Split (1)

train · 11.7k rows

text stringlengths 204 3.13k
not. Despite the fact that Microsoft’s payment of interest on the bond and the ultimate repayment of the face value of the bond will exceed what the company originally received from the bond purchaser, Microsoft is surely not unhappy with the arrangement. It expects to put that money to more productive use; that is the reason it issued the bond in the first place. A second concern about foreign asset purchases is that the United States in some sense loses sovereignty when foreigners buy its assets. But why should this be a problem? Foreign-owned firms competing in U.S. markets are at the mercy of those markets, as are firms owned by U.S. nationals. Foreign owners of U.S. real estate have no special power. What about foreign buyers of bonds 15.2.3 https://socialsci.libretexts.org/@go/page/21775 issued by the U.S. government? Foreigners owned about 28% of these bonds at the end of September 2008; they are thus the creditors for about 28% of the national debt. But this position hardly puts them in control of the government of the United States. They hold an obligation of the U.S. government to pay them a certain amount of U.S. dollars on a certain date, nothing more. A foreign owner could sell his or her bonds, but more than $100 billion worth of these bonds are sold every day. The resale of U.S. bonds by a foreign owner will not affect the U.S. government. In short, there is no economic justification for concern about having a current account deficit and a capital account surplus—nor would there be an economic reason to be concerned about the opposite state of affairs. The important feature of international trade is its potential to improve living standards for people. It is not a game in which current account balances are the scorecard. Key Takeaways The balance of payments shows spending flowing into and out of a country. The current account is an accounting statement that includes all spending flows across a nation’s border except those that represent purchases of assets. In our simplified analysis, the balance on current account equals net exports. A nation’s balance on capital account equals rest-of-world purchases of its assets during a period less its purchases of rest-ofworld assets. Provided that the market for a nation’s currency is in equilibrium, the balance on current account equals the negative of the balance on capital account. There is no economic justification for viewing any particular
current account balance as a good or bad thing. Try It! Use Equation 30.3 and Equation 30.4 to compute the variables given in each of the following. Assume that the market for a nation’s currency is in equilibrium and that the balance on current account equals net exports. 1. Suppose U.S. exports equal $300 billion, imports equal $400 billion, and rest-of-world purchases of U.S. assets equal $150 billion. What is the U.S. balance on current account? The balance on capital account? What is the value of U.S. purchases of rest-of-world assets? 2. Suppose Japanese exports equal ¥200 trillion (¥ is the symbol for the yen, Japan’s currency), imports equal ¥120 trillion, and Japan’s purchases of rest-of-world assets equal ¥90 trillion. What is the balance on Japan’s current account? The balance on Japan’s capital account? What is the value of rest-of-world purchases of Japan’s assets? 3. Suppose Britain’s purchases of rest-of-world assets equal £70 billion (£ is the symbol for the pound, Britain’s currency), rest-ofworld purchases of British assets equal £90 billion, and Britain’s exports equal £40 billion. What is Britain’s balance on capital account? Its balance on current account? Its total imports? 4. Suppose Mexico’s purchases of rest-of-world assets equal $500 billion ($ is the symbol for the peso, Mexico’s currency), restof-world purchases of Mexico’s assets equal $700 billion, and Mexico’s imports equal $550 billion. What is Mexico’s balance on capital account? Its balance on current account? Its total exports?  Case in Point: Alan Greenspan on the U.S. Current Account Deficit Figure 30.7 Javier – Alan Greenspan 2 – CC BY-NC-ND 2.0. 15.2.4 https://socialsci.libretexts.org/@go/page/21775 The growing U.S. current account deficit has generated considerable alarm. But, is there cause for alarm? In a speech in December 2005, former Federal Reserve Chairman Alan Greenspan analyzed what he feels are the causes of the growing deficit and explains how the U.S. current account deficit may, under
certain circumstances, decrease over time without a crisis. “In November 2003, I noted that we saw little evidence of stress in funding the U.S. current account deficit even though the real exchange rate for the dollar, on net, had declined more than 10% since early 2002. … Two years later, little has changed except that our current account deficit has grown still larger. Most policy makers marvel at the seeming ease with which the United States continues to finance its current account deficit. “Of course, deficits that cumulate to ever-increasing net external debt, with its attendant rise in servicing costs, cannot persist indefinitely. At some point, foreign investors will balk at a growing concentration of claims against U.S. residents … and will begin to alter their portfolios. … The rise of the U.S. current account deficit over the past decade appears to have coincided with a pronounced new phase of globalization that is characterized by a major acceleration in U.S. productivity growth and the decline in what economists call home bias. In brief, home bias is the parochial tendency of persons, though faced with comparable or superior foreign opportunities, to invest domestic savings in the home country. The decline in home bias is reflected in savers increasingly reaching across national borders to invest in foreign assets. The rise in U.S. productivity attracted much of those savings toward investments in the United States. … “Accordingly, it is tempting to conclude that the U.S. current account deficit is essentially a byproduct of long-term secular forces, and thus is largely benign. After all, we do seem to have been able to finance our international current account deficit with relative ease in recent years. “But does the apparent continued rise in the deficits of U.S. individual households and nonfinancial businesses themselves reflect growing economic strain? (We do not think so.) And does it matter how those deficits of individual economic entities are being financed? Specifically, does the recent growing proportion of these deficits being financed, net, by foreigners matter? … “If the currently disturbing drift toward protectionism is contained and markets remain sufficiently flexible, changing terms of trade, interest rates, asset prices, and exchange rates will cause U.S. saving to rise, reducing the need for foreign finance, and reversing the trend of the past decade toward increasing reliance on it. If, however, the pernicious drift toward fiscal instability in the United States and elsewhere is not arrested and is compounded by a protectionist reversal of globalization, the adjustment process could
be quite painful for the world economy.” Source: Alan Greenspan, “International Imbalances” (speech, Advancing Enterprise Conference, London, England, December 2, 2005), available at http://www.federalreserve.gov/boarddocs/speeches/2005/200512022/default.htm. Answers to Try It! Problems 1. All figures are in billions of U.S. dollars per period. The left-hand side of Equation 30.3 is the current account balance Exports − imports = $300 − $400 = −$100 Using Equation 30.4, the balance on capital account is −$100 = −(capital account balance) Solving this equation for the capital account balance, we find that it is $100. The term in parentheses on the right-hand side of Equation 30.3 is also the balance on capital account. We thus have $100 = $150 − U.S. purchases of rest-of-world assets Solving this for U.S. purchase of rest-of-world assets, we find they are $50. 2. All figures are in trillions of yen per period. The left-hand side of Equation 30.3 is the current account balance Exports − imports = ¥200 − ¥120 = ¥80 Using Equation 30.4, the balance on capital account is ¥80 = −(capital account balance) 15.2.5 https://socialsci.libretexts.org/@go/page/21775 Solving this equation for the capital account balance, we find that it is −¥80. The term in parentheses on the right-hand side of Equation 30.3 is also the balance on capital account. We thus have −¥80 = rest-of-world purchases of Japan’s assets − ¥90 Solving this for the rest-of-world purchases of Japan’s assets, we find they are ¥10. 3. All figures are in billions of pounds per period. The term in parentheses on the right-hand side of Equation 30.3 is the balance on capital account. We thus have £90 − £70 = £20 Using Equation 30.4, the balance on current account is Current account balance = −(£20) The left-hand side of Equation 30.3 is also the current account balance £40 − imports = −£20 Solving for imports, we
find they are £60. Britain’s balance on current account is −£20 billion, its balance on capital account is £20 billion, and its total imports equal £60 billion per period. 4. All figures are in billions of pesos per period. The term in parentheses on the right-hand side of Equation 30.3 is the balance on capital account. We thus have $700 − $500 = $200 Using Equation 30.4, the balance on current account is Current account balance = −($200) The left-hand side of Equation 30.3 is also the current account balance Exports − $550 = −$200 Solving for exports, we find they are $350. This page titled 15.2: International Finance is shared under a CC BY-NC-SA 3.0 license and was authored, remixed, and/or curated by Anonymous. 30.2: International Finance by Anonymous is licensed CC BY-NC-SA 3.0. Original source: https://2012books.lardbucket.org/books/economics-principles-v2.0/. 15.2.6 https://socialsci.libretexts.org/@go/page/21775 15.3: Exchange Rate Systems  Learning Objective 1. Define the various types of exchange rate systems. 2. Discuss some of the pros and cons of different exchange rate systems. Exchange rates are determined by demand and supply. But governments can influence those exchange rates in various ways. The extent and nature of government involvement in currency markets define alternative systems of exchange rates. In this section we will examine some common systems and explore some of their macroeconomic implications. There are three broad categories of exchange rate systems. In one system, exchange rates are set purely by private market forces with no government involvement. Values change constantly as the demand for and supply of currencies fluctuate. In another system, currency values are allowed to change, but governments participate in currency markets in an effort to influence those values. Finally, governments may seek to fix the values of their currencies, either through participation in the market or through regulatory policy. Free-Floating Systems In a free-floating exchange rate system, governments and central banks do not participate in the market for foreign exchange. The relationship between governments and central banks on the one hand and currency markets on the other is much the same as the typical relationship between these institutions and stock markets. Governments may regulate stock markets to prevent
fraud, but stock values themselves are left to float in the market. The U.S. government, for example, does not intervene in the stock market to influence stock prices. The concept of a completely free-floating exchange rate system is a theoretical one. In practice, all governments or central banks intervene in currency markets in an effort to influence exchange rates. Some countries, such as the United States, intervene to only a small degree, so that the notion of a free-floating exchange rate system comes close to what actually exists in the United States. A free-floating system has the advantage of being self-regulating. There is no need for government intervention if the exchange rate is left to the market. Market forces also restrain large swings in demand or supply. Suppose, for example, that a dramatic shift in world preferences led to a sharply increased demand for goods and services produced in Canada. This would increase the demand for Canadian dollars, raise Canada’s exchange rate, and make Canadian goods and services more expensive for foreigners to buy. Some of the impact of the swing in foreign demand would thus be absorbed in a rising exchange rate. In effect, a free-floating exchange rate acts as a buffer to insulate an economy from the impact of international events. The primary difficulty with free-floating exchange rates lies in their unpredictability. Contracts between buyers and sellers in different countries must not only reckon with possible changes in prices and other factors during the lives of those contracts, they must also consider the possibility of exchange rate changes. An agreement by a U.S. distributor to purchase a certain quantity of Canadian lumber each year, for example, will be affected by the possibility that the exchange rate between the Canadian dollar and the U.S. dollar will change while the contract is in effect. Fluctuating exchange rates make international transactions riskier and thus increase the cost of doing business with other countries. Managed Float Systems Governments and central banks often seek to increase or decrease their exchange rates by buying or selling their own currencies. Exchange rates are still free to float, but governments try to influence their values. Government or central bank participation in a floating exchange rate system is called a managed float. Countries that have a floating exchange rate system intervene from time to time in the currency market in an effort to raise or lower the price of their own currency. Typically, the purpose of such intervention is to prevent sudden large swings in the value of a nation’s currency. Such intervention is likely to have only a small impact
, if any, on exchange rates. Roughly $1.5 trillion worth of currencies changes hands every day in the world market; it is difficult for any one agency—even an agency the size of the U.S. government or the Fed—to force significant changes in exchange rates. Still, governments or central banks can sometimes influence their exchange rates. Suppose the price of a country’s currency is rising very rapidly. The country’s government or central bank might seek to hold off further increases in order to prevent a major reduction in net exports. An announcement that a further increase in its exchange rate is unacceptable, followed by sales of that 15.3.1 https://socialsci.libretexts.org/@go/page/21776 country’s currency by the central bank in order to bring its exchange rate down, can sometimes convince other participants in the currency market that the exchange rate will not rise further. That change in expectations could reduce demand for and increase supply of the currency, thus achieving the goal of holding the exchange rate down. Fixed Exchange Rates In a fixed exchange rate system, the exchange rate between two currencies is set by government policy. There are several mechanisms through which fixed exchange rates may be maintained. Whatever the system for maintaining these rates, however, all fixed exchange rate systems share some important features. A Commodity Standard In a commodity standard system, countries fix the value of their respective currencies relative to a certain commodity or group of commodities. With each currency’s value fixed in terms of the commodity, currencies are fixed relative to one another. For centuries, the values of many currencies were fixed relative to gold. Suppose, for example, that the price of gold were fixed at $20 per ounce in the United States. This would mean that the government of the United States was committed to exchanging 1 ounce of gold to anyone who handed over $20. (That was the case in the United States—and $20 was roughly the price—up to 1933.) Now suppose that the exchange rate between the British pound and gold was £5 per ounce of gold. With £5 and $20 both trading for 1 ounce of gold, £1 would exchange for $4. No one would pay more than $4 for £1, because $4 could always be exchanged for 1/5 ounce of gold, and that gold could be exchanged for £1. And no one would sell £1 for less than $4, because the owner of £1 could always exchange it
for 1/5 ounce of gold, which could be exchanged for $4. In practice, actual currency values could vary slightly from the levels implied by their commodity values because of the costs involved in exchanging currencies for gold, but these variations are slight. Under the gold standard, the quantity of money was regulated by the quantity of gold in a country. If, for example, the United States guaranteed to exchange dollars for gold at the rate of $20 per ounce, it could not issue more money than it could back up with the gold it owned. The gold standard was a self-regulating system. Suppose that at the fixed exchange rate implied by the gold standard, the supply of a country’s currency exceeded the demand. That would imply that spending flowing out of the country exceeded spending flowing in. As residents supplied their currency to make foreign purchases, foreigners acquiring that currency could redeem it for gold, since countries guaranteed to exchange gold for their currencies at a fixed rate. Gold would thus flow out of the country running a deficit. Given an obligation to exchange the country’s currency for gold, a reduction in a country’s gold holdings would force it to reduce its money supply. That would reduce aggregate demand in the country, lowering income and the price level. But both of those events would increase net exports in the country, eliminating the deficit in the balance of payments. Balance would be achieved, but at the cost of a recession. A country with a surplus in its balance of payments would experience an inflow of gold. That would boost its money supply and increase aggregate demand. That, in turn, would generate higher prices and higher real GDP. Those events would reduce net exports and correct the surplus in the balance of payments, but again at the cost of changes in the domestic economy. Because of this tendency for imbalances in a country’s balance of payments to be corrected only through changes in the entire economy, nations began abandoning the gold standard in the 1930s. That was the period of the Great Depression, during which world trade virtually was ground to a halt. World War II made the shipment of goods an extremely risky proposition, so trade remained minimal during the war. As the war was coming to an end, representatives of the United States and its allies met in 1944 at Bretton Woods, New Hampshire, to fashion a new mechanism through which international trade could be financed after the war. The system was to be one of fixed exchange rates, but with much less emphasis on gold as a backing for the
system. In recent years, a number of countries have set up currency board arrangements, which are a kind of commodity standard, fixed exchange rate system in which there is explicit legislative commitment to exchange domestic currency for a specified foreign currency at a fixed rate and a currency board to ensure fulfillment of the legal obligations this arrangement entails. In its simplest form, this type of arrangement implies that domestic currency can be issued only when the currency board has an equivalent amount of the foreign currency to which the domestic currency is pegged. With a currency board arrangement, the country’s ability to conduct independent monetary policy is severely limited. It can create reserves only when the currency board has an excess of foreign currency. If the currency board is short of foreign currency, it must cut back on reserves. Argentina established a currency board in 1991 and fixed its currency to the U.S. dollar. For an economy plagued in the 1980s with falling real GDP and rising inflation, the currency board served to restore confidence in the government’s commitment to 15.3.2 https://socialsci.libretexts.org/@go/page/21776 stabilization policies and to a restoration of economic growth. The currency board seemed to work well for Argentina for most of the 1990s, as inflation subsided and growth of real GDP picked up. The drawbacks of a currency board are essentially the same as those associated with the gold standard. Faced with a decrease in consumption, investment, and net exports in 1999, Argentina could not use monetary and fiscal policies to try to shift its aggregate demand curve to the right. It abandoned the system in 2002. Fixed Exchange Rates Through Intervention The Bretton Woods Agreement called for each currency’s value to be fixed relative to other currencies. The mechanism for maintaining these rates, however, was to be intervention by governments and central banks in the currency market. Again suppose that the exchange rate between the dollar and the British pound is fixed at $4 per £1. Suppose further that this rate is an equilibrium rate, as illustrated in Figure 30.8. As long as the fixed rate coincides with the equilibrium rate, the fixed exchange rate operates in the same fashion as a free-floating rate. Figure 30.8 Maintaining a Fixed Exchange Rate Through Intervention Initially, the equilibrium price of the British pound equals $4, the fixed rate between the pound and the dollar. Now suppose an increased supply of British pounds lowers the equilibrium price of the pound to $3. The Bank of England could purchase pounds by selling
dollars in order to shift the demand curve for pounds to D. Alternatively, the Fed could shift the demand curve to D by buying pounds. 2 2 Now suppose that the British choose to purchase more U.S. goods and services. The supply curve for pounds increases, and the equilibrium exchange rate for the pound (in terms of dollars) falls to, say, $3. Under the terms of the Bretton Woods Agreement, Britain and the United States would be required to intervene in the market to bring the exchange rate back to the rate fixed in the agreement, $4. If the adjustment were to be made by the British central bank, the Bank of England, it would have to purchase pounds. It would do so by exchanging dollars it had previously acquired in other transactions for pounds. As it sold dollars, it would take in checks written in pounds. When a central bank sells an asset, the checks that come into the central bank reduce the money supply and bank reserves in that country. We saw in the chapter explaining the money supply, for example, that the sale of bonds by the Fed reduces the U.S. money supply. Similarly, the sale of dollars by the Bank of England would reduce the British money supply. In order to bring its exchange rate back to the agreed-to level, Britain would have to carry out a contractionary monetary policy. Alternatively, the Fed could intervene. It could purchase pounds, writing checks in dollars. But when a central bank purchases assets, it adds reserves to the system and increases the money supply. The United States would thus be forced to carry out an expansionary monetary policy. Domestic disturbances created by efforts to maintain fixed exchange rates brought about the demise of the Bretton Woods system. Japan and West Germany gave up the effort to maintain the fixed values of their currencies in the spring of 1971 and announced they were withdrawing from the Bretton Woods system. President Richard Nixon pulled the United States out of the system in August of that year, and the system collapsed. An attempt to revive fixed exchange rates in 1973 collapsed almost immediately, and the world has operated largely on a managed float ever since. Under the Bretton Woods system, the United States had redeemed dollars held by other governments for gold; President Nixon terminated that policy as he withdrew the United States from the Bretton Woods system. The dollar is no longer backed by gold. 15.3.3 https://socialsci.libretexts.org/@go/page/21776 Fixed exchange rate systems offer the advantage of predictable currency
values—when they are working. But for fixed exchange rates to work, the countries participating in them must maintain domestic economic conditions that will keep equilibrium currency values close to the fixed rates. Sovereign nations must be willing to coordinate their monetary and fiscal policies. Achieving that kind of coordination among independent countries can be a difficult task. The fact that coordination of monetary and fiscal policies is difficult does not mean it is impossible. Eleven members of the European Union not only agreed to fix their exchange rates to one another, they agreed to adopt a common currency, the euro. The new currency was introduced in 1998 and became fully adopted in 1999. Since then, four other nations have joined. The nations that have adopted it have agreed to strict limits on their fiscal policies. Each will continue to have its own central bank, but these national central banks will operate similarly to the regional banks of the Federal Reserve System in the United States. The new European Central Bank will conduct monetary policy throughout the area. Details of this revolutionary venture are provided in the accompanying Case in Point. When exchange rates are fixed but fiscal and monetary policies are not coordinated, equilibrium exchange rates can move away from their fixed levels. Once exchange rates start to diverge, the effort to force currencies up or down through market intervention can be extremely disruptive. And when countries suddenly decide to give that effort up, exchange rates can swing sharply in one direction or another. When that happens, the main virtue of fixed exchange rates, their predictability, is lost. Thailand’s experience with the baht illustrates the potential difficulty with attempts to maintain a fixed exchange rate. Thailand’s central bank had held the exchange rate between the dollar and the baht steady, at a price for the baht of $0.04. Several factors, including weakness in the Japanese economy, reduced the demand for Thai exports and thus reduced the demand for the baht, as shown in Panel (a) of Figure 30.9. Thailand’s central bank, committed to maintaining the price of the baht at $0.04, bought baht to increase the demand, as shown in Panel (b). Central banks buy their own currency using their reserves of foreign currencies. We have seen that when a central bank sells bonds, the money supply falls. When it sells foreign currency, the result is no different. Sales of foreign currency by Thailand’s central bank in order to purchase the baht thus reduced Thailand’s money supply and reduced the bank
’s holdings of foreign currencies. As currency traders began to suspect that the bank might give up its effort to hold the baht’s value, they sold baht, shifting the supply curve to the right, as shown in Panel (c). That forced the central bank to buy even more baht—selling even more foreign currency—until it finally gave up the effort and allowed the baht to become a freefloating currency. By the end of 1997, the baht had lost nearly half its value relative to the dollar. Figure 30.9 The Anatomy of a Currency Collapse Weakness in the Japanese economy, among other factors, led to a reduced demand for the baht (Panel [a]). That put downward pressure on the baht’s value relative to other currencies. Committed to keeping the price of the baht at $0.04, Thailand’s central bank bought baht to increase the demand, as shown in Panel (b). However, as holders of baht and other Thai assets began to fear that the central bank might give up its effort to prop up the baht, they sold baht, shifting the supply curve for baht to the right (Panel [c]) and putting more downward pressure on the baht’s price. Finally, in July of 1997, the central bank gave up its effort to prop up the currency. By the end of the year, the baht’s dollar value had fallen to about $0.02. As we saw in the introduction to this chapter, the plunge in the baht was the first in a chain of currency crises that rocked the world in 1997 and 1998. International trade has the great virtue of increasing the availability of goods and services to the world’s consumers. But financing trade—and the way nations handle that financing—can create difficulties. Key Takeaways In a free-floating exchange rate system, exchange rates are determined by demand and supply. Exchange rates are determined by demand and supply in a managed float system, but governments intervene as buyers or sellers of currencies in an effort to influence exchange rates. In a fixed exchange rate system, exchange rates among currencies are not allowed to change. The gold standard and the Bretton Woods system are examples of fixed exchange rate systems. Try It! Suppose a nation’s central bank is committed to holding the value of its currency, the mon, at $2
per mon. Suppose further that holders of the mon fear that its value is about to fall and begin selling mon to purchase U.S. dollars. What will happen in the market 15.3.4 https://socialsci.libretexts.org/@go/page/21776 for mon? Explain your answer carefully, and illustrate it using a demand and supply graph for the market for mon. What action will the nation’s central bank take? Use your graph to show the result of the central bank’s action. Why might this action fuel concern among holders of the mon about its future prospects? What difficulties will this create for the nation’s central bank?  Case in Point: The Euro Figure 30.10 Dana McMahan – Found euros – CC BY-NC 2.0. It marks the most dramatic development in international finance since the collapse of the Bretton Woods system. A new currency, the euro, began trading among 11 European nations—Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and Spain—in 1999. During a three-year transition, each nation continued to have its own currency, which traded at a fixed rate with the euro. In 2002, the currencies of the participant nations disappeared altogether and were replaced by the euro. In 2007, Slovenia adopted the euro, as did Cyprus and Malta in 2008 and Slovakia in 2009. Several other countries are also hoping to join. Notable exceptions are Britain, Sweden, Switzerland, and Denmark. Still, most of Europe now operates as the ultimate fixed exchange rate regime, a region with a single currency. To participate in this radical experiment, the nations switching to the euro had to agree to give up considerable autonomy in monetary and fiscal policy. While each nation continues to have its own central bank, those central banks operate more like regional banks of the Federal Reserve System in the United States; they have no authority to conduct monetary policy. That authority is vested in a new central bank, the European Central Bank. The participants have also agreed in principle to strict limits on their fiscal policies. Their deficits can be no greater than 3% of nominal GDP, and their total national debt cannot exceed 60% of nominal GDP. Whether sovereign nations will be able—or willing—to operate under economic restrictions as strict as these remains to be seen. Indeed, several of the nations in the eurozone have exceeded the limit on national deficits. A major test of the euro coincided with its 10
th anniversary at about the same time the 2008 world financial crisis occurred. It has been a mixed blessing in getting through this difficult period. For example, guarantees that the Irish government made concerning bank deposits and debt have been better received, because Ireland is part of the euro system. On the other hand, if Ireland had a floating currency, its depreciation might enhance Irish exports, which would help Ireland to get out of its recession. The 2008 crisis also revealed insights into the value of the euro as an international currency. The dollar accounts for about twothirds of global currency reserves, while the euro accounts for about 25%. Most of world trade is still conducted in dollars, and even within the eurozone about a third of trade is conducted in dollars. One reason that the euro has not gained more on the dollar in terms of world usage during its first 10 years is that, whereas the U.S. government is the single issuer of its public debt, each of the 16 separate European governments in the eurozone issues its own debt. The smaller market for each country’s debt, each with different risk premiums, makes them less liquid, especially in difficult financial times. When the euro was launched it was hoped that having a single currency would nudge the countries toward greater market flexibility and higher productivity. However, income per capita is about at the same level in the eurozone as it was 10 years ago in comparison to that of the United States—about 70%. 15.3.5 https://socialsci.libretexts.org/@go/page/21776 Source: “Demonstrably Durable: The Euro at Ten,” Economist, January 3, 2009, p. 50–52. Answer to Try It! Problem 2 The value of the mon is initially $2. Fear that the mon might fall will lead to an increase in its supply to S, putting downward pressure on the currency. To maintain the value of the mon at $2, the central bank will buy mon, thus shifting the demand curve to D. This policy, though, creates two difficulties. First, it requires that the bank sell other currencies, and a sale of any asset by a central bank is a contractionary monetary policy. Second, the sale depletes the bank’s holdings of foreign currencies. If holders of the mon fear the central bank will give up its effort, then they might sell mon, shifting the supply curve farther to the right and forcing even more vigorous action by the central bank. 2 Figure 30.11
This page titled 15.3: Exchange Rate Systems is shared under a CC BY-NC-SA 3.0 license and was authored, remixed, and/or curated by Anonymous. 30.3: Exchange Rate Systems by Anonymous is licensed CC BY-NC-SA 3.0. Original source: https://2012books.lardbucket.org/books/economics-principles-v2.0/. 15.3.6 https://socialsci.libretexts.org/@go/page/21776 15.4: Review and Practice Summary In this chapter we examined the role of net exports in the economy. We found that export and import demand are influenced by many different factors, the most important being domestic and foreign income levels, changes in relative prices, the exchange rate, and preferences and technology. An increase in net exports shifts the aggregate demand curve to the right; a reduction shifts it to the left. In the foreign exchange market, the equilibrium exchange rate is determined by the intersection of the demand and supply curves for a currency. Given the ease with which most currencies can be traded, we can assume this equilibrium is achieved, so that the quantity of a currency demanded equals the quantity supplied. An economy can experience current account surpluses or deficits. The balance on current account equals the negative of the balance on capital account. We saw that one reason for the current account deficit in the United States is the U.S. capital account surplus; the United States has attracted a great deal of foreign financial investment. The chapter closed with an examination of floating and fixed exchange rate systems. Fixed exchange rate systems include commodity-based systems and fixed rates that are maintained through intervention. Exchange rate systems have moved from a gold standard, to a system of fixed rates with intervention, to a mixed set of arrangements of floating and fixed exchange rates. Concept Problems 1. David Ricardo, a famous English economist of the 19th century, stressed that a nation has a comparative advantage in those products for which its efficiency relative to other nations is the highest. He argued in favor of specialization and trade based on comparative, not absolute, advantage. From a global perspective, what would be the “advantage” of such a system? 2. For several months prior to your vacation trip to Naples, Italy, you note that the exchange rate for the dollar has been increasing relative to the euro (that is, it takes more euro to buy a dollar). Are you pleased or sad? Explain. 3.
