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that a country’s balance on current account equals the negative of its balance on capital account. Suppose, for example, that buyers in the rest of the world are spending $100 billion per year acquiring assets in a country, while that country’s buyers are spending $70 billion per year to acquire assets in the rest of the world. The country thus has a capital account surplus of $30 billion per year. Equation 15.3 tells us the country must have a current account deficit of $30 billion per year. Alternatively, suppose buyers from the rest of the world acquire $25 billion of a country’s assets per year and that buyers in that country buy $40 billion per year in assets in other countries. The economy has a capital account deficit of $15 billion; its capital account balance equals −$15 billion. Equation 15.3 tells us it thus has a current account surplus of $15 billion. In general, we may write the following: Equation 15.4 Current account balance = − (capital account balance) Assuming the market for a nation’s currency is in equilibrium, a capital account surplus necessarily means a current account deficit. A capital account deficit necessarily means a current account surplus. Similarly, a current account surplus 7. Situation that occurs when spending flowing in for the purchase of goods and services exceeds spending that flows out. 8. Situation that occurs when spending for goods and services that flows out of the country exceeds spending that flows in. 9. An accounting statement of spending flows into and out of the country during a particular period for purchases of assets. 10. The balance between rest-ofworld purchases of domestic assets and domestic purchases of rest-of-world assets. 11. A positive balance on capital account. 12. A negative balance on capital account. 15.2 International Finance 619 Chapter 15 Net Exports and International Finance implies a capital account deficit; a current account deficit implies a capital account surplus. Whenever the market for a country’s currency is in equilibrium, and it virtually always is in the absence of exchange rate controls, Equation 15.3 is an identity—it must be true. Thus, any surplus or deficit in the current account means the capital account has an offsetting deficit or surplus. The accounting relationships underlying international finance hold as long as a country’s currency market is in equilibrium. But what are the economic forces at work that cause these equalities to hold? Consider how global turmoil in 1997 and 1998, discussed in the chapter opening
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, affected the United States. Holders of assets, including foreign currencies, in the rest of the world were understandably concerned that the values of those assets might fall. To avoid a plunge in the values of their own holdings, many of them purchased U.S. assets, including U.S. dollars. Those purchases of U.S. assets increased the U.S. surplus on capital account. To buy those assets, foreign purchasers had to purchase dollars. Also, U.S. citizens became less willing to hold foreign assets, and their preference for holding U.S. assets increased. United States citizens were thus less willing to supply dollars to the foreign exchange market. The increased demand for dollars and the decreased supply of dollars sent the U.S. exchange rate higher, as shown in Panel (a) of Figure 15.4 "A Change in the Exchange Rate Affected the U.S. Current and Capital Accounts in 1997 and 1998". Panel (b) shows the actual movement of the U.S. exchange rate in 1997 and 1998. Notice the sharp increases in the exchange rate throughout most of the period. A higher exchange rate in the United States reduces U.S. exports and increases U.S. imports, increasing the current account deficit. Panel (c) shows the movement of the current and capital accounts in the United States in 1997 and 1998. Notice that as the capital account surplus increased, the current account deficit rose. A reduction in the U.S. exchange rate at the end of 1998 coincided with a movement of these balances in the opposite direction. Figure 15.4 A Change in the Exchange Rate Affected the U.S. Current and Capital Accounts in 1997 and 1998 Turmoil in currency markets all over the world in 1997 and 1998 increased the demand for dollars and decreased the supply of dollars in the foreign exchange market, which caused an increase in the U.S. exchange rate, as shown in Panel (a). Panel (b) shows actual values of the U.S. exchange rate during that period; Panel (c) shows U.S. balances 15.2 International Finance 620 Chapter 15 Net Exports and International Finance on current and on capital accounts. Notice that the balance on capital account generally rose while the balance on current account generally fell. Deficits and Surpluses: Good or Bad? For the past quarter century, the United States has had a current account deficit and a capital account surplus. Is this good or bad? Viewed from the perspective of consumers, neither
