure 5-2(b).

Figure 5-2(b) plots equilibrium output Y on the horizontal axis against the interest rate on the vertical axis. Point A in Figure 5-2(b) corresponds to point A in Figure 5-2(a), and point A′ in Figure 5-3(b) corresponds to A= in Figure 5-2(a). The higher interest rate is associated with a lower level of output.

This relation between the interest rate and output is represented by the downward– sloping curve in Figure 5-2(b). This curve is called the IS curve.

Shifts of the IS Curve We have drawn the IS curve in Figure 5-2 taking as given the values of taxes, T, and gov- ernment spending, G. Changes in either T or G will shift the IS curve.

b

Can you show graphically what the size of the multiplier is? (Hint: Look at the ratio of the decrease in equilibrium output to the initial decrease in investment.)

b

Equilibrium in the goods mar- ket implies that an increase in the interest rate leads to a decrease in output. This re- lation is represented by the downward-sloping IS curve.

IS (for T > T )

IS (for taxes T )

In te

re st

, i

Y

Output, Y Y

i

Figure 5-3

Shifts of the IS Curve

An increase in taxes shifts the IS curve to the left.

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94 The Short Run The Core

To see how, consider Figure 5-3. The IS curve gives the equilibrium level of output as a function of the interest rate. It is drawn for given values of taxes and spending. Now consider an increase in taxes, from T to T′. At a given interest rate, say i, dispos- able income decreases, leading to a decrease in consumption, leading in turn to a de- crease in the demand for goods and a decrease in equilibrium output. The equilibrium level of output decreases from Y to Y′. Put another way, the IS curve shifts to the left: At a given interest rate, the equilibrium level of output is lower than it was before the increase in taxes.

More generally, any factor that, for a given interest rate, decreases the equilibrium level of output causes the IS curve to shift to the left. We have looked at an increase in taxes. But the same would hold for a decrease in government spending, or a de- crease in consumer confidence (which decreases consumption given disposable income). Symmetrically, any factor that, for a given interest rate, increases the equilibrium level of output—a decrease in taxes, an increase in government spending, an increase in con- sumer confidence—causes the IS curve to shift to the right. Let’s summarize:

■■ Equilibrium in the goods market implies that an increase in the interest rate leads to a decrease in output. This relation is represented by the downward-sloping IS curve.

■■ Changes in factors that decrease the demand for goods given the interest rate shift the IS curve to the left. Changes in factors that increase the demand for goods given the interest rate shift the IS curve to the right.

5-2 Financial Markets and the LM Relation Let’s now turn to financial markets. We saw in Chapter 4 that the interest rate is deter- mined by the equality of the supply of and the demand for money:

M = $Y L1i2 The variable M on the left side is the nominal money stock. We shall ignore here the details of the money-supply process that we saw in Section 4-3, and simply think of the central bank as controlling M directly.

The right side gives the demand for money, which is a function of nominal income, $Y, and of the nominal interest rate, i. As we saw in Section 4-1, an increase in nominal income increases the demand for money; an increase in the interest rate decreases the demand for money. Equilibrium requires that money supply (the left side of the equation) be equal to money demand (the right side of the equation).

Real Money, Real Income, and the Interest Rate The equation M = $Y L1i2 gives a relation between money, nominal income, and the interest rate. It will be more convenient here to rewrite it as a relation among real money (that is, money in terms of goods), real income (that is, income in terms of goods), and the interest rate.

Recall that nominal income divided by the price level equals real income, Y. Dividing both sides of the equation by the price level P gives

M P

= Y L1i2 (5.3)

Hence, we can restate our equilibrium condition as the condition that the real money supply—that is, the money stock in terms of goods, not dollars—be equal to the real money demand, which depends on real income, Y, and the interest rate, i.

c

For a given interest rate, an increase in taxes leads to a decrease in output. In graphic terms: An increase in taxes shifts the IS curve to the left.

c

Suppose that the government announces that the Social Security system is in trouble, and it may have to cut retire- ment benefits in the future. How are consumers likely to react? What is then likely to happen to demand and output today?

c

From Chapter 2: Nominal GDP = Real GDP multiplied by the GDP deflator $ Y = YP. Equivalently: Real GDP = Nominal GDP divided by the GDP deflator $ Y / P = Y.

Chapter 5 Goods and Financial Markets; The IS-LM Model 95

The notion of a “real” demand for money may feel a bit abstract, so an example will help. Think not of your demand for money in general but just of your demand for coins. Suppose you like to have coins in your pocket to buy two cups of coffee during the day. If a cup costs $1.20, you will want to keep about $2.40 in coins: This is your nominal demand for coins. Equivalently, you want to keep enough coins in your pocket to buy two cups of coffee. This is your demand for coins in terms of goods—here in terms of cups of coffee.

From now on, we shall refer to equation (5.3) as the LM relation. The advantage of writing things this way is that real income, Y, appears on the right side of the equation in- stead of nominal income, $Y. And real income (equivalently real output) is the variable we focus on when looking at equilibrium in the goods market. To make the reading lighter, we will refer to the left and right sides of equation (5.3) simply as “money supply” and “money demand” rather than the more accurate but heavier “real money supply” and “real money demand.” Similarly, we will refer to income rather than “real income.”

Deriving the LM Curve In deriving the IS curve, we took the two policy variables as government spending, G, and taxes, T. In deriving the LM curve, we have to decide how we characterize monetary policy, as the choice of M, the money stock, or as the choice of i, the interest rate.

If we think of monetary policy as choosing the nominal money supply, M,and, by implication, given the price level which we shall take as fixed in the short run, choosing M/P, the real money stock, equation (5.3) tells us that real money demand, the right hand side of the equation, must be equal to the given real money supply, the left-hand side of the equation. Thus, if for example, real income increases, increasing money de- mand, the interest rate must increase so as money demand remains equal to the given money supply. In other words, for a given money supply, an increase in income automati- cally leads to an increase in the interest rate.

This is the traditional way of deriving the LM relation and the resulting LM curve. The assumption that the central bank chooses the money stock and then just lets the interest rate adjust is at odds however with reality today. Although, in the past, central banks thought of the money supply as the monetary policy variable, they now focus directly on the interest rate. They choose an interest rate, call it, iQ, and adjust the money supply so as to achieve it. Thus, in the rest of the book, we shall think of the central bank as choosing the interest rate (and doing what it needs to do with the money supply to achieve this in- terest rate). This will make for an extremely simple LM curve, namely, a horizontal line in Figure 5-4, at the value of the interest rate, iQ, chosen by the central bank.

b Go back to Figure 4-3 in the previous chapter.

LM curve is a bit of a misnomer, as, under our assumption, the LM relation is a simple horizon- tal line. But the use of the term curve is traditional, and I shall follow tradition.b

Output, Y

LMi

In te

re st

r at

e, i

Figure 5-4

The LM Curve

The central bank chooses the interest rate (and adjusts the money supply so as to achieve it).

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96 The Short Run The Core

5-3 Putting the IS and the LM Relations Together The IS relation follows from goods market equilibrium. The LM relation follows from financial market equilibrium. They must both hold.

IS relation: Y = C1Y - T2 + I1Y, i2 + G LM relation: i = iQ

Together they determine output. Figure 5-5 plots both the IS curve and the LM curve on one graph. Output—equivalently, production or income—is measured on the horizontal axis. The interest rate is measured on the vertical axis.

Any point on the downward-sloping IS curve corresponds to equilibrium in the goods market. Any point on the horizontal LM curve corresponds to equilibrium in financial markets. Only at point A are both equilibrium conditions satisfied. That means point A, with the associated level of output Y and interest rate iQ is the overall equilibrium—the point at which there is equilibrium in both the goods market and the financial markets.

The IS and LM relations that underlie Figure 5-5 contain a lot of information about consumption, investment, and equilibrium conditions. But you may ask: So what if the equilibrium is at point A? How does this fact translate into anything directly useful about the world? Don’t despair: Figure 5-5 holds the answer to many questions in macroeco- nomics. Used properly, it allows us to study what happens to output when the central bank decides to decrease the interest rate, or when the government decides to increase taxes, or when consumers become more pessimistic about the future, and so on.

Let’s now see what the IS-LM model tells us, by looking separately at the effects of fiscal and monetary policy.

Fiscal Policy Suppose the government decides to reduce the budget deficit and does so by increasing taxes while keeping government spending unchanged. Such a reduction in the budget deficit is often called a fiscal contraction or a fiscal consolidation. (An increase in the deficit, either due to an increase in government spending or to a decrease in taxes, is called a fiscal expansion.) What are the effects of this fiscal contraction on output, on its composition, and on the interest rate?

c

In future chapters, you will see how we can extend it to think about the financial crisis, or about the role of expectations, or about the role of policy in an open economy.

c

Decrease in G-T 3 fiscal contraction 3 fiscal consolidation

Increase in G-T 3 fiscal expansion

Output, (Income), Y

Equilibrium in LM

IS

Y

Financial Markets A

In te

re st

r at

e, i

Equilibrium in Goods Market

i

Figure 5-5

The IS-LM Model

Equilibrium in the goods mar- ket implies that an increase in the interest rate leads to a decrease in output. This is represented by the IS curve. Equilibrium in financial mar- kets is represented by the horizontal LM curve. Only at point A, which is on both curves, are both goods and fi- nancial markets in equilibrium.

MyEconLab Animation

Chapter 5 Goods and Financial Markets; The IS-LM Model 97

When you answer this or any question about the effects of changes in policy (or, more generally, changes in exogenous variables), always go through the following three steps:

1. Ask how the change affects equilibrium in the goods market and how it affects equilibrium in the financial markets. Put another way: Does it shift the IS curve and/ or the LM curve, and, if so, how?

2. Characterize the effects of these shifts on the intersection of the IS and the LM curves. What does this do to equilibrium output and the equilibrium interest rate?

3. Describe the effects in words.

With time and experience, you will often be able to go directly to step 3. By then you will be ready to give an instant commentary on the economic events of the day. But until you get to that level of expertise, go step by step.

In this case, the three steps are easy. But going through them is good practice anyway:

■■ Start with step 1. The first question is how the increase in taxes affects equilibrium in the goods market—that is, how it affects the relation between output and the in- terest rate captured in the IS curve. We derived the answer in Figure 5-3 previously: At a given interest rate, the increase in taxes decreases output. The IS curve shifts to the left, from IS to IS′, in Figure 5-6.

Next, let’s see if anything happens to the LM curve. By assumption, as we are looking at a change only in fiscal policy, the central bank does not change the inter- est rate. Thus, the LM curve, i.e. the horizontal line at i = iQ remains unchanged. The LM curve does not shift.

■■ Now consider step 2, the determination of the equilibrium. Before the increase in taxes, the equilibrium is given by point A, at the inter-

section of the IS and LM curves. After the increase in taxes and the shift to the left of the IS curve from IS to IS′, the new equilibrium is given by point A′. Output decreases from Y to Y′. By assumption, the interest rate does not change. Thus, as the IS curve shifts, the economy moves along the LM curve, from A to A′. The reason these words are italicized is that it is important always to distinguish between the shift of a curve (here the shift of the IS curve) and the movement along a curve (here the movement along the LM curve). Many mistakes come from not distinguishing between the two.

b

And when you feel really con- fident, put on a bow tie and go explain events on TV. (Why so many TV economists actually wear bow ties is a mystery.)

MyEconLab Video

b

The increase in taxes shifts the IS curve. The LM curve does not shift. The economy moves along the LM curve.

LM

IS

IS

Output, Y

In te

re st

r at

e, i

YY

A A i

Figure 5-6

The Effects of an Increase in Taxes

An increase in taxes shifts the IS curve to the left. This leads to a decrease in the equilibrium level of output.

MyEconLab Animation

98 The Short Run The Core

■■ Step 3 is to tell the story in words:

The increase in taxes leads to lower disposable income, which causes people to decrease their consumption. This decrease in demand leads, in turn through a multiplier, to a decrease in output and income. At a given interest rate, the in- crease in taxes leads therefore to a decrease in output. Looking at the components of output: The decrease in income and the increase in taxes both contribute to the decrease in disposable income and, in turn, a decrease in consumption. The decrease in output leads to a decrease in investment. Thus, both consumption and investment decrease.

Monetary Policy Now turn to monetary policy. Suppose the central bank decreases the interest rate. Recall that, to do so, it increases the money supply, so such a change in monetary policy is called a monetary expansion. (Conversely, an increase in the interest rate, which is achieved through a decrease in the money supply, is called a monetary contraction or monetary tightening.)

■■ Again, step 1 is to see whether and how the IS and the LM curves shift. Let’s look at the IS curve first. The change in the interest rate does not change

the relation between output and the interest rate. It does not shift the IS curve. The change in the interest rate however leads (trivially) to a shift in the LM curve.

The LM curve shifts down, from the horizontal line at i = iQ to the horizontal line i = iQ′. ■■ Step 2 is to see how these shifts affect the equilibrium. The equilibrium is represented

in Figure 5-7. The IS curve does not shift. The LM curve shifts down. The economy moves down along the IS curve, and the equilibrium moves from point A to point A′. Output increases from Y to Y′, and the interest rate decreases from i to i9.

■■ Step 3 is to say it in words: The lower interest rate leads to an increase in invest- ment and, in turn, to an increase in demand and output. Looking at the compo- nents of output: The increase in output and the decrease in the interest rate both lead to an increase in investment. The increase in income leads to an increase in disposable income and, in turn, in consumption. So both consumption and investment increase.

c

Note that we have just given a formal treatment of the infor- mal discussion of the effects of an increase in public sav- ing given in the Focus Box on “The Paradox of Saving” in Chapter 3.

Decrease in i 3 increase in M 3 monetary expansion.

Output, Y

YY

IS

A

A LM

LM

In te

re st

r at

e, i

i

i

Figure 5-7

The Effects of a Decrease in the Interest Rate

A monetary expansion shifts the LM curve down, and leads to higher output.

MyEconLab Animation

c

Increase in i 3 decrease in M 3 monetary contraction 3 monetary tightening.

Chapter 5 Goods and Financial Markets; The IS-LM Model 99

5-4 Using a Policy Mix We have looked so far at fiscal policy and monetary policy in isolation. Our purpose was to show how each worked. In practice, the two are often used together. The combination of monetary and fiscal policies is known as the monetary-fiscal policy mix, or simply the policy mix.

Sometimes, the right mix is to use fiscal and monetary policy in the same direction. Suppose for example that the economy is in a recession and output is too low. Then, both fiscal and monetary policies can be used to increase output. This combination is repre- sented in Figure 5-8. The initial equilibrium is given by the intersection of IS and LM at point A, with corresponding output Y. Expansionary fiscal policy, say through a decrease in taxes, shifts the IS curve to the right, from IS to IS′. Expansionary monetary policy shifts the LM curve from LM to LM′. The new equilibrium is at A′, with corresponding output Y′. Thus, both fiscal and monetary policies contribute to the increase in output. Higher income and lower taxes imply that consumption is also higher. Higher output and a lower interest rate imply that investment is also higher.

Such a combination of fiscal and monetary policy is typically used to fight reces- sions, and it was for example used during the 2001 recession. The story of the reces- sion and the role of monetary and fiscal policy are described in the Focus box “The U.S. Recession of 2001.” You might ask: Why use both policies when either one on its own could achieve the desired increase in output? As we saw in the previous section, the in- crease in output could in principle be achieved just by using fiscal policy—say through a sufficiently large increase in government spending, or a sufficiently large decrease in taxes—or just by using monetary policy, through a sufficiently large decrease in the interest rate? The answer is that there are a number of reasons why policy makers may want to use a policy mix:

■■ A fiscal expansion means either an increase in government spending, or an increase in taxes, or both. This means an increase in the budget deficit (or, if the budget was initially in surplus, a smaller surplus). As we shall see later, but you surely can guess why already, running a large deficit and increasing government debt may be dangerous. In this case, it is better to rely, at least in part, on monetary policy.

MyEconLab Video

b More on this in Chapter 22.

Output, Y Y Y

IS IS

A

A

In te

re st

r at

e, i

LM

LM

i

Figure 5-8

The Effects of a Combined Fiscal and Monetary Expansion

The fiscal expansion shifts the IS curve to the right. A monetary expansion shifts the LM curve down. Both lead to higher output.

MyEconLab Animation

100 The Short Run The Core

Focus: The U.S. Recession of 2001 Fo

c U

S In 1992, the U.S. economy embarked on a long expansion. For the rest of the decade, GDP growth was positive and high. In 2000, however, the expansion came to an end. From the third quarter of 2000 to the fourth quarter of 2001, GDP growth was either positive and close to zero or negative. Based on data available at the time, it was thought that growth was negative through the first three quarters of 2001. Based on revised data, shown in Figure 1, which gives the growth rate for each quarter from 1999–1 to 2002–4, measured at annual rate, it appears that growth was actually small but positive in the second quarter. (These data revisions happen often, so that what we see when we look back is not always what national income statisticians and policy mak- ers perceived at the time.) The National Bureau of Economic Research (NBER), an academic organization that has tra- ditionally dated U.S. recessions and expansions, concluded that the U.S. economy had indeed had a recession in 2001, starting in March 2001 and ending in December 2001; this period is represented by the shaded area in the figure.

What triggered the recession was a sharp decline in in- vestment demand. Nonresidential investment — the demand for plant and equipment by firms —decreased by 4.5% in 2001. The cause was the end of what Alan Greenspan, the chairman of the Fed at the time, had dubbed a period of “ir- rational exuberance”: During the second part of the 1990s, firms had been extremely optimistic about the future, and the rate of investment had been very high —the average yearly growth rate of investment from 1995 to 2000 exceeded 10%. In 2001, however, it became clear to firms that they had been overly optimistic and had invested too much. This led them to cut back on investment, leading to a decrease in demand and, through the multiplier, a decrease in GDP.

The recession could have been much worse. But it was met by a strong macroeconomic policy response, which cer- tainly limited the depth and the length of the recession.

Take monetary policy first. Starting in early 2001, the Fed, feeling that the economy was slowing down, started decreas- ing the federal funds rate aggressively. (Figure 2 shows the behavior of the federal funds rate, from 1991–1 to 2002–4.) It continued to do so throughout the year. The funds rate, which stood at 6.5% in January, stood at less than 2% at the end of the year.

Turn to fiscal policy. During the 2000 presidential cam- paign, then candidate George Bush had run on a platform of lower taxes. The argument was that the federal budget was in surplus, and so there was room to reduce tax rates while keeping the budget in balance. When President Bush took office in 2001 and it became clear that the economy was slowing down, he had an additional rationale to cut tax rates, namely the use of lower taxes to increase demand and fight the recession. Both the 2001 and the 2002 budgets included substantial reductions in tax rates. On the spending side, the events of September 11, 2001 also led to an increase in spending, mostly on defense and homeland security.

Figure 3 shows the evolution of federal government revenues and spending during 1999–1 to 2002–4, both expressed as ratios to GDP. Note the dramatic decrease in revenues starting in the third quarter of 2001. Even without decreases in tax rates, revenues would have gone down dur- ing the recession: Lower output and lower income mechani- cally imply lower tax revenues. But, because of the tax cuts, the decrease in revenues in 2001 and 2002 was much larger than can be explained by the recession. Note also the smaller but steady increase in spending starting around the same

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Figure 1 The U.S. Growth Rate, 1999–1 to 2002–4

Source: Calculated using Series GDPC1, Federal Reserve Economic Data (FRED) http://research.stlouisfed.org/fred2/.

Chapter 5 Goods and Financial Markets; The IS-LM Model 101

time. As a result, the budget surplus—the difference between revenues and spending—went from positive up until 2000, to negative in 2001 and, much more so, in 2002.

Let me end by taking up four questions you might be ask- ing yourself at this point:

■■ Why weren’t monetary and fiscal policy used to avoid rather than just to limit the size of the recession? The reason is that changes in policy affect demand and

output only over time (more on this in Section 5-5). Thus, by the time it became clear that the U.S. economy was entering a recession, it was already too late to use policy to avoid it. What the policy did was to reduce both the depth and the length of the recession.

■■ Weren’t the events of September 11, 2001, also a cause of the recession? The answer, in short, is no, tragic as the event was. As we have seen, the reces- sion started long before September 11, and ended soon

0

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Source: Series FEDFUNDS, Federal Reserve Economic Data (FRED) http://research. stlouisfed.org/fred2/.

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Figure 3 U.S. Federal Government Revenues and Spending (as Ratios to GDP), 1999–1 to 2002–4

Source: Calculated using Series GDP, FGRECPY, FGEXPND, Federal Reserve Economic Data (FRED) http://research.stlouisfed.org/fred2/.

102 The Short Run The Core

after. Indeed, GDP growth was positive in the last quar- ter of 2001. One might have expected—and, indeed, most economists expected—the events of September 11 to have large adverse effects on output, leading, in particular, consumers and firms to delay spending decisions until the outlook was clearer. In fact, the drop in spending was short and limited. Decreases in the federal funds rate after September 11—and large discounts by automobile producers in the last quarter of 2001—are believed to have been crucial in main- taining consumer confidence and consumer spending during that period.

■■ Was the monetary–fiscal mix used to fight the reces- sion a textbook example of how policy should be conducted?

On this, economists differ. Most economists give high marks to the Fed for strongly decreasing interest rates as soon as the economy slowed down. But most economists are worried that the tax cuts introduced in 2001 and 2002 led to large and persistent budget deficits long after the recession was over. They argue that the tax cuts should have been temporary, helping the U.S. economy get out of the recession but stopping thereafter.

■■ Why were monetary and fiscal policy unable to avoid the recession of 2009? The answer, in short, is two- fold. The shocks were much larger, and much harder to react to. And the room for policy responses was more limited. We shall return to these two aspects in Chapter 6.

■■ A monetary expansion means a decrease in the interest rate. If the interest rate is very low, then the room for using monetary policy may be limited. In this case, fis- cal policy has to do more of the job. If the interest rate is already equal to zero, the case of the zero lower bound we saw in the previous chapter, then fiscal policy has to do all the job.

■■ Fiscal and monetary policies have different effects on the composition of output. A decrease in income taxes for example will tend to increase consumption relative to investment. A decrease in the interest rate will affect investment more than con- sumption. Thus, depending on the initial composition of output, policy makers may want to rely more on fiscal or more on monetary policy.

■■ Finally, neither fiscal policy nor monetary policy work perfectly. A decrease in taxes may fail to increase consumption. A decrease in the interest rate may fail to increase investment. Thus, in case one policy does not work as well as hoped for, it is better to use both.

Sometimes, the right policy mix is instead to use the two policies in opposite di- rections, for example, combining a fiscal consolidation with a monetary expansion.

MyEconLab Video

Output, Y

Y, YY

IS IS

LM

LM

A

A

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re st

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Figure 5-9

The Effects of a Combined Fiscal Consolidation and a Monetary Expansion

The fiscal consolidation shifts the IS curve to the left. A monetary expansion shifts the LM curve down. Both lead to higher output.

MyEconLab Animation

Chapter 5 Goods and Financial Markets; The IS-LM Model 103

Fo c

U S

Deficit Reduction: Good or Bad for Investment?

You may have heard this argument in some form before: “Private saving goes either toward financing the budget defi- cit or financing investment. It does not take a genius to conclude that reducing the budget deficit leaves more saving available for investment, so investment increases.”

This argument sounds convincing. But, as we have seen in the text, it must be wrong. If, for example, deficit reduction is not accompanied by a decrease in the interest rate, then we know that output decreases (see Figure 5-7), and by implica- tion, so does investment—as it depends on output. So what is going on in this case?

To make progress, go back to Chapter 3, equation (3.10). There we learned that we can also think of the goods-market equilibrium condition as

Investment = Private saving + Public saving

I = S + 1T - G2

In equilibrium, investment is indeed equal to private saving plus public saving. If public saving is positive, the government is said to be running a budget surplus; if public saving is negative, the government is said to be running a budget deficit. So it is true that given private saving, if the government reduces its deficit—either by increasing taxes or reducing government spending so that T-G goes

up—investment must go up: Given S, T-G going up implies that I goes up.

The crucial part of this statement, however, is “given private saving.” The point is that a fiscal contraction affects private saving as well: The contraction leads to lower output and therefore to lower income. As consumption goes down by less than income, private saving also goes down. It actu- ally goes down by more than the reduction in the budget deficit, leading to a decrease in investment. In terms of the equation: S decreases by more than T-G increases, and so I decreases. (You may want to do the algebra and convince yourself that saving actually goes down by more than the increase in T-G. See problem 3 in the Questions and Problems section.)

Does this mean that deficit reduction always decreases investment? The answer is clearly no. We saw this in Figure  5-9. If when the deficit is reduced, the central bank also decreases the interest rate so as to keep output constant, then investment necessarily goes up. Although output is unchanged, the lower interest rate leads to higher investment.

The morale of this box is clear: Whether deficit reduction leads to an increase in investment is far from automatic. It may or it may not, depending on the response of monetary policy.

Suppose for example that the government is running a large budget deficit and would like to reduce it, but does not want to trigger a recession. In terms of Figure 5-9, the initial equilibrium is given by the intersection of the IS and LM curves at point A, with associated output Y. Output is thought to be at the right level, but the budget deficit, T-G, is too large.

If the government reduces the deficit, say by increasing T or by decreasing G (or both), the IS curve will shift to the left, from IS to IS′. The equilibrium will be at point A′, with level of output Y′. At a given interest rate, higher taxes or lower spending will decrease demand, and through the multiplier, decrease output. Thus, the reduction in the deficit will lead to a recession.

The recession can be avoided however if monetary policy is also used. If the central bank reduces the interest rate to iQ′, the equilibrium is given by point A′, with corre- sponding output Y″ = Y. The combination of both policies thus allows for the reduction in the deficit, but without a recession.

What happens to consumption and investment in this case? What happens to con- sumption depends on how the deficit is reduced. If the reduction takes the form of a de- crease in government spending rather than an increase in taxes, income is unchanged, disposable income is unchanged, and so consumption is unchanged. If the reduction takes the form of an increase in income taxes, then disposable income is lower, and so is consumption. What happens to investment is unambiguous: Unchanged output and a lower interest rate implies higher investment. The relation between deficit reduction and investment is discussed further in the Focus Box “Deficit Reduction: Good or Bad for Investment?”

104 The Short Run The Core

We have just seen a second example of a policy mix. Such a policy mix was used in the early 1990s in the United States. When Bill Clinton was elected President in 1992, one of his priorities was to reduce the budget deficit using a combination of cuts in spending and increases in taxes. Clinton was worried, however, that, by itself, such a fis- cal contraction would lead to a decrease in demand and trigger another recession. The right strategy was to combine a fiscal contraction (so as to get rid of the deficit) with a monetary expansion (to make sure that demand and output remained high). This was the strategy adopted and carried out by Bill Clinton (who was in charge of fiscal policy) and Alan Greenspan (who was in charge of monetary policy). The result of this strat- egy—and a bit of economic luck—was a steady reduction of the budget deficit (which turned into a budget surplus at the end of the 1990s) and a steady increase in output throughout the rest of the decade.

5-5 How Does the IS-LM Model Fit the Facts? We have so far ignored dynamics. For example, when looking at the effects of an increase in taxes in Figure 5-6—or the effects of a monetary expansion in Figure 5-7—we made it look as if the economy moved instantaneously from A to A′, as if output went instanta- neously from Y to Y′. This is clearly not realistic: The adjustment of output clearly takes time. To capture this time dimension, we need to reintroduce dynamics.

Introducing dynamics formally would be difficult. But, as we did in Chapter 3, we can describe the basic mechanisms in words. Some of the mechanisms will be familiar from Chapter 3, some are new:

■■ Consumers are likely to take some time to adjust their consumption following a change in disposable income.

■■ Firms are likely to take some time to adjust investment spending following a change in their sales.

■■ Firms are likely to take some time to adjust investment spending following a change in the interest rate.

■■ Firms are likely to take some time to adjust production following a change in their sales.

So, in response to an increase in taxes, it takes some time for consumption spend- ing to respond to the decrease in disposable income, some more time for production to decrease in response to the decrease in consumption spending, yet more time for invest- ment to decrease in response to lower sales, for consumption to decrease in response to the decrease in income, and so on.

In response to a decrease in the interest rate, it takes some time for investment spending to respond to the decrease in the interest rate, some more time for production to increase in response to the increase in demand, yet more time for consumption and investment to increase in response to the induced change in output, and so on.

Describing precisely the adjustment process implied by all these sources of dynamics is obviously complicated. But the basic implication is straightforward: Time is needed for output to adjust to changes in fiscal and monetary policy. How much time? This question can only be answered by looking at the data and using econometrics. Figure 5-10 shows the results of such an econometric study, which uses data from the United States from 1960 to 1990.

The study looks at the effects of a decision by the Fed to increase the federal funds rate by 1%. It traces the typical effects of such an increase on a number of macroeco- nomic variables.

Each panel in Figure 5-10 represents the effects of the change in the interest rate on a given variable. Each panel plots three lines. The solid line in the center of a band

c

We discussed the federal funds market and the federal funds rate in Chapter 4, Section 4-3.

Chapter 5 Goods and Financial Markets; The IS-LM Model 105

confidence band

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Figure 5-10

The Empirical Effects of an Increase in the Federal Funds Rate

In the short run, an increase in the federal funds rate leads to a decrease in output and to an increase in unemployment, but it has little effect on the price level.

Source: Lawrence Christiano, Martin Eichenbaum, and Charles Evans, “The Effects of Monetary Policy Shocks: Evidence From the Flow of Funds,” Review of Economics and Statistics. 1996, 78 (February): pp. 16–34.

MyEconLab Animation

gives the best estimate of the effect of the change in the interest rate on the variable we look at in the panel. The two dashed lines and the tinted space between the dashed lines represents a confidence band, a band within which the true value of the effect lies with 60% probability.

■■ Panel 5-10(a) shows the effects of an increase in the federal funds rate of 1% on retail sales over time. The percentage change in retail sales is plotted on the vertical axis; time, measured in quarters, is on the horizontal axis. Focusing on the best estimate—the solid line—we see that the increase in the federal funds rate of 1% leads to a decline in retail sales. The largest decrease in retail sales, - 0.9%, is achieved after five quarters.

■■ Figure 5-10(b) shows how lower sales lead to lower output. In response to the decrease in sales, firms cut production, but by less than the decrease in sales. Put another way, firms accumulate inventories for some time. The adjustment of pro- duction is smoother and slower than the adjustment of sales. The largest decrease,

c

There is no such thing in econometrics as learning the exact value of a coefficient or the exact effect of one vari- able on another. Rather, what econometrics does is to pro- vide us a best estimate—here, the thick line—and a measure of confidence we can have in the estimate—here, the confi- dence band.

- 0.7%, is reached after eight quarters. In other words, monetary policy works, but it works with long lags. It takes nearly two years for monetary policy to have its full effect on output.

■■ Panel 5-10(c) shows how lower output leads to lower employment: As firms cut production, they also cut employment. As with output, the decline in employment is slow and steady, reaching −0.5% after eight quarters. The decline in employment is reflected in an increase in the unemployment rate, shown in Panel 5-10(d).

■■ Panel 5-10(e) looks at the behavior of the price level. Remember, one of the assumptions of the IS-LM model is that the price level is given, and so it does not change in response to changes in demand. Panel 5-10(b) shows that this assump- tion is not a bad approximation of reality in the short run. The price level is nearly unchanged for the first six quarters or so. Only after the first six quarters does the price level appear to decline. This gives us a strong hint as to why the IS-LM model becomes less reliable as we look at the medium run: In the medium run, we can no longer assume that the price level is given, and movements in the price level become important.

Figure 5-10 provides two important lessons. First, it gives us a sense of the dynamic adjustment of output and other variables to monetary policy.

Second, and more fundamentally, it shows that what we observe in the economy is consistent with the implications of the IS-LM model. This does not prove that the IS-LM model is the right model. It may be that what we observe in the economy is the result of a completely different mechanism, and the fact that the IS-LM model fits well is a coincidence. But this seems unlikely. The IS-LM model looks like a solid basis on which to build when looking at movements in activity in the short run. Later on, we shall extend the model to look at the role of expectations (Chapters 14 to 16) and the implications of openness in goods and financial markets (Chapters 17 to 20). But we must first understand what determines output in the medium run. This is the topic of the next four chapters.

This explains why monetary policy could not prevent the 2001 recession (See the Fo- cus box: “The U.S. Reces- sion of 2001.”) When at the start of 2001, the Fed starting decreasing the federal funds rate, it was already too late for these cuts to have much effect in 2001.

b

■■ The IS-LM model characterizes the implications of equilib- rium in both the goods and the financial markets.

■■ The IS relation and the IS curve show the combinations of the interest rate and the level of output that are consistent with equilibrium in the goods market. An increase in the interest rate leads to a decline in output. Consequently, the IS curve is downward sloping.

■■ The LM relation and the LM curve show the combinations of the interest rate and the level of output consistent with equi- librium in financial markets. Under the assumption that the central bank chooses the interest rate, the LM curve is a hori- zontal line at the interest rate chosen by the central bank.

■■ A fiscal expansion shifts the IS curve to the right, leading to an increase in output. A fiscal contraction shifts the IS curve to the left, leading to a decrease in output.

■■ A monetary expansion shifts the LM curve down, lead- ing to a decrease in the interest rate and an increase in

output. A monetary contraction shifts the LM curve up, leading to an increase in the interest rate and a decrease in output.

■■ The combination of monetary and fiscal policies is known as the monetary-fiscal policy mix, or simply the policy mix. Sometimes monetary and fiscal policy are used in the same direction. Sometimes, they are used in opposite directions. Together, fiscal contraction and monetary expansion can, for example, achieve a decrease in the budget deficit while avoiding a decrease in output.

■■ The IS-LM model appears to describe well the behavior of the economy in the short run. In particular, the effects of monetary policy appear to be similar to those implied by the IS-LM model once dynamics are introduced in the model. An increase in the interest rate due to a monetary contrac- tion leads to a steady decrease in output, with the maximum effect taking place after about eight quarters.

Summary

106 The Short Run The Core

Chapter 5 Goods and Financial Markets; The IS-LM Model 107

3. The response of the economy to fiscal policy a. Use an IS-LM diagram, show the effects on output of a de-

crease in government spending. Can you tell what happens to investment? Why? Now consider the following IS-LM model:

C = c0 + c11Y - T2 I = b0 + b1Y - b2i Z = C + I + G i = iQ

b. Solve for equilibrium output when the interest rate is iQ. Assume c1 + b1 6 1. (Hint: You may want to rework through Problem 2 if you are having trouble with this step.)

c. Solve for equilibrium level of investment. d. Let’s go behind the scene in the money market. Use the

equilibrium in the money market M/P = d1Y - d2i to solve for the equilibrium level of the real money supply when i = iQ. How does the real money supply vary with government spending?

4. Consider the money market to better understand the horizontal LM curve in this chapter.

The money market relation (equation 5.3) is M P

= Y L1i2

a. What is on the left-hand side of equation (5.3)? b. What is on the right-hand side of equation (5.3)? c. Go back to Figure 4-3 in the previous chapter. How is the

function L(i) represented in that figure? d. You need to modify Figure 4-3 to represent equation (5.3)

in two ways. How does the horizontal axis have to be re- labeled? What is the variable that now shifts the money demand function? Draw a modified Figure 4-3 with the appropriate labels.

e. Use your modified Figure 4-3 to show that (1) as output rises, to keep the interest rate constant, the central bank must increase the real money supply; (2) as output falls, to keep the interest rate constant, the central bank must decrease the real money supply.

5. Consider the following numerical example of the IS-LM model: C = 200 + 0.25YD I = 150 + 0.25Y - 1000i

G = 250 T = 200 iQ = .05

Key Terms IS curve, 93 LM curve, 95 fiscal contraction, 96 fiscal consolidation, 96 fiscal expansion, 96

monetary expansion, 98 monetary contraction, 98 monetary tightening, 98 monetary-fiscal policy mix, 99 confidence band, 105

Questions and Problems

Quick check MyEconLab Visit www.myeconlab.com to complete all Quick Check problems and get instant feedback. 1. Using the information in this chapter, label each of the following statements true, false, or uncertain. Explain briefly.

a. The main determinants of investment are the level of sales and the interest rate.

b. If all the exogenous variables in the IS relation are con- stant, then a higher level of output can be achieved only by lowering the interest rate.

c. The IS curve is downward sloping because goods market equilibrium implies that an increase in taxes leads to a lower level of output.

d. If government spending and taxes increase by the same amount, the IS curve does not shift.

e. The LM curve is horizontal at the central bank’s policy choice of the interest rate.

f. The real money supply is constant along the LM curve. g. If the nominal money supply is $400 billion and the price

level rises from an index value of 100 to an index value of 103; the real money supply rises.

h. If the nominal money supply rises from $400 billion to $420 billion and the price level rises from an index value of 100 to 102, the real money supply rises.

i. An increase in government spending leads to a decrease in investment in the IS-LM model.

2. Consider first the goods market model with constant investment that we saw in Chapter 3. Consumption is given by

C = c0 + c11Y - T2 and I, G, and T are given.

a. Solve for equilibrium output. What is the value of the mul- tiplier for a change in autonomous spending?

Now let investment depend on both sales and the interest rate:

I = b0 + b1Y - b2i

b. Solve for equilibrium output using the methods learned in Chapter 3. At a given interest rate, why is the effect of a change in autonomous spending bigger than what it was in part (a)? Why? (Assume c1 + b1 6 1.)

c. Suppose the central bank chooses an interest rate of iQ. Solve for equilibrium output at that interest rate.

d. Draw the equilibrium of this economy using an IS-LM diagram.

108 The Short Run The Core

9. The (less paradoxical) paradox of saving A chapter problem at the end of Chapter 3 considered the effect

of a drop in consumer confidence on private saving and investment, when investment depended on output but not on the interest rate. Here, we consider the same experiment in the context of the IS-LM framework, in which investment depends on the interest rate and out- put but the central bank moves interest rates to keep output constant.

a. Suppose households attempt to save more, so that consum- er confidence falls. In an IS-LM diagram where the central bank moves interest rates to keep output constant, show the effect of the fall in consumer confidence on the equilibrium in the economy.

b. How will the fall in consumer confidence affect consump- tion, investment, and private saving? Will the attempt to save more necessarily lead to more saving? Will this attempt necessarily lead to less saving?

explore Further 10. The Clinton-Greenspan policy mix

As described in this chapter, during the Clinton administration the policy mix changed toward more contractionary fiscal policy and more expansionary monetary policy. This question explores the implications of this change in the policy mix, both in theory and fact.

a. What must the Federal Reserve do to ensure that if G falls and T rises so that combination of policies has no effect on output. Show the effects of these policies in an IS-LM diagram. What happens to the interest rate? What happens to investment?

b. Go to the Web site of the Economic Report of the President (www.whitehouse.gov/administration/eop/cea/economic- report-of-the-President) Look at Table B-79 in the sta- tistical appendix. What happened to federal receipts (tax revenues), federal outlays, and the budget deficit as a per- centage of GDP over the period 1992 to 2000? (Note that federal outlays include transfer payments, which would be excluded from the variable G, as we define it in our IS-LM model. Ignore the difference.)

c. The Federal Reserve Board of Governors posts the re- cent history of the federal funds rate at http://www. federalreserve.gov/releases/h15/data.htm. You will have to choose to look at the rate on a daily, weekly, monthly, or annual interval. Look at the years between 1992 and 2000. When did monetary policy become more expansionary?

d. Go to Table B-2 of the Economic Report of the President and collect data on real GDP and real gross domestic invest- ment for the period 1992 to 2000. Calculate investment as a percentage of GDP for each year. What happened to investment over the period?

e. Finally, go to Table B-31 and retrieve data on real GDP per capita (in chained 2005 dollars) for the period. Calculate the growth rate for each year. What was the average an- nual growth rate over the period 1992 to 2000? In Chapter 10 you will learn that the average annual growth rate of U.S. real GDP per capita was 2.6% between 1950 and 2004. How did growth between 1992 and 2000 compare to the Post World War II average?

a. Derive the IS relation. (Hint: You want an equation with Y on the left side and everything else on the right.)

b. The central bank sets an interest rate of 5%. How is that decision represented in the equations?

c. What is the level of real money supply when the interest rate is 5%? Use the expression:

1M/P2 = 2Y - 8000 i d. Solve for the equilibrium values of C and I, and verify the

value you obtained for Y by adding C, I, and G. e. Now suppose that the central bank cuts the interest rate

to 3%. How does this change the LM curve? Solve for Y, I, and C, and describe in words the effects of an expansionary monetary policy. What is the new equilibrium value of M/P supply?

f. Return to the initial situation in which the interest rate set by the central bank is 5%. Now suppose that government spending increases to G = 400. Summarize the effects of an expansionary fiscal policy on Y, I, and C. What is the effect of the expansionary fiscal policy on the real money supply?

Dig Deeper MyEconLab Visit www.myeconlab.com to complete all Dig Deeper problems and get instant feedback.

6. Investment and the interest rate The chapter argues that investment depends negatively on the

interest rate because an increase in the cost of borrowing discour- ages investment. However, firms often finance their investment projects using their own funds.

If a firm is considering using its own funds (rather than borrowing) to finance investment projects, will higher interest rates discourage the firm from undertaking these projects? Explain. (Hint: Think of yourself as the owner of a firm that has earned profits and imagine that you are going to use the profits either to finance new investment projects or to buy bonds. Will your decision to invest in new projects in your firm be affected by the interest rate?)

7. The Bush-Greenspan policy mix In 2001, the Fed pursued an expansionary monetary policy and reduced interest rates. At the same time, President George W. Bush pushed through legislation that lowered income taxes.

a. Illustrate the effect of such a policy mix on output. b. How does this policy mix differ from the Clinton-Greenspan

mix? c. What happened to output in 2001? How do you reconcile

the fact that both fiscal and monetary policies were ex- pansionary with the fact that growth was so low in 2002? (Hint: What else happened?)

8. What policy mix of monetary and fiscal policy is needed to meet the objectives given here?

a. Increase Y while keeping iQ constant. Would investment (I) change?

b. Decrease a fiscal deficit while keeping Y constant. Why must iQ also change?

Chapter 5 Goods and Financial Markets; The IS-LM Model 109

11. Consumption, investment, and the recession of 2001 This question asks you to examine the movements of investment

and consumption before, during, and after the recession of 2001. It also asks you to consider the response of investment and consumption to the events of September 11, 2001.

Go to the Web site of the Bureau of Economic Analysis (www. bea.gov). Find the NIPA tables, in particular the quarterly versions of Table 1.1.1, which shows the percentage change in real GDP and its components, and Table 1.1.2, which shows the contribu- tion of the components of GDP to the overall percentage change in GDP. Table 1.1.2 weighs the percentage change of the components by their size. Investment is more variable than consumption, but consumption is much bigger than investment, so smaller percentage changes in consumption can have the same impact on GDP as much larger percentage changes in investment. Note that the quarterly percentage changes are annualized (i.e., expressed as annual rates). Retrieve the quarterly data on real GDP, consumption, gross private domestic investment, and nonresidential fixed investment for the years 1999 to 2002 from Tables 1.1.1 and 1.1.2.

a. Identify the quarters of negative growth in 2000 and 2001. b. Track consumption and investment around 2000 and

2001. From Table 1.1.1, which variable had the bigger per- centage change around this time? Compare nonresidential fixed investment with overall investment. Which variable had the bigger percentage change?

c. From Table 1.1.2, get the contribution to GDP growth of consumption and investment for 1999 to 2001. Calculate the average of the quarterly contributions for each variable for each year. Now calculate the change in the contribu- tion of each variable for 2000 and 2001 (i.e., subtract the average contribution of consumption in 1999 from the average contribution of consumption in 2000, subtract the average contribution of consumption in 2000 from the average contribution of consumption in 2001, and do the same for investment for both years). Which variable had the largest decrease in its contribution to growth? What do you think was the proximate cause of the recession of 2001? (Was it a fall in investment demand or a fall in consumption demand?)

d. Now look at what happened to consumption and invest- ment after the events of September 11th in the third and fourth quarters of 2001 and in the first two quarters of 2002. Does the drop in investment at the end of 2001 make sense to you? How long did this drop in investment last? What happened to consumption about this time? How do you explain, in particular, the change in consumption in the fourth quarter of 2001? Did the events of September 11, 2001 cause the recession of 2001? Use the discussion in the chapter and your own intuition as guides in answer- ing these questions.

Further Reading ■■ A description of the U.S. economy, from the period of

“irrational exuberance” to the 2001 recession and the role of fiscal and monetary policy, is given by Paul Krugman,

in The Great Unraveling, W.W. Norton, 2003. New York. (Warning: Krugman did not like the Bush administration or its policies!)

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111

U

6 Financial Markets II: The Extended IS-LM Model ntil now, we assumed that there were only two financial assets—money and bonds—and just one interest rate—the rate on bonds—determined by monetary policy. As you well know, the financial system is vastly more complex than that. There are many interest rates and many finan- cial institutions. And the financial system plays a major role in the economy: In the United States, the financial system as a whole accounts for 7% of GDP, a large number.

Before the 2008 crisis, the importance of the financial system was downplayed in macro- economics. All interest rates were often assumed to move together with the rate determined by monetary policy, so one could just focus on the rate determined by monetary policy and assume that other rates would move with it. The crisis made painfully clear that this assumption was too simplistic and that the financial system can be subject to crises with major macroeconomic im- plications. The purpose of this chapter is to look more closely at the role of the financial system and its macroeconomic implications, and having done so, give an account of what happened in the late 2000s.

Section 6-1 introduces the distinction between the nominal and the real interest rates.

Section 6-2 introduces the notion of risk and how this affects the interest rates charged to different borrowers.

Section 6-3 looks at the role of financial intermediaries.

Section 6-4 extends the IS-LM model to integrate what we have just learned.

Section 6-5 then uses this extended model to describe the recent financial crisis and its macroeconomic implications.

However, be under no illusion. This chap- ter cannot replace a text in finance. But it will tell you enough to know why under- standing the financial system is central to macroeconomics.b

112 The Short Run The Core

6-1 Nominal versus Real Interest Rates In January 1980, the one-year U.S. T-bill rate—the interest rate on one-year government bonds—was 10.9%. In January 2006, the one-year T-bill rate was only 4.2%. It was clearly much cheaper to borrow in 2006 than it was in 1981.

Or was it? In January 1980, expected inflation was around 9.5%. In January 2006, expected inflation was around 2.5%. This would seem relevant. The interest rate tells us how many dollars we shall have to pay in the future in exchange for having one more dollar today. But we do not consume dollars. We consume goods.

When we borrow, what we really want to know is how many goods we will have to give up in the future in exchange for the goods we get today. Likewise, when we lend, we want to know how many goods—not how many dollars—we will get in the future for the goods we give up today. The presence of inflation makes this distinction important. What is the point of receiving high interest payments in the future if inflation between now and then is so high that with what we shall receive then, we shall be unable to buy more goods?

This is where the distinction between nominal interest rates and real interest rates comes in.

■■ Interest rates expressed in terms of dollars (or, more generally, in units of the na- tional currency) are called nominal interest rates. The interest rates printed in the financial pages of newspapers are typically nominal interest rates. For example, when we say that the one-year T-bill rate is 4.2%, we mean that for ev- ery dollar the government borrows by issuing one-year T-bills, it promises to pay 1.042 dollars a year from now. More generally, if the nominal interest rate for year t is it, borrowing 1 dollar this year requires you to pay 1 + it dollars next year. (I shall use interchangeably “this year” for “today” and “next year” for “one year from today.”)

■■ Interest rates expressed in terms of a basket of goods are called real interest rates. If we denote the real interest rate for year t by rt, then, by definition, borrow- ing the equivalent of one basket of goods this year requires you to pay the equivalent of 1 + rt baskets of goods next year.

What is the relation between nominal and real interest rates? How do we go from nominal interest rates—which we do observe—to real interest rates—which we typically do not observe? The intuitive answer: We must adjust the nominal interest rate to take into account expected inflation.

Let’s go through the step-by-step derivation: Assume there is only one good in the economy, bread (we shall add jam and other

goods later). Denote the one-year nominal interest rate, in terms of dollars, by it, If you borrow one dollar this year, you will have to repay 1 + rt dollars next year. But you are not interested in dollars. What you really want to know is: If you borrow enough to eat one more pound of bread this year, how much will you have to repay, in terms of pounds of bread, next year?

Figure 6-1 helps us derive the answer. The top part repeats the definition of the one-year real interest rate. The bottom part shows how we can derive the one-year real interest rate from information about the one-year nominal interest rate and the price of bread.

■■ Start with the downward pointing arrow in the lower left of Figure 6-1. Suppose you want to eat one more pound of bread this year. If the price of a pound of bread this year is Pt dollars, to eat one more pound of bread, you must borrow Pt dollars.

c

At the time of this writing, the one-year T-bill rate is even lower and is close to zero. For our purposes, comparing 1981 with 2006 is the best way to convey this point.

cNominal interest rate is the interest rate in terms of dollars.

cReal interest rate is the inter- est rate in terms of a basket of goods.

Chapter 6 Financial Markets II: The Extended IS-LM Model 113

■■ If it is the one-year nominal interest rate—the interest rate in terms of dollars—and if you borrow Pt dollars, you will have to repay 11 + it2Pt dollars next year. This is represented by the arrow from left to right at the bottom of Figure 6-1.