Who might respond in a way different from your own to the falling value of the euro in Question 2? 4. Suppose a nation has a deficit on capital account. What does this mean? What can you conclude about its balance on current account? 5. Suppose a nation has a surplus on capital account. What does this mean? What can you conclude about its balance on current account? 6. The following analysis appeared in a newspaper editorial: “If foreigners own our businesses and land, that’s one thing, but when they own billions in U.S. bonds, that’s another. We don’t care who owns the businesses, but our grandchildren will have to put up with a lower standard of living because of the interest payments sent overseas. Therefore, we must reduce our trade deficit.” Critically analyze this editorial view. Are the basic premises correct? The conclusion? 7. In the years prior to the abandonment of the gold standard, foreigners cashed in their dollars and the U.S. Treasury “lost gold” at unprecedented rates. Today, the dollar is no longer tied to gold and is free to float. What are the fundamental differences between a currency based on the gold standard and one that is allowed to float? What would the U.S. “lose” if foreigners decided to “cash in” their dollars today? 8. Can there be a deficit on current account and a deficit on capital account at the same time? Explain. 9. Suppose the people of a certain economy increase their spending on foreign-produced goods and services. What will be the effect on real GDP and the price level in the short run? In the long run? 10. Now suppose the people of a certain economy reduce their spending on foreign-produced goods and services. What will be the effect on real GDP and the price level in the short run? In the long run? 11. Canada, Mexico, and the United States have a free trade zone. What would be some of the advantages of having a common currency as well? The disadvantages? Do you think it would be a good idea? Why or why not? 12. The text says that the U.S. capital account surplus necessarily implies a current account deficit. Suppose that the United States were to undertake measures to eliminate its capital account surplus. What sorts of measures might it take? Do you think such measures would be a good idea? Why or why not? 15.4.1 https://socials
ci.libretexts.org/@go/page/21777 Numerical Problems 1. For each of the following scenarios, determine whether the aggregate demand curve will shift. If so, in which direction will it shift and by how much? 1. A change in consumer preferences leads to an initial $25-billion decrease in net exports. The multiplier is 1.5. 2. A change in trade policies leads to an initial $25-billion increase in net exports. The multiplier is 1. 3. There is an increase in the domestic price level from 1 to 1.05, while the price level of the country’s major trading partner does not change. The multiplier is 2. 4. Recession in a country’s trading partner lowers exports by $20 billion. The multiplier is 2. 2. Fill in the missing items in the table below. All figures are in U.S. billions of dollars. U.S. exports U.S. imports Domestic purchases of foreign assets Rest-of-world purchases of U.S. assets a. b. c. d. 100 100 300 100 200 800 400 400 800 200 600 1,100 3. Suppose the market for a country’s currency is in equilibrium and that its exports equal $700 billion, its purchases of rest-ofworld assets equal $1,000 billion, and foreign purchases of its assets equal $1,200 billion. Assuming it has no international transfer payments and that output is measured as GNP: 1. What are the country’s imports? 2. What is the country’s balance on current account? 3. What is the country’s balance on capital account? 4. Suppose that the market for a country’s currency is in equilibrium and that its exports equal $400, its imports equal $500 billion, and rest-of-world purchases of the country’s assets equal $100. Assuming it has no international transfer payments and that output is measured as GNP: 1. What is the country’s balance on current account? 2. What is the country’s balance on capital account? 3. What is the value of the country’s purchases of rest-of-world assets? 5. The information below describes the trade-weighted exchange rate for the dollar (standardized at a value of 100) and net exports (in billions of dollars) for an eight-month period. Month January February March April May June July August
Trade-weighted exchange rate Net exports 100.5 99.9 100.5 100.3 99.6 100.9 101.4 101.8 −9.8 −11.6 −13.5 −14.0 −15.6 −14.2 −14.9 −16.7 1. Plot the data on a graph. 2. Do the data support the expected relationship between the trade-weighted exchange rate and net exports? Explain. 6. The graph below shows the foreign exchange market between the United States and Japan before and after an increase in the demand for Japanese goods by U.S. consumers. 15.4.2 https://socialsci.libretexts.org/@go/page/21777 1. If the exchange rate was free-floating prior to the change in demand for Japanese goods, what was its likely value? 2. After the change in demand, the free-floating exchange rate would be how many yen per dollar? 3. If the Japanese central bank wanted to keep the exchange rate fixed at its initial value, how many dollars would it have to buy? Figure 30.12 7. Suppose Japan relaxes its restrictions on imports of foreign goods and services and begins importing more from the United States. Illustrate graphically how this will affect the U.S. exchange rate, price level, and level of real GDP in the short run and in the long run. How will it affect these same variables in Japan? (Assume both economies are initially operating at their potential levels of output.) 8. Suppose U.S. investors begin purchasing assets in Mexico. Illustrate graphically how this will affect the U.S. exchange rate, price level, and level of real GDP in the short run and in the long run. How will it affect these same variables in Mexico? (Assume both economies are initially operating at their potential levels of output.) 9. Suppose foreigners begin buying more assets in the United States. Illustrate graphically how this will affect the U.S. exchange rate, price level, and level of real GDP in the short run and in the long run. (Assume the economy is initially operating at its potential output.) This page titled 15.4: Review and Practice is shared under a CC BY-NC-SA 3.0 license and was authored, remixed, and/or curated by Anonymous. 30.4: Review and Practice by Anonymous is licensed CC BY-NC-SA 3.0
. Original source: https://2012books.lardbucket.org/books/economics-principles-v2.0/. 15.4.3 https://socialsci.libretexts.org/@go/page/21777 CHAPTER OVERVIEW 16: Inflation and Unemployment 16.1: Relating Inflation and Unemployment 16.2: Explaining Inflation–Unemployment Relationships 16.3: Inflation and Unemployment in the Long Run 16.4: Review and Practice Thumbnail: https://unsplash.com/photos/untSDM2Hihg This page titled 16: Inflation and Unemployment is shared under a CC BY-NC-SA 3.0 license and was authored, remixed, and/or curated by Anonymous. 1 16.1: Relating Inflation and Unemployment  Learning Objective 1. Draw a Phillips curve and describe the relationship between inflation and unemployment that it expresses. 2. Describe the other relationships or phases that have been observed between inflation and unemployment. It has often been the case that progress against inflation comes at the expense of greater unemployment, and that reduced unemployment comes at the expense of greater inflation. This section looks at the record and traces the emergence of the view that a simple trade-off between these macroeconomic “bad guys” exists. Clearly, it is desirable to reduce unemployment and inflation. Unemployment represents a lost opportunity for workers to engage in productive effort—and to earn income. Inflation erodes the value of money people hold, and more importantly, the threat of inflation adds to uncertainty and makes people less willing to save and firms less willing to invest. If there were a trade-off between the two, we could reduce the rate of inflation or the rate of unemployment, but not both. The fact that the United States did make progress against unemployment and inflation through most of the 1990s and early 2000s represented a macroeconomic triumph, one that appeared impossible just a few years earlier. The next section examines the argument that once dominated macroeconomic thought—that a simple trade-off between inflation and unemployment did, indeed, exist. The argument continues to appear in discussions of macroeconomic policy today; it will be useful to examine it. The Phillips Curve In 1958, New Zealand-born economist Almarin Phillips reported that his analysis of a century of British wage and unemployment data suggested that an inverse relationship existed between rates of increase in wages and British unemployment (Phillips, 1958). Economists were
quick to incorporate this idea into their thinking, extending the relationship to the rate of price-level changes— inflation—and unemployment. The notion that there is a trade-off between the two is expressed by a Phillips curve, a curve that suggests a negative relationship between inflation and unemployment. Figure 31.1 shows a Phillips curve. Figure 31.1 The Phillips Curve The relationship between inflation and unemployment suggested by the work of Almarin Phillips is shown by a Phillips curve. The Phillips curve seemed to make good theoretical sense. The dominant school of economic thought in the 1960s suggested that the economy was likely to experience either a recessionary or an inflationary gap. An economy with a recessionary gap would have high unemployment and little or no inflation. An economy with an inflationary gap would have very little unemployment and a higher rate of inflation. The Phillips curve suggested a smooth transition between the two. As expansionary policies were undertaken to move the economy out of a recessionary gap, unemployment would fall and inflation would rise. Policies to correct an inflationary gap would bring down the inflation rate, but at a cost of higher unemployment. The experience of the 1960s suggested that precisely the kind of trade-off the Phillips curve implied did, in fact, exist in the United States. Figure 31.2 shows annual rates of inflation (computed using the implicit price deflator) plotted against annual rates of unemployment from 1961 to 1969. The points appear to follow a path quite similar to a Phillips curve relationship. The civilian unemployment rate fell from 6.7% in 1961 to 3.5% in 1969. The inflation rate rose from 1.1% in 1961 to 4.8% in 1969. While inflation dipped slightly in 1963, it appeared that, for the decade as a whole, a reduction in unemployment had been “traded” for an increase in inflation. 16.1.1 https://socialsci.libretexts.org/@go/page/21779 Figure 31.2 The Phillips Curve in the 1960s Values of U.S. inflation and unemployment rates during the 1960s generally conformed to the trade-off implied by the Phillips curve. The points for each year lie close to a curve with the shape that Phillips’s analysis predicted. Source: Economic Report of the President, 2009, Tables B-3 and B-42. In the mid-1960s, the economy moved into an inflationary gap as unemployment fell below its natural level. The economy had already reached its full
employment level of output when the 1964 tax cut was passed. The Fed undertook a more expansionary monetary policy at the same time. The combined effect of the two policies increased aggregate demand and pushed the economy beyond full employment and into an inflationary gap. Aggregate demand continued to rise as U.S. spending for the war in Vietnam expanded and as President Lyndon Johnson launched an ambitious program aimed at putting an end to poverty in the United States. By the end of the decade, unemployment at 3.5% was substantially below its natural level, estimated by the Congressional Budget Office to be 5.6% that year. When Richard Nixon became president in 1969, it was widely believed that, with an economy operating with an inflationary gap, it was time to move back down the Phillips curve, trading a reduction in inflation for an increase in unemployment. President Nixon moved to do precisely that, serving up a contractionary fiscal policy by ordering cuts in federal government purchases. The Fed pursued a contractionary monetary policy aimed at bringing inflation down. The Phillips Curve Goes Awry The effort to nudge the economy back down the Phillips curve to an unemployment rate closer to the natural level and a lower rate of inflation met with an unhappy surprise in 1970. Unemployment increased as expected. But inflation rose! The inflation rate rose to 5.3% from its 1969 rate of 4.8%. The tidy relationship between inflation and unemployment that had been suggested by the experience of the 1960s fell apart in the 1970s. Unemployment rose substantially, but inflation remained the same in 1971. In 1972, both rates fell. The economy seemed to fall back into the pattern described by the Phillips curve in 1973, as inflation rose while unemployment fell. But the next two years saw increases in both rates. The Phillips curve relationship between inflation and unemployment that had seemed to hold true in the 1960s no longer prevailed. Indeed, a look at annual rates of inflation and unemployment since 1961 suggests that the 1960s were quite atypical. Figure 31.3 shows the two variables over the period from 1961 through 2009. It is hard to see a Phillips curve lurking within that seemingly random scatter of points. 16.1.2 https://socialsci.libretexts.org/@go/page/21779 Figure 31.3 Inflation and Unemployment, 1961–2009 Annual observations of inflation and unemployment in the United States from 1961 to 2009 do not seem consistent with a Phillips curve. Sources: Economic Report of the President, 2010, Tables B-3 and B-42
. Cycles of Inflation and Unemployment Although the points plotted in Figure 31.3 are not consistent with a Phillips curve, we can find a relationship. Suppose we draw connecting lines through the sequence of observations, as is done in Figure 31.4. This approach suggests a pattern of clockwise loops, at least until 2002 when we see the beginnings of a counterclockwise loop. We see periods in which inflation rises as unemployment falls, followed by periods in which unemployment rises while inflation remains high or fairly constant. And those periods are followed by periods in which inflation and unemployment both fall. Figure 31.4 Inflation and Unemployment: Loops Connecting observed values for unemployment and inflation sequentially suggests a cyclical pattern of clockwise loops over the 1961–2002 period, after which we see a counterclockwise loop. Sources: Economic Report of the President, 2010, Tables B-3 and B-42. Figure 31.5 gives an idealized version of the general cycle suggested by the data in Figure 31.4. There is a Phillips phase in which inflation rises as unemployment falls. In this phase, the relationship suggested by the Phillips curve holds. The Phillips phase is followed by a stagflation phase in which inflation remains high while unemployment increases. The term, coined by Massachusetts Institute of Technology economist and Nobel laureate Paul Samuelson during the 1970s, suggests a combination of a stagnating economy and continued inflation. And finally, there is a recovery phase in which inflation and unemployment both decline. This pattern of a Phillips phase, then stagflation, and then a recovery can be termed the inflation—unemployment cycle. 16.1.3 https://socialsci.libretexts.org/@go/page/21779 Figure 31.5 Phases of the inflation—unemployment cycle The figure shows the way an economy may move from a Phillips phase to a stagflation phase and then to a recovery phase. Trace the path of the inflation—unemployment cycle as it unfolds in Figure 31.4. Starting with the Phillips phase in the 1960s, we see that the economy went through three inflation—unemployment cycles through the 1970s. Each took the United States to successively higher rates of inflation and unemployment. As the cycle that began in the late 1970s passed through the stagflation phase, however, something quite significant happened. The economy suffered its highest rate of unemployment since the Great Depression during that period. It also achieved its most dramatic gains against inflation. The recovery phase of the 1990s was the
longest since the U.S. government began tracking inflation and unemployment. Good luck explains some of that: oil prices fell in the late 1990s, shifting the short-run aggregate supply curve to the right. That boosted real GDP and put downward pressure on the price level. But one cause of that improved performance seemed to be the better understanding economists gained from some policy mistakes of the 1970s. In the early 2000s, following the brief recession in 2001, the inflation–unemployment trajectory moves in a counterclockwise direction, as the economy moved back quickly into the Phillips phase of falling unemployment and rising inflation but at higher levels of both compared to what prevailed in the late 1990s. During this recent period, oil and other commodity prices were rising, due primarily to rising demand in developing countries, principally China and India. Thus, the short-run aggregate supply curve was moving to the left while aggregate demand was shifting to the right. During the recession of 2007 to 2009, the unemployment rate spiked while inflation fell. The primary reason was that the aggregate demand curve was shifting to the left. The next section will explain these experiences in a stylized way in terms of the aggregate demand and supply model. Key Takeaways The view that there is a trade-off between inflation and unemployment is expressed by a Phillips curve. While there are periods in which a trade-off between inflation and unemployment exists, the actual relationship between these variables between 1961 and 2002 followed a cyclical pattern: the inflation—unemployment cycle. In a Phillips phase, the inflation rate rises and unemployment falls. A stagflation phase is marked by rising unemployment while inflation remains high. In a recovery phase, inflation and unemployment both fall. Try It! Suppose an economy has experienced the rates of inflation and of unemployment shown below. Plot these data graphically in a grid with the inflation rate on the vertical axis and the unemployment rate on the horizontal axis. Identify the periods during which the economy experienced each of the three phases of the inflation—unemployment cycle identified in the text. Period Unemployment rate (%) Inflation rate (%) 1 2 2.5 2.6 6.3 5.9 16.1.4 https://socialsci.libretexts.org/@go/page/21779 Period Unemployment rate (%) Inflation rate (%) 3 4 5 6 7 8 2.8 4.7 4.9 5.0 4.5 4.0 4.8 4.1 5.0 6.1 5.7 5.1  Case
in Point: Some Reflections on the 1970s Figure 31.6 Rupert Colley – Richard Nixon – CC BY 2.0. Looking back, we may find it difficult to appreciate how stunning the experience of 1970 and 1971 was. But those two years changed the face of macroeconomic thought. Introductory textbooks of that time contained no mention of aggregate supply. The model of choice was the aggregate expenditures model. Students learned that the economy could be in equilibrium below full employment, in which case unemployment would be the primary macroeconomic problem. Alternatively, equilibrium could occur at an income greater than the full employment level, in which case inflation would be the main culprit to worry about. These ideas could be summarized using a Phillips curve, a new analytical device. It suggested that economists could lay out for policy makers a menu of possibilities. Policy makers could then choose the mix of inflation and unemployment they were willing to accept. Economists would then show them how to attain that mix with the appropriate fiscal and monetary policies. Then 1970 and 1971 came crashing in on this well-ordered fantasy. President Richard Nixon had come to office with a pledge to bring down inflation. The consumer price index had risen 4.7% during 1968, the highest rate since 1951. Mr. Nixon cut government purchases in 1969, and the Fed produced a sharp slowing in money growth. The president’s economic advisers predicted at the beginning of 1970 that inflation and unemployment would both fall. Appraising the 1970 debacle early in 1971, the president’s economists said that the experience had not been consistent with what standard models would predict. The economists suggested, however, that this was probably due to a number of transitory factors. Their forecast that inflation and unemployment 16.1.5 https://socialsci.libretexts.org/@go/page/21779 would improve in 1971 proved wide of the mark—the unemployment rate rose from 4.9% to 5.9% (an increase of 20%), while the rate of inflation measured by the change in the implicit price deflator barely changed from 5.3% to 5.2%. As we will see, the experience can be readily explained using the model of aggregate demand and aggregate supply. But this tool was not well developed then. The experience of the 1970s forced economists back to their analytical drawing boards and spawned dramatic advances in our understanding of macroeconomic events. We will explore many of those advances in the next chapter. Source: Economic Report of the President, 1971, pp. 60–84.