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phenomenon seems to pose a problem. A current account deficit is likely to imply a trade deficit. That means more goods and services are flowing into the country than are flowing out. A capital account surplus means more spending is flowing into the country for the purchase of assets than is flowing out. It is hard to see the harm in any of that. Public opinion, however, appears to regard a current account deficit and capital account surplus as highly undesirable, perhaps because people associate a trade deficit with a loss of jobs. But that is erroneous; employment in the long run is determined by forces that have nothing to do with a trade deficit. An increase in the trade deficit (that is, a reduction in net exports) reduces aggregate demand in the short run, but net exports are only one component of aggregate demand. Other factors—consumption, investment, and government purchases—affect aggregate demand as well. There is no reason a trade deficit should imply a loss of jobs. What about foreign purchases of U.S. assets? One objection to such purchases is that if foreigners own U.S. assets, they will receive the income from those assets—spending will flow out of the country. But it is hard to see the harm in paying income to financial investors. When someone buys a bond issued by Microsoft, interest payments will flow from Microsoft to the bond holder. Does Microsoft view the purchase of its bond as a bad thing? Of course 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 issued by the U.S. government? Foreigners owned about 52% of these bonds at the end of December 15.2 International Finance 621 Chapter 15 Net Exports and International Finance 2010; they are thus the creditors for about half the national debt. But this position hardly puts them in control of the government of the United States. They
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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 • 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-of-world 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. 15.2 International Finance 622 Chapter 15 Net Exports and International Finance T R Y I T! Use Equation 15.3 and Equation 15.4 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
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-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-of-world 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), rest-of-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? 15.2 International Finance 623 Chapter 15 Net Exports and International Finance Case in Point: Alan Greenspan on the U.S. Current Account Deficit 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
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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. … 15.2 International Finance 624 Chapter 15 Net Exports and International Finance “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. 15.2 International Finance 625 Chapter 15 Net Exports and International Finance. All figures are in billions of U.S. dollars per period. The left-hand side of Equation 15.3 is the current account balance Exports − imports = $300 − $400 = −$100 Using Equation 15.4, 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 15.3 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
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, we find they are $50. 2. All figures are in trillions of yen per period. The left-hand side of Equation 15.3 is the current account balance Exports − imports = ¥200 − ¥120 = ¥80 Using Equation 15.4, the balance on capital account is ¥80 = −(capital account balance) 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 15.3 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. 15.2 International Finance 626 Chapter 15 Net Exports and International Finance 3. All figures are in billions of pounds per period. The term in parentheses on the right-hand side of Equation 15.3 is the balance on capital account. We thus have £90 − £70 = £20 Using Equation 15.4, the balance on current account is Current account balance = −(£20) The left-hand side of Equation 15.3 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 15.3 is the balance on capital account. We thus have $700 − $500 = $200 Using Equation 15.4, the balance on current account is Current account balance = −($200) The left-hand side of Equation 15.3 is also the current account balance Exports − $550 = −$200 Solving for exports, we find they are $350. 15.2 International Finance 627 Chapter 15 Net Exports and International Finance 15.3 Exchange Rate Systems. 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
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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 system13, 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. 628 13. System in which governments and central banks do not participate in the market for foreign exchange. Chapter 15 Net Exports and International Finance 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
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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 float14. 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 country’s currency by the central bank in order to bring its exchange rate down, can sometimes convince 14. Government or central bank participation in a floating exchange rate system. 15.3 Exchange Rate Systems 629 Chapter 15 Net Exports and International Finance 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 system15, 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 system16, countries fix the value of their respective currencies relative to a certain commodity
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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. 15. System in which the exchange rate between two currencies is set by government policy. 16. System in which countries fix the value of their respective currencies relative to a certain commodity or group of commodities. 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 15.3 Exchange Rate Systems 630 Chapter 15 Net Exports and International Finance 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
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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 arrangements17, 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 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.