■■ What you care about, however, is not dollars, but pounds of bread. Thus, the last step involves converting dollars back to pounds of bread next year. Let P et + 1 be the price of bread you expect to pay next year. (The superscript e indicates that this is an expectation; you do not know yet what the price of bread will be next year.) How much you expect to repay next year, in terms of pounds of bread, is therefore equal to 11 + it2Pt (the number of dollars you have to repay next year) divided by Pet + 1 (the price of bread in terms of dollars expected for next year), so 11 + it2Pt>Pet + 1. This is represented by the arrow pointing up in the lower right of Figure 6-1.

Putting together what you see in both the top part and the bottom part of Figure 6-1, it follows that the one-year real interest rate, rt is given by:

1 + rt = 11 + it2 Pt

Pt + 1 e (6.1)

This relation looks intimidating. Two simple manipulations make it look much friendlier:

■■ Denote expected inflation between t and t + 1 by pet + 1. Given that there is only one good—bread—the expected rate of inflation equals the expected change in the dollar price of bread between this year and next year, divided by the dollar price of bread this year:

pt + 1 e =

1Pt + 1e - Pt2 Pt

(6.2)

Using equation (6.2), rewrite Pt>Pt + 1e in equation (6.1) as 1> 11 + pt + 1e 2. Replace in equation (6.1) to get

11 + rt2 = 1 + it

1 + pt + 1e (6.3)

b

If you have to pay $10 next year and you expect the price of bread next year to be $2 a loaf, you expect to have to repay the equivalent of 10>2 = 5 loaves of bread next year. This is why we divide the dollar amount 11 + it2Pt by the expected price of bread next year, Pet + 1.

b

Add 1 to both sides in equation (6.2):

1 + pt + 1e = 1 + 1Pt + 1e - Pt2

Pt

Reorganize:

1 + pt + 1e = Pt + 1e

Pt

Take the inverse on both sides:

1 1 + pt + 1e

= Pt

Pt + 1e

Replace in equation (6.1) and you get equation (6.3).

t 1 1

Derivation of the real rate:

1 good goods Goods (1 1 it) Pt

Definition of the real rate:

This year

1 good (1 1 rt) goods Goods

Next year

(1 1 rt) 5 (1 1 it) Pt

Pe

t 1 1 P e

Pt dollars (1 1 it) Pt dollars

Figure 6-1

Definition and Derivation of the Real Interest Rate

MyEconLab Animation

114 The Short Run The Core

One plus the real interest rate equals the ratio of one plus the nominal interest rate, divided by one plus the expected rate of inflation.

■■ Equation (6.3) gives us the exact relation of the real interest rate to the nominal interest rate and expected inflation. However, when the nominal interest rate and expected inflation are not too large—say, less than 20% per year—a close approxi- mation to this equation is given by a simpler relation.

rt ≈ it - pt + 1e (6.4)

Make sure you remember equation (6.4). It says that the real interest rate is (approximately) equal to the nominal interest rate minus expected inflation. (In the rest of the text, we shall often treat the relation in equation (6.4) as if it were an equality. Remember, however, it is only an approximation.)

Note some of the implications of equation (6.4):

■■ When expected inflation equals zero, the nominal and the real interest rates are equal.

■■ Because expected inflation is typically positive, the real interest rate is typically lower than the nominal interest rate.

■■ For a given nominal interest rate, the higher the expected rate of inflation, the lower the real interest rate.

The case where expected inflation happens to be equal to the nominal interest rate is worth looking at more closely. Suppose the nominal interest rate and expected infla- tion both equal 10%, and you are the borrower. For every dollar you borrow this year, you will have to repay 1.10 dollars next year. This looks expensive. But dollars will be worth 10% less in terms of bread next year. So, if you borrow the equivalent of one pound of bread, you will have to repay the equivalent of one pound of bread next year. The real cost of borrowing—the real interest rate—is equal to zero. Now suppose you are the lender: For every dollar you lend this year, you will receive 1.10 dollars next year. This looks attractive, but dollars next year will be worth 10% less in terms of bread. If you lend the equivalent of one pound of bread this year, you will get the equivalent of one pound of bread next year: Despite the 10% nominal interest rate, the real interest rate is equal to zero.

We have assumed so far that there is only one good—bread. But what we have done generalizes easily to many goods. All we need to do is to substitute the price level—the price of a basket of goods—for the price of bread in equation (6.1) or (6.3). If we use the consumer price index (CPI) to measure the price level, the real interest rate tells us how much consumption we must give up next year to consume more today.

Nominal and Real Interest Rates in the United States since 1978 Let us return to the question at the start of this section. We can now restate it as follows: Was the real interest rate lower in 2006 than it was in 1981? More generally, what has happened to the real interest rate in the United States since the early 1980s?

The answer is shown in Figure 6-2, which plots both nominal and real interest rates since 1978. For each year, the nominal interest rate is the one-year T-bill rate at the be- ginning of the year. To construct the real interest rate, we need a measure of expected inflation—more precisely, the rate of inflation expected as of the beginning of each year. We use, for each year, the forecast of inflation, using the GDP deflator, for that year pub- lished at the end of the previous year by the OECD. For example, the forecast of inflation used to construct the real interest rate for 2006 is the forecast of inflation to occur over 2006 as published by the OECD in December 2005—2.5%.

c

See Proposition 6, Appendix 2 at the end of the text. Suppose i = 10% and pe = 5%. The exact relation in equation (6.3) gives rt = 4.8%. The approxi- mation given by equation (6.4) gives 5%—close enough. The approximation can be quite bad, however, when i and pe are high. If i = 100% and pe = 80%. the exact relation gives r = 11%; but the ap- proximation gives r = 20%— a big difference.

Chapter 6 Financial Markets II: The Extended IS-LM Model 115

Note that the real interest rate 1i - pe2 is based on expected inflation. If actual inflation turns out to be different from expected inflation, the realized real interest rate 1i - p2 will be different from the real interest rate. For this reason, the real interest rate is sometimes called the ex-ante real interest rate (ex-ante means “before the fact”; here, be- fore inflation is known). The realized real interest rate is called the ex-post real interest rate (ex-post means “after the fact”; here, after inflation is known).

Figure 6-2 shows the importance of adjusting for inflation. Although the nominal interest was much lower in 2006 than it was in 1981, the real interest rate was actually higher in 2006 than it was in 1981. The real rate was about 1.7% in 2006 and about 1.4% in 1981. Put another way, despite the large decline in nominal interest rates, bor- rowing was actually more expensive in 2006 than it was 1981. This is due to the fact that inflation (and with it, expected inflation) has steadily declined since the early 1980s.

Nominal and Real Interest Rates: The Zero Lower Bound and Deflation Which interest rate should enter the IS relation? Clearly, in thinking about consump- tion or investment decisions, what matters to people or to firms is the real interest rate, the rate in terms of goods. This has a straightforward implication for monetary policy. Although the central bank chooses the nominal rate (as we saw in Chapter 3), it cares about the real interest rate because this is the rate that affects spending decisions. To set the real interest rate it wants, it thus has to take into account expected inflation. If, for example, it wants to set the real interest rate equal to r, it must choose the nominal rate i so that, given expected inflation, pe, the real interest rate, r = i - pe, is at the level it desires. For example, if it wants the real interest rate to be 4%, and expected inflation is 2%, it will set the nominal interest rate, i, at 6%. So, we can think of the central bank as choosing the real interest rate.

This conclusion comes however with an important warning, one we discussed in Chapter 4 in the context of the liquidity trap. As we saw there, zero lower bound implies that the nominal interest rate cannot be negative; otherwise people would not want to hold bonds. This implies that the real interest rate cannot be lower than the negative of inflation. So, if expected inflation is 2% for example, then the lowest the real rate can be

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78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 14

Nominal rate

Real rate

P er

ce nt

Figure 6-2

Nominal and Real One-Year T-Bill Rates in the United States since 1978

The nominal rate has declined considerably since the early 1980s, but because expected inflation has declined as well, the real rate has declined much less than the nominal rate.

Source: Nominal interest rate is the 1-year Treasury bill in December of the previous year: Series TB1YR, Federal Reserve Economic Data (FRED) http://research.stlouisfed. org/fred2/ (Series TB6MS in December 2001, 2002, 2003, and 2004.) Expected inflation is the 12-month forecast of infla- tion, using the GDP deflator, from the December OECD Economic Outlook from the previous year.

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116 The Short Run The Core

is 0% - 2% = -2%. So long as expected inflation is positive, this allows for negative real interest rates. But if expected inflation turns negative, if people anticipate defla- tion, then the lower bound on the real rate is positive and can turn out to be high. If, for example, expected deflation is 2%, the real rate cannot be less than 2%. This may not be low enough to increase the demand for goods by much, and the economy may remain in recession. As we shall see in Section 6-5, the zero lower bound turned out to be a serious concern during the 2008 crisis.

6-2 Risk and Risk Premia Until now, we assumed there was only one type of bond. Bonds however differ in a num- ber of ways. They differ in terms of maturity—i.e. the length of time over which they promise payments. For example, 1-year government bonds promise one payment a year hence. Ten-year government bonds promise instead a stream of payments over 10 years. They also differ in terms of risk. Some bonds are nearly riskless; the probability that the borrower will not repay is negligible. Some bonds instead are risky, with a non-negligible probability that the borrower will not be able or willing to repay. In this chapter, we shall focus on risk, leaving aside the issue of maturity.

Neither you nor I can borrow at the federal funds rate set by the Fed. Nor can we borrow at the same rate as the U.S. government. There is a good reason for this. Whoever might be lending to us knows that there is a chance that we may not be able to repay. The same is true for firms that issue bonds. Some firms present little risk and others more. To compensate for the risk, bond holders require a risk premium.

What determines this risk premium?

■■ The first factor is the probability of default itself. The higher this probability, the higher the interest rate investors will ask for. More formally, let i be the nominal interest rate on a riskless bond, and i + x be the nominal interest rate on a risky bond, which is a bond which has probability, p, of defaulting. Call x the risk pre- mium. Then, to get the same expected return on the risky bonds as on the riskless bond, the following relation must hold:

11 + i2 = 11 - p211 + i + x2 + 1p2102 The left-hand side gives the return on the riskless bond. The right-hand side

gives the expected return on the risky bond. With probability 11 - p2, there is no default and the bond will pay 11 + i + x2. With probability p, there is default, and the bond will pay nothing. Reorganizing gives:

x = 11 + i2p > 11 - p 2 So for example, if the interest rate on a riskless bond is 4%, and the probability

of default is 2%, then the risk premium required to give the same expected rate of return as on the riskless bond is equal to 2.1%.

■■ The second factor is the degree of risk aversion of the bond holders. Even if the ex- pected return on the risky bond was the same as on a riskless bond, the risk itself will make them reluctant to hold the risky bond. Thus, they will ask for an even higher premium to compensate for the risk. How much more will depend on their degree of risk aversion. And, if they become more risk averse, the risk premium will go up even if the probability of default itself has not changed.

To show why this matters, Figure 6-3 plots the interest rates on three types of bonds since 2000. First, U.S. government bonds, which are considered nearly riskless. Second and third, corporate bonds rated respectively as safe (AAA) and less safe (BBB) by ratings

We shall return to a discus- sion of maturity, and the rela- tion between interest rates on bonds of different maturities once I have introduced a more formal treatment of expecta- tions, in Chapter 14.

c

MyEconLab Video For small values of i and p, a good approximation to this formula is simply x = p.

c

Chapter 6 Financial Markets II: The Extended IS-LM Model 117

agencies. Note three things about the figure. First, the rate on even the most highly rated (AAA) corporate bonds is higher than the rate on U.S. government bonds, by a premium of about 2% on average. The U.S. government can borrow at cheaper rates than U.S. corporations. Second, the rate on lower rated (BBB) corporate bonds is higher than the rate on the most highly rated bonds by a premium often exceeding 5%. Third, note what happened during 2008 and 2009 as the financial crisis developed. Although the rate on government bonds decreased, reflecting the decision of the Fed to decrease the policy rate, the interest rate on lower-rated bonds increased sharply, reaching 10% at the height of the crisis. Put another way, despite the fact that the Fed was lowering the policy rate down to zero, the rate at which lower rated firms could borrow became much higher, making it extremely unattractive for these firms to invest. In terms of the IS-LM model, this shows why we have to relax our assumption that it is the policy rate that enters the IS relation. The rate at which many borrowers can borrow may be much higher than the policy rate.

To summarize: In the last two sections, I have introduced the concepts of real versus nominal rates and the concept of a risk premium. In Section 6-4, we shall extend the IS-LM model to take both concepts into account. Before we do, let’s turn to the role of financial intermediaries.

6-3 The Role of Financial Intermediaries Until now, we have looked at direct finance, that is, borrowing directly by the ultimate borrowers from the ultimate lenders. In fact, much of the borrowing and lending takes place through financial intermediaries, which are financial institutions that receive funds from some investors and then lend these funds to others. Among these institutions are banks, but also, and increasingly so, “non-banks,” for example mortgage companies, money market funds, hedge funds, and such.

Financial intermediaries perform an important function. They develop expertise about specific borrowers and can tailor lending to their specific needs. In normal times, they function smoothly. They borrow and lend, charging a slightly higher interest rate than the rate at which they borrow so as to make a profit. Once in a while how- ever, they run into trouble, and this is indeed what happened in the recent crisis. To

b Different rating agencies use different rating systems. The rating scale used here is that of Standard and Poor’s and ranges from AAA (nearly risk- less) and BBB to C (bonds with a high probability of default).

b

Because it grew in the “shadow” of banks, the non-bank part of the financial system is called shadow banking. But it is now large and no longer in the shadows.

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Jan-00 Jan-02 Jan-04 Jan-06 Jan–08 Jan-10 Jan-12 Jan-14

AAA

BBB

10-year U.S. Treasury Yield

P er

ce nt

9/11

Figure 6-3

Yields on 10-Year U.S. Government Treasury, AAA, and BBB Corporate Bonds, since 2000

In September 2008, the financial crisis led to a sharp increase in the rates at which firms could borrow.

Source: For AAA and BBB corpo- rate bonds, Bank of America Merrill Lynch; for 10-year U.S. treasury yield, Federal Reserve Board.

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118 The Short Run The Core

understand why, let’s first focus on banks and start, in Figure 6-4, with a much simpli- fied bank balance sheet (the arguments apply to non-banks as well and we shall return to them later).

Consider a bank that has assets of 100, liabilities of 80, and capital of 20. You can think of the owners of the bank as having directly invested 20 of their own funds, then borrowed another 80 from other investors, and bought various assets for 100. The liabili- ties may be checkable deposits, interest-paying deposits, or borrowing from investors and other banks. The assets may be reserves (central bank money), loans to consumers, loans to firms, loans to other banks, mortgages, government bonds, or other forms of securities.

In drawing a bank balance sheet in Chapter 4, we ignored capital (and focused in- stead on the distinction between reserves and other assets). Ignoring capital was unim- portant there. But it is important here. Let’s see why.

The Choice of Leverage Start with two definitions. The capital ratio of a bank is defined as the ratio of its capital to its assets, so, for the bank in Figure 6-4, 20 >100 = 20%. The leverage ratio of a bank is defined as the ratio of assets to capital, so as the inverse of the capital ratio, in this case 100 >20 = 5. It is traditional to think in terms of leverage and to focus on the leverage ratio. I shall follow tradition. But given the simple relation between the two, the discussion could equivalently be in terms of the capital ratio.

In thinking what leverage ratio it should choose, the bank has to balance two fac- tors. A higher leverage ratio implies a higher expected profit rate. But a higher leverage ratio also implies a higher risk of bankruptcy. Let’s look at each factor in turn.

■■ Suppose the expected rate of return on assets is 5%, and the expected rate of return on liabilities is 4%. Then, the expected profit of the bank is equal to 1100 * 5% - 80 * 4%2 = 1.8. Given that the owners of the bank have put 20 of their own funds, the expected profit per unit of capital is equal to 1.8>20 = 9%. Now suppose the owners of the bank decided instead to put only 10 of their own funds and borrowed 90. The capital ratio of the bank would then be equal to 10>100 = 10%, and its leverage would be 10. Its expected profit would be equal to 1100 * 5% - 90 * 4%2 = 1.4. Its expected profit per unit of capital would be 1.4>10 = 14%, so substantially higher. By increasing its leverage, and decreasing its own funds, the bank would increase its expected profit per unit of capital.

■■ So why shouldn’t the bank choose a high leverage ratio? Because higher leverage also implies a higher risk that the value of the assets becomes less than the value of its liabilities, which, in turn, implies a higher risk of insolvency. For the bank in Figure 6-4, its assets can decrease in value down to 80 without the bank becoming insolvent and going bankrupt. But if it were to choose a leverage ratio of 10, any de- crease in the value of the assets below 90 would lead the bank to become insolvent. The risk of bankruptcy would be much higher.

Thus, the bank must choose a leverage ratio that takes into account both factors. Too low a leverage ratio means less profit. Too high a leverage ratio means too high a risk of bankruptcy.

c

One wishes that the balance sheets of banks were that simple and transparent. Had it been the case, the crisis would have been much more limited.

c

What would be the expected profit per unit of capital if the bank chose to have zero le- verage? If the bank chose to have full leverage (no capital)? (The second question is a trick question.)

cA bank is solvent if the value of its assets exceeds the value of its liabilities. It is insolvent otherwise.

Assets 100 Liabilities 80

Capital 20

Bank Balance SheetFigure 6-4

Bank Assets, Capital, and Liabilities

Chapter 6 Financial Markets II: The Extended IS-LM Model 119

Leverage and Lending Suppose a bank has chosen its preferred leverage ratio, and suppose that the value of its assets declines. For example, the assets of the bank in Figure 6-4 decrease in value from 100 to 90, say as a result of bad loans. The capital of the bank is now down to 90 - 80 = 10. Its leverage ratio increases from 5 to 10. The bank is still solvent, but it is clearly more at risk than it was before. What will it want to do? It may want to increase capital, for example, by asking other investors to provide funds. But it is also likely to want to decrease the size of its balance sheet. For example, if it can call back some loans for an amount of 40 and thus reduce its assets down to 90 - 40 = 50, and then use the 40 to decrease its liabilities to 80 - 40 = 40, its capital ratio will be 10>50 = 20%, back to its original value. But although the capital ratio of the bank is back to its desired level, the effect is to lead to a sharp decrease in lending by the bank.

Let’s go one step further. Suppose that, starting from the balance sheet in Figure 6-4, the decline in the value of the assets is large, say down from 100 to 70. Then the bank will become insolvent and go bankrupt. The borrowers that depended on the bank may have a hard time finding another lender.

Why is this relevant to us? Because whether banks remain solvent but cut lending or become insolvent, the decrease in lending that this triggers may well have major adverse macroeconomic effects. Again, let’s defer a discussion of macroeconomic implications to the next section. And before we get there, let’s explore things further.

Liquidity We looked at the case where bank assets declined in value and saw that this led banks to reduce lending. Now consider a case in which investors are unsure of the value of the assets of the bank, and believe, right or wrong, that the value of the assets may have come down. Then, leverage can have disastrous effects. Let’s see why.

■■ If investors have doubts about the value of the bank assets, the safe thing for them to do is to take their funds out of the bank. But this creates serious problems for the bank, which needs to find the funds to repay the investors. The loans it has made cannot easily be called back. Typically, the borrowers no longer have the funds at the ready; they have used them to pay bills, buy a car, purchase a ma- chine, and such. Selling the loans to another bank is likely to be difficult as well. Assessing the value of the loans is difficult for the other banks, which do not have the specific knowledge about the borrowers the original bank has. In general, the harder it is for others to assess the value of the assets of the bank, the more likely the bank is to either be simply unable to sell them or to have to do it at fire sale prices, which are prices far below the true value of the loans. Such sales however only make matters worse for the bank. As the value of the assets decreases, the bank may well become insolvent and go bankrupt. In turn, as investors realize this may happen, this gives them even more reason to want to get their funds out, forcing more fire sales, and making the problem worse. Note that this can happen even if the initial doubts of investors were totally unfounded, even if the value of the bank assets had not decreased in the first place. The decision by investors to ask for their funds, and the fire sales this triggers, can make the bank insolvent even if it was fully solvent to start.

■■ Note also that the problem is worse if investors can ask for their funds at short notice. This is clearly the case for checkable deposits at banks. Checkable depos- its are also called demand deposits, precisely because people can ask for their funds on demand. The fact that banks’ assets are largely composed of loans and their liabilities are largely composed of demand deposits makes them particularly

MyEconLab Video

120 The Short Run The Core

Bank Runs Fo

c U

s Take a healthy bank, that is, a bank with a portfolio of good loans. Suppose rumors start that the bank is not doing well and some loans will not be repaid. Believing that the bank may fail, people with deposits at the bank will want to close their accounts and withdraw cash. If enough people do so, the bank will run out of funds. Given that the loans cannot easily be called back, the bank will not be able to satisfy the demand for cash, and it will have to close.

Conclusion: Fear that a bank will close can actually cause it to close—even if all its loans were good in the first place. The financial history of the United States up to the 1930s is full of such bank runs. One bank fails for the right reason (because it has made bad loans). This causes deposi- tors at other banks to panic and withdraw money from their banks, forcing them to close. You have probably seen It’s a Wonderful Life, a classic movie with James Stewart that runs on TV every year around Christmas. After another bank in Stewart’s town fails, depositors at the savings and loan he manages get scared and want to withdraw their money, too. Stewart successfully persuades them this is not a good idea. It’s a Wonderful Life has a happy ending. But in real life, most bank runs didn’t end well. (For another famous movie bank run, and how it can start, watch Mary Poppins.)

What can be done to avoid bank runs? One potential solution is called narrow banking.

Narrow banking would restrict banks to holding liquid and safe government bonds, like T-bills. Loans would have to be made by financial intermediaries other than banks. This would likely eliminate bank runs. Some recent changes in U.S. regulation have gone in that direction, restricting banks that rely on deposits from engaging in some financial operations, but they stop far short of imposing narrow bank- ing. One worry with narrow banking is that, although it might indeed eliminate runs on banks, the problem might migrate to shadow banking and create runs there.

In practice, the problem has been tackled in two ways. First, by trying to limit bank runs in the first place; second, if bank runs happen nevertheless, by having the central bank provide funds to banks so they do not have to engage in fire sales.

To limit bank runs, governments in most advanced coun- tries have put in place a system of deposit insurance. The United States, for example, introduced federal deposit insurance in 1934. The U.S. government now insures each

checkable deposit account up to a ceiling, which, since 2008, is $250,000. As a result, there is no reason for depositors to run and withdraw their money.

Deposit insurance leads, however, to problems of its own. Depositors, who do not have to worry about their deposits, no longer look at the activities of the banks in which they have their accounts. Banks may then misbehave, by making loans they wouldn’t have made in the absence of deposit insurance. They may take too much risk, take too much leverage.

And as the crisis unfortunately showed, deposit insurance is no longer enough. First, banks rely on other sources of funds than deposits, often borrowing overnight from other financial institutions and investors. These other funds are not insured, and during the crisis, there was in effect a run on many banks, and this time, not from the traditional deposi- tors but from wholesale funders. Second, financial institu- tions other than banks can be subject to the same problem, with investors wanting their funds back quickly and with assets difficult to dispose of or sell quickly.

So, to the extent that runs cannot be fully prevented, central banks have put in place programs to provide funds to banks in case they face a run. In such circumstances, the  central bank will accept to lend to a bank against the value of the assets of the bank. This way, the bank does not have to sell the assets and fire sales can be avoided. Access to such provision was traditionally reserved for banks. But again, the recent crisis has shown that other financial institu- tions may be subject to runs and may also need access.

Just like deposit insurance, such liquidity provision (as it is called) by the central bank is not a perfect solution. In practice, central banks may face a difficult choice. Assessing which financial institutions beyond banks can have access to such liquidity provision is delicate. Assessing the value of the assets, and thus deciding how much can be lent to a financial institution, can also be difficult. The central bank would not want to provide funds to an institution that is actually insol- vent; but, in the middle of a financial crisis, the difference be- tween insolvency and illiquidity may be difficult to establish.

To watch the bank run in It’s a Wonderful Life, go to https:// www.youtube.com/watch?v=lbwjS9iJ2Sw

To watch the bank run in Mary Poppins, go to https://www. youtube.com/watch?v=C6DGs3qjRwQ

exposed to the risk of runs, and the history of the financial system is full of ex- amples of bank runs, during which worries about the assets of the banks led to runs on banks, forcing them to close. Bank runs were a major feature of the Great Depression, and as discussed in the Focus Box “Bank Runs,” central banks have taken measures to limit them. As we shall see later in this chapter however, this has not fully taken care of the problem, and a modern form of runs—this time not on banks but on other financial intermediaries—again played a major role in the recent financial crisis.

Chapter 6 Financial Markets II: The Extended IS-LM Model 121

We can summarize what we have just learned in terms of the liquidity of assets and liabilities. The lower the liquidity of the assets (i.e., the more difficult they are to sell), the higher the risk of fire sales, and the risk that the bank becomes insolvent and goes bank- rupt. The higher the liquidity of the liabilities (i.e., the easier it is for investors to get their funds at short notice), the higher the risk of fire sales as well, and the risk that the bank becomes insolvent and goes bankrupt. Again, the reason this is relevant for us is that such bankruptcies, if they occur, may well have major macroeconomic consequences. This is the topic of the next section.

6-4 Extending the IS-LM The IS-LM model we introduced in Chapter 5 had only one interest rate. This interest rate was determined by the central bank, and it entered spending decisions. It appeared both in the LM relation and the IS relation. The first three sections of this chapter should have convinced you that, although this was a useful first step, reality is substantially more complex, and we must extend our initial model.

First, we must distinguish between the nominal interest rate and the real interest rate. Second, we must distinguish the policy rate set by the central bank and the interest rates faced by borrowers. As we saw, these interest rates depend both on the risk associated with borrowers and on the state of health of financial intermediaries. The higher the risks, or the higher the leverage ratio of intermediaries, the higher the interest rate borrowers have to pay. We capture those two aspects by rewriting the IS-LM in the following way:

IS relation: Y = C1Y - T2 + I1Y, i - pe + x2 + G LM re lation: i = iQ

The LM relation remains the same. The central bank still controls the nominal interest rate. But there are two changes to the IS relation, the presence of expected inflation, pe, and a new term that we shall call the risk premium and denote by x.

■■ The expected inflation term reflects the fact that spending decisions depend, all other things equal, on the real interest rate, r = i - pe rather than on the nominal rate.

■■ The risk premium, x, captures, in a simplistic way, the factors we discussed previ- ously. It may be high because lenders perceive a higher risk that borrowers will not repay or because they are more risk averse. Or it may be high because financial in- termediaries are reducing lending, out either of solvency or liquidity worries.

The two equations make clear that the interest rate entering the LM equation, i is no longer the same as the interest rate entering the IS relation, r + x. Let’s call the rate en- tering the LM equation the (nominal) policy rate (because it is determined by monetary policy), and the rate entering the IS equation the (real) borrowing rate (because it is the rate at which consumers and firms can borrow).

One simplification: As we discussed in Section 6-2, although the central bank for- mally chooses the nominal interest rate, it can choose it in such a way as to achieve the real interest rate it wants (this ignores the issue of the zero lower bound to which we shall come back). Thus, we can think of the central banks as choosing the real policy rate directly and rewrite the two equations as:

IS relation: Y = C1Y - T2 + I1Y, r + x2 + G (6.5) LM relation: r = rQ (6.6)

The central bank chooses the real policy rate, r. But the real interest rate relevant for spending decisions is the borrowing rate, r + x, which depends not only on the policy rate, but also on the risk premium.

b The way in which the central bank controls the nominal in- terest rate is by adjusting the money supply. If you need a re- fresher, go back to Chapter 4.

Two important distinctions: Real versus nominal interest rate, and policy rate versus borrowing rate.

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The two equations are represented in Figure 6-5. The policy rate is measured on the vertical axis and output on the horizontal axis. The IS curve is drawn for given values of G, T, and x. All other things equal, an increase in the real policy rate decreases spending and in turn output: The IS curve is downward sloping. The LM is just a horizontal line at the policy rate, the real interest rate implicitly chosen by the central bank. Equilibrium is given by point A, with associated level of output Y.

Financial Shocks and Policies Suppose that, for some reason, x, increases. There are many potential scenarios here. This may be for example because investors have become more risk averse and require a higher risk premium, or it may be because one financial institution has gone bankrupt and investors have become worried about the health of other banks, starting a run, forc- ing these other banks to reduce lending. In terms of Figure 6-5, the IS curve shifts to the left. At the same policy rate r, the borrowing rate, r + x, increases, leading to a decrease in demand and a decrease in output. The new equilibrium is at point A'. Problems in the financial system lead to a recession. Put another way, a financial crisis becomes a macro- economic crisis.

What can policy do? Just as in Chapter 5, fiscal policy, be it an increase in G, or a decrease in T can shift the IS curve to the right and increase output. But a large increase in spending or a cut in taxes may imply a large increase in the budget deficit, and the government may be reluctant to do so.

Given that the cause of the low output is that the interest rate facing borrowers is too high, monetary policy appears to be a better tool. Indeed, a sufficient decrease in the policy rate, as drawn in Figure 6-6, can in principle be enough to take the economy to point A0 and return output to its initial level. In effect, in the face of the increase in x, the central bank must decrease r so as to keep r + x, the rate relevant to spending decisions, unchanged.

Note that the policy rate that is needed to increase demand sufficiently and return output to its previous level may well be negative. This is indeed how I have drawn the equilibrium in Figure 6-6. Suppose that, for example, in the initial equilibrium, r was equal to 2% and x was equal to 1%. Suppose that x increases by 4%, from 1 to 5%. To maintain the same value of r + x, the central bank must decrease the policy rate from 2% to 2% - 4% = -2%. This raises an issue, which we have already discussed

MyEconLab Video

c

For simplicity, we have looked at an exogenous increase in x. But x itself may well depend on output. A decrease in out- put, say a recession, increas- es the probability that some borrowers will be unable to repay; workers who become unemployed may not be able to repay the loans; firms that lose sales may go bankrupt. The increase in risk leads to a further increase in the risk premium, and thus to a further increase in the borrowing rate, which can further decrease output.

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Figure 6-5

Financial Shocks and Output

An increase in x leads to a shift of the IS curve to the left and a decrease in equilibrium output.

MyEconLab Animation

Chapter 6 Financial Markets II: The Extended IS-LM Model 123

in Chapter 4, namely the constraint arising from the zero lower bound on the nominal interest rate.

Given the zero lower bound on the nominal rate, the lowest real rate the central bank can achieve is given by r = i - pe = 0 - pe = -pe. In words, the lowest real policy rate the central bank can achieve is the negative of inflation. If inflation is high enough, say for example 5%, then a zero nominal rate implies a real rate of -5%, which is likely to be low enough to offset the increase in x. But, if inflation is low or even negative, then the lowest real rate the central bank can achieve may not be enough to offset the increase in x. It may not be enough to return the economy to its initial equilibrium. As we shall see, two characteristics of the recent crisis were indeed a large increase in x and low actual and expected inflation, limiting how much central banks could use monetary policy to offset the increase in x.

We now have the elements we need to understand what triggered the financial crisis in 2008, and how it morphed into a major macroeconomic crisis. This is the topic of the next and last section of this chapter.

6-5 From a Housing Problem to a Financial Crisis When housing prices started declining in the United States in 2006, most economists forecast that this would lead to a decrease in demand and a slowdown in growth. Few economists anticipated that it would lead to a major macroeconomic crisis. What most had not anticipated was the effect of the decline of housing prices on the financial system, and in turn, the effect on the economy. This is the focus of this section.

Housing Prices and Subprime Mortgages Figure 6-7 shows the evolution of an index of U.S. housing prices since 2000. The index is known as the Case-Shiller index, named for the two economists who constructed it. The index is normalized to equal 100 in January 2000. You can see the large increase in prices in the early 2000s, followed by a large decrease later. From a value of 100 in 2000, the index increased to 226 in mid-2006. It then started to decline. By the end of

Output, Y

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Figure 6-6

Financial Shocks, Monetary Policy, and Output

If sufficiently large, a decrease in the policy rate can in prin- ciple offset the increase in the risk premium. The zero lower bound may however put a limit on the decrease in the real policy rate.

MyEconLab Animation

Look up Case-Shiller on the Internet if you want to find the index and see its recent evo- lution. You can also see what has happened to prices in the city in which you live.

b

124 The Short Run The Core

2008, at the start of the financial crisis, the index was down to 162. It reached a low of 146 in early 2012 and started recovering thereafter. At the time of this writing, it stands at 195, still below its 2006 peak.

Was the sharp price increase from 2000 to 2006 justified? In retrospect, and given the ensuing collapse, surely not. But at the time, when prices were increasing, econo- mists were not so sure. Some increase in prices was clearly justified.

■■ The 2000s were a period of unusually low interest rates. Mortgage rates were low, increasing the demand for housing and thus pushing up the price.

■■ Other factors were also at work. Mortgage lenders became increasingly willing to make loans to more risky borrowers. These mortgages, known as subprime mortgages, or subprimes for short, had existed since the mid-1990s but be- came more prevalent in the 2000s. By 2006, about 20% of all U.S. mortgages were subprimes. Was it necessarily bad? Again, at the time, this was seen by most economists as a positive development. It allowed more poor people to buy homes, and under the assumption that housing prices would continue to increase, so the value of the mortgage would decrease over time relative to the price of the house, it looked safe both for lenders and for borrowers. Judging from the past, the as- sumption that housing prices would not decrease also seemed reasonable. As you can see from Figure 6-7, housing prices had not decreased even during the 2000–2001 recession.

In retrospect, again, these developments were much less benign than most econo- mists thought. First, housing prices could go down, as became evident from 2006 on. When this happened, many borrowers found themselves in a situation in which the mortgage they owed now exceeded the value of their house (when the value of the mort- gage exceeds the value of the house, the mortgage is said to be underwater). Second, it became clear that, in many cases, the mortgages were in fact much riskier than either the lender pretended or the borrower understood. In many cases, borrowers had taken mortgages with low initial interest rates, known as “teaser rates,” and thus low initial in- terest payments, probably not fully realizing that payments would increase sharply over time. Even if house prices had not declined, many of these borrowers would have been unable to meet their mortgage payments.

Thus, as house prices turned around and many borrowers defaulted, lenders found themselves faced with large losses. In mid-2008, losses on mortgages were estimated to be around $300 billion. This is a large number, but, relative to the size of the U.S. economy, it is not a large one. Three hundred billion dollars is only about 2% of U.S. GDP. One might have thought that the U.S. financial system could absorb the shock and that the adverse effect

c Even if people did not finance the purchase of a house by taking a mortgage, low inter- est rates would lead to an in- crease in the price of houses. More on this when we discuss present discounted values in Chapter 14.

c

Some economists were wor- ried even as prices were go- ing up. Robert Shiller, one of the two economists behind the Case-Shiller index, was among them, warning that the price increase was a bubble that would most likely crash. Robert Shiller received the Nobel Prize in 2013 for his work on asset prices.

Some of these loans became known as NINJA loans (for no income, no job, no assets).

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Figure 6-7

U.S. Housing Prices since 2000

The increase in housing prices from 2000 to 2006 was fol- lowed by a sharp decline thereafter.

Source: Case-Shiller Home Price Indices, 10-city home price index, http://www.standardandpoors. com/indices/main/en/us

MyEconLab Real-time data

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Chapter 6 Financial Markets II: The Extended IS-LM Model 125

on output would be limited. This was not to be. Although the trigger of the crisis was indeed the decline in housing prices, its effects were enormously amplified. Even those economists who had anticipated the housing price decline did not realize how strong the amplifica- tion mechanisms would be. To understand those, we must return to the role of financial intermediaries.

The Role of Financial Intermediaries In the previous section, we saw that high leverage, illiquidity of assets, and liquidity of liabilities all increased the risk of trouble in the financial system. All three elements were present in 2008, creating a perfect storm.

Leverage Banks were highly levered. Why was it so? For a number of reasons: First, banks probably underestimated the risk they were taking: Times were good, and in good times, banks, just like people, tend to underestimate the risk of bad times. Second, the compensation and bonus system gave incentives to managers to go for high expected returns without fully taking the risk of bankruptcy into account. Third, although financial regulation re- quired banks to keep their capital ratio above some minimum, banks found new ways of avoiding the regulation, by creating new financial structures called structured invest- ment vehicles (SIVs).

On the liability side, SIVs borrowed from investors, typically in the form of short- term debt. On the asset side, SIVs held various forms of securities. To reassure the inves- tors that they would get repaid, SIVs typically had a guarantee from the bank that had created them that, if needed, the bank would provide funds to the SIV. Although the first SIV was set up by Citigroup in 1988, SIVs rapidly grew in size in the 2000s. You may ask why banks did not simply do all these things on their own balance sheet rather than cre- ate a separate vehicle. The main reason was to be able to increase leverage. If the banks had done these operations themselves, the operations would have appeared on their balance sheet and been subject to regulatory capital requirements, forcing them to hold enough capital to limit the risk of bankruptcy. Doing these operations through an SIV did not require banks to put capital down. For that reason, through setting up an SIV, banks could increase leverage and increase expected profits, and they did.

When housing prices started declining and many mortgages turned out to be bad, the securities held by SIVs dropped in value. Questions arose about the solvency of the SIVs, and given the guarantee by banks to provide funds to the SIVs if needed, questions arose about the solvency of the banks themselves. Then, two other factors, securitiza- tion, and wholesale funding, came into play.

Securitization An important financial development of the 1990s and the 2000s was the growth of securitization. Traditionally, the financial intermediaries that made loans or issued mortgages kept them on their own balance sheet. This had obvious drawbacks. A local bank, with local loans and mortgages on its books, was much exposed to the local eco- nomic situation. When, for example, oil prices had come down sharply in the mid-1980s and Texas was in recession, many local banks went bankrupt. Had they had a more diversified portfolio of mortgages, say mortgages from many parts of the country, these banks might have avoided bankruptcy.

This is the idea behind securitization. Securitization is the creation of securities based on a bundle of assets (e.g., a bundle of loans, or a bundle of mortgages). For in- stance, a mortgage-based security (MBS) for short, is a title to the returns from a bundle of mortgages, with the number of underlying mortgages often in the tens of

126 The Short Run The Core

thousands. The advantage is that many investors, who would not want to hold individ- ual mortgages, will be willing to buy and hold these securities. This increase in the supply of funds from investors is, in turn, likely to decrease the cost of borrowing.

Securitization can go further. For example, instead of issuing identical claims to the returns on the underlying bundle of assets, one can issue different types of securities. For example, one can issue senior securities, which have first claims on the returns from the bundle, and junior securities, which come after and pay only if anything remains after the senior securities have been paid. Senior securities will appeal to inves- tors who want little risk; junior securities will appeal to investors who are willing to take more risk. Such securities, known as collateralized debt obligations (CDOs), were first issued in the late 1980s but, again, grew in importance in the 1990s and 2000s. Securitization went even further, with the creation of CDOs using previously created CDOs, or CDO2.

Securitization would seem like a good idea, a way of diversifying risk and getting a larger group of investors involved in lending to households or firms. And, indeed, it is. But it also came with two large costs, which became clear during the crisis. The first was that if the bank sold the mortgage it had given as part of a securitization bundle and thus did not keep it on its balance sheet, it had fewer incentives to make sure that the borrower could repay. The second was the risk that rating agencies, those firms that as- sess the risk of various securities, had largely missed. When underlying mortgages went bad, assessing the value of the underlying bundles in the MBSs, or, even more so, of the underlying MBSs in the CDOs, was extremely hard to do. These assets came to be known as toxic assets. It led investors to assume the worst and be reluctant either to hold them or to continue lending to those institutions such as SIVs that did hold them. In terms of the discussion in the previous section, many of the assets held by banks, SIVs, and other financial intermediaries, were illiquid. They were extremely hard to assess and thus hard to sell, except at fire sale prices.

Wholesale Funding Yet another development of the 1990s and 2000s was the development of other sources of finance than checkable deposits by banks. Increasingly, they relied on borrowing from other banks or other investors, in the form of short-term debt, to finance the purchase of their assets, a process known as wholesale funding. SIVs, the financial entities set up by banks, were entirely funded through such wholesale funding.

Wholesale funding again would seem like a good idea, giving banks more flexibility in the amount of funds they could use to make loans or buy assets. But it had a cost, and that cost again became clear during the crisis. Although holders of checkable deposits were protected by deposit insurance and did not have to worry about the value of their deposits, this was not the case for the other investors. Thus, when those investors wor- ried about the value of the assets held by the banks or the SIVs, they asked for their funds back. In terms of the discussion in the previous section, banks and SIVs had liquid liabili- ties, much more liquid than their assets.

The result of this combination of high leverage, illiquid assets, and liquid liabilities was a major financial crisis. As housing prices declined and some mortgages went bad, high leverage implied a sharp decline in the capital of banks and SIVs. This in turn forced them to sell some of their assets. Because these assets were often hard to value, they had to sell  them at fire sale prices. This, in turn, decreased the value of similar assets remaining on their balance sheet, or on the balance sheet of other financial in- termediaries, leading to a further decline in capital ratios and forcing further sales of assets and further declines in prices. The complexity of the securities held by banks and SIVs made it difficult to assess their solvency. Investors became reluctant to continue to lend to them, wholesale funding came to a stop, which forced further asset sales and

c

One of the main obstacles to understanding the financial system is the alphabet soup of acronyms: SIVs, MBS, CDOs, etc.

MyEconLab Video

Chapter 6 Financial Markets II: The Extended IS-LM Model 127

price declines. Even the banks became reluctant to lend to each other. On September 15, 2008, Lehman Brothers, a major bank with more than $600 billion in assets, declared bankruptcy, leading financial participants to conclude that many, if not most, other banks and financial institutions were indeed at risk. By mid-September 2008, the finan- cial system had become paralyzed. Banks basically stopped lending to each other or to anyone else. Quickly, what had been largely a financial crisis turned into a macroeco- nomic crisis.

Macroeconomic Implications The immediate effects of the financial crisis on the macroeconomy were twofold. First, a large increase in the interest rates at which people and firms could borrow, if they could borrow at all; second, a dramatic decrease in confidence.

We saw the effect on various interest rates in Figure 6-3. In late 2008, interest rates on highly rated (AAA) bonds increased to more than 8%, interest rates on lower rated (BBB) bonds increased to 10%. Suddenly, borrowing became extremely expensive for most firms. And for the many firms too small to issue bonds and thus depending on bank credit, it became nearly impossible to borrow at all.

The events of September 2008 also triggered wide anxiety among consumers and firms. Thoughts of  another Great Depression and, more generally, confusion and fear about what was happening in the financial system, led to a large drop in confidence. The evolution of consumer confidence and business confidence indexes for the United States are shown in Figure 6-8. Both indexes are normalized to equal 100 in January 2007. Note how consumer confidence, which had started declining in mid-2007, took a sharp turn in the fall of 2008 and reached a low of 22 in early 2009, a level far below previous historical lows. The result of lower confidence and lower housing and stock prices was a sharp decrease in consumption.

Policy Responses The high cost of borrowing, lower stock prices, and lower confidence all combined to decrease the demand for goods. In terms of the IS-LM model, there was a sharp adverse shift of the IS curve, just as we drew in Figure 6-5. In the face of this large decrease in demand, policy makers did not remain passive.

See the Focus box “The Lehman Bankruptcy, Fears of Another Great Depression, and Shifts in the Consumption Function” in Chapter 3.b

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U.S. Consumer and Business Confidence, 2007–2011

The financial crisis led to a sharp drop in confidence, which bottomed in early 2009.

Source: Bloomberg L.P.

128 The Short Run The Core

Financial Policies The most urgent measures were aimed at strengthening the financial system:

■■ To prevent a run by depositors, federal deposit insurance was increased from $100,000 to $250,000 per account. Recall, however, that much of banks’ funding came not from deposits but from the issuance of short-term debt to investors. To allow the banks to continue to fund themselves through whole- sale funding, the federal government offered a program guaranteeing new debt issues by banks.

■■ The Federal Reserve provided widespread liquidity to the financial system. We have seen that, if investors wanted to take their funds back, the banks had to sell some of their assets, often at fire sale prices. In many cases, this would have meant bank- ruptcy. To avoid this, the Fed put in place a number of liquidity facilities to make it easier to borrow from the Fed. It allowed not only banks, but also other financial intermediaries, to borrow from the Fed. Finally, it increased the set of assets that financial institutions could use as collateral when borrowing from the Fed (col- lateral refers to the asset a borrower pledges when borrowing from a lender. If the borrower defaults, the asset then goes to the lender). Together, these facilities al- lowed banks and financial intermediaries to pay back investors without having to sell their assets. It also decreased the incentives of investors to ask for their funds because these facilities decreased the risk that banks and financial intermediaries would go bankrupt.

■■ The government introduced a program, called the Troubled Asset Relief Program (TARP), aimed at cleaning up banks. The initial goal of the $700 bil- lion program, introduced in October 2008, was to remove the complex assets from the balance sheet of banks, thus decreasing uncertainty, reassuring investors, and making it easier to assess the health of each bank. The Treasury, however, faced the same problems as private investors. If these complex assets were going to be exchanged for, say, Treasury bills, at what price should the exchange be done? Within a few weeks, it became clear that the task of assessing the value of each of these assets was extremely hard and would take a long time, and the initial goal was abandoned. The new goal became to increase the capital of banks. This was done by the government acquiring shares and thus providing funds to most of the largest U.S. banks. By increasing their capital ratio, and thus decreasing their lever- age, the goal of the program was to allow the banks to avoid bankruptcy and, over time, return to normal. As of the end of September 2009, total spending under the TARP was $360 billion, of which $200 billion was spent through the purchase of shares in banks.

Fiscal and monetary policies were used aggressively as well.

Monetary Policy Starting in the summer of 2007, the Fed began to worry about a slowdown in growth and had started decreasing the policy rate, slowly at first, faster later as evidence of the crisis mounted. The evolution of the federal funds rate from 2000 on was shown in Figure 1-4 in Chapter 1. By December 2008, the rate was down to zero. By then, however, monetary policy was constrained by the zero lower bound. The policy rate could not be decreased further. The Fed then turned to what has become known as unconventional monetary policy, buying other assets so as to directly affect the rate faced by borrow- ers. We shall explore the various dimensions of unconventional monetary policy at more length in Chapter 23. Suffice it to say that, although these measures were useful, the ef- ficacy of monetary policy was nevertheless severely constrained by the zero lower bound.

c

At the time of writing, all banks have bought back their shares and have reimbursed the gov- ernment. Indeed, in the final estimation, TARP actually has made a small profit.

c

Recall that the interest rate faced by borrowers is given by r + x. You can think of conventional monetary policy as the choice of r, and uncon- ventional monetary policy as measures to reduce x.

Chapter 6 Financial Markets II: The Extended IS-LM Model 129

Fiscal Policy When the size of the adverse shock became clear, the U.S. government turned to fiscal policy. When the Obama administration assumed office in 2009, its first priority was to design a fiscal program that would increase demand and reduce the size of the re- cession. Such a fiscal program, called the American Recovery and Reinvestment Act, was passed in February 2009. It called for $780 billion in new measures, in the form of both tax reductions and spending increases, over 2009 and 2010. The U.S. budget deficit increased from 1.7% of GDP in 2007 to a high of 9.0% in 2010. The increase was largely the mechanical effect of the crisis because the decrease in output led automatically to a decrease in tax revenues and to an increase in transfer programs such as unemployment benefits. But it was also the result of the specific measures in the fiscal program aimed at increasing either private or public spending. Some economists argued that the increase in spending and the cuts in taxes should be even larger, given the seriousness of the situation. Others however worried that deficits were becoming too large, that it might lead to an explosion of public debt, and that they had to be reduced. From 2011, the deficit was indeed reduced, and it is much smaller today.

We can summarize our discussion by going back to the IS-LM model we developed in the previous section. This is done in Figure 6-9. The financial crisis led to a large shift of the IS curve to the left, from IS to IS9. In the absence of changes in policy, the equilibrium would have moved from point A to point B. Financial and fiscal policies offset some of the shift, so that, instead of shifting to IS9, the economy shifted to IS0. And monetary policy led to a shift of the LM down, from LM to LM9, so the resulting equilibrium was at point A9. At that point, the zero lower bound on the nominal policy rate implied that the real policy rate could not be decreased further. The result was a decrease in output from Y to Y9. The initial shock was so large that the combina- tion of financial, fiscal, and monetary measures was just not enough to avoid a large decrease in output, with U.S. GDP falling by 3.5% in 2009 and recovering only slowly thereafter.

It is difficult to know what would have happened in the absence of those policies. It is reasonable to think, but impossible to prove, that the decrease in output would have been much larger, lead- ing to a repeat of the Great Depression.b

IS

IS

LM

LMIn te

re st

r at

e, r

Output, Y

YY

A

AB

IS

r

Figure 6-9

The Financial Crisis, and the Use of Financial, Fiscal, and Monetary Policies

The financial crisis led to a shift of the IS to the left. Financial and fiscal policies led to some shift back of the IS to the right. Monetary pol- icy led to a shift of the LM curve down. Policies were not enough however to avoid a major recession.

MyEconLab Animation

130 The Short Run The Core

■■ The higher the leverage ratio, or the more illiquid the assets, or the more liquid the liabilities, the higher the risk of a bank run, or more generally, a run on financial intermediaries.

■■ The IS-LM model must be extended to take into account the difference between the nominal and the real interest rate, and the difference between the policy rate chosen by the central bank and the interest rate at which firms and people can borrow.

■■ A shock to the financial system leads to an increase in the interest rate at which people and firms can borrow for a given policy rate. It leads to a decrease in output.

■■ The financial crisis of the late 2000s was triggered by a decrease in housing prices. It was amplified by the financial system.

■■ Financial intermediaries were highly leveraged. Because of securitization, their assets were hard to assess, and thus il- liquid. Because of wholesale funding, their liabilities were liquid. Runs forced financial intermediaries to reduce lend- ing, with strong adverse effects on output.

■■ Financial, fiscal, and monetary policies were used. They were not sufficient however to prevent a deep recession.

■■ The nominal interest rate tells you how many dollars you need to repay in the future in exchange for one dollar today.

■■ The real interest rate tells you how many goods you need to repay in the future in exchange for one good today.

■■ The real interest rate is approximately equal to the nominal rate minus expected inflation.

■■ The zero lower bound on the nominal interest rate implies that the real interest rate cannot be lower than minus expected inflation.

■■ The interest rate on a bond depends both on the prob- ability that the issuer of the bond will default and on the degree of risk aversion of bond holders. A higher prob- ability or a higher degree of risk aversion lead to a higher interest rate.

■■ Financial intermediaries receive funds from investors and then lend these funds to others. In choosing their lever- age ratio, financial intermediaries trade off expected profit against the risk of insolvency.

■■ Because of leverage, the financial system is exposed to both solvency and illiquidity risks. Both may lead financial inter- mediaries to decrease lending.

Summary

Key Terms nominal interest rate, 112 real interest rate, 112 risk premium, 116 risk aversion, 116 direct finance, 117 shadow banking, 117 capital ratio, 118 leverage ratio, 118 insolvency, 118 fire sale prices, 119 demand deposits, 119 narrow banking, 120 federal deposit insurance, 120 liquidity provision, 120 bank runs, 120 liquidity, 121 policy rate, 121 borrowing rate, 121

mortgage lenders, 124 subprime mortgages, or subprimes, 124 underwater, 124 structured investment vehicles (SIVs), 125 securitization, 125 mortgage based security (MBS), 125 senior securities, 126 junior securities, 126 collateralized debt obligations (CDOs), 126 rating agencies, 126 toxic assets, 126 wholesale funding, 126 liquidity facilities, 128 collateral, 128 Trouble Asset Relief Program (TARP), 128 unconventional monetary policy, 128 American Recovery and Reinvestment

Act, 129

Questions and Problems QuIck check MyEconLab Visit www.myeconlab.com to complete all Quick Check problems and get instant feedback. 1. Using the information in this chapter, label each of the following statements true, false, or uncertain. Explain briefly.

a. The nominal interest rate is measured in terms of goods; the real interest rate is measured in terms of money.

b. As long as expected inflation remains roughly constant, the movements in the real interest rate are roughly equal to the movements in the nominal interest rate.

Chapter 6 Financial Markets II: The Extended IS-LM Model 131

c. The nominal policy interest rate was at the zero lower bound in the United States in 2013.

d. When expected inflation increases, the real rate of interest falls.

e. All bonds have equal risk of default and thus pay equal rates of interest.

f. The nominal policy interest rate is set by the central bank. g. An increase in a bank’s leverage ratio tends to increase

both the expected profit of the bank and the risk of the bank going bankrupt.

h. The real borrowing rate and the real policy rate always move in the same direction.

i. It can be difficult to value assets of banks and other finan- cial intermediaries, particularly in a financial crisis.

j. When a bank has high leverage and low liquidity, it may have to sell assets at fire sale prices.

k. Banks and other financial intermediaries have assets that are less liquid than their liabilities.

l. House prices have risen constantly since the year 2000. m. The fiscal stimulus program adopted by the United States

in response to the financial crisis helped offset the decline in aggregate demand and reduce the size of the recession.

n. The fiscal stimulus program adopted by the United States in- cluded a large increase in the deficit measured as a percent of GDP.

2. Compute the real interest rate using the exact formula and the approx- imation formula for each set of assumptions listed in (a) through (c).

a. i = 4%; pe = 2% b. i = 15%; pe = 11% c. i = 54%; pe = 46%

3. Fill in the table below and answer the questions that relate to the data in the table

S itu

at io

n

Nominal policy interest rate

expected inflation

Real policy interest rate

Risk premium

Nominal borrowing interest rate

Real borrowing interest rate

A 3 0 0

B 4 2 1

C 0 2 4

D 2 6 3

E 0 -2 5

a. Which situations correspond to a liquidity trap as defined in Chapter 4?

b. Which situations correspond to the case where the nomi- nal policy interest rate is at the Zero Lower Bound?

c. Which situation has the highest risk premium? What two factors in bond markets lead to a positive risk premium?

d. Why is it so important when the nominal policy interest rate is at the Zero Lower Bound to maintain a positive ex- pected rate of inflation?

4. Modern bank runs Consider a simple bank that has assets of 100, capital of 20,

and checking deposits of 80. Recall from Chapter 4 that checking deposits are liabilities of a bank.

a. Set up the bank’s balance sheet. b. Now suppose that the perceived value of the bank’s assets

falls by 10. What is the new value of the bank’s capital? What is the bank’s leverage ratio?

c. Suppose the deposits are insured by the government. Despite the decline in the value of bank capital, is there any immediate reason for depositors to withdraw their funds from the bank? Would your answer change if the perceived value of the bank’s assets fell by 15? 20? 25? Explain.

Now consider a different sort of bank, still with assets of 100 and capital of 20, but now with short-term credit of 80 instead of checkable deposits. Short-term credit must be repaid or rolled over (borrowed again) when it comes due.

d. Set up this bank’s balance sheet. e. Again suppose the perceived value of the bank’s assets falls.

If lenders are nervous about the solvency of the bank, will they be willing to continue to provide short-term credit to the bank at low interest rates?

f. Assuming that the bank cannot raise additional capital, how can it raise the funds necessary to repay its debt com- ing due? If many banks are in this position at the same time (and if banks hold similar kinds of assets), what will likely happen to the value of the assets of these banks? How will this affect the willingness of lenders to provide short-term credit?

5. The IS-LM view of the world with more complex financial markets

Consider an economy described by Figure 6-6 in the text.

a. What are the units on the vertical axis of Figure 6-6? b. If the nominal policy interest rate is 5% and the expected

rate of inflation is 3%, what is the value for the vertical in- tercept of the LM curve?

c. Suppose the nominal policy interest rate is 5%. If expected inflation decreases from 3% to 2%, in order to keep the LM curve from shifting in Figure 6-6, what must the central bank do to the nominal policy rate of interest?

d. If the expected rate of inflation were to decrease from 3% to 2%, does the IS curve shift?

e. If the expected rate of inflation were to decrease from 3% to 2%, does the LM curve shift?

f. If the risk premium on risky bonds increases from 5% to 6%, does the LM curve shift?

g. If the risk premium on risky bonds increases from 5% to 6%, does the IS curve shift?

h. What are the fiscal policy options that prevent an increase in the risk premium on risky bonds from decreasing the level of output?

i. What are the monetary policy options that prevent an in- crease in the risk premium on risky bonds from decreasing the level of output?

132 The Short Run The Core

became.) The government exchanges treasury bonds (which become assets for the bank) for ownership shares.

d. Suppose the government exchanges 25 of Treasury bonds for ownership shares. Assuming the worst-case scenario (so that the troubled assets are worth only 25), set up the new balance sheet of the bank. (Remember that the firm now has three assets: 50 of untroubled assets, 25 of troubled assets, and 25 of Treasury bonds.) What is the total value of the bank’s capital? Will the bank be insolvent?

e. Given your answers and the material in the text, why might recapitalization be a better policy than buying the troubled assets?

8. Calculating the risk premium on bonds The text presents a formula where

11 + i2 = 11 - p211 + i + x2 + p 102 p is the probability the bond does not pay at all (the bond issuer is bankrupt) and has a zero return.

i is the nominal policy interest rate. x is the risk premium.

a. If the probability of bankruptcy is zero, what is the rate of interest on the risky bond?

b. Calculate the probability of bankruptcy when the nominal interest rate for a risky borrower is 8% and the nominal policy rate of interest is 3%.

c. Calculate the nominal interest rate for a borrower when the probability of bankruptcy is 1% and the nominal policy rate of interest is 4%.

d. Calculate the nominal interest rate for a borrower when the probability of bankruptcy is 5% and the nominal policy rate of interest is 4%.

e. The formula assumes that payment upon default is zero. In fact, it is often positive. How would you change the formula in this case?

9. Uncoventional monetary policy: financial policy and quantitative easing

We have written the IS-LM model in terms

IS relation: Y = C1Y - T2 + I1Y, r + x2 + G (6.5) LM relation: r = rQ (6.6)

Interpret the interest rate as the federal funds rate adjusted for expected inflation, the real policy interest rate of the Federal Reserve. Assume that the rate at which firms can borrow is much higher than the federal funds rate, equivalently that the premium, x, in the IS equation is high.

a. Suppose that the government takes action to improve the solvency of the financial system. If the government’s action is successful and banks become more willing to lend—both to one another and to nonfinancial firms—what is likely to happen to the premium? What will happen to the IS-LM diagram based on Figure 6-6? Can we consider financial policy as a kind of macroeconomic policy?

b. Faced with a zero nominal interest rate, suppose the Fed decides to purchase securities directly to facilitate the flow of credit in the financial markets. This policy is called

DIg DeepeR MyEconLab Visit www.myeconlab.com to complete all Dig Deeper problems and get instant feedback.

6. Nominal and real interest rates around the world a. There are a few episodes of negative nominal interest

rates around the world. Some may or may not be in play as you read this book. The Swiss nominal policy rate, the Swiss equivalent of the federal funds rate is series IRST- CI01CHM156N from the FRED database maintained at the Federal Reserve Bank of St. Louis. The Swiss nominal policy rate was negative in 2014 and 2015. If so, why not hold cash instead of bonds? In the United States, the Federal Reserve has not (yet) set the nominal policy rate below zero.

b. The real rate of interest is frequently negative, see Figure 6-2. Under what circumstances can it be negative? If so, why not just hold cash instead of bonds?

c. What are the effects of a negative real interest rate on bor- rowing and lending?

d. Find a recent issue of The Economist and look at the table in the back (titled “Economic and financial indicators”). Use the three-month money market rate as a proxy for the nominal policy interest rate, and the most recent three- month rate of change in consumer prices as a measure of the expected rate of inflation (both are expressed in annual terms). Which countries have the lowest nominal interest rates? Do any countries have a negative nominal policy rate? Which countries have the lowest real interest rates? Are some of these real interest rates negative?

7. The Troubled Asset Relief Program (TARP) Consider a bank that has assets of 100, capital of 20, and short-

term credit of 80. Among the bank’s assets are securitized assets whose value depends on the price of houses. These assets have a value of 50.

a. Set up the bank’s balance sheet. Suppose that as a result of a housing price decline, the value of the bank’s securitized assets falls by an uncertain amount, so that these assets are now worth somewhere between 25 and 45. Call the secu- ritized assets “troubled assets.” The value of the other assets remains at 50. As a result of the uncertainty about the value of the bank’s assets, lenders are reluctant to provide any short-term credit to the bank.

b. Given the uncertainty about the value of the bank’s assets, what is the range in the value of the bank’s capital?

As a response to this problem, the government considers purchasing the troubled assets, with the intention of reselling them again when the markets stabilize. (This is the original version of the TARP.)

c. If the government pays 25 for the troubled assets, what will be the value of the bank’s capital? How much would the government have to pay for the troubled assets to ensure that the bank’s capital does not have a negative value? If the government pays 45 for the troubled assets, but the true value turns out to be much lower, who bears the cost of this mistaken valuation? Explain.

Suppose instead of buying the troubled assets, the gov- ernment provides capital to the bank by buying ownership shares, with the intention of reselling the shares when the markets stabilize. (This is what the TARP ultimately

Chapter 6 Financial Markets II: The Extended IS-LM Model 133

quantitative easing. If quantitative easing is successful, so that it becomes easier for financial and nonfinancial firms to obtain credit, what is likely to happen to the premium? What effect will this have on the IS-LM diagram? If quantitative easing has some effect, is it true that the Fed has no policy options to stimulate the economy when the federal funds rate is zero?

c. We will see later in the course that one argument for quantitative easing is that it increases expected inflation. Suppose quantitative easing does increase expected infla- tion. How does that affect the LM curve in Figure 6-6?

expLoRe FuRtheR 10. The spread between riskless and risky bonds

The text used Figure 6-3 to describe fluctuations in the spreads between riskless rate on 10-year U.S. Treasury bonds and 10-year AAA and BBB corporate bonds. This figure can be updated by going to the Federal Reserve Bank of St. Louis FRED data base. The 10-year Treasury bond yield is variable DGS10. Moody’s 10-year seasoned AAA bond is series DAAA. Finally, the Bank of America BBB bond yield is series BAMLC0A4CBBBEY.

a. Find the values of these three yields for the day closest to the day you are looking at this question. Which is the highest yield and which is the lowest yield? What is the spread be- tween the BBB and AAA yield? What is the spread between the BBB and AAA yield?

b. Now go back one calendar year and find the same yields and calculate the spreads. You could fill in the table below:

Date BBB AAA Treasury BBB-AAA AAA- Treasury

BBB- Treasury

Today

One year Ago

c. Do you see any evidence of a change in the risk premium over the past year or has it been relatively stable? Explain.

11. Inflation-indexed bonds Some bonds issued by the U.S. Treasury make payments indexed

to inflation. These inflation-indexed bonds compensate investors for inflation. Therefore, the current interest rates on these bonds are real interest rates—interest rates in terms of goods. These interest rates can be used, together with nominal interest rates, to provide a measure of expected inflation. Let’s see how.

Go to the Web site of the Federal Reserve Board and get the most recent statistical release listing interest rates (www.federalreserve. gov/releases/h15/Current). Find the current nominal interest rate on Treasury securities with a five-year maturity. Now find the current interest rate on “inflation-indexed” Treasury securities with a five-year maturity. What do you think participants in financial markets think the average inflation rate will be over the next five years?

Further Readings ■■ There are many good books on the crisis, among them

Michael Lewis’s The Big Short (2010) and Gillian Tett’s Fool’s Gold (2009). Both books show how the financial system be- came increasingly risky until it finally collapsed. Both read like detective novels, with a lot of action and fascinating characters. The Big Short was made into a movie in 2015.

■■ In Fed We Trust (2009), written by David Wessel, the eco- nomics editor of the Wall Street Journal, describes how the Fed reacted to the crisis. It also makes for fascinating read- ing. Read also the insider version, The Courage to Act: A Memoir of a Crisis and Its Aftermath (2015), by Ben Bernanke, who was Chairman of the Fed throughout the crisis.

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135

Chapter 9

Chapter 9 presents a model of the short run and the medium run. The model puts together the IS-LM model and the Phillips curve and thus is called the IS-LM-PC model. It describes the dynamics of output and unemployment, both in the short and the medium run.

Chapter 8

Chapter 8 looks at the relation between inflation and unemployment, a relation known as the Phillips curve. In the short run, unemployment typically deviates from its natural rate. The behavior of inflation depends on the deviation of unemployment from its natural rate.

Chapter 7

Chapter 7 looks at equilibrium in the labor market. It characterizes the natural rate of unemployment, which is the unemployment rate to which the economy tends to return in the medium run.

Th e

C o

r e The Medium Run

In the medium run, the economy returns to a level of output associated with the natural rate of unemployment.

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137

T

7 The Labor Market hink about what happens when firms respond to an increase in demand by increasing production. Higher production leads to higher employment. Higher employment leads to lower unemployment. Lower unemployment leads to higher wages. Higher wages increase produc- tion costs, leading firms to increase prices. Higher prices lead workers to ask for higher wages. Higher wages lead to further increases in prices, and so on.

So far, we have simply ignored this sequence of events. By assuming a constant price level in the IS-LM model, we in effect assumed that firms were able and willing to supply any amount of output at a given price level. So as long as our focus was on the short run, this assumption was fine. But, as our attention now turns to the medium run, we must now abandon this assump- tion, explore how prices and wages adjust over time, and how this, in turn, affects output. This will be our task in this and the next two chapters.

At the center of the sequence of events described in the first paragraph is the labor market, which is the market in which wages are determined. This chapter focuses on the labor market. It has six sections:

Section 7-1 provides an overview of the labor market.

Section 7-2 focuses on unemployment, how it moves over time, and how its movements affect individual workers.

Sections 7-3 and 7-4 look at wage and price determination.

Section 7-5 then looks at equilibrium in the labor market. It characterizes the natural rate of unemployment, which is the rate of unemployment to which the economy tends to return in the medium run.

Section 7-6 gives a map of where we will be going next.

138 The Medium Run The Core

7-1 A Tour of the Labor Market The total U.S. population in 2014 was 318.9 million (Figure 7-1). Excluding those who were either younger than working age (under 16), in the armed forces, or behind bars, the number of people potentially available for civilian employment, the non-institutional civilian population, was 247.9 million.

The civilian labor force, which is the sum of those either working or looking for work, was only 155.9 million. The other 92.0 million people were out of the labor force, neither working in the market place nor looking for work. The participation rate, which is defined as the ratio of the labor force to the non-institutional civilian popu- lation, therefore was 155.9/247.9, or 62%. The participation rate has steadily increased over time, reflecting mostly the increasing participation rate of women. In 1950, one woman out of three was in the labor force; now the number is close to two out of three.

Of those in the labor force, 146.3 million were employed, and 9.5 million were unemployed—looking for work. The unemployment rate, which is defined as the ratio of the unemployed to the labor force, therefore was 9.5>155.9 = 6.1%.

The Large Flows of Workers To get a sense of what a given unemployment rate implies for individual workers, consider the following analogy.

Take an airport full of passengers. It may be crowded because many planes are com- ing and going, and many passengers are quickly moving in and out of the airport. Or it may be because bad weather is delaying flights and passengers are stranded, waiting for the weather to improve. The number of passengers in the airport will be high in both cases, but their plights are quite different. Passengers in the second scenario are likely to be much less happy.

In the same way, a given unemployment rate may reflect two different realities. It may reflect an active labor market, with many separations and many hires, and so with many workers entering and exiting unemployment, or it may reflect a sclerotic labor market, with few separations, few hires, and a stagnant unemployment pool.

Finding out which reality hides behind the aggregate unemployment rate requires data on the movements of workers. In the United States, the data are available from

c

Work in the home, such as cooking or raising children, is not classified as work in the official statistics. This is a reflection of the difficulty of measuring these activities, not a value judgment about what constitutes work and what does not.

c

Sclerosis, a medical term, means “hardening of the arteries.” By analogy, it is used in economics to describe mar- kets that function poorly and have few transactions.

Total population: 318.9 million

Non-institutional civilian population: 247.9 million

Civilian labor force 155.9 million

Employed 146.3 million

Out of the labor force 92.0 million

Unemployed 9.5 million

Figure 7-1

Population, Labor Force, Employment, and Unemployment in the United States (in Millions), 2014

Source: Current Population Survey http://www.bls.gov/cps/.

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Chapter 7 The Labor Market 139

a  monthly survey called the Current Population Survey (CPS). Average monthly flows,  computed from the CPS for the United States from 1996 to 2014, are reported in Figure 7-2. (For more on the ins and outs of the CPS, see the Focus box “The Current Population Survey.”)

Figure 7-2 has three striking features.

■■ The flows of workers in and out of employment are large. On average, there are 8.2 million separations each month in the United States

(out of an employment pool of 139.0 million), 3.0 million change jobs (shown by the circular arrow at the top), 3.4 million move from employment to out of the labor force (shown by the arrow from employment to out of the labor force), and 1.8 million move from employment to unemployment (shown by the arrow from employment to unemployment).

Why are there so many separations each month? About three-fourths of all sep- arations are quits, which are workers leaving their jobs for what they perceive as a better alternative. The remaining one-fourth are layoffs. Layoffs come mostly from changes in employment levels across firms. The slowly changing aggregate employ- ment numbers hide a reality of continual job destruction and job creation across firms. At any given time, some firms are suffering decreases in demand and decreas- ing their employment; other firms are enjoying increases in demand and increasing employment.

■■ The flows in and out of unemployment are large relative to the number of unem- ployed. The average monthly flow out of unemployment each month is 3.9 million: 2.0 million people get a job, and 1.9 million stop searching for a job and drop out of the labor force. Put another way, the proportion of unemployed leaving unemploy- ment equals 3.9/8.8 or about 44% each month. Put yet another way, the average duration of unemployment, which is the average length of time people spend unemployed, is between two and three months.

This fact has an important implication. You should not think of unemploy- ment in the United States as a stagnant pool of workers waiting indefinitely for jobs. For most (but obviously not all) of the unemployed, being unemployed is more a quick transition than a long wait between jobs. One needs, however, to make two remarks at this point. First, the United States is unusual in this re- spect. In many European countries, the average duration is much longer than

The numbers for employment, unemployment, and those out of the labor force in Figure 7-1 referred to 2014. The num- bers for the same variables in Figure 7-2 refer to averages from 1996 to 2014. This is why they are different.

b

Put another, and perhaps more dramatic way: On aver- age, every day in the United States, about 60,000 workers become unemployed.

The average duration of unem- ployment equals the inverse of the proportion of unemployed leaving unemployment each month. To see why, consider an example. Suppose the number of unemployed is constant and equal to 100, and each unemployed per- son remains unemployed for two months. So, at any given time, there are 50 people who have been unemployed for one month and 50 who have been unemployed for two months. Each month, the 50 unemployed who have been unemployed for two months leave unemployment. In this example, the proportion of un- employed leaving unemploy- ment each month is 50/100, or 50%. The duration of unem- ployment is two months, which is the inverse of 1/50%.

b

2.0

Employment 139 million

Out of the labor force 77.0 million

Unemployment 8.8 million

1.9

3.0

2.0

1.8

3.4

3.7

Figure 7-2

Average Monthly Flows between Employment, Unemployment, and Non-participation in the United States, 1996 to 2014 (Millions)

(1) The flows of workers in and out of employment are large. (2) The flows in and out of unemployment are large relative to the number of unemployed. (3) There are also large flows in and out of the labor force, much of it directly to and from employment.

Source: Calculated from the series con- structed by Fleischman and Fallick, http:// www.federalreserve.gov/econresdata/ researchdata/feds200434.xls.

MyEconLab Animation

b

140 The Medium Run The Core

The Current Population Survey Fo

C u

S The Current Population Survey (CPS) is the main source of statistics on the labor force, employment, participation, and earnings in the United States.

When the CPS began in 1940, it was based on in- terviews of 8,000 households. The sample has grown considerably, and now about 60,000 households are interviewed every month. The households are chosen so that the sample is representative of the U.S. population. Each household stays in the sample for four months, leaves the sample for the following eight months, then comes back for another four months before leaving the sample permanently.

The survey is now based on computer-assisted interviews. Interviews are either done in person, in which case inter- viewers use laptop computers, or by phone. Some questions are asked in every survey. Other questions are specific to a particular survey and are used to find out about particular aspects of the labor market.

The Labor Department uses the data to compute and pub- lish numbers on employment, unemployment, and participa tion by age, gender, education, and industry. Economists use these data, which are available in large computer files, in two ways.

The first is to get snapshots of how things are at various points in time, to answer such questions as: What is the dis- tribution of wages for Hispanic American workers with only primary education, and how does it compare with the same distribution 10 or 20 years ago?

The second way, of which Figure 7-2 is an example, relies on the fact that the survey follows people through time. By looking at the same people in two consecutive months, econo- mists can find out, for example, how many of those who were unemployed last month are employed this month. This num- ber gives them an estimate of the probability of somebody who was unemployed last month found a job this month.

For more on the CPS, go to the CPS homepage (www.bls. gov/cps/home.htm).

in the United States. Second, as we shall see, even in the United States, when un- employment is high, such as was the case in the crisis, the average duration of unemployment becomes much longer. Being unemployed becomes much more painful.

■■ The flows in and out of the labor force are also surprisingly large. Each month, 5.3 million workers drop out of the labor force (3.4 plus 1.9), and a roughly equal slightly larger number, 5.7, join the labor force (3.7 plus 2.0). You might have ex- pected these two flows to be composed, on one side, of those completing school and entering the labor force for the first time, and on the other side, of workers entering retirement. But each of these two groups actually represents a small fraction of the total flows. Each month only about 450,000 new people enter the labor force, and  about 350,000 retire. But the actual flows in and out of the labor force are 11.2 million, so about 14 times larger.

What this fact implies is that many of those classified as “out of the labor force” are in fact willing to work and move back and forth between participation and non-participation. Indeed, among those classified as out of the labor force, a large proportion report that although they are not looking, they “want a job.” What they really mean by this statement is unclear, but the evidence is that many do take jobs when offered them.

This fact has another important implication. The sharp focus on the unemploy- ment rate by economists, policy makers, and news media is partly misdirected. Some of the people classified as out of the labor force are much like the unemployed. They are in effect discouraged workers. And although they are not actively looking for a job, they will take it if they find one.

This is why economists sometimes focus on the employment rate, which is the ratio of employment to the population available for work, rather than on the unem- ployment rate. The higher unemployment, or the higher the number of people out of the labor force, the lower the employment rate.

c

Working in the opposite direc- tion: Some of the unemployed may be unwilling to accept any job offered to them and should probably not be counted as unemployed because they are not really looking for a job.

c

In 2014, employment was 146.3 million and the popula- tion available for work was 247.9 million. The employ- ment rate was 59.0%. The employment rate is some- times called the employment- to-population ratio.

Chapter 7 The Labor Market 141

I shall follow tradition in this text and focus on the unemployment rate as an indicator of the state of the labor market, but you should keep in mind that the un- employment rate is not the best estimate of the number of people available for work.

7-2 Movements in Unemployment Let’s now look at movements in unemployment. Figure 7-3 shows the average value of the U.S. unemployment rate over the year, for each year, all the way back to 1948. The shaded areas represent years during which there was a recession.

Figure 7-3 has two important features.

■■ Until the mid-1980s, it looked as if the U.S. unemployment rate was on an upward trend, from an average of 4.5% in the 1950s to 4.7% in the 1960s, 6.2% in the 1970s, and 7.3% in the 1980s. From the 1980s on however, the unemployment rate steadily declined for more than two decades. By 2006, the unemployment rate was down to 4.6%. These decreases led a number of economists to conclude that the trend from 1950 to the 1980s had been reversed, and that the normal rate of unem- ployment in the United States had fallen. The unemployment rate increased sharply with the crisis, and then started coming down again. At the time of writing, it stands at 5.0%; whether it will go back to the low precrisis level is unclear.

■■ Leaving aside these trend changes, year-to-year movements in the unemployment rate are closely associated with recessions and expansions. Look, for example, at the last four peaks in unemployment in Figure 7-3. The most recent peak, at 9.6% is in 2010, was the result of the crisis. The previous two peaks, associated with the recessions of 2001 and 1990–1991 recessions, had much lower unemployment rate peaks, around 7%. Only the recession of 1982, where the unemployment rate reached 9.7%, is com- parable to the recent crisis. (Annual averages can mask larger values within the year. In the 1982 recession, although the average unemployment rate over the year was 9.7%, the unemployment rate actually reached 10.8% in November 1982. Similarly, the monthly unemployment rate in the crisis peaked at 10.0% in October 2009.)

Note also that the unemploy- ment rate sometimes peaks in the year after the reces- sion, not in the actual reces- sion year. This occurred, for example, in the 2001 reces- sion. The reason is that, al- though growth is positive, so the economy is technically no longer in recession, the addi- tional output does not lead to enough new hires to reduce the unemployment rate.

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Source: Series UNRATE: Federal Reserve Economic Data (FRED) http://research.stlouisfed.org/fred2/.

MyEconLab Real-time data

142 The Medium Run The Core

How do these fluctuations in the aggregate unemployment rate affect individual workers? This is an important question because the answer determines both:

■■ The effect of movements in the aggregate unemployment rate on the welfare of individual workers, and

■■ The effect of the aggregate unemployment rate on wages.

Let’s start by asking how firms can decrease their employment in response to a decrease in demand. They can hire fewer new workers, or they can lay off the workers they currently employ. Typically, firms prefer to slow or stop the hiring of new workers first, relying on quits and retirements to achieve a decrease in employment. But doing only this may not be enough if the decrease in demand is large, so firms may then have to lay off workers.

Now think about the implications for both employed and unemployed workers.

■■ If the adjustment takes place through fewer hires, the chance that an unemployed worker will find a job diminishes. Fewer hires means fewer job openings; higher unemployment means more job applicants. Fewer openings and more applicants combine to make it harder for the unemployed to find jobs.

■■ If the adjustment takes place instead through higher layoffs, then employed workers are at a higher risk of losing their job.

In general, as firms do both, higher unemployment is associated with both a lower chance of finding a job if one is unemployed and a higher chance of losing it if one is employed. Figures 7-4 and 7-5 show these two effects at work over the period 1996 to 2014.

Figure 7-4 plots two variables against time: the unemployment rate (measured on the left vertical axis) and the proportion of unemployed workers finding a job each month (measured on the right vertical axis). This proportion is constructed by divid- ing the flow from unemployment to employment during each month by the number of unemployed. To show the relation between the two variables more clearly, the proportion of unemployed finding jobs is plotted on an inverted scale. Be sure you see that on the right vertical scale, the proportion is lowest at the top and highest at the bottom.

The relation between movements in the proportion of unemployed workers find- ing jobs and the unemployment rate is striking. Periods of higher unemployment are associated with much lower proportions of unemployed workers finding jobs. In 2010,

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Figure 7-4

The Unemployment Rate and the Proportion of Unemployed Finding Jobs, 1996–2014

When unemployment is higher, the proportion of unemployed finding jobs within one month is lower. Note that the scale on the right is an inverse scale.

Sources: Series UNRATE: Federal Reserve Economic Data (FRED) http://research.stlouisfed.org/fred2/. Series constructed by Fleischman and Fallick, http://www.federal reserve.gov/econresdata/research data/.

Chapter 7 The Labor Market 143

for example, with unemployment close to 10%, only about 17% of the unemployed found a job within a month, as opposed to 28% in 2007, when unemployment was much lower.

Similarly, Figure 7-5 plots two variables against time: the unemployment rate (measured on the left vertical axis) and the monthly separation rate from employment (measured on the right vertical axis). The monthly separation rate is constructed by dividing the flow from employment (to unemployment and to out of the labor force) during each month by the number of employed in the month. The relation between the separation rate and the unemployment rate plotted is quite strong. Higher unemploy- ment implies a higher separation rate—that is, a higher chance of employed workers losing their jobs. The probability nearly doubles between times of low unemployment and times of high unemployment.

Let’s summarize: When unemployment is high, workers are worse off in two ways:

■■ Employed workers face a higher probability of losing their job. ■■ Unemployed workers face a lower probability of finding a job; equivalently, they can

expect to remain unemployed for a longer time.

7-3 Wage Determination Having looked at unemployment, let’s turn to wage determination, and to the relation between wages and unemployment.

Wages are set in many ways. Sometimes they are set by collective bargaining, that is, bargaining between firms and unions. In the United States, however, collective bargaining plays a limited role, especially outside the manufacturing sector. Today, barely more than 10% of U.S. workers have their wages set by collective bargaining agreements. For the rest, wages are either set by employers or by bargaining between the employer and individual employees. The higher the skills needed to do the job, the more likely there is to be bargaining. Wages offered for entry-level jobs at McDonald’s are on a take-it-or-leave-it basis. New college graduates, on the other hand, can typi- cally negotiate a few aspects of their contracts. CEOs and baseball stars can negotiate a lot more.

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To be slightly more precise, we only learn from Figure 7-5 that, when unemployment is higher, separations into unem- ployment and out of the labor force are higher. Separations however include both quits and layoffs. We know from other sources that quits are lower when unemployment is high. It is more attractive to quit when there are plenty of jobs. So, if separations go up and quits go down, this im- plies that layoffs (which equal separations minus quits) go up even more than separations.

Collective bargaining is bar- gaining between a union (or a set of unions) and a firm (or a set of firms).

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Sources: Series UNRATE: Federal Reserve Economic Data (FRED) http://research.st louisfed.org/ fred2/. Series constructed by Fleischman and Fallick, http://www.federalre serve. gov/econresdata/research data/ feds200434.xls.

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144 The Medium Run The Core

There are also large differences across countries. Collective bargaining plays an important role in Japan and in most European countries. Negotiations may take place at the firm level, at the industry level, or at the national level. Sometimes contract agree- ments apply only to firms that have signed the agreement. Sometimes they are automati- cally extended to all firms and all workers in the sector or the economy.

Given these differences across workers and across countries, can we hope to formu- late anything like a general theory of wage determination? Yes. Although institutional differences influence wage determination, there are common forces at work in all coun- tries. Two sets of facts stand out:

■■ Workers are typically paid a wage that exceeds their reservation wage, which is the wage that would make them indifferent between working or being unemployed. In other words, most workers are paid a high enough wage that they prefer being employed to being unemployed.

■■ Wages typically depend on labor-market conditions. The lower the unemployment rate, the higher the wages. (I shall state this more precisely in the next section.)

To think about these facts, economists have focused on two broad lines of explana- tion. The first is that even in the absence of collective bargaining, most workers have some bargaining power, which they can and do use to obtain wages above their reserva- tion wages. The second is that firms themselves may, for a number of reasons, want to pay wages higher than the reservation wage. Let’s look at each explanation in turn.

Bargaining How much bargaining power workers have depends on two factors. The first is how costly it would be for the firm to find other workers, were they to leave the firm. The second is how hard it would be for them to find another job, were they to leave the firm. The costlier it is for the firm to replace them, and the easier it is for them to find an- other job, the more bargaining power they will have. This has two implications:

■■ How much bargaining power a worker has depends first on the nature of the job. Replacing a worker at McDonald’s is not costly. The required skills can be taught quickly, and typically a large number of willing applicants have already filled out job application forms. In this situation, the worker is unlikely to have much bargaining power. If he or she asks for a higher wage, the firm can lay him or her off and find a replacement at minimum cost. In contrast, a highly skilled worker who knows in detail how the firm operates may be difficult and costly to replace. This gives him or her more bargaining power. If he or she asks for a higher wage, the firm may decide that it is best to give it to him or her.

■■ How much bargaining power a worker has also depends on labor market conditions. When the unemployment rate is low, it is more difficult for firms to find acceptable replacement workers. At the same time, it is easier for workers to find  other jobs. Under these conditions, workers are in a stronger bargaining position and may be able to obtain a higher wage. Conversely, when the unemployment rate is high, finding good replacement workers is easier for firms, whereas finding another job is harder for workers. Being in a weak bargaining position, workers may have no choice but to accept a lower wage.

Efficiency Wages Regardless of workers’ bargaining power, firms may want to pay more than the reserva- tion wage. They may want their workers to be productive, and a higher wage can help them achieve that goal. If, for example, it takes a while for workers to learn how to do a

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Peter Diamond, Dale Mortensen, and Christopher Pissarides re- ceived the 2010 Nobel Prize in economics precisely for work- ing out the characteristics of a labor market with large flows and wage bargaining.

Chapter 7 The Labor Market 145

job correctly, firms will want their workers to stay for some time. But if workers are paid only their reservation wage, they will be indifferent between their staying or leaving. In this case, many of them will quit, and the turnover rate will be high. Paying a wage above the reservation wage makes it more attractive for workers to stay. It decreases turnover and increases productivity.

Behind this example lies a more general proposition. Most firms want their workers to feel good about their jobs. Feeling good promotes good work, which leads to higher productivity. Paying a high wage is one instrument the firm can use to achieve these goals. (See the Focus box “Henry Ford and Efficiency Wages.”) Economists call the theories that link the productivity or the efficiency of workers to the wage they are paid efficiency wage theories.

Like theories based on bargaining, efficiency wage theories suggest that wages de- pend on both the nature of the job and on labor-market conditions.

■■ Firms, such as high-tech firms, that see employee morale and commitment as essen- tial to the quality of their work will pay more than firms in sectors where workers’ activities are more routine.

■■ Labor-market conditions will affect the wage. A low unemployment rate makes it more attractive for employed workers to quit. When unemployment is low, it is easy to find another job. That means, when unemployment decreases, a firm that wants to avoid an increase in quits will have to increase wages to induce workers to stay with the firm. When this happens, lower unemployment will again lead to higher wages. Conversely, higher unemployment will lead to lower wages.

MyEconLab Video

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Before September 11, 2001, the approach to airport secu- rity was to hire workers at low wages and accept the result- ing high turnover. Now that airport security has become a higher priority, the approach has been to make the jobs more attractive and increase pay, so as to get more moti- vated and more competent workers and reduce turnover. Turnover at the Transport Se- curity Administration (TSA) is now roughly equal to the ser- vice industry average.

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henry Ford and efficiency Wages

In 1914, Henry Ford the builder of the most popular car in the world at the time, the Model-T—made a stunning announcement. His company would pay all qualified employees a minimum of $5.00 a day for an eight-hour day. This was a large salary increase for most employees, who had been earning an average $2.30 for a nine-hour day. From the point of view of the Ford Company, this increase in pay was far from negligible; it represented about half of the com- pany’s profits at the time.

What Ford’s motivations were is not entirely clear. Ford himself gave too many reasons for us to know which ones he actually believed. The reason was not that the company had a hard time finding workers at the previous wage. But the company clearly had a hard time retaining workers. There was a high turnover rate, as well as high dissatisfaction among workers.

Whatever the reasons behind Ford’s decision, as Table 1 shows. the results of the wage increase were astounding, as the table shows.

Table 1 Annual Turnover and Layoff Rates (%) at Ford, 1913–1915

1913 1914 1915

Turnover rate (%) 370 54 16

Layoff rate (%) 62 7 0.1

The annual turnover rate (the ratio of separations to em- ployment) plunged from a high of 370% in 1913 to a low of 16% in 1915. (An annual turnover rate of 370% means that on average 31% of the company’s workers left each month, so that over the course of a year the ratio of separations to employment was 31% : 12 = 370%.) The layoff rate col- lapsed from 62% to nearly 0%. The average rate of absentee- ism (not shown in the table), which ran at close to 10% in 1913, was down to 2.5% one year later. There is little question that higher wages were the main source of these changes.

Did productivity at the Ford plant increase enough to offset the cost of increased wages? The answer to this question is less clear. Productivity was much higher in 1914 than in 1913. Estimates of the productivity increases range from 30 to 50%. Despite higher wages, profits were also higher in 1914 than in 1913. But how much of this increase in profits was the result of changes in workers’ behavior and how much was because of the increasing success of Model-T cars is harder to establish.

Although the effects support efficiency wage theories, it may be that the increase in wages to five dollars a day was excessive, at least from the point of view of profit maximiza- tion. But Henry Ford probably had other objectives as well, from keeping the unions out—which he did—to generating publicity for himself and the company—which he surely did.

Source: Dan Raff and Lawrence Summers, “Did Henry Ford Pay Efficiency Wages?” Journal of Labor Economics 1987 5 (No. 4 Part 2): pp. S57–S87.

146 The Medium Run The Core

Wages, Prices, and Unemployment We can capture our discussion of wage determination by using the following equation:

W = Pe F1u, z2 (7.1) 1-,+2

The aggregate nominal wage W depends on three factors:

■■ The expected price level, Pe

■■ The unemployment rate, u ■■ A catch-all variable, z, that stands for all other variables that may affect the outcome

of wage setting.

Let’s look at each factor.

The Expected Price Level First, ignore the difference between the expected and the actual price level and ask: Why does the price level affect nominal wages? The answer: Because both workers and firms care about real wages, not nominal wages.

■■ Workers do not care about how many dollars they receive but about how many goods they can buy with those dollars. In other words, they do not care about the nominal wages they receive, but about the nominal wages (W) they receive relative to the price of the goods they buy (P). They care about W/P.

■■ In the same way, firms do not care about the nominal wages they pay but about the nominal wages (W) they pay relative to the price of the goods they sell (P). So they also care about W/P.

Think of it another way. If workers expect the price level—the price of the goods they buy—to double, they will ask for a doubling of their nominal wage. If firms expect the price level—the price of the goods they sell—to double, they will be willing to double the nominal wage. So, if both workers and firms expect the price level to double, they will agree to double the nominal wage, keeping the real wage constant. This is captured in equation (7.1): A doubling in the expected price level leads to a doubling of the nominal wage chosen when wages are set.

Return now to the distinction we set aside at the start of the paragraph: Why do wages depend on the expected price level, Pe, rather than the actual price level, P?

Because wages are set in nominal (dollar) terms, and when they are set, the relevant price level is not yet known.

For example, in some union contracts in the United States, nominal wages are set in advance for three years. Unions and firms have to decide what nominal wages will be over the following three years based on what they expect the price level to be over those three years. Even when wages are set by firms, or by bargaining between the firm and each worker, nominal wages are typically set for a year. If the price level goes up unex- pectedly during the year, nominal wages are typically not readjusted. (How workers and firms form expectations of the price level will occupy us for much of the next two chap- ters; we will leave this issue aside for the moment.)

The Unemployment Rate Also affecting the aggregate wage in equation (7.1) is the unemployment rate, u. The minus sign under u indicates that an increase in the unemployment rate decreases wages.

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An increase in the expected price level leads to an increase in the nominal wage in the same proportion.

Chapter 7 The Labor Market 147

The fact that wages depend on the unemployment rate was one of the main conclusions of our previous discussion. If we think of wages as being determined by bar- gaining, then higher unemployment weakens workers’ bargaining power, forcing them to accept lower wages. If we think of wages as being determined by efficiency wage con- siderations, then higher unemployment allows firms to pay lower wages and still keep workers willing to work.

The Other Factors The third variable in equation (7.1), z, is a catch-all variable that stands for all the factors that affect wages given the expected price level and the unemployment rate. By conven- tion, we will define z so that an increase in z implies an increase in the wage (thus, the positive sign under z in the equation). Our previous discussion suggests a long list of potential factors here.

Take, for example, unemployment insurance, which is the payment of unem- ployment benefits to workers who lose their jobs. There are good reasons why society should provide some insurance to workers who lose their job and have a hard time find- ing another. But there is little question that, by making the prospects of unemployment less distressing, more generous unemployment benefits do increase wages at a given unemployment rate. To take an extreme example, suppose unemployment insurance did not exist. Some workers would have little to live on and would be willing to accept low wages to avoid remaining unemployed. But unemployment insurance does exist, and it allows unemployed workers to hold out for higher wages. In this case, we can think of z as representing the level of unemployment benefits. At a given unemployment rate, higher unemployment benefits increase the wage.

It is easy to think of other factors. An increase in the minimum wage may increase not only the minimum wage itself, but also wages just above the minimum wage, lead- ing to an increase in the average wage, W, at a given unemployment rate. Or take an increase in employment protection, which makes it more expensive for firms to lay off workers. Such a change is likely to increase the bargaining power of workers covered by this protection (laying them off and hiring other workers is now costlier for firms), increasing the wage for a given unemployment rate.

We will explore some of these factors as we go along.

7-4 Price Determination Having looked at wage determination, let’s now turn to price determination.

The prices set by firms depend on the costs they face. These costs depend, in turn, on the nature of the production function, which is the relation between the inputs used in production and the quantity of output produced, and on the prices of these inputs.

For the moment, we will assume firms produce goods using labor as the only factor of production. We will write the production function as follows:

Y = AN

where Y is output, N is employment, and A is labor productivity. This way of writing the production function implies that labor productivity, which is output per worker, is constant and equal to A.

It should be clear that this is a strong simplification. In reality, firms use other factors of production in addition to labor. They use capital—machines and factories. They use raw materials—oil, for example. Moreover, there is technological progress, so that labor productivity (A) is not constant but steadily increases over time. We shall introduce these complications later. We shall introduce raw materials in Chapter 9 when we  discuss

An increase in unemployment leads to a decrease in the nominal wage.

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By the definition of z, an in- crease in z leads to an increase in the nominal wage.

Using a term from micro- economics, this assumption implies constant returns to labor in production. If firms double the number of workers they employ, they double the amount of output they produce.

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148 The Medium Run The Core

changes in the price of oil. We shall focus on the role of capital and technological prog- ress when we turn to the determination of output in the long run in Chapter 10 through Chapter 13. For the moment, though, this simple relation between output and employ- ment will make our lives easier and still serve our purposes.

Given the assumption that labor productivity, A, is constant, we can make one fur- ther simplification. We can choose the units of output so that one worker produces one unit of output—in other words, so that A = 1. (This way we do not have to carry the letter A around, and this will simplify notation.) With this assumption, the production function becomes:

Y = N (7.2)

The production function Y = N implies that the cost of producing one more unit of output is the cost of employing one more worker, at wage W. Using the terminology introduced in your microeconomics course: The marginal cost of production—the cost of producing one more unit of output—is equal to W.

If there was perfect competition in the goods market, the price of a unit of output would be equal to marginal cost: P would be equal to W. But many goods markets are not competitive, and firms charge a price higher than their marginal cost. A simple way of capturing this fact is to assume that firms set their price according to

P = 11 + m2W (7.3) where m is the markup of the price over the cost. If goods markets were perfectly com- petitive, m would be equal to zero, and the price, P, would simply equal the cost, W. To the extent they are not competitive and firms have market power, m is positive, and the price, P, will exceed the cost, W, by a factor equal to 11 + m2.

7-5 The Natural Rate of Unemployment Let’s now look at the implications of wage and price determination for unemployment.

For the rest of this chapter, we shall do so under the assumption that nominal wages depend on the actual price level, P, rather than on the expected price level, Pe (why we make this assumption will become clear soon). Under this additional assumption, wage setting and price setting determine the equilibrium (also called natural) rate of unem- ployment. Let’s see how.

The Wage-Setting Relation Given the assumption that nominal wages depend on the actual price level (P) rather than on the expected price level (Pe), equation (7.1), which characterizes wage determi- nation, becomes:

W = P F1u, z2 Dividing both sides by the price level,

W P

= F1u, z2 (7.4) 1-,+2

Wage determination implies a negative relation between the real wage, W/P, and the unemployment rate, u: The higher the unemployment rate, the lower the real wage chosen by wage setters. The intuition is straightforward. The higher the unemployment rate, the weaker the workers’ bargaining position, and the lower the real wage will be.

cThe rest of the chapter is based on the assumption that Pe = P.

“Wage setters” are unions and firms if wages are set by col- lective bargaining; individual workers and firms if wages are set on a case-by-case basis; or firms if wages are set on a take-it-or-leave-it basis.

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Chapter 7 The Labor Market 149

This relation between the real wage and the rate of unemployment—let’s call it the wage-setting relation—is drawn in Figure 7-6. The real wage is measured on the ver- tical axis. The unemployment rate is measured on the horizontal axis. The wage-setting relation is drawn as the downward–sloping curve WS (for wage setting). The higher the unemployment rate, the lower the real wage.

The Price-Setting Relation Let’s now look at the implications of price determination. If we divide both sides of the price-determination equation, (7.3), by the nominal wage, we get

P W

= 1 + m (7.5)

The ratio of the price level to the wage implied by the price-setting behavior of firms equals 1 plus the markup. Now invert both sides of this equation to get the implied real wage:

W P

= 1

1 + m (7.6)

Note what this equation says: Price-setting decisions determine the real wage paid by firms. An increase in the markup leads firms to increase their prices given the wage they have to pay; equivalently, it leads to a decrease in the real wage.

The step from equation (7.5) to equation (7.6) is algebraically straightforward. But how price setting actually determines the real wage paid by firms may not be intuitively obvious. Think of it this way: Suppose the firm you work for increases its markup and therefore increases the price of its product. Your real wage does not change much; you are still paid the same nominal wage, and the product produced by the firm is at most a small part of your consumption basket. Now suppose that not only the firm you work for, but all the firms in the economy increase their markup. All the prices go up. Even if you are paid the same nominal wage, your real wage goes down. So, the higher the markup set by firms, the lower your (and everyone else’s) real wage will be. This is what equation (7.6) says.

WS

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Figure 7-6

Wages, Prices, and the Natural Rate of Unemployment

The natural rate of unemploy- ment is the unemployment rate such that the real wage chosen in wage setting is equal to the real wage implied by price setting.

MyEconLab Animation

150 The Medium Run The Core

The price-setting relation in equation (7.6) is drawn as the horizontal line PS (for price setting) in Figure 7-6. The real wage implied by price setting is 1>11 + m2; it does not depend on the unemployment rate.

Equilibrium Real Wages and Unemployment Equilibrium in the labor market requires that the real wage chosen in wage setting be equal to the real wage implied by price setting. (This way of stating equilibrium may sound strange if you learned to think in terms of labor supply and labor demand in your microeconomics course. The relation between wage setting and price setting, on the one hand, and labor supply and labor demand, on the other, is closer than it looks at first and is explored further in the appendix at the end of this chapter.) In Figure 7-6, equilibrium is therefore given by point A, and the equilibrium unemployment rate is given by un.

We can also characterize the equilibrium unemployment rate algebraically; eliminating W/P between equations (7.4) and (7.6) gives

F1un , z2 = 11 + m (7.7)

The equilibrium unemployment rate, un , is such that the real wage chosen in wage setting—the left side of equation (7.7)—is equal to the real wage implied by price setting—the right side of equation (7.7).

The equilibrium unemployment rate un is called the natural rate of unemploy- ment (which is why we have used the subscript n to denote it). The terminology has be- come standard, so we shall adopt it, but this is actually a bad choice of words. The word natural suggests a constant of nature, one that is unaffected by institutions and policy. As its derivation makes clear, however, the natural rate of unemployment is anything but natural. The positions of the wage-setting and price-setting curves, and thus the equilib- rium unemployment rate, depend on both z and m. Consider two examples:

■■ An increase in unemployment benefits. An increase in unemployment benefits can be represented by an increase in z. Because an increase in benefits makes the prospect of unemployment less painful, it increases the wage set by wage setters at a given unemployment rate. It shifts the wage-setting relation up, from WS to WS= in Figure 7-7. The economy moves along the PS line, from A to A=. The natural rate of unemployment increases from un to un

= . In words: At a given unemployment rate, higher unemployment benefits lead to

a higher real wage. A higher unemployment rate brings the real wage back to what firms are willing to pay.

■■ A less stringent enforcement of existing antitrust legislation. To the extent that this allows firms to collude more easily and increase their market power, it will lead to an increase in their markup an increase in m. The increase in m implies a decrease in the real wage paid by firms, and so it shifts the price-setting relation down, from PS  to PS= in Figure 7-8. The economy moves along WS. The equilib- rium moves from A to A=, and the natural rate of unemployment increases from un to un

= .

An increase in markups decreases the real wage and leads to an increase in the natural rate of unemployment. By letting firms increase their prices given the wage, less stringent enforcement of antitrust legislation leads to a decrease in the real wage. Higher unemployment is required to make workers accept this lower real wage, leading to an increase in the natural rate of unemployment.

Factors like the generosity of unemployment benefits or antitrust legislation can hardly be thought of as the result of nature. Rather, they reflect various characteristics

cNatural in Webster’s Diction- ary, means “in a state provided by nature, without man-made changes.”

MyEconLab Video An increase in unemployment benefits shifts the wage setting curve up. The economy moves along the price-setting curve. Equilibrium unemployment in- creases. Does this imply that unemployment benefits are necessarily a bad idea? (Hint: No, but they have side effects.)

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This has led some econo- mists to call unemployment a “discipline device.” Higher un- employment is the economic device that forces wages to correspond to what firms are willing to pay.

c

c

An increase in the markup shifts the price setting curve (line in this case). The economy moves along the wage-setting curve. Equilibrium unemploy- ment increases.

Chapter 7 The Labor Market 151

PS

Unemployment rate, u uun

WS

A

R ea

l w ag

e, W

/P

n

1 1 1 m

A

WS

Figure 7-7

Unemployment Benefits and the Natural Rate of Unemployment

An increase in unemployment benefits leads to an in- crease in the natural rate of unemployment.

MyEconLab Animation

of the structure of the economy. For that reason, a better name for the equilibrium rate of unemployment would be the structural rate of unemployment, but so far the name has not caught on.

7-6 Where We Go from Here We have just seen how equilibrium in the labor market determines the equilibrium un- employment rate (we have called it the natural rate of unemployment). Although we leave a precise derivation to Chapter 9, it is clear, for a given labor force, the unemployment rate determines the level of employment, and that, given the production function, the

b This name has been suggest- ed by Edmund Phelps, from Columbia University. Phelps was awarded the Nobel Prize in 2006. For more on some of his contributions, see Chapters 8 and 24.

PS

Unemployment rate, u u un

WS

A

R ea

l w ag

e, W

/P

n

1 1 1 m

1 1 1

A m PS

Figure 7-8

Markups and the Natural Rate of Unemployment

An increase in the markup leads to an increase in the natural rate of unemployment.

MyEconLab Animation

152 The Medium Run The Core

Summary ■■ The labor force consists of those who are working

(employed) or looking for work (unemployed). The unem- ployment rate is equal to the ratio of the number of unem- ployed to the number in the labor force. The participation rate is equal to the ratio of the labor force to the working- age population.

■■ The U.S. labor market is characterized by large flows be- tween employment, unemployment, and “out of the labor force.” On average, each month, about 44% of the unem- ployed move out of unemployment, either to take a job or to drop out of the labor force.

■■ Unemployment is high in recessions and low in expansions. During periods of high unemployment, the probability of losing a job increases and the probability of finding a job decreases.

■■ Wages are set unilaterally by firms or by bargaining between workers and firms. They depend negatively on the unem- ployment rate and positively on the expected price level. The reason why wages depend on the expected price level is that they are typically set in nominal terms for some period of time. During that time, even if the price level turns out to be different from what was expected, wages are typically not readjusted.

■■ The price set by firms depends on the wage and on the markup of prices over wages. A higher markup implies a higher price given the wage, and thus a lower real wage.

■■ Equilibrium in the labor market requires that the real wage chosen in wage setting be equal to the real wage implied by price setting. Under the additional assumption that the expected price level is equal to the actual price level,

level of employment determines the level of output. Thus, associated with the natural rate of unemployment is a natural level of output.

So, you may (and, indeed, you should) ask, what did we do in the previous four chapters? If equilibrium in the labor market determines the unemployment rate and, by implication, determines the level of output, why did we spend so much time looking at the goods and financial markets? What about our previous conclusions that the level of output was deter- mined by factors such as monetary policy, fiscal policy, consumer confidence, and so on—all factors that do not enter equation (7.8) and therefore do not affect the natural level of output?

The key to the answer lies in the difference between the short run and the medium run:

■■ We have derived the natural rate of unemployment and, by implication, the associ- ated level of output, under two assumptions. First, we have assumed equilibrium in the labor market. Second, we have assumed that the price level was equal to the expected price level.

■■ However, there is no reason for the second assumption to be true in the short run. The price level may well turn out to be different from what was expected when nomi- nal wages were set. Hence, in the short run, there is no reason for unemployment to be equal to the natural rate or for output to be equal to its natural level.

As we shall see in Chapter 9, the factors that determine movements in output in the short run are indeed the factors we focused on in the preceding three chapters: monetary policy, fiscal policy, and so on. Your time (and mine) was not wasted.

■■ But expectations are unlikely to be systematically wrong (say, too high or too low) forever. That is why, in the medium run, output tends to return to its natural level. In the medium run, the factors that determine unemployment and output are the fac- tors that appear in equations (7.7) and (7.8).

These, in short, are the answers to the questions asked in the first paragraph of this chapter. Developing these answers in detail will be our task in the next two chapters. Chapter 8 relaxes the assumption that the price level is equal to the expected price level and derives the relation between unemployment and inflation known as the Phillips curve. Chapter 9 puts all the pieces together.

In the short run, the factors that determine movements in output are the factors we focused on in the preceding four chapters: monetary poli- cy, fiscal policy, and so on.

c

MyEconLab Video In the medium run, output tends to return to the natural level. The factors that deter- mine unemployment and, by implication, output, are the factors we have focused on this chapter.

c

Chapter 7 The Labor Market 153

equilibrium in the labor market determines the unemploy- ment rate. This unemployment rate is known as the natural rate of unemployment.

■■ In general, the actual price level may turn out to be different from the price level expected by wage setters. Therefore, the unemployment rate need not be equal to the natural rate.

■■ The coming chapters will show that, in the short run, unemployment and output are determined by the factors we focused on in the previous four chapters, but, in the medium run, unemployment tends to return to the natural rate, and output tends to return to its natural level.

Key Terms non-institutional civilian population, 138 labor force, 138 out of the labor force, 138 participation rate, 138 unemployment rate, 138 separations, 138 hires, 138 Current Population Survey (CPS), 139 quits, 139 layoffs, 139 duration of unemployment, 139 discouraged workers, 140 employment rate, 140

collective bargaining, 143 reservation wage, 144 bargaining power, 144 efficiency wage theories, 145 unemployment insurance, 147 employment protection, 147 production function, 147 labor productivity, 147 markup, 148 wage-setting relation, 149 price-setting relation, 150 natural rate of unemployment, 150 structural rate of unemployment, 151

Questions and Problems QuICk CheCk MyEconLab Visit www.myeconlab.com to complete all Quick Check problems and get instant feedback. 1. Using the information in this chapter, label each of the following statements true, false, or uncertain. Explain briefly.

a. Since 1950, the participation rate in the United States has remained roughly constant at 60%.

b. Each month, the flows into and out of employment are very small compared to the size of the labor force.

c. Fewer than 10% of all unemployed workers exit the unem- ployment pool each year.

d. The unemployment rate tends to be high in recessions and low in expansions.

e. Most workers are typically paid their reservation wage. f. Workers who do not belong to unions have no bargaining

power. g. It may be in the best interest of employers to pay wages

higher than their workers’ reservation wage. h. The natural rate of unemployment is unaffected by policy

changes.

2. Answer the following questions using the information provided in this chapter.

a. As a percentage of employed workers, what is the size of the flows into and out of employment (i.e., hires and separa- tions) each month?

b. As a percentage of unemployed workers, what is the size of the flows from unemployment into employment each month?

c. As a percentage of the unemployed, what is the size of total flows out of unemployment each month? What is the aver- age duration of unemployment?

d. As a percentage of the labor force, what is the size of the total flows into and out of the labor force each month?

e. In the text we say that there is an average of 450,000 new workers entering the labor force each month. What per- centage of total flows into the labor force do new workers entering the labor force constitute?

3. The natural rate of unemployment Suppose that the markup of goods prices over marginal cost is

5%, and that the wage-setting equation is

W = P11 - u2, where u is the unemployment rate.

a. What is the real wage, as determined by the price-setting equation?

b. What is the natural rate of unemployment? c. Suppose that the markup of prices over costs increases to

10%. What happens to the natural rate of unemployment? Explain the logic behind your answer.

DIg Deeper MyEconLab Visit www.myeconlab.com to complete all Dig Deeper problems and get instant feedback.

4. Reservation wages In the mid-1980s, a famous supermodel once said that she

would not get out of bed for less than $10,000 (presumably per day).

154 The Medium Run The Core

a. Calculate measured employment and unemployment and the measured labor force for each economy. Calcu- late the measured unemployment rate and participation rate for each economy. In which economy is measured GDP higher?

b. Suppose now that EatIn’s economy changes. A few restau- rants open, and the food preparation workers in 10 house- holds take jobs in restaurants. The members of these 10 households now eat all of their meals in restaurants. The food-preparation workers in the remaining 15 households continue to work at home and do not seek jobs in the formal sector. The members of these 15 households continue to eat all of their meals at home. Without calculating the num- bers, what will happen to measured employment and unem- ployment and to the measured labor force, unemployment rate, and participation rate in EatIn? What will happen to measured GDP in EatIn?

c. Suppose that you want to include work at home in GDP and the employment statistics. How would you measure the value of work at home in GDP? How would you alter the definitions of employment, unemployment, and out of the labor force?

d. Given your new definitions in part (c), would the labor- market statistics differ for EatIn and EatOut? Assuming that the food produced by these economies has the same value, would measured GDP in these economies differ? Under your new definitions, would the experiment in part (b) have any effect on the labor market or GDP statistics for EatIn?

expLore FurTher 8. Unemployment durations and long-term unemployment

According to the data presented in this chapter, about 44% of unemployed workers leave unemployment each month.

a. Assume that the probability of leaving unemployment is the same for all unemployed, independent of how they have been unemployed. What is the probability that an unem- ployed worker will still be unemployed after one month? two months? six months?

Now consider the composition of the unemployment pool. We will use a simple experiment to determine the proportion of the unemployed who have been unemployed six months or more. Suppose the number of unemployed workers is constant and equal to x. Each month, 47% of the unemployed find jobs, and an equivalent number of previously employed workers become unemployed.

b. Consider the group of x workers who are unemployed this month. After a month, what percentage of this group will still be unemployed? (Hint: If 47% of unemployed workers find jobs every month, what percentage of the original x unemployed workers did not find jobs in the first month?)

c. After a second month, what percentage of the original x unemployed workers has been unemployed for at least two months? [Hint: Given your answer to part (b), what percentage of those unemployed for at least one month do not find jobs in the second month?] After the sixth month, what percentage of the original x unemployed workers has been unemployed for at least six months?

a. What is your own reservation wage? b. Did your first job pay more than your reservation wage at

the time? c. Relative to your reservation wage at the time you accept

each job, which job pays more: your first one or the one you expect to have in 10 years?

d. Explain your answers to parts (a) through (c) in terms of the efficiency wage theory.

e. Part of the policy response to the crisis was to extend the length of time workers could receive unemployment ben- efits. How would this affect reservation wages if this change was made permanent?

5. Bargaining power and wage determination Even in the absence of collective bargaining, workers do have

some bargaining power that allows them to receive wages higher than their reservation wage. Each worker’s bargaining power depends both on the nature of the job and on the economy-wide labor market conditions. Let’s consider each factor in turn.

a. Compare the job of a delivery person and a computer net- work administrator. In which of these jobs does a worker have more bargaining power? Why?

b. For any given job, how do labor market conditions affect a worker’s bargaining power? Which labor-market variable would you look at to assess labor-market conditions?

c. Suppose that for given labor-market conditions [the variable you identified in part (b)], worker bargaining power through- out the economy increases. What effect would this have on the real wage in the medium run? in the short run? What de- termines the real wage in the model described in this chapter?

6. The existence of unemployment a. Consider Figure 7-6. Suppose the unemployment rate is

very low. How does the low unemployment rate change the relative bargaining power of workers and firms? What do your answers imply about what happens to the wage as the unemployment rate gets very low?

b. Given your answer to part (a), why is there unemployment in the economy? (What would happen to real wages if the unemployment rate were equal to zero?)

7. The informal labor market You learned in Chapter 2 that informal work at home (e.g., 

preparing meals, taking care of children) is not counted as part of GDP. Such work also does not constitute employment in labor-market statistics. With these observations in mind, consider two economies, each with 100 people, divided into 25 households each composed of four people. In each household, one person stays at home and pre- pares the food, two people work in the nonfood sector, and one person is unemployed. Assume that the workers outside food preparation produce the same actual and measured output in both economies.

In the first economy, EatIn, the 25 food-preparation work- ers (one per household) cook for their families and do not work outside the home. All meals are prepared and eaten at home. The 25 food-preparation workers in this economy do not seek work in the formal labor market (and when asked, they say they are not looking for work). In the second economy, EatOut, the 25 food-preparation workers are employed by restaurants. All meals are purchased in restaurants.

Chapter 7 The Labor Market 155

d. Using Table B-13 of the Economic Report of the President [this is the Table number as of the 2015 Report) you can compute the proportion of unemployed who have been un- employed six months or more (27 weeks or more) for each year between 2000 and 2014. How do the numbers be- tween 2000 and 2008 (the pre-crisis years) compare with the answer you obtained in part (c)? Can you guess what may account for the difference between the actual num- bers and the answer you obtained in this problem? (Hint: Suppose that the probability of exiting unemployment decreases the longer you are unemployed.)

e. What happens to the percentage of unemployed who have been unemployed 6 months or more during the crisis years 2009 to 2011?

f. Is there any evidence of the crisis ending when you look at the percentage of the unemployed who have been unem- ployed 6 months or more?

g. Part of the policy response to the crisis was an extension of the length of time that an unemployed worker could receive unemployment benefits. How do you predict this change would affect the proportion of those unemployed more than six months? Did this occur?

9. Go to the Web site maintained by the U.S. Bureau of Labor Statistics (www.bls.gov). Find the latest Employment Situation Summary. Look under the link “National Employment.”

a. What are the latest monthly data on the size of the U.S. civil- ian labor force, on the number of unemployed, and on the unemployment rate?

b. How many people are employed? c. Compute the change in the number of unemployed from

the first number in the table to the most recent month in the table. Do the same for the number of employed work- ers. Is the decline in unemployment equal to the increase in employment? Explain in words.

10. The typical dynamics of unemployment over a recession The table below shows the behavior of annual real GDP growth

during three recessions. These data are from Table B-4 of the Eco- nomic Report of the President.

Year Real GDP Growth Unemployment Rate

1981 2.5

1982 - 1.9

1983 4.5

1990 1.9

1991 - 0.2

1992 3.4

2008 0.0

2009 - 2.6

2010 2.9

Use Table B-35 from the Economic Report of the President to fill in the annual values of the unemployment rate in the table above and consider these questions.

a. When is the unemployment rate in a recession higher, during the year of declining output or the following year? Explain why?

b. Explain the pattern of the unemployment rate after a reces- sion if discouraged workers return to the labor force as the economy recovers.

c. The rate of unemployment remains substantially higher after the crisis-induced recession in 2009. In that reces- sion, unemployment benefits were extended in length from 6 months to 12 months. What does the model predict the effect of this policy will be on the natural rate of unemploy- ment? Do the data support this prediction in any way?

Further Reading ■■ A further discussion of unemployment along the lines of

this chapter is given by Richard Layard, Stephen Nickell, and Richard Jackman in The Unemployment Crisis (1994).

APPEnDIx: Wage- and Price-Setting Relations versus Labor Supply and Labor Demand

If you have taken a microeconomics course, you probably saw a representation of labor-market equilibrium in terms of labor supply and labor demand. You may therefore be asking your- self: How does the representation in terms of wage setting and price setting relate to the representation of the labor market I saw in that course?

In an important sense, the two representations are similar. To see why, let’s redraw Figure 7-6 in terms of the real

wage on the vertical axis, and the level of employment (rather

than the unemployment rate) on the horizontal axis. We do this in Figure 1.

Employment, N, is measured on the horizontal axis. The level of employment must be somewhere between zero and L, the labor force. Employment cannot exceed the number of people available for work (i.e., the labor force). For any employ- ment level N, unemployment is given by U = L - N. Knowing this, we can measure unemployment by starting from L and moving to the left on the horizontal axis. Unemployment is given

156 The Medium Run The Core

conventionally, that there were decreasing returns to labor in production, our price-setting curve would, like the standard labor-demand curve, be downward sloping. As employment increased, the marginal cost of production would increase, forcing firms to increase their prices given the wages they pay. In other words, the real wage implied by price setting would decrease as employment increased.

But in a number of ways, the two approaches are different:

■■ The standard labor-supply relation gives the wage at which a given number of workers are willing to work. The higher the wage, the larger the number of workers who are willing to work.

In contrast, the wage corresponding to a given level of employment in the wage-setting relation is the result of a process of bargaining between workers and firms or uni- lateral wage setting by firms. Factors like the structure of collective bargaining or the use of wages to deter quits affect the wage-setting relation. In the real world, they seem to play an important role. Yet they play no role in the standard labor-supply relation.

■■ The standard labor-demand relation gives the level of em- ployment chosen by firms at a given real wage. It is de- rived under the assumption that firms operate in competi- tive goods and labor markets and therefore take wages and prices—and by implication the real wage—as given.

In contrast, the price-setting relation takes into account the fact that in most markets firms actually set prices. Factors such as the degree of competition in the goods market affect the price-setting relation by affecting the markup. But these factors aren’t considered in the standard labor-demand relation.

■■ In the labor supply-labor demand framework, those un- employed are willingly unemployed. At the equilibrium real wage, they prefer to be unemployed rather than work.

In contrast, in the wage setting-price setting framework, unemployment is likely to be involuntary. For example, if firms pay an efficiency wage—a wage above the reserva- tion wage—workers would rather be employed than un- employed. Yet, in equilibrium, there is still involuntary un- employment. This also seems to capture reality better than does the labor supply–labor demand framework.

These are the three reasons why we have relied on the wage-setting and the price-setting relations rather than on the labor supply–labor demand approach to characterize equilibrium in this chapter.

by the distance between L and N. The lower is employment, N, the higher is unemployment, and by implication the higher is the unemployment rate, U.

Let’s now draw the wage-setting and price-setting rela- tions and characterize the equilibrium.

■■ An increase in employment (a movement to the right along the horizontal axis) implies a decrease in unemployment and therefore an increase in the real wage chosen in wage setting. Thus, the wage-setting relation is now upward sloping. Higher employment implies a higher real wage.

■■ The price-setting relation is still a horizontal line at W>P = 1>11 + m2.

■■ The equilibrium is given by point A, with “natural” employ- ment level Nn (and an implied natural unemployment rate equal to Un = 1L - Nn2>L2.

In this figure the wage-setting relation looks like a labor- supply relation. As the level of employment increases, the real wage paid to workers increases as well. For that reason, the wage-setting relation is sometimes called the “labor-supply” relation (in quotes).

What we have called the price-setting relation looks like a flat labor-demand relation. The reason it is flat rather than downward sloping has to do with our simplifying assumption of constant returns to labor in production. Had we assumed, more

Price setting

Wage setting

Employment, N LNn

N U

A

R ea

l w ag

e, W

/P

1 1 1 m

Figure 1

Wage and Price Setting and the Natural Level of Employment

157

I

8 The Phillips Curve, the Natural Rate of Unemployment, and Inflation n 1958, A. W. Phillips drew a diagram plotting the rate of inflation against the rate of unemploy- ment in the United Kingdom for each year from 1861 to 1957. He found clear evidence of a negative relation between inflation and unemployment. When unemployment was low, inflation was high, and when unemployment was high, inflation was low, often even negative.

Two years later, two U.S. economists, Paul Samuelson and Robert Solow replicated Phillips’s exercise for the United States, using data from 1900 to 1960. Figure 8-1, on page 158, reproduces their findings using consumer price index (CPI) inflation as a measure of the inflation rate. Apart from the period of high unemployment during the 1930s (the years from 1931 to 1939 are denoted by triangles and are clearly to the right of the other points in the figure), there also appeared to be a negative relation between inflation and unemployment in the United States. This relation, which Samuelson and Solow labeled the Phillips curve, rapidly became central to macroeconomic thinking and policy. It appeared to imply that countries could choose between different combinations of unemployment and inflation. A country could achieve low unemploy- ment if it were willing to tolerate higher inflation, or it could achieve price level stability—zero inflation—if it were willing to tolerate higher unemployment. Much of the discussion about mac- roeconomic policy became a discussion about which point to choose on the Phillips curve.

During the 1970s, however, this relation broke down. In the United States and most OECD countries, there was both high inflation and high unemployment, clearly contradicting the origi- nal Phillips curve. A relation reappeared, but it reappeared as a relation between the unemploy- ment rate and the change in the inflation rate. The purpose of this chapter is to explore these mutations of the Phillips curve and, more generally, to understand the relation between inflation

b A. W. Phillips was a New Zealander who taught at the London School of Econom- ics. He had, among other things, been a crocodile hunter in his youth. He also built a hydraulic machine to describe the behavior of the macroeconomy. A working version of the machine is still on display in Cambridge, England.

158 The Medium Run The Core

and unemployment. We shall derive the Phillips curve from the model of the labor market we saw in Chapter 7. And you will see how the mutations of the Phillips curve have come from changes in the way people and firms have formed expectations.

The chapter has four sections:

Section 8-1 shows how the model of the labor market we saw previously implies a relation between inflation, expected inflation, and unemployment.

Section 8-2 uses this relation to interpret the mutations of the Phillips curve over time.

Section 8-3 shows the relation between the Phillips curve and the natural rate of unemployment.

Section 8-4 further discusses the relation between unemployment and inflation across countries and over time.

8-1 Inflation, Expected Inflation, and Unemployment In Chapter 7, we derived the following equation for wage determination (equation (7.1)):

W = P e F1u, z2 The nominal wage W, set by wage setters, depends on the expected price level, P e,

on the unemployment rate, u, and on a variable, z, which captures all the other factors that affect wage determination, from unemployment benefits to the form of collective bargaining.

Also in Chapter 7, we derived the following equation for price determination (equation (6.3)):

P = 11 + m2W The price, P, set by firms (equivalently, the price level) is equal to the nominal wage,

W, times 1 plus the markup, m. We then used these two relations together with the additional assumption that the

actual price level was equal to the expected price level. Under this additional assumption,

Unemployment rate (percent)

In fla

tio n

ra te

(p er

ce nt

)

20

15

10

5

0

–5

–10

–15

0 5 10 15 20 25

Figure 8-1

Inflation versus Unemployment in the United States, 1900–1960

During the period 1900–1960 in the United States, a low unemployment rate was typi- cally associated with a high inflation rate, and a high un- employment rate was typically associated with a low or neg- ative inflation rate.

Source: Historical Statistics of the United States. http://hsus.cambridge. org/HSUSWeb/index.do.

MyEconLab Animation

Chapter 8 The Phillips Curve, the Natural Rate of Unemployment, and Inflation 159

we then derived the natural rate of unemployment. We now explore what happens when we do not impose this additional assumption.

Replacing the nominal wage in the second equation by its expression from the first gives

P = P e11 + m2 F1u, z2 An increase in the expected price level leads to an increase in nominal wages, which

in turn leads firms to increase their prices, and thus leads to an increase in the price level. An increase in the unemployment rate leads to a decrease in nominal wages, which in turn leads to lower prices, and a decrease in the price level.

It will be convenient to assume a specific form for the function, F:

F1u, z2 = 1 - au + z This captures the notion that the higher the unemployment rate, the lower is the

wage; and the higher z (e.g., the more generous unemployment benefits are), the higher is the wage. The parameter a (the Greek lowercase letter alpha) captures the strength of the effect of unemployment on the wage. Replacing the function, F, by this specific form in the equation above gives:

P = P e11 + m211 - au + z2 (8.1) This gives us a relation between the price level, the expected price level, and the unemploy-

ment rate. Our next step is to derive a relation between inflation, expected inflation, and the unemployment rate. Let p denote the inflation rate, and pe denote the expected inflation rate. Then equation (8.1) can be rewritten as:

p = p e + 1m + z2 - au (8.2) Deriving equation (8.2) from equation (8.1) is not difficult, but it is tedious; so it is

left to an appendix at the end of this chapter. What is important is that you understand each of the effects at work in equation (8.2):

■■ An increase in expected inflation, p e, leads to an increase in actual inflation, p. To see why, start from equation (8.1). An increase in the expected price level P e

leads, one for one, to an increase in the actual price level, P: If wage setters expect a higher price level, they set a higher nominal wage, which leads in turn to an increase in the price level.

Now note that, given last period’s price level, a higher price level this period im- plies a higher rate of increase in the price level from last period to this period—that is, higher inflation. Similarly, given last period’s price level, a higher expected price level this period implies a higher expected rate of increase in the price level from last period to this period—that is, higher expected inflation. Thus the fact that an in- crease in the expected price level leads to an increase in the actual price level can be restated as: An increase in expected inflation leads to an increase in inflation.

■■ Given expected inflation, pe, an increase in the markup, m, or an increase in the factors that affect wage determination—an increase in z—leads to an increase in actual inflation, p.

From equation (8.1): Given the expected price level, P e, an increase in either m or z increases the price level, P. Using the same argument as in the previous bullet to restate this proposition in terms of inflation and expected inflation: Given expected inflation, pe, an increase in either m or z leads to an increase in inflation p.

■■ Given expected inflation, pe, a decrease in the unemployment rate, u, leads to an increase in actual inflation p.

From equation (8.1): Given the expected price level, P e, a decrease in the un- employment rate, u, leads to a higher nominal wage, which leads to a higher price

b

From now on, to lighten your reading, I shall often refer to the inflation rate simply as inflation, and to the unemployment rate simply as unemployment.

b Increase in pe 1 Increase in p.

b

Increase in m or z S Increase in p.

160 The Medium Run The Core

level, P. Restating this in terms of inflation and expected inflation: Given expected inflation, pe, an increase in the unemployment rate, u, leads to an increase in inflation, p.

We need one more step before we return to a discussion of the Phillips curve. When we look at movements in inflation and unemployment in the rest of the chapter, it will often be convenient to use time indexes so that we can refer to variables such as inflation, expected inflation, or unemployment, in a specific year. So we rewrite equation (8.2) as:

pt = pte + 1m + z2 - aut (8.3) The variables pt, pt

e , and ut refer to inflation, expected inflation, and unemployment in year t. Note that there are no time indexes on m and z. This is because although m and z may move over time, they are likely to move slowly, especially relative to movement in inflation and unemployment. Thus, for the moment, we shall treat them as constant.

Equipped with equation (8.3), we can now return to the Phillips curve, and its mutations.

8-2 The Phillips Curve and Its Mutations Let’s start with the relation between unemployment and inflation as it was first discov- ered by Phillips, Samuelson, and Solow.

The Early Incarnation Assume that inflation varies from year to year around some value pQ . Assume also that inflation is not persistent, so that inflation this year is not a good predictor of inflation next year. This happens to be a good characterization of the behavior of inflation over the period that Phillips, or Solow and Samuelson, were studying. In such an environment, it makes sense for wage setters to assume that, whatever inflation was last year, inflation this year will simply be equal to pQ . In this case, pt

e = pQ and equation (8.3) becomes:

pt = pQ + 1m + z2 - aut (8.4) In this case, we shall observe a negative relation between unemployment and infla-

tion. This is precisely the negative relation between unemployment and inflation that Phillips found for the United Kingdom and Solow and Samuelson found for the United States. When unemployment was high, inflation was low, even sometimes negative. When unemployment was low, inflation was positive.

The Apparent Trade-Off and Its Disappearance When these findings were published, they suggested that policy makers faced a trade- off between inflation and unemployment. If they were willing to accept more inflation, they could achieve lower unemployment. This looked like an attractive trade-off, and starting in the early 1960s, U.S. macroeconomic policy aimed at steadily decreasing unemployment. Figure 8-2 plots the combinations of the inflation rate and the unem- ployment rate in the United States for each year from 1961 to 1969. Note how well the relation between unemployment and inflation corresponding to equation (8.4) held during the long economic expansion that lasted throughout most of the 1960s. From 1961 to 1969, the unemployment rate declined steadily from 6.8 to 3.4%, and the inflation rate steadily increased, from 1.0 to 5.5%. Put informally, the U.S. economy moved up along the original Phillips curve. It indeed appeared that, if policy makers were willing to accept higher inflation, they could achieve lower unemployment.

cDecrease in u S Increase in p.

Chapter 8 The Phillips Curve, the Natural Rate of Unemployment, and Inflation 161

Around 1970, however, the relation between the inflation rate and the unemploy- ment rate, so visible in Figure 8-2, broke down. Figure 8-3 shows the combination of the inflation rate and the unemployment rate in the United States for each year from 1970 to today. The points are scattered in a roughly symmetric cloud. There is no longer any visible relation between the unemployment rate and the inflation rate.

Why did the original Phillips curve vanish? Because wage setters changed the way they formed their expectations about inflation.

This change came, in turn, from a change in the behavior of inflation. The rate of inflation became more persistent. High inflation in one year became more likely to be followed by high inflation the next year. As a result, people, when forming expectations, started to take into account the persistence of inflation. In turn, this change in expectation formation changed the nature of the relation between unemployment and inflation.

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Inflation versus Unemployment in the United States, 1948–1969

The steady decline in the U.S. unemployment rate through- out the 1960s was associated with a steady increase in the inflation rate.

Source: Series UNRATE, CPIAUSCL Federal Reserve Economic Data (FRED) http://research.stlouisfed. org/fred2/.

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Inflation versus Unemployment in the United States, 1970–2014

Beginning in 1970 in the United States, the relation between the unemployment rate and the inflation rate disappeared.

Source: Series UNRATE, CPIAUSCL Federal Reserve Economic Data (FRED).

MyEconLab Animation MyEconLab Real-time data

162 The Medium Run The Core

Let’s look at the argument in the previous paragraph more closely. Suppose expecta- tions of inflation are formed according to:

pt e = 11 - u2pQ + upt - 1 (8.5)

In words: Expected inflation this year depends partly on a constant value, pQ , with weight, 1 - u, and partly on inflation last year, which we denote by pt - 1, with weight, u. The higher the value of u, the more last year’s inflation leads workers and firms to revise their expectations of what inflation will be this year, and so the higher is the expected inflation rate.

We can then think of what happened in the 1970s as an increase in the value of u over time:

■■ So long as inflation was not persistent, it was reasonable for workers and firms to just ignore past inflation and to assume a constant value for inflation. For the period that Phillips and Samuelson and Solow had looked at, u was close to zero, and expectations were roughly given by pe = pQ . The Phillips curve was given by equation (8.4).

■■ But as inflation became more persistent, workers and firms started changing the way they formed expectations. They started assuming that, if inflation had been high last year, inflation was likely to be high this year as well. The parameter u, the effect of last year’s inflation rate on this year’s expected inflation rate, increased. The evidence suggests that, by the mid-1970s, people expected this year’s inflation rate to be the same as last year’s inflation rate—in other words, that u was now equal to 1.

Now turn to the implications of different values of u for the relation between inflation and unemployment. To do so, substitute equation (8.5) for the value of pt

e into equation (8.2):

pt = 11 - u2pQ + upt - 1 + 1m + z2 - aut ■■ When u equals zero, we get the original Phillips curve, a relation between the

inflation rate and the unemployment rate:

pt = pQ + 1m + z2 - aut ■■ When u is positive, the inflation rate depends not only on the unemployment rate

but also on last year’s inflation rate:

pt = [11 - u2pQ + 1m + z2] + upt - 1 - aut ■■ When u equals 1, the relation becomes (moving last year’s inflation rate to the left

side of the equation)

pt - pt - 1 = 1m + z2 - aut (8.6) So, when u = 1, the unemployment rate affects not the inflation rate, but rather the

change in the inflation rate. High unemployment leads to decreasing inflation; low unem- ployment leads to increasing inflation.

This discussion is the key to what happened after 1970. As u increased from 0 to 1, the simple relation between the unemployment rate and the inflation rate disappeared. This disappearance is what we saw in Figure 8-3. But a new relation emerged, this time between the unemployment rate and the change in the inflation rate, as predicted by equation (8.5). This relation is shown in Figure 8-4, which plots the change in the inflation rate versus the unemployment rate observed for each year since 1970, and shows a clear negative relation between the change in inflation and unemployment.

pe6

Chapter 8 The Phillips Curve, the Natural Rate of Unemployment, and Inflation 163

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Change in Inflation versus Unemployment in the United States, 1970–2014

Since 1970, there has been a negative relation between the unemployment rate and the change in the inflation rate in the United States.

Series CPIAUCSL, UNRATE: Federal Reserve Economic Data (FRED) http://research.stlouisfed.org/fred2/.

MyEconLab Animation MyEconLab Real-time data

The line that best fits the scatter of points for the period 1970–2014 is given by

pt - pt - 1 = 3.0% - 0.5ut (8.7)

The line is drawn in Figure 8-4. For low unemployment, the change in inflation is positive. For high unemployment, the change in inflation is negative. To distinguish it from the original Phillips curve (equation (8.4)), equation (8.6)—or its empirical counter- part, equation (8.7)—is often called the modified Phillips curve, or the expectations- augmented Phillips curve (to indicate that pt - 1 stands for expected inflation), or the accelerationist Phillips curve (to indicate that a low unemployment rate leads to an increase in the inflation rate and thus an acceleration of the price level). We shall simply call equation (8.7) the Phillips curve and refer to the previous incarnation, equation (8.4), as the original Phillips curve.

Before we move on, one last observation. Although there is a clear negative rela- tion between unemployment and the change in the inflation rate, you can see that the relation is far from tight. Some points are far from the regression line. The Phillips curve is both a crucial and a complex economic relation. It comes with plenty of warn- ings, which we shall discuss in Section 8-4. Before we do so, let’s look at the relation of the Phillips curve to the concept of the natural rate of unemployment we derived in Chapter 7.

8-3 The Phillips Curve and the Natural Rate of Unemployment The history of the Phillips curve is closely related to the discovery of the concept of the natural rate of unemployment that we introduced in Chapter 7.

The original Phillips curve implied that there was no such thing as a natural unem- ployment rate. If policy makers were willing to tolerate a higher inflation rate, they could maintain a lower unemployment rate forever. And, indeed, throughout the 1960s, it looked as though they were right.

b This line, called a regression line, is obtained using econo- metrics. (See Appendix 3 at the end of the text.)

Original Phillips curve: Increase in ut 1 Lower inflation. (Modified) Phillips curve Increase in ut 1 Decreasing inflation

b

164 The Medium Run The Core

In the late 1960s however, although the original Phillips curve still gave a good de- scription of the data, two economists, Milton Friedman and Edmund Phelps, questioned the existence of such a trade-off between unemployment and inflation. They questioned it on logical grounds, arguing that such a trade-off could exist only if wage setters systematically underpredicted inflation and that they were unlikely to make the same mistake forever. Friedman and Phelps also argued that if the government attempted to sustain lower unemployment by accepting higher inflation, the trade-off would ulti- mately disappear; the unemployment rate could not be sustained below a certain level, a level they called the natural rate of unemployment. Events proved them right, and the trade-off between the unemployment rate and the inflation rate indeed disappeared. (See the Focus box “Theory ahead of the Facts: Milton Friedman and Edmund Phelps.”) Today, most economists accept the notion of a natural rate of unemployment, that is, subject to the many caveats we shall see in the next section.

Let’s make explicit the connection between the Phillips curve and the natural rate of unemployment.

By definition (see Chapter 7), the natural rate of unemployment is the unemploy- ment rate at which the actual price level is equal to the expected price level. Equivalently, and more conveniently here, the natural rate of unemployment is the unemployment rate such that the actual inflation rate is equal to the expected inflation rate. Denote the natural unemployment rate by un (the index n stands for “natural”). Then, imposing the condition that actual inflation and expected inflation be the same 1p = pe2 in equation (8.3) gives:

0 = 1m + z2 - aun

c

Friedman was awarded the Nobel Prize in 1976. Phelps was awarded the Nobel Prize in 2006.

Theory ahead of Facts: Milton Friedman and Edmund Phelps

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Economists are usually not good at predicting major changes before they happen, and most of their insights are derived after the fact. Here is an exception.

In the late 1960s—precisely as the original Phillips curve relation was working like a charm—two economists, Milton Friedman and Edmund Phelps, argued that the appearance of a trade-off between inflation and unemployment was an illusion.

Here are a few quotes from Milton Friedman about the Phillips curve:

“Implicitly, Phillips wrote his article for a world in which everyone anticipated that nominal prices would be stable and in which this anticipation remained unshaken and immuta- ble whatever happened to actual prices and wages. Suppose, by contrast, that everyone anticipates that prices will rise at a rate of more than 75% a year—as, for example, Brazilians did a few years ago. Then, wages must rise at that rate simply to keep real wages unchanged. An excess supply of labor [by this, Friedman means high unemployment] will be reflected in a less rapid rise in nominal wages than in anticipated prices, not in an absolute decline in wages.”

He went on:

“To state [my] conclusion differently, there is al- ways a temporary trade-off between inflation and

unemployment; there is no permanent trade-off. The tem- porary trade-off comes not from inflation per se, but from a rising rate of inflation.”

He then tried to guess how much longer the apparent trade-off between inflation and unemployment would last in the United States:

“But how long, you will say, is ‘temporary’? Á I can at most venture a personal judgment, based on some examination of the historical evidence, that the initial effect of a higher and unanticipated rate of inflation lasts for something like two to five years; that this initial effect then begins to be reversed; and that a full adjustment to the new rate of infla- tion takes as long for employment as for interest rates, say, a couple of decades.”

Friedman could not have been more right. A few years later, the original Phillips curve started to disappear, in exactly the way Friedman had predicted.

Source: Milton Friedman, “The Role of Monetary Policy,” American Economic Review 1968 58(1): pp. 1–17. (The article by Phelps, “Money-Wage Dynamics and Labor- Market Equilibrium,” Journal of Political Economy 1968 76(4–part 2): pp. 678–711, made many of the same points more formally.)

Chapter 8 The Phillips Curve, the Natural Rate of Unemployment, and Inflation 165

Solving for the natural rate un,

un = m + z

a (8.8)

The higher the markup, m, or the higher the factors that affect wage setting, z, the higher the natural rate of unemployment.

Now rewrite equation (8.3) as

pt - pte = -aaut - m + za b

Note from equation (8.8) that the fraction on the right side is equal to un, so we can rewrite the equation as

pt - pte = -a1ut - un2 (8.9) If the expected rate of inflation, pe, is well approximated by last year’s inflation rate,

pt - 1, the equation finally becomes

pt - pt - 1 = -a1ut - un2 (8.10) Equation (8.10) is an important relation, for two reasons:

■■ It gives us another way of thinking about the Phillips curve, as a relation between the actual unemployment rate u, the natural unemployment rate un, and the change in the inflation rate pt - pt - 1.

The change in the inflation rate depends on the difference between the actual and the natural unemployment rates. When the actual unemployment rate is higher than the natural unemployment rate, the inflation rate decreases; when the actual unemployment rate is lower than the natural unemployment rate, the inflation rate increases.

■■ It also gives us another way of thinking about the natural rate of unemployment: The natural rate of unemployment is the rate of unemployment required to

keep the inflation rate constant. This is why the natural rate is also called the non- accelerating inflation rate of unemployment (NAIRU).

What has been the natural rate of unemployment in the United States since 1970? Put another way: What has been the unemployment rate that, on average, has led to constant inflation?

To answer this question, all we need to do is to return to equation (8.7), the estimated relation between the change in inflation and the unemployment rate since 1970. Setting the change in inflation equal to zero in the left of the equation implies a value for the natural unemployment rate of 3.0%>0.5 = 6%. The evidence suggests that, since 1970 in the United States, the average rate of unemployment required to keep inflation constant has been equal to 6%.

8-4 A Summary and Many Warnings Let’s take stock of what we have learned:

■■ The relation between unemployment and inflation in the United States today is well captured by a relation between the change in the inflation rate and the deviation of the unemployment rate from the natural rate of unemployment (equation (8.10)).

Note that under our assump- tion that m and z are constant, the natural rate is also con- stant, so we can drop the time index. We shall return to a dis- cussion of what happens if m and z change over time.

b

ut 6 un 1 pt 7 pt - 1 ut 7 un 1 pt 6 pt - 1

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Calling the natural rate the nonaccelerating inflation rate of unemployment is actually wrong. It should be called the nonincreasing inflation rate of unemployment, or NIIRU. But NAIRU has now become so standard that it is too late to change it.

b

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166 The Medium Run The Core

■■ When the unemployment rate exceeds the natural rate of unemployment, the infla- tion rate typically decreases. When the unemployment rate is below the natural rate of unemployment, the inflation rate typically increases.

This relation has held quite well since 1970. But evidence from its earlier history, as well as the evidence from other countries, points to the need for a number of warnings. All of them are on the same theme. The relation between inflation and unemployment can and does vary across countries and time.

Variations in the Natural Rate across Countries Recall from equation (8.8) that the natural rate of unemployment depends on all the factors that affect wage setting, represented by the catchall variable, z; the markup set by firms, m; and the response of inflation to unemployment, represented by a. If these factors differ across countries, there is no reason to expect all countries to have the same natural rate of unemployment. And natural rates indeed differ across countries, some- times considerably.

Take, for example, the unemployment rate in the Euro area, which has averaged close to 9% since 1990. A high unemployment rate for a few years may well reflect a de- viation of the unemployment rate from the natural rate. A high average unemployment rate for 25 years, together with no sustained decrease in inflation, surely reflects a high natural rate. This tells us where we should look for explanations, namely in the factors determining the wage-setting and the price-setting relations.

Is it easy to identify the relevant factors? One often hears the statement that one of the main problems of Europe is its labor-market rigidities. These rigidities, the argu- ment goes, are responsible for its high unemployment. Although there is some truth to this statement, the reality is more complex. The Focus box, “What Explains European Unemployment?” discusses these issues further.

Variations in the Natural Rate over Time In estimating equation (8.6), we implicitly treated m + z as a constant. But there are good reasons to believe that m and z may vary over time. The degree of monopoly power of firms, the costs of inputs other than labor, the structure of wage bargain- ing, the system of unemployment benefits, and so on, are likely to change over time, leading to changes in either m or z and, by implication, changes in the natural rate of unemployment.

Changes in the natural unemployment rate over time are hard to measure. The reason is simply that we do not observe the natural rate, only the actual rate. But broad evolutions can be established by comparing average unemployment rates, say across decades. Using this approach, the Focus box “What Explains European Unemployment?” discusses how and why the natural rate of unemployment has in- creased in Europe since the 1960s. The U.S. natural rate has moved much less than that in Europe. Nevertheless, it is also far from constant. Go back and look at Figure 7-3. You can see that, from the 1950s to the 1980s, the unemployment rate fluctuated around a slowly increasing trend: Average unemployment was 4.5% in the 1950s, and 7.3% in the 1980s. Then, from 1990 on, and until the crisis, the trend was re- versed, with an average unemployment rate of 5.8% in the 1990s, and an average unemployment rate of 5.0% from 2000 to 2007. In 2007, the unemployment rate was 4.6%, and inflation was roughly constant, suggesting that unemployment was close to the natural rate. Why the U.S. natural rate of unemployment fell from the early 1990s on and what the effects of the crisis may be for the future are discussed

cGo back and look at Table 1-3 in Chapter 1.

Chapter 8 The Phillips Curve, the Natural Rate of Unemployment, and Inflation 167

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What Explains European unemployment?

What do critics have in mind when they talk about the “labor-market rigidities” afflicting Europe? They have in mind in particular:

■■ A generous system of unemployment insurance. The replacement rate—that is, the ratio of unemployment benefits to the after-tax wage—is often high in Europe, and the duration of benefits—the period of time for which the unemployed are entitled to receive benefits— often runs in years.

Some unemployment insurance is clearly desirable. But generous benefits are likely to increase unemploy- ment in at least two ways. They decrease the incentives the unemployed have to search for jobs. They may also increase the wage that firms have to pay. Recall our dis- cussion of efficiency wages in Chapter 7. The higher unemployment benefits are, the higher the wages firms have to pay to motivate and keep workers.

■■ A high degree of employment protection. By employ- ment protection, economists have in mind the set of rules that increase the cost of layoffs for firms. These range from high severance payments, to the need for firms to justify layoffs, to the possibility for workers to appeal the decision and have it reversed.

The purpose of employment protection is to decrease layoffs, and thus to protect workers from the risk of un- employment. It indeed does that. What it also does, how- ever, is to increase the cost of labor for firms and thus to reduce hires and make it harder for the unemployed to get jobs. The evidence suggests that, although employment protection does not necessarily increase unemployment, it changes its nature. The flows in and out of unemploy- ment decrease, but the average duration of unemploy- ment increases. Such long durations increase the risk that the unemployed lose skills and morale, decreasing their employability.

■■ Minimum wages. Most European countries have na- tional minimum wages. And in some countries, the ratio of the minimum wage to the median wage can be quite high. High minimum wages clearly run the risk of limiting employment for the least-skilled workers, thus increasing their unemployment rate.

■■ Bargaining rules. In most European countries, labor con- tracts are subject to extension agreements. A con- tract agreed to by a subset of firms and unions can be automatically extended to all firms in the sector. This considerably reinforces the bargaining power of unions because it reduces the scope for competition by nonunion- ized firms. As we saw in Chapter 7, stronger bargaining power on the part of the unions may result in higher un- employment. Higher unemployment is needed to recon- cile the demands of workers with the wages paid by firms.

Do these labor-market institutions really explain high un- employment in Europe? Is the case open and shut? Not quite. Here it is important to recall two important facts.

Fact 1: Unemployment was not always high in Europe. In the 1960s, the unemployment rate in the four major conti- nental European countries was lower than that in the United States, around 2 to 3%. U.S. economists would cross the ocean to study the “European unemployment miracle”! The natural rate in these countries today is around 8 to 9%. How do we explain this increase?

One hypothesis is that institutions were different then, and that labor-market rigidities have only appeared in the last 40 years. This turns out not to be the case, however. It is true that, in response to the adverse shocks of the 1970s (in particular the two recessions following the increases in the price of oil), many European governments increased the generosity of unemployment insurance and the degree of employment protection. But even in the 1960s, European la- bor-market institutions looked nothing like U.S. labor-market institutions. Social protection was much higher in Europe; yet unemployment was lower.

A more convincing line of explanation focuses on the interaction between institutions and shocks. Some labor- market institutions may be benign in some environments, yet costly in others. Take employment protection. If competition between firms is limited, the need to adjust employment in each firm may be limited as well, and so the cost of employ- ment protection may be low. But if competition, either from other domestic firms or from foreign firms, increases, the cost of employment protection may become high. Firms that can- not adjust their labor force quickly may simply be unable to compete and go out of business.

Fact 2: Prior to the start of the current crisis started, a number of European countries actually had low unemploy- ment. This is shown in Figure 1, which gives the unemploy- ment rate for 15 European countries (the 15 members of the European Union before the increase in membership to 27) in 2006. I chose 2006 because, in all these countries, infla- tion was stable, suggesting that the unemployment rate was roughly equal to the natural rate.

As you can see, the unemployment rate was indeed high in the four large continental countries: France, Spain, Germany, and Italy. But note how low the unemployment rate was in some of the other countries, in particular Denmark, Ireland, and the Netherlands.

Is it the case that these low unemployment countries had low benefits, low employment protection, and weak unions? Things are unfortunately not so simple. Countries such as Ireland or the United Kingdom indeed have labor-market institutions that resemble those of the United States: limited benefits, low employment protection, and weak unions. But countries such as Denmark or the Netherlands have a high degree of social protection (in particular high unemployment benefits) and strong unions.

So what is one to conclude? An emerging consensus among economists is that the devil is in the details. Generous social protection is consistent with low unemployment. But it has to be provided efficiently. For example, unemployment

168 The Medium Run The Core

benefits can be generous, so long as the unemployed are, at the same time, forced to take jobs if such jobs are available. Employment protection (e.g., in the form of generous sever- ance payments) may be consistent with low unemployment, so long as firms do not face the prospect of long adminis- trative or judicial uncertainty when they lay off workers. Countries such as Denmark appear to have been more successful in achieving these goals. Creating incentives for

the unemployed to take jobs and simplifying the rules of employment protection are on the reform agenda of many European governments. One may hope they will lead to a decrease in the natural rate in the future.

For more on European unemployment, read Olivier Blanchard, “European Unemployment. The Evolution of Facts and Ideas,” Economic Policy, 2006 (1): pp. 1–54.

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Figure 1 Unemployment Rates in 15 European Countries, 2006

in the Focus box “Changes in the U.S. Natural Rate of Unemployment since 1990.” We draw two conclusions from the behavior of the U.S. unemployment rate since 1990 and these conclusions parallel the conclusion from our look at European unemployment in the Focus box. The determinants of the natural rate are many. We can identify a num- ber of them, but knowing their respective role and drawing policy lessons is not easy.

High Inflation and the Phillips Curve Relation Recall how, in the 1970s, the U.S. Phillips curve changed as inflation became more per- sistent and wage setters changed the way they formed inflation expectations. The lesson is a general one. The relation between unemployment and inflation is likely to change with the level and the persistence of inflation. Evidence from countries with high infla- tion confirms this lesson. Not only does the way workers and firms form their expecta- tions change, but so do institutional arrangements.

When the inflation rate becomes high, inflation also tends to become more variable. As a result, workers and firms become more reluctant to enter into labor contracts that set nominal wages for a long period of time. If inflation turns out higher than expected, real wages may plunge and workers will suffer a large cut in their living standard. If

More concretely, when infla- tion runs on average at 3% a year, wage setters can be rea- sonably confident inflation will be between 1 and 5%. When inflation runs on average at 30% a year, wage setters can be confident inflation will be between 20 and 40%. In the first case, the real wage may end up 2% higher or lower than they expected when they set the nominal wage. In the second case, it may end up 10% higher or lower than they expected. There is much more uncertainty in the second case.

c

Chapter 8 The Phillips Curve, the Natural Rate of Unemployment, and Inflation 169

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changes in the u.s. Natural Rate of unemployment since 1990

As we discussed in the text, the natural rate of unemploy- ment appears to have decreased in the United States from around 7 to 8% in the 1980s to close to 5% today. (At the time of writing, the unemployment rate stands at 5.5%, and inflation is stable). Researchers have offered a number of explanations.

■■ Increased globalization and stronger competition be- tween U.S. and foreign firms may have led to a decrease in monopoly power and a decrease in the markup. Also, the fact that firms can more easily move some of their operations abroad surely makes them stronger when bargaining with their workers. The evidence is that unions in the U.S. economy are becoming weaker. The unionization rate in the United States, which stood at 25% in the mid-1970s, is around 10% today. As we saw, weaker bargaining power on the part of workers is likely to lead to lower unemployment.

■■ The nature of the labor market has changed. In 1980, employment by temporary help agencies accounted for less than 0.5% of total U.S. employment. Today, it ac- counts for more than 2%. This is also likely to have reduced the natural rate of unemployment. In effect, it allows many workers to look for jobs while being em- ployed rather than unemployed. The increasing role of Internet-based job sites, such as Monster.com, has also made matching of jobs and workers easier, leading to lower unemployment.

Some of the other explanations may surprise you. For example, researchers have also pointed to:

■■ The aging of the U.S. population. The proportion of young workers (workers between the ages of 16 and 24) fell from 24% in 1980 to 14% today. This reflects the end of the baby boom, which ended in the mid-1960s. Young workers tend to start their working life by going from job to job and typically have a higher unemployment rate. So, a decrease in the proportion of young workers leads to a decrease in the overall unemployment rate.

■■ An increase in the incarceration rate. The proportion of the population in prison or in jail has tripled in the last 20 years in the United States. In 1980, 0.3% of the U.S.

population of working age was in prison. Today the pro- portion has increased to 1.0%. Because many of those in prison would likely have been unemployed were they not incarcerated, this is likely to have had an effect on the unemployment rate.

■■ The increase in the number of workers on disability. A relaxation of eligibility criteria since 1984 has led to a steady increase in the number of workers receiving disability insurance, from 2.2% of the working age population in 1984 to 4.3% today. It is again likely that, absent changes in the rules, some of the workers on dis- ability insurance would have been unemployed instead.

Will the natural rate of unemployment remain low in the future? Globalization, aging, prisons, temporary help agen- cies, and the increasing role of the Internet are probably here to stay, suggesting that the natural rate could indeed remain low. During the crisis, there was however the worry that the large increase in actual unemployment (close to 10% in 2010) might eventually translate into an increase in the natural unemployment rate. The mechanism through which this may happen is known as hysteresis (in economics, hysteresis is used to mean that, “after a shock, a variable does not return to its initial value, even when the shock has gone away”). Workers who have been unemployed for a long time may lose their skills, or their morale, and become, in effect, unemploy- able, leading to a higher natural rate. This was a relevant concern. As we saw in Chapter 7, in 2010, the average dura- tion of unemployment was 33 weeks, an exceptionally high number by historical standards. Forty-three percent of the unemployed had been unemployed for more than six months, and 28% for more than a year. When the economy picked up, how many of them would be scarred by their unemployment experience and hard to reemploy? The verdict is not in yet. But, given the current relatively low unemployment rate and the absence of pressure on inflation, it looks like this worry may not have been justified, at least at the macroeconomic level.

For more on the decrease in the natural rate, read “The High- Pressure U.S. Labor Market of the 1990s,” by Lawrence Katz and Alan Krueger, Brookings Papers on Economic Activity, 1999 (1): pp. 1–87.

inflation turns out lower than expected, real wages may sharply increase. Firms may not be able to pay their workers. Some may go bankrupt.

For this reason, the terms of wage agreements change with the level of inflation. Nominal wages are set for shorter periods of time, down from a year to a month or even less. Wage indexation, which is a provision that automatically increases wages in line with inflation, becomes more prevalent.

These changes lead in turn to a stronger response of inflation to unemployment. To see this, an example based on wage indexation will help. Imagine an economy that has two types of labor contracts. A proportion l (the Greek lowercase letter lambda) of labor

170 The Medium Run The Core

contracts is indexed. Nominal wages in those contracts move one-for-one with variations in the actual price level. A proportion 1 - l of labor contracts is not indexed. Nominal wages are set on the basis of expected inflation.

Under this assumption, equation (8.9) becomes

pt = 3lpt + 11 - l2pte4 - a1ut - un2 The term in brackets on the right reflects the fact that a proportion l of contracts

is indexed and thus responds to actual inflation pt, and a proportion, 1 - l, responds to expected inflation, pt

e. If we assume that this year’s expected inflation is equal to last year’s actual inflation, pt

e = pt - 1, we get

pt = 3lpt + 11 - l2pt - 14 - a1ut - un2 (8.11) When l = 0, all wages are set on the basis of expected inflation—which is equal to

last year’s inflation, pt - 1—and the equation reduces to equation (8.10):

pt - pt - 1 = -a1ut - un2 When l is positive, however, a proportion l of wages is set on the basis of actual

inflation rather than expected inflation. To see what this implies, reorganize equation (8.11). Move the term in brackets to the left, factor 11 - l2 on the left of the equation, and divide both sides by 1 - l to get:

pt - pt - 1 = - a

11 - l2 1ut - un2

Wage indexation increases the effect of unemployment on inflation. The higher the proportion of wage contracts that are indexed—the higher l—the larger the effect the unemployment rate has on the change in inflation—the higher the coefficient a>11 - l2.

The intuition is as follows: Without wage indexation, lower unemployment in- creases wages, which in turn increases prices. But because wages do not respond to prices right away, there is no further increase in prices within the year. With wage index- ation, however, an increase in prices leads to a further increase in wages within the year, which leads to a further increase in prices, and so on, so that the effect of unemployment on inflation within the year is higher.

If, and when, l gets close to 1—which is when most labor contracts allow for wage in- dexation—small changes in unemployment can lead to large changes in inflation. Put an- other way, there can be large changes in inflation with nearly no change in unemployment. This is what happens in countries where inflation is high. The relation between inflation and unemployment becomes more and more tenuous and eventually disappears altogether.

Deflation and the Phillips Curve Relation We have just looked at what happens to the Phillips curve when inflation is high. Another issue is what happens when inflation is low, and possibly negative—when there is deflation.

The motivation for asking this question is given by an aspect of Figure 8-1 we men- tioned at the start of the chapter but then left aside. In that figure, note how the points corresponding to the 1930s (they are denoted by triangles) lie to the right of the others. Not only is unemployment unusually high—this is no surprise because we are looking at the years corresponding to the Great Depression—but, given the high unemployment rate, the inflation rate is surprisingly high. In other words, given the high unemployment rate, we would have expected not merely deflation, but a large rate of deflation. In fact, deflation was limited, and from 1934 to 1937, despite still high unemployment, inflation actually turned positive.

Chapter 8 The Phillips Curve, the Natural Rate of Unemployment, and Inflation 171

How do we interpret this fact? There are two potential explanations. One is that the Great Depression was associated with an increase not only in the

actual unemployment rate but also in the natural unemployment rate. This seems un- likely. Most economic historians see the Great Depression primarily as the result of a large adverse shift in aggregate demand leading to an increase in the actual unemploy- ment rate over the natural rate of unemployment, rather than an increase in the natural rate of unemployment itself.

The other is that, when the economy starts experiencing deflation, the Phillips curve relation breaks down. One possible reason is the reluctance of workers to accept de- creases in their nominal wages. Workers will unwittingly accept a cut in their real wages that occurs when their nominal wages increase more slowly than inflation. However, they are likely to fight the same cut in their real wages if it results from an overt cut in their nominal wages. This mechanism is clearly at work in some countries. Figure 8-5 for example plots the distribution of wage changes in Portugal in two different years, 1984 when inflation rate was a high 27%, and in 2012, when the inflation rate was just 2.1%. Note how the distribution of wage changes is roughly symmetric in 1984, and how it is bunched at zero in 2012, with nearly no negative wage changes. To the extent that this mechanism is at work, this implies that the Phillips curve relation between the change in inflation and unemployment may disappear, or at least become weaker, when the economy is close to zero inflation.

b

If un increases with u, then u - un may remain small even if u is high.

b

Consider two scenarios. In one, inflation is 4%, and your nomi- nal wage goes up by 2%. In the other, inflation is 0%, and your nominal wage is cut by 2%. Which do you dislike most? You should be indifferent be- tween the two. In both cases, your real wage goes down by 2%. There is some evidence, however, that most people find the first scenario less painful, and thus suffer from money illusion, a term made more explicit in Chapter 24.

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Figure 8-5

Distribution of wage changes in Portugal, in times of high and low inflation

Source: Pedro Portugal, based on Portuguese household survey.

MyEconLab Animation

172 The Medium Run The Core

When inflation is low, few workers accept a cut in nominal wages. This issue is not just of historical interest. During the recent crisis, unemployment

increased dramatically in many countries. One would have expected it to lead to a large decrease in inflation, indeed to substantial deflation. Yet, although a few countries ex- perienced deflation, it has remained limited. In general, inflation has been higher than would have been predicted by estimated versions of equation (8.6) (estimated separately in each country). Whether this is due to the mechanism we just described, or whether it reflects a change in expectation formation (a decrease in u) remains to be seen.

c

A decrease in u would imply a return to a relation closer to equation (8.3), with a relation between the level of inflation and unemployment. This could explain why high unemploy- ment has led to lower inflation, rather than steadily decreasing inflation.

Summary natural unemployment rate, the inflation rate typically increases.

■■ The natural rate of unemployment depends on many factors that differ across countries and can change over time. This is why the natural rate of unemployment varies across coun- tries. It is higher in Europe than in the United States. Also, the natural unemployment rate varies over time. In Europe, the natural unemployment rate has greatly increased since the 1960s. In the United States, the natural unemployment rate increased from the 1960s to the 1980s and appears to have decreased since.

■■ Changes in the way the inflation rate varies over time affect the way wage setters form expectations and also affects how much they use wage indexation. When wage indexation is widespread, small changes in unemployment can lead to large changes in inflation. At high rates of inflation, the relation between inflation and unemployment disappears altogether.

■■ At very low or negative rates of inflation, the Phillips curve relation appears to become weaker. During the Great Depression even high unemployment led only to limited de- flation. The issue is important because many countries have both high unemployment and low inflation today.

■■ Labor market equilibrium implies a relation between infla- tion, expected inflation, and unemployment. Given unem- ployment, higher expected inflation leads to higher inflation. Given expected inflation, higher unemployment leads to lower inflation.

■■ When inflation is not persistent, expected inflation does not depend on past inflation. Thus, the relation becomes a relation between inflation and unemployment. This is what Phillips in the United Kingdom and Solow and Samuelson in the United States discovered when they looked, in the late 1950s, at the joint behavior of unemployment and inflation.

■■ As inflation became more persistent starting in the 1960s, expectations of inflation became based more and more on past inflation. The relation became a relation between un- employment and the change in inflation. High unemploy- ment led to decreasing inflation; low unemployment led to increasing inflation.

■■ The natural unemployment rate is the unemployment rate at which the inflation rate remains constant. When the actual unemployment rate exceeds the natural rate of unemployment, the inflation rate typically decreases; when the actual unemployment rate is less than the

Key Terms Phillips curve, 157 modified Phillips curve, 163 expectations-augmented Phillips curve, 163 accelerationist Phillips curve, 163

non-accelerating inflation rate of unemployment (NAIRU), 165 labor-market rigidities, 166 extension agreements, 167 wage indexation, 169

Questions and Problems Quick check MyEconLab Visit www.myeconlab.com to complete all Quick Check problems and get instant feedback. 1. Using the information in this chapter, label each of the following statements true, false, or uncertain. Explain briefly.

a. The original Phillips curve is the negative relation between unemployment and inflation that was first observed in the United Kingdom.

b. The original Phillips curve relation has proven to be very stable across countries and over time.

c. For some periods of history, inflation has been very persis- tent between adjacent years. In other periods of history, this year’s inflation has been a poor predictor of next year’s inflation.

d. Policy makers can exploit the inflation–unemployment trade-off only temporarily.

MyEconLab Real-time data exercises are marked .

Chapter 8 The Phillips Curve, the Natural Rate of Unemployment, and Inflation 173

e. Expected inflation always equals actual inflation. f. In the late 1960s, the economists Milton Friedman and

Edmund Phelps said that policy makers could achieve as low a rate of unemployment as they wanted.

g. If people assume that inflation will be the same as last year’s inflation, the Phillips curve relation will be a relation between the change in the inflation rate and the unemploy- ment rate.

h. The natural rate of unemployment is constant over time within a country.

i. The natural rate of unemployment is the same in all countries.

j. Deflation means that the rate of inflation is negative.

2. Discuss the following statements. a. The Phillips curve implies that when unemployment is

high, inflation is low, and vice versa. Therefore, we may ex- perience either high inflation or high unemployment, but we will never experience both together.

b. As long as we do not mind having high inflation, we can achieve as low a level of unemployment as we want. All we have to do is increase the demand for goods and services by using, for example, expansionary fiscal policy.

c. In periods of deflation, workers resist reductions in their nominal wages in spite of the fact prices are falling.

3. The natural rate of unemployment a. The Phillips curve is pt = pte + 1m + z2 - aut.

Rewrite this relation as a relation between the deviation of the unemployment rate from the natural rate, inflation, and expected inflation.

b. In the previous chapter, we derived the natural rate of unemployment. What condition on the price level and the expected price level was imposed in that derivation? How does it relate to the condition imposed in part a?

c. How does the natural rate of unemployment vary with the markup?

d. How does the natural rate of unemployment vary with the catchall term z ?

e. Identify two important sources of variation in the natu- ral rate of unemployment across countries and across time.

4. The formation of expected inflation

The text proposes the following model of expected inflation

pt e = 11 - u2 pQ + upt - 1

a. Describe the process of the formation of expected inflation when u = 0.

b. Describe the process of the formation of expected inflation when u = 1.

c. How do you form your own expectation of inflation? More like a, or more like b?

5. Mutations of the Phillips curve

Suppose that the Phillips curve is given by

pt = pte + 0.1 - 2ut

and expected inflation is given by

pt e = 11 - u2 pQ + upt - 1

and suppose that u is initially equal to 0 and pQ is given and does not change. It could be zero or any positive value. Suppose that the rate of unemployment is initially equal to the natural rate. In year t, the authorities decide to bring the unemployment rate down to 3% and hold it there forever.

a. Determine the rate of inflation in periods t + 1, t + 2, t + 3, t + 4, t + 5. How does pQ compare to pibar?

b. Do you believe the answer given in (a)? Why or why not? (Hint: Think about how people are more likely to form expectations of inflation.) Now suppose that in year t + 6, u increases from 0 to 1. Suppose that the government is still determined to keep u at 3% forever.

c. Why might u increase in this way? d. What will the inflation rate be in years t + 6, t + 7, and

t + 8? e. What happens to inflation when u = 1 and unemploy-

ment is kept below the natural rate of unemployment? f. What happens to inflation when u = 1 and unemployment

is kept at the natural rate of unemployment?

Dig DeePer MyEconLab Visit www.myeconlab.com to complete all Dig Deeper problems and get instant feedback. 6. The macroeconomic effects of the indexation of wages

Suppose that the Phillips curve is given by

pt - pte = 0.1 - 2ut where

pt e = pt - 1

Suppose that inflation in year t - 1 is zero. In year t, the central bank decides to keep the unemployment rate at 4% forever.

a. Compute the rate of inflation for years t, t + 1, t + 2, and t + 3. Now suppose that half the workers have indexed labor contracts.

b. What is the new equation for the Phillips curve? c. Based on your answer to part (b), recompute your answer

to part (a). d. What is the effect of wage indexation on the relation be-

tween p and u?

7. Estimating the natural rate of unemployment To answer this question, you will need data on the annual

U.S. unemployment and inflation rates since 1970, which can be obtained very easily from the Economic Report of the President https://www.whitehouse.gov/sites/default/files/ docs/2015_erp_appendix_b.pdf Excel tables of the values can be downloaded.

Retrieve the annual data for the civilian unemployment rate. In the 2015 ERP, this is Table B-12. In addition, retrieve the annual percentage increase for the consumer price index (CPI), all urban consumers. In the 2015 ERP, this is Table B-10. You can access the same data at the Federal Reserve Bank of St. Louis FRED Web site.

174 The Medium Run The Core

a. Plot the data for all the years since 1970 on a diagram, with the change in inflation on the vertical axis and the rate of unemployment on the horizontal axis. Is your graph similar to Figure 8-4 ?

b. Using a ruler, draw the line that appears to fit best the points in the figure. Approximately what is the slope of the line? What is the intercept? Write down your equation.

c. According to your analysis in (b), what has been the natural rate of unemployment since 1970?

8. Changes in the natural rate of unemployment a. Repeat Problem 6 but now draw separate graphs for the

period 1970 to 1990 and the period since 1990. b. Do you find that the relation between inflation and unem-

ployment is different in the two periods? If so, how has the natural rate of unemployment changed?

exPlore Further

9. Using the natural rate of unemployment to predict changes in inflation The estimated Phillips curve from Figure 8.4 is

pt - pt - 1 = 3.0 - 0.5 ut

Fill in the table below using the data collected in Question 6. You will want to use a spreadsheet

a. Assess the ability of the Phillips curve to predict changes in inflation over the whole time period.

b. Assess the ability of the Phillips curve to predict changes in inflation during the crisis years 2009 and 2010? What do you think may be going on?

c. You will be able to add years after 2014 to your table. Assess the out-of-sample predictive ability of the expecta- tions augmented Phillips curve estimated with the data ending in 2014 to predict inflation after 2014.

Year Inflation Unemployment Predicted change in inflation

Predicted change in inflation minus actual change in inflation

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

Future years

10. The rate of inflation and expected inflation in different decades

Fill in the values in table below for inflation and expected inflation using the 1960s. Here you will have to find the data

using the FRED data base operated by the Federal Reserve Bank of St. Louis. The series are found in Question 9. You will have the most success using a spreadsheet.

From the 1960’s:

Year pt

Actual inflation

pt - 1 Lagged actual

inflation

pet Expected inflation under different

assumptions

pet - pt Difference: expected minus actual

inflation under different assumptions

Year Assume u = 0 and pQ = 0 Assume u = 1.0

Assume u = 0 and pQ = 0 Assume u = 1.0

1963

1964

1965

1966

1967

1968

1969

Chapter 8 The Phillips Curve, the Natural Rate of Unemployment, and Inflation 175

Fill in the values in the table below for inflation and expected inflation using the 1970s and 80s. You will have the most success using a spreadsheet

From the 1970’s and 1980’s:

a. Is zero a good choice for the value of u in the 1960s? Is pQ = 0 a good choice for a value of pQ ? How are you making these judgements?

b. Is 1 a good choice for the value of u in the 1960s? How are you making that judgement?

Year pt

Actual inflation

pt - 1 Lagged actual

inflation

pet Expected inflation under different

assumptions

pet - pt Difference: expected minus actual

inflation under different assumptions

Year Assume u = 0 and pQ = 0 Assume u = 1.0

Assume u = 0 and pQ = 0 Assume u = 1.0

1973

1974

1975

1976

1977

1978

1979

1980

1981

c. Is zero a good choice for the value of u or pQ in the 1970s? How are you making that judgement?

d. Is 1 a good choice for the value of u in the 1970s? How are you making that judgement?

e. How do you compare the behavior of inflation, its average level and its persistence across these two time periods?

APPENDIx: Derivation of the Relation to a Relation between Inflation, Expected Inflation, and Unemployment

This appendix shows how to go from the relation between the price level, the expected price level, and the unemployment rate given by equation (8.1),

P = P e11 + m211 - au + z2 to the relation between inflation, expected inflation, and the unemployment rate given by equation (8.2),

p = pe + 1m + z2 - au First, introduce time subscripts for the price level, the

expected price level, and the unemployment rate, so Pt, P e t, and

ut refer to the price level, the expected price level, and the unem- ployment rate in year t. Equation (8.1) becomes

Pt = Pte11 + m211 - aut + z2 Next, go from an expression in terms of price levels to an

expression in terms of inflation rates. Divide both sides by last year’s price level, Pt - 1:

Pt

Pt - 1 =

Pt e

Pt - 1 11 + m211 - aut + z2 (8A.1)

Take the fraction Pt>Pt - 1 on the left side and rewrite it as Pt

Pt - 1 =

Pt - Pt - 1 + Pt - 1 Pt - 1

= 1 + Pt - Pt - 1

Pt - 1 = 1 + pt

where the first equality follows from actually subtract- ing and adding Pt - 1 in the numerator of the fraction, the second equality follows from the fact that Pt - 1 >Pt - 1 = 1, and the third follows from the definition of the inflation rate 1pt K 1Pt - Pt - 12>Pt - 12.

Do the same for the fraction Pet >Pt - 1 on the right side, using the definition of the expected inflation rate 1pte K 1Pte - Pt - 12>Pt - 12:

Pt e

Pt - 1 =

Pt e - Pt - 1 + Pt - 1

Pt - 1 = 1 +

Pt e - Pt - 1

Pt - 1 = 1 + pte

Replacing Pt>Pt - 1 and Pte>Pt - 1 in equation (8A.1) by the expressions we have just derived,

11 + pt2 = 11 + pte211 + m211 - aut + z2

176 The Medium Run The Core

6 in Appendix 2 at the end of the book). Replacing in the previ- ous equation and rearranging gives

pt = pte + 1m + z2 - aut Dropping the time indexes, this is equation (8.2) in the text.

With the time indexes kept, this is equation (8.3) in the text. The inflation rate, pt, depends on the expected inflation

rate pt e and the unemployment rate ut. The relation also de-

pends on the markup, m, on the factors that affect wage setting, z, and on the effect of the unemployment rate on wages, a.

This gives us a relation between inflation, pt, expected inflation, pet, and the unemployment rate, ut. The remaining steps make the relation look more friendly.

Divide both sides by 11 + pte211 + m2: 11 + pt2

11 + pte211 + m2 = 1 - aut + z

So long as inflation, expected inflation, and the markup are not too large, a good approximation to the left side of this equation is given by 1 + pt - pte - m (see Propositions 3 and

177

I

9 From the Short to the Medium Run: The IS-LM-PC Model n Chapters 3 through 6, we looked at equilibrium in the goods and financial markets and saw how, in the short run, output is determined by demand. In Chapters 7 and 8, we looked at equi- librium in the labor market and derived how unemployment affects inflation. We now put the two parts together and use it to characterize the behavior of output, unemployment, and inflation, both in the short and the medium runs. When confronted with a macroeconomic question about a particular shock or a particular policy, this model, which we shall call the IS-LM-PC (PC for Phillips curve), is typically the model I use or I start from. I hope you find it as useful as I do.

The chapter is organized as follows.

Section 9-1 develops the IS-LM-PC model.

Section 9-2 looks at the dynamics of adjustment of output and inflation.

Section 9-3 looks at the dynamic effects of a fiscal consolidation.

Section 9-4 looks at the dynamic effects of an increase in the price of oil.

Section 9-5 concludes the chapter.

178 The Medium Run The Core

9-1 The IS-LM-PC model In Chapter 6, we derived the following equation (equation 6.5) for the behavior of output in the short run:

Y = C1Y - T2 + I1Y, r + x2 + G (9.1) In the short run, output is determined by demand. Demand is the sum of consump-

tion, investment, and government spending. Consumption depends on disposable in- come, which is equal to income net of taxes. Investment depends on output and on the real borrowing rate; the real interest rate relevant to investment decisions is equal to the borrowing rate, the sum of real policy rate, r, chosen by the central bank, and a risk pre- mium, x. Government spending is exogenous.

As we did in Chapter 6, we can draw the IS curve implied by equation (9.1) between output, Y, and the policy rate, r, for given taxes, T, risk premium x, and government spending G. This is done in the top half of Figure 9-1. The curve is downward sloping. The lower is real policy rate, r, given by the flat LM curve, the higher the equilibrium level of output. The mechanism behind the relation should be familiar by now: A lower policy rate increases investment. Higher investment leads to higher demand. Higher demand leads to higher output. The increase in output further increases consumption and invest- ment, leading to a further increase in demand, and so on.

Now turn to the construction of the bottom half of Figure 9-1. In Chapter 8, we derived the following equation (equation 8.9) for the relation between inflation and un- employment, a relation we called the Phillips curve:

p - pe = -a1u - un2 (9.2)

C ha

ng e

in in

fla tio

n ra

te

0

R ea

l i nt

er es

t r at

e, r

p–p(–1)

r LM

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Output, Y

A

A

IS

Y

PC

YYn

Figure 9-1

The IS-LM-PC Model

Top graph: A lower policy rate leads to higher output. Bottom graph: A higher output leads to a larger change in inflation.

MyEconLab Animation

Chapter 9 From the Short to the Medium Run: The IS-LM-PC Model 179

When the unemployment rate is lower than the natural rate, inflation turns out to be higher than expected. If the unemployment is higher than the natural rate, inflation turns out to be lower than expected.

Given that the first relation (equation (9.1)) is in terms of output, our first step must be to rewrite the Phillips curve in terms of output rather than unemployment. It is easy, but it takes a few steps. Start by looking at the relation between the unemployment rate and employment. By definition, the unemployment rate is equal to unemployment divided by the labor force:

u K U>L = 1L - N2>L = 1 - N>L where N denotes employment and L denotes the labor force. The first equality is simply the definition of the unemployment rate. The second equality follows from the defini- tion of unemployment, and the third equality is obtained through simplification. The unemployment rate is equal to one minus the ratio of employment to the labor force. Reorganizing to express N as a function of u gives:

N = L11 - u2 Employment is equal to the labor force times one minus the unemployment rate.

Turning to output, we shall maintain for the moment the simplifying assumption we made in Chapter 7, namely that output is simply equal to employment, so:

Y = N = L11 - u2 where the second equality follows from the previous equation.

Thus, when the unemployment rate is equal to the natural rate, un , employment is given by Nn = L11 - un2 and output is equal to Yn = L11 - un2. Call Nn the natural level of employment (natural employment for short), and Yn the natural level of output (natural output for short). Yn is also called potential output and I shall often use that expression in what follows.

It follows that we can express the deviation of employment from its natural level as:

Y - Yn = L111 - u2 - 11 - un22 = -L1u - un2 This gives us a simple relation between the deviation of output from potential and

the deviation of unemployment from its natural rate. The difference between output and potential output is called the output gap. If unemployment is equal to the natural rate, output is equal to potential, and the output gap is equal to zero; if unemployment is above the natural rate, output is below potential and the output gap is negative; and if unemployment is below the natural rate, output is above potential and the output gap is positive. (The relation of this equation to the actual relation between output and unemployment, known as Okun’s law, is explored further in the Focus box, “Okun’s Law across Time and Countries.”)

Replacing u - un in equation (9.2) gives:

p - pe = 1a>L21Y - Yn2 (9.3) We need to take one last step. We saw in Chapter 7 how the way wage setters form

expectations has changed through time. We shall work in this chapter under the as- sumption that they assume inflation this year to be the same as last year. (I shall also discuss how results differ under alternative assumptions.) This assumption implies that the Phillips curve relation is given by:

p - p1-12 = 1a>L21Y - Yn2 (9.4) In words: When output is above potential and therefore the output gap positive,

inflation increases. When the output is below potential and therefore the output gap is

For a refresher, see Chapter 2.b

To keep the notation light, in- stead of using time indexes in this chapter, I shall use (-1) to denote the value of a variable in the previous period. So, for example, p1-12 denotes inflation last year.

b

180 The Medium Run The Core

Okun’s Law across Time and Countries FO

C u

s How does the relation between output and unemployment we have derived in the text relate to the empirical relation between the two, known as Okun’s law, which we saw in Chapter 2?

To answer this question, we must first rewrite the rela- tion in the text in a way which makes the comparison easy between the two. Before giving you the derivation, which takes a few steps, let me give you the bottom line. The rela- tion between unemployment and output derived in the text can be rewritten as:

u − u 1 −1 2 ? −gY (9B.1) The change in the unemployment rate is approximately equal to the negative of the growth rate of output. (The symbol ? means approximately equal.)

Here is the derivation. Start from the relation between employment, the labor force, and the unemployment rate N = L 11 − u 2 . Write the same relation for the year before, assuming a constant labor force L, so N 1 −1 2 = L 11 − u 1 −1 2 2 . Put the two relations together to get:

N − N 1 −1 2 = L 11 − u 2 − L 11 − u 1 −1 2 2 = −L 1u − u 1 −1 2 2

The change in employment is equal to minus the change in the unemployment rate, times the labor force. Divide both sides by N 1 −1 2 to get 1N − N 1 −1 2 2 >N 1 −1 2 = − 1L ,N 1 −1 2 2 1u − u 1 −1 2 2

Note that the expression on the left-hand side gives the rate of growth of employment, call it gN. Given our assump- tion that output is proportional to employment, the rate of growth of output, call it gY, is simply equal to gN. Note also that L ,N 1 −1 2 is a number close to one. If the unemploy- ment rate is equal to 5% for example, then the ratio of the labor force to employment is 1.05. So, rounding it to one, we can rewrite the expression as:

gY ? − 1u − u 1 −1 2 2 , Reorganizing gives us the equation we want:

u − u 1 −1 2 ? −gY (9B.1) Now turn to the actual relation between the change in

the unemployment rate and output growth, which we saw in Figure 2-5 in Chapter 2, and is reproduced here as Figure 1. The regression line that fits the points best in Figure 1 is given by:

u − u 1 −1 2 = −0.4 1gY − 3% 2 (9B.2) Like equation (9B.1), equation (9B.2) shows a negative

relation between the change in unemployment and output growth. But it differs from equation (9B.1) in two ways.

■■ First, annual output growth has to be at least 3% to pre- vent the unemployment rate from rising. This is because of two factors we ignored in our derivation: Labor-force growth and labor-productivity growth. To maintain a constant unemployment rate, employment must grow at the same rate as the labor force. Suppose the labor force grows at 1.7% per year; then employment must grow at 1.7% per year. If, in addition, labor productivity

(i.e., output per worker) grows at 1.3% per year, this implies that output must grow at 1.7% + 1.3% = 3% per year. In other words, just to maintain a constant un- employment rate, output growth must be equal to the sum of labor—force growth and labor— productivity growth. In the United States, the sum of the rate of la- bor—force growth and of labor—productivity growth has been equal to 3% per year on average since 1960, and this is why the number 3% appears on the right side of equation (9.2). (There is some evidence however, to which we shall come back to in later chapters, that productivity growth has declined in the last decade, and that the growth rate needed to maintain a constant unemployment rate is now closer to 2% than to 3%.)

■■ The coefficient on the right side of equation (9B.2) is −0.4, compared to −1.0 in equation (9B.1). Put an- other way, output growth 1% above normal leads only to a 0.4% reduction in the unemployment rate in equation (9B.2) rather than the 1% reduction in equation (9B.1). There are two reasons why:

Firms adjust employment less than one for one in response to deviations of output growth from normal. More specifically, output growth 1% above normal for one year leads to only a 0.6% increase in the employment rate. One reason is that some workers are needed no matter what the level of output is. The accounting department of a firm, for example, needs

–3

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0

1

2

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4

–4 –2 0 2 4 6 8

C ha

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in th

e un

em pl

oy m

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at e

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ce nt

ag e

po in

ts )

Output growth (percent)

Figure 1 Changes in the Unemployment Rate versus Output Growth in the United States, 1960–2014

High output growth is associated with a reduction in the unemployment rate; low output growth is associated with an increase in the unemployment rate.

Source: Series GDPCA,GDPA: Federal Reserve Economic Data (FRED) http://research.stlouisfed.org/fred2/.

MyEconLab Real-time data

Chapter 9 From the Short to the Medium Run: The IS-LM-PC Model 181

roughly the same number of employees whether the firm is selling more or less than normal. Another rea- son is that training new employees is costly; for this reason, firms prefer to keep current workers rather than lay them off when output is lower than normal and ask them to work overtime rather than hire new employees when output is higher than normal. In bad times, firms in effect hoard labor, the labor they will need when times are better; this is why this behavior of firms is called labor hoarding.

An increase in the employment rate does not lead to a one-for-one decrease in the unemployment rate. More specifically, a 0.6% increase in the employment rate leads to only a 0.4% decrease in the unemploy- ment rate. The reason is that labor force participation increases. When employment increases, not all the new jobs are filled by the unemployed. Some of the jobs go to people who were classified as out of the labor force, meaning they were not actively looking for a job.

Also, as labor-market prospects improve for the unemployed, some discouraged workers, who were

previously classified as out of the labor force, decide to start actively looking for a job and become classi- fied as unemployed. For both reasons, unemployment decreases less than employment increases.

Putting the two steps together: Unemployment responds less than one for one to movements in employment, which itself responds less than one for one to movements in output. The coefficient giving the effect of output growth on the change in the unemployment rate, here 0.4, is called the Okun coefficient. Given the factors which determine this coefficient, one would expect the coefficient to differ across countries and indeed it does. For example in Japan, which has a tradition of lifetime employment, firms to adjust employ- ment much less in response to movements in output, leading to an Okun coefficient of only 0.1. Fluctuations in output are associated with much smaller fluctuations in unemployment in Japan than in the United States.

For more on Okun’s law across countries and time, read “Okun’s law: Fit at 50?” by Laurence Ball, Daniel Leigh, and Prakash Loungani, working paper 606, The Johns Hopkins University, 2012.

negative, inflation decreases. The positive relation between output and the change in inflation is drawn as the upward sloping curve in the bottom half of Figure 9-1. Output is measured on the horizontal axis, the change in inflation is measured on the vertical axis. When output is equal to potential, equivalently when the output gap is equal to zero, the change in inflation is equal to zero. Thus, the Phillips curve crosses the horizon- tal axis at the point where output is equal to potential.

We now have the two equations we need to describe what happens in the short and the medium run. This is what we do in the next section.

9-2 Dynamics and the Medium Run Equilibrium Let’s return to Figure 9-1. Suppose that the policy rate chosen by the central bank is equal to r. The top part of the figure tells us that, associated with this interest rate, the level of output is given by Y. The bottom part of the figure tells us that this level of output Y implies a change in inflation equal to 1p - p1-122. Given the way we have drawn the figure, Y is larger than Yn, so output is above potential. This implies that inflation is increasing. Put less formally, the economy is overheating, putting pressure on inflation. This is the short-run equilibrium.

What happens over time if there is no change in the policy rate, nor in any of the variables which affect the position of the IS curve? Then output remains above potential, and inflation keeps increasing. At some point however, policy is likely to react to this increase in inflation. If we focus on the central bank, sooner or later the central bank will increase the policy rate so as to decrease output back to potential and there is no longer pressure on inflation. The adjustment process and the medium run equilibrium are represented in Figure 9-2. Let the initial equilibrium be denoted by point A in both the top and bottom graph. You can think of the central bank as increasing the policy rate over time, so the economy moves along the IS curve up from A to A=. Output decreases. Now turn to the bottom graph. As output decreases, the economy moves down the PC curve from A to A=. At point A=, the policy rate is equal to rn, output is equal to Yn, and by implication, inflation is constant. This is the medium-run equilibrium. Output is equal to

PC curve is a bit repetitive be- cause the C stands for curve already. But it will do.

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182 The Medium Run The Core

to the decrease in income, and for firms to adjust to the decrease in sales. In short, so even if the central bank acts quickly, it takes time for the economy to go back to the natu- ral level of output.

The fact that it takes time for output to go back to its natural level raises an issue about inflation. During the process of adjustment, output is consistently above poten- tial, thus inflation is consistently increasing. Thus, when the economy reaches point A=, inflation is higher than it was at point A. If the central bank cares not only about stable inflation, but about the level of inflation, it may well decide that it has to not only stabilize but also reduce inflation. To do this, it needs to increase the policy rate beyond rn to generate a decrease in inflation, until inflation is back to a level acceptable to the central bank. In this case, the adjustment is more complex. The economy moves up from A and passes A=, reaching for example point C, at which stage the central bank starts de- creasing the policy rate back to rn. In other words, if the central bank wants to achieve a constant level of inflation over the medium run, then the initial boom must be followed by a recession.

The Role of Expectations Revisited The previous discussion depends on the way people form expectations, and on the spe- cific form of the Phillips curve. To see this, return to our discussion of expectation forma- tion in Chapter 8, and instead of assuming that expected inflation is equal to last year’s inflation, p1-12, assume instead that people think that inflation will be equal to some constant, pQ , irrespective of what inflation was last year.

In this case, equation (9.3) becomes:

p - pQ = 1a>L21Y - Yn2 (9.5) To see what happens in this case, we can still use Figure 9-2, except for the fact

that what is measured on the vertical axis of the bottom graph is p - pQ rather than p - p1-12. A positive output gap generates a higher level of inflation rather than an increase in inflation. Now suppose that the economy is at point A, with associated level of output Y. Given that output is above potential, inflation is higher than expected in- flation: p - pQ 7 0. As the central bank increases the policy rate to decrease output to its natural level, and the economy moves along the IS curve from A to A=. When the economy is at A= and the policy rate is equal to rn, output is back to potential, and infla- tion is back to pQ . The difference with the previous case is clear. To return inflation to pQ , there is no need in this case for the central bank to increase the rate beyond rn for some time, as was the case before. Thus, the central bank has an easier job. So long as inflation expectations remain anchored (to use the term used by central banks), it does not need to compensate for the initial boom by a recession later.

The Zero Lower Bound and Debt Spirals Our description of the adjustment has made the adjustment to the medium-run equi- librium look relatively easy. If output is too high, the central bank increases the policy rate until output is back up to potential. If output is too low, the central bank decreases the policy rate until output is back up to potential. This is however too optimistic a pic- ture and things can go wrong. The reason is the combination of the zero lower bound and deflation.

In Figure 9-2, we considered the case where output was above potential, and infla- tion was increasing. Consider instead the case, represented in Figure 9-3, where the economy is in a recession. At the current policy rate r, output is equal to Y, which is far below Yn. The output gap is negative, and inflation is decreasing. This initial equilibrium is represented by point A, in the top and the bottom graphs.

At the time of writing, this is an issue facing the Fed. The unemployment rate is down to 5.0%, and inflation is roughly constant. How close unem- ployment is to the natural rate is the subject of much discus- sion and disagreement.

MyEconLab Video

potential, and, as a result, there is no longer any pressure on inflation. The interest rate rn associated with Yn is often the natural rate of interest (to reflect the fact that it is as- sociated with the natural rate of unemployment, or the natural level of output); it is also sometimes called the neutral rate of interest, or the Wicksellian rate of interest (coming from the fact that the concept was first introduced by Wicksell, a Swedish econ- omist who characterized it at the end of the 19th century).

Let’s look at the dynamics and at the medium-run equilibrium more closely. You may (and indeed you should) have the following reaction to the description of

the dynamics. If the central bank wants to achieve stable inflation and keep output at Yn, why doesn’t it increase the policy rate to rn right away, so that the medium run equilib- rium is reached without delay? The answer is that the central bank would indeed like to keep the economy at Yn. But, although it looks easy to do in Figure 9-2, reality is more complicated. The reasons parallel the discussion we had in Chapter 3 about the adjust- ment of the economy over time. First, it is often difficult for the central bank to know where potential output is exactly, and thus how far output is from potential. The change in inflation provides a signal of the output gap, the distance between actual and poten- tial output, but in contrast to the simple equation (9.4), the signal is noisy. The central bank may thus want to adjust the policy rate slowly and see what happens. Second, it takes time for the economy to respond. Firms take time to adjust their investment deci- sions. As investment spending slows down in response to the higher policy rate, leading to lower demand, lower output, and lower income, it takes time for consumers to adjust

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Figure 9-2

Medium-Run Output and Inflation

Over the medium run, the eco- nomy converges to the natu- ral level of output and stable inflation.

MyEconLab Animation

Chapter 9 From the Short to the Medium Run: The IS-LM-PC Model 183

to the decrease in income, and for firms to adjust to the decrease in sales. In short, so even if the central bank acts quickly, it takes time for the economy to go back to the natu- ral level of output.

The fact that it takes time for output to go back to its natural level raises an issue about inflation. During the process of adjustment, output is consistently above poten- tial, thus inflation is consistently increasing. Thus, when the economy reaches point A=, inflation is higher than it was at point A. If the central bank cares not only about stable inflation, but about the level of inflation, it may well decide that it has to not only stabilize but also reduce inflation. To do this, it needs to increase the policy rate beyond rn to generate a decrease in inflation, until inflation is back to a level acceptable to the central bank. In this case, the adjustment is more complex. The economy moves up from A and passes A=, reaching for example point C, at which stage the central bank starts de- creasing the policy rate back to rn. In other words, if the central bank wants to achieve a constant level of inflation over the medium run, then the initial boom must be followed by a recession.

The Role of Expectations Revisited The previous discussion depends on the way people form expectations, and on the spe- cific form of the Phillips curve. To see this, return to our discussion of expectation forma- tion in Chapter 8, and instead of assuming that expected inflation is equal to last year’s inflation, p1-12, assume instead that people think that inflation will be equal to some constant, pQ , irrespective of what inflation was last year.

In this case, equation (9.3) becomes:

p - pQ = 1a>L21Y - Yn2 (9.5) To see what happens in this case, we can still use Figure 9-2, except for the fact

that what is measured on the vertical axis of the bottom graph is p - pQ rather than p - p1-12. A positive output gap generates a higher level of inflation rather than an increase in inflation. Now suppose that the economy is at point A, with associated level of output Y. Given that output is above potential, inflation is higher than expected in- flation: p - pQ 7 0. As the central bank increases the policy rate to decrease output to its natural level, and the economy moves along the IS curve from A to A=. When the economy is at A= and the policy rate is equal to rn, output is back to potential, and infla- tion is back to pQ . The difference with the previous case is clear. To return inflation to pQ , there is no need in this case for the central bank to increase the rate beyond rn for some time, as was the case before. Thus, the central bank has an easier job. So long as inflation expectations remain anchored (to use the term used by central banks), it does not need to compensate for the initial boom by a recession later.

The Zero Lower Bound and Debt Spirals Our description of the adjustment has made the adjustment to the medium-run equi- librium look relatively easy. If output is too high, the central bank increases the policy rate until output is back up to potential. If output is too low, the central bank decreases the policy rate until output is back up to potential. This is however too optimistic a pic- ture and things can go wrong. The reason is the combination of the zero lower bound and deflation.

In Figure 9-2, we considered the case where output was above potential, and infla- tion was increasing. Consider instead the case, represented in Figure 9-3, where the economy is in a recession. At the current policy rate r, output is equal to Y, which is far below Yn. The output gap is negative, and inflation is decreasing. This initial equilibrium is represented by point A, in the top and the bottom graphs.

At the time of writing, this is an issue facing the Fed. The unemployment rate is down to 5.0%, and inflation is roughly constant. How close unem- ployment is to the natural rate is the subject of much discus- sion and disagreement.

MyEconLab Video

184 The Medium Run The Core

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Figure 9-3

The Deflation Spiral

If the zero lower bound pre- vents monetary policy from increasing output back to po- tential, the result may be a deflation spiral. More deflation leads to a higher real policy rate, and the higher policy rate in turn leads to lower output and more deflation.

MyEconLab Animation

What the central bank should do in this case appears straightforward. It should decrease the policy rate until output has increased back to its natural level. In terms of Figure 9-3, it should decrease the policy rate from r down to rn. At rn, output is equal to Yn, and inflation is stable again. Note that, if the economy is sufficiently depressed, the real policy rate, rn, needed to return output to its natural level may be negative, and this is indeed how I have drawn it in the figure.

The zero lower bound constraint may however make it impossible to achieve this negative real policy rate. Suppose for example that initial inflation is zero. Because of the zero lower bound, the lowest the central bank can decrease the nominal policy rate is 0%, which, combined with zero inflation, implies a real policy rate of 0%. In terms of Figure 9-3, the central bank can decrease the real policy rate only down to 0%, with associated level of output Y=. At Y=, output is still below potential, and thus inflation is still decreasing. This starts what economists call a deflation spiral, or a deflation trap. Let’s continue to assume that inflation expectations are such that wage setters expect inflation to be the same as last year, so a negative output gap implies decreasing inflation. If inflation was equal to zero to start with, it becomes negative. Zero infla- tion turns into deflation. In turn, this implies that even if the nominal rate remains equal to zero, the real policy rate increases, leading to even lower demand and lower output. Deflation and low output feed on each other. Lower output leads to more deflation, and more deflation leads to a higher real interest rate and lower output. As indicated by the arrows in Figure 9-3, instead of converging to the medium-run equilibrium, the economy moves away from it, with output steadily decreasing and

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Recall that a negative real policy rate does not neces- sarily imply that people and firms, who borrow at a real rate equal to r + x also face a negative real rate. If x is suf- ficiently large, the real rate at which they can borrow is posi- tive even if the real policy rate is negative.

Chapter 9 From the Short to the Medium Run: The IS-LM-PC Model 185

FO C

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Deflation in the Great Depression

After the collapse of the stock market in 1929, the U.S. econ- omy plunged into an economic depression. As the first two columns of Table 1 show, the unemployment rate increased from 3.2% in 1929 to 24.9% in 1933, and output growth was strongly negative for four years in a row. From 1933 on, the economy recovered slowly, but by 1940, the unemploy- ment rate was still a high 14.6%.

The Great Depression has many elements in common with the recent crisis. A large increase in asset prices before the crash—housing prices in the recent crisis, stock market prices in the Great Depression, and the amplification of the shock through the banking system. There are also important dif- ferences. As you can see by comparing the output growth and unemployment numbers in Table 1 to the numbers for the recent crisis in Chapter 1, the decrease in output and the increase in unemployment were much larger then than they have been in the recent crisis. In this box, we shall focus on just one aspect of the Great Depression: the evolution of the nomi- nal and the real interest rates and the dangers of deflation.

As you can see in the third column of the table, monetary policy decreased the nominal rate, measured in the table by the one-year T-bill rate, although it did this slowly and did not quite go all the way to zero. The nominal rate decreased from 5.3% in 1929 to 2.6% in 1933. At the same time, as shown in the fourth column, the decline in output and the increase in unemployment led to a sharp decrease in infla- tion. Inflation, equal to zero 1929, turned negative in 1930, reaching -9.2% in 1931, and -10.8% in 1932. If we make the assumption that expected deflation was equal to actual deflation in each year, we can construct a series for the real rate. This is done in the last column of the table and gives a

hint for why output continued to decline until 1933. The real rate reached 12.3% in 1931, 14.8% in 1932, and still a high 7.8% in 1933! It is no great surprise that, at those interest rates, both consumption and investment demand remained very low, and the depression worsened.

In 1933, the economy seemed to be in a deflation trap, with low activity leading to more deflation, a higher real interest rate, lower spending, and so on. Starting in 1934, however, deflation gave way to inflation, leading to a large decrease in the real interest rate, and the economy began to recover. Why, despite a high unemployment rate, the U.S. economy was able to avoid further deflation remains a hotly debated issue in economics. Some point to a change in mon- etary policy, a large increase in the money supply, leading to a change in inflation expectations. Others point to the policies of the New Deal, in particular the establishment of a mini- mum wage, thus limiting further wage decreases. Whatever the reason, this was the end of the deflation trap and the beginning of a long recovery.

For more on the Great Depression: Lester Chandler, America’s Greatest Depression (1970), gives the basic facts. So does the book by John A. Garraty, The Great Depression (1986).

Did Monetary Forces Cause the Great Depression? (1976), by Peter Temin, looks more specifically at the macroeconomic issues. So do the articles in a symposium on the Great Depression in the Journal of Economic Perspectives, Spring 1993.

For a look at the Great Depression in countries other than the United States, read Peter Temin’s Lessons from the Great Depression (1989).

Table 1 The Nominal Interest Rate, Inflation, and the Real Interest Rate, 1929–1933

Year Unemployment

Rate (%)

Output Growth Rate

(%)

One-Year Nominal

Interest Rate (%), i Inflation Rate

(%), P

One-Year Real Interest Rate (%), r

1929 3.2 −9.8 5.3 0.0 5.3

1930 8.7 −7.6 4.4 −2.5 6.9

1931 15.9 −14.7 3.1 −9.2 12.3

1932 23.6 −1.8 4.0 −10.8 14.8

1933 24.9 9.1 2.6 −5.2 7.8

deflation steadily becoming larger. There is little the central bank can do, and the economy goes from bad to worse.

This scenario is not just a theoretical concern. This is very much the scenario which played out during the Great Depression. As shown in the Focus Box “Deflation in the Great Depression,” from 1929 to 1933, inflation turned into larger and larger deflation,

186 The Medium Run The Core

steadily increasing the real policy rate and decreasing spending and output, until other measures were taken and the economy started turning around. The recent crisis gave rise to similar worries. With the policy rate down to zero in the major advanced coun- tries, the worry was that inflation would turn negative and start a similar spiral. This did not happen. Inflation decreased and in some countries turned to deflation. As we saw in Chapter 6, this limited the ability of the central banks to decrease the real policy rate and increase output. But deflation remained limited, and the deflation spiral did not happen. One reason, which connects to our previous discussion of expectation formation, is that inflation expectations remained largely anchored. As a result, the Phillips curve relation took the form of equation (9.5) rather than (9.4). Low output led to low inflation, and in some cases, mild deflation, but not to steadily larger deflation, as had been the case dur- ing the Great Depression.

9-3 Fiscal Consolidation Revisited We can now take the IS-LM-PC model through its paces. In this section, we go back to the fiscal consolidation we discussed in Chapter 5. We can now look not only at its short-run effects but at its medium-run effects as well.

Suppose that output is at potential, so the economy is at point A in both the top and the bottom graphs of Figure 9-4. Output Y is equal to Yn, the policy rate is equal to rn, and inflation is stable. Now, assume that the government, which was running a deficit, decides to reduce it by, say, increasing taxes. In terms of Figure 9-4, the increase in taxes shifts the IS curve to the left, from IS to IS=. The new short-run equilibrium is given by point A= in both the top and bottom graphs of Figure 9-4. At the given policy rate rn, output decreases from Yn to Y

=, and inflation starts decreasing. In other words, if output was at potential to start with, the fiscal consolidation, as desirable as it may be on other grounds, leads to a recession. This is the short-run equilibrium we character- ized in Section 5-3 of Chapter 5. Note that, as income comes down and taxes increase, consumption decreases on both counts. Note also that, as output decreases, so does investment. In the short run, on macroeconomic grounds, fiscal consolidation looks rather unappealing: Both consumption and investment go down.

Let’s however turn to the dynamics and to the medium run. As output is too low, and inflation is decreasing, the central bank is likely to react and decrease the policy rate until output is back to potential. In terms of Figure 9-4, the economy moves down the IS curve in the top graph, and output increases. As output increases, the economy moves up the PC curve in the bottom graph, until output is back to potential. Thus, the medium-run equilibrium is given by point A″ in both the top and bottom graph. Output is back at Yn, and inflation is again stable. The policy rate needed to maintain output at potential is now lower than before, equal to rn

= rather than rn. Now look at the composition of output in this new equilibrium. As income is the same as it was before fiscal consolidation but taxes are higher, consumption is lower, although not as low as it was in the short run. As output is the same as before but the interest rate is lower, investment is higher than before. In other words, the decrease in consumption is offset by an increase in investment, so demand, and by implication, is unchanged. This is in sharp contrast to what happened in the short run and makes fiscal consolidation look more attractive. Although consolidation may de- crease investment in the short run, it increases investment in the medium run.

This discussion raises some of the same issues we discussed in the previous section. First, it looks as if fiscal consolidation could take place without a decrease in output in the short run. All that is needed is for the central bank and the government to coordinate carefully. As fiscal consolidation takes place, the central bank should decrease the policy rate so as to maintain output at the natural level. In other words, the proper combination

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We have looked at a fiscal consolidation, equivalently at an increase in public saving. The same argument would apply to an increase in private saving. At a given policy rate, such an increase would lead to a decrease investment in the short run, but to an increase in investment in the medium run. (In the light of these results, you may want to go back to the Focus Boxes on “The Par- adox of Saving” in Chapter 3, and on “Deficit Reduction: Good or Bad for Investment,” in Chapter 5.)

Chapter 9 From the Short to the Medium Run: The IS-LM-PC Model 187

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Fiscal Consolidation in the Short and the Medium Run

Fiscal consolidation leads to a decrease in output in the short run. In the medium run, output returns to potential, and the interest rate is lower.

MyEconLab Animation

of fiscal and monetary policy can achieve the medium-run equilibrium outcome in the short run. Such coordination indeed happens sometimes; as we saw in Chapter 5, it happened in the United States in the 1990s, when a fiscal consolidation was accompa- nied with a monetary expansion. But it does not always happen. One reason is that the central bank may be unable to decrease the policy rate sufficiently. This takes us back to another issue we discussed previously, the zero lower bound. The central bank may have limited room to decrease the policy rate. This indeed has been the case in the Euro area in the recent crisis. With the nominal policy rate at zero in the Euro area, monetary policy was unable to offset the adverse effects of fiscal consolidation on output. The result was a stronger and longer lasting adverse effect of fiscal consolidation on output than would have been the case, had the European Central Bank been able to decrease the policy rate further.

9-4 The Effects of an Increase in the Price of Oil So far we have looked at shocks to demand, shocks that shifted the IS curve, but left potential output and thus the position of the PC curve unaffected. There are other shocks however that affect both demand and potential output and play an important role in fluctuations. An obvious candidate is movements in the price of oil. To see why, turn to Figure 9-5.

188 The Medium Run The Core

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The Nominal and the Real Price of Oil, 1970–2015

Over the last 40 years, there have been two sharp in- creases in the real price of oil, the first in the 1970s and the second in the 2000s.

Source: Series OILPRICE, CPIAUSCL Federal Reserve Economic Data (FRED) http://research.stlouisfed.org/ fred2/. The value of the index is set equal to 100 in 1970.

MyEconLab Real-time data

Figure 9-5 plots two series. The first, represented by the blue line, is the dollar price of oil—that is, the price of a barrel of oil in dollars—since 1970. It is measured on the vertical axis on the left. This is the series that is quoted in the newspapers every day. What matters, however, for economic decisions is not the dollar price, but the real price of oil; that is, the dollar price of oil divided by the price level. Thus, the second series in the fig- ure, represented by the red line, shows the real price of oil, constructed as the dollar price of oil divided by the U.S. consumer price index. Note that the real price is an index; it is normalized to equal 100 in 1970. It is measured on the vertical axis on the right.

What is striking in the figure is the size of the movements in the real price of oil. Twice over the last 40 years, the U.S. economy was hit with a fivefold increase in the real price of oil, the first time in the 1970s, and the second time in the 2000s. The crisis then led to a dramatic drop in late 2008, followed by a partial recovery. And since 2014, the price has again dropped to pre-2000 levels.

What was behind the two large increases? In the 1970s, the main factors were the formation of OPEC (the Organization of Petroleum Exporting Countries), a cartel of oil producers that was able to act as a monopoly and increase prices, and disruptions because of wars and revolutions in the Middle East. In the 2000s, the main factor was quite different, namely the fast growth of emerging economies, in particular China, which led to a rapid increase in the world demand for oil and, by implication, a steady increase in real oil prices.

What was behind the two large decreases? The sudden drop in the price at the end of the 2008 was as a result of the crisis, which led to a large recession, and in turn to a large and sudden decrease in the demand for oil. The causes of the more recent drop since 2014 are still being debated. Most observers believe that it is a combination of increased supply because of the increase in shale oil production in the United States and the partial breakdown of the OPEC cartel.

Let’s focus on the two large increases. Although the causes were different, the im- plication for U.S. firms and consumers was the same: more expensive oil. The question is: What would we expect the short- and medium-run effects of such increases to be? It is clear however that, in answering the question, we face a problem. The price of oil ap- pears nowhere in the model we have developed so far! The reason is that, until now, we have assumed that output was produced using only labor. One way to extend our model would be to recognize explicitly that output is produced using labor and other inputs (including energy), and then figure out what effect an increase in the price of oil has on the price set by firms and on the relation between output and employment. An easier

Chapter 9 From the Short to the Medium Run: The IS-LM-PC Model 189

way, and the way we shall go here, is simply to capture the increase in the price of oil by an increase in m—the markup of the price over the nominal wage. The justification is straightforward. Given wages, an increase in the price of oil increases the cost of produc- tion, forcing firms to increase prices to maintain the same profit rate.

Having made this assumption, we can then track the dynamic effects of an increase in the markup on output and inflation.

Effects on the Natural Rate of Unemployment Let’s start by asking what happens to the natural rate of unemployment when the real price of oil increases (for simplicity, I shall drop “real” in what follows). Figure 9-6 repro- duces the characterization of labor-market equilibrium from Figure 7-8 in Chapter 7.

The wage-setting relation is downward sloping; a higher unemployment rate leads to lower real wages. The price-setting relation is represented by the horizontal line at W>P = 1>11 + m2. The initial equilibrium is at point A, and the initial natural unem- ployment rate is un. An increase in the markup leads to a downward shift of the price- setting line, from PS to PS=. The higher the markup, the lower the real wage implied by price setting. The equilibrium moves from A to A=. The real wage is lower and the natural unemployment rate is higher. Think of it this way: Because firms have to pay more for the oil, the wage they can pay is lower. Getting workers to accept the lower real wage re- quires an increase in unemployment.

The increase in the natural rate of unemployment leads in turn to a decrease in the natural level of employment. If we assume that the relation between employment and output is unchanged—that is, that each unit of output still requires one worker in ad- dition to the energy input—then the decrease in the natural level of employment leads to an identical decrease in potential output. Putting things together: An increase in the price of oil leads to a decrease in potential output.

We can now go back to the IS-LM-PC model, and this is done in Figure 9-7. Assume the initial equilibrium is at point A in both the top and bottom panels, with output at potential, so Y is equal to Yn, inflation is stable, and the policy rate is equal to rn. As the price of oil increases, the natural level of output decreases (this is what we just saw), say from Yn to Yn

= . The PC curve shifts up, from PC to PC=. If the IS curve does not shift (we return to this assumption later) and the central bank does not change the policy rate, output does not change, but the same level of output is now associated with higher

b

This assumes that the increase in the price of oil is permanent. If, in the medium run, the price of oil goes back to its initial value, then the natural rate of unem- ployment is clearly unaffected.

PS

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Figure 9-6

The Effects of an Increase in the Price of Oil on the Natural Rate of Unemployment

An increase in the price of oil is equivalent to an increase in the markup. It leads to lower real wages and a higher natu- ral rate of unemployment.

MyEconLab Animation

190 The Medium Run The Core

C ha

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Figure 9-7

Short and Medium Run Effects of an Increase in the Price of Oil

MyEconLab Animation

inflation. For given wages, the price of oil leads firms to increase their prices, so inflation is higher. The short-run equilibrium is given by point A= in the top and bottom panels. In the short run, output does not change, but inflation is higher.

Turn to the dynamics. If the central bank were to leave the policy rate unchanged, output would continue to exceed the now lower level of potential output, and infla- tion would keep increasing. Thus, at some point, the central bank will increase the policy rate to stabilize inflation. As it does so, the economy moves up from A= to A== along the IS curve in the top panel, and down from A= to A== along the PC curve in the bottom panel. As output decreases to its lower level, inflation continues to increase, although more and more slowly until eventually it becomes stable again. Once the economy is at point A==, the economy is in its medium-run equilibrium. Because po- tential output is lower, the increase in the price of oil is reflected in a permanently lower level of output. Note that along the way, lower output is associated with higher inflation, a combination that economists call stagflation (stag for stagnation, and flation for inflation).

As in the previous sections, this description raises a number of issues. The first is our assumption that the IS curve does not shift. In fact, there are many channels through which the increase in the price of oil may affect demand and shift the IS curve. The higher price of oil may lead firms to change their investment plans, canceling some investment projects, shifting to less energy-intensive equipment. The increase in the price of oil also redistributes income from oil buyers to oil producers. Oil producers may spend less than oil buyers, leading to a decrease in demand. So it may well be that the IS c

This is especially true if the oil producers are located in other countries than the oil buyers (which is the case when the United States buys oil from the Middle East for example). As the price increases and their in- come increases, the oil produc- ers are likely to spend most of it on their own goods, not on the goods produced by the oil buy- ers. Thus, demand for domes- tic goods is likely to go down.

Chapter 9 From the Short to the Medium Run: The IS-LM-PC Model 191

FO C

u s

Oil Price Increases: Why Were the 2000s so Different from the 1970s?

Why is it that oil price increases were associated with stag- flation in the 1970s but had little apparent effect on the economy in the 2000s?

A first line of explanation is that shocks other than the increase in the price of oil were at work in the 1970s but not in the 2000s. In the 1970s, not only did the price of oil increase, but so did the price of many other raw materials. So the effect was stronger than would have been the case, had only the price of oil increased.

In the 2000s, many economists believe that, partly be- cause of globalization and foreign competition, workers bar- gaining power weakened. If true, this implies that, although the increase in oil prices increased the natural rate, the de- crease in bargaining power of workers decreased it, with the two effects largely offsetting each other.

Econometric studies suggest, however, that more was at work, and that, even after controlling for the presence of these other factors, the effects of the price of oil have changed since the 1970s. Figure 1 shows the effects of a 100% increase in the price of oil on output and on the price level, estimated using data from two different periods. The black and blue lines show the effects of an increase in the price of oil on the consumer price index (CPI) deflator and on gross domestic product (GDP), based on data from 1970:1 to 1986:4; the green and red lines do the same, but based on data from 1987:1 to 2006:4 (the time scale on the horizontal axis is in quarters). The figure suggests two main conclusions. First, in both periods, as predicted

by our model, the increase in the price of oil led to an in- crease in the CPI and a decrease in GDP. Second, the effects of the increase in the price of oil on both the CPI and on GDP have become smaller, roughly half of what they were previously.

Why have the adverse effects of the increase in the price of oil become smaller? This is still a topic of research. But, at this stage, two hypotheses appear plausible.

The first hypothesis is that, today, U.S. workers have less bargaining power than they did in the 1970s. Thus, as the price of oil has increased, workers have been more willing to accept a reduction in wages, limiting the increase in the natural unemployment rate.

The second hypothesis has to do with monetary pol- icy. As we discussed in Chapter 8, when the price of oil increased in the 1970s, inflation expectations were not anchored. Seeing the initial increase in inflation as a result of the increase in the price of oil, wage setters assumed that inflation would continue to be high, and thus asked for higher nominal wages, which led to further increases in inflation. In contrast, in the 2000s, inflation was much more anchored. Seeing the initial increase in inflation, wage setters assumed it was a one-time increase and did not change their expectations of future inflation as much as they would have in the 1970s. Thus, the effect on inflation was much more muted, and the need for the Fed to control inflation through higher policy rates and low output was much more limited.

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GDP response, pre-1987 data

Figure 1 The Effects of a 100% Permanent Increase in the Price of Oil on the CPI and on GDP

The effects of an increase in the price of oil on output and the price level are smaller than they used to be.

192 The Medium Run The Core

curve shifts to the left, leading to a decrease in output not only in the medium run, but in the short run as well.

A second issue has to do with the evolution of inflation. Note that, until output decreases to its new lower potential level, inflation continues to increase. Thus, when the  economy reaches point A==, inflation is higher than it was before the increase in the price of oil. If the central bank wants to return inflation to its initial level, it must decrease output below potential for some time to decrease inflation. In this case, the decrease in output along the adjustment process will exceed the medium-run decrease for some time. Put more simply, the economy may go through a large recession, with only a partial recovery.

The third issue is related to the second and again has to do with the formation of in- flation expectations. Suppose that instead of assuming that inflation will be equal to last year’s inflation, wage setters expect inflation to be constant. In this case, as we have seen, output above potential leads to high rather than increasing inflation. Then, as output declines to its lower potential level, inflation declines as well. When the economy reaches point A==, inflation is back to where it was before the increase in the price of oil. There is no need for the central bank to further decrease output to decrease inflation. This again shows the importance of expectation formation on the dynamic effects of shocks. It also helps explain the difference between the effect of the price of oil in the 1970s, which led to high inflation and a large recession, with the effects of the price of oil in the 2000s, which was much more benign. This is explored at more length in the Focus Box “Oil Price Increases: Why Were the 2000s So Different from the 1970s?”

9-5 Conclusions This chapter has covered a lot of ground. Let us repeat some key ideas and develop some of the conclusions.

The Short Run versus the Medium Run One key message of this chapter is that shocks or changes in policy typically have differ- ent effects in the short run and in the medium run. Disagreements among economists about the effects of various policies often come from differences in the time frame they have in mind. If you are worried about output and investment in the short run, you might be reluctant to proceed with fiscal consolidation. But if your focus is on the me- dium and long run, you will see the consolidation as helping investment and eventually, through higher investment and thus capital accumulation, increasing output. One implication is that where you stand depends in particular on how fast you think the economy adjusts to shocks. If you believe that it takes a long time for output to return to potential you will naturally focus more on the short run and be willing to use policies that increase output in the short run, even if medium-run effects are nil or negative. If you believe instead that output returns to potential quickly, you will put more empha- sis on the medium-run implications and will, by implication, be more reluctant to use those policies.

Shocks and Propagation Mechanisms This chapter also gives you a general way of thinking about output fluctuations (sometimes called business cycles)—movements in output around its trend (a trend that we have ignored so far but on which we will focus in Chapters 10 through 13).

You can think of the economy as being constantly hit by shocks. These shocks may be shifts in consumption coming from changes in consumer confidence, shifts

MyEconLab Video

in investment, and so on. Or they may come from changes in policy—from the introduc- tion of a new tax law, to a new program of infrastructure investment, to a decision by the central bank to fight inflation.

Each shock has dynamic effects on output and its components. These dynamic ef- fects are called the propagation mechanism of the shock. Propagation mechanisms are different for different shocks. The effects of a shock on activity may build up over time, affecting output in the medium run. Or the effects may build up for a while and then decrease and disappear. At times, some shocks are sufficiently large or come in suf- ficiently bad combinations that they create a recession. The two recessions of the 1970s were due largely to increases in the price of oil; the recession of the early 1980s was due to a sharp contraction in money; the recession of the early 1990s was due primarily to a sudden decline in consumer confidence; the recession of 2001 was due to a sharp drop in investment spending. The recent crisis and the sharp decrease in output in 2009 had its origins in the problems of the housing market, which then led to a major financial shock, and in turn to a sharp reduction in output. What we call economic fluctuations are the result of these shocks and their dynamic effects on output. Typically, the economy returns over time to its medium-run equilibrium. But, as we have seen when discussing for example the interaction between the zero lower bound and deflation, things can get quite bad for some time.

c

How to define shocks is hard- er than it looks. Suppose a failed economic program in an Eastern European coun- try leads to political chaos in that country, which leads to increased risk of nuclear war in the region, which leads to a fall in consumer confidence in the United States, which leads to a recession in the United States. What is the “shock”? The failed program? The fall of democracy? The increased risk of nuclear war? Or the decrease in consumer confi- dence? In practice, we have to cut the chain of causation somewhere. Thus, we may refer to the drop in consumer confidence as the shock and ignore its underlying causes.

Summary

■■ In the short run, output is determined by demand. The out- put gap, defined as the difference between output and poten- tial output, affects inflation.

■■ A positive output gap leads to higher inflation. Higher inflation leads the central bank to increase the policy rate. The increase in the policy rate leads to a decrease in output and thus to a decrease in the output gap. Symmetrically, a negative output gap leads to lower inflation. Lower inflation leads to the central bank to decrease the policy rate. The decrease in the policy rate increases output and thus decreases the output gap.

■■ In the medium run, output is equal to potential output. The output gap is equal to zero, and inflation is stable. The inter- est rate associated with output equal to potential is called the natural interest rate.

■■ When the output gap is negative, the combination of the zero lower bound and deflation may lead to a deflation spiral. Lower output leads to lower inflation. Lower infla- tion leads to a higher real interest rate. The higher real interest rate further decreases output, further lowering inflation.

■■ In the short run, a fiscal consolidation through higher taxes leads, at an unchanged policy rate, to a decrease in output, a decrease in consumption, and a decrease in investment. In

the medium run, output returns to potential. Consumption is lower, and investment is higher.

■■ An increase in the price of oil leads in the short run to higher inflation. Depending on the effect of the price of oil on demand, it may also lead to a decrease in output. The combination of higher inflation and lower output is called stagflation. In the medium run, the increase in the price of oil leads to leads to lower potential output and thus lower actual output.

■■ The difference between short-run effects and medium-run effects of policies is one of the reasons economists disagree in their policy recommendations. Some economists believe the economy adjusts quickly to its medium-run equilib- rium, so they emphasize medium-run implications of policy. Others believe the adjustment mechanism through which output returns to the natural level of output is a slow pro- cess at best, and so they put more emphasis on the short-run effects of policy.

■■ Economic fluctuations are the result of a continual stream of shocks to aggregate supply or to aggregate demand and of the dynamic effects of each of these shocks on output. Sometimes the shocks are sufficiently adverse, alone or in combination, that they lead to a recession.

Chapter 9 From the Short to the Medium Run: The IS-LM-PC Model 193

194 The Medium Run The Core

central bank change rn to maintain the existing medium- run equilibrium. Explain in words.

d. Suppose G increases. How must the central bank change rn to maintain the existing medium-run equilibrium? Explain in words.

e. Suppose T decreases. How must the central bank change rn to maintain the existing medium-run equilibrium? Explain in words.

f. Discuss: In the medium run, a fiscal expansion leads to an increase in the natural rate of interest.

3. The two paths to the medium-run equilibrium explored in this chapter make two different assumptions about the formation of the level of expected inflation. One path assumes the level of expected inflation equals lagged inflation. The level of expected inflation changes over time. The other path assumes the level of expected inflation is anchored to a specific value and never changes. Begin in medium-run equilibrium where actual and expected inflation equals 2% in period t.

a. Suppose there is an increase in consumer confidence in pe- riod t + 1. How does the IS curve shift? Assume that the central bank does not change the real policy rate. How will the short-run equilibrium in period t + 1 compare to the equilibrium in period t?

b. Consider the period t + 2 equilibrium under the assump- tion that pt + 2

e = pt + 1. If the central bank leaves the real policy rate unchanged, how does actual inflation in period t + 2 compare to inflation in period t + 1? How must the central bank change the nominal policy rate to keep the real policy rate unchanged? Continue to period t + 3. Making the same assumption about the level of expected inflation and the real policy rate, how does actual inflation in period t + 3 compare to inflation in period t + 2.

c. Consider the period t + 2 equilibrium making the as- sumption that pt + 2

e = pQ . If the central bank leaves the real policy rate unchanged, how does actual inflation in period t + 2 compare to inflation in period t + 1? How must the central bank change the nominal policy rate to keep the real policy rate unchanged? Continue to period t + 3. Making the same assumption about the level of expected inflation and the real policy rate, how does

Questions and Problems

QUICk CheCk MyEconLab Visit www.myeconlab.com to complete all Quick Check problems and get instant feedback. 1. Using the information in this chapter, label each of the following statements true, false, or uncertain. Explain briefly.

a. The IS curve shifts up with an increase in G, up with an increase in T, and up with an increase in x.

b. If 1u - un2 is greater than zero, then 1Y - Yn2 is greater than zero.

c. If 1u - un2 is equal to zero, the output is at potential. d. If 1u - un2 is less than zero, the output gap is negative. e. If the output gap is positive, inflation is higher than

expected inflation. f. Okun’s law says that if output growth increases by one

percentage point, the rate of unemployment drops by one percentage point.

g. At the natural rate of unemployment, inflation is neither rising nor falling.

h. In a medium-run equilibrium, the rate of inflation is stable. i. The central bank can always act to keep output equal to

potential output. j. It is easier for the central bank to keep output at potential

output if expectations of inflation are anchored. k. A large increase in the price of oil increases the natural rate

of unemployment.

2. The medium-run equilibrium is characterized by four conditions:

Output is equal to potential output Y = Yn. The unemployment rate is equal to the natural rate u = un. The real policy interest rate is equal to the natural rate of interest rn where aggregate demand equals Yn. The expected rate of inflation pe is equal to the actual rate of inflation p.

a. If the level of expected inflation is formed so pe equals p1-12, characterize the behavior of inflation in a medium- run equilibrium.

b. If the level of expected inflation is pQ , what is the level of actual inflation in the medium-run equilibrium?

c. Write the IS relation as Y = C1Y - T2 + I1Y, r + x2 + G. Suppose rn is 2%. If x increases from 3 to 5%, how must the

Key Terms

potential output, 179 output gap, 179 labor hoarding, 181 Okun coefficient, 181 natural rate of interest, 182 neutral rate of interest, 182 Wicksellian rate of interest, 182 anchored (expectations), 183

deflation spiral, 184 deflation trap, 184 Organization of Petroleum Exporting Countries (OPEC), 188 stagflation, 190 output fluctuations, 192 business cycles, 192 shocks, 192 propagation mechanism, 193

Chapter 9 From the Short to the Medium Run: The IS-LM-PC Model 195

actual inflation in period t + 3 compare to inflation in period t + 2?

d. Compare the inflation and output outcomes in part b to that in part c.

e. Which scenario, part b or part c, do you think is more real- istic. Discuss.

f. Suppose in period t + 4, the central bank decides to raise the real policy rate high enough to return the economy immediately to potential output and to the period t rate of inflation. Explain the difference between central bank poli- cies using the two assumptions about expected inflation in part b and part c.

4. A shock to aggregate supply will also have different outcomes when there are different assumptions about the formation of the level of expected inflation. As in Question 3, one path assumes that the level of expected inflation equals lagged inflation. The level of expected inflation changes over time. The second path assumes the level of expected inflation is anchored to a specific value and never changes. Begin in medium-run equilibrium where actual and expected inflation equal 2% in period t.

a. Suppose there is a permanent increase in the price of oil in period t + 1. How does the PC curve shift? Assume that the central bank does not change the real policy rate. How will the short-run equilibrium in period t + 1 compare to the equilibrium in period t? What happens to output? What happens to inflation?

b. Consider the period t + 2 equilibrium under the assumption that pt + 2

e = pt + 1. If the central bank leaves the real policy rate unchanged, how does actual inflation in period t + 2 compare to inflation in period t + 1? Continue to period t + 3. Making the same assumption about the level of ex- pected inflation and the real policy rate, how does actual in- flation in period t + 3 compare to inflation in period t + 2?

c. Consider the period t + 2 equilibrium under the assump- tion that pt + 2

e = pQ . If the central bank leaves the real policy rate unchanged, how does actual inflation in period t + 2 compare to inflation in period t + 1? Continue to period t + 3. Making the same assumption about the level of ex- pected inflation and the real policy rate, how does actual in- flation in period t + 3 compare to inflation in period t + 2.

d. Compare the inflation and output outcomes in part b to that in part c.

e. In period t + 4, the central bank decides to change the real policy rate to return the economy as quickly as pos- sible to potential output and to the inflation rate of pe- riod t. Under which path for the formation of expected inflation is the nominal policy rate of interest higher in period t + 4, the path from b or the path from c. Explain why, when inflation expectations are anchored as in part c, the central bank can change the policy rate to immediately reach the new level of potential out- put and the period t level of inflation in period t + 4. Make the argument that is not possible for the central bank to immediately hit both the new level of potential output and the period t level of inflation in period t + 4 when ex- pected inflation is equal to its lagged value.

DIG DeePeR MyEconLab Visit www.myeconlab.com to complete all Dig Deeper problems and get instant feedback. 5. Okun’s Law is written as u - u1-12 = -0.4 1gY - 3%2

a. What is the sign of u - u1-12 in a recession? What is the sign of u - u1-12 in a recovery?

b. Explain where the 3% number comes from? c. Explain why the coefficient on the term 1gY - 3%2 is -0.4

and not -1. d. Suppose the number of immigrants per year allowed to

enter the United States is sharply increased. How would Okun’s law change?

6. Fiscal consolidation at the Zero Lower Bound Suppose the economy is operating at the zero lower bound for

the nominal policy rate; there is a large government deficit and the economy is operating at potential output in period t. A newly elected government vows to cut spending and reduces the deficit in period t + 1, period t + 2 and subsequent periods.

a. Show the effects of the policy on output in period t + 1. b. Show the effects of the policy on the change in inflation in

period t + 1. c. If expected inflation depends on past inflation, then what

happens to the real policy rate in period t + 2? How will this affect output in period t + 3?

d. How does the zero lower bound on nominal interest rates make a fiscal consolidation more difficult?

exPLORe FURtheR

7. Consider the data in the Focus Box, “Deflation in the Great Depression.”

a. Do you believe that output had returned to its potential level in 1933?

b. Which years suggest a deflation spiral as described in Figure 9-3?

c. Make the argument that if the expected level of inflation had remained anchored at the actual value of inflation in 1929, the Great Depression would have been less severe.

d. Make the argument that a substantial fiscal stimulus in 1930 would have made the Great Depression less severe.

8. Consider the data in the Focus Box, “Deflation in the Great Depression.”

a. Calculate real interest rates in each year making the as- sumption that the expected level of inflation is last year’s rate of inflation. The rate of inflation in 1928 was -1.7%. Do the changes in real interest rates explain the data on real output growth and unemployment better than when you make the assumption the expected rate of inflation is the current year’s rate of inflation?

b. Calculate the Okun’s law coefficient for each year from 1930 to 1933. To do so, assume potential output is not growing. Speculate on why firms did not take on additional workers in 1933 even though output growth was 9.1%. Hint: If potential output is not growing, Okun’s law is u - u1-12 = -agY .

196 The Medium Run The Core

b. Is there evidence of the effect of high real interest rates on output?

c. Is there evidence of a poor choice of the real policy interest rate by the central bank?

The Nominal Interest Rate, Inflation, and the Real Interest Rate in the United Kingdom, 1929–1933

Year Unemployment

Rate (%)

Output Growth Rate

(%) One-Year Nominal Interest Rate (%), i

Inflation Rate (%), P

One-Year Real Interest Rate (%), r

1929 10.4 3.0 5.0 −0.90 5.9

1930 21.3 −1.0 3.0 −2.8 5.8

1931 22.1 −5.0 6.0 −4.3 10.3

1932 19.9 0.4 2.0 −2.6 4.6

1933 16.7 3.3 2.0 −2.1 4.1

9. The Great Depression in the United Kingdom Answer the following questions based on information found in

the table below a. Is there evidence of the deflation spiral from 1929 to 1933

in the United Kingdom?

197

Chapter 12

Chapter 12 turns to technological progress. It shows how, in the long run, the growth rate of an economy is determined by the rate of technological progress. It then looks at the role of research and development in generating such progress. It returns to the facts of growth presented in Chapter 10 and shows how to interpret these facts in the light of the theories developed in Chapters 11 and 12.

Chapter 11

Chapter 11 focuses on the role of capital accumulation in growth. It shows that capital accumulation cannot by itself sustain growth, but that it does affect the level of output. A higher saving rate typically leads to lower consumption initially, but to more consumption in the long run.

Chapter 10

Chapter 10 looks at the facts of growth. It first documents the large increase in output that has taken place in rich countries over the past 50 years. Then, taking a wider look, it shows that on the scale of human history, such growth is a recent phenomenon. And it is not a universal phenomenon: Some countries are catching up, but some poor countries are suffering from no or low growth.

Th e

C o

r e The Long Run

The next four chapters focus on the long run. In the long run, what dominates is not fluctuations, but growth. So now we need to ask: What determines growth?

Chapter 13

Chapter 13 looks at a number of issues raised by technological progress in the short, the medium, and the long run. Focusing on the short and the medium run, it discusses the relation between technological progress, unemployment, and wage inequality. Focusing on the long run, it discusses the role of institutions in sustaining technological progress and growth.

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199

o

10 The Facts of Growth ur perceptions of how the economy is doing are often dominated by year-to-year fluctuations in economic activity. A recession leads to gloom, and an expansion to optimism. But if we step back to get a look at activity over longer periods—say over many decades—the picture changes. Fluctuations fade. Growth, which is the steady increase in aggregate output over time, dominates the picture.

Figure 10-1, panels (a) and (b), shows the evolution of U.S. GDP and the evolution of U.S. GDP per person (both in 2009 dollars), respectively, since 1890. (The scale used to measure GDP on the vertical axis in Figure 10-1 is called a logarithmic scale. The defining characteristic of a logarithmic scale is that the same proportional increase in a variable is represented by the same distance on the vertical axis.)

The shaded years from 1929 to 1933 correspond to the large decrease in output during the Great Depression, and the other two shaded ranges correspond to the 1980–1982 recession, which is the largest post-war recession before the recent crisis, and 2008–2010, the most recent crisis and the subject of much of the analysis in the rest of this text. Note how small these three episodes appear compared to the steady increase in output per person over the last 100 years. The cartoon makes the same point about growth and fluctuations, in an even more obvious way.

With this in mind, we now shift our focus from fluctuations to growth. Put another way, we turn from the study of the determination of output in the short and medium run—where fluctua- tions dominate—to the determination of output in the long run—where growth dominates. Our goal is to understand what determines growth, why some countries are growing while others are not, and why some countries are rich while many others are still poor.

Section 10-1 discusses a central measurement issue; namely how to measure the standard of living.

Section 10-2 looks at growth in the United States and other rich countries over the last 50 years.

Section 10-3 takes a broader look, across both time and space.

Section 10-4 then gives a primer on growth and introduces the framework that will be developed in the next three chapters.

b For more on log scales, see Appendix 2 at the end of the book.

200 The Long Run The Core

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Figure 10-1

U.S. GDP since 1890 and U.S. GDP per Person since 1890

Panel A shows the enormous increase in U.S. output since 1890, by a factor of 46. Panel B shows that the increase in output is not simply the result of the large increase in U.S. population from 63 million to more than 300 million over this period. Output per person has risen by a factor of 9.

Source: 1890–1947: Historical Statistics of the United States. http:// hsus.cambridge.org/HSUSWeb/ toc/hsusHome.do. 1948 to 2014: National Income and Product Accounts. Population estimates 1890 to 2014, from Louis Johnston and Samuel H. Williamson, “What Was the U.S. GDP Then?” Measuring Worth, 2015, https://www.measuring worth.com/datasets/usgdp/

MyEconLab Real-time data

10-1 Measuring the Standard of Living The reason we care about growth is that we care about the standard of living. Looking across time, we want to know by how much the standard of living has increased. Looking across countries, we want to know how much higher the standard of living is in one country relative to another. Thus, the variable we want to focus on, and compare either over time or across countries, is output per person, rather than output itself.

A practical problem then arises: How do we compare output per person across coun- tries? Countries use different currencies; thus output in each country is expressed in terms of its own currency. A natural solution is to use exchange rates. When comparing, say, the output per person of India to the output per person of the United States, we can compute Indian GDP per person in rupees, use the exchange rate to get Indian GDP per person in dollars, and compare it to the U.S. GDP per person in dollars. This simple ap- proach will not do, however, for two reasons.

■■ First, exchange rates can vary a lot (more on this in Chapters 17 to 20). For exam- ple, the dollar increased and then decreased in the 1980s by roughly 50% vis-à-vis the currencies of the trading partners of the United States. But surely the standard of living in the United States did not increase by 50% and then decrease by 50% compared to the standard of living of its trading partners during the decade. Yet this is the conclusion we would reach if we were to compare GDP per person using exchange rates.

c

Output per person is also called output per capita (capita means “head” in Latin). And given that output and income are always equal, it is also called income per person, or income per capita.

Chapter 10 The Facts of Growth 201

■■ The second reason goes beyond fluctuations in exchange rates. In 2011, GDP per person in India, using the current exchange rate, was $1,529 compared to $47,880 in the United States. Surely no one could live on $1,529 a year in the United States. But people live on it—admittedly, not very well—in India, where the prices of basic goods, which are those goods needed for subsistence, are much lower than in the United States. The level of consumption of the average person in India, who con- sumes mostly basic goods, is not 31.3 (47,880 divided by 1,529) times smaller than that of the average person in the United States. This point applies to other countries besides the United States and India. In general, the lower a country’s output per person, the lower the prices of food and basic services in that country.

So, when we focus on comparing standards of living, we get more meaningful com- parisons by correcting for the two effects we just discussed—variations in exchange rates and systematic differences in prices across countries. The details of constructing these differences are complicated, but the principle is simple. The numbers for GDP—and hence for GDP per person—are constructed using a common set of prices for all coun- tries. Such adjusted real GDP numbers, which you can think of as measures of pur- chasing power across time or across countries, are called purchasing power parity (PPP) numbers. Further discussion is given in the Focus box “The Construction of PPP Numbers.”

When comparing rich versus poor countries, the differences between PPP num- bers and the numbers based on current exchange rates can be large. Return to the comparison between India and the United States. We saw that, at current exchange rates, the ratio of GDP per person in the United States to GDP per person in India was 31.3. Using PPP numbers, the ratio is “only” 11. Although this is still a large differ- ence, it is much smaller than the ratio we obtained using current exchange rates. Differences between PPP numbers and numbers based on current exchange rates are typically smaller when making comparisons among rich countries. For example,

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The Construction of PPP Numbers Fo

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s Consider two countries—let’s call them the United States and Russia, although we are not attempting to fit the characteris- tics of those two countries very closely.

In the United States, annual consumption per person equals $20,000. People in the United States each buy two goods. Every year, they buy a new car for $10,000 and spend the rest on food. The price of a yearly bundle of food in the United States is $10,000.

In Russia, annual consumption per person equals 60,000 rubles. People there keep their cars for 15 years. The price of a car is 300,000 rubles, so individuals spend on average 20,000 rubles—300,000>15—a year on cars. They buy the same yearly bundle of food as their U.S. counterparts, at a price of 40,000 rubles.

Russian and U.S. cars are of identical quality, and so are Russian and U.S. food. (You may dispute the realism of these assumptions. Whether a car in country X is the same as a car in country Y is the type of problem confronting economists when constructing PPP measures.) The exchange rate is such that one dollar is equal to 30 rubles. What is consumption per person in Russia relative to consumption per person in the United States?

One way to answer is by taking consumption per person in Russia and converting it into dollars using the exchange rate. Using this method, Russian consumption per person in dollars is $2,000 (60,000 rubles divided by the exchange rate, 30 rubles to the dollar). According to these numbers, consumption per person in Russia is only 10% of U.S. con- sumption per person.

Does this answer make sense? True, Russians are poorer, but food is much cheaper in Russia. A U.S. consumer spending all of his 20,000 dollars on food would buy 2 bundles of food ($20,000>$10,000). A Russian consumer spending all of his 60,000 rubles on food would buy 1.5 bundles of food (60,000 rubles>40,000 rubles). In terms of food bundles, the differ- ence looks much smaller between U.S. and Russian consump- tion per person. And given that one-half of consumption in the United States and two-thirds of consumption in Russia go to spending on food, this seems like a relevant computation.

Can we improve on our initial answer? Yes. One way is to use the same set of prices for both countries and then measure

the quantities of each good consumed in each country using this common set of prices. Suppose we use U.S. prices. In terms of U.S. prices, annual consumption per person in the United States is obviously still $20,000. What is it in Russia? Every year, the average Russian buys approximately 0.07 car (one car every fifteen years) and one bundle of food. Using U.S. prices—specifically, $10,000 for a car and $10,000 for a bundle of food—gives Russian consumption per person as 3 10.07 : $10,000 2 + 11 : $10,000 2 4 = 3$ 700 + $10,000 4 = $10,700. So, using U.S. prices to compute consumption in both countries puts annual Russian con- sumption per person at $10,700 ,$20,000 = 53.5% of annual U.S. consumption per person, a better estimate of relative standards of living than we obtained using our first method (which put the number at only 10%).

This type of computation, namely the construction of variables across countries using a common set of prices, underlies PPP estimates. Rather than using U.S. dollar prices as in our example (why use U.S. rather than Russian or, for that matter, French prices?), these estimates use average prices across countries. These average prices are called international dollar prices. Many of the estimates we use in this chapter are the result of an ambitious project known as the “Penn World Tables.” (Penn stands for the University of Pennsylvania, where the project was initially located.) Led by three economists—Irving Kravis, Robert Summers, and Alan Heston—over the course of more than 40 years, researchers working on the project have con- structed PPP series not only for consumption (as we just did in our example), but more generally for GDP and its components, going back to 1950, for most countries in the world. Recently the Penn World Tables project, while keep- ing the same name, has been taken over by the University of California–Davis and the University of Groningen in the Netherlands, with continued input from Alan Heston at the University of Pennsylvania. The most recent data (version 8.1 of the Tables) are available at http://cid.econ.ucdavis. edu/instead of internationaldata.org (See Feenstra, Robert C., Robert Inklaar, and Marcel P. Timmer (2015), “The Next Generation of the Penn World Tables” published in the American Economic Review.)

using current exchange rates, GDP per person in the United States in 2011 was equal to 109% of GDP per person in Germany; based on PPP numbers, GDP per person in the United States was equal to 123% of GDP per person in Germany. More gener- ally, PPP numbers suggest that the United States still has the highest GDP per person among the world’s major countries.

Let me end this section with three remarks before we move on and look at growth.

■■ What matters for people’s welfare is their consumption rather than their income. One might therefore want to use consumption per person rather than output per per- son as a measure of the standard of living. (This is indeed what we did in the Focus

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The bottom line: When com- paring the standard of living across countries, make sure to use PPP numbers.

Chapter 10 The Facts of Growth 203

box, “The Construction of PPP Numbers.”) Because the ratio of consumption to output is rather similar across countries, the ranking of countries is roughly the same, whether we use consumption per person or output per person.

■■ Thinking about the production side, we may be interested in differences in produc- tivity rather than in differences in the standard of living across countries. In this case, the right measure is output per worker—or, even better, output per hour worked if the information about total hours worked is available—rather than output per per- son. Output per person and output per worker (or per hour) will differ to the extent that the ratio of the number of workers (or hours) to population differs across coun- tries. Most of the difference we saw between output per person in the United States and in Germany comes, for example, from differences in hours worked per person rather than from differences in productivity. Put another way, German workers are about as productive as their U.S. counterparts. However, they work fewer hours, so their standard of living, measured by output per person, is lower. In exchange, how- ever, they enjoy more leisure time.

■■ The reason we ultimately care about the standard of living is presumably that we care about happiness. We may therefore ask the obvious question: Does a higher standard of living lead to greater happiness? The answer is given in the Focus box “Does Money Buy Happiness?”. The answer: a qualified yes.

10-2 Growth in Rich Countries since 1950 Let’s start by looking, in this section, at growth in rich countries since 1950. In the next section, we shall look further back in time and across a wider range of countries.

Table 10-1 shows the evolution of output per person (GDP divided by population, measured at PPP prices) for France, Japan, the United Kingdom, and the United States, since 1950. We have chosen these four countries not only because they are some of the world’s major economic powers, but also because what has happened to them is broadly representative of what has happened in other advanced countries over the last half- century or so.

Table 10-1 yields two main conclusions:

■■ There has been a large increase in output per person. ■■ There has been a convergence of output per person across countries.

Let’s look at each of these points in turn.

Table 10-1 The Evolution of Output per Person in Four Rich Countries since 1950

Annual Growth Rate Output per Person (%)

Real Output per Person (2005 dollars)

1950–2011 1950 2011 2011/1950

France 2.5 6,499 29,586 4.6

Japan 4.1 2,832 31,867 11.3

United Kingdom 2.0 9,673 32,093 3.3

United States 2.0 12,725 42,244 3.3

Average 2.4 7,933 33,947 4.3

Notes: The data stop in 2011, the latest year (at this point) available in the Penn tables. The average in the last line is a simple unweighted average.

Source: Penn Tables. http://cid.econ.ucdavis.edu/pwt.html

204 The Long Run The Core

Does Money Lead to happiness? Fo

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s Does money lead to happiness? Or, put more accurately, does higher income per person lead to more happiness? The im- plicit assumption, when economists assess the performance of an economy by looking at its level of income per person or at its growth rate, is that this is indeed the case. Early examinations of data on the relation between income and self-reported measures of happiness suggested that this as- sumption may not be right. They yielded what is now known as the Easterlin paradox (so named for Richard Easterlin, who was one of the first economists to look systematically at the evidence):

■■ Looking across countries, happiness in a country ap- peared to be higher, the higher the level of income per person. The relation, however, appeared to hold only in relatively poor countries. Looking at rich countries, say the set of Organisation for Economic Co-operation and Development (OECD) countries (look at Chapter 1 for the list), there appeared to be little relation between income per person and happiness.

■■ Looking at individual countries over time, average hap- piness in rich countries did not seem to increase much, if at all, with income. (There were no reliable data for poor countries.) In other words, in rich countries, higher income per person did not appear to increase happiness.

■■ Looking across people within a given country, happi- ness appeared to be strongly correlated with income.

Rich people were consistently happier than poor people. This was true in both poor and rich countries.

The first two facts suggested that, once basic needs are satisfied, higher income per person does not increase happi- ness. The third fact suggested that what was important was not the absolute level of income but the level of income rela- tive to others.

If this interpretation is right, it has major implications for the way we think about the world and about economic policies. In rich countries, policies aimed at increasing in- come per person might be misdirected because what matters is the distribution of income rather than its average level. Globalization and the diffusion of information, to the extent that it makes people in poor countries compare themselves not to rich people in the same country but to people in richer countries, may actually decrease rather than increase hap- piness. So, as you can guess, these findings have led to an intense debate and further research. As new data sets have become available, better evidence has accumulated. The state of knowledge and the remaining controversies are analyzed in a recent article by Betsey Stevenson and Justin Wolfers. Their conclusions are well summarized in Figure 1.

The figure contains a lot of information. Let’s go through it step by step.

The horizontal axis measures PPP GDP per person for 131 countries. The scale is a logarithmic scale, so a given size interval represents a given percentage increase in GDP per

Afghanistan

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Each dot represents one country

Higher-income and lower- income people are equally satisfied

Higher-income people are more satisfied

The line around the dot shows how satisfaction relates to income within that country:

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Figure 1 Life Satisfaction and Income per Person

Source: Betsey Stevenson and Justin Wolfers, Wharton School at the University of Pennsylvania.

Chapter 10 The Facts of Growth 205

person. The vertical axis measures average life satisfaction in each country. The source for this variable is a 2006 Gallup World Poll survey, which asked about a thousand individuals in each country the following question:

“Here is a ladder representing the ‘ladder of life.’ Let’s sup- pose the top of the ladder represents the best possible life for you; and the bottom, the worst possible life for you. On which step of the ladder do you feel you personally stand at the present time?”

The ladder went from 0 to 10. The variable measured on the vertical axis is the average of the individual answers in each country.

Focus first on the dots representing each country, ignor- ing for the moment the lines that cross each dot. The visual impression is clear. There is a strong relation across countries between average income and average happiness. The index is around 4 in the poorest countries, around 8 in the richest. And, more importantly in view of the early Easterlin paradox, this relation appears to hold both for poor and rich countries; if anything, life satisfaction appears to increase faster, as GDP per person increases, in rich than in poor countries.

Focus now on the lines through each dot. The slope of each line reflects the estimated relation between life satis- faction and income across individuals within each country. Note first that all the lines slope upward. This confirms the third leg of the Easterlin paradox. In each country, rich people are happier than poor people. Note also that the slopes of most of these lines are roughly similar to the slope of the relation across countries. This goes against the Easterlin paradox. Individual happiness increases with in- come, whether this is because the country is getting richer or because the individual becomes relatively richer within the country.

Stevenson and Wolfers draw a strong conclusion from their findings. Although individual happiness surely depends on much more than income, it definitely increases with income. While the idea that there is some critical level of income beyond which income no longer impacts well-being is intuitively appealing, it is at odds with the data. Thus, it is not a crime for economists to focus first on levels and growth rates of GDP per person.

So, is the debate over? The answer is no. Even if we ac- cept this interpretation of the evidence, clearly, many other aspects of the economy matter for welfare, income distribu- tion surely being one of them. And not everyone is convinced by the evidence. In particular, the evidence on the relation between happiness and income per person over time within a country is not as clear as the evidence across countries or across individuals presented in Figure 1.

Given the importance of the question, the debate will continue for some time. One aspect which has become clear, for example from the work of Nobel Prize winners Angus Deaton and Daniel Kahneman is that, when thinking about “happiness,” it is important to distinguish between two ways in which a person may assess her or his well-being. The first one is emotional well-being—the frequency and intensity of experiences such as joy, stress, sadness, anger, and affec- tion that make one’s life pleasant or unpleasant. Emotional well-being appears to rise with income because low income exacerbates the emotional pain associated with such misfor- tunes as divorce, ill health, and being alone. But only up to a threshold; there is no further progress beyond an annual income of about $75,000 (the experiment was run in 2009). The second is life satisfaction, a person’s assessment of her or his life when they think about it. Life satisfaction appears more closely correlated with income. Deaton and Kahneman conclude that high income buys life satisfaction but does not necessarily buy happiness. If measures of well-being are to be used to guide policy, their findings raise the question of whether life evaluation or emotional well-being is better suited to these aims.

Sources: Betsey Stevenson and Justin Wolfers, “Economic Growth and Subjective Well-Being: Reassessing the Easterlin Paradox,” Brookings Papers on Economic Activity, Vol. 2008 (Spring 2008): 1–87 and “Subjective Well-Being and Income: Is There Any Evidence of Satiation?” American Economic Review: Papers & Proceedings 2013, 103(3): 598–604; Daniel Kahneman and Angus Deaton, “High income improves evalu- ation of life but not emotional well-being,” Proceedings of the National Academy of Sciences 107.38 (2010): 16,489–16,493. For a view closer to the Easterlin paradox and a fascinating dis- cussion of policy implications, read Richard Layard, Happiness: Lessons from a New Science (2005).

The Large Increase in the Standard of Living since 1950 Look at the column on the far right of Table 10.1. Output per person has increased by a factor of 3.3 since 1950 in the United States, by a factor of 4.6 in France, and by a factor of 11.3 in Japan. These numbers show what is sometimes called the force of compounding. In a different context, you probably have heard how saving even a little while you are young will build to a large amount by the time you retire. For example, if the interest rate is 4.0% a year, an investment of one dollar, with the proceeds reinvested every year, will grow to about 11 dollars 61 years later. The same logic applies to growth rates. The average annual growth rate in Japan over the period 1950 to 2011 (which is 61 years) was equal to 4.0%. This high growth rate has led to an 11-fold increase in real output per person in Japan over the period.

Most of the increase in Japan took place before 1990. Since then, Japan has been in a pro- longed economic slump, with much lower growth.

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Clearly, a better understanding of growth, if it leads to the design of policies that stimulate growth, can have a large effect on the standard of living. Suppose we could find a policy measure that permanently increased the growth rate by 1% per year. This would lead, after 40 years, to a standard of living 48% higher than it would have been without the policy—a substantial difference.

The Convergence of Output per Person The second and third columns of Table 10-1 show that the levels of output per person have converged (become closer) over time. The numbers for output per person are much more similar in 2011 than they were in 1950. Put another way, those countries that were behind have grown faster, reducing the gap between them and the United States.

In 1950, output per person in the United States was roughly twice the level of output per person in France and more than four times the level of output per person in Japan. From the perspective of Europe or Japan, the United States was seen as the land of plenty, where everything was bigger and better.

Today these perceptions have faded, and the numbers explain why. Using PPP num- bers, U.S. output per person is still the highest, but in 2011, it was only 7% above average output per person in the other three countries, a much smaller difference than in the 1950s.

This convergence of levels of output per person across countries is not specific to the four countries we are looking at. It extends to the set of OECD countries. This is shown in Figure 10-2, which plots the average annual growth rate of output per person since 1950 against the initial level of output per person in 1950 for the set of countries that are members of the OECD today. There is a clear negative relation between the initial level of output per person and the growth rate since 1950. Countries that were be- hind in 1950 have typically grown faster. The relation is not perfect. Turkey, which had roughly the same low level of output per person as Japan in 1950, has had a growth rate equal to only about one-half that of Japan. But the relation is clearly there.

Some economists have pointed to a problem in graphs like Figure 10-2. By looking at the subset of countries that are members of the OECD today, what we have done in ef- fect is to look at a club of economic winners. OECD membership is not officially based on economic success, but economic success is surely an important determinant of member- ship. But when you look at a club whose membership is based on economic success, you will find that those who came from behind had the fastest growth. This is precisely why they made it to the club! The finding of convergence could come in part from the way we selected the countries in the first place.

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Unfortunately, policy measures with such magic results have proven difficult to discover!

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As a child in France in the 1950s, I thought of the United States as the land of sky- scrapers, big automobiles, and Hollywood movies.

c For the list of countries, see the appendix to Chapter 1. The figure includes only those OECD members for which we have a reliable estimate of the level of output per person in 1950.

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Growth Rate of GDP per Person since 1950 versus GDP per Person in 1950; OECD Countries

Countries with lower levels of output per person in 1950 have typically grown faster.

Source: Penn World Table Version 8.1./Feenstra, Robert C., Robert Inklaar and Marcel P. Timmer (2015), “The Next Generation of the Penn World Table” forthcoming American Economic Review, available for download at www.ggdc.net/pwt.

MyEconLab Animation

Chapter 10 The Facts of Growth 207

So a better way of looking at convergence is to define the set of countries we look at not on the basis of where they are today—as we did in Figure 10-2 by taking today’s OECD members—but on the basis of where they were in, say, 1950. For example, we can look at all countries that had an output per person of at least one-fourth of U.S. output per person in 1950, and then look for convergence within that group. It turns out that most of the countries in that group have indeed converged, and therefore convergence is not solely an OECD phenomenon. However, a few countries—Uruguay, Argentina, and Venezuela among them—have not converged. In 1950, those three countries had roughly the same output per person as France. In 2009, they had fallen far behind; their level of output per person stood only between one-fourth and one-half of the French level.

10-3 A Broader Look across Time and Space In the previous section, we focused on growth over the last 50 years in rich countries. Let’s now put this in context by looking at the evidence both over a much longer time span and a wider set of countries.

Looking across Two Millennia Has output per person in the currently rich economies always grown at rates similar to the growth rates in Table 10-1? The answer is no. Estimates of growth are clearly harder to construct as we look further back in time. But there is agreement among economic historians about the main evolutions over the last 2,000 years.

From the end of the Roman Empire to roughly year 1500, there was essentially no growth of output per person in Europe. Most workers were employed in agriculture in which there was little technological progress. Because agriculture’s share of output was so large, inventions with applications outside agriculture could only contribute little to overall production and output. Although there was some output growth, a roughly pro- portional increase in population led to roughly constant output per person.

This period of stagnation of output per person is often called the Malthusian era. Thomas Robert Malthus, an English economist at the end of the 18th century, argued that this proportional increase in output and population was not a coincidence. Any increase in output, he argued, would lead to a decrease in mortality, leading to an in- crease in population until output per person was back to its initial level. Europe was in a Malthusian trap, unable to increase its output per person.

Eventually, Europe was able to escape this trap. From about 1500 to 1700, growth of output per person turned positive, but it was still small—only around 0.1% per year. It then increased to just 0.2% per year from 1700 to 1820. Starting with the Industrial Revolution, growth rates increased, but from 1820 to 1950 the growth rate of output per person in the United States was still only 1.5% per year. On the scale of human his- tory, therefore, sustained growth of output per person—especially the high growth rates we have seen since 1950—is definitely a recent phenomenon.

Looking across Countries We have seen how output per person has converged among OECD countries. But what about the other countries? Are the poorest countries also growing faster? Are they con- verging toward the United States, even if they are still far behind?

The answer is given in Figure 10-3 on page 208, which plots the average annual growth rate of output per person since 1960 against output per person for the year 1960, for the 85 countries for which we have data.

The numbers for 1950 are missing for too many countries to use 1950 as the initial year, as we did in Figure 10-2.

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Figure 10-3

Growth Rate of GDP per Person since 1960, versus GDP per Person in 1960 (2005 dollars); 85 Countries

There is no clear relation between the growth rate of output since 1960 and the level of output per person in 1960.

Source: Penn World Table Version 8.1./Feenstra, Robert C., Robert Inklaar and Marcel P. Timmer (2015), “The Next Generation of the Penn World Table” forthcoming American Economic Review, available for download at www.ggdc.net/pwt.

MyEconLab Animation The striking feature of Figure 10-3 is that there is no clear pattern. It is not the case that, in general, countries that were behind in 1960 have grown faster. Some have, but many have clearly not.

The cloud of points in Figure 10-3 hides, however, a number of interesting patterns that appear when we put countries into different groups. Note that we have used differ- ent symbols in the figure. The diamonds represent OECD countries; the squares represent African countries; the triangles represent Asian countries. Looking at patterns by groups yields three main conclusions.

1. The picture for the OECD countries (for the rich countries) is much the same as in Figure 10-2, which looked at a slightly longer period of time (from 1950 onward, rather than from 1960). Nearly all start at high levels of output per person (say, at least one-third of the U.S. level in 1960), and there is clear evidence of convergence.

2. Convergence is also visible for many Asian countries: Most of the countries with high growth rates over the period are in Asia. Japan was the first country to take off. Starting a decade later, in the 1960s, four countries—Singapore, Taiwan, Hong Kong, and South Korea, a group of countries sometimes called the four tigers— started catching up as well. In 1960, their average output per person was about 18% of the United States; by 2011, it had increased to 85% of U.S. output. More recently, the major story has been China—both because of its very high growth rates and because of its sheer size. Over the period 1960–2011, growth of output per person in China has been 5.2% per year on average. But, because it started low, its output per person is still only about one-sixth of the United States.

3. The picture is different, however, for African countries. Most African countries (represented by squares) were very poor in 1960, and most have not done well over the period. Many have suffered from either internal or external conflicts. Eight of them have had negative growth of output per person—an absolute decline in their standard of living between 1960 and 2011. Growth averaged –0.83% in the Central African Republic as it did in Niger. As a result, output per person in the Central African Republic in 2011 is only 63% of its level in 1960. Hope for Africa, however, comes from more recent numbers. Growth of output per person in sub-Saharan Africa, which averaged only 1.3% in the 1990s, has been close to 5.5% since 2000.

Looking further back in time, the following picture emerges. For much of the first millennium, and until the 15th century, China probably had the world’s highest level of output per person. For a couple of centuries, leadership moved to the cities of

MyEconLab Video

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Paradoxically, the two fastest growing countries in Figure 10-3 are Botswana and Equa- torial Guinea, both in Africa. In both cases, however, high growth reflects primarily fa- vorable natural resources— diamonds in Botswana and oil in Guinea.

Chapter 10 The Facts of Growth 209

northern Italy. But until the 19th century, differences across countries were typically much smaller than they are today. Starting in the 19th century, a number of countries, first in Western Europe, then in North and South America, started growing faster than others. Since then, a number of other countries, most notably in Asia, have started growing fast and are converging. Many others, mainly in Africa, are not.

Our main focus, in this and the next chapter, will primarily be on growth in rich and emerging countries. We shall not take on some of the wider challenges raised by the facts we have just seen, such as why growth of output per person started in earnest in the 19th century or why Africa has remained so poor. Doing so would take us too far into economic history and development economics. But these facts put into perspective the two basic facts we discussed previously when looking at the OECD. Neither growth nor convergence is a historical necessity.

10-4 Thinking about Growth: A Primer To think about growth, economists use a framework developed originally by Robert Solow, from the Massachusetts Institute of Technology (MIT) in the late 1950s. The framework has proven sturdy and useful, and we will use it here. This section provides an introduction. Chapters 11 and 12 will provide a more detailed analysis, first of the role of capital accumulation and then of the role of technological progress in the process of growth.

The Aggregate Production Function The starting point for any theory of growth must be an aggregate production function, which is a specification of the relation between aggregate output and the in- puts in production.

The aggregate production function we introduced in Chapter 7 to study the determi- nation of output in the short run and the medium run took a particularly simple form. Output was simply proportional to the amount of labor used by firms; more specifically, proportional to the number of workers employed by firms (equation (7.2)). So long as our focus was on fluctuations in output and employment, the assumption was accept- able. But now that our focus has shifted to growth this assumption will no longer do. It implies that output per worker is constant, ruling out growth (or at least growth of out- put per worker) altogether. It is time to relax it. From now on, we will assume that there are two inputs—capital and labor—and that the relation between aggregate output and the two inputs is given by:

Y = F1K, N2 (10.1) As before, Y is aggregate output. K is capital—the sum of all the machines, plants,

and office buildings in the economy. N is labor—the number of workers in the economy. The function F, which tells us how much output is produced for given quantities of capi- tal and labor, is the aggregate production function.

This way of thinking about aggregate production is an improvement on our treat- ment in Chapter 7. But it should be clear that it is still a dramatic simplification of real- ity. Surely, machines and office buildings play different roles in production and should be treated as separate inputs. Surely, workers with doctorate degrees are different from high-school dropouts; yet, by constructing the labor input as simply the number of work- ers in the economy, we treat all workers as identical. We will relax some of these simpli- fications later. For the time being, equation (10.1), which emphasizes the role of both labor and capital in production, will do.

b

The distinction between growth theory and develop- ment economics is fuzzy. A rough distinction: Growth theory takes many of the in- stitutions of a country (e.g., its legal system and its form of government) as given. Devel- opment economics asks what institutions are needed to sus- tain steady growth, and how they can be put in place.

b See Robert M. Solow’s article, “A Contribution to the Theory of Economic Growth,” The Quarterly Journal of Econom- ics, Vol. 70, No. 1. (Feb., 1956), pp. 65–94. Solow was award- ed the Nobel Prize in 1987 for his work on growth.

b

The aggregate production function is

Y = F1K, N2

Aggregate output ( Y ) depends on the aggregate capital stock ( K ) and aggregate employ- ment ( N ).

210 The Long Run The Core

The next step must be to think about where the aggregate production function F, which relates output to the two inputs, comes from. In other words, what determines how much output can be produced for given quantities of capital and labor? The answer: the state of technology. A country with a more advanced technology will produce more output from the same quantities of capital and labor than will an economy with a primitive technology.

How should we define the state of technology? Should we think of it as the list of blue- prints defining both the range of products that can be produced in the economy as well as the techniques available to produce them? Or should we think of it more broadly, in- cluding not only the list of blueprints, but also the way the economy is organized—from the internal organization of firms, to the system of laws and the quality of their enforce- ment, to the political system, and so on? In the next two chapters we will have in mind the narrower definition—the set of blueprints. In Chapter 13, however, we will consider the broader definition and return to what we know about the role of the other factors, from legal institutions to the quality of government.

Returns to Scale and Returns to Factors Now that we have introduced the aggregate production function, the next question is: What restrictions can we reasonably impose on this function?

Consider first a thought experiment in which we double both the number of workers and the amount of capital in the economy. What do you expect will happen to output? A reasonable answer is that output will double as well. In effect, we have cloned the origi- nal economy, and the clone economy can produce output in the same way as the original economy. This property is called constant returns to scale. If the scale of operation is doubled—that is, if the quantities of capital and labor are doubled—then output will also double.

2Y = F12K, 2N2 Or, more generally, for any number x (this will be useful later)

xY = F1xK, xN2 (10.2) We have just looked at what happens to production when both capital and labor are

increased. Let’s now ask a different question. What should we expect to happen if only one of the two inputs in the economy—say capital—is increased?

Surely output will increase. That part is clear. But it is also reasonable to assume that the same increase in capital will lead to smaller and smaller increases in output as the level of capital increases. In other words, if there is little capital to start with, a little more capital will help a lot. If there is a lot of capital to start with, a little more capital may make little difference. Why? Think, for example, of a secretarial pool, composed of a given number of secretaries. Think of capital as computers. The introduction of the first computer will substantially increase the pool’s production because some of the more time-consuming tasks can now be done automatically by the computer. As the num- ber of computers increases and more secretaries in the pool get their own computers, production will further increase, although by less per additional computer than was the case when the first one was introduced. Once each and every secretary has a computer, increasing the number of computers further is unlikely to increase production much, if at all. Additional computers might simply remain unused and left in their shipping boxes and lead to no increase in output.

We shall refer to the property that increases in capital lead to smaller and smaller increases in output as decreasing returns to capital (a property that will be familiar to those who have taken a course in microeconomics).

c

The function F depends on the state of technology. The higher the state of technology, the higher F( K, N ) for a given K and a given N.

c

Constant returns to scale: F1xK, xN2 = xY.

Output here is secretarial ser- vices. The two inputs are sec- retaries and computers. The production function relates secretarial services to the number of secretaries and the number of computers.

c

Chapter 10 The Facts of Growth 211

A similar argument applies to the other input, labor. Increases in labor, given capital, lead to smaller and smaller increases in output. (Return to our example, and think of what happens as you increase the number of secretaries for a given number of computers.) There are decreasing returns to labor as well.

Output per Worker and Capital per Worker The production function we have written down, together with the assumption of con- stant returns to scale, implies that there is a simple relation between output per worker and capital per worker.

To see this, set x = 1>N in equation (10.2), so that

Y N

= Fa K N

, N N

b = Fa K N

, 1b (10.3)

Note that Y>N is output per worker, K>N is capital per worker. So equation (10.3) tells us that the amount of output per worker depends on the amount of capital per worker. This relation between output per worker and capital per worker will play a central role in what follows, so let’s look at it more closely.

This relation is drawn in Figure 10-4. Output per worker (Y>N) is measured on the vertical axis, and capital per worker (K>N) is measured on the horizontal axis. The relation between the two is given by the upward-sloping curve. As capital per worker increases, so does output per worker. Note that the curve is drawn so that increases in capital lead to smaller and smaller increases in output. This follows from the property that there are decreasing returns to capital: At point A, where capital per worker is low, an increase in capital per worker, represented by the horizontal distance AB, leads to an in- crease in output per worker equal to the vertical distance A=B=. At point C, where capital per worker is larger, the same increase in capital per worker, represented by the horizontal distance CD (where the distance CD is equal to the distance AB), leads to a much smaller increase in output per worker, only the distance C =D=. This is just like our secretarial pool example, in which additional computers had less and less impact on total output.

The Sources of Growth We are now ready to return to our basic question. Where does growth come from? Why does output per worker—or output per person, if we assume the ratio of workers to the population as a whole remains constant over time—go up over time? Equation (10.3) gives a first answer:

b

Even under constant returns to scale, there are decreasing returns to each factor, keeping the other factor constant. There are decreasing returns to capital. Given labor, increases in capital lead to smaller and smaller increases in output. There are decreasing returns to labor. Given capital, increases in labor lead to smaller and smaller increases in output.

b

Make sure you understand what is behind the algebra. Suppose capital and the num- ber of workers both double. What happens to output per worker?

b

Increases in capital per worker lead to smaller and smaller in- creases in output per worker as the level of capital per worker increases.

Capital per worker, K/N

A

O ut

pu t p

er w

or ke

r, Y

/N

Y/N 5 F (K/N, 1)

B C D

A

B

C D

Figure 10-4

Output and Capital per Worker

Increases in capital per worker lead to smaller and smaller in- creases in output per worker.

MyEconLab Animation

212 The Long Run The Core

■■ Increases in output per worker (Y>N) can come from increases in capital per worker (K>N). This is the relation we just looked at in Figure 10-4. As (K>N) increases— that is, as we move to the right on the horizontal axis—(Y>N) increases.

■■ Or they can come from improvements in the state of technology that shift the pro- duction function, F, and lead to more output per worker given capital per worker. This is shown in Figure 10-5. An improvement in the state of technology shifts the production function up, from F1K>N, 12 to F1K>N, 12=. For a given level of capital per worker, the improvement in technology leads to an increase in output per worker. For example, for the level of capital per worker corresponding to point A, output per worker increases from A= to B=. (To go back to our secretarial pool exam- ple, a reallocation of tasks within the pool may lead to a better division of labor and an increase in the output per secretary.)

Hence, we can think of growth as coming from capital accumulation and from technological progress—the improvement in the state of technology. We will see, however, that these two factors play different roles in the growth process.

■■ Capital accumulation by itself cannot sustain growth. A formal argument will have to wait until Chapter 11. But you can already see the intuition behind this from Figure 10-5. Because of decreasing returns to capital, sustaining a steady increase in output per worker will require larger and larger increases in the level of capital per worker. At some stage, the economy will be unwilling or unable to save and invest enough to further increase capital. At that stage, output per worker will stop growing.

Does this mean that an economy’s saving rate, which is the proportion of income that is saved, is irrelevant? No. It is true that a higher saving rate cannot permanently increase the growth rate of output. But a higher saving rate can sustain a higher level of output. Let me state this in a slightly different way. Take two econo- mies that differ only in their saving rates. The two economies will grow at the same rate, but at any point in time, the economy with the higher saving rate will have a higher level of output per person than the other. How this happens, how much the saving rate affects the level of output, and whether or not a country like the United States (which has a low saving rate) should try to increase its saving rate will be one of the topics we take up in Chapter 11.

■■ Sustained growth requires sustained technological progress. This really follows from the previous proposition. Given that the two factors that can lead to an in- crease in output are capital accumulation and technological progress, if capital

c

Increases in capital per worker: Movements along the produc- tion function.

Improvements in the state of technology: Shifts (up) of the production function.

Capital per worker, K/N A

O ut

pu t p

er w

or ke

r, Y

/N

F(K/N, 1)

F(K/N, 1)A

B

Figure 10-5

The Effects of an Improvement in the State of Technology

An improvement in technology shifts the production function up, leading to an increase in output per worker for a given level of capital per worker.

MyEconLab Animation

Chapter 10 The Facts of Growth 213

accumulation cannot sustain growth forever, then technological progress must be the key to growth. And it is. We will see in Chapter 12 that the economy’s rate of growth of output per person is eventually determined by its rate of technological progress.

This is important. It means that in the long run, an economy that sustains a higher rate of technological progress will eventually overtake all other economies. This, of course, raises the next question. What determines the rate of technological progress? Recall the two definitions of the state of technology we discussed previ- ously: a narrow definition, namely the set of blueprints available to the economy, and a broader definition, which captures how the economy is organized, from the nature of institutions to the role of the government. What we know about the deter- minants of technological progress narrowly defined—the role of fundamental and applied research, the role of patent laws, the role of education and training—will be taken up in Chapter 12. The role of broader factors will be discussed in Chapter 13. b

Summary

■■ Over long periods, fluctuations in output are dwarfed by growth, which is the steady increase of aggregate output over time.

■■ Looking at growth in four rich countries (France, Japan, the United Kingdom, and the United States) since 1950, two main facts emerge. 1. All four countries have experienced strong growth and

a large increase in the standard of living. Growth from 1950 to 2011 increased real output per person by a factor of 3.3 in the United States and by a factor of 11.3 in Japan.

2. The levels of output per person across the four countries have converged over time. Put another way, those countries that were behind have grown faster, reducing the gap between them and the current leader, the United States.

■■ Looking at the evidence across a broader set of countries and a longer period, the following facts emerge. 1. On the scale of human history, sustained output growth

is a recent phenomenon.

2. The convergence of levels of output per person is not a worldwide phenomenon. Many Asian countries are rap- idly catching up, while most African countries have both low levels of output per person and low growth rates.

■■ To think about growth, economists start from an aggregate production function relating aggregate output to two factors of production: capital and labor. How much output is pro- duced given these inputs depends on the state of technology.

■■ Under the assumption of constant returns, the aggregate production function implies that increases in output per worker can come either from increases in capital per worker or from improvements in the state of technology.

■■ Capital accumulation by itself cannot permanently sustain growth of output per person. Nevertheless, how much a country saves is important because the saving rate deter- mines the level of output per person, if not its growth rate.

■■ Sustained growth of output per person is ultimately due to technological progress. Perhaps the most important ques- tion in growth theory is what the determinants of techno- logical progress are.

Key Terms

growth, 199 logarithmic scale, 199 standard of living, 200 output per person, 200 purchasing power, 201 purchasing power parity (PPP), 201 Easterlin paradox, 204 force of compounding, 205 convergence, 206 Malthusian trap, 207

four tigers, 208 aggregate production function, 209 state of technology, 210 constant returns to scale, 210 decreasing returns to capital, 210 decreasing returns to labor, 211 capital accumulation, 212 technological progress, 212 saving rate, 212

Following up on the distinction introduced previously between growth theory and develop- ment economics: Chapter 12 will deal with technological progress from the viewpoint of growth theory; Chapter 13 will come closer to development economics.

214 The Long Run The Core

g. Is your answer to (f) the same as your answer to (c)? Why or why not?

h. Plot the relation between output per worker and capital per worker. Does it have the same general shape as the relation in Figure 10-4? Explain.

DiG DeePeR MyEconLab Visit www.myeconlab.com to complete all Dig Deeper problems and get instant feedback.

4. The growth rates of capital and output Consider the production function given in problem 3. Assume that

N is constant and equal to 1. Note that if z = xa, then gz ≈ a gx, where gz and gx are the growth rates of z and x.

a. Given the growth approximation here, derive the relation be- tween the growth rate of output and the growth rate of capital.

b. Suppose we want to achieve output growth equal to 2% per year. What is the required rate of growth of capital?

c. In (b), what happens to the ratio of capital to output over time?

d. Is it possible to sustain output growth of 2% forever in this economy? Why or why not?

5. Between 1950 and 1973, France, Germany, and Japan all experi- enced growth rates that were at least two percentage points higher than those in the United States. Yet the most important technological ad- vances of that period were made in the United States. How can this be?

exPlORe FURtheR

6. Convergence between Japan and the United States since 1960 The Bureau of Labor Statistics has a user-friendly Web site of GDP

per capita at http://www.bls.gov/ilc/intl_gdp_capita_gdp_hour.htm#table0. Find GDP per capita in Japan and in the United States in 1960, 1990, and the most recent year.

a. Compute the average annual growth rates of GDP per person for the United States and Japan for two time peri- ods: 1960 to 1990 and 1990 to the most recent year avail- able. Did the level of real output per person in Japan tend to converge to the level of real output per person in the United States in both these periods? Explain.

b. Suppose that in every year since 1990, Japan and the United States had each continued to have their average an- nual growth rates for the period 1960 to 1990. How would real GDP per person compare in Japan and the United States today?

c. What actually happened to growth in real GDP per capita in Japan and the United States from 1990 to 2011?

7. Convergence in two sets of countries Go to the Web site containing the Penn World Table and collect

data on real GDP per person (chained series) from 1950 to 2011 (or the most recent year available) for the United States, France, Belgium, Italy, Ethiopia, Kenya, Nigeria, and Uganda. You will need to download total real GDP in chained 2005 US dollars and popula- tion. Define for each country for each year the ratio of its real GDP per person to that of the United States for that year (so that this ratio will be equal to 1 for the United States for all years).

QUicK checK MyEconLab Visit www.myeconlab.com to complete all Quick Check problems and get instant feedback. 1. Using the information in this chapter, label each of the following statements true, false, or uncertain. Explain briefly.

a. On a logarithmic scale, a variable that increases at 5% per year will move along an upward-sloping line with a slope of 0.05.

b. The price of food is higher in poor countries than it is in rich countries.

c. Evidence suggests that happiness in rich countries in- creases with output per person.

d. In virtually all the countries of the world, output per per- son is converging to the level of output per person in the United States.

e. For about 1,000 years after the fall of the Roman Empire, there was essentially no growth in output per person in Europe because any increase in output led to a proportional increase in population.

f. Capital accumulation does not affect the level of output in the long run, only technological progress does.

g. The aggregate production function is a relation between output on one hand and labor and capital on the other.

2. Assume that the average consumer in Mexico and the average consumer in the United States buy the quantities and pay the prices indicated in the following table:

Food transportation Services

Price Quantity Price Quantity

Mexico 5 pesos 400 20 pesos 200

United States $1 1,000 $2 2,000

a. Compute U.S. consumption per capita in dollars. b. Compute Mexican consumption per capita in pesos. c. Suppose that 1 dollar is worth 10 pesos. Compute Mexico’s

consumption per capita in dollars. d. Using the purchasing power parity method and U.S. prices,

compute Mexican consumption per capita in dollars. e. Under each method, how much lower is the standard of liv-

ing in Mexico than in the United States? Does the choice of method make a difference?

3. Consider the production function

Y = 1K 1N a. Compute output when K = 49 and N = 81. b. If both capital and labor double, what happens to output? c. Is this production function characterized by constant

returns to scale? Explain. d. Write this production function as a relation between output

per worker and capital per worker. e. Let K>N = 4. What is Y>N? Now double K>N to 8. Does

Y>N double as a result? f. Does the relation between output per worker and capital

per worker exhibit constant returns to scale?

Questions and Problems

Chapter 10 The Facts of Growth 215

a. Plot these ratios for France, Belgium, and Italy over the pe- riod for which you have data. Does your data support the notion of convergence among France, Belgium, and Italy with the United States?

b. Plot these ratios for Ethiopia, Kenya, Nigeria, and Uganda. Does this data support the notion of convergence among Ethiopia, Kenya, Nigeria, and Uganda with the United States?

8. Growth successes and failures Go to the Web site containing the Penn World Table and col-

lect data on real GDP per capita (chained series) for 1970 for all available countries. Do the same for a recent year of data, say one year before the most recent year available in the Penn World Table. (If you choose the most recent year available, the Penn World Table may not have the data for some countries relevant to this question.)

a. Rank the countries according to GDP per person in 1970. List the countries with the 10 highest levels of GDP per per- son in 1970. Are there any surprises?

b. Carry out the analysis in part (a) for the most recent year for which you collected data. Has the composition of the 10 richest countries changed since 1970?

c. Use all the countries for which there are data in both 1970 and the latest year. Which five countries have the highest proportional increase in real GDP per capita?

d. Use all the countries for which there are data in both 1970 and the latest year. Which five countries have the lowest proportional increase in real GDP per capita?

e. Do a brief Internet search on either the country from part (c) with the greatest increase in GDP per capita or the country from part (d) with the smallest increase. Can you ascertain any reasons for the economic success, or lack of it, for this country?

Further Readings ■■ Brad deLong has a number of fascinating articles on growth

(http://web.efzg.hr/dok/MGR/vcavrak//Berkeley%20Faculty% 20Lunch%20Talk.pdf). Read in particular “Berkeley Faculty Lunch Talk: Main Themes of Twentieth Century Economic History,” which covers many of the themes of this chapter.

■■ A broad presentation of facts about growth is given by Angus Maddison in The World Economy. A Millenium Perspective

(2001). The associated site, www.theworldeconomy.org, has a large number of facts and data on growth over the last two millenia.

■■ Chapter 3 in Productivity and American Leadership, by William Baumol, Sue Anne Batey Blackman, and Edward Wolff (1989), gives a vivid description of how life has been trans- formed by growth in the United States since the mid-1880s.

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217

S

11 Saving, Capital Accumulation, and Output ince 1970, the U.S. saving rate—the ratio of saving to gross domestic product (GDP)—has aver- aged only 17%, compared to 22% in Germany and 30% in Japan. Can this explain why the U.S. growth rate has been lower than in most OECD countries in the last 40 years? Would increasing the U.S. saving rate lead to sustained higher U.S. growth in the future?

We have already given the basic answer to these questions at the end of Chapter 10. The answer is no. Over long periods—an important qualification to which we will return—an econo- my’s growth rate does not depend on its saving rate. It does not appear that lower U.S. growth in the last 50 years comes primarily from a low saving rate. Nor should we expect that an increase in the saving rate will lead to sustained higher U.S. growth.

This conclusion does not mean, however, that we should not be concerned about the low U.S. saving rate. Even if the saving rate does not permanently affect the growth rate, it does affect the level of output and the standard of living. An increase in the saving rate would lead to higher growth for some time and eventually to a higher standard of living in the United States.

This chapter focuses on the effects of the saving rate on the level and the growth rate of output.

Sections 11-1 and 11-2 look at the interactions between output and capital accumulation and the effects of the saving rate.

Section 11-3 plugs in numbers to give a better sense of the magnitudes involved.

Section 11-4 extends our discussion to take into account not only physical but also human capital.

218 The Long Run The Core

11-1 Interactions between Output and Capital At the center of the determination of output in the long run are two relations between output and capital:

■■ The amount of capital determines the amount of output being produced. ■■ The amount of output being produced determines the amount of saving and, in

turn, the amount of capital being accumulated over time.

Together, these two relations, which are represented in Figure 11-1, determine the evolution of output and capital over time. The green arrow captures the first relation, from capital to output. The blue and purple arrows capture the two parts of the second relation, from output to saving and investment, and from investment to the change in the capital stock. Let’s look at each relation in turn.

The Effects of Capital on Output We started discussing the first of these two relations, the effect of capital on output, in Section 10-3. There we introduced the aggregate production function and you saw that, under the assumption of constant returns to scale, we can write the following relation between output and capital per worker:

Y N

= Fa K N

, 1b

Output per worker 1Y>N2 is an increasing function of capital per worker 1K>N2. Under the assumption of decreasing returns to capital, the effect of a given increase in capital per worker on output per worker decreases as the ratio of capital per worker gets larger. When capital per worker is already high, further increases in capital per worker have only a small effect on output per worker.

To simplify notation, we will rewrite this relation between output and capital per worker simply as

Y N

= f a K N b

where the function f represents the same relation between output and capital per worker as the function F:

f a K N b K Fa K

N , 1b

In this chapter, we shall make two further assumptions:

■■ The first is that the size of the population, the participation rate, and the unemploy- ment rate are all constant. This implies that employment, N, is also constant. To see why, go back to the relations we saw in Chapter 2 and again in Chapter 7, between population, the labor force, unemployment, and employment.

c

Suppose, for example, the function F has the “double square root” form F1K, N2 =2K2N, so

Y = 2K2N Divide both sides by N, so

Y>N = 2K2N>N Note 2N>N = 2N>12N2N2 Using this result in the preced- ing equation leads to a model of income per person:

Y>N = 2K>2N = 2K>N So, in this case, the function f giving the relation between output per worker and capi- tal per worker is simply the square root function

f1K>N2 = 2K>N Capital stock

Change in the capital

stock Saving/investment

Output/income Figure 11-1

Capital, Output, and Saving/Investment

MyEconLab Animation

Chapter 11 Saving, Capital Accumulation, and Output 219

– The labor force is equal to population multiplied by the participation rate. So if population is constant and the participation rate is constant, the labor force is also constant.

– Employment, in turn, is equal to the labor force multiplied by 1 minus the unem- ployment rate. If, for example, the size of the labor force is 100 million and the unemployment rate is 5%, then employment is equal to 95 million (100 million times (1 - 0.05)). So, if the labor force is constant and the unemployment rate is constant, employment is also constant.

Under these assumptions, output per worker, output per person, and output itself all move proportionately. Although we will usually refer to movements in output or capital per worker, to lighten the text we shall sometimes just talk about movements in output or capital, leaving out the “per worker” or “per person” qualification.

The reason for assuming that N is constant is to make it easier to focus on how capital accumulation affects growth. If N is constant, the only factor of production that changes over time is capital. The assumption is not realistic, however, so we will relax it in the next two chapters. In Chapter 12, we will allow for steady population and employment growth. In Chapter 13, we shall see how we can integrate our analysis of the long run—which ignores fluctuations in employment—with our earlier analysis of the short and medium runs—which focused precisely on these fluctuations in employment (and the associated fluctuations in output and unem- ployment). Both steps are better left to later.

■■ The second assumption is that there is no technological progress, so the production function f (or, equivalently, F) does not change over time.

Again, the reason for making this assumption—which is obviously contrary to reality—is to focus just on the role of capital accumulation. In Chapter 12, we shall introduce technological progress and see that the basic conclusions we derive here about the role of capital in growth also hold when there is technological progress. Again, this step is better left to later.

With these two assumptions, our first relation between output and capital per worker, from the production side, can be written as

Yt N

= f aKt N b (11.1)

where we have introduced time indexes for output and capital—but not for labor, N, which we assume to be constant and so does not need a time index.

In words: Higher capital per worker leads to higher output per worker.

The Effects of Output on Capital Accumulation To derive the second relation between output and capital accumulation, we proceed in two steps.

First, we derive the relation between output and investment. Then we derive the relation between investment and capital accumulation.

Output and Investment To derive the relation between output and investment, we make three assumptions:

■■ We continue to assume that the economy is closed. As we saw in Chapter 3 (equa- tion (3.10)), this means that investment, I, is equal to saving—the sum of private saving, S, and public saving, T - G.

I = S + 1T - G2

b In the United States in 2014, output per person (in 2005 PPP dollars) was $46,400; output per worker was much higher, at $100,790. (From these two numbers, can you derive the ratio of employment to popu- lation?)

From the production side: The level of capital per worker de- termines the level of output per worker.b

As we shall see in Chapter 17, saving and investment need not be equal in an open econ- omy. A country can save less than it invests, and borrow the difference from the rest of the world. This is indeed the case for the United States today.

b

220 The Long Run The Core

■■ To focus on the behavior of private saving, we assume that public saving, T - G, is equal to zero. (We shall later relax this assumption when we focus on the effects of fiscal policy on growth.) With this assumption, the previous equation becomes

I = S

Investment is equal to private saving. ■■ We assume that private saving is proportional to income, so

S = sY

The parameter s is the saving rate. It has a value between zero and 1. This assump- tion captures two basic facts about saving. First, the saving rate does not appear to systematically increase or decrease as a country becomes richer. Second, richer countries do not appear to have systematically higher or lower saving rates than poorer ones.

Combining these two relations and introducing time indexes gives a simple relation between investment and output:

It = sYt

Investment is proportional to output; the higher output is, the higher is saving and so the higher is investment.

Investment and Capital Accumulation The second step relates investment, which is a flow (the new machines produced and new plants built during a given period), to capital, which is a stock (the existing ma- chines and plants in the economy at a point in time).

Think of time as measured in years, so t denotes year t, t + 1 denotes year t + 1, and so on. Think of the capital stock as being measured at the beginning of each year, so Kt refers to the capital stock at the beginning of year t, Kt + 1 to the capital stock at the beginning of year t + 1 and so on.

Assume that capital depreciates at rate d (the lowercase Greek letter delta) per year. That is, from one year to the next, a proportion d of the capital stock breaks down and becomes useless. Equivalently, a proportion 11 - d2 of the capital stock remains intact from one year to the next.

The evolution of the capital stock is then given by

Kt + 1 = 11 - d2Kt + It The capital stock at the beginning of year t + 1, Kt + 1, is equal to the capital stock at

the beginning of year t, which is still intact in year t + 1, 11 - d2Kt , plus the new capi- tal stock put in place during year t (i.e., investment during year t, It).

We can now combine the relation between output and investment and the relation between investment and capital accumulation to obtain the second relation we need to think about growth: the relation from output to capital accumulation.

Replacing investment by its expression from above and dividing both sides by N (the number of workers in the economy) gives

Kt + 1 N

= 11 - d2Kt N

+ s Yt N

In words: Capital per worker at the beginning of year t + 1 is equal to capital per worker at the beginning of year t, adjusted for depreciation, plus investment per worker during year t, which is equal to the saving rate times output per worker during year t.

You have now seen two speci- fications of saving behavior (equivalently consumption be- havior): one for the short run in Chapter 3, and one for the long run in this chapter. You may wonder how the two specifica- tions relate to each other and whether they are consistent. The answer is yes. A full dis- cussion is given in Chapter 15.

c

c

Recall: Flows are variables that have a time dimension (that is, they are defined per unit of time); stocks are variables that do not have a time dimension (they are defined at a point in time). Output, saving, and investment are flows. Employ- ment and capital are stocks.

Chapter 11 Saving, Capital Accumulation, and Output 221

Expanding the term 11 - d2 Kt>N to Kt>N - dKt>N, moving Kt>N to the left, and reorganizing the right side,

Kt + 1

N -

Kt N

= s Yt N

- d Kt N

(11.2)

In words: The change in the capital stock per worker, represented by the difference between the two terms on the left, is equal to saving per worker, represented by the first term on the right, minus depreciation, represented by the second term on the right. This equation gives us the second relation between output and capital per worker.

11-2 The Implications of Alternative Saving Rates We have derived two relations:

■■ From the production side, we have seen in equation (11.1) how capital determines output.

■■ From the saving side, we have seen in equation (11.2) how output in turn deter- mines capital accumulation.

We can now put the two relations together and see how they determine the behavior of output and capital over time.

Dynamics of Capital and Output Replacing output per worker 1Yt>N2 in equation (11.2) by its expression in terms of capital per worker from equation (11.1) gives

Kt + 1

N -

Kt N

= s f aKt N b - daKt

N b (11.3)

change in capital = Invesment - depreciation from year t to year t + 1 during year t during year t

This relation describes what happens to capital per worker. The change in capital per worker from this year to next year depends on the difference between two terms:

■■ Investment per worker, the first term on the right: The level of capital per worker this year determines output per worker this year. Given the saving rate, output per worker determines the amount of saving per worker and thus the investment per worker this year.

■■ Depreciation per worker, the second term on the right: The capital stock per worker determines the amount of depreciation per worker this year.

If investment per worker exceeds depreciation per worker, the change in capital per worker is positive. Capital per worker increases.

If investment per worker is less than depreciation per worker, the change in capital per worker is negative. Capital per worker decreases.

Given capital per worker, output per worker is then given by equation (11.1):

Yt N

= f aKt N b

Equations (11.3) and (11.1) contain all the information we need to understand the dynamics of capital and output over time. The easiest way to interpret them is to use a

b

From the saving side: The level of output per worker deter- mines the change in the level of capital per worker over time.

Kt>N 1 f1Kt>N2 1 sf1Kt>N2b

Kt>N 1 dKt>Nb

222 The Long Run The Core

graph. We do this in Figure 11-2: Output per worker is measured on the vertical axis, and capital per worker is measured on the horizontal axis.

In Figure 11-2, look first at the curve representing output per worker, f1Kt>N2, as a function of capital per worker. The relation is the same as in Figure 10-4: Output per worker increases with capital per worker, but, because of decreasing returns to capital, the effect is smaller the higher the level of capital per worker.

Now look at the two curves representing the two components on the right of equa- tion (11.3):

■■ The relation representing investment per worker, s f1Kt>N2, has the same shape as the production function except that it is lower by a factor s (the saving rate). Suppose the level of capital per worker is equal to K0>N in Figure 11-2. Output per worker is then given by the distance AB, and investment per worker is given by the vertical dis- tance AC, which is equal to s times the vertical distance AB. Thus, just like output per worker, investment per worker increases with capital per worker, but by less and less as capital per worker increases. When capital per worker is already high, the effect of a further increase in capital per worker on output per worker, and by implication on investment per worker, is small.

■■ The relation representing depreciation per worker, d Kt>N, is represented by a straight line. Depreciation per worker increases in proportion to capital per worker so the relation is represented by a straight line with slope equal to d. At the level of capi- tal per worker K0>N, depreciation per worker is given by the vertical distance AD. The change in capital per worker is given by the difference between investment per

worker and depreciation per worker. At K0>N, the difference is positive; investment per worker exceeds depreciation per worker by an amount represented by the vertical dis- tance CD = AC - AD, so capital per worker increases. As we move to the right along the horizontal axis and look at higher and higher levels of capital per worker, investment increases by less and less, while depreciation keeps increasing in proportion to capital. For some level of capital per worker, K*>N in Figure 11-2, investment is just enough to cover depreciation, and capital per worker remains constant. To the left of K*>N, invest- ment exceeds depreciation and capital per worker increases. This is indicated by the ar- rows pointing to the right along the curve representing the production function. To the right of K*>N, depreciation exceeds investment, and capital per worker decreases. This is indicated by the arrows pointing to the left along the curve representing the production function.

To make the graph easier to read, I have assumed an un- realistically high saving rate. (Can you tell roughly what value we have assumed for s? What would be a plausible value for s?)

c

c

When capital per worker is low, capital per worker and output per worker increase over time. When capital per worker is high, capital per worker and output per worker decrease over time.

Capital per worker, K/N (K0/N) K*/N

A

B

C

D

O ut

pu t p

er w

or ke

r, Y

/N

Investment per worker sf (Kt /N)

Output per worker f (Kt /N)

Depreciation per worker Kt /N

Y*/N

Figure 11-2

Capital and Output Dynamics

When capital and output are low, investment exceeds depreciation and capital in- creases. When capital and output are high, investment is less than depreciation and capital decreases.

MyEconLab Animation

Chapter 11 Saving, Capital Accumulation, and Output 223

Characterizing the evolution of capital per worker and output per worker over time now is easy. Consider an economy that starts with a low level of capital per worker—say, K*>N in Figure 11-2. Because investment exceeds depreciation at this point, capital per worker increases. And because output moves with capital, output per worker increases as well. Capital per worker eventually reaches K*>N, the level at which investment is equal to depreciation. Once the economy has reached the level of capital per worker K*N, output per worker and capital per worker remain constant at Y*>N and K*>N, their long-run equilibrium levels.

Think, for example, of a country that loses part of its capital stock, say as a re- sult of bombing during a war. The mechanism we have just seen suggests that, if the country has suffered larger capital losses than population losses, it will come out of the war with a low level of capital per worker; that is, at a point to the left of K*>N. The country will then experience a large increase in both capital per worker and output per worker for some time. This describes well what happened after World War II to coun- tries that had proportionately larger destructions of capital than losses of human lives (see the Focus box “Capital Accumulation and Growth in France in the Aftermath of World War II”).

If a country starts instead from a high level of capital per worker—that is, from a point to the right of K*>N—then depreciation will exceed investment, and capital per worker and output per worker will decrease. The initial level of capital per worker is too high to be sustained given the saving rate. This decrease in capital per worker will continue until the economy again reaches the point where investment is equal to depre- ciation and capital per worker is equal to K*>N. From then on, capital per worker and output per worker will remain constant.

Let’s look more closely at the levels of output per worker and capital per worker to which the economy converges in the long run. The state in which output per worker and capital per worker are no longer changing is called the steady state of the economy. Setting the left side of equation (11.3) equal to zero (in steady state, by definition, the change in capital per worker is zero), the steady-state value of capital per worker, K*>N, is given by

s f aK* N

b = d K* N

(11.4)

The steady-state value of capital per worker is such that the amount of saving per worker (the left side) is just sufficient to cover depreciation of the capital stock per worker (the right side of the equation).

Given steady-state capital per worker 1K*>N2, the steady-state value of output per worker 1Y*>N2 is given by the production function

Y* N

= f aK* N

b (11.5)

We now have all the elements we need to discuss the effects of the saving rate on output per worker, both over time and in steady state.

The Saving Rate and Output Let’s return to the question we posed at the beginning of the chapter: How does the sav- ing rate affect the growth rate of output per worker? Our analysis leads to a three-part answer:

1. The saving rate has no effect on the long-run growth rate of output per worker, which is equal to zero.

What does the model predict for postwar growth if a country suffers proportional losses in population and in capital? Do you find this answer convinc- ing? What elements may be missing from the model?

b K*>N is the long-run level of capital per worker.

b

224 The Long Run The Core

Capital Accumulation and Growth in France in the Aftermath of World War II

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When World War II ended in 1945, France had suffered some of the heaviest losses of all European countries. The losses in lives were large. Out of a population of 42 million, more than 550,000 people died. Relatively speaking, though, the losses in capital were much larger. It is estimated that the French capital stock in 1945 was about 30% below its prewar value. A vivid picture of the destruction of capital is provided by the numbers in Table 1.

The model of growth we have just seen makes a clear prediction about what will happen to a country that loses a large part of its capital stock. The country will experience high capital accumulation and output growth for some time. In terms of Figure 11-2, a country with capital per worker initially far below K* ,N will grow rapidly as it converges to K* ,N and output per worker converges to Y* ,N.

This prediction fares well in the case of postwar France. There is plenty of anecdotal evidence that small increases in capital led to large increases in output. Minor repairs to a major bridge would lead to the reopening of the bridge. Reopening the bridge would significantly shorten the travel time between two cities, leading to much lower transport

costs. The lower transport costs would then enable a plant to get much needed inputs, increase its production, and so on.

More convincing evidence, however, comes directly from actual aggregate output numbers. From 1946 to 1950, the annual growth rate of French real GDP was a high 9.6% per year. This led to an increase in real GDP of about 60% over the course of 5 years.

Was all of the increase in French GDP the result of capital accumulation? The answer is no. There were other forces at work in addition to the mechanism in our model. Much of the remaining capital stock in 1945 was old. Investment had been low in the 1930s (a decade dominated by the Great Depression) and nearly nonexistent during the war. A good portion of the postwar capital accumulation was associated with the introduction of more modern capital and the use of more modern production techniques. This was another rea- son for the high growth rates of the postwar period.

Source: Gilles Saint-Paul, “Economic Reconstruction in France, 1945–1958,” in Rudiger Dornbusch, Willem Nolling, and Richard Layard, eds. Postwar Economic Reconstruction and Lessons for the East Today (Cambridge, MA: MIT Press, 1993).

Table 1 Proportion of the French Capital Stock Destroyed by the End of World War II

Railways Tracks 6% Rivers Waterways 86%

Stations 38% Canal locks 11%

Engines 21% Barges 80%

Hardware 60% Buildings (numbers)

Roads Cars 31% Dwellings 1,229,000

Trucks 40% Industrial 246,000

This conclusion is rather obvious; we have seen that, eventually, the econ- omy converges to a constant level of output per worker. In other words, in the long run, the growth rate of output is equal to zero, no matter what the saving rate is.

There is, however, a way of thinking about this conclusion that will be useful when we introduce technological progress in Chapter 12. Think of what would be needed to sustain a constant positive growth rate of output per worker in the long run. Capital per worker would have to increase. Not only that, but, because of decreasing returns to capital, it would have to increase faster than output per worker. This implies that each year the economy would have to save a larger and larger fraction of its output and dedicate it to capital accumulation. At some point, the fraction of output it would need to save would be greater than 1—something clearly impossible. This is why it is impossible, absent technological progress, to sustain a constant positive growth rate forever. In the long run, capital per worker must be constant, and so output per worker must also be constant.

c

Some economists argue that the high output growth achieved by the Soviet Union from 1950 to 1990 was the result of such a steady in- crease in the saving rate over time, which could not be sus- tained forever. Paul Krugman has used the term Stalinist growth to denote this type of growth, which is growth result- ing from a higher and higher saving rate over time.

Chapter 11 Saving, Capital Accumulation, and Output 225

2. Nonetheless, the saving rate determines the level of output per worker in the long run. Other things being equal, countries with a higher saving rate will achieve higher output per worker in the long run.

Figure 11-3 illustrates this point. Consider two countries with the same produc- tion function, the same level of employment, and the same depreciation rate, but with different saving rates, say s0 and s1 7 s0. Figure 11-3 draws their common production function, f1Kt>N2, and the functions showing saving/investment per worker as a function of capital per worker for each of the two countries, s0 f1Kt>N2 and s1 f1Kt>N2. In the long run, the country with saving rate s0 will reach the level of capital per worker K0>N and output per worker Y0>N. The country with saving rate s1 will reach the higher levels K1>N and Y1>N.

3. An increase in the saving rate will lead to higher growth of output per worker for some time, but not forever.

This conclusion follows from the two propositions we just discussed. From the first, we know that an increase in the saving rate does not affect the long-run growth rate of output per worker, which remains equal to zero. From the second, we know that an increase in the saving rate leads to an increase in the long-run level of output per worker. It follows that, as output per worker increases to its new higher level in response to the increase in the saving rate, the economy will go through a period of positive growth. This period of growth will come to an end when the economy reaches its new steady state.

We can use Figure 11-3 again to illustrate this point. Consider a country that has an initial saving rate of s0. Assume that capital per worker is initially equal to K0>N, with associated output per worker Y0>N. Now consider the effects of an increase in the saving rate from s0 to s1. The function giving saving/investment per worker as a function of capital per worker shifts upward from s0 f1Kt>N2 to s1 f1Kt>N2.

At the initial level of capital per worker, K0>N, investment exceeds depreciation, so capital per worker increases. As capital per worker increases, so does output per worker, and the economy goes through a period of positive growth. When capital per worker eventually reaches K1>N, however, investment is again equal to deprecia- tion, and growth ends. From then on, the economy remains at K1>N, with associ- ated output per worker Y1>N. The movement of output per worker is plotted against

Note that the first proposition is a statement about the growth rate of output per worker. The second proposition is a state- ment about the level of output per worker.

b

Capital per worker, K/N K0 /N K1/N

O ut

pu t p

er w

or ke

r, Y

/N Investment per worker

s1f (Kt /N)

Investment per worker s0f (Kt /N )

Output per worker f (Kt /N )

Depreciation per worker Kt /N

Y1 /N

Y0 /N

Figure 11-3

The Effects of Different Saving Rates

A country with a higher sav- ing rate achieves a higher steady-state level of output per worker.

MyEconLab Animation

226 The Long Run The Core

time in Figure 11-4. Output per worker is initially constant at level Y0>N. After the increase in the saving rate, say, at time t, output per worker increases for some time until it reaches the higher level of output per worker Y1>N and the growth rate re- turns to zero.

We have derived these three results under the assumption that there was no technological progress, and therefore, no growth of output per worker in the long run. But, as we will see in Chapter 12, the three results extend to an economy in which there is technological progress. Let us briefly indicate how.

An economy in which there is technological progress has a positive growth rate of output per worker, even in the long run. This long-run growth rate is independent of the saving rate—the extension of the first result just discussed. The saving rate affects the level of output per worker, however—the extension of the second result. An increase in the saving rate leads to growth greater than steady-state growth for some time until the economy reaches its new higher path—the extension of our third result.

These three results are illustrated in Figure 11-5, which extends Figure 11-4 by plotting the effect an increase in the saving rate has on an economy with positive technological progress. The figure uses a logarithmic scale to measure output per worker. It follows that an economy in which output per worker grows at a constant rate is represented by a line with slope equal to that growth rate. At the initial sav- ing rate, s0, the economy moves along AA. If, at time t, the saving rate increases to s1, the economy experiences higher growth for some time until it reaches its new, higher path, BB. On path BB, the growth rate is again the same as before the in- crease in the saving rate (that is, the slope of BB is the same as the slope of AA).

c

See the discussion of logarith- mic scales in Appendix 2 at the end of the book.

Time

t

O ut

pu t p

er w

or ke

r, Y

/N Associated with saving rate s1 > s0

Associated with saving rate s0

Y1 /N

Y0 /N

Figure 11-4

The Effects of an Increase in the Saving Rate on Output per Worker in an Economy without Technological Progress

An increase in the saving rate leads to a period of higher growth until output reaches its new higher steady-state level.

MyEconLab Animation

Time t

O ut

pu t p

er w

or ke

r, Y

/N (lo

g sc

al e)

Associated with saving rate s1 > s0

Associated with saving rate s0 A

A B

B Figure 11-5

The Effects of an Increase in the Saving Rate on Output per Worker in an Economy with Technological Progress

An increase in the saving rate leads to a period of higher growth until output reaches a new, higher path.

MyEconLab Animation

Chapter 11 Saving, Capital Accumulation, and Output 227

The Saving Rate and Consumption Governments can affect the saving rate in various ways. First, they can vary public saving. Given private saving, positive public saving—a budget surplus, in other words— leads to higher overall saving. Conversely, negative public saving—a budget deficit— leads to lower overall saving. Second, governments can use taxes to affect private saving. For example, they can give tax breaks to people who save, making it more attractive to save and thus increasing private saving.

What saving rate should governments aim for? To think about the answer, we must shift our focus from the behavior of output to the behavior of consumption. The reason: What matters to people is not how much is produced, but how much they consume.

It is clear that an increase in saving must come initially at the expense of lower con- sumption (except when we think it helpful, we drop “per worker” in this subsection and just refer to consumption rather than consumption per worker, capital rather than capi- tal per worker, and so on). A change in the saving rate this year has no effect on capital this year, and consequently no effect on output and income this year. So an increase in saving comes initially with an equal decrease in consumption.

Does an increase in saving lead to an increase in consumption in the long run? Not necessarily. Consumption may decrease, not only initially, but also in the long run. You may find this surprising. After all, we know from Figure 11-3 that an increase in the sav- ing rate always leads to an increase in the level of output per worker. But output is not the same as consumption. To see why not, consider what happens for two extreme values of the saving rate.

■■ An economy in which the saving rate is (and has always been) zero is an economy in which capital is equal to zero. In this case, output is also equal to zero, and so is consumption. A saving rate equal to zero implies zero consumption in the long run.

■■ Now consider an economy in which the saving rate is equal to one. People save all their income. The level of capital, and thus output, in this economy will be high. But because people save all of their income, consumption is equal to zero. What happens is that the economy is carrying an excessive amount of capital. Simply maintaining that level of output requires that all output be devoted to replacing depreciation! A saving rate equal to one also implies zero consumption in the long run.

These two extreme cases mean that there must be some value of the saving rate be- tween zero and one that maximizes the steady-state level of consumption. Increases in the saving rate below this value lead to a decrease in consumption initially, but lead to an increase in consumption in the long run. Increases in the saving rate beyond this value decrease consumption not only initially but also in the long run. This happens because the increase in capital associated with the increase in the saving rate leads to only a small increase in output—an increase that is too small to cover the increased depreciation. In other words, the economy carries too much capital. The level of capital associated with the value of the saving rate that yields the highest level of consumption in steady state is known as the golden-rule level of capital. Increases in capital beyond the golden-rule level reduce steady-state consumption.

This argument is illustrated in Figure 11-6, which plots consumption per worker in steady state (on the vertical axis) against the saving rate (on the horizontal axis). A sav- ing rate equal to zero implies a capital stock per worker equal to zero, a level of output per worker equal to zero, and, by implication, a level of consumption per worker equal to zero. For s between zero and sG (G for golden rule), a higher saving rate leads to higher capital per worker, higher output per worker, and higher consumption per worker. For s larger than sG, increases in the saving rate still lead to higher values of capital per worker and output per worker; but they now lead to lower values of consumption per worker.

b

Recall: Saving is the sum of private plus public saving. Re- call also, that

Public saving 3 Budget surplus;

Public dissaving 3 Budget deficit.

b

Because we assume that em- ployment is constant, we are ignoring the short-run effect of an increase in the saving rate on output we focused on in Chapters 3, 5, and 9. In the short run, not only does an increase in the saving rate reduce consumption given income, but it may also cre- ate a recession and decrease income further. We shall re- turn to a discussion of short- run and long-run effects of changes in saving in Chapters 16 and 22.

228 The Long Run The Core

This is because the increase in output is more than offset by the increase in depreciation as a result of the larger capital stock. For s = 1, consumption per worker is equal to zero. Capital per worker and output per worker are high, but all of the output is used just to replace depreciation, leaving nothing for consumption.

If an economy already has so much capital that it is operating beyond the golden rule, then increasing saving further will decrease consumption not only now, but also later. Is this a relevant worry? Do some countries actually have too much capital? The empirical evidence indicates that most OECD countries are actually far below their golden-rule level of capital. If they were to increase the saving rate, it would lead to higher consumption in the future—not lower consumption.

This means that, in practice, governments face a trade-off: An increase in the saving rate leads to lower consumption for some time but higher consumption later. So what should governments do? How close to the golden rule should they try to get? That depends on how much weight they put on the welfare of current generations— who are more likely to lose from policies aimed at increasing the saving rate—versus the welfare of future generations—who are more likely to gain. Enter politics; future generations do not vote. This means that governments are unlikely to ask current gen- erations to make large sacrifices, which, in turn, means that capital is likely to stay far below its golden-rule level. These intergenerational issues are at the forefront of the current debate on Social Security reform in the United States. The Focus box “Social Security, Saving, and Capital Accumulation in the United States” explores this further.

11-3 Getting a Sense of Magnitudes How big an impact does a change in the saving rate have on output in the long run? For how long and by how much does an increase in the saving rate affect growth? How far is the United States from the golden-rule level of capital? To get a better sense of the answers to these questions, let’s now make more specific assumptions, plug in some numbers, and see what we get.

Assume the production function is

Y = 1K 1N (11.6) Output equals the product of the square root of capital and the square root of labor.

(A more general specification of the production function known as the Cobb-Douglas production function, and its implications for growth, is given in the appendix to this chapter.)

MyEconLab Video

cCheck that this production function exhibits both constant returns to scale and decreasing returns to either capital or labor.

Saving rate, s

10

C on

su m

pt io

n pe

r w

or ke

r, C

/N

Maximum steady-state consumption per worker

sG

Figure 11-6

The Effects of the Saving Rate on Steady-State Consumption per Worker

An increase in the saving rate leads to an increase, then to a decrease in steady-state con- sumption per worker.

MyEconLab Animation

Chapter 11 Saving, Capital Accumulation, and Output 229

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Social Security, Saving, and Capital Accumulation in the united States

Social Security was introduced in the United States in 1935. The goal of the program was to make sure the elderly would have enough to live on. Over time, Social Security has become the largest government program in the United States. Benefits paid to retirees now exceed 4% of GDP. For two-thirds of retirees, Social Security benefits account for more than 50% of their income. There is little question that, on its own terms, the Social Security system has been a great success and has decreased poverty among the elderly. There is also little question that it has also led to a lower U.S. sav- ing rate and therefore lower capital accumulation and lower output per person in the long run.

To understand why, we must take a theoretical detour. Think of an economy in which there is no social security system—one where workers have to save to provide for their own retirement. Now, introduce a social security system that collects taxes from workers and distributes benefits to the retirees. It can do so in one of two ways:

■■ One way is by taxing workers, investing their contribu- tions in financial assets, and paying back the principal plus the interest to the workers when they retire. Such a system is called a fully funded social security system: At any time, the system has funds equal to the accumulated contributions of workers, from which it will be able to pay benefits to these workers when they retire.

■■ The other way is by taxing workers and redistributing the tax contributions as benefits to the current retir- ees. Such a system is called a pay-as-you-go social security system. The system pays benefits out “as it goes,” that is, as it collects them through contributions.

From the point of view of workers, the two systems may look broadly similar. In both cases, they pay contributions when they work and receive benefits when they retire. But there are two major differences.

First, what retirees receive is different in each case:

■■ What they receive in a fully funded system depends on the rate of return on the financial assets held by the fund.

■■ What they receive in a pay-as-you-go system depends on demographics—the ratio of retirees to workers— and on the evolution of the tax rate set by the system. When the population ages, and the ratio of retirees to workers increases, then either retirees receive less, or workers have to contribute more. This is very much the case in the United States today. The ratio of retirees to workers, which was equal to 0.3 in 2000 is already up to 0.4 today and is forecast to increase to close to 0.5 by 2030. Under current rules, benefits will increase from 4% of GDP today to 6% in 2030. Thus, either benefits will have to be reduced, in which case the rate of return

to workers who contributed in the past will be low, or contributions will have to be increased, in which case this will decrease the rate of return to workers who are contributing today, or more likely, some combination of both will have to be implemented.

Second, and leaving aside the aging issue, the two sys- tems have different macroeconomic implications:

■■ In the fully funded system, workers save less because they anticipate receiving benefits when they are old. But the Social Security system saves on their behalf, by investing their contributions in financial assets. The presence of a social security system changes the compo- sition of overall saving: Private saving goes down, and public saving goes up. But, to a first approximation, it has no effect on total saving and therefore no effect on capital accumulation.

■■ In the pay-as-you-go system, workers also save less because they again anticipate receiving benefits when they are old. But now, the Social Security system does not save on their behalf. The decrease in private saving is not compensated by an increase in public saving. Total saving goes down, and so does capital accumulation.

Most actual social security systems are somewhere be- tween pay-as-you-go and fully funded systems. When the U.S. system was set up in 1935, the intention was to par- tially fund it. But this did not happen. Rather than being invested, contributions from workers were used to pay ben- efits to the retirees, and this has been the case ever since. Today, because contributions have slightly exceeded benefits since the early 1980s, Social Security has built a social security trust fund. But this trust fund is far smaller than the value of benefits promised to current contributors when they retire. The U.S. system is basically a pay-as-you- go system, and this has probably led to a lower U.S. saving rate over the last 70 years.

In this context, some economists and politicians have suggested that the United States should shift back to a fully funded system. One of their arguments is that the U.S. saving rate is indeed too low and that funding the Social Security system would increase it. Such a shift could be achieved by investing, from now on, tax contributions in financial assets rather than distributing them as benefits to retirees. Under such a shift, the Social Security system would steadily ac- cumulate funds and would eventually become fully funded. Martin Feldstein, an economist at Harvard and an advocate of such a shift, has concluded that it could lead to a 34% in- crease of the capital stock in the long run.

How should we think about such a proposal? It would probably have been a good idea to fully fund the system at the start. The United States would have a higher saving rate. The

230 The Long Run The Core

U.S. capital stock would be higher, and output and consump- tion would also be higher. But we cannot rewrite history. The existing system has promised benefits to retirees and these promises have to be honored. This means that, under the proposal we just described, current workers would, in effect, have to contribute twice; once to fund the system and finance their own retirement, and then again to finance the benefits owed to current retirees. This would impose a disproportion- ate cost on current workers (and this would come on top of the problems coming from aging, which are likely to require larger contributions from workers in any case). The practi- cal implication is that, if it is to happen, the move to a fully funded system will have to be slow, so that the burden of adjustment does not fall too much on one generation relative to the others.

The debate is likely to be with us for some time. In as- sessing proposals from the administration or from Congress, ask yourself how they deal with the issue we just discussed. Take, for example, the proposal to allow workers, from now

on, to make contributions to personal accounts instead of to the Social Security system, and to be able to draw from these accounts when they retire. By itself, this proposal would clearly increase private saving. Workers will be saving more. But its ultimate effect on saving depends on how the ben- efits already promised to current workers and retirees by the Social Security system are financed. If, as is the case under some proposals, these benefits are financed not through ad- ditional taxes but through debt finance, then the increase in private saving will be offset by an increase in deficits (i.e., a decrease in public saving). The shift to personal accounts will not increase the U.S. saving rate. If, instead, these benefits are financed through higher taxes, then the U.S. saving rate will increase. But in that case, current workers will have both to contribute to their personal accounts and pay the higher taxes. They will indeed pay twice.

To follow the debate on Social Security, look at the site run by the (nonpartisan) Concord Coalition (www.concordcoali- tion.org) and find the discussion related to Social Security.

Dividing both sides by N (because we are interested in output per worker),

Y N

= 1K1N

N =

1K1N = A KN Output per worker equals the square root of capital per worker. Put another way, the

production function f relating output per worker to capital per worker is given by

f aKt N b = AKtN

Replacing f1Kt>N2 by 2Kt>N in equation (11.3),

Kt + 1 N

- Kt N

= sAKtN - dKtN (11.7) This equation describes the evolution of capital per worker over time. Let’s look at

what it implies.

The Effects of the Saving Rate on Steady-State Output How big an impact does an increase in the saving rate have on the steady-state level of output per worker?

Start with equation (11.7). In steady state the amount of capital per worker is constant, so the left side of the equation equals zero. This implies

s AK*N = d K*N (We have dropped time indexes, which are no longer needed because in steady state

K/N is constant. The star is to remind you that we are looking at the steady-state value of capital.) Square both sides:

s2 K* N

= d2aK* N

b 2

cThe second equality follows from: 1N>N = 1N>11N1N2 = 1>1N.

Chapter 11 Saving, Capital Accumulation, and Output 231

Divide both sides by 1K>N2 and reorganize:

K* N

= a s d b

2

(11.8)

Steady-state capital per worker is equal to the square of the ratio of the saving rate to the depreciation rate.

From equations (11.6) and (11.8), steady-state output per worker is given by

Y* N

= CK*N = Ca sd b2 = sd (11.9) Steady-state output per worker is equal to the ratio of the saving rate to the

depreciation rate. A higher saving rate and a lower depreciation rate both lead to higher steady-state

capital per worker (equation (11.8)) and higher steady-state output per worker (equation (11.9)). To see what this means, let’s take a numerical example. Suppose the deprecia- tion rate is 10% per year, and suppose the saving rate is also 10%. Then, from equations (11.8) and (11.9), steady-state capital per worker and output per worker are both equal to 1. Now suppose that the saving rate doubles, from 10% to 20%. It follows from equa- tion (11.8) that in the new steady state, capital per worker increases from 1 to 4. And, from equation (11.9), output per worker doubles, from 1 to 2. Thus, doubling the saving rate leads, in the long run, to doubling the output per worker; this is a large effect.

The Dynamic Effects of an Increase in the Saving Rate We have just seen that an increase in the saving rate leads to an increase in the steady- state level of output. But how long does it take for output to reach its new steady-state level? Put another way, by how much and for how long does an increase in the saving rate affect the growth rate?

To answer these questions, we must use equation (11.7) and solve it for capital per worker in year 0, in year 1, and so on.

Suppose that the saving rate, which had always been equal to 10%, increases in year 0 from 10% to 20% and remains at this higher value forever. In year 0, nothing happens to the capital stock (recall that it takes one year for higher saving and higher investment to show up in higher capital). So, capital per worker remains equal to the steady-state value associated with a saving rate of 0.1. From equation (11.8),

K0 N

= 10.1>0.122 = 12 = 1

In year 1, equation (11.7) gives

K1 N

- K0 N

= sAK0N - dK0N With a depreciation rate equal to 0.1 and a saving rate now equal to 0.2, this

equation implies

K1 N

- 1 = [10.221112] - [10.121] so

K1 N

= 1.1

232 The Long Run The Core

In the same way, we can solve for K2>N, and so on. Once we have determined the values of capital per worker in year 0, year 1, and so on, we can then use equa- tion (11.6) to solve for output per worker in year 0, year 1, and so on. The results of this computation are presented in Figure 11-7. Panel (a) plots the level of output per worker against time. 1Y>N2 increases over time from its initial value of 1 in year 0 to its steady-state value of 2 in the long run. Panel (b) gives the same information in a different way, plotting instead the growth rate of output per worker against time. As panel (b) shows, growth of output per worker is highest at the beginning and then decreases over time. As the economy reaches its new steady state, growth of output per worker returns to zero.

Figure 11-7 clearly shows that the adjustment to the new, higher, long-run equilib- rium takes a long time. It is only 40% complete after 10 years, and 63% complete after 20 years. Put another way, the increase in the saving rate increases the growth rate of output per worker for a long time. The average annual growth rate is 3.1% for the first 10 years, and 1.5% for the next 10. Although the changes in the saving rate have no effect on growth in the long run, they do lead to higher growth for a long time.

To go back to the question raised at the beginning of the chapter, can the low sav- ing/investment rate in the United States explain why the U.S. growth rate has been so low—relative to other OECD countries—since 1950? The answer would be yes if the United States had had a higher saving rate in the past, and if this saving rate had fallen

c

The difference between in- vestment and depreciation is greatest at the beginning. This is why capital accumulation, and in turn, output growth, is highest at the beginning.

Le ve

l o f o

ut pu

t p er

w or

ke r,

Y /N

2.00

1.75

1.50

1.25

1.00

0 Years

(a) Effect on the level of output per worker

G ro

w th

r at

e of

o ut

pu t p

er w

or ke

r (p

er ce

nt )

5

4

3

2

1

0

(b) Effect on output growth

10 20 30 40 50

0 Years

10 20 30 40 50

Figure 11-7

The Dynamic Effects of an Increase in the Saving Rate from 10% to 20% on the Level and the Growth Rate of Output per Worker

It takes a long time for out- put to adjust to its new higher level after an increase in the saving rate. Put another way, an increase in the saving rate leads to a long period of higher growth.

MyEconLab Animation

Chapter 11 Saving, Capital Accumulation, and Output 233

substantially in the last 50 years. If this were the case, it could explain the period of lower growth in the United States in the last 50 years along the lines of the mechanism in Figure 11-7 (with the sign reversed, as we would be looking at a decrease—not an increase—in the saving rate). But this is not the case. The U.S. saving rate has been low for a long time. Low saving cannot explain the relative poor U.S. growth performance over the last 50 years.

The U.S. Saving Rate and the Golden Rule What is the saving rate that would maximize steady-state consumption per worker? Recall that, in steady state, consumption is equal to what is left after enough is put aside to maintain a constant level of capital. More formally, in steady state, consumption per worker is equal to output per worker minus depreciation per worker:

C N

= Y N

- d K N

Using equations (11.8) and (11.9) for the steady-state values of output per worker and capital per worker, consumption per worker is thus given by

C N

= s d

- da s d b

2

= s11 - s2

d

Using this equation, together with equations (11.8) and (11.9), Table 11-1 gives the steady-state values of capital per worker, output per worker, and consumption per worker for different values of the saving rate (and for a depreciation rate equal to 10%).

Steady-state consumption per worker is largest when s equals 1/2. In other words, the golden-rule level of capital is associated with a saving rate of 50%. Below that level, increases in the saving rate lead to an increase in long-run consumption per worker. We saw previously that the average U.S. saving rate since 1970 has been only 17%. So we can be quite confident that, at least in the United States, an increase in the saving rate would increase both output per worker and consumption per worker in the long run.

Check your understanding of the issues: Using the equa- tions in this section, argue the pros and cons of policy mea- sures aimed at increasing the U.S. saving rate.

b

Table 11-1 The Saving Rate and the Steady-State Levels of Capital, Output, and Consumption per Worker

Saving Rate s Capital per

Worker K / N Output per

Worker Y / N Consumption per

Worker C / N

0.0 0.0 0.0 0.0

0.1 1.0 1.0 0.9

0.2 4.0 2.0 1.6

0.3 9.0 3.0 2.1

0.4 16.0 4.0 2.4

0.5 25.0 5.0 2.5

0.6 36.0 6.0 2.4

. . . . . . . . . . . .

1.0 100.0 10.0 0.0

234 The Long Run The Core

11-4 Physical versus Human Capital We have concentrated so far on physical capital—machines, plants, office buildings, and so on. But economies have another type of capital: the set of skills of the workers in the economy, or what economists call human capital. An economy with many highly skilled workers is likely to be much more productive than an economy in which most workers cannot read or write.

The increase in human capital has been as large as the increase in physical capital over the last two centuries. At the beginning of the Industrial Revolution, only 30% of the population of the countries that constitute the OECD today knew how to read. Today, the literacy rate in OECD countries is above 95%. Schooling was not compulsory prior to the Industrial Revolution. Today it is compulsory, usually until the age of 16. Still, there are large differences across countries. Today, in OECD countries, nearly 100% of chil- dren get a primary education, 90% get a secondary education, and 38% get a higher ed- ucation. The corresponding numbers in poor countries, countries with GDP per person below $400, are 95%, 32%, and 4% respectively.

How should we think about the effect of human capital on output? How does the introduction of human capital change our earlier conclusions? These are the questions we take up in this last section.

Extending the Production Function The most natural way of extending our analysis to allow for human capital is to modify the production function relation (11.1) to read

Y N

= f a K N

, H N b (11.10)

1+ ,+2 The level of output per worker depends on both the level of physical capital per

worker, K/N, and the level of human capital per worker, H/N. As before, an increase in capital per worker 1K>N2 leads to an increase in output per worker. And an increase in the average level of skill 1H>N2also leads to more output per worker. More skilled work- ers can do more complex tasks; they can deal more easily with unexpected complica- tions. All of this leads to higher output per worker.

We assumed previously that increases in physical capital per worker increased output per worker, but that the effect became smaller as the level of capital per worker increased. We can make the same assumption for human capital per worker: Think of increases in H/N as coming from increases in the number of years of education. The evidence is that the returns to increasing the proportion of children acquiring a primary education are large. At the very least, the ability to read and write allows people to use equipment that is more complicated but more productive. For rich countries, however, primary education—and, for that matter, secondary education—are no longer the relevant margin. Most children now get both. The relevant margin is now higher educa- tion. We are sure it will come as good news to you that the evidence shows that higher education increases people’s skills, at least as measured by the increase in the wages of those who acquire it. But to take an extreme example, it is not clear that forcing ev- eryone to acquire an advanced college degree would increase aggregate output much. Many people would end up overqualified and probably more frustrated rather than more productive.

How should we construct the measure for human capital, H? The answer is very much the same way we construct the measure for physical capital, K. To construct K, we

c

Even this comparison may be misleading because the qual- ity of education can be quite different across countries.

cNote that we are using the same symbol, H, to denote central bank money in Chapter 4, and human capital in this chapter. Both uses are traditional. Do not be confused.

c

We look at this evidence in Chapter 13.

Chapter 11 Saving, Capital Accumulation, and Output 235

just add the values of the different pieces of capital, so that a machine that costs $2,000 gets twice the weight of a machine that costs $1,000. Similarly, we construct the mea- sure of H such that workers who are paid twice as much get twice the weight. Take, for example, an economy with 100 workers, half of them unskilled and half of them skilled. Suppose the relative wage of the skilled workers is twice that of the unskilled work- ers. We can then construct H as [150 * 12 + 150 * 22] = 150. Human capital per worker, H/N is then equal to 150>100 = 1.5.

Human Capital, Physical Capital, and Output How does the introduction of human capital change the analysis of the previous sections?

Our conclusions about physical capital accumulation remain valid. An increase in the saving rate increases steady-state physical capital per worker and therefore increases output per worker. But our conclusions now extend to human capital accumulation as well. An increase in how much society “saves” in the form of human capital—through education and on-the-job training—increases steady-state human capital per worker, which leads to an increase in output per worker. Our extended model gives us a richer picture of how output per worker is determined. In the long run, it tells us that out- put per worker depends on both how much society saves and how much it spends on education.

What is the relative importance of human capital and of physical capital in the determination of output per worker? A place to start is to compare how much is spent on formal education to how much is invested in physical capital. In the United States, spending on formal education is about 6.5% of GDP. This number includes both gov- ernment expenditures on education and private expenditures by people on education. It is between one-third and one-half of the gross investment rate for physical capital (which is around 16%). But this comparison is only a first pass. Consider the following complications:

■■ Education, especially higher education, is partly consumption—done for its own sake—and partly investment. We should include only the investment part for our purposes. However, the 6.5% number in the preceding paragraph includes both.

■■ At least for post-secondary education, the opportunity cost of a person’s education is his or her forgone wages while acquiring the education. Spending on education should include not only the actual cost of education but also this opportunity cost. The 6.5% number does not include this opportunity cost.

■■ Formal education is only a part of education. Much of what we learn comes from on-the-job training, formal or informal. Both the actual costs and the opportunity costs of on-the-job training should also be included. The 6.5% number does not in- clude the costs associated with on-the-job training.

■■ We should compare investment rates net of depreciation. Depreciation of physical capital, especially of machines, is likely to be higher than depreciation of human capital. Skills deteriorate, but do so only slowly. And unlike physical capital, they deteriorate less quickly the more they are used.

For all these reasons, it is difficult to come up with reliable numbers for invest- ment in human capital. Recent studies conclude that investment in physical capital and in education play roughly similar roles in the determination of output. This implies that output per worker depends roughly equally on the amount of physical capital and the amount of human capital in the economy. Countries that save more or spend more on education can achieve substantially higher steady-state levels of output per worker.

b

The rationale for using rela- tive wages as weights is that they reflect relative marginal products. A worker who is paid three times as much as another is assumed to have a marginal product that is three times higher.

An issue, however, is whether or not relative wages accurately reflect relative mar- ginal products. To take a con- troversial example, in the same job, with the same seniority, women still often earn less than men. Is it because their marginal product is lower? Should they be given a lower weight than men in the con- struction of human capital?

How large is your opportunity cost relative to your tuition?b

236 The Long Run The Core

Endogenous Growth Note what the conclusion we just reached did say and did not say. It did say that a coun- try that saves more or spends more on education will achieve a higher level of output per worker in steady state. It did not say that by saving or spending more on education a country can sustain permanently higher growth of output per worker.

This conclusion, however, has been challenged. Following the lead of Robert Lucas and Paul Romer, researchers have explored the possibility that the joint accumulation of physical capital and human capital might actually be enough to sustain growth. Given human capital, increases in physical capital will run into decreasing returns. And given physical capital, increases in human capital will also run into decreasing returns. But these researchers have asked, what if both physical and human capital increase in tandem? Can’t an economy grow forever just by steadily having more capital and more skilled workers?

Models that generate steady growth even without technological progress are called models of endogenous growth to reflect the fact that in those models—in contrast to the model we saw in previous sections of this chapter—the growth rate depends, even in the long run, on variables such as the saving rate and the rate of spending on education. The jury on this class of models is still out, but the indications so far are that the conclu- sions we drew earlier need to be qualified and not abandoned. The current consensus is as follows:

■■ Output per worker depends on the level of both physical capital per worker and human capital per worker. Both forms of capital can be accumulated, one through physical investment, the other through education and training. Increasing either the saving rate or the fraction of output spent on education and training can lead to much higher levels of output per worker in the long run. However, given the rate of technological progress, such measures do not lead to a permanently higher growth rate.

■■ Note the qualifier in the last proposition: given the rate of technological progress. But is technological progress unrelated to the level of human capital in the economy? Can’t a better educated labor force lead to a higher rate of technological progress? These questions take us to the topic of the next chapter, the sources and the effects of technological progress.

Robert Lucas was awarded the Nobel Prize in 1995. He teaches at the University of Chicago. Paul Romer teaches at New York University.

Summary ■■ In the long run, the evolution of output is determined by two

relations. (To make the reading of this summary easier, we shall omit “per worker” in what follows.) First, the level of output depends on the amount of capital. Second, capital accumulation depends on the level of output, which deter- mines saving and investment.

■■ These interactions between capital and output imply that, start- ing from any level of capital (and ignoring technological prog- ress, the topic of Chapter 12), an economy converges in the long run to a steady-state (constant) level of capital. Associated with this level of capital is a steady-state level of output.

■■ The steady-state level of capital, and thus the steady-state level of output, depends positively on the saving rate. A

higher saving rate leads to a higher steady-state level of out- put; during the transition to the new steady state, a higher saving rate leads to positive output growth. But (again ig- noring technological progress) in the long run, the growth rate of output is equal to zero and so does not depend on the saving rate.

■■ An increase in the saving rate requires an initial de- crease in consumption. In the long run, the increase in the saving rate may lead to an increase or a decrease in consumption, depending on whether the economy is below or above the golden-rule level of capital, which is the level of capital at which steady-state consumption is highest.

c

MEL Video

Chapter 11 Saving, Capital Accumulation, and Output 237

■■ Although most of the analysis of this chapter focuses on the effects of physical capital accumulation, output depends on the levels of both physical and human capital. Both forms of capital can be accumulated, one through investment, the other through education and training. Increasing the saving rate or the fraction of output spent on education and training can lead to large increases in output in the long run.

■■ Most countries have a level of capital below the golden-rule level. Thus, an increase in the saving rate leads to an initial de- crease in consumption followed by an increase in consumption in the long run. When considering whether or not to adopt pol- icy measures aimed at changing a country’s saving rate, policy makers must decide how much weight to put on the welfare of current generations versus the welfare of future generations.

Key Terms saving rate, 217 steady state, 223 golden-rule level of capital, 227 fully funded social security system, 229

pay-as-you-go social security system, 229 Social Security trust fund, 229 human capital, 234 models of endogenous growth, 236

QuICk CHECk MyEconLab Visit www.myeconlab.com to complete all Quick Check problems and get instant feedback. 1. Using the information in this chapter, label each of the following statements true, false, or uncertain. Explain briefly.

a. The saving rate is always equal to the investment rate. b. A higher investment rate can sustain higher growth of

output forever. c. If capital never depreciated, growth could go on forever. d. The higher the saving rate, the higher consumption in

steady state. e. We should transform Social Security from a pay-as-you-go

system to a fully funded system. This would increase con- sumption both now and in the future.

f. The U.S. capital stock is far below the golden-rule level. The government should give tax breaks for saving because the U.S. capital stock is far below the golden-rule level.

g. Education increases human capital and thus output. It follows that governments should subsidize education.

2. Consider the following statement: “The Solow model shows that the saving rate does not affect the growth rate in the long run, so we should stop worrying about the low U.S. saving rate. Increasing the saving rate wouldn’t have any important effects on the economy.” Explain why you agree or disagree with this statement?

3. In Chapter 3 we saw that an increase in the saving rate can lead to a recession in the short run (i.e., the paradox of saving). We ex- amined the issue in the medium run in Problem 5 at at the end of Chapter 7. We can now examine the long-run effects of an increase in saving.

Using the model presented in this chapter, what is the effect of an increase in the saving rate on output per worker likely to be after one decade? After five decades?

DIg DEEpER MyEconLab Visit www.myeconlab.com to complete all Dig Deeper problems and get instant feedback. 4. Discuss how the level of output per person in the long run would likely be affected by each of the following changes:

a. The right to exclude saving from income when paying income taxes.

b. A higher rate of female participation in the labor market (but constant population).

5. Suppose the United States moved from the current pay-as- you-go Social Security system to a fully funded one and financed the transition without additional government borrowing. How would the shift to a fully funded system affect the level and the rate of growth of output per worker in the long run?

6. Suppose that the production function is given by

Y = 0.51K 1N a. Derive the steady-state levels of output per worker and

capital per worker in terms of the saving rate, s, and the depreciation rate, d.

b. Derive the equation for steady-state output per worker and steady-state consumption per worker in terms of s and d.

c. Suppose that d = 0.05. With your favorite spreadsheet software, compute steady-state output per worker and steady-state consumption per worker for s = 0; s = 0.1; s = 0.2; s = 1. Explain the intuition behind your results.

d. Use your favorite spreadsheet software to graph the steady-state level of output per worker and the steady- state level of consumption per worker as a function of the saving rate (i.e., measure the saving rate on the horizon- tal axis of your graph and the corresponding values of output per worker and consumption per worker on the vertical axis).

Questions and Problems

238 The Long Run The Core

9. Deficits and the capital stock For the production function, Y = 1K 1N equation (11.9)

gives the solution for the steady-state capital stock per worker. a. Retrace the steps in the text that derive equation (11.9). b. Suppose that the saving rate, s, is initially 15% per year, and

the depreciation rate, d, is 7.5%. What is the steady-state capital stock per worker? What is steady-state output per worker?

c. Suppose that there is a government deficit of 5% of GDP and that the government eliminates this deficit. Assume that private saving is unchanged so that total saving in- creases to 20%. What is the new steady-state capital stock per worker? What is the new steady-state output per work- er? How does this compare to your answer to part b?

ExplORE FuRTHER

10. U.S. saving and government deficits This question continues the logic of Problem 9 to explore the

implications of the U.S. government budget deficit for the long-run capital stock. The question assumes that the United States will have a budget deficit over the life of this edition of the text.

a. The World Bank reports gross domestic saving rate by coun- try and year. The Web site is http://data.worldbank.org/ indicator/NY.GDS.TOTL.KN. Find the most recent number for the United States. What is the total saving rate in the United States as a percentage of GDP? Using the depre- ciation rate and the logic from Problem 9, what would be the steady-state capital stock per worker? What would be steady-state output per worker?

b. Go to the most recent Economic Report of the President (ERP) and find the most recent federal deficit as a percentage of GDP. In the 2015 ERP, this is found in Table B-20. Using the reason- ing from Problem 9, suppose that the federal budget deficit was eliminated and there was no change in private saving. What would be the effect on the long-run capital stock per worker? What would be the effect on long-run output per worker?

c. Return to the World Bank table of gross domestic saving rates. How does the saving rate in China compare to the saving rate in the United States?

e. Does the graph show that there is a value of s that maxi- mizes output per worker? Does the graph show that there is a value of s that maximizes consumption per worker? If so, what is this value?

7. The Cobb-Douglas production function and the steady state This problem is based on the material in the chapter appendix.

Suppose that the economy’s production function is given by

Y = KaN1 - a

and assume that a = 1>3. a. Is this production function characterized by constant

returns to scale? Explain. b. Are there decreasing returns to capital? c. Are there decreasing returns to labor? d. Transform the production function into a relation between

output per worker and capital per worker. e. For a given saving rate, s, and depreciation rate, d, give an

expression for capital per worker in the steady state. f. Give an expression for output per worker in the steady

state. g. Solve for the steady-state level of output per worker when

s = 0.32 and d = 0.08. h. Suppose that the depreciation rate remains constant at

d = 0.08, while the saving rate is reduced by half, to s = 0.16. What is the new steady-state output per worker?

8. Continuing with the logic from Problem 7, suppose that the economy’s production function is given by Y = K1>3N2>3 and that both the saving rate, s, and the depreciation rate, d are equal to 0.10.

a. What is the steady-state level of capital per worker? b. What is the steady-state level of output per worker?

Suppose that the economy is in steady state and that, in period t, the depreciation rate increases permanently from 0.10 to 0.20.

c. What will be the new steady-state levels of capital per work- er and output per worker?

d. Compute the path of capital per worker and output per worker over the first three periods after the change in the depreciation rate.

Further Readings ■■ The classic treatment of the relation between the saving

rate and output is by Robert Solow, Growth Theory: An Exposition (1970).

■■ An easy-to-read discussion of whether and how to increase saving and improve education in the United States

is given in Memoranda 23 to 27 in Memos to the President: A Guide through Macroeconomics for the Busy Policymaker, by Charles Schultze, who was the Chairman of the Council of Economic Advisers during the Carter administration (1992).

Chapter 11 Saving, Capital Accumulation, and Output 239

APPEnDIx: The Cobb-Douglas Production Function and the Steady State

In 1928, Charles Cobb (a mathematician) and Paul Douglas (an economist, who went on to become a U.S. senator) con- cluded that the following production function gave a good description of the relation between output, physical capital, and labor in the United States from 1899 to 1922:

Y = KaN1 - a (11.A1)

with a being a number between zero and one. Their findings proved surprisingly robust. Even today, the production function (11.A1), now known as the Cobb-Douglas production func- tion, still gives a good description of the relation between out- put, capital, and labor in the United States, and it has become a standard tool in the economist’s toolbox. (Verify for yourself that it satisfies the two properties we discussed in the text: constant returns to scale and decreasing returns to capital and to labor.)

The purpose of this appendix is to characterize the steady state of an economy when the production function is given by (11.A1). (All you need to follow the steps is a knowledge of the properties of exponents.)

Recall that, in steady state, saving per worker must be equal to depreciation per worker. Let’s see what this implies.

■■ To derive saving per worker, we must first derive the relation between output per worker and capital per worker implied by equation (11.A1). Divide both sides of equation (11.A1) by N:

Y>N = KaN1 - a>N Using the properties of exponents,

N1 - a>N = N1 - aN-1 = N-a so, replacing the terms in N in the preceding equation, we get:

Y>N = KaN-a = 1K>N2a Output per worker, Y/N, is equal to the ratio of capital

per worker, K/N, raised to the power a. Saving per worker is equal to the saving rate times out-

put per worker, so, using the previous equation, it is equal to

s 1K*>N2a ■■ Depreciation per worker is equal to the depreciation rate

times capital per worker:

d 1K*>N2 ■■ The steady-state level of capital, K*, is determined by the

condition that saving per worker be equal to depreciation per worker, so:

s1K*>N2a = d1K*>N2 To solve this expression for the steady-state level of capital per worker K*>N, divide both sides by 1K*>N2a:

s = d1K*>N21 - a

Divide both sides by d, and change the order of the equality:

1K*>N21 - a = s>d Finally, raise both sides to the power 1>11 - a2:

1K*>N2 = 1s>d21>11 - a2 This gives us the steady-state level of capital per worker. From the production function, the steady-state level of

output per worker is then equal to

1Y*>N2 = K>Na = 1s>d2a>11 - a2 Let’s see what this last equation implies.

■■ In the text, we actually worked with a special case of an equation (11.A1), the case where a = 0.5. (Taking a vari- able to the power 0.5 is the same as taking the square root of this variable.) If a = 0.5, the preceding equation means

Y*>N = s>d Output per worker is equal to the ratio of the saving rate

to the depreciation rate. This is the equation we discussed in the text. A doubling of the saving rate leads to a doubling in steady-state output per worker.

■■ The empirical evidence suggests, however, that, if we think of K as physical capital, a is closer to one-third than to one-half. Assuming a = 1>3, then a11 - a2 = 11>32>11 - 11>322 = 11>32>12>32 = 1>2, and the equation for output per worker yields

Y*>N = 1s>d21>2 = 2s>d This implies smaller effects of the saving rate on output

per worker than was suggested by the computations in the text. A doubling of the saving rate, for example, means that output per worker increases by a factor of 12, or only about 1.4 (put another way, a 40% increase in output per worker).

■■ There is, however, an interpretation of our model in which the appropriate value of a is close to 1/2, so the computa- tions in the text are applicable. If, along the lines of Section 11-4, we take human capital into account as well as physical capital, then a value of a around 1/2 for the contribution of this broader definition of capital to output is, indeed, roughly appropriate. Thus, one interpretation of the nu- merical results in Section 11-3 is that they show the effects of a given saving rate, but that saving must be interpreted to include saving in both physical capital and in human capital (more machines and more education).

Key Term Cobb-Douglas production function, 239

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241

T

12 Technological Progress and Growth he conclusion in Chapter 11 that capital accumulation cannot by itself sustain growth has a straight-forward implication: Sustained growth requires technological progress. This chapter looks at the role of technological progress in growth.

Section 12-1 looks at the respective role of technological progress and capital accumulation in growth. It shows how, in steady state, the rate of growth of output per person is simply equal to the rate of technological progress. This does not mean, however, that the saving rate is irrelevant. The saving rate affects the level of output per person but not its steady state rate of growth.

Section 12-2 turns to the determinants of technological progress, the role of research and development (R&D), and the role of innovation versus imitation.

Section 12-3 discusses why some countries are able to achieve steady technological progress while others do not. In so doing, it looks at the role of institutions in sustaining growth.

Section 12-4 returns to the facts of growth presented in Chapter 10 and interprets them in the light of what we have learned in this and the previous chapter.

242 The Long Run The Core

12-1 Technological Progress and the Rate of Growth In an economy in which there is both capital accumulation and technological progress, at what rate will output grow? To answer this question, we need to extend the model developed in Chapter 11 to allow for technological progress. To introduce technological progress into the picture, we must first revisit the aggregate production function.

Technological Progress and the Production Function Technological progress has many dimensions:

■■ It can lead to larger quantities of output for given quantities of capital and labor. Think of a new type of lubricant that allows a machine to run at a higher speed and to increase production.

■■ It can lead to better products. Think of the steady improvement in automobile safety and comfort over time.

■■ It can lead to new products. Think of the introduction of the iPad, wireless commu- nication technology, flat screen monitors, and high-definition television.

■■ It can lead to a larger variety of products. Think of the steady increase in the num- ber of breakfast cereals available at your local supermarket.

These dimensions are more similar than they appear. If we think of consumers as caring not about the goods themselves but about the services these goods provide, then they all have something in common. In each case, consumers receive more services. A better car provides more safety, a new product such as an iPad or faster communication technology provides more communication services, and so on. If we think of output as the set of underlying services provided by the goods produced in the economy, we can think of technological progress as leading to increases in output for given amounts of capital and labor. We can then think of the state of technology as a variable that tells us how much output can be produced from given amounts of capital and labor at any time. If we denote the state of technology by A, we can rewrite the production function as

Y = F 1K, N, A2 1+ ,+ ,+2

This is our extended production function. Output depends on both capital and labor (K and N) and on the state of technology (A). Given capital and labor, an improvement in the state of technology, A, leads to an increase in output.

It will be convenient to use a more restrictive form of the preceding equation, namely

Y = F1K, AN2 (12.1) This equation states that production depends on capital and on labor multiplied by

the state of technology. Introducing the state of technology in this way makes it easier to think about the effect of technological progress on the relation between output, capital, and labor. Equation (12.1) implies that we can think of technological progress in two equivalent ways:

■■ Technological progress reduces the number of workers needed to produce a given amount of output. Doubling A produces the same quantity of output with only half the original number of workers, N.

■■ Technological progress increases the output that can be produced with a given number of workers. We can think of AN as the amount of effective labor in the

c

The average number of items carried by a supermarket in- creased from 2,200 in 1950 to 38,700 in 2010. To get a sense of what this means, see Robin Williams (who plays an immi- grant from the Soviet Union) in the supermarket scene in the movie Moscow on the Hudson.

c

As you saw in the Focus box “Real GDP, Technological Prog- ress, and the Price of Comput- ers” in Chapter 2, thinking of products as providing a num- ber of underlying services is the method used to construct the price index for computers.

c

For simplicity, we shall ignore human capital here. We return to it later in the chapter.

Chapter 12 Technological Progress and Growth 243

economy. If the state of technology A doubles, it is as if the economy had twice as many workers. In other words, we can think of output being produced by two fac- tors: capital 1K2, and effective labor 1AN2. What restrictions should we impose on the extended production function (12.1)?

We can build directly here on our discussion in Chapter 11. Again, it is reasonable to assume constant returns to scale. For a given state of tech-

nology 1A2, doubling both the amount of capital 1K2 and the amount of labor 1N2 is likely to lead to a doubling of output

2Y = F12K, 2AN2 More generally, for any number x,

xY = F1x K, x AN2 It is also reasonable to assume decreasing returns to each of the two factors—

capital and effective labor. Given effective labor, an increase in capital is likely to increase output but at a decreasing rate. Symmetrically, given capital, an increase in effective labor is likely to increase output, but at a decreasing rate.

It was convenient in Chapter 11 to think in terms of output per worker and capital per worker. That was because the steady state of the economy was a state where output per worker and capital per worker were constant. It is convenient here to look at output per effective worker and capital per effective worker. The reason is the same; as we shall soon see, in steady state, output per effective worker and capital per effective worker are constant.

To get a relation between output per effective worker and capital per effective worker, take x = 1>AN in the preceding equation. This gives

Y AN

= F a K AN

, 1b

Or, if we define the function f so that f1K>AN2 = F1K>AN, 12:

Y

AN = f a K

AN b (12.2)

In words: Output per effective worker (the left side) is a function of capital per effective worker (the expression in the function on the right side).

The relation between output per effective worker and capital per effective worker is drawn in Figure 12-1. It looks much the same as the relation we drew in Figure 11-2

b

AN is also sometimes called labor in efficiency units. The use of efficiency for “efficiency units” here and for “efficiency wages” in Chapter 6 is a co- incidence; the two notions are unrelated.

b

Per worker: divided by the number of workers (N ).

Per effective worker: di- vided by the number of effec- tive workers (AN)—the number of workers, N, times the state of technology, A.

b

Suppose that F has the “double square root” form:

Y = F1K, AN2 = 2K 2AN Then

Y AN

= 2K 2AN

AN =

2K2AN So the function f is simply the square root function:

f a K AN

b = A KAN

Capital per effective worker, K/AN

O ut

pu t p

er e

ff ec

tiv e

w or

ke r,

Y /A

N

f (K/AN)

Figure 12-1

Output per Effective Worker versus Capital per Effective Worker

Because of decreasing returns to capital, increases in capital per effective worker lead to smaller and smaller increases in output per effective worker.

MyEconLab Animation

244 The Long Run The Core

between output per worker and capital per worker in the absence of technological prog- ress. There, increases in K>N led to increases in Y>N, but at a decreasing rate. Here, increases in K>AN lead to increases in Y>AN, but at a decreasing rate.

Interactions between Output and Capital We now have the elements we need to think about the d