Answer to Try It! Problem Figure 31.7 References Phillips, A. W., “The Relation between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861–1957,” Economica 25 (November 1958): 283–99. This page titled 16.1: Relating Inflation and Unemployment is shared under a CC BY-NC-SA 3.0 license and was authored, remixed, and/or curated by Anonymous. 31.1: Relating Inflation and Unemployment by Anonymous is licensed CC BY-NC-SA 3.0. Original source: https://2012books.lardbucket.org/books/economics-principles-v2.0/. 16.1.6 https://socialsci.libretexts.org/@go/page/21779 16.2: Explaining Inflation–Unemployment Relationships  Learning Objective 1. Use the model of aggregate demand and aggregate supply to explain a Phillips phase, a stagflation phase, and a recovery phase. We have examined the cyclical pattern of inflation and unemployment suggested by the experience of the past four decades. Our task now is to explain it. We will apply the model of aggregate demand and aggregate supply, along with our knowledge of monetary and fiscal policy, to explain just why the economy performed as it did. We will find that the relationship between inflation and unemployment depends crucially on macroeconomic policy and on expectations. The next three sections illustrate the unfolding of the inflation—unemployment cycle. Each phase of the cycle results from a specific pattern of shifts in the aggregate demand and short-run aggregate supply curves. It is important to be careful in thinking about the meaning of changes in inflation as we examine the cycle of inflation and unemployment. The rise in inflation during the Phillips phase does not simply mean that the price level rises. It means that the price level rises by larger and larger percentages. Rising inflation means that the price level is rising at an increasing rate. In the recovery phase, a falling rate of inflation does not imply a falling price level. It means the price level is rising, but by smaller and smaller percentages. Falling inflation means that the price level is rising more slowly, not that the price level is falling. The Phillips Phase: Increasing Aggregate Demand As we saw in the last section, the Phillips phase of the inflation—unemployment cycle conforms to the concept of a Phillips curve. It is a period in which inflation tends to rise
and unemployment tends to fall. Figure 31.8 shows how a Phillips phase can unfold. Panel (a) shows the model of aggregate demand and aggregate supply; Panel (b) shows the corresponding path of inflation and unemployment. Figure 31.8 The Phillips Phase The Phillips phase is marked by increases in aggregate demand pushing real GDP and the price level up along the short-run aggregate supply curve SRAS. The result is rising inflation and falling unemployment. The points 1,2,3 labeled in Panels (a) and (b) correspond to one another; point 1 in Panel (a) corresponds to point 1 in Panel (b), and so on. We shall assume in Figure 31.8 and in the next two figures that the following relationship between real GDP and the unemployment rate holds. In our example, the level of potential output will be $1,000 billion, while the natural rate of unemployment is 5.0%. The numbers given in the table correspond to the numbers used in Figure 31.8 through Figure 31.10. Notice that the higher the level of real GDP, the lower the unemployment rate. That is because the production of more goods and services requires more employment. For a given labor force, a higher level of employment implies a lower rate of unemployment. Real GDP (billions) Rate of unemployment (%) $880 910 940 970 9.0 8.0 7.0 6.0 16.2.1 https://socialsci.libretexts.org/@go/page/21780 Real GDP (billions) Rate of unemployment (%) 1,000 1,030 1,060 1,090 5.0 4.0 3.0 2.0 Suppose that in Period 1 the price level is 1.01 and real GDP equals $880 billion. The economy is operating below its potential level. The unemployment rate is 9.0%; we shall assume the price level in Period 1 has risen by 0.8% from the previous period. Point 1 in Panel (b) thus shows an initial rate of inflation of 0.8% and an unemployment rate of 9.0%. Now suppose policy makers respond to the recessionary gap of the first period with an expansionary monetary or fiscal policy. Aggregate demand in Period 2 shifts to AD. In Panel (a), we see that the price level rises to 1.02 and real GDP rises to $940 billion. Unemployment falls to 7.0%. The price increase from 1.01 to 1.02 gives us an
inflation rate of about 1.0%. Panel (b) shows the new combination of inflation and unemployment rates for Period 2. 2 Impact lags mean that expansionary policies, even those undertaken in response to the recessionary gap in Periods 1 and 2, continue to expand aggregate demand in Period 3. In the case shown, aggregate demand rises to AD, pushing the economy well past its level of potential output into an inflationary gap. Real GDP rises to $1,090 billion, and the price level rises to 1.045 in Panel (a) of Figure 31.8. The increase in real GDP lowers the unemployment rate to 2.0%, and the inflation rate rises to 2.5% at point 3 in Panel (b). Unemployment has fallen at a cost of rising inflation. 3 1,2,3 The shifts from point 1 to point 2 to point 3 in Panel (b) are characteristic of the Phillips phase. It is crucial to note how these changes occurred. Inflation rose and unemployment fell, because increasing aggregate demand moved along the original short-run aggregate supply curve SRAS. We saw in the chapter that introduced the model of aggregate demand and aggregate supply that a short-run aggregate supply curve is drawn for a given level of the nominal wage and for a given set of expected prices. The Phillips phase, however, drives prices above what workers and firms expected when they agreed to a given set of nominal wages; real wages are thus driven below their expected level during this phase. Firms that have sticky prices are in the same situation. Firms set their prices based on some expected price level. As rising inflation drives the price level beyond their expectations, their prices will be too low relative to the rest of the economy. Because some firms and workers are committed to their present set of prices and wages for some period of time, they will be stuck with the wrong prices and wages for a while. During that time, their lower-than-expected relative prices will mean greater sales and greater production. The combination of increased production and lower real wages means greater employment and, thus, lower unemployment. Ultimately, we should expect that workers and firms will begin adjusting nominal wages and other sticky prices to reflect the new, higher level of prices that emerges during the Phillips phase. It is this adjustment that can set the stage for a stagflation phase. Changes in Expectations and the Stagflation Phase As workers and firms become aware that the general price level is rising, they will incorporate this fact into their expectations of future prices.
In reaching new agreements on wages, they are likely to settle on higher nominal wages. Firms with sticky prices will adjust their prices upward as they anticipate higher prices throughout the economy. As we saw in the chapter introducing the model of aggregate demand and aggregate supply, increases in nominal wages and in prices that were sticky will shift the short-run aggregate supply curve to the left. Such a shift is illustrated in Panel (a) of Figure 31.9, where SRAS shifts to SRAS. The result is a shift to point 4; the price level rises to 1.075, and real GDP falls to $970 billion. The increase in the price level to 1.075 from 1.045 implies an inflation rate of 2.9% ([1.075 − 1.045] / 1.045 = 2.9%); unemployment rises to 6.0% with the decrease in real GDP. The new combination of inflation and unemployment is given by point 4 in Panel (b). 1,2,3 4 16.2.2 https://socialsci.libretexts.org/@go/page/21780 Figure 31.9 The Stagflation Phase In the stagflation phase, workers and firms adjust their expectations in a higher price level. As they act on their expectations, the short-run aggregate supply curve shifts leftward in Panel (a). The price level rises to 1.075, and real GDP falls to $970 billion. The inflation rate rises to 2.9% as unemployment rises to 6.0% at point 4 in Panel (b). The essential feature of the stagflation phase is a change in expectations. Workers and firms that were blindsided by rising prices during the Phillips phase ended up with lower real wages and lower relative price levels than they intended. In the stagflation phase, they catch up. But the catching up shifts the short-run aggregate supply curve to the left, producing a reduction in real GDP and an increase in the price level. The Recovery Phase The stagflation phase shown in Figure 31.9 leaves the economy with a recessionary gap at point 4 in Panel (a). The economy is bumped into a recession by changing expectations. Policy makers can be expected to respond to the recessionary gap by boosting aggregate demand. That increase in aggregate demand will lead the economy into the recovery phase of the inflation— unemployment cycle. Figure 31.10 illustrates a recovery phase. In Panel (a), aggregate demand increases to AD, boosting the price level to 1.09 and
real GDP to $1,060. The new price level represents a 1.4% ([1.09 − 1.075] / 1.075 = 1.4%) increase over the previous price level. The price level is higher, but the inflation rate has fallen sharply. Meanwhile, the increase in real GDP cuts the unemployment rate to 3.0%, shown by point 5 in Panel (b). 5 Figure 31.10 The Recovery Phase Policy makers act to increase aggregate demand in order to move the economy out of the recessionary gap created during the stagflation phase. Here, aggregate demand shifts to AD, boosting the price level to 1.09 and real GDP to $1,060 billion at point 5 in Panel (a). The increase in real GDP reduces unemployment. The price level has risen, but at a slower rate than in the previous period. The result is a reduction in inflation. The new combination of unemployment and inflation is shown by point 5 in Panel (b). 4 Policies that stimulate aggregate demand and changes in expected price levels are not the only forces that affect the values of inflation and unemployment. Changes in production costs shift the short-run aggregate supply curve. Depending on when these changes occur, they can reinforce or reduce the swings in inflation and unemployment that mark the inflation—unemployment cycle. For example, Figure 31.4 shows that inflation was exceedingly low in the late 1990s. During this period, oil prices were very low—only $12.50 per barrel in 1998, for example. In terms of Figure 31.9, we can represent the low oil prices by a short-run aggregate supply curve that is to the right of SRAS. That would mean that output would be somewhat higher, unemployment somewhat lower, and inflation somewhat lower than what is shown as point 5 in Panels (a) and (b) of Figure 31.10. 4,5 Comparing the late 1990s to the early 2000s, Figure 31.4 shows that both periods exhibit Phillips phases, but that the early 2000s has both higher inflation and higher unemployment. One way to explain these back-to-back Phillips phases is to look at Figure 16.2.3 https://socialsci.libretexts.org/@go/page/21780 31.8. Assume point 1 represents the economy in 2001, with aggregate demand increasing. At the same time, though, oil and other commodity prices were rising markedly—tripling between 2001 and 2007. Thus, the short-run
aggregate supply curve was also. This would mean that output would be somewhat lower, unemployment somewhat higher, and shifting to the left of SRAS inflation somewhat higher than what is shown as points 2 and 3 in Panels (a) and (b) of Figure 31.8. The 2000s Phillips curve would thus be above the late 1990s Phillips curve. While the Phillips phase of the early 2000s is farther from the origin than that of the late 1990s, it is noteworthy that the economy did not go through a severe stagflation phase, suggesting some learning about how to conduct monetary and fiscal policy. It will be interesting to see how the U.S. economy emerges from the 2007-2009 recession. Will the expansionary monetary and fiscal policies generate inflation or will inflation remain low as the unemployment rate drops? 1,2,3 So, while the economy does not move neatly through the phases outlined in the inflation—unemployment cycle, we can conclude that efforts to stimulate aggregate demand, together with changes in expectations, have played an important role in generating the inflation–unemployment patterns we observe in the past half-century. Lags have played a crucial role in the cycle as well. If policy makers respond to a recessionary gap with an expansionary fiscal or monetary policy, then we know that aggregate demand will increase, but with a lag. Policy makers could thus undertake an expansionary policy and see little or no response at first. They might respond by making further expansionary efforts. When the first efforts finally shift aggregate demand, subsequent expansionary efforts can shift it too far, pushing real GDP beyond potential and creating an inflationary gap. These increases in aggregate demand create a Phillips phase. The economy’s correction of the gap creates a stagflation phase. If policy makers respond to the stagflation phase with a new round of expansionary policies, the initial result will be a recovery phase. Sufficiently large increases in aggregate demand can then push the economy into another Phillips phase, and the cycle continues. Key Takeaways In a Phillips phase, aggregate demand rises and boosts real GDP, lowering the unemployment rate. The price level rises by larger and larger percentages. Inflation thus rises while unemployment falls. A stagflation phase is marked by a leftward shift in short-run aggregate supply as wages and sticky prices are adjusted upwards. Unemployment rises while inflation remains high. In a recovery phase, policy makers boost aggregate demand. The price level rises, but at a slower rate than in the stagflation phase, so inflation falls.
Unemployment falls as well. Try It! Using the model of aggregate demand and aggregate supply; sketch the changes in the curve(s) that produced each of the phases you identified in Try It! 16-1. Do not worry about specific numbers; just show the direction of changes in aggregate demand and/or short-run aggregate supply in each phase.  Case in Point: From the Challenging 1970s to the Calm 1990s Figure 31.11 16.2.4 https://socialsci.libretexts.org/@go/page/21780 Third Way Think Tank – Paul Volcker, former Federal Reserve Chairman – CC BY-NC-ND 2.0. The path of U.S. inflation and unemployment followed a fairly consistent pattern of clockwise loops from 1961 to 2002, but the nature of these loops changed with changes in policy. If we follow the cycle shown in Figure 31.4, we see that the three Phillips phases that began in 1961, 1972, and 1976 started at successively higher rates of inflation. Fiscal and monetary policy became expansionary at the beginnings of each of these phases, despite rising rates of inflation. As inflation soared into the double-digit range in 1979, President Jimmy Carter appointed a new Fed chairman, Paul Volcker. The president gave the new chairman a clear mandate: bring inflation under control, regardless of the cost. The Fed responded with a sharply contractionary monetary policy and stuck with it even as the economy experienced its worse recession since the Great Depression. Falling oil prices after 1982 contributed to an unusually long recovery phase: Inflation and unemployment both fell from 1982 to 1986. The inflation rate at which the economy started its next Phillips phase was the lowest since the Phillips phase of the 1960s. The Fed’s policies since then have clearly shown a reduced tolerance for inflation. The Fed shifted to a contractionary monetary policy in 1988, so that inflation during the 1986–1989 Phillips phase never exceeded 4%. When oil prices rose at the outset of the Persian Gulf War in 1990, the resultant swings in inflation and unemployment were much less pronounced than they had been in the 1970s. The Fed continued its effort to restrain inflation in 1994 and 1995. It shifted to a contractionary policy early in 1994 when the economy was still in a recessionary gap left over from the 1990–1991 recession. The Fed’s announced intention was to prevent any future increase in inflation. In effect, the Fed was taking explicit account of the lag in monetary policy. Had
it continued an expansionary monetary policy, it might well have put the economy in another Phillips phase. Instead, the Fed has conducted a carefully orchestrated series of slight shifts in policy that succeeded in keeping the economy in the longest recovery phase since World War II. To be sure, the stellar economic performance of the United States in the late 1990s was due in part to falling oil prices, which shifted the short-run aggregate supply curve to the right and helped push inflation and unemployment down. But it seems clear that a good deal of the credit can be claimed by the Fed, which paid closer attention to the lags inherent in macroeconomic policy. Ignoring those lags helped create the inflation—unemployment cycles that emerged with activist stabilization policies in the 1960s. Answer to Try It! Problem Figure 31.12 16.2.5 https://socialsci.libretexts.org/@go/page/21780 This page titled 16.2: Explaining Inflation–Unemployment Relationships is shared under a CC BY-NC-SA 3.0 license and was authored, remixed, and/or curated by Anonymous. 31.2: Explaining Inflation–Unemployment Relationships by Anonymous is licensed CC BY-NC-SA 3.0. Original source: https://2012books.lardbucket.org/books/economics-principles-v2.0/. 16.2.6 https://socialsci.libretexts.org/@go/page/21780 16.3: Inflation and Unemployment in the Long Run  Learning Objective 1. Use the equation of exchange to explain what determines the inflation rate in the long run. 2. Explain why in the long run the Phillips curve is vertical. 3. Describe frictional and structural unemployment and the factors that may affect these two types of unemployment. 4. Describe efficiency wage theory and its predictions concerning cyclical unemployment. In the last section, we saw how stabilization policy, together with changes in expectations, can produce the cycles of inflation and unemployment that characterized the past several decades. These cycles, though, are short-run phenomena. They involve swings in economic activity around the economy’s potential output. This section examines forces that affect the values of inflation and the unemployment rate in the long run. We shall see that the rates of money growth and of economic growth determine the inflation rate. Unemployment that persists in the long run includes frictional and structural unemployment. We
shall examine some of the forces that affect both types of unemployment, as well as a new theory of unemployment. The Inflation Rate in the Long Run What factors determine the inflation rate? The price level is determined by the intersection of aggregate demand and short-run aggregate supply; anything that shifts either of these two curves changes the price level and thus affects the inflation rate. We have seen how these shifts can generate different inflation–unemployment combinations in the short run. In the long run, the rate of inflation will be determined by two factors: the rate of money growth and the rate of economic growth. Economists generally agree that the rate of money growth is one determinant of an economy’s inflation rate in the long run. The conceptual basis for that conclusion lies in the equation of exchange: MV = PY. That is, the money supply times the velocity of money equals the price level times the value of real GDP. Given the equation of exchange, which holds by definition, we learned in the chapter on monetary policy that the sum of the percentage rates of change in M and V will be roughly equal to the sum of the percentage rates of change in P and Y. That is, Equation 31.1 Suppose that velocity is stable in the long run, so that %ΔV equals zero. Then, the inflation rate (%ΔP) roughly equals the percentage rate of change in the money supply minus the percentage rate of change in real GDP: Equation 31.2 In the long run, real GDP moves to its potential level, Y. Thus, in the long run we can write Equation 31.2 as follows: P Equation 31.3 There is a limit to how fast the economy’s potential output can grow. Economists generally agree that potential output increases at only about a 2% to 3% annual rate in the United States. Given that the economy stays close to its potential, this puts a rough limit on the speed with which Y can grow. Velocity can vary, but it is not likely to change at a rapid rate over a sustained period. These two facts suggest that very rapid increases in the quantity of money, M, will inevitably produce very rapid increases in the price level, P. If the money supply grows more slowly than potential output, then the right-hand side of Equation 31.3 will be negative. The price level will fall; the economy experiences deflation. Numerous studies point to the strong relationship between money growth and inflation, especially for high-inflation countries
. Figure 31.13 is from a recent study by economists Paul De Grauwe and Magdalena Polan. It is based on a sample of 160 countries over a 30-year period. Panel (a) includes all 160 countries and suggests a positive relationship between money growth and the rate of inflation. The relationship is clearly not precise, and the relationship is strengthened by the presence of countries with very high inflation rates. When the researchers break down the sample into countries with inflation rates of less than 10%, less than 20%, and 16.3.1 https://socialsci.libretexts.org/@go/page/21781 less than 50%, they find that for countries with single-digit inflation the relationship between inflation and money growth is quite weak. Panel (b) shows that there is still a visible, though of course not perfect, correlation when examining countries with inflation rates of less than 50% (Grauwe & Polan, 2005). Figure 31.13 Money Growth Rates and Inflation over the Long Run Data for 160 countries over a 30-year period suggest a positive relationship between the rate of money growth and inflation. The graph shows the inflation rate against a broad definition of the money supply, M2. Source: Paul De Grauwe and Magdalena Polan, “Is Inflation Always and Everywhere a Monetary Phenomenon?” Scandinavian Journal of Economics 107, no. 2 (2005): 245–46. In the model of aggregate demand and aggregate supply, increases in the money supply shift the aggregate demand curve to the right and thus force the price level upward. Money growth thus produces inflation. Of course, other factors can shift the aggregate demand curve as well. For example, expansionary fiscal policy or an increase in investment will shift aggregate demand. We have already seen that changes in the expected price level or in production costs shift the short-run aggregate supply curve. But such increases are not likely to continue year after year, as money growth can. Factors other than money growth may influence the inflation rate from one year to the next, but they are not likely to cause sustained inflation. Inflation Rates and Economic Growth Our conclusion is a simple and an important one. In the long run, the inflation rate is determined by the relative values of the economy’s rate of money growth and of its rate of economic growth. If the money supply increases more rapidly than the rate of economic growth, inflation is likely to result. A money growth rate equal to the rate of
economic growth will, in the absence of a change in velocity, produce a zero rate of inflation. Finally, a money growth rate that falls short of the rate of economic growth is likely to lead to deflation. Unemployment in the Long Run 0 Economists distinguish three types of unemployment: frictional unemployment, structural unemployment, and cyclical unemployment. The first two exist at all times, even when the economy operates at its potential. These two types of unemployment together determine the natural rate of unemployment. In the long run, the economy will operate at potential, and the unemployment rate will be the natural rate of unemployment. For this reason, in the long run the Phillips curve will be vertical at the natural rate of unemployment. Figure 31.14 explains why. Suppose the economy is operating at Y on AD and SRAS. Suppose the price level is P, the same as in the last period. In that case, the inflation rate is 0. Panel (b) shows that the unemployment rate is U, the natural rate of unemployment. Now suppose that the aggregate demand curve shifts to AD. In the short run, output will increase to Y. The price level will rise to P, and the unemployment rate will fall to U. In Panel (b) we show the new unemployment rate, U, to be associated with an inflation rate of π, and the beginnings of the negatively sloped short-run Phillips curve emerges. In the long run, as price and nominal wages increase, the short-run aggregate supply curve moves to SRAS and output returns to Y, as shown in Panel (a). In Panel (b), unemployment returns to U, regardless of the rate of inflation. Thus, in the long-run, the Phillips curve is vertical 16.3.2 https://socialsci.libretexts.org/@go/page/21781 0 Figure 31.14 The Phillips Curve in the Long Run Suppose the economy is operating at Y on AD and SRAS in Panel (a) with price level of P, the same as in the last period. Panel (b) shows that the unemployment rate is U, the natural rate of unemployment. If the aggregate demand curve shifts to AD, in the short run output will increase to Y, and the price level will rise to P. In Panel (b), the unemployment rate will fall to U, and the inflation rate will be π. In the long run, as price and nominal wages increase, the short-run aggregate supply curve moves to SRAS,
and output returns to Y, as shown in Panel (a). In Panel (b), unemployment returns to U, regardless of the rate of inflation. Thus, in the long-run, the Phillips curve is vertical An economy operating at its potential would have no cyclical unemployment. Because an economy achieves its potential output in the long run, an analysis of unemployment in the long run is an analysis of frictional and structural unemployment. In this section, we will also look at some new research that challenges the very concept of an economy achieving its potential output. Frictional Unemployment Frictional unemployment occurs because it takes time for people seeking jobs and employers seeking workers to find each other. If the amount of time could be reduced, frictional unemployment would fall. The economy’s natural rate of unemployment would drop, and its potential output would rise. This section presents a model of frictional unemployment and examines some issues in reducing the frictional unemployment rate. A period of frictional unemployment ends with the individual getting a job. The process through which the job is obtained suggests some important clues to the nature of frictional unemployment. By definition, a person who is unemployed is seeking work. At the outset of a job search, we presume that the individual has a particular wage in mind as he or she considers various job possibilities. The lowest wage that an unemployed worker would accept, if it were offered, is called the reservation wage. This is the wage an individual would accept; any offer below it would be rejected. Once a firm offers the reservation wage, the individual will take it and the job search will be terminated. Many people may hold out for more than just a wage—they may be seeking a certain set of working conditions, opportunities for advancement, or a job in a particular area. In practice, then, an unemployed worker might be willing to accept a variety of combinations of wages and other job characteristics. We shall simplify our analysis by lumping all these other characteristics into a single reservation wage. A worker’s reservation wage is likely to change as his or her search continues. One might initiate a job search with high expectations and thus have a high reservation wage. As the job search continues, however, this reservation wage might be adjusted downward as the worker obtains better information about what is likely to be available in the market and as the financial difficulties associated with unemployment mount. We can thus draw a reservation wage curve (Figure 31.15), that suggests a negative relationship between the reservation wage and the duration of a person’s job search
. Similarly, as a job search continues, the worker will accumulate better offers. The “best-offer-received” curve shows what its name implies; it is the best offer the individual has received so far in the job search. The upward slope of the curve suggests that, as a worker’s search continues, the best offer received will rise. 16.3.3 https://socialsci.libretexts.org/@go/page/21781 Figure 31.15 A Model of a Job Search An individual begins a job search at time t with a reservation wage W. As long as the reservation wage exceeds the best offer received, the individual will continue searching. A job is accepted, and the search is terminated, at time t, at which the reservation and “best-offer-received” curves intersect at wage W. c 0 0 c The search begins at time t, with the unemployed worker seeking wage W. Because the worker’s reservation wage exceeds the best offer received, the worker continues the search. The worker reduces his or her reservation wage and accumulates better offers until the two curves intersect at time t. The worker accepts wage W, and the job search is terminated. 0 0 c c The job search model in Figure 31.15 does not determine an equilibrium duration of job search or an equilibrium initial wage. The reservation wage and best-offer-received curves will be unique to each individual’s experience. We can, however, use the model to reach some conclusions about factors that affect frictional unemployment. First, the duration of search will be shorter when more job market information is available. Suppose, for example, that the only way to determine what jobs and wages are available is to visit each firm separately. Such a situation would require a lengthy period of search before a given offer was received. Alternatively, suppose there are agencies that make such information readily available and that link unemployed workers to firms seeking to hire workers. In that second situation, the time required to obtain a given offer would be reduced, and the best-offer-received curves for individual workers would shift to the left. The lower the cost for obtaining job market information, the lower the average duration of unemployment. Government and private agencies that provide job information and placement services help to reduce information costs to unemployed workers and firms. They tend to lower frictional unemployment by shifting the best-offer-received curves for individual workers to the left, as shown in Panel (a) of Figure 31.16
. Workers obtain higher-paying jobs when they do find work; the wage at which searches are terminated rises to W. 2 Figure 31.16 Public Policy and Frictional Unemployment Public policy can influence the time required for job-seeking workers and worker-seeking firms to find each other. Programs that provide labor-market information tend to shift the best-offer-received (BOR) curves of individual workers to the left, reducing the duration of job search and reducing unemployment, as in Panel (a). Note that the wage these workers obtain also rises to W. Unemployment compensation tends to increase the period over which a worker will hold out for a particular wage, shifting the reservation wage (RW) curve to the right, as in Panel (b). Unemployment compensation thus boosts the unemployment rate and increases the wage workers obtain when they find employment. 2 Unemployment compensation, which was introduced in the United States during the Great Depression to help workers who had lost jobs through unemployment, also affects frictional unemployment. Because unemployment compensation reduces the financial burden of being unemployed, it is likely to increase the amount of time people will wait for a given wage. It thus shifts the reservation wage curve to the right, raises the average duration of unemployment, and increases the wage at which searches end, as shown in Panel (b). An increase in the average duration of unemployment implies a higher unemployment rate. Unemployment compensation thus has a paradoxical effect—it tends to increase the problem against which it protects. 16.3.4 https://socialsci.libretexts.org/@go/page/21781 Structural Unemployment Structural unemployment occurs when a firm is looking for a worker and an unemployed worker is looking for a job, but the particular characteristics the firm seeks do not match up with the characteristics the worker offers. Technological change is one source of structural unemployment. New technologies are likely to require different skills than old technologies. Workers with training to equip them for the old technology may find themselves caught up in a structural mismatch. Technological and managerial changes have, for example, changed the characteristics firms seek in workers they hire. Firms looking for assembly-line workers once sought men and women with qualities such as reliability, integrity, strength, and manual dexterity. Reliability and integrity remain important, but many assembly-line jobs now require greater analytical and communications skills. Automobile manufacturers, for example, now test applicants for entry-level factory jobs on their abilities in algebra, in trigonometry, and in written and oral communications. Strong, agile workers
with weak analytical and language skills may find many job openings for which they do not qualify. They would be examples of the structurally unemployed. Changes in demand can also produce structural unemployment. As consumers shift their demands to different products, firms that are expanding and seeking more workers may need different skills than firms for which demand has shrunk. Similarly, firms may shift their use of different types of jobs in response to changing market conditions, leaving some workers with the “wrong” set of skills. Regional shifts in demand can produce structural unemployment as well. The economy of one region may be expanding rapidly, creating job vacancies, while another region is in a slump, with many workers seeking jobs but not finding them. Public and private job training firms seek to reduce structural unemployment by providing workers with skills now in demand. Employment services that provide workers with information about jobs in other regions also reduce the extent of structural unemployment. Cyclical Unemployment and Efficiency Wages In our model, unemployment above the natural level occurs if, at a given real wage, the quantity of labor supplied exceeds the quantity of labor demanded. In the analysis we’ve done so far, the failure to achieve equilibrium is a short-run phenomenon. In the long run, wages and prices will adjust so that the real wage reaches its equilibrium level. Employment reaches its natural level. Some economists, however, argue that a real wage that achieves equilibrium in the labor market may never be reached. They suggest that firms may intentionally pay a wage greater than the market equilibrium. Such firms could hire additional workers at a lower wage, but they choose not to do so. The idea that firms may hold to a real wage greater than the equilibrium wage is called efficiency-wage theory. Why would a firm pay higher wages than the market requires? Suppose that by paying higher wages, the firm is able to boost the productivity of its workers. Workers become more contented and more eager to perform in ways that boost the firm’s profits. Workers who receive real wages above the equilibrium level may also be less likely to leave their jobs. That would reduce job turnover. A firm that pays its workers wages in excess of the equilibrium wage expects to gain by retaining its employees and by inducing those employees to be more productive. Efficiency-wage theory thus suggests that the labor market may divide into two segments. Workers with jobs will receive high wages. Workers without jobs, who would be willing to work at an even lower wage than the workers with jobs, find themselves closed out of the market. Whether efficiency wages really
exist remains a controversial issue, but the argument is an important one. If it is correct, then the wage rigidity that perpetuates a recessionary gap is transformed from a temporary phenomenon that will be overcome in the long run to a permanent feature of the market. The argument implies that the ordinary processes of self-correction will not eliminate a 1 recessionary gap. Key Takeaways Two factors that can influence the rate of inflation in the long run are the rate of money growth and the rate of economic growth. In the long run, the Phillips curve will be vertical since when output is at potential, the unemployment rate will be the natural rate of unemployment, regardless of the rate of inflation. The rate of frictional unemployment is affected by information costs and by the existence of unemployment compensation. Policies to reduce structural unemployment include the provision of job training and information about labor-market conditions in other regions. Efficiency-wage theory predicts that profit-maximizing firms will maintain the wage level at a rate too high to achieve full employment in the labor market. 16.3.5 https://socialsci.libretexts.org/@go/page/21781 Try It! Using the model of a job search (see Figure 31.15), show graphically how each of the following would be likely to affect the duration of an unemployed worker’s job search and thus the unemployment rate: 1. A new program provides that workers who have lost their jobs will receive unemployment compensation from the government equal to the pay they were earning when they lost their jobs, and that this compensation will continue for at least five years. 2. Unemployment compensation is provided, but it falls by 20% each month a person is out of work. 3. Access to the Internet becomes much more widely available and is used by firms looking for workers and by workers seeking jobs.  Case in Point: Altering the Incentives for Unemployment Insurance Claimants Figure 31.17 Tax Credits – Unemployment – CC BY 2.0. While the rationale for unemployment insurance is clear—to help people weather bouts of unemployment—especially during economic downturns, designing programs that reduce adverse incentives is challenging. A review article by economists Peter Fredriksson and Bertil Holmlund examined decades of research that looks at how unemployment insurance programs could be improved. In particular, they consider the value of changing the duration and profile of benefit payments, increasing monitoring and sanctions imposed on unemployment insurance recipients, and changing work requirements. Some of the research is theoretical, while some
comes out of actual experiments. Concerning benefit payments, they suggest that reducing payments over time provides better incentives than either keeping payments constant or increasing them over time. Research also suggests that a waiting period might also be useful. Concerning monitoring and sanctions, most unemployment insurance systems require claimants to demonstrate in some way that they have 16.3.6 https://socialsci.libretexts.org/@go/page/21781 looked for work. For example, they must report regularly to employment agencies or provide evidence they have applied for jobs. If they do not, the benefit may be temporarily cut. A number of experiments support the notion that greater search requirements reduce the length of unemployment. One experiment conducted in Maryland assigned recipients to different processes ranging from the standard requirement at the time of two employer contacts per week to requiring at least four contacts per week, attending a four-day job search workshop, and telling claimants that their employer contacts would be verified. The results showed that increasing the number of employer contacts reduced the duration by 6%, attending the workshop reduced duration by 5%, and the possibility of verification reduced it by 7.5%. Indeed, just telling claimants that they were going to have to attend the workshop led to a reduction in claimants. Evidence on instituting some kind of work requirement is similar to that of instituting workshop attendance. The authors conclude that the effectiveness of all these instruments results from the fact that they encourage more active job search. Source: Peter Fredriksson and Bertil Holmlund, “Improving Incentives in Unemployment Insurance: A Review of Recent Research,” Journal of Economic Surveys 20, no. 3 (July 2006): 357–86. Answer to Try It! Problem The duration of an unemployed worker’s job search increases in situation (1), as illustrated in panel (a) and decreases in situations (2) and (3), as illustrated in panels (b) and (c) respectively. Thus, the unemployment rate increases in situation (1) and decreases in situations (2) and (3) Figure 31.18 1 For a discussion of the argument, see Janet Yellen, “Efficiency Wage Models of Unemployment,” American Economic Review, Papers and Proceedings (May 1984): 200–205. References Grauwe, P. D., and Magdalena Polan, “Is Inflation Always and Everywhere a Monetary Phenomenon?” Scandinavian Journal of Economics 107, no. 2 (2005): 239–59. This
page titled 16.3: Inflation and Unemployment in the Long Run is shared under a CC BY-NC-SA 3.0 license and was authored, remixed, and/or curated by Anonymous. 31.3: Inflation and Unemployment in the Long Run by Anonymous is licensed CC BY-NC-SA 3.0. Original source: https://2012books.lardbucket.org/books/economics-principles-v2.0/. 16.3.7 https://socialsci.libretexts.org/@go/page/21781 16.4: Review and Practice Summary During the 1960s, it appeared that there was a stable trade-off between the rate of unemployment and the rate of inflation. The Phillips curve, which describes such a trade-off, suggests that lower rates of unemployment come with higher rates of inflation, and that lower rates of inflation come with higher rates of unemployment. But during subsequent decades, the actual values for unemployment and inflation have not always followed the Phillips curve script. There has, however, been a relationship between unemployment and inflation over the four decades from 1961. Periods of rising inflation and falling unemployment have been followed by periods of rising unemployment and continued inflation; those periods have, in turn, been followed by periods in which both the inflation rate and the unemployment rate fall. These periods are defined as the Phillips phase, the stagflation phase, and the recovery phase of the inflation—unemployment cycle, respectively. Following the recession of 2001, the economy returned quickly to a Phillips phase. The Phillips phase is a period in which aggregate demand increases, boosting output and the price level. Unemployment drops and inflation rises. An essential feature of the Phillips phase is that the price increases that occur are unexpected. Workers thus experience lower real wages than they anticipated. Firms with sticky prices find that their prices are low relative to other prices. As workers and firms adjust to the higher inflation of the Phillips phase, they demand higher wages and post higher prices, so the short-run aggregate supply curve shifts leftward. Inflation continues, but real GDP falls. This is the stagflation phase. Finally, aggregate demand begins to increase again, boosting both real GDP and the price level. The higher price level, however, is likely to represent a much smaller percentage increase than had occurred during the stagflation phase. This is the recovery phase: inflation and unemployment fall together. There is nothing inherent in a market economy that would produce the inflation—unemployment cycle
we have observed since 1961. The cycle can begin if expansionary policies are launched to correct a recessionary gap, producing the Phillips phase. If those policies push the economy into an inflationary gap, then the adjustment of short-run aggregate supply will produce the stagflation phase. And, in the economy’s first response to an expansionary policy launched to deal with the recession of the stagflation phase, the price level rises, but at a slower rate than before. The economy experiences falling inflation and falling unemployment at the same time: the recovery phase. In the long run, the Phillips curve is vertical, and inflation is essentially a monetary phenomenon. Assuming stable velocity of money over the long run, the inflation rate roughly equals the money growth rate minus the rate of growth of real GDP. For a given money growth rate, inflation is thus reduced by faster economic growth. Frictional unemployment is affected by information costs in the labor market. A reduction in those costs would reduce frictional unemployment. Hastening the retraining of workers would reduce structural unemployment. Reductions in frictional or structural unemployment would lower the natural rate of unemployment and thus raise potential output. Unemployment compensation is likely to increase frictional unemployment. Some economists believe that cyclical unemployment may persist because firms have an incentive to maintain real wages above the equilibrium level. Whether this efficiency-wage argument holds is controversial. Concept Problems 1. The Case in Point titled “Some Reflections on the 1970s” describes the changes in inflation and in unemployment in 1970 and 1971 as a watershed development for macroeconomic thought. Why was an increase in unemployment such a significant event? 2. As the economy slipped into recession in 1980 and 1981, the Fed was under enormous pressure to adopt an expansionary monetary policy. Suppose it had begun an expansionary policy early in 1981. What does the text’s analysis of the inflation— unemployment cycle suggest about how the macroeconomic history of the 1980s might have been changed? 3. Here are some news reports covering events of the past 35 years. In each case, identify the stage of the inflation— unemployment cycle, and suggest what change in aggregate demand or aggregate supply might have caused it. 1. “President Nixon expressed satisfaction with last year’s economic performance. He said that with inflation and unemployment heading down, the nation ‘is on the right course.’” 2. “The nation’s inflation rate rose to a record high last month, the government reported yesterday. The consumer price index jumped
0.3% in January. Coupled with the announcement earlier this month that unemployment had risen by 0.5 percentage 16.4.1 https://socialsci.libretexts.org/@go/page/21782 points, the reports suggested that the first month of President Nixon’s second term had gotten off to a rocky start.” 3. “President Carter expressed concern about reports of rising inflation but insisted the economy is on the right course. He pointed to recent reductions in unemployment as evidence that his economic policies are working.” 4. The text notes that changes in oil prices can affect the inflation—unemployment cycle. Should they be incorporated as part of the theory of the cycle? 5. The introduction to this chapter suggests that unemployment fell, and inflation generally fell, through most of the 1990s. What phase of the inflation—unemployment cycle does this represent? Relative to U.S. experience since the 1960s, what was unusual about this? 6. Suppose that declining resource supplies reduce potential output in each period by 4%. What kind of monetary policy would be needed to maintain a zero rate of inflation at full employment? 7. The Humphrey–Hawkins Act of 1978 required that the federal government maintain an unemployment rate of 4% and hold the inflation rate to less than 3%. What does the inflation–unemployment relationship tell you about achieving such goals? 8. The American Economic Association publishes a newsletter (which is available on the AEA’s Internet site at http://www.aeaweb.org/joe/) called Job Openings for Economists (JOE). Virtually all academic and many nonacademic positions for which applicants are being sought for economics positions are listed in the newsletter, which is quite inexpensive. How do you think that the publication of this journal affects the unemployment rate among economists? What type of unemployment does it affect? 9. Many economists think that we are in the very early stages of putting computer technology to work and that full incorporation of computers will cause a massive restructuring of virtually every institution of modern life. If they are right, what are the implications for unemployment? What kind of unemployment would be affected? 10. The natural unemployment rate in the United States has varied over the last 50 years. According to the Congressional Budget Office, the natural rate was 5.5% in 1960, rose to about 6.5% in the 1970s, and had declined to about 4.8% by 2000. What do you
think might have caused this variation? 11. Suppose the Fed begins carrying out an expansionary monetary policy in order to close a recessionary gap. Relate what happens during the next two phases of the inflation—unemployment cycle to the maxim “You can fool some of the people some of the time, but you can’t fool all of the people all of the time.” Numerical Problems 1. Here are annual data for the inflation and unemployment rates for the United States for the 1948–1961 period. Year Unemployment rate (%) Inflation rate (%) 1948 1949 1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 3.8 5.9 5.3 3.3 3.0 2.9 5.5 4.4 4.1 4.3 6.8 5.5 5.5 6.7 3.0 −2.1 5.9 6.0 0.8 0.7 −0.7 0.4 3.0 2.9 1.8 1.7 1.4 0.7 1. Plot these observations and connect the points as in Figure 31.5. 2. How does this period compare to the decades that followed? 16.4.2 https://socialsci.libretexts.org/@go/page/21782 3. What do you think accounts for the difference? 2. Here are hypothetical inflation and unemployment data for Econoland. Time period Inflation rate (%) Unemployment rate (%). Plot these points. 2. Identify which points correspond to a Phillips phase, which correspond to a stagflation phase, and which correspond to a recovery phase. 3. Relate the observations in Numerical Problem 2 to what must have been happening in the aggregate demand–aggregate supply model. 4. Suppose the full-employment level of real GDP is increasing at a rate of 3% per period and the money supply is growing at a 4% rate. What will happen to the long-run inflation rate, assuming constant velocity? This page titled 16.4: Review and Practice is shared under a CC BY-NC-SA 3.0 license and was authored, remixed, and/or curated by Anonymous. 31.4: Review and Practice by Anonymous is licensed CC BY-NC-SA 3.0. Original source: https://2012books.lardbucket.org/books/economics-principles-v2.0/. 16.4.3 https://socialsci
.libretexts.org/@go/page/21782 CHAPTER OVERVIEW 17: A Brief History of Macroeconomic Thought and Policy 17.1: The Great Depression and Keynesian Economics 17.2: Keynesian Economics in the 1960s and 1970s 17.3: 32.3:. An Emerging Consensus: Macroeconomics for the Twenty-First Century 17.4: Review and Practice Thumbnail: https://pixabay.com/photos/dollar-currency-money-us-dollar-4057665/ This page titled 17: A Brief History of Macroeconomic Thought and Policy is shared under a CC BY-NC-SA 3.0 license and was authored, remixed, and/or curated by Anonymous. 1 17.1: The Great Depression and Keynesian Economics  Learning Objective 1. Explain the basic assumptions of the classical school of thought that dominated macroeconomic thinking before the Great Depression, and tell why the severity of the Depression struck a major blow to this view. 2. Compare Keynesian and classical macroeconomic thought, discussing the Keynesian explanation of prolonged recessionary and inflationary gaps as well as the Keynesian approach to correcting these problems. It is hard to imagine that anyone who lived during the Great Depression was not profoundly affected by it. From the beginning of the Depression in 1929 to the time the economy hit bottom in 1933, real GDP plunged nearly 30%. Real per capita disposable income sank nearly 40%. More than 12 million people were thrown out of work; the unemployment rate soared from 3% in 1929 to 25% in 1933. Some 85,000 businesses failed. Hundreds of thousands of families lost their homes. By 1933, about half of all mortgages on all urban, owner-occupied houses were delinquent (Wheelock, 2008). The economy began to recover after 1933, but a huge recessionary gap persisted. Another downturn began in 1937, pushing the unemployment rate back up to 19% the following year. The contraction in output that began in 1929 was not, of course, the first time the economy had slumped. But never had the U.S. economy fallen so far and for so long a period. Economic historians estimate that in the 75 years before the Depression there had been 19 recessions. But those contractions had lasted an average of less than two years. The Great Depression lasted for more than a decade. The severity and duration of the Great Depression distinguish it from other contractions; it is for that reason that we give it a much stronger name
than “recession.” Figure 32.1 shows the course of real GDP compared to potential output during the Great Depression. The economy did not approach potential output until 1941, when the pressures of world war forced sharp increases in aggregate demand. Figure 32.1 The Depression and the Recessionary Gap The dark-shaded area shows real GDP from 1929 to 1942, the upper line shows potential output, and the light-shaded area shows the difference between the two—the recessionary gap. The gap nearly closed in 1941; an inflationary gap had opened by 1942. The chart suggests that the recessionary gap remained very large throughout the 1930s. The Classical School and the Great Depression The Great Depression came as a shock to what was then the conventional wisdom of economics. To see why, we must go back to the classical tradition of macroeconomics that dominated the economics profession when the Depression began. Classical economics is the body of macroeconomic thought associated primarily with 19th-century British economist David Ricardo. His Principles of Political Economy and Taxation, published in 1817, established a tradition that dominated macroeconomic thought for over a century. Ricardo focused on the long run and on the forces that determine and produce growth in an economy’s potential output. He emphasized the ability of flexible wages and prices to keep the economy at or near its natural level of employment. According to the classical school, achieving what we now call the natural level of employment and potential output is not a problem; the economy can do that on its own. Classical economists recognized, however, that the process would take time. Ricardo admitted that there could be temporary periods in which employment would fall below the natural level. But his emphasis was on the long run, and in the long run all would be set right by the smooth functioning of the price system. 17.1.1 https://socialsci.libretexts.org/@go/page/21784 Economists of the classical school saw the massive slump that occurred in much of the world in the late 1920s and early 1930s as a short-run aberration. The economy would right itself in the long run, returning to its potential output and to the natural level of employment. Keynesian Economics In Britain, which had been plunged into a depression of its own, John Maynard Keynes had begun to develop a new framework of macroeconomic analysis, one that suggested that what for Ricardo were “temporary effects” could persist for a long time, and at terrible cost.
Keynes’s 1936 book, The General Theory of Employment, Interest and Money, was to transform the way many economists thought about macroeconomic problems. Keynes versus the Classical Tradition In a nutshell, we can say that Keynes’s book shifted the thrust of macroeconomic thought from the concept of aggregate supply to the concept of aggregate demand. Ricardo’s focus on the tendency of an economy to reach potential output inevitably stressed the supply side—an economy tends to operate at a level of output given by the long-run aggregate supply curve. Keynes, in arguing that what we now call recessionary or inflationary gaps could be created by shifts in aggregate demand, moved the focus of macroeconomic analysis to the demand side. He argued that prices in the short run are quite sticky and suggested that this stickiness would block adjustments to full employment. Keynes dismissed the notion that the economy would achieve full employment in the long run as irrelevant. “In the long run,” he wrote acidly, “we are all dead.” Keynes’s work spawned a new school of macroeconomic thought, the Keynesian school. Keynesian economics asserts that changes in aggregate demand can create gaps between the actual and potential levels of output, and that such gaps can be prolonged. Keynesian economists stress the use of fiscal and of monetary policy to close such gaps. Keynesian Economics and the Great Depression The experience of the Great Depression certainly seemed consistent with Keynes’s argument. A reduction in aggregate demand took the economy from above its potential output to below its potential output, and, as we saw in Figure 32.1, the resulting recessionary gap lasted for more than a decade. While the Great Depression affected many countries, we shall focus on the U.S. experience. The plunge in aggregate demand began with a collapse in investment. The investment boom of the 1920s had left firms with an expanded stock of capital. As the capital stock approached its desired level, firms did not need as much new capital, and they cut back investment. The stock market crash of 1929 shook business confidence, further reducing investment. Real gross private domestic investment plunged nearly 80% between 1929 and 1932. We have learned of the volatility of the investment component of aggregate demand; it was very much in evidence in the first years of the Great Depression. Other factors contributed to the sharp reduction in aggregate demand. The stock market crash reduced the wealth of a small fraction of the population (just 5% of Americans owned stock at that time), but it certainly reduced
the consumption of the general population. The stock market crash also reduced consumer confidence throughout the economy. The reduction in wealth and the reduction in confidence reduced consumption spending and shifted the aggregate demand curve to the left. Fiscal policy also acted to reduce aggregate demand. As consumption and income fell, governments at all levels found their tax revenues falling. They responded by raising tax rates in an effort to balance their budgets. The federal government, for example, doubled income tax rates in 1932. Total government tax revenues as a percentage of GDP shot up from 10.8% in 1929 to 16.6% in 1933. Higher tax rates tended to reduce consumption and aggregate demand. Other countries were suffering declining incomes as well. Their demand for U.S. goods and services fell, reducing the real level of exports by 46% between 1929 and 1933. The Smoot–Hawley Tariff Act of 1930 dramatically raised tariffs on products imported into the United States and led to retaliatory trade-restricting legislation around the world. This act, which more than 1,000 economists opposed in a formal petition, contributed to the collapse of world trade and to the recession. As if all this were not enough, the Fed, in effect, conducted a sharply contractionary monetary policy in the early years of the Depression. The Fed took no action to prevent a wave of bank failures that swept the country at the outset of the Depression. Between 1929 and 1933, one-third of all banks in the United States failed. As a result, the money supply plunged 31% during the period. 17.1.2 https://socialsci.libretexts.org/@go/page/21784 The Fed could have prevented many of the failures by engaging in open-market operations to inject new reserves into the system and by lending reserves to troubled banks through the discount window. But it generally refused to do so; Fed officials sometimes even applauded bank failures as a desirable way to weed out bad management! Figure 32.2 Aggregate Demand and Short-Run Aggregate Supply: 1929–1933 Slumping aggregate demand brought the economy well below the full-employment level of output by 1933. The short-run aggregate supply curve increased as nominal wages fell. In this analysis, and in subsequent applications in this chapter of the model of aggregate demand and aggregate supply to macroeconomic events, we are ignoring shifts in the long-run aggregate supply curve in order to simplify the diagram. Figure 32.2 shows the shift in aggregate demand between 1929, when the economy was operating just
above its potential output, and 1933. The plunge in aggregate demand produced a recessionary gap. Our model tells us that such a gap should produce falling wages, shifting the short-run aggregate supply curve to the right. That happened; nominal wages plunged roughly 20% between 1929 and 1933. But we see that the shift in short-run aggregate supply was insufficient to bring the economy back to its potential output. The failure of shifts in short-run aggregate supply to bring the economy back to its potential output in the early 1930s was partly the result of the magnitude of the reductions in aggregate demand, which plunged the economy into the deepest recessionary gap ever recorded in the United States. We know that the short-run aggregate supply curve began shifting to the right in 1930 as nominal wages fell, but these shifts, which would ordinarily increase real GDP, were overwhelmed by continued reductions in aggregate demand. A further factor blocking the economy’s return to its potential output was federal policy. President Franklin Roosevelt thought that falling wages and prices were in large part to blame for the Depression; programs initiated by his administration in 1933 sought to block further reductions in wages and prices. That stopped further reductions in nominal wages in 1933, thus stopping further shifts in aggregate supply. With recovery blocked from the supply side, and with no policy in place to boost aggregate demand, it is easy to see now why the economy remained locked in a recessionary gap so long. Keynes argued that expansionary fiscal policy represented the surest tool for bringing the economy back to full employment. The United States did not carry out such a policy until world war prompted increased federal spending for defense. New Deal policies did seek to stimulate employment through a variety of federal programs. But, with state and local governments continuing to cut purchases and raise taxes, the net effect of government at all levels on the economy did not increase aggregate demand during the Roosevelt administration until the onset of world war. As Figure 32.3 shows, expansionary fiscal policies forced by the war had brought output back to potential by 1941. The U.S. entry into World War II after Japan’s attack on American forces in Pearl Harbor in December of 1941 led to much sharper increases in government purchases, and the economy pushed quickly into an inflationary gap. 1 17.1.3 https://socialsci.libretexts.org/@go/page/21784 Figure 32.3 World War II Ends the Great Depression Increased U.S. government purchases, prompted by the beginning of World War II,
ended the Great Depression. By 1942, increasing aggregate demand had pushed real GDP beyond potential output. For Keynesian economists, the Great Depression provided impressive confirmation of Keynes’s ideas. A sharp reduction in aggregate demand had gotten the trouble started. The recessionary gap created by the change in aggregate demand had persisted for more than a decade. And expansionary fiscal policy had put a swift end to the worst macroeconomic nightmare in U.S. history— even if that policy had been forced on the country by a war that would prove to be one of the worst episodes of world history. Key Takeaways Classical economic thought stressed the ability of the economy to achieve what we now call its potential output in the long run. It thus stressed the forces that determine the position of the long-run aggregate supply curve as the determinants of income. Keynesian economics focuses on changes in aggregate demand and their ability to create recessionary or inflationary gaps. Keynesian economists argue that sticky prices and wages would make it difficult for the economy to adjust to its potential output. Because Keynesian economists believe that recessionary and inflationary gaps can persist for long periods, they urge the use of fiscal and monetary policy to shift the aggregate demand curve and to close these gaps. Aggregate demand fell sharply in the first four years of the Great Depression. As the recessionary gap widened, nominal wages began to fall, and the short-run aggregate supply curve began shifting to the right. These shifts, however, were not sufficient to close the recessionary gap. World War II forced the U.S. government to shift to a sharply expansionary fiscal policy, and the Depression ended. Try It! Imagine that it is 1933. President Franklin Roosevelt has just been inaugurated and has named you as his senior economic adviser. Devise a program to bring the economy back to its potential output. Using the model of aggregate demand and aggregate supply, demonstrate graphically how your proposal could work.  Case in Point: Early Views on Stickiness Figure 32.4 17.1.4 https://socialsci.libretexts.org/@go/page/21784 Wikimedia Commons – public domain. Although David Ricardo’s focus on the long run emerged as the dominant approach to macroeconomic thought, not all of his contemporaries agreed with his perspective. Many eighteenth- and nineteenth-century economists developed theoretical arguments suggesting that changes in aggregate demand could affect the real level of economic activity in the short run. Like the new Keynesians, they based their arguments
on the concept of price stickiness. Henry Thornton’s 1802 book, An Enquiry into the Nature and Effects of the Paper Credit of Great Britain, argued that a reduction in the money supply could, because of wage stickiness, produce a short-run slump in output: “The tendency, however, of a very great and sudden reduction of the accustomed number of bank notes, is to create an unusual and temporary distress, and a fall of price arising from that distress. But a fall arising from temporary distress, will be attended probably with no correspondent fall in the rate of wages; for the fall of price, and the distress, will be understood to be temporary, and the rate of wages, we know, is not so variable as the price of goods. There is reason, therefore, to fear that the unnatural and extraordinary low price arising from the sort of distress of which we now speak, would occasion much discouragement of the fabrication of manufactures.” A half-century earlier, David Hume had noted that an increase in the quantity of money would boost output in the short run, again because of the stickiness of prices. In an essay titled “Of Money,” published in 1752, Hume described the process through which an increased money supply could boost output: “At first, no alteration is perceived; by degrees the price rises, first of one commodity, then of another, till the whole at least reaches a just proportion with the new quantity of (money) which is in the kingdom. In my opinion, it is only in this interval or intermediate situation … that the encreasing quantity of gold and silver is favourable to industry.” 17.1.5 https://socialsci.libretexts.org/@go/page/21784 Hume’s argument implies sticky prices; some prices are slower to respond to the increase in the money supply than others. Eighteenth- and nineteenth-century economists are generally lumped together as adherents to the classical school, but their views were anything but uniform. Many developed an analytical framework that was quite similar to the essential elements of new Keynesian economists today. Economist Thomas Humphrey, at the Federal Reserve Bank of Richmond, marvels at the insights shown by early economists: “When you read these old guys, you find out first that they didn’t speak with one voice. There was no single body of thought to which everyone subscribed. And second, you find out how much they knew
. You could take Henry Thornton’s 1802 book as a textbook in any money course today.” Source: Thomas M. Humphrey, “Nonneutrality of Money in Classical Monetary Thought,” Federal Reserve Bank of Richmond Economic Review 77, no. 2 (March/April 1991): 3–15, and personal interview. Answer to Try It! Problem An expansionary fiscal or monetary policy, or a combination of the two, would shift aggregate demand to the right as shown in Panel (a), ideally returning the economy to potential output. One piece of evidence suggesting that fiscal policy would work is the swiftness with which the economy recovered from the Great Depression once World War II forced the government to carry out such a policy. An alternative approach would be to do nothing. Ultimately, that should force nominal wages down further, producing increases in short-run aggregate supply, as in Panel (b). We do not know if such an approach might have worked; federal policies enacted in 1933 prevented wages and prices from falling further than they already had. Figure 32.5 1 For a discussion of fiscal policy during the Great Depression, see E. Cary Brown, “Fiscal Policy in the ’Thirties: A Reappraisal,” American Economic Review 46, no. 5 (December 1956): 857–79. References Wheelock, D. C., “The Federal Response to Home Mortgage Distress: Lessons from the Great Depression,” Federal Reserve Bank of St. Louis Review 90, no. 3 (Part 1) (May/June 2008): 133–48. This page titled 17.1: The Great Depression and Keynesian Economics is shared under a CC BY-NC-SA 3.0 license and was authored, remixed, and/or curated by Anonymous. 32.1: The Great Depression and Keynesian Economics by Anonymous is licensed CC BY-NC-SA 3.0. Original source: https://2012books.lardbucket.org/books/economics-principles-v2.0/. 17.1.6 https://socialsci.libretexts.org/@go/page/21784 17.2: Keynesian Economics in the 1960s and 1970s  Learning Objective 1. Briefly summarize the monetarist school of thought that emerged in the 1960s, and discuss how the experiences of the 1960s and 1970s seemed to be broadly consistent with it. 2. Briefly summarize
the new classical school of thought that emerged in the 1970s, and discuss how the experiences of the 1970s seemed to be broadly consistent with it. 3. Summarize the lessons that economists learned from the decade of the 1970s. The experience of the Great Depression led to the widespread acceptance of Keynesian ideas among economists, but its acceptance as a basis for economic policy was slower. The administrations of Presidents Roosevelt, Truman, and Eisenhower rejected the notion that fiscal policy could or should be used to manipulate real GDP. Truman vetoed a 1948 Republican-sponsored tax cut aimed at stimulating the economy after World War II (Congress, however, overrode the veto), and Eisenhower resisted stimulative measures to deal with the recessions of 1953, 1957, and 1960. It was the administration of President John F. Kennedy that first used fiscal policy with the intent of manipulating aggregate demand to move the economy toward its potential output. Kennedy’s willingness to embrace Keynes’s ideas changed the nation’s approach to fiscal policy for the next two decades. Expansionary Policy in the 1960s We can think of the macroeconomic history of the 1960s as encompassing two distinct phases. The first showed the power of Keynesian policies to correct economic difficulties. The second showed the power of these same policies to create them. Correcting a Recessionary Gap President Kennedy took office in 1961 with the economy in a recessionary gap. He had appointed a team of economic advisers who believed in Keynesian economics, and they advocated an activist approach to fiscal policy. The new president was quick to act on their advice. Expansionary policy served the administration’s foreign-policy purposes. Kennedy argued that the United States had fallen behind the Soviet Union, its avowed enemy, in military preparedness. He won approval from Congress for sharp increases in defense spending in 1961. The Kennedy administration also added accelerated depreciation to the tax code. Under the measure, firms could deduct depreciation expenses more quickly, reducing their taxable profits—and thus their taxes—early in the life of a capital asset. The measure encouraged investment. The administration also introduced an investment tax credit, which allowed corporations to reduce their income taxes by 10% of their investment in any one year. The combination of increased defense spending and tax measures to stimulate investment provided a quick boost to aggregate demand. The Fed followed the administration’s lead. It, too, shifted to an expansionary policy in 1961. The Fed purchased government bonds to increase the money supply and reduce interest rates. As shown in Panel
(a) of Figure 32.6, the expansionary fiscal and monetary policies of the early 1960s had pushed real GDP to its potential by 1963. But the concept of potential output had not been developed in 1963; Kennedy administration economists had defined full employment to be an unemployment rate of 4%. The actual unemployment rate in 1963 was 5.7%; the perception of the time was that the economy needed further stimulus. 17.2.1 https://socialsci.libretexts.org/@go/page/21785 Figure 32.6 The Two Faces of Expansionary Policy in the 1960s Expansionary fiscal and monetary policy early in the 1960s (Panel [a]) closed a recessionary gap, but continued expansionary policy created an inflationary gap by the end of the decade (Panel [b]). The short-run aggregate supply curve began shifting to the left, but expansionary policy continued to shift aggregate demand to the right and kept the economy in an inflationary gap. Expansionary Policy and an Inflationary Gap Kennedy proposed a tax cut in 1963, which Congress would approve the following year, after the president had been assassinated. In retrospect, we may regard the tax cut as representing a kind of a recognition lag— policy makers did not realize the economy had already reached what we now recognize was its potential output. Instead of closing a recessionary gap, the tax cut helped push the economy into an inflationary gap, as illustrated in Panel (b) of Figure 32.6. The expansionary policies, however, did not stop with the tax cut. Continued increases in federal spending for the newly expanded war in Vietnam and for President Lyndon Johnson’s agenda of domestic programs, together with continued high rates of money growth, sent the aggregate demand curve further to the right. While President Johnson’s Council of Economic Advisers recommended contractionary policy as early as 1965, macroeconomic policy remained generally expansionary through 1969. Wage increases began shifting the short-run aggregate supply curve to the left, but expansionary policy continued to increase aggregate demand and kept the economy in an inflationary gap for the last six years of the 1960s. Panel (b) of Figure 32.6 shows expansionary policies pushing the economy beyond its potential output after 1963. The 1960s had demonstrated two important lessons about Keynesian macroeconomic policy. First, stimulative fiscal and monetary policy could be used to close a recessionary gap. Second, fiscal policies could have a long implementation lag. The tax cut recommended by President Kennedy�
�s economic advisers in 1961 was not enacted until 1964—after the recessionary gap it was designed to fight had been closed. The tax increase recommended by President Johnson’s economic advisers in 1965 was not passed until 1968—after the inflationary gap it was designed to close had widened. Macroeconomic policy after 1963 pushed the economy into an inflationary gap. The push into an inflationary gap did produce rising employment and a rising real GDP. But the inflation that came with it, together with other problems, would create real difficulties for the economy and for macroeconomic policy in the 1970s. The 1970s: Troubles from the Supply Side For many observers, the use of Keynesian fiscal and monetary policies in the 1960s had been a triumph. That triumph turned into a series of macroeconomic disasters in the 1970s as inflation and unemployment spiraled to ever-higher levels. The fiscal and monetary medicine that had seemed to work so well in the 1960s seemed capable of producing only instability in the 1970s. The experience of the period shook the faith of many economists in Keynesian remedies and made them receptive to alternative approaches. This section describes the major macroeconomic events of the 1970s. It then examines the emergence of two schools of economic thought as major challengers to the Keynesian orthodoxy that had seemed so dominant a decade earlier. Macroeconomic Policy: Coping with the Supply Side When Richard Nixon became president in 1969, he faced a very different economic situation than the one that had confronted John Kennedy eight years earlier. The economy had clearly pushed beyond full employment; the unemployment rate had plunged to 3.6% in 1968. Inflation, measured using the implicit price deflator, had soared to 4.3%, the highest rate that had been recorded since 1951. The economy needed a cooling off. Nixon, the Fed, and the economy’s own process of self-correction delivered it. Figure 32.7 tells the story—it is a simple one. The economy in 1969 was in an inflationary gap. It had been in such a gap for years, but this time policy makers were no longer forcing increases in aggregate demand to keep it there. The adjustment in short-run aggregate supply brought the economy back to its potential output. 17.2.2 https://socialsci.libretexts.org/@go/page/21785 Figure 32.7 The Economy Closes an Inflationary Gap The Nixon administration and the Fed joined to end the expansionary policies that had prevailed in the
1960s, so that aggregate demand did not rise in 1970, but the short-run aggregate supply curve shifted to the left as the economy responded to an inflationary gap. But what we can see now as a simple adjustment seemed anything but simple in 1970. Economists did not think in terms of shifts in short-run aggregate supply. Keynesian economics focused on shifts in aggregate demand, not supply. For the Nixon administration, the slump in real GDP in 1970 was a recession, albeit an odd one. The price level had risen sharply. That was not, according to the Keynesian story, supposed to happen; there was simply no reason to expect the price level to soar when real GDP and employment were falling. The administration dealt with the recession by shifting to an expansionary fiscal policy. By 1973, the economy was again in an inflationary gap. The economy’s 1974 adjustment to the gap came with another jolt. The Organization of Petroleum Exporting Countries (OPEC) tripled the price of oil. The resulting shift to the left in short-run aggregate supply gave the economy another recession and another jump in the price level. The second half of the decade was, in some respects, a repeat of the first. The administrations of Gerald Ford and then Jimmy Carter, along with the Fed, pursued expansionary policies to stimulate the economy. Those helped boost output, but they also pushed up prices. As we saw in the chapter on inflation and unemployment, inflation and unemployment followed a cycle to higher and higher levels. The 1970s presented a challenge not just to policy makers, but to economists as well. The sharp changes in real GDP and in the price level could not be explained by a Keynesian analysis that focused on aggregate demand. Something else was happening. As economists grappled to explain it, their efforts would produce the model with which we have been dealing and around which a broad consensus of economists has emerged. But, before that consensus was to come, two additional elements of the puzzle had to be added. The first was the recognition of the importance of monetary policy. The second was the recognition of the role of aggregate supply, both in the long and in the short run. The Monetarist Challenge The idea that changes in the money supply are the principal determinant of the nominal value of total output is one of the oldest in economic thought; it is implied by the equation of exchange, assuming the stability of velocity. Classical economists stressed the long run and thus the determination of the economy’s potential output. This meant
that changes in the price level were, in the long run, the result of changes in the money supply. At roughly the same time Keynesian economics was emerging as the dominant school of macroeconomic thought, some economists focused on changes in the money supply as the primary determinant of changes in the nominal value of output. Led by Milton Friedman, they stressed the role of changes in the money supply as the principal determinant of changes in nominal output in the short run as well as in the long run. They argued that fiscal policy had no effect on the economy. Their “money rules” doctrine led to the name monetarists. The monetarist school holds that changes in the money supply are the primary cause of changes in nominal GDP. 17.2.3 https://socialsci.libretexts.org/@go/page/21785 Monetarists generally argue that the impact lags of monetary policy—the lags from the time monetary policy is undertaken to the time the policy affects nominal GDP—are so long and variable that trying to stabilize the economy using monetary policy can be destabilizing. Monetarists thus are critical of activist stabilization policies. They argue that, because of crowding-out effects, fiscal policy has no effect on GDP. Monetary policy does, but it should not be used. Instead, most monetarists urge the Fed to increase the money supply at a fixed annual rate, preferably the rate at which potential output rises. With stable velocity, that would eliminate inflation in the long run. Recessionary or inflationary gaps could occur in the short run, but monetarists generally argue that selfcorrection will take care of them more effectively than would activist monetary policy. While monetarists differ from Keynesians in their assessment of the impact of fiscal policy, the primary difference in the two schools lies in their degree of optimism about whether stabilization policy can, in fact, be counted on to bring the economy back to its potential output. For monetarists, the complexity of economic life and the uncertain nature of lags mean that efforts to use monetary policy to stabilize the economy can be destabilizing. Monetarists argued that the difficulties encountered by policy makers as they tried to respond to the dramatic events of the 1970s demonstrated the superiority of a policy that simply increased the money supply at a slow, steady rate. Monetarists could also cite the apparent validity of an adjustment mechanism proposed by Milton Friedman in 1968. As the economy continued to expand in the 1960s,
and as unemployment continued to fall, Friedman said that unemployment had fallen below its natural rate, the rate consistent with equilibrium in the labor market. Any divergence of unemployment from its natural rate, he insisted, would necessarily be temporary. He suggested that the low unemployment of 1968 (the rate was 3.6% that year) meant that workers had been surprised by rising prices. Higher prices had produced a real wage below what workers and firms had expected. Friedman predicted that as workers demanded and got higher nominal wages, the price level would shoot up and unemployment would rise. That, of course, is precisely what happened in 1970 and 1971. Friedman’s notion of the natural rate of unemployment buttressed the monetarist argument that the economy moves to its potential output on its own. Perhaps the most potent argument from the monetarist camp was the behavior of the economy itself. During the 1960s, monetarist and Keynesian economists alike could argue that economic performance was consistent with their respective views of the world. Keynesians could point to expansions in economic activity that they could ascribe to expansionary fiscal policy, but economic activity also moved closely with changes in the money supply, just as monetarists predicted. During the 1970s, however, it was difficult for Keynesians to argue that policies that affected aggregate demand were having the predicted impact on the economy. Changes in aggregate supply had repeatedly pushed the economy off a Keynesian course. But monetarists, once again, could point to a consistent relationship between changes in the money supply and changes in economic activity. Figure 32.8 shows the movement of nominal GDP and M2 during the 1960s and 1970s. In the figure, annual percentage changes in M2 are plotted against percentage changes in nominal GDP a year later to account for the lagged effects of changes in the money supply. We see that there was a close relationship between changes in the quantity of money and subsequent changes in nominal GDP. Figure 32.8 M2 and Nominal GDP, 1960–1980 The chart shows annual rates of change in M2 and in nominal GDP, lagged one year. The observation for 1961, for example, shows that nominal GDP increased 3.5% and that M2 increased 4.9% in the previous year, 1960. The two variables showed a close relationship in the 1960s and 1970s. Monetarist doctrine emerged as a potent challenge to Keynesian economics in the 1970s largely because of the close correspondence between nominal GDP and the money supply. The next section examines another school of thought that
came to prominence in the 1970s. 17.2.4 https://socialsci.libretexts.org/@go/page/21785 New Classical Economics: A Focus on Aggregate Supply Much of the difficulty policy makers encountered during the decade of the 1970s resulted from shifts in aggregate supply. Keynesian economics and, to a lesser degree, monetarism had focused on aggregate demand. As it became clear that an analysis incorporating the supply side was an essential part of the macroeconomic puzzle, some economists turned to an entirely new way of looking at macroeconomic issues. These economists started with what we identified at the beginning of this text as a distinguishing characteristic of economic thought: a focus on individuals and their decisions. Keynesian economics employed aggregate analysis and paid little attention to individual choices. Monetarist doctrine was based on the analysis of individuals’ maximizing behavior with respect to money demand, but it did not extend that analysis to decisions that affect aggregate supply. The new approach aimed at an analysis of how individual choices would affect the entire spectrum of economic activity. These economists rejected the entire framework of conventional macroeconomic analysis. Indeed, they rejected the very term. For them there is no macroeconomics, nor is there something called microeconomics. For them, there is only economics, which they regard as the analysis of behavior based on individual maximization. The analysis of the determination of the price level and real GDP becomes an application of basic economic theory, not a separate body of thought. The approach to macroeconomic analysis built from an analysis of individual maximizing choices is called new classical economics. Like classical economic thought, new classical economics focuses on the determination of long-run aggregate supply and the economy’s ability to reach this level of output quickly. But the similarity ends there. Classical economics emerged in large part before economists had developed sophisticated mathematical models of maximizing behavior. The new classical economics puts mathematics to work in an extremely complex way to generalize from individual behavior to aggregate results. Because the new classical approach suggests that the economy will remain at or near its potential output, it follows that the changes we observe in economic activity result not from changes in aggregate demand but from changes in long-run aggregate supply. New classical economics suggests that economic changes don’t necessarily imply economic problems. New classical economists pointed to the supply-side shocks of the 1970s, both from changes in oil prices and changes in expectations, as evidence that their emphasis on aggregate supply was on the mark. They argued that the large observed
swings in real GDP reflected underlying changes in the economy’s potential output. The recessionary and inflationary gaps that so perplexed policy makers during the 1970s were not gaps at all, the new classical economists insisted. Instead, they reflected changes in the economy’s own potential output. Two particularly controversial propositions of new classical theory relate to the impacts of monetary and of fiscal policy. Both are implications of the rational expectations hypothesis, which assumes that individuals form expectations about the future based on the information available to them, and that they act on those expectations. The rational expectations hypothesis suggests that monetary policy, even though it will affect the aggregate demand curve, might have no effect on real GDP. This possibility, which was suggested by Robert Lucas, is illustrated in Figure 32.9. Suppose the economy is initially in equilibrium at point 1 in Panel (a). Real GDP equals its potential output, Y. Now suppose a reduction in the money supply causes aggregate demand to fall to AD. In our model, the solution moves to point 2; the price level falls to P, and real GDP falls to Y. There is a recessionary gap. In the long run, the short-run aggregate supply curve shifts to SRAS, the price level falls to P, and the economy returns to its potential output at point 3. P 2 2 2 2 3 17.2.5 https://socialsci.libretexts.org/@go/page/21785 Figure 32.9 Contractionary Monetary Policy: With and Without Rational Expectations Panels (a) and (b) show an economy operating at potential output (1); a contractionary monetary policy shifts aggregate demand to AD. Panel (a) shows the kind of response we have studied up to this point; real GDP falls to Y in period (2); the recessionary gap is closed in the long run by 2 falling nominal wages that cause an increase in short-run aggregate supply in period (3). Panel (b) shows the rational expectations argument. People anticipate the impact of the contractionary policy when it is undertaken, so that the short-run aggregate supply curve shifts to the right at the same time the aggregate demand curve shifts to the left. The result is a reduction in the price level but no change in real GDP; the solution moves from (1) to (2). 2 The new classical story is quite different. Consumers and firms observe that the money supply has fallen and anticipate the eventual reduction in the price level to P. They adjust their
expectations accordingly. Workers agree to lower nominal wages, and the short-run aggregate supply curve shifts to SRAS. This occurs as aggregate demand falls. As suggested in Panel (b), the price level falls to P, and output remains at potential. The solution moves from (1) to (2) with no loss in real GDP. 2 3 3 In this new classical world, there is only one way for a change in the money supply to affect output, and that is for the change to take people by surprise. An unexpected change cannot affect expectations, so the short-run aggregate supply curve does not shift in the short run, and events play out as in Panel (a). Monetary policy can affect output, but only if it takes people by surprise. The new classical school offers an even stronger case against the operation of fiscal policy. It argues that fiscal policy does not shift the aggregate demand curve at all! Consider, for example, an expansionary fiscal policy. Such a policy involves an increase in government purchases or transfer payments or a cut in taxes. Any of these policies will increase the deficit or reduce the surplus. New classical economists argue that households, when they observe the government carrying out a policy that increases the debt, will anticipate that they, or their children, or their children’s children, will end up paying more in taxes. And, according to the new classical story, these households will reduce their consumption as a result. This will, the new classical economists argue, cancel any tendency for the expansionary policy to affect aggregate demand. Lessons from the 1970s The 1970s put Keynesian economics and its prescription for activist policies on the defensive. The period lent considerable support to the monetarist argument that changes in the money supply were the primary determinant of changes in the nominal level of GDP. A series of dramatic shifts in aggregate supply gave credence to the new classical emphasis on long-run aggregate supply as the primary determinant of real GDP. Events did not create the new ideas, but they produced an environment in which those ideas could win greater support. For economists, the period offered some important lessons. These lessons, as we will see in the next section, forced a rethinking of some of the ideas that had dominated Keynesian thought. The experience of the 1970s suggested the following: 1. The short-run aggregate supply curve could not be viewed as something that provided a passive path over which aggregate demand could roam. The short-run aggregate supply curve could shift in ways that clearly affected real GDP, unemployment
, and the price level. 2. Money mattered more than Keynesians had previously suspected. Keynes had expressed doubts about the effectiveness of monetary policy, particularly in the face of a recessionary gap. Work by monetarists suggested a close correspondence between changes in M2 and subsequent changes in nominal GDP, convincing many Keynesian economists that money was more important than they had thought. 3. Stabilization was a more difficult task than many economists had anticipated. Shifts in aggregate supply could frustrate the efforts of policy makers to achieve certain macroeconomic goals. 17.2.6 https://socialsci.libretexts.org/@go/page/21785 Key Takeaways Beginning in 1961, expansionary fiscal and monetary policies were used to close a recessionary gap; this was the first major U.S. application of Keynesian macroeconomic policy. The experience of the 1960s and 1970s appeared to be broadly consistent with the monetarist argument that changes in the money supply are the primary determinant of changes in nominal GDP. The new classical school’s argument that the economy operates at its potential output implies that real GDP is determined by long-run aggregate supply. The experience of the 1970s, in which changes in aggregate supply forced changes in real GDP and in the price level, seemed consistent with the new classical economists’ arguments that focused on aggregate supply. The experience of the 1970s suggested that changes in the money supply and in aggregate supply were more important determinants of economic activity than many Keynesians had previously thought. Try It! Draw the aggregate demand and the short-run and long-run aggregate supply curves for an economy operating with an inflationary gap. Show how expansionary fiscal and/or monetary policies would affect such an economy. Now show how this economy could experience a recession and an increase in the price level at the same time.  Case in Point: Tough Medicine Figure 32.10 Wikimedia Commons – public domain. The Keynesian prescription for an inflationary gap seems simple enough. The federal government applies contractionary fiscal policy, or the Fed applies contractionary monetary policy, or both. But what seems simple in a graph can be maddeningly difficult in the real world. The medicine for an inflationary gap is tough, and it is tough to take. President Johnson’s new chairman of the Council of Economic Advisers, Gardner Ackley, urged the president in 1965 to adopt fiscal policies aimed at nudging the aggregate demand curve back to the left. The president
reluctantly agreed and called in the chairman of the House Ways and Means Committee, the committee that must initiate all revenue measures, to see what he thought of the idea. Wilbur Mills flatly told Johnson that he wouldn’t even hold hearings to consider a tax increase. For the time being, the tax boost was dead. 17.2.7 https://socialsci.libretexts.org/@go/page/21785 The Federal Reserve System did slow the rate of money growth in 1966. But fiscal policy remained sharply expansionary. Mr. Ackley continued to press his case, and in 1967 President Johnson proposed a temporary 10% increase in personal income taxes. Mr. Mills now endorsed the measure. The temporary tax boost went into effect the following year. The Fed, concerned that the tax hike would be too contractionary, countered the administration’s shift in fiscal policy with a policy of vigorous money growth in 1967 and 1968. The late 1960s suggested a sobering reality about the new Keynesian orthodoxy. Stimulating the economy was politically more palatable than contracting it. President Kennedy, while he was not able to win approval of his tax cut during his lifetime, did manage to put the other expansionary aspects of his program into place early in his administration. The Fed reinforced his policies. Dealing with an inflationary gap proved to be quite another matter. President Johnson, a master of the legislative process, took three years to get even a mildly contractionary tax increase put into place, and the Fed acted to counter the impact of this measure by shifting to an expansionary policy. The second half of the 1960s was marked, in short, by persistent efforts to boost aggregate demand, efforts that kept the economy in an inflationary gap through most of the decade. It was a gap that would usher in a series of supply-side troubles in the next decade. Answer to Try It! Problem Even with an inflationary gap, it is possible to pursue expansionary fiscal and monetary policies, shifting the aggregate demand curve to the right, as shown. The inflationary gap will, however, produce an increase in nominal wages, reducing short-run aggregate supply over time. In the case shown here, real GDP rises at first, then falls back to potential output with the reduction in short-run aggregate supply. Figure 32.11 17.2.8 https://socialsci.libretexts.org/@go/page/21785 This page titled 17.2: Keynes
ian Economics in the 1960s and 1970s is shared under a CC BY-NC-SA 3.0 license and was authored, remixed, and/or curated by Anonymous. 32.2: Keynesian Economics in the 1960s and 1970s by Anonymous is licensed CC BY-NC-SA 3.0. Original source: https://2012books.lardbucket.org/books/economics-principles-v2.0/. 17.2.9 https://socialsci.libretexts.org/@go/page/21785 17.3: 32.3:. An Emerging Consensus: Macroeconomics for the Twenty-First Century  Learning Objective 1. Discuss how the Fed incorporated a strong inflation constraint and lags into its policies from the 1980s onwards. 2. Describe the fiscal policies that were undertaken from the 1980s onwards and their rationales. 3. Discuss the challenges that events from the 1980s onwards raised for the monetarist and new classical schools of thought. 4. Summarize the views and policy approaches of the new Keynesian school of economic thought. The last two decades of the twentieth century brought progress in macroeconomic policy and in macroeconomic theory. The outlines of a broad consensus in macroeconomic theory began to take shape in the 1980s. This consensus has grown out of the three bodies of macroeconomic thought that, in turn, grew out of the experiences of the twentieth century. Keynesian economics, monetarism, and new classical economics all developed from economists’ attempts to understand macroeconomic change. We shall see how all three schools of macroeconomic thought have contributed to the development of a new school of macroeconomic thought: the new Keynesian school. New Keynesian economics is a body of macroeconomic thought that stresses the stickiness of prices and the need for activist stabilization policies through the manipulation of aggregate demand to keep the economy operating close to its potential output. It incorporates monetarist ideas about the importance of monetary policy and new classical ideas about the importance of aggregate supply, both in the long and in the short run. Another “new” element in new Keynesian economic thought is the greater use of microeconomic analysis to explain macroeconomic phenomena, particularly the analysis of price and wage stickiness. We saw in the chapter that introduced the model of aggregate demand and aggregate supply, for example, that sticky prices and wages may be a response to the preferences of consumers and of firms. That idea emerged from research by
economists of the new Keynesian school. New Keynesian ideas guide macroeconomic policy; they are the basis for the model of aggregate demand and aggregate supply with which we have been working. To see how the new Keynesian school has come to dominate macroeconomic policy, we shall review the major macroeconomic events and policies of the 1980s, 1990s, and early 2000s. The 1980s and Beyond: Advances in Macroeconomic Policy The exercise of monetary and of fiscal policy has changed dramatically in the last few decades. The Revolution in Monetary Policy It is fair to say that the monetary policy revolution of the last two decades began on July 25, 1979. On that day, President Jimmy Carter appointed Paul Volcker to be chairman of the Fed’s Board of Governors. Mr. Volcker, with President Carter’s support, charted a new direction for the Fed. The new direction damaged Mr. Carter politically but ultimately produced dramatic gains for the economy. Oil prices rose sharply in 1979 as war broke out between Iran and Iraq. Such an increase would, by itself, shift the short-run aggregate supply curve to the left, causing the price level to rise and real GDP to fall. But expansionary fiscal and monetary policies had pushed aggregate demand up at the same time. As a result, real GDP stayed at potential output, while the price level soared. The implicit price deflator jumped 8.1%; the CPI rose 13.5%, the highest inflation rate recorded in the twentieth century. Public opinion polls in 1979 consistently showed that most people regarded inflation as the leading problem facing the nation. 17.3.1 https://socialsci.libretexts.org/@go/page/21786 Figure 32.12 The Fed’s Fight Against Inflation By 1979, expansionary fiscal and monetary policies had brought the economy to its potential output. Then war between Iran and Iraq caused oil prices to increase, shifting the short-run aggregate supply curve to the left. In the second half of 1979, the Fed launched an aggressive contractionary policy aimed at reducing inflation. The Fed’s action shifted the aggregate demand curve to the left. The result in 1980 was a recession with continued inflation. Chairman Volcker charted a monetarist course of fixing the growth rate of the money supply at a rate that would bring inflation down. After the high rates of money growth of the past, the policy was sharply contractionary. Its first effects were to shift the aggregate demand curve to the left. Continued oil price
increases produced more leftward shifts in the short-run aggregate supply curve, and the economy suffered a recession in 1980. Inflation remained high. Figure 32.12 shows how the combined shifts in aggregate demand and short-run aggregate supply produced a reduction in real GDP and an increase in the price level. The Fed stuck to its contractionary guns, and the inflation rate finally began to fall in 1981. But the recession worsened. Unemployment soared, shooting above 10% late in the year. It was the worst recession since the Great Depression. The inflation rate, though, fell sharply in 1982, and the Fed began to shift to a modestly expansionary policy in 1983. But inflation had been licked. Inflation, measured by the implicit price deflator, dropped to a 4.1% rate that year, the lowest since 1967. The Fed’s actions represented a sharp departure from those of the previous two decades. Faced with soaring unemployment, the Fed did not shift to an expansionary policy until inflation was well under control. Inflation continued to edge downward through most of the remaining years of the 20th century and into the new century. The Fed has clearly shifted to a stabilization policy with a strong inflation constraint. It shifts to expansionary policy when the economy has a recessionary gap, but only if it regards inflation as being under control. This concern about inflation was evident again when the U.S. economy began to weaken in 2008, and there was initially discussion among the members of the Federal Open Market Committee about whether or not easing would contribute to inflation. At that time, it looked like inflation was becoming a more serious problem, largely due to increases in oil and other commodity prices. Some members of the Fed, including Chairman Bernanke, argued that these price increases were likely to be temporary and the Fed began using expansionary monetary policy early on. By late summer and early fall, inflationary pressures had subsided, and all the members of the FOMC were behind continued expansionary policy. Indeed, at that point, the Fed let it be known that it was willing to do anything in its power to fight the current recession. The next major advance in monetary policy came in the 1990s, under Federal Reserve Chairman Alan Greenspan. The Fed had shifted to an expansionary policy as the economy slipped into a recession when Iraq’s invasion of Kuwait in 1990 began the Persian Gulf War and sent oil prices soaring. By early 1994, real GDP was rising, but the economy remained in a recessionary gap
. Nevertheless, the Fed announced on February 4, 1994, that it had shifted to a contractionary policy, selling bonds to boost interest rates and to reduce the money supply. While the economy had not reached its potential output, Chairman Greenspan explained that the Fed was concerned that it might push past its potential output within a year. The Fed, for the first time, had explicitly taken the impact lag of monetary policy into account. The issue of lags was also a part of Fed discussions in the 2000s. Fiscal Policy: A Resurgence of Interest President Ronald Reagan, whose 1980 election victory was aided by a recession that year, introduced a tax cut, combined with increased defense spending, in 1981. While this expansionary fiscal policy was virtually identical to the policy President Kennedy had introduced 20 years earlier, President Reagan rejected Keynesian economics, embracing supply-side arguments instead. He 17.3.2 https://socialsci.libretexts.org/@go/page/21786 argued that the cut in tax rates, particularly in high marginal rates, would encourage work effort. He reintroduced an investment tax credit, which stimulated investment. With people working harder and firms investing more, he expected long-run aggregate supply to increase more rapidly. His policy, he said, would stimulate economic growth. The tax cut and increased defense spending increased the federal deficit. Increased spending for welfare programs and unemployment compensation, both of which were induced by the plunge in real GDP in the early 1980s, contributed to the deficit as well. As deficits continued to rise, they began to dominate discussions of fiscal policy. In 1990, with the economy slipping into a recession, President George H. W. Bush agreed to a tax increase despite an earlier promise not to do so. President Bill Clinton, whose 1992 election resulted largely from the recession of 1990–1991, introduced another tax increase in 1994, with the economy still in a recessionary gap. Both tax increases were designed to curb the rising deficit. Congress in the first years of the 1990s rejected the idea of using an expansionary fiscal policy to close a recessionary gap on grounds it would increase the deficit. President Clinton, for example, introduced a stimulus package of increased government investment and tax cuts designed to stimulate private investment in 1993; a Democratic Congress rejected the proposal. The deficit acted like a straitjacket for fiscal policy. The Bush and Clinton tax increases, coupled with spending restraint and increased revenues from economic growth, brought an end to the deficit in 1998. Initially,
it was expected that the budget surplus would continue well into the new century. But, this picture changed rapidly. President George W. Bush campaigned on a platform of large tax cuts, arguing that less government intervention in the economy would be good for long-term economic growth. His administration saw the enactment of two major pieces of tax-cutting legislation in 2001 and 2003. Coupled with increases in government spending, in part for defense but also for domestic purposes including a Medicare prescription drug benefit, the government budget surpluses gave way to budget deficits. To deal with times of economic weakness during President Bush’s administration, temporary tax cuts were enacted, both in 2001 and again in 2008. As the economy continued to weaken in 2008, there seemed to be a resurgence of interest in using discretionary increases in government spending, as discussed in the Case in Point, to respond to the recession. Three factors were paramount: (1) the temporary tax cuts had provided only a minor amount of stimulus to the economy, as sizable portions had been used for saving rather than spending, (2) expansionary monetary policy, while useful, had not seemed adequate, and (3) the recession threatening the global economy seemed to be larger than those in recent economic history. The Rise of New Keynesian Economics New Keynesian economics emerged in the last three decades as the dominant school of macroeconomic thought for two reasons. First, it successfully incorporated important monetarist and new classical ideas into Keynesian economics. Second, developments in the 1980s and 1990s shook economists’ confidence in the ability of the monetarist or the new classical school alone to explain macroeconomic change. Monetary Change and Monetarism Look again at Figure 32.8. The close relationship between M2 and nominal GDP in the 1960s and 1970s helped win over many economists to the monetarist camp. Now look at Figure 32.13. It shows the same two variables, M2 and nominal GDP, from the 1980s through 2009. The tidy relationship between the two seems to have vanished. What happened? Figure 32.13 M2 and Nominal GDP, 1980–2009 The close relationship between M2 and nominal GDP a year later that had prevailed in the 1960s and 1970s seemed to vanish from the 1980s onward. 17.3.3 https://socialsci.libretexts.org/@go/page/21786 The close relationship between M2 and nominal GDP a year later that had prevailed in the 1960s and 1970s seemed to vanish from the
1980s onward. The sudden change in the relationship between the money stock and nominal GDP has resulted partly from public policy. Deregulation of the banking industry in the early 1980s produced sharp changes in the ways individuals dealt with money, thus changing the relationship of money to economic activity. Banks have been freed to offer a wide range of financial alternatives to their customers. One of the most important developments has been the introduction of bond funds offered by banks. These funds allowed customers to earn the higher interest rates paid by long-term bonds while at the same time being able to transfer funds easily into checking accounts as needed. Balances in these bond funds are not counted as part of M2. As people shifted assets out of M2 accounts and into bond funds, velocity rose. That changed the once-close relationship between changes in the quantity of money and changes in nominal GDP. Many monetarists have argued that the experience of the 1980s, 1990s, and 2000s reinforces their view that the instability of velocity in the short run makes monetary policy an inappropriate tool for short-run stabilization. They continue to insist, however, that the velocity of M2 remains stable in the long run. But the velocity of M2 appears to have diverged in recent years from its long-run path. Although it may return to its long-run level, the stability of velocity remains very much in doubt. Because of this instability, in 2000, when the Fed was no longer required by law to report money target ranges, it discontinued the practice. The New Classical School and Responses to Policy New classical economics suggests that people should have responded to the fiscal and monetary policies of the 1980s in predictable ways. They did not, and that has created new doubts among economists about the validity of the new classical argument. The rational expectations hypothesis predicts that if a shift in monetary policy by the Fed is anticipated, it will have no effect on real GDP. The slowing in the rate of growth of the money supply over the period from 1979 to 1982 was surely well known. The Fed announced at the outset what it was going to do, and then did it. It had the full support first of President Carter and then of President Reagan. But the policy plunged the economy into what was then its worst recession since the Great Depression. The experience hardly seemed consistent with new classical logic. New classical economists argued that people may have doubted the Fed would keep its word, but the episode still cast doubt on the rational expectations argument. The public’s response to the huge
deficits of the Reagan era also seemed to belie new classical ideas. One new classical argument predicts that people will increase their saving rate in response to an increase in public sector borrowing. The resultant reduction in consumption will cancel the impact of the increase in deficit-financed government expenditures. But the private saving rate in the United States fell during the 1980s. New classical economists contend that standard measures of saving do not fully represent the actual saving rate, but the experience of the 1980s did not seem to support the new classical argument. The events of the 1980s do not suggest that either monetarist or new classical ideas should be abandoned, but those events certainly raised doubts about relying solely on these approaches. Doubts about Keynesian economics raised by the events of the 1970s led Keynesians to modify and strengthen their approach. Perhaps the events of the 1980s and 1990s will produce similar progress within the monetarist and new classical camps. A Macroeconomic Consensus? While there is less consensus on macroeconomic policy issues than on some other economic issues (particularly those in the microeconomic and international areas), surveys of economists generally show that the new Keynesian approach has emerged as the preferred approach to macroeconomic analysis. The finding that about 80% of economists agree that expansionary fiscal measures can deal with recessionary gaps certainly suggests that most economists can be counted in the new Keynesian camp. Neither monetarist nor new classical analysis would support such measures. At the same time, there is considerable discomfort about actually using discretionary fiscal policy, as the same survey shows that about 70% of economists feel that discretionary fiscal policy should be avoided and that the business cycle should be managed by the Fed (Fuller & Geide-Stevenson, 2003). Just as the new Keynesian approach appears to have won support among most economists, it has become dominant in terms of macroeconomic policy. Did the experience of the 2007-2009 recession affect the views of economists concerning macroeconomic policy? One source for gauging possible changes in opinions of economists is the National Association For Business Economics twice yearly survey of economic policy (National Association for Business Economics, 2009). According to the August 2010 survey of 242 members of NABE, almost 60% were supportive of monetary policy at that time, which was expansionary and continued to be so at least through 2010. Concerning fiscal policy, there was less agreement. Still, according to the survey taken at the time the 2009 fiscal 17.3.4 https://socialsci.libretexts.org/@go/page
/21786 stimulus was being debated, 22% characterized it as “about right,” another third found it too restrictive, and only one third found it too simulative. In the August 2010 survey, 39% thought fiscal policy “about right,” 24% found it too restrictive, and 37% found it too simulative. Also, nearly 75% ranked promotion of economic growth more important than deficit reduction, roughly two thirds supported the extension of unemployment benefits, and 60% agreed that federal assistance funds to states from the 2009 stimulus package was appropriate. Taken together, the new Keynesian approach still seems to reflect the dominant opinion. Key Takeaways The actions of the Fed starting in late 1979 reflected a strong inflation constraint and a growing recognition of the impact lag for monetary policy. Reducing the deficit dominated much of fiscal policy discussion during the 1980s and 1990s. The events of the 1980s and early 1990s do not appear to have been consistent with the hypotheses of either the monetarist or new classical schools. New Keynesian economists have incorporated major elements of the ideas of the monetarist and new classical schools into their formulation of macroeconomic theory. Try It! Show the effect of an expansionary monetary policy on real GDP 1. according to new Keynesian economics 2. according to the rational expectations hypothesis In both cases, consider both the short-run and the long-run effects.  Case in Point: Steering on a Difficult Course Figure 32.14 Sean MacEntee – steering wheel – CC BY 2.0. Imagine that you are driving a test car on a special course. You get to steer, accelerate, and brake, but you cannot be sure whether the car will respond to your commands within a few feet or within a few miles. The windshield and side windows are blackened, so you cannot see where you are going or even where you are. You can only see where you have been with the rear-view mirror. The course is designed so that you will face difficulties you have never experienced. Your job is to get through the course unscathed. Oh, and by the way, you have to observe the speed limit, but you do not know what it is. Have a nice trip. Now imagine that the welfare of people all over the world will be affected by how well you drive the course. They are watching you. They are giving you a great deal of often-conflicting advice about what you should do. Thinking about the problems you would face driving such
a car will give you some idea of the obstacle course fiscal and monetary authorities must negotiate. They 17.3.5 https://socialsci.libretexts.org/@go/page/21786 cannot know where the economy is going or where it is—economic indicators such as GDP and the CPI only suggest where the economy has been. And the perils through which it must steer can be awesome indeed. One policy response that most acknowledge as having been successful was how the Fed dealt with the financial crises in Southeast Asia and elsewhere that shook the world economy in 1997 and 1998. There were serious concerns at the time that economic difficulties around the world would bring the high-flying U.S. economy to its knees and worsen an already difficult economic situation in other countries. The Fed had to steer through the pitfalls that global economic crises threw in front of it. In the fall of 1998, the Fed chose to accelerate to avoid a possible downturn. The Federal Open Market Committee (FOMC) engaged in expansionary monetary policy by lowering its target for the federal funds rate. Some critics argued at the time that the Fed’s action was too weak to counter the impact of world economic crisis. Others, though, criticized the Fed for undertaking an expansionary policy when the U.S. economy seemed already to be in an inflationary gap. In the summer of 1999, the Fed put on the brakes, shifting back to a slightly contractionary policy. It raised the target for the federal funds rate, first to 5.0% and then to 5.25%. These actions reflected concern about speeding when in an inflationary gap. But was the economy speeding? Was it in an inflationary gap? Certainly, the U.S. unemployment rate of 4.2% in the fall of 1999 stood well below standard estimates of the natural rate of unemployment. There were few, if any, indications that inflation was a problem, but the Fed had to recognize that inflation might not appear for a very long time after the Fed had taken a particular course. As noted in the text, this was also during a time when the once-close relationship between money growth and nominal GDP seemed to break down. The shifts in demand for money created unexplained and unexpected changes in velocity. The outcome of the Fed’s actions has been judged a success. While with 20/20 hindsight the Fed’s decisions might seem obvious, in fact it was steering a car whose performance seemed less and less predictable over a course that was becoming more
and more treacherous. Since 2008, both the Fed and the government have been again trying to get the economy back on track. In this case, the car is already in the ditch. The Fed has decided on a “no holds barred” approach. It has moved aggressively to lower the federal funds rate target and engaged in a variety of other measures to improve liquidity to the banking system, to lower other interest rates by purchasing longer-term securities (such as 10-year treasuries and those of Fannie Mae and Freddie Mac), and, working with the Treasury Department, to provide loans related to consumer and business debt. The Obama administration for its part advocated and Congress passed a massive spending and tax relief package of about $800 billion. Besides the members of his economic team, many economists seem to be on board in using discretionary fiscal policy in this instance. Federal Reserve Bank of San Francisco President Janet Yellen put it this way: “The new enthusiasm for fiscal stimulus, and particularly government spending, represents a huge evolution in mainstream thinking.” A notable convert to using fiscal policy to deal with this recession was Harvard economist and former adviser to President Ronald Reagan, Martin Feldstein. His spending proposal encouraged increased military spending and he stated, “While good tax policy can contribute to ending the recession, the heavy lifting will have to be done by increased government spending.” Predictably, not all economists have jumped onto the fiscal policy bandwagon. Concerns included whether so-called shovel-ready projects could really be implemented in time, whether government spending would crowd out private spending, whether monetary policy alone was providing enough stimulus, and whether the spending would flow efficiently to truly worthwhile projects. According to University of California-Berkeley economist Alan J. Auerbach, “We have spent so many years thinking that discretionary fiscal policy was a bad idea, that we have not figured out the right things to do to cure a recession that is scaring all of us.” Sources: Ben S. Bernanke, “The Crisis and the Policy Response” (speech, London School of Economics, January 13, 2009); Louis Uchitelle, “Economists Warm to Government Spending but Debate Its Form,” New York Times, January 7, 2009, p. B1. Answer to Try It! Problem Panel (a) shows an expansionary monetary policy according to new Keynesian economics. Aggregate demand increases, with no immediate reduction in short-run aggregate supply. Real GDP rises to Y.
In the long run, nominal wages rise, reducing short-run aggregate supply and returning real GDP to potential. Panel (b) shows what happens with rational expectations. When the Fed increases the money supply, people anticipate the rise in prices. Workers and firms agree to an increase in nominal wages, so that there is a reduction in short-run aggregate supply at the same time there is an increase in aggregate demand. The result is no change in real GDP; it remains at potential. There is, however, an increase in the price level. 2 Figure 32.15 17.3.6 https://socialsci.libretexts.org/@go/page/21786 References Fuller, D., and Doris Geide-Stevenson, “Consensus among Economists: Revisited,” Journal of Economic Education 34, no. 4 (Fall 2003): 369–87. National Association for Business Economics, Economic Policy Surveys, March 2009 and August 2010. Available at www.nabe.com. This page titled 17.3: 32.3:. An Emerging Consensus: Macroeconomics for the Twenty-First Century is shared under a CC BY-NC-SA 3.0 license and was authored, remixed, and/or curated by Anonymous. 32.3: 32.3:. An Emerging Consensus: Macroeconomics for the Twenty-First Century by Anonymous is licensed CC BY-NC-SA 3.0. Original source: https://2012books.lardbucket.org/books/economics-principles-v2.0/. 17.3.7 https://socialsci.libretexts.org/@go/page/21786 17.4: Review and Practice Summary We have surveyed the experience of the United States in light of the economic theories that prevailed or emerged during five decades. We have seen that events in the past century have had significant effects on the ways in which economists look at and interpret macroeconomic ideas. Before the Great Depression, macroeconomic thought was dominated by the classical school. That body of theory stressed the economy’s ability to reach full employment equilibrium on its own. The severity and duration of the Depression caused many economists to rethink their acceptance of natural equilibrating forces in the economy. John Maynard Keynes issued the most telling challenge. He argued that wage rigidities and other factors could prevent the economy from closing a recessionary gap on its own. Further, he showed that expansion
ary fiscal and monetary policies could be used to increase aggregate demand and move the economy to its potential output. Although these ideas did not immediately affect U.S. policy, the increases in aggregate demand brought by the onset of World War II did bring the economy to full employment. Many economists became convinced of the validity of Keynes’s analysis and his prescriptions for macroeconomic policy. Keynesian economics dominated economic policy in the United States in the 1960s. Fiscal and monetary policies increased aggregate demand and produced what was then the longest expansion in U.S. history. But the economy pushed well beyond full employment in the latter part of the decade, and inflation increased. While Keynesians were dominant, monetarist economists argued that it was monetary policy that accounted for the expansion of the 1960s and that fiscal policy could not affect aggregate demand. Efforts by the Nixon administration in 1969 and 1970 to cool the economy ran afoul of shifts in the short-run aggregate supply curve. The ensuing decade saw a series of shifts in aggregate supply that contributed to three more recessions by 1982. As economists studied these shifts, they developed further the basic notions we now express in the aggregate demand–aggregate supply model: that changes in aggregate demand and aggregate supply affect income and the price level; that changes in fiscal and monetary policy can affect aggregate demand; and that in the long run, the economy moves to its potential level of output. The events of the 1980s and beyond raised serious challenges for the monetarist and new classical schools. New Keynesian economists formulated revisions in their theories, incorporating many of the ideas suggested by monetarist and new classical economists. The new, more powerful theory of macroeconomic events has won considerable support among economists today. Problems 1. “For many years, the hands-off fiscal policies advocated by the classical economists held sway with American government. When times were hard, the prevailing response was to tough it out, awaiting the ‘inevitable’ turnaround. The lessons of the Great Depression and a booming wartime economy have since taught us, however, that government intervention is sometimes necessary and desirable—and that to an extent, we can take charge of our own economic lives.” Evaluate the foregoing quotation based upon the discussion in this chapter. How would you classify the speaker in terms of a school of economic thought? 2. In his 1982 Economic Report of the President, Ronald Reagan said, “We simply cannot blame crop failures and oil price increases for our basic inflation problem. The continuous, underlying cause was poor
government policy.” What policies might he have been referring to? 3. Many journalists blamed economic policies of the Reagan administration for the extremely high levels of unemployment in 1982 and 1983. Given the record of the rest of the decade, do you agree that President Reagan’s economic policies were a failure? Why or why not? 4. The day after the U.S. stock market crash of October 19, 1987, Federal Reserve Board Chairman Alan Greenspan issued the following statement: “The Federal Reserve, consistent with its responsibilities as the nation’s central bank, affirmed today its readiness to serve as a source of liquidity to support the economic and financial system.” Evaluate why the Fed chairman might have been prompted to make such a statement. 5. Compare the rationale of the Reagan administration for the 1981 tax reductions with the rationale behind the Kennedy–Johnson tax cut of 1964, the Bush tax cut of 2001, and the Bush tax cut of 2003. 17.4.1 https://socialsci.libretexts.org/@go/page/21787 6. If the economy is operating below its potential output, what kind of gap exists? What kinds of fiscal or monetary policies might you use to close this gap? Can you think of any objection to the use of such policies? 7. If the economy is operating above its potential output, what kind of gap exists? What kinds of fiscal or monetary policies might you use to close this gap? Can you think of any objection to the use of such policies? 8. In General Theory, Keynes wrote of the importance of ideas. The world, he said, is ruled by little else. How important do you think his ideas have been for economic policy today? 9. State whether each of the following events appears to be the result of a shift in short-run aggregate supply or aggregate demand, and state the direction of the shift involved. 1. The price level rises sharply while real GDP falls. 2. The price level and real GDP rise. 3. The price level falls while real GDP rises. 4. The price level and real GDP fall. 10. Explain whether each of the following events and policies will affect the aggregate demand curve or the short-run aggregate supply curve, and state what will happen to the price level and real GDP. 1. Oil prices rise 2. The Fed sells bonds 3. Government purchases increase 4. Federal taxes increase 5. The government slashes transfer payment spending 6. Oil prices fall 11. Using the model
of aggregate demand and aggregate supply, illustrate an economy with a recessionary gap. Show how a policy of nonintervention would ultimately close the gap. Show the alternative of closing the gap through stabilization policy. 12. Using the model of aggregate demand and aggregate supply, illustrate an economy with an inflationary gap. Show how a policy of nonintervention would ultimately close the gap. Show the alternative of closing the gap through stabilization policy. This page titled 17.4: Review and Practice is shared under a CC BY-NC-SA 3.0 license and was authored, remixed, and/or curated by Anonymous. 32.4: Review and Practice by Anonymous is licensed CC BY-NC-SA 3.0. Original source: https://2012books.lardbucket.org/books/economics-principles-v2.0/. 17.4.2 https://socialsci.libretexts.org/@go/page/21787 CHAPTER OVERVIEW 18: Inequality, Poverty, and Discrimination 18.1: Income Inequality 18.2: The Economics of Poverty 18.3: The Economics of Discrimination 18.4: Review and Practice Thumbnail: https://pixabay.com/illustrations/poverty-men-arm-wealth-begging-96293/ This page titled 18: Inequality, Poverty, and Discrimination is shared under a CC BY-NC-SA 3.0 license and was authored, remixed, and/or curated by Anonymous. 1 18.1: Income Inequality  Learning Objective 1. Explain how the Lorenz curve and the Gini coefficient provide information on a country’s distribution of income. 2. Discuss and evaluate the factors that have been looked at to explain changes in the distribution of income in the United States. Income inequality in the United States has soared in the last half century. Since 1967, real median household income has risen 30%. For the top 1%, incomes shot up by over 200%. Consider recent experience. Median household-size-adjusted disposable income rose 13% between 1988 and 2004. At the 75 percentile it rose 16%, at the 90 percentile 21%, and at the 95 percentile 27% (Burtless, G., 2007). th th th Increasingly, education is the key to a better material life. The gap between the average annual incomes of high school graduates and those with a bachelor’s degree increased by nearly a factor of five between 1975 and 2006
. Read that sentence again. The gap went from under $5,000 to over $23,000 per year. That is a phenomenal change in such a short period of time. A special study by the U.S. Census Bureau estimated that compared to the full-time year-around work-life earnings of a high school graduate, a person with a bachelors degree would earn 75% more, while a person with a professional degree would earn almost four times more over their working lifetime. Moreover, education is not an equal opportunity employer. A student from a family in the top quarter of the income distribution is six times more likely to get a college degree than a student whose family is in the bottom quarter of the income distribution. 1 That inequality perpetuates itself. College graduates marry other college graduates and earn higher incomes. Those who do not go to college earn lower incomes. Some may have children out of wedlock—an almost sure route to poverty. That does not, of course, mean that young people who go to college are assured high incomes while those who do not are certain to experience poverty, but the odds certainly push in that direction. We shall learn in this section how the degree of inequality can be measured. We shall examine the sources of rising inequality and consider what policy measures, if any, are suggested. In this section on inequality we are essentially focusing the way the economic pie is shared, while setting aside the important fact that the size of the economic pie has certainly grown over time. A Changing Distribution of Income We have seen that the income distribution has become more unequal. This section describes a graphical approach to measuring the equality, or inequality, of the distribution of income. Measuring Inequality The primary evidence of growing inequality is provided by census data. Households are asked to report their income, and they are ranked from the household with the lowest income to the household with the highest income. The Census Bureau then reports the percentage of total income earned by those households ranked among the bottom 20%, the next 20%, and so on, up to the top 20%. Each 20% of households is called a quintile. The bureau also reports the share of income going to the top 5% of households. Income distribution data can be presented graphically using a Lorenz curve, a curve that shows cumulative shares of income received by individuals or groups. It was developed by economist Max O. Lorenz in 1905. To plot the curve, we begin with the lowest quintile and mark a point to show the percentage of total income
those households received. We then add the next quintile and its share and mark a point to show the share of the lowest 40% of households. Then, we add the third quintile, and then the fourth. Since the share of income received by all the quintiles will be 100%, the last point on the curve always shows that 100% of households receive 100% of the income. If every household in the United States received the same income, the Lorenz curve would coincide with the 45-degree line drawn in Figure 19.1. The bottom 20% of households would receive 20% of income; the bottom 40% would receive 40%, and so on. If the distribution of income were completely unequal, with one household receiving all the income and the rest zero, then the Lorenz curve would be shaped like a backward L, with a horizontal line across the bottom of the graph at 0% of income and a vertical line up the right-hand side. The vertical line would show, as always, that 100% of families still receive 100% of income. Actual Lorenz curves lie between these extremes. The closer a Lorenz curve lies to the 45-degree line, the more equal the distribution. The more 18.1.1 https://socialsci.libretexts.org/@go/page/21789 bowed out the curve, the less equal the distribution. We see in Figure 19.1 that the Lorenz curve for the United States became more bowed out between 1968 and 2006. Figure 19.1 The Distribution of U.S. Income, 1968 and 2006 The distribution of income among households in the United States became more unequal from 1968 to 2006. The shares of income received by each of the first four quintiles fell, while the share received by the top 20% rose sharply. The Lorenz curve for 2006 was more bowed out than was the curve for 1968. (Mean income adjusted for inflation and reported in 2006 dollars; percentages do not sum to 100% due to rounding.) Sources: Carmen DeNavas-Walt, Bernadette D. Proctor, and Cheryl Hill Lee, U.S. Census Bureau, Current Population Reports, P60-229, Income, Poverty, and Health Insurance Coverage in the United States: 2004, U.S. Government Printing Office, Washington, DC, 2005, Table A-3; U.S. Census Bureau, Current Population Survey, 2005 Annual Social and Economic Supplement, Table HINC-05. The degree
of inequality is often measured with a Gini coefficient, the ratio between the Lorenz curve and the 45° line and the total area under the 45° line. The smaller the Gini coefficient, the more equal the income distribution. Larger Gini coefficients mean 18.1.2 https://socialsci.libretexts.org/@go/page/21789 more unequal distributions. The Census Bureau reported that the Gini coefficient was 0.397 in 1968 and 0.470 in 2006—the highest ever recorded for the United States (U.S. Census Bureau, 2006). Mobility and Income Distribution When we speak of the bottom 20% or the middle 20% of families, we are not speaking of a static group. Some families who are in the bottom quintile one year move up to higher quintiles in subsequent years; some families move down. Because people move up and down the distribution, we get a quite different picture of income change when we look at the incomes of a fixed set of persons over time rather than comparing average incomes for a particular quintile at a particular point in time, as was done in Figure 19.1. Addressing the question of mobility requires that researchers follow a specific group of families over a long period of time. Since 1968, the Panel Survey of Income Dynamics (PSID) at the University of Michigan has followed more than 5,000 families and their descendents. The effort has produced a much deeper understanding of changes in income inequality than it is possible to obtain from census data, which simply take a snapshot of incomes at a particular time. Based on the University of Michigan’s data, Federal Reserve Bank of Boston economists Katharine Bradbury and Jane Katz compared mobility in the 1970s, 1980s, and 1990s. In the 1970s, just under half the families in the poorest quintile at the start of that decade were still in that quintile at the end of that decade and overall about 32% of families moved up one quintile or more. The mobility figures for the 1980s were about the same as for the 1970s. In the 1990s, however, mobility declined. About 30% of families moved up one quintile or more and 53% of families that started the 1990s in the poorest quintile were still in that quintile at the end of the 1990s. In every decade, some of the movement to higher quintiles results simply from gaining age and experience. The researchers further comment that, for the 1990s, moving across quint
iles has become harder to achieve precisely because of the increased income inequality (Bradbury, K. and Jane Katz, 2002). Explaining Inequality Everyone agrees that the distribution of income in the United States generally became more equal during the first two decades after World War II and that it has become more unequal since 1968. While some people conclude that this increase in inequality suggests the latter period was unfair, others want to know why the distribution changed. We shall examine some of the explanations. Family Structure Clearly an important source of rising inequality since 1968 has been the sharp increase in the number of families headed by women. In 2006, the median income of families headed by married couples was 2.4 times that of families headed by women with no spouse present. The percentage of families headed by women with no spouse present has more than doubled since 1968 and is thus contributing to increased inequality across households. Technological and Managerial Change Technological change has affected the demand for labor. One of the most dramatic changes since the late 1970s has been an increase in the demand for skilled labor and a reduction in the demand for unskilled labor. The result has been an increase in the gap between the wages of skilled and unskilled workers. That has produced a widening gap between college- and high-school-trained workers. As we saw earlier, that gap has quintupled in the last few decades. Technological change has meant the integration of computers into virtually every aspect of production. And that has increased the demand for workers with the knowledge to put new methods to work—and to adapt to the even more dramatic changes in production likely to come. At the same time, the demand for workers who do not have that knowledge has fallen. Along with new technologies that require greater technical expertise, firms are adopting new management styles that require stronger communication skills. The use of production teams, for example, shifts decision-making authority to small groups of assembly-line workers. That means those workers need more than the manual dexterity that was required of them in the past. They need strong communication skills. They must write effectively, speak effectively, and interact effectively with other workers. Workers who cannot do so simply are not in demand to the degree they once were. The “intellectual wage gap” seems likely to widen as we move even further into the twenty-first century. That is likely to lead to an even higher degree of inequality and to pose a challenge to public policy for decades to come. Increasing education and training could lead to reductions in inequality. Indeed, individuals seem
to have already begun to respond to this changing market situation, since the percentage who graduate from high school and college is rising. 18.1.3 https://socialsci.libretexts.org/@go/page/21789 Tax Policy Did tax policy contribute to rising inequality over the past four decades? The tax changes most often cited in the fairness debate are the Bush tax cuts introduced in 2001, 2002, and 2003 and the Reagan tax cuts introduced in 1981. An analysis of the Bush tax cuts by the Tax Foundation combines the three Bush tax cuts and assumes they occurred in 2003. Table 19.1 “Income Tax Liability Before and After the Bush Tax Cuts” gives the share of total income tax liability for each quintile before and after the Bush tax cuts. It also gives the share of the Bush tax cuts received by each quintile. Table 19.1 Income Tax Liability Before and After the Bush Tax Cuts Quintile First quintile Second quintile Third quintile Fourth quintile Top quintile Share of income tax liability before tax cuts Share of income tax liability after tax cuts Share of total tax relief 0.5% 2.3% 5.9% 12.6% 78.7% 0.3% 1.9% 5.2% 11.6% 81.0% 1.2% 4.2% 9.4% 17.5% 67.7% The share of total tax relief received by the first four quintiles was modest, while those in the top quintile received more than twothirds of the total benefits of the three tax cuts. However, the share of income taxes paid by each of the first four quintiles fell as a result of the tax cuts, while the share paid by the top quintile rose. Source: William Ahean, “Comparing the Kennedy, Reagan, and Bush Tax Cuts,” Tax Foundation Fiscal Facts, August 24, 2004. Tax cuts under George W. Bush were widely criticized as being tilted unfairly toward the rich. And certainly, Figure 19.1 that those in the top quintile received just over half of total income. After the Bush tax cuts, they paid 81% of income taxes. On that basis, one might conclude that the Bush tax cuts contributed to equalizing income. Others are quick to point out that those same tax cuts were accompanied by reductions in expenditures for some social service programs designed to help lower income families. Still others point out that the tax cuts contributed
to an increase in the federal deficit and, therefore, are likely to have distributional effects over many years and across several generations. Whether these changes increased or decreased fairness in the society is ultimately a normative question. Methodology The method by which the Census Bureau computes income shares has been challenged by some observers. Robert Rector, of the Heritage Foundation, a conservative think tank, notes three flaws in the Census Bureau approach. First, it ignores taxes. Second, it ignores the $750 billion in spending for the poor and elderly. Third, each quintile does not contain the same number of people. The top quintile, for example, contains 70% more people than the bottom quintile because households in the lowest quintile tend to have fewer people than those in the highest quintile. Taking the Census Bureau finding that the top quintile receives 50.1% of total income while the bottom quintile receives 3.4% of income implies that people in the top quintile receive $14.74 for every $1.00 received by people in the bottom quintile. But, Mr. Rector points out that once one adjusts for taxes, transfers, and the unequal number of people in each quintile, that 14.74:1 gap falls to $4.21 in the top quintile for every $1.00 in the bottom. By this accounting, incomes in the United States are not nearly as unequal as reported by the Census Bureau (Rector, R., 2004). This suggests that more precise measurements may provide more insight into explaining inequality. Key Takeaways The distribution of income can be illustrated with a Lorenz curve. If all households had the same income, the Lorenz curve would be a 45° line. In general, the more equal the distribution of income, the closer the Lorenz curve will be to the 45° line. A more bowed out curves shows a less equal distribution. The Gini coefficient is another method for describing the distribution of income. The distribution of income has, according to the Census Bureau, become somewhat more unequal in the United States during the past 36 years. The degree of mobility up and down the distribution of income appears to have declined in recent years. 18.1.4 https://socialsci.libretexts.org/@go/page/21789 Among the factors explaining increased inequality have been changes in family structure and changes in the demand for labor that have rewarded those with college degrees and have penalized unskilled workers. Try It! The accompanying
Lorenz curves show the distribution of income in a country before taxes and welfare benefits are taken into account (curve A) and after taxes and welfare benefits are taken into account (curve B). Do taxes and benefits serve to make the distribution of income in the country more equal or more unequal?  Case in Point: Attitudes and Inequality Figure 19.2 Craig Allen – A person too? The same needs and wants? – CC BY-NC-ND 2.0. In a fascinating examination of attitudes in the United States and in continental Western Europe, economists Alberto Alesina of Harvard University and George-Marios Angeletos of the Massachusetts Institute of Technology suggest that attitudes about the nature of income earning can lead to quite different economic systems and outcomes concerning the distribution of income. The economists cite survey evidence from the World Values Survey, which concludes that 71% of Americans, and only 40% of Europeans, agree with the proposition: “The poor could become rich if they worked hard enough.” Further, Americans are much more likely to attribute material success to hard work, while Europeans tend to attribute success to factors such as luck, connections, and even corruption. The result, according to Professors Alesina and Angeletos, is that Americans select a government that is smaller and engages in less redistributive activity than is selected by Europeans. Government in continental Western Europe is 50% larger than in the United States, the tax system in Europe is much more progressive than in the United States, regulation of labor and product markets is more extensive in Europe, and redistributive programs are more extensive in Europe than in the United States. As a result, the income distribution in Europe is much more equal than in the United States. People get what they expect. The economists derive two sets of equilibria. Equilibrium in a society in which people think incomes are a result of luck, connections, and corruption turns out to be precisely that. And, in a society in which people believe incomes 18.1.5 https://socialsci.libretexts.org/@go/page/21789 are chiefly the result of effort and skill, they are. In the latter society, people work harder and invest more. In the United States, the average worker works 1,600 hours per year. In Europe, the average worker works 1,200 hours per year. So, who is right—Americans with their “you get what you deserve” or Europeans with their �
�you get what luck, connections, and corruption bring you” attitude? The two economists show that people get, in effect, what they expect. European values and beliefs produce societies that are more egalitarian. American values and beliefs produce the American result: a society in which the distribution of income is more unequal, the government smaller, and redistribution relatively minor. Professors Alesina and Angeletos conclude that Europeans tend to underestimate the degree to which people can improve their material well-being through hard work, while Americans tend to overestimate that same phenomenon. Source: Alberto Alesina and George-Marios Angeletos, “Fairness and Redistribution,” American Economic Review 95:4 (September, 2005) 960–80. Answer to Try It! Problem The Lorenz curve showing the distribution of income after taxes and benefits are taken into account is less bowed out than the Lorenz curve showing the distribution of income before taxes and benefits are taken into account. Thus, income is more equally distributed after taking them into account. Figure 19.3 The 40 year synthetic earnings estimates (in $millions of 1999 dollars) are: high school dropout, $1.0; high school graduate, $1.2; Bachelors degree, $2.2; Masters degree, $2.5; Doctoral degree, $3.4; Professional degree, $4.4. Jennifer Cheeseman Day and Eric C. Newburger, “The Big Payoff: Education Attainment and Synthetic Estimates of Work-life Earnings,” U.S. Census Bureau, Current Population Reports (P23-210, July, 2002). Synthetic earnings estimates represent what a typical person with a certain education level could expect to earn over a 40-year worklife. 18.1.6 https://socialsci.libretexts.org/@go/page/21789 References Bradbury, K., and Jane Katz, “Issues in Economics: Are Lifetime Incomes Growing More Unequal? Looking at New Evidence on Family Income Mobility,” Regional Review 12:4 (4 Quarter, 2002): 2–5. th Burtless, G., “Inequality Trends: The Facts and Why They Matter,” Cato Unbound Block Archive, February 20, 2007. Rector, R., “Understanding Poverty and Economic Inequality in the United States,” The Heritage Foundation, Policy Research & Analysis,
September 15, 2004. U.S. Census Bureau, Current Population Reports, P60-233, Income, Poverty, and Health Insurance Coverage in the United States: 2006, U.S. Government Printing Office, Washington, D.C. This page titled 18.1: Income Inequality is shared under a CC BY-NC-SA 3.0 license and was authored, remixed, and/or curated by Anonymous. 19.1: Income Inequality by Anonymous is licensed CC BY-NC-SA 3.0. Original source: https://2012books.lardbucket.org/books/economicsprinciples-v2.0/. 18.1.7 https://socialsci.libretexts.org/@go/page/21789 18.2: The Economics of Poverty  Learning Objective 1. Distinguish between relative and absolute measures of poverty and discuss the uses and merits of each. 2. Describe the demographics of poverty in the United States. 3. Describe the forms of welfare programs in the United States and the reform of welfare in the mid-1990s. 4. Discuss the factors that have been looked at to explain the persistence of poverty in the United States. Poverty in the United States is something of a paradox. Per capita incomes in this country are among the highest on earth. Yet, the United States has a greater percentage of its population below the official poverty line than in the other industrialized nations. How can a nation that is so rich have so many people who are poor? There is no single answer to the question of why so many people are poor. But we shall see that there are economic factors at work that help to explain poverty. We shall also examine the nature of the government’s response to poverty and the impact that response has. First, however, we shall examine the definition of poverty and look at some characteristics of the poor in the United States. Defining Poverty Suppose you were asked to determine whether a particular family was poor or not poor. How would you do it? You might begin by listing the goods and services that would be needed to provide a minimum standard of living and then finding out if the family’s income was enough to purchase those items. If it were not, you might conclude that the family was poor. Alternatively, you might examine the family’s income relative to the incomes of other families in the community or in the nation. If the family was on the low end of the
income scale, you might classify it as poor. These two approaches represent two bases on which poverty is defined. The first is an absolute income test, which sets a specific income level and defines a person as poor if his or her income falls below that level. The second is a relative income test, in which people whose incomes fall at the bottom of the income distribution are considered poor. For example, we could rank households according to income as we did in the previous section on income inequality and define the lowest one-fifth of households as poor. In 2006, any U.S. household with an annual income below $20,035 fell in this category. In contrast, to determine who is poor according to the absolute income test, we define a specific level of income, independent of how many households fall above or below it. The federal government defines a household as poor if the household’s annual income falls below a dollar figure called the poverty line. In 2006 the poverty line for a family of four was an income of $20,614. Figure 19.4 shows the poverty line for various family sizes. Figure 19.4 Weighted Average Poverty Thresholds in 2006, by Size of Family The Census Bureau uses a set of 48 money income thresholds that vary by family size and composition to determine who is in poverty. The “Weighted Average Poverty Thresholds” in the accompanying table is a summary of the 48 thresholds used by the census bureau. It provides a general sense of the “poverty line” based on the relative number of families by size and composition. Source: DeNavas-Walt, Carmen, Bernadette D. Proctor, and Jessica Smith, U.S. Census Bureau, Current Population Reports, P60233, Income, Poverty, and Health Insurance Coverage in the United States: 2006, U.S. Government Printing Office, Washington, D.C., 2007; p. 45. 18.2.1 https://socialsci.libretexts.org/@go/page/21790 The concept of a poverty line grew out of a Department of Agriculture study in 1955 that found families spending one-third of their incomes on food. With the one-third figure as a guide, the Department then selected four food plans that met the minimum daily nutritional requirements established by the federal government. The cost of the least expensive plan for each household size was multiplied by three to determine the income below which a household would be considered poor. The government used this
method to count the number of poor people from 1959 to 1969. The poverty line was adjusted each year as food prices changed. Beginning in 1969, the poverty line was adjusted annually by the average percentage price change for all consumer goods, not just changes in the price of food. There is little to be said for this methodology for defining poverty. No attempt is made to establish an income at which a household could purchase basic necessities. Indeed, no attempt is made in the definition to establish what such necessities might be. The day has long passed when the average household devoted one-third of its income to food purchases; today such purchases account for less than one-fifth of household income. Still, it is useful to have some threshold that is consistent from one year to the next so that progress—or the lack thereof—in the fight against poverty can be assessed. The percentage of the population that falls below the poverty line is called the poverty rate. Figure 19.5 shows both the number of people and the percentage of the population that fell below the poverty line each year since 1959. Figure 19.5 The Poverty Rate in the United States, 1959–2006 The curve shows the percentage of people who lived in households that fell below the poverty line in each year from 1959 to 2006. The poverty rate has generally fallen since 1959. Still, the poverty rate in the United States is greater than that of any other industrialized nation. Source: DeNavas-Walt, Carmen, Bernadette D. Proctor, and Jessica Smith, U.S. Census Bureau, Current Population Reports P60233, Income, Poverty, and Health Insurance Coverage in the United States: 2006, U.S. Government Printing Office, Washington DC, 2007; Table B-1, p. 44. Despite its shortcomings, measuring poverty using an absolute measure allows for the possibility of progress in reducing it; using a relative measure of poverty does not, since there will always be a lowest 1/5, or 1/10 of the population. But relative measures do make an important point: Poverty is in large measure a relative concept. In the United States, poor people have much higher incomes than most of the world’s people or even than average Americans did as recently as the early 1970s. By international and historical standards, the average poor person in the United States is rich! The material possessions of America’s poor would be considered lavish in another time and in another place. For example, in 2005, 43% of poor households in the
United States owned their own homes, nearly 75% owned a car, and 78% owned a VCR. About 80% of poor households had air conditioning. Forty years ago, only 36% of the entire population in the United States had air conditioning. The average poor person in the United States has more living space than the average person in London, Paris, Vienna, or Athens (Rector, R., 2007). We often think of poverty as meaning that poor people are unable to purchase adequate food. Yet, according to Department of Agriculture surveys, 89% of poor people report that they have adequate food. Only 2% reported that they are hungry most of the time. In short, poor people in the United States enjoy a standard of living that would be considered quite comfortable in many parts of the developed world—and lavish in the less developed world (Ibid). But people judge their incomes relative to incomes of people around them, not relative to people everywhere on the planet or to people in years past. You may feel poor when you compare yourself to some of your classmates who may have fancier cars or better clothes. And a family of four in a Los Angeles slum with an annual income of $13,000 surely does not feel rich because its income is many times higher than the average family income in Ethiopia or of Americans of several decades ago. While the material possessions of poor Americans are vast by Ethiopian standards, they are low in comparison to how the average American lives. What we think of as poverty clearly depends more on what people around us are earning than on some absolute measure of income. Both the absolute and relative income approaches are used in discussions of the poverty problem. When we speak of the number of poor people, we are typically using an absolute income test of poverty. When we speak of the problems of those at the bottom of 18.2.2 https://socialsci.libretexts.org/@go/page/21790 the income distribution, we are speaking in terms of a relative income test. In the European Union, for example, the poverty line is set at 60% of the median income of each member nation in a particular year. That is an example of a relative measure of poverty. In the rest of this section, we focus on the absolute income test of poverty used in the United States. The Demographics of Poverty There is no iron law of poverty that dictates that a household with certain characteristics will be poor. Nonetheless, poverty is much more highly concentrated among some groups than among others.
The six characteristics of families that are important for describing who in the United States constitute the poor are whether or not the family is headed by a female, age, the level of education, whether or not the head of the family is working, the race of the household, and geography. Figure 19.6 shows poverty rates for various groups and for the population as a whole in 2004. What does it tell us? 1. A family headed by a female is more than five times as likely to live in poverty as compared to a family with a husband present. This fact contributes to child poverty. 2. Children under 18 are about two times more likely to be poor than “middle-aged” (45–64) persons. 3. The less education the adults in the family have, the more likely the family is to be poor. A college education is an almost sure ticket out of poverty; the poverty rate for college graduates is just 3.9%. 4. The poverty rate is higher among those who do not work than among those who do. The poverty rate for people who did not work was almost six times the poverty rate of those who worked full time. 5. The prevalence of poverty varies by race and ethnicity. Specifically, the poverty rate in 2006 for whites (non-Hispanic origin) was less than half that for Hispanics or of blacks. 6. The poverty rate in central cities is higher than in other areas of residence. The incidence of poverty soars when several of these demographic factors associated with poverty are combined. For example, the poverty rate for families with children that are headed by women who lack a high school education is higher than 50%. Figure 19.6 The Demographics of Poverty in the United States, 2006 Poverty rates in the United States vary significantly according to a variety of demographic factors. The data are for 2006. Source: DeNavas-Walt, Carmen, Bernadette D. Proctor, and Jessica Smith, U.S. Census Bureau, Current Population Reports, P60233, Income, Poverty, and Health Insurance Coverage: 2006, U.S. Government Printing Office, Washington DC, 2007. Data for 18.2.3 https://socialsci.libretexts.org/@go/page/21790 age, educational attainment, employment status, and residence generated by authors using Current Population Survey (CPS) Table Creator for the Annual Social and Economic Supplement 2007. (www.census.gov/hhes/www/cpstc/c
ps_table_creator.html) Government Policy and Poverty Consider a young single parent with three small children. The parent is not employed and has no support from other relatives. What does the government provide for the family? The primary form of cash assistance is likely to come from a program called Temporary Assistance for Needy Families (TANF). This program began with the passage of the Personal Responsibility and Work Opportunity Reconciliation Act of 1996. It replaced Aid to Families with Dependent Children (AFDC). TANF is funded by the federal government but administered through the states. Eligibility is limited to two years of continuous payments and to five years in a person’s lifetime, although 20% of a state’s caseload may be exempted from this requirement. In addition to this assistance, the family is likely to qualify for food stamps, which are vouchers that can be exchanged for food at the grocery store. The family may also receive rent vouchers, which can be used as payment for private housing. The family may qualify for Medicaid, a program that pays for physician and hospital care as well as for prescription drugs. A host of other programs provide help ranging from counseling in nutrition to job placement services. The parent may qualify for federal assistance in attending college. The children may participate in the Head Start program, a program of preschool education designed primarily for low-income children. If the poverty rate in the area is unusually high, local public schools the children attend may receive extra federal aid. Welfare programs are the array of programs that government provides to alleviate poverty. In addition to public sector support, a wide range of help is available from private sector charities. These may provide scholarships for education, employment assistance, and other aid. Figure 19.7 shows participation rates in the major federal programs to help the poor. Figure 19.7 Welfare Programs and the Poor Many people who fall below the poverty line have not received aid from particular programs. Source: U.S. Census Bureau, Current Population Survey, 2006 Annual Social and Economic Supplement. Not all people whose incomes fall below the poverty line received aid. In 2006, a substantial majority of those counted as poor received some form of aid. But as shown by Figure 19.7, the percentages who were helped by individual programs were much lower. Less than 20% of people below the poverty line received some form of cash assistance in 2006. Less than 40% received food stamps and slightly more than half lived in a household in which one or more people received medical services through Medicaid.
Only about one-sixth of the people living in poverty received some form of housing aid. Although for the most part poverty programs are federally funded, individual states set eligibility standards and administer the programs. Allowing states to establish their own programs was a hallmark feature of the 1996 welfare reform. As state budgets have come under greater pressure, many states have tightened standards. Cash Versus Noncash Assistance Aid provided to people falls into two broad categories: cash and noncash assistance. Cash assistance is a money payment that a recipient can spend as he or she wishes. Noncash assistance is the provision of specific goods and services, such as food or medical services, job training, or subsidized child care rather than cash. Noncash assistance is the most important form of aid to the poor. The large share of noncash relative to cash assistance raises two issues. First, since the poor would be better off (that is, reach a higher level of satisfaction) with cash rather than noncash assistance, why is noncash aid such a large percentage of total aid to the poor? Second, the importance of noncash assistance raises 18.2.4 https://socialsci.libretexts.org/@go/page/21790 an important issue concerning the methodology by which the poverty rate is measured in the United States. We examine these issues in turn. 1. Why Noncash Aid? Suppose you had a choice between receiving $515 or a television set worth $515. Neither gift is taxable. Which would you take? Given a choice between cash and an equivalent value in merchandise, you would probably take the cash. Unless the television set happened to be exactly what you would purchase with the $515, you could find some other set of goods and services that you would prefer to the TV set. The same is true of funds that you can spend on anything versus funds whose spending is restricted. Given a choice of $515 that you could spend on anything and $515 that you could spend only on food, which would you choose? A given pool of funds allows consumers a greater degree of satisfaction than does a specific set of goods and services. We can conclude that poor people who receive government aid would be better off from their own perspectives with cash grants than with noncash aid. Why, then, is most government aid given as noncash benefits? Economists have suggested two explanations. The first is based on the preferences of donors. Recipients might prefer cash, but the preferences of donors matter also. The donors, in this case,
are taxpayers. Suppose they want poor people to have specific things—perhaps food, housing, and medical care. Given such donor preferences, it is not surprising to find aid targeted at providing these basic goods and services. A second explanation has to do with the political clout of the poor. The poor are not likely to be successful competitors in the contest to be at the receiving end of public sector income redistribution efforts; most redistribution goes to people who are not poor. But firms that provide services such as housing or medical care might be highly effective lobbyists for programs that increase the demand for their products. They could be expected to seek more help for the poor in the form of noncash aid that increases their 1 own demand and profits. 2. Poverty Management and Noncash Aid Only cash income is counted in determining the official poverty rate. The value of food, medical care, or housing provided through various noncash assistance programs is not included in household income. That is an important omission, because most government aid is noncash aid. Data for the official poverty rate thus do not reflect the full extent to which government programs act to reduce poverty. The Census Bureau estimates the impact of noncash assistance on poverty. If a typical household would prefer, say, $515 in cash to $515 in food stamps, then $515 worth of food stamps is not valued at $515 in cash. Economists at the Census Bureau adjust the value of noncash aid downward to reflect an estimate of its lesser value to households. Suppose, for example, that given the choice between $515 in food stamps and $475 in cash, a household reports that it is indifferent between the two— either would be equally satisfactory. That implies that $515 in food stamps generates satisfaction equal to $475 in cash; the food stamps are thus “worth” $475 to the household. Welfare Reform The welfare system in the United States came under increasing attack in the 1980s and early 1990s. It was perceived to be expensive, and it had clearly failed to eliminate poverty. Many observers worried that welfare was becoming a way of life for people who had withdrawn from the labor force, and that existing welfare programs did not provide an incentive for people to work. President Clinton made welfare reform one of the key issues in the 1992 presidential campaign. The Personal Responsibility and Work Opportunity Reconciliation Act of 1996 was designed to move people from welfare to work. It eliminated the entitlement aspect of welfare by defining a maximum period of eligibility. It gave states considerable scope in designing their own programs. In
the first two years following welfare reform, the number of people on welfare dropped by several million. Advocates of welfare reform proclaimed victory, while critics pointed to the booming economy, the tight labor market, and the general increase in the number of jobs over the same period. The critics also pointed out that the most employable welfare recipients (those with a high school education, no school-aged children living at home, and/or fewer personal problems) were the first to find jobs. The remaining welfare recipients, the critics argue, will have a harder time doing so. Moreover, having a job is not synonymous with getting out of poverty. Though some cities and states have reported notable successes, more experience is 18.2.5 https://socialsci.libretexts.org/@go/page/21790 required before a final verdict on welfare reform can be reached. The downturn which started in 2008 and which could be prolonged may provide a real–time test. Explaining Poverty Just as the increase in income inequality begs for explanation, so does the question of why poverty seems so persistent. Should not the long periods of economic growth in the 1980s and 1990s and since 2003 have substantially reduced poverty? Have the various government programs been ineffective? Clearly, some of the same factors that have contributed to rising income inequality have also contributed to the persistence of poverty. In particular, the increases in households headed by females and the growing gaps in wages between skilled and unskilled workers have been major contributors. Tax policy changes have reduced the extent of poverty. In addition to general reductions in tax rates, the Earned Income Tax Credit, which began in 1975 and was expanded in the 1990s, provides people below a certain income level with a supplement for each dollar of income earned. This supplement, roughly 30 cents for every dollar earned, is received as a tax refund at the end of the year. Figure 19.8 Percentages of Population in Eight Countries with Disposable Incomes Less Than 1/2 the National Median 2 the National Median Source: Timothy M. Smeeding, “Public Policy, Economic Inequality, and Poverty: The United States in Comparative Perspectives,” Social Science Quarterly, 86 (December 2005): 955–983. Taken together, though, transfer payment and tax programs in the United States are less effective in reducing poverty that are the programs of other developed countries. Figure 19.8 shows the percentage of the population in eight developed countries with a disposable income (income after taxes) less
than one-half the national median. The exhibit shows this percentage both before and after tax and transfer payment programs are considered. Clearly, the United States is the least aggressive in seeking to eliminate poverty among the eight countries shown. Poverty and Work How does poverty relate to work? Look back at Figure 19.6. Many of the poor are children or adults who do not work. That suggests one explanation for the weak relationship between poverty and economic growth in recent years. A growing economy reduces poverty by creating more jobs and higher incomes. Neither of those will reach those who, for various reasons, are not in the labor force. Figure 19.9 Poor People and the Labor Force Only a small fraction of the nation’s poor in 2006 could be considered available to the labor force. Source: 2006 Annual Social and Economic Supplement; www.census.gov/hhes/www/cpstc/cps_table_creator.html. Look at Figure 19.9. Of the nation’s 36.5 million poor people in 2006, only about 13.6 million—roughly a third–could be considered available to participate in the labor market. The rest were too young, retired, sick or disabled. Even of the 13.6 million, 18.2.6 https://socialsci.libretexts.org/@go/page/21790 many were already working part-time or seasonally (3.8 million) and others were college students or people who were unavailable for work because of their family situations, such as responsibility for caring for disabled family members. In sum, most of the nation’s poor people are unlikely to be available for additional work. Poverty and Welfare Programs How effective have government programs been in alleviating poverty? Here, it is important to distinguish between the poverty rate and the degree of poverty. Cash programs might reduce the degree of poverty, but might not affect a family’s income enough to actually move that family above the poverty line. Thus, even though the gap between the family’s income and the poverty line is lessened, the family is still classified as poor and would thus still be included in the poverty-rate figures. The data in Figure 19.9 show that significant gains in work participation will be difficult to achieve. Economist Rebecca M. Blank of the University of Michigan argued that empirical studies prior to federal welfare reform generally showed that welfare payments discouraged work effort, but the effect was fairly small. On the other hand, she also
concluded that, following welfare reform, welfare caseloads fell more and labor force participation increased more than analysts had expected (Blank, R. M., 2002). Evaluation of the effect of the federal welfare reform program on work participation, particularly over the long term, and on poverty continues. 2 Key Takeaways Poverty may be defined according to a relative or an absolute definition. Official estimates of the number of people who are “poor” are typically based on an absolute definition of poverty, one that makes very little economic sense. Several demographic factors appear to be associated with poverty. Families headed by single women are three times as likely to be poor as are other families. Poverty is also associated with low levels of education and with minority status. There is a wide range of welfare programs; the majority of welfare spending is for noncash assistance. Those receiving this aid do not have it counted as income in the official calculations of poverty. Welfare reform has focused on requiring recipients to enter the labor force. Many poor people, however, are not candidates for the labor force. Try It! The Smiths, a family of four, have an income of $20,500 in 2006. Using the absolute income test approach and the data given in the chapter, determine if this family is poor. Use the relative income test to determine if this family is poor.  Case in Point: Welfare Reform in Britain and in the United States Figure 19.10 18.2.7 https://socialsci.libretexts.org/@go/page/21790 BuzzFarmers – Homeless man. – CC BY 2.0. The governments of the United States and of Great Britain have taken sharply different courses in their welfare reform efforts. In the United States, the primary reform effort was undertaken in 1996, with the declaration to eliminate welfare as an entitlement and the beginning of programs that required recipients to enter the labor force within two years. President Clinton promised to “end welfare as we know it.” In Britain, the government of Tony Blair took a radically different approach. Prime Minister Blair promised to “make welfare popular again.” His government undertook to establish what he called a “third way” to welfare reform, one that emphasized returning recipients to the workforce but that also sought explicitly to end child poverty. The British program required recipients to get counseling aimed at encouraging them to return to the labor force. It did not, however, require that they obtain jobs. It also included a program of “
making work pay,” the primary feature of which was the creation of a National Minimum Wage, one that was set higher than the minimum wage in the United States. In the United States, the minimum wage equaled 34% of median private sector wages in 2002; the British minimum wage was set at 45% of the median private sector wage in 2002. 18.2.8 https://socialsci.libretexts.org/@go/page/21790 The British program, which was called the New Deal, featured tax benefits for poor families with children, whether they worked or not. It also included a Sure Start program of child care for poor people with children under three years old. In short, the Blair program was a more extensive social welfare program than the 1996 act in the United States. The table below compares results of the two programs in terms of their impact on child poverty, using an “absolute” poverty line and also using a relative poverty line. Child Poverty Rates in Single-Mother Families, Pre- and Post- Reform United Kingdom Absolute (percent) Relative (percent) 1997–1998 2002–2003 Change United States 1992 2001 Change 40 15 −25 41 33 −8 Absolute (percent) Relative (percent) 44 28 −16 67 59 −8 The relative measure of child poverty is the method of measuring poverty adopted by the European Union. It draws the poverty line at 60% of median income. The poverty line is thus a moving target against which it is more difficult to make progress. Hills and Waldfogel compared the British results to those in the United States in terms of the relative impact on welfare caseloads, employment of women having families, and reduction in child poverty. They note that reduction in welfare caseloads was much greater in the United States, with caseloads falling from 5.5 million to 2.3 million. In Britain, the reduction in caseloads was much smaller. In terms of impact on employment among women, the United States again experienced a much more significant increase. In terms of reduction of child poverty, however, the British approach clearly achieved a greater reduction. The British approach also increased incomes of families in the bottom 10% of the income distribution (i.e., the bottom decile) by more than that achieved in the United States. In Britain, incomes of families in the bottom decile rose 22%, and for families with children they rose 24%. In the United States, those in the bottom decile had more
modest gains. Would the United States ever adopt a New Deal program such as the Blair program in Great Britain? That, according to Hills and Waldfogel, would require a change in attitudes in the United States that they regard as unlikely. Source: John Hills and Jane Waldfogel, “A ‘Third Way’ in Welfare Reform? Evidence from the United Kingdom,” Journal of Policy Analysis and Management, 23(4) (2004): 765–88. Answer to Try It! Problem According to the absolute income test, the Smiths are poor because their income of $20,500 falls below the 2006 poverty threshold of $20,614. According to the relative income test, they are not poor because their $20,500 income is above the upper limit of the lowest quintile, $20,035. 1 Students who have studied rent seeking behavior will recognize this argument. It falls within the public choice perspective of public finance theory. 2 For a review of the literature, see Rebecca M. Blank, It Takes a Nation (New York: Russell Sage Foundation: 1997). References Blank, R. M., “Evaluating Welfare Reform in the United States,” Journal of Economic Literature 40:4 (December 2002): 1105–66. Ibid. Rector, R., “How Poor Are America’s Poor? Examining the “Plague” of Poverty in America,” The Heritage Foundation, Policy Research & Analysis, August 27, 2007. 18.2.9 https://socialsci.libretexts.org/@go/page/21790 This page titled 18.2: The Economics of Poverty is shared under a CC BY-NC-SA 3.0 license and was authored, remixed, and/or curated by Anonymous. 19.2: The Economics of Poverty by Anonymous is licensed CC BY-NC-SA 3.0. Original source: https://2012books.lardbucket.org/books/economics-principles-v2.0/. 18.2.10 https://socialsci.libretexts.org/@go/page/21790 18.3: The Economics of Discrimination  Learning Objective 1. Define discrimination, identify some sources of it, and illustrate Becker’s model of discrimination using demand and supply in a hypothetical labor market. 2. Assess the effectiveness of government efforts to reduce discrimination in the United States.
We have seen that being a female head of household or being a member of a racial minority increases the likelihood of being at the low end of the income distribution and of being poor. In the real world, we know that on average women and members of racial minorities receive different wages from white male workers, even though they may have similar qualifications and backgrounds. They might be charged different prices or denied employment opportunities. This section examines the economic forces that create such discrimination, as well as the measures that can be used to address it. Discrimination in the Marketplace: A Model Discrimination occurs when people with similar economic characteristics experience different economic outcomes because of their race, sex, or other noneconomic characteristics. A black worker whose skills and experience are identical to those of a white worker but who receives a lower wage is a victim of discrimination. A woman denied a job opportunity solely on the basis of her gender is the victim of discrimination. To the extent that discrimination exists, a country will not be allocating resources efficiently; the economy will be operating inside its production possibilities curve. Pioneering work on the economics of discrimination was done by Gary S. Becker, an economist at the University of Chicago, who won the Nobel Prize in economics in 1992. He suggested that discrimination occurs because of people’s preferences or attitudes. If enough people have prejudices against certain racial groups, or against women, or against people with any particular characteristic, the market will respond to those preferences. In Becker’s model, discriminatory preferences drive a wedge between the outcomes experienced by different groups. Discriminatory preferences can make salespeople less willing to sell to one group than to another or make consumers less willing to buy from the members of one group than from another or to make workers of one race or sex or ethnic group less willing to work with those of another race, sex, or ethnic group. Let us explore Becker’s model by examining labor-market discrimination against black workers. We begin by assuming that no discriminatory preferences or attitudes exist. For simplicity, suppose that the supply curves of black and white workers are identical; they are shown as a single curve in Figure 19.11. Suppose further that all workers have identical marginal products; they are equally productive. In the absence of racial preferences, the demand for workers of both races would be D. Black and white workers would each receive a wage W per unit of labor. A total of L black workers and L white workers would be employed. 18.3.1 https://socialsci.libretexts.org

Subsets and Splits

No community queries yet

The top public SQL queries from the community will appear here once available.