The Importance of Institutions and Causes of Long Run Performance

Comments on Assignment Questions

John Maynard Keynes/Managing Aggregate Demand 1. Keynesian economics is often viewed as justifying increases in deficit spending … How does this proposal related to Keynes own writing? There is an important point to emphasize: Keynes didn’t necessarily believe that the only way to stimulate the economy was through more spending by government. He also argued that tax cuts and instilling confidence to get people spending again were also important. You could draw a picture of the game with two players who each face a save/spend decision that we discussed in class. Then the challenge for the government is to shift the economy from the low to the high welfare Nash equilibrium. This may depend as much on instilling confidence as the government spending more money/cutting taxes. Greater confidence may be reflected in a higher multiplier, c (where C = a + cY) so that people decide to go out and spend more of the money they are earning. This effect can even boost output with no extra government spending required. 2. What role do confidence and psychology play in Keynes understanding of the economy and role of government? You should emphasize the quote of Keynes that he believed that the Great Depression “comes from some failure of the material devices of the mind”. And quote the examples of speculative stock market booms and busts that concerned Keynes. The key issue is that lack of confidence and uncertainty about the future may lead business to stop investing and consumers to stop spending which may bring on a slump. So psychology plays an important role. 3. Why is Keynes so concerned with uncertainty? The main point here concerns how uncertainty can lead to sudden changes in business ‘bullishness’, or desire to invest (see also question 2). You could add that it was a special kind of uncertainty that Keynes focussed on, called ‘Knightian uncertainty’, where you just don’t even know enough to assign probabilities. This kind of uncertainty leads to ‘herding’ / animal spirits, whereby people tend to replicate average behaviour. More uncertainty can lead to less investment and consumption demand and consequently a recession - and the effect can be magnified by herd behaviour. This is why Keynes was so concerned with uncertainty.

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4. Explain intuitively the mechanism by which an increase in government spending can lead to more output. This is discussed in the case: ‘Fiscal Policy, Managing Aggregate Demand’ and in our discussions of the multiplier. The key equations are Y = C + I + G which explains how higher G has a direct effect on creating more demand and leading to higher Y. The other key equation is C = a + cY which says that when Y goes up, there is an extra effect whereby consumption demand goes up which further raises Y and so on (i.e., the multiplier). 5. Is it reasonable to assume that firms will supply more output when consumers and the government demand to purchase it? You must emphasize the concept of the ‘Output Gap’ here. If actual output is greater than potential output then firms will be depleting stocks so that more demand is eventually going to push up prices/cause inflation (and not lead to more output). Only if actual output is less than potential output will firms have spare productive capacity to supply more when there is more demand from the government or consumers. The Central Bank and Inflation 1. What revealed objectives do the actions of the Fed suggest that it is following with respect to its conduct of monetary policy? I think the best answer would include a reference to the Taylor Rule that we discussed in class (see also Mankiw’s discussion of it in his essay on US monetary policy in the 1990s). The idea is that the Taylor rule does a good job of explaining how interest rates were changed: they were lowered when unemployment went up to help stabilize the economy and raised whenever inflation started going up to help avoid more inflation (by more than one for one). So the revealed objectives appear to be that it is trying to achieve low and stable inflation and also avoid recessions when unemployment starts to rise. 2. Do you believe that the US Federal Reserve is independent? Has it been influenced by politicians? The question is about whether the US Fed has set interest rates to help satisfy political objectives (e.g., to win elections) or whether they have solely been aimed at fighting inflation / stabilizing the economy.

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Mankiw has a section with answers to this in his essay on US monetary policy in the 1990s. For example, he discusses how (Democratic) Clinton renewed (Republican) Greenspan’s appointment. 3. Are the costs of falling prices the same as the costs of rising prices? Why may they differ? There is discussion on this question in Mankiw’s essay on “US Monetary Policy in the 1990s”. Falling prices may cause firms to default on their loans and go bankrupt (if they are denominated in nominal amounts). This is because as prices fall then in real terms the value owed goes up. It is this sort of problem that can make the costs of deflation different from the costs of inflation. 4. Should so much power be given to unelected central bankers like Greenspan? One of the main points here is that giving lots of power to unelected central bankers may be good since then they have independence from politicians and the need to win elections. That can result in monetary policy aimed more at keeping inflation low than trying to boost the economy even when actual output equals potential output. However the downside is that you need a person who the markets have confidence in - that is, someone who conducts policy in a transparent and credible way. 5. Has Greenspan been a success at the Fed? What prepared him for the role of Chairman? Most commentators seem to have judged that Greenspan has been a success using a range of indicators. You should use objective evidence to back up this view. For example, using measures of inflation, real GDP growth, unemployment, stock price rises and productivity growth, all of these do better under Greenspan than in the 14 years prior to his tenure. 6. Should Greenspan speak more clearly to Congress, the public and financial markets? Why or why not? This is not a question with a right or wrong answer. You could discuss examples that we did in class about how the yield curve barely changed at all across the ‘anticipated’ interest rate cut of 2 October, 2001 (shortly after September 11). This suggests that Greenspan had been communicating so well with the markets that they fully expected what was about to happen and the change was both transparent and credible. However remember there was also an earlier interest rate cut on 4 January, 2001 which did change the yield curve and ‘surprised’ the markets, suggesting that communication had not been

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so perfect. This is the kind of discussion that is expected here, including the idea that Greenspan may deliberately be eloquent or obfuscating, as the situation required. 7. Should economists be celebrities? An important point to make here is the idea that celebrities leave no legacy (i.e., how do you copy one?) whereas rules can be implemented by any person, regardless of their celebrity status. This is an opportunity to discuss the question of discretion versus rules (like the Taylor Rule) in the setting of monetary policy. The German Hyperinflation 1. Who is to blame for the German Hyperinflation? We covered this in class. In addition to blaming the government and central bank governor, there is also an argument that the German extremists were to blame. There were extremists on the far right (Hitler) and far left (communists) and the government may have been trying to print money in an attempt to pacify them. Also you could argue that the Allies were to blame - the French, who were intransigent on reparations and occupied the Ruhr, and the US for not forgiving War loans. There is also a view that some German industrialists were to blame (e.g., Stinnes) who got access to cheap loans. 2. What were the consequences of the German Hyperinflation? There are two categories of consequences: economic and political (e.g., undermining the regime). On economic, you could include the extreme volatility of relative prices, random redistribution of wealth and also that the savvy were able to take advantage of the situation whereas the not-so-savvy got their life savings wiped out (like the Fuhrer’s story of the old lady selling her postcards). 3. What advice would you have given the German government about how best to reduce the country’s inflation in November 1923? Examples include stopping increasing the money supply and cutting the budget deficit (reducing spending / increasing taxes) although you should also emphasize the possibility of reducing the reparation payments and renegotiating with the Allies.

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The Blair Wealth Project 1. What were the causes of Britain's "stop-go" economy? Did Mrs. Thatcher address them successfully? Two points to emphasize here are that stop-go had its origins in the Keynesian Demand Management policies of the government (both fiscal and monetary). And that Thatcher blamed the Unions for destabilizing the economy in the first place. To the extent that she crushed the unions, her actions backed up her rhetoric that unions were to blame. 2. What is the difference – if any – between "stop-go" in the 1950s and '60s and what Gordon Brown, New Labour's Chancellor of the Exchequer (i.e., Finance Minister) has called "twenty years of Tory boom and bust" under Mrs. Thatcher and her Conservative successors? This question is comparing the origin of “stop-go” cycles with the (“boom-bust”) cycles that occurred under Thatcher. One difference is that “boom-bust” appears to have part of their origin in the deregulation of the economy and were a consequence of markets (like the credit boom / bust that occurred after financial deregulation). That is, boom-bust seems to have been caused by herd behavior and “irrational exuberance” - whereas “stop- go” was more a result of the unions and government intervention. This is an important theme of the case study – that maybe we’ve just replaced one source of instability with another in the UK. 3. Do you believe that the policies implemented by Blair's New Labour government will finally abolish macroeconomic instability in the U.K.? What role – if any – would adoption of the Euro play in containing such instability? There are several issues to discuss here regarding New Labour. One is that they have made the Bank of England more independent, which should improve macro-stability. We discussed in class how adopting the Euro would mean that the Bank of England loses its ability (via controlling the supply of pounds and UK interest rates) to conduct its own demand management of the economy (e.g., by cutting UK interest rates during a recession). The Euro-skeptics argue that joining the Euro could thereby make the UK economy less stable, rather than more.

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Inequality and the American Model 1a. Which is of greater concern: poverty or inequality? ‘Poverty’ refers usually to an absolute – you cannot afford to buy the basic necessities of life – whereas ‘inequality’ is always a relative concept. The question is asking about which is more important. So you need to be able to discuss issues like whether the large inequality in the US (between Michael Dell, Bill Gates and the poorest Americans) is really a problem since a relatively poor American may still be richer than a relatively well-off Somalian. 1b. Should we be concerned with rising inequality in the US? You should emphasize that high inequality may not be a problem at all, to the extent that it simply reflects capitalism at work, rewarding those who put in lots of effort (the American Dream) and punishing those who don’t. On the side of the argument that it is a problem, you should mention the morality/fairness question. 2. How should business respond to rising inequality? You should discuss corporate responsibility and the stake-holder model here. And mention that companies could maybe try to limit ‘excessive’ CEO pay, especially to the extent that this is viewed as ‘unfair’ or unjustified by workers. Involving more ‘stakeholders’ in business decisions is how the Europeans appear to have reacted to keep inequality low and maintain ‘fairness’. 3. What are the causes of higher inequality in the US? We covered this in class and the answers are in one of the slides on Web CT: the answers include globalisation, higher returns to skilled labour, government (tax/spend) policies and corporate avarice. 4. What policy responses are appropriate? Can the US learn from others? It’s important to emphasize how which approach is adopted is affected the belief system of the country. For example, the US (with belief in free markets and the ‘American Dream) is more likely to support programs requiring effort from beneficiaries (so are more likely to dress up redistribution as a ‘credit’, like the earned income tax credit). By comparison Europe (with its assumption of stagnant classes) is more likely to tolerate direct transfer programs.

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Exchange rates What effect may large volumes of short-term portfolio flows have on exchange rate volatility? You should include discussion of how short-term capital flows coming from changes in investment portfolios can play a big role in precipitating large capital outflows from countries when foreign investors get the jitters, leading to devaluations and problems for the government (if it is trying to support the value of the currency). That is, short-term capital flows coming from changes in investment portfolios can be a cause of greater exchange rate volatility. Remember we discussed in class how exchange rates are determined by supply and demand for a country’s currency – which comes from trade (imports and exports) and also capital flows. But capital flows have become more short term in recent times as international investors (like hedge funds) shuffle their portfolios as they chase high returns. What are the advantages and disadvantages to a country of having a fixed versus floating exchange rate regime? These are listed in the case on exchange rates under the headings “trade”, “risk of a destabilizing speculative attack” and also “institutional credibility versus monetary autonomy” (see page 5). The “trade” argument is about how fixed exchange rates can give exporters more certainty and promote trade (this was a big argument in favour of the Euro – to deepen European trade links by fixing their exchange rates). The “institutional credibility versus monetary autonomy” argument is about how countries like Germany after World War I may have been able to gain credibility for its Central Bank by promising to fix its exchange rate to, say, the US dollar. This kind of promise would prevent them from doing a hyperinflation since that would result in the currency devaluing – which they have made a promise will not happen. Mexico and the “Tequila Crisis” 1. How could extensive and well-executed fiscal, supply side and trade reforms end up in such a dismal situation? You could emphasize the heavy reliance on foreigners and the self-fulfilling cycle of more foreign inflows and higher expectations of growth (as per the diagram in the lecture slide). This can cut both ways – when there is a shock like a political assassination, there

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can be outflows of foreign capital and lower expectations of growth that can also generate a self-fulfilling cycle that leads to a big slump. 2. What best explains the collapse of the Mexican currency: psychological factors or fundamentals? This question is focussing on whether psychological factors and crises of confidence that are unrelated to fundamentals may have caused the collapse (see Paul Krugman’s quote in the case study that blames herd behaviour) versus the Martin Feldstein view quoted in the case study that it was “fundamental problems” (like an overvalued exchange rate, lack of competitiveness and the financial fragility of the banking system) that caused all the problems. That is, some people argue there were “fundamental” problems in the Mexican economy and society that led to the crisis whereas others argue that, in an age of globalization, short term portfolio investment flows may cause crises purely due to problems with confidence (that are primarily psychological and are not related to the fundamentals). 3. Should Mexico be bailed out? How does your answer to this relate to your position of the earlier questions? One approach to answering this question is as follows: if it is bad fundamentals in Mexico (e.g., political, social instability, bad banking system) maybe they shouldn’t be bailed out (i.e., it’s their own fault!). However if it’s psychological factors on behalf of fund managers in New York who have suddenly lost confidence in a country that in fact is in pretty good shape, then maybe they should be bailed out (i.e., it’s not the Mexicans that are to blame!). In this scenario it’s the fault of the wild and unstable global capital markets. 4. Is Paul Krugman’s analogy between the Mexican crisis and the ‘irrational exuberance’ usually associated with tulipmania a good one? This question again relates to the issue of whether the crisis is a psychological ‘bubble’ bursting or is due to fundamental factors.