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17. Fixed exchange rate systems in which there is explicit legislative commitment to exchange domestic currency for a specified foreign currency at a fixed rate. 15.3 Exchange Rate Systems 631 Chapter 15 Net Exports and International Finance 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 15.5 "Maintaining a Fixed Exchange Rate Through Intervention". 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. 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 Figure 15.5 Maintaining a Fixed Exchange Rate Through Intervention Initially
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, 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 D2. Alternatively, the Fed could shift the demand curve to D2 by buying pounds. 15.3 Exchange Rate Systems 632 Chapter 15 Net Exports and International Finance 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. 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, six other nations have joined. The nations that adopted it agreed to strict limits on their fiscal policies. Each continues to have its own central bank, but these national central banks operate similarly to the regional banks of the Federal Reserve System in the United States. The new European Central Bank conducts monetary policy throughout the area. Details of this revolutionary venture and the extraordinary problems it has encountered in recent years are provided in the accompanying Case in Point. When exchange rates are fixed but
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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. 15.3 Exchange Rate Systems 633 Chapter 15 Net Exports and International Finance 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 15.6 "The Anatomy of a Currency Collapse". 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 free-floating currency. By the end of 1997, the baht had lost nearly half its value relative to the dollar. Figure 15.6 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
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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 15.3 Exchange Rate Systems 634 Chapter 15 Net Exports and International Finance 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 • 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. T R Y I T! 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 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? 15.3 Exchange Rate Systems 635 Chapter 15 Net Exports and International Finance Case in Point: The Euro It was 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
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, 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 2001, Greece joined, and 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, Slovakia in 2009, and Estonia in 2011. 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 also agreed in principle to strict limits on their fiscal policies. Their deficits could be no greater than 3% of nominal GDP, and their total national debt could not exceed 60% of nominal GDP. The fact that many of the euro nations had disregarded these limits became a major problem for the new currency when the recession and financial crisis hit in 2008. The biggest “sinner” turned out to be Greece, but there were others, such as Italy, that also had not adhered to the agreement. The fiscal situation of other countries, such as Ireland, went sour as the recession and financial problems deepened. The countries that seemed most at risk of being unable to 15.3 Exchange Rate Systems 636 Chapter 15 Net Exports and International Finance pay their sovereign (government) debts as they became due came to be known as the PIIGS—Portugal, Ireland, Italy, Greece, and Spain—but there was a period in 2011 when even the interest rate on French bonds was abnormally high. The whole world seemed to be waiting throughout most of 2011 to see if the euro would hold together and, in particular, if Greece would default on its debt. Finally, in early 2012, the situation seemed to calm down. The European Union nations (excluding the United Kingdom and the Czech Republic, which are not part of the eurozone) agreed to a new treaty that again requires fiscal discipline but this time has more enforcement associated with it.
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The European Union was setting up the European Stability Mechanism: a fund to help out with short-term liquidity problems that nations might encounter. Greece agreed to tough demands to reduce its deficit and then became eligible for a second EU bailout. It also managed to negotiate a debt-restricting deal with its privatesector lenders. The euro has been a mixed blessing for eurozone countries trying to get 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 euro exchange rate has probably benefited German exports, since a German currency would probably trade at a premium over the euro, but it has hurt exports from countries whose single-nation currencies would likely be weaker. Also, even though there is a single currency, each country 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. In contrast, the U.S. government is a single issuer of federal debt. Even with general regulation of overall parameters, fiscal policy for the 17 nations is largely a separate matter. Each has its own retirement and unemployment insurance programs, for example. In the United States, if one state is experiencing high unemployment, more federal unemployment insurance benefits will flow to that state. But if unemployment rises in Portugal, for example, its budget deficit will be negatively impacted, and Portugal will have to undertake additional austerity measures to stay within the EU-imposed deficit limit. 15.3 Exchange Rate Systems 637 Chapter 15 Net Exports and International Finance As of mid-2012, the fate of the euro was again dominating news on a nearly daily basis, and the currency experiment was still not out of the woods. Even with the restructuring and bailouts, would Greece be able to meet its debt obligations? With some EU countries slipping into another recession, would the austerity measures they were taking to meet the EU guidelines be self-defeating by making government budget balances even worse as tax revenues fell with the worsening states of their economies? Were countries taking on the marketorienting reforms that might increase their long-term growth rates and productivity? This last possibility seemed the most likely to help over time, but implementation was certainly not a foregone conclusion The value of the mon is initially $2. Fear that the mon might fall
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will lead to an increase in its supply to S2, 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 D2. 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. 15.3 Exchange Rate Systems 638 Chapter 15 Net Exports and International Finance 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. 639 Chapter 15 Net Exports and International Finance. 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
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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? 15.4 Review and Practice 640 Chapter 15 Net Exports and International Finance 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
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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 Review and Practice 641 Chapter 15 Net Exports and International Finance. 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? a. A change in consumer preferences leads to an initial $25-billion decrease in net exports. The multiplier is 1.5. b. A change in trade policies leads to an initial $25-billion increase in net exports. The multiplier is 1. c. 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. d. 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 100 100 300 a. b. c. d. 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: a. What are the country’s imports? b. What is the country’s balance on current account? c. 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 15.4 Review and Practice 642 Chapter 15 Net Exports and International Finance $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: a. What is the country’s balance on current account? b. What is the country’s balance on capital account? c. What is the
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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 Trade-weighted exchange rate Net exports January February March April May June July August 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 a. Plot the data on a graph. b. 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. a. If the exchange rate was free-floating prior to the change in demand for Japanese goods, what was its likely value? b. After the change in demand, the free-floating exchange rate would be how many yen per dollar? 15.4 Review and Practice 643 Chapter 15 Net Exports and International Finance c. If the Japanese central bank wanted to keep the exchange rate fixed at its initial value, how many dollars would it have to buy? 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.) 15.4 Review
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and Practice 644 Chapter 16 Inflation and Unemployment Start Up: The Inflation/Unemployment Conundrum As the twentieth century drew to a close, the people of the United States could look back on a remarkable achievement. From 1992 through 2000, the unemployment rate fell every year. The inflation rate, measured as the annual percentage change in the implicit price deflator, was about 2% or less during this period. The dramatic reduction in the two rates provided welcome relief to a nation that had seen soaring unemployment early in the 1980s, soaring inflation in the late 1970s, and painful increases in both rates early in the 1970s. Unemployment and inflation rates remained fairly low during the early 2000s. Following a brief recession in 2001, in which unemployment reached nearly 6% (though this actually occurred after the recession officially ended), it fell back to 4.6% in 2006 and 2007. Through 2007, inflation never exceeded 3.3%. With the start of the recession in December 2007, the unemployment rate began to rise. At first, though, it appeared that inflation was becoming a bigger problem, as rising gas and food prices until summer 2008 seemed to be driving up other prices and increasing inflationary expectations. Indeed, through much of 2008, a debate over the appropriate direction of monetary policy occurred over just this issue: should the Fed ease the federal funds rate in an attempt to reduce unemployment or at least to keep it from rising as much as it would otherwise have, or should it stem rising inflation and inflationary expectations by holding the federal funds rate constant or even increasing it? While the Fed voted during most of its 2008 meetings for easing, the year is notable in that there were often dissenters at the Federal Open Market Committee meetings. For example, the minutes of the March 18, 2008, meeting note that two members, Richard W. Fisher of the Dallas Fed and Charles I. Plosser of the Philadelphia Fed voted against the 0.75% point drop approved at that meeting. Their rationale was that the inflation risks were simply too great. The minutes state, “Incoming data suggested a weaker near-term outlook for economic growth, but the Committee’s earlier policy moves had already reduced the target federal funds rate by 225 basis points to address risks to growth, and the full effect of those rate cuts had yet to be felt. … Both Messrs. Fisher and Plosser were concerned that inflation expectations could potentially become unhinged should the Committee 645 Chapter 16 Inflation and Unemployment continue to lower the funds rate in
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the current environment. They pointed to measures of inflation and indicators of inflation expectations that had risen and Mr. Fisher stressed the international influences on U.S. inflation rates. Mr. Plosser noted that the Committee could not afford to wait until there was clear evidence that inflation expectations were no longer anchored, as by then it would be too late to prevent a further increase in inflation pressures.”Minutes of the Federal Open Market Committee March 18, 2008. But as the depth of the recession increased toward the latter part of 2008, with the unemployment rate reaching 7.2% in December and prices of both oil and other commodities falling back substantially, the inflation threat had dissipated. Unanimity had returned to the FOMC: the Fed should use all of its powers to fight the recession. This chapter examines the relationship between inflation and unemployment. We will find that there have been periods in which a clear trade-off between inflation and unemployment seemed to exist. During such periods, the economy achieved reductions in unemployment at the expense of increased inflation. But there have also been periods in which inflation and unemployment rose together and periods in which both variables fell together. We will examine some explanations for the sometimes perplexing relationship between the two variables. We will see that the use of stabilization policy, coupled with the lags for monetary and for fiscal policy, have at times led to a cyclical relationship between inflation and unemployment. The explanation for the fact that Americans enjoyed such a long period of falling inflation and unemployment in the 1990s lies partly in improved policy, policy that takes those lags into account. We will see that a bit of macroeconomic luck in aggregate supply has also played a role. 646 Chapter 16 Inflation and Unemployment 16.1 Relating Inflation and Unemployment. Draw a short-run 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
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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 the Short Run 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.Almarin W. Phillips, “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. 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 short-run Phillips curve1, a curve that suggests 647 1. A curve that suggests a negative relationship between inflation and unemployment. Chapter 16 Inflation and Unemployment a negative relationship between inflation and unemployment. Figure 16.1 "The Short-Run Phillips Curve" shows a short-run Phillips curve. The short-run 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. Figure 16.1 The Short-Run Phillips Curve The relationship between inflation and unemployment suggested by the work of Almarin Phillips is shown by a short-run Phillips curve. The experience of the 1960s suggested that precisely the kind of
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trade-off the Phillips curve implied did, in fact, exist in the United States. Figure 16.2 "The Short-Run Phillips Curve in the 1960s" 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. Figure 16.2 The Short-Run Phillips Curve in the 1960s 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. 16.1 Relating Inflation and Unemployment 648 Chapter 16 Inflation and Unemployment 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. Values of U.S. inflation and unemployment rates during the 1960s generally conformed to the trade-off implied by the shortrun 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, 2011, Tables B-3 and B-42. The Short-Run Phillips Curve Goes Awry The effort to nudge the economy back down the Phillips curve
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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 negatively sloped 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 16.3 "Inflation and Unemployment, 1961–2011" shows the two variables over the period from 1961 through 2011. It is hard to see a negatively sloped Phillips curve lurking within that seemingly random scatter of points. 16.1 Relating Inflation and Unemployment 649 Chapter 16 Inflation and Unemployment Figure 16.3 Inflation and Unemployment, 1961–2011 Annual observations of inflation and unemployment in the United States from 1961 to 2011 do not seem consistent with a Phillips curve. Sources: Economic Report of the President, 2011, Table B-42; Bureau of Economic Analysis, Implicit Price Deflators for Gross Domestic Product, NIPA Table 1.1.9. Unemployment rate for 2011 is annual average from Bureau of Labor Statistics home page. Inflation and Unemployment Relationships Over Time Although the points plotted in Figure 16.3 "Inflation and Unemployment, 1961–2011" are not consistent with a negatively sloped, stable Phillips curve, connecting the inflation/unemployment points over time allows us to focus on various ways that these two variables may be related. In Figure 16.4 "Connecting the Points: Inflation and Unemployment" we draw connecting lines through the sequence of observations. By doing so, we see periods in which inflation and unemployment are inversely related (as in the 1960s, late 1970s, late 1980s, the end of the twentieth century, and the first decade of the 2000s). We refer to a period when inflation and unemployment are inversely related as a Phillips phase2. 2. Period in which inflation and unemployment are inversely related. 16.1 Relating Inflation and Unemployment 650
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Chapter 16 Inflation and Unemployment During other periods, both inflation and unemployment were increasing (as from 1973 to 1975 or 1979 to 1981). A period of rising inflation and unemployment is called a stagflation phase3. Finally, a recovery phase4 is a period in which both unemployment and inflation fall (as from 1975 to 1976, 1982 to 1984, and 1992 to 1998). Figure 16.5 "Inflation—Unemployment Phases" presents a stylized version of these three phases. Figure 16.4 Connecting the Points: Inflation and Unemployment 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 series of inverse relationships. Sources: Economic Report of the President, 2011, Tables B-3 and B-42. 3. Period in which inflation remains high while unemployment increases. 4. Period in which inflation and unemployment both decline. 16.1 Relating Inflation and Unemployment 651 Chapter 16 Inflation and Unemployment Trace the path of inflation and unemployment as it unfolds in Figure 16.4 "Connecting the Points: Inflation and Unemployment". Starting with the Phillips phase in the 1960s, we see that the economy went through three clockwise loops, representing a stagflation phase, then a recovery phase, a Phillips phase, and so on. Each took the United States to successively higher rates of inflation and unemployment. Following the stagflation of the late 1970s and early 1980s, however, something quite significant happened. The economy suffered a very high rate of unemployment but also achieved very 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. Figure 16.5 Inflation—Unemployment Phases The figure shows the way an economy may move from a Phillips phase to a stagflation phase and then to a recovery phase. The 2000s look like a series of Phillips phases. The brief recession in 2001 brought higher unemployment and slightly lower inflation. Unemployment fell from 2003 to 2006 but with slightly higher inflation each year. The Great Recession, which began at the end of 2007, was characterized by higher unemployment and lower inflation.
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The next section will explain these experiences in a stylized way in terms of the aggregate demand and supply model • The view that there is a trade-off between inflation and unemployment is expressed by a short-run Phillips curve. • While there are periods in which a trade-off between inflation and • unemployment exists, the actual relationship between these variables is more varied. 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. 16.1 Relating Inflation and Unemployment 652 Chapter 16 Inflation and Unemployment T R Y I T! 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 3 4 5 6 7 8 2.5 2.6 2.8 4.7 4.9 5.0 4.5 4.0 6.3 5.9 4.8 4.1 5.0 6.1 5.7 5.1 16.1 Relating Inflation and Unemployment 653 Chapter 16 Inflation and Unemployment Case in Point: Some Reflections on the 1970s 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
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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. 16.1 Relating Inflation and Unemployment 654 Chapter 16 Inflation and Unemployment The economists suggested, however, that this was probably due to a number of transitory factors. Their forecast that inflation and unemployment 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 16.1 Relating Inflation and Unemployment 655 Chapter 16 Inflation and Unemployment 16.2 Explaining Inflation–Unemployment Relationships. 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 inflation and unemployment experience in the United States during the past half century. 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 events, macroeconomic policy, and expectations. The next three sections discuss the pattern that unfolded from the 1970s through the 1990s in which stagflation and then recovery followed Phillips phases. We will also look at the behavior of the economy in the first decade of the 21st century. Each phase 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 a Phillips phase does not simply mean that the price level rises. It means that the price level
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rises by larger and larger percentages. Rising inflation means that the price level is rising at an increasing rate. In a 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 relationship conforms to the concept of a short-run Phillips curve. It is a period in which inflation tends to rise and unemployment tends to fall. Figure 16.6 "A Phillips Phase" 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. 656 Chapter 16 Inflation and Unemployment Figure 16.6 A Phillips Phase A Phillips phase is marked by increases in aggregate demand pushing real GDP and the price level up along the short-run aggregate supply curve SRAS1,2,3. The result is rising inflation and falling unemployment. The points 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 16.6 "A Phillips Phase" 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 16.6 "A Phillips Phase" through Figure 16.8 "The Recovery Phase". 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) Unemployment Rate (%) $880 910 940 970 1,000 1,030 1,060 1,090 9.0 8.0 7.0 6.0 5.0 4.0 3.0 2.0 16.2 Explaining Inflation–Unemployment Relationships 657 Chapter 16 Inflation and Unemployment 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
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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 AD2. 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. 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 AD3, 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 16.6 "A Phillips Phase". 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. 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 SRAS1,2,3. 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,
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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 16.2 Explaining Inflation–Unemployment Relationships 658 Chapter 16 Inflation and Unemployment during the Phillips phase. It is this adjustment that can set the stage for a stagflation phase. Changes in Expectations and a 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 16.7 "A Stagflation Phase", where SRAS1,2,3 shifts to SRAS4. 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). Figure 16.7 A Stagflation Phase In a stagflation phase, workers and firms adjust their expectations to 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). 16.2 Explaining Inflation–Unemployment Relationships 659 Chapter 16 Inflation and Unemployment The essential feature of a stagflation phase is a change in expectations. Workers and firms that were blindsided by rising prices during a Phillips phase ended up with
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lower real wages and lower relative price levels than they intended. In a 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. A Recovery Phase The stagflation phase shown in Figure 16.7 "A Stagflation Phase" 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 a recessionary gap by boosting aggregate demand. That increase in aggregate demand will lead the economy into a recovery phase. Figure 16.8 "The Recovery Phase" illustrates a recovery phase. In Panel (a), aggregate demand increases to AD5, 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). Figure 16.8 The Recovery Phase Policy makers act to increase aggregate demand in order to move the economy out of a recessionary gap created during a stagflation phase. Here, aggregate demand shifts to AD4, 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). 16.2 Explaining Inflation–Unemployment Relationships 660 Chapter 16 Inflation and Unemployment 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. For example, Figure 16.4 "Connecting the Points: Inflation and Unemployment" 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 16.7 "A Stagflation Phase",
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we can represent the low oil prices by a short-run aggregate supply curve that is to the right of SRAS4,5. 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 16.8 "The Recovery Phase". The U.S. Economy in the 21st Century: A Series of Phillips Phases Comparing the very late 1990s to the early 2000s, Figure 16.4 "Connecting the Points: Inflation and Unemployment" 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 16.6 "A Phillips Phase". 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 shifting to the left of SRAS1,2,3. This would mean that output would be somewhat lower, unemployment somewhat higher, and inflation somewhat higher than what is shown as points 2 and 3 in Panels (a) and (b) of Figure 16.6 "A Phillips Phase". 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. The recession that began in late 2007 is largely seen as a shift to the left in aggregate demand due to the marked fall in housing prices and financial market stresses. As a result, the economy went through a Phillips phase of higher unemployment and lower inflation. The expansionary monetary and fiscal policies of the late 2000s were geared toward pushing the aggregate demand curve back toward the right, thereby cajoling the economy back up the negatively sloped short-run Phillips curve. We can conclude that policy efforts to change aggregate demand, together with changes in expectations and a wide variety of factors that cause the aggregate demand or aggregate supply curve to shift, have played an important role in 16.2 Explaining Inflation–Unemployment Relationships 661 Chapter 16 Inflation and Unemployment generating the inflation-unemployment patterns we observe in the past half century. Lags have
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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 so on • 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. • T R Y I T! 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. 16.2 Explaining Inflation–Unemployment Relationships 662 Chapter 16 Inflation and Unemployment Case in Point: From the Challenging 1970s to the Calm 1990s 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 16.4 "Connecting the Points: Inflation and Unemployment", 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
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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. 16.2 Explaining Inflation–Unemployment Relationships 663 Chapter 16 Inflation and Unemployment 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 16.2 Explaining Inflation–Unemployment Relationships 664 Chapter 16 Inflation and Unemployment 16.3 Inflation and Unemployment in the Long Run. 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.
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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 inflationunemployment 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. 665 Chapter 16 Inflation and Unemployment 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 16.1 %ΔM + %ΔV ≅ %ΔP + %ΔY 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 16.2 %ΔP ≅ %ΔM − %ΔY In the long run, real GDP moves to its potential level, YP. Thus, in the long run we can write Equation 16.2 as follows: Equation 16.3 %Δ
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P ≅ %ΔM − %ΔY P 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 16.3 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 16.9 "Money Growth Rates and Inflation over the Long Run" is from a recent study by economist John Thornton. It is based on a sample of 116 countries from 1960 to 2007. Panel (a) includes all 116 countries, while Panel (b) excludes 6 outlier countries with inflation rates ranging from 200% to more than 850%. While the relationship is clearly not precise, the graphs suggest support for the quantity theory of money. A more 16.3 Inflation and Unemployment in the Long Run 666 Chapter 16 Inflation and Unemployment detailed statistical analysis shows that when the annual inflation rate averages more than 10%, the relationship seems to hold. The Thornton study uses currency as the monetary aggregate because the definitions of M1 and M2 are not stable across such a wide sample of countries over long periods of time.John Thornton, “Further Evidence on Money and Inflation in the Long Run,” Applied Economics Letters 18 (2011): 1443–447. Figure 16.9 Money Growth Rates and Inflation over the Long Run Data for 116 countries from 1960 to 2007 suggest a positive relationship between the rate of money growth and inflation. Source: John Thornton, “Further Evidence on Money and Inflation in the Long Run,” Applied Economics Letters 18 (2011): 1443–447. 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. 16.3 Inflation and Unemployment in the Long Run 667 Chapter 16 Inflation and Unemployment Of course, other factors
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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 and the Phillips Curve in the Long Run 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. Thus, the long-run Phillips curve5 is a vertical line at the natural rate of unemployment, showing that in the long run, there is no trade-off between inflation and unemployment. Figure 16.10 "The Phillips Curve in the Long Run" explains why. Suppose the economy is operating at YP on AD1 and SRAS1. Suppose the price level is P0, the same as in the last period. In that case, the inflation rate is zero. Panel (b) shows that the unemployment rate is UP, the natural rate of unemployment. Now suppose that the aggregate demand curve shifts to AD2. In the short run, output will increase to Y1. The price level will rise to P1, and the unemployment rate will fall to U1. In Panel (b) we show the new unemployment rate, U1, to be associated with an inflation rate of π1, and the beginnings of the negatively sloped short-
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run Phillips curve emerges. In the long run, as price and nominal wages increase, the short-run aggregate supply curve moves to SRAS2 and output returns to YP, as shown in Panel (a). In Panel (b), unemployment returns to UP, regardless of the rate of inflation. Thus, in the longrun, the Phillips curve is vertical. 5. A vertical line at the natural rate of unemployment, showing that in the long run, there is no trade-off between inflation and unemployment. 16.3 Inflation and Unemployment in the Long Run 668 Chapter 16 Inflation and Unemployment Figure 16.10 The Phillips Curve in the Long Run Suppose the economy is operating at YP on AD1 and SRAS1 in Panel (a) with price level of P0, the same as in the last period. Panel (b) shows that the unemployment rate is UP, the natural rate of unemployment. If the aggregate demand curve shifts to AD2, in the short run output will increase to Y1, and the price level will rise to P1. In Panel (b), the unemployment rate will fall to U1, and the inflation rate will be π1. In the long run, as price and nominal wages increase, the short-run aggregate supply curve moves to SRAS2, and output returns to YP, as shown in Panel (a). In Panel (b), unemployment returns to UP, 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. 16.3 Inflation and Unemployment in the Long Run 669 Chapter 16 Inflation and Unemployment
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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 wage6. 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 16.11 "A Model of a Job Search"), 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-offerreceived” 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. 6. The lowest wage that an unemployed worker would accept, if it were offered. 16.3 Inflation and Unemployment in the Long Run 670 Chapter 16 Inflation and Unemployment Figure 16.11 A Model of a Job Search An individual begins a job search at time t0 with a reservation wage W0. 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 tc, at which the reservation and “best-offer-received” curves intersect at wage Wc. The search begins at time t0, with the unemployed worker seeking wage W0. Because the worker’s reservation wage exceeds
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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 tc. The worker accepts wage Wc, and the job search is terminated. The job search model in Figure 16.11 "A Model of a Job Search" 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 16.3 Inflation and Unemployment in the Long Run 671 Chapter 16 Inflation and Unemployment 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-offerreceived curves for individual workers to the left, as shown in Panel (a) of Figure 16.12 "Public Policy and Frictional Unemployment". Workers obtain higher-paying jobs when they do find work; the wage at which searches are terminated rises to W2. Figure 16.12 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 W2. 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. Unemployment compensation, which was introduced
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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 Inflation and Unemployment in the Long Run 672 Chapter 16 Inflation and Unemployment 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
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. 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. 16.3 Inflation and Unemployment in the Long Run 673 Chapter 16 Inflation and Unemployment 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 theory7. 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 recessionary gap.For a discussion of the argument, see Janet Yellen, “Efficiency Wage Models of Unemployment,” American Economic Review, Papers and Proceedings (May 1984): 200–205. 7. The idea that firms may hold to a real wage greater than the equilibrium wage. 16.3 Inflation and Unemployment in the Long Run 674 Chapter 16 Inflation and Unemployment • Two factors that can influence the rate of inflation in the long run
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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. T R Y I T! Using the model of a job search (see Figure 16.11 "A Model of a Job Search"), 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. 16.3 Inflation and Unemployment in the Long Run 675 Chapter 16 Inflation and Unemployment Case in Point: Altering the Incentives for Unemployment Insurance Claimants 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 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
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. 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 16.3 Inflation and Unemployment in the Long Run 676 Chapter 16 Inflation and Unemployment 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 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). 16.3 Inflation and Unemployment in the Long Run 677 Chapter 16 Inflation and Unemployment 16.4 Review and Practice 678 Chapter 16 Inflation and Unemployment Summary During the 1960s, it appeared that there was a stable trade-off between the rate of unemployment and the rate of inflation. The short-run 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 trade-off script. There has, however, been a relationship between unemployment and inflation over the four decades from 1961. Periods of rising inflation and falling unemployment were often followed by periods of rising unemployment and continued or higher inflation; those periods, in turn, were followed by periods in which both the inflation rate and the unemployment rate fell. These periods are defined as the Phillips phase, the stagflation phase, and the recovery phase.
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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 a 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 a 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 a recovery phase: inflation and unemployment fall together. There is nothing inherent in a market economy that would produce the inflation-unemployment pattern we observed from 1961 until 2000. The cycle can begin if expansionary policies are launched to correct a recessionary gap, producing a Phillips phase. If those policies push the economy into an inflationary gap, then the adjustment of short-run aggregate supply will produce a 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: a recovery phase. The years since 2000 look more like a series of Phillips phases. 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. 16.4 Review and Practice 679 Chapter 16 Inflation and 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. 16
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.4 Review and Practice 680 Chapter 16 Inflation and Unemployment. 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 phase (Phillips, stagflation, or recovery) the economy is in, and suggest what change in aggregate demand or aggregate supply might have caused it. a. “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.’” b. “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 points, the reports suggested that the first month of President Nixon’s second term had gotten off to a rocky start.” c. “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 outcome. Explain what effect changes in oil prices may have on these two variables. 5. The introduction to this chapter suggests that unemployment fell, and inflation generally fell, through most of the 1990s. What phase (Phillips, stagflation, or recovery) does this represent? Relative to U.S. experience from the 1960s until the 1990s, 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? 16.4 Review and Practice 681 Chapter 16 Inflation and Unemployment 7. The Humphrey–Hawkins Act of 1978 required that the federal government maintain an unemployment rate of 4%
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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 people think that the process of putting computer technology to work and incorporating computers into the workplace is causing 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.” 16.4 Review and Practice 682 Chapter 16 Inflation and Unemployment. 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 a. Plot these observations and connect the points as in Figure 16.5 "Inflation—Unemployment Phases". b. How does this period compare to the decades that followed? c. What do you
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think accounts for the difference? 2. Here are hypothetical inflation and unemployment data for Econoland. Time Period Inflation Rate (%) Unemployment Rate (%) 1 2 0 3 6 4 16.4 Review and Practice 683 Chapter 16 Inflation and Unemployment Time Period Inflation Rate (%) Unemployment Rate (%). Plot these points. b. 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? 16.4 Review and Practice 684 Chapter 17 A Brief History of Macroeconomic Thought and Policy Start Up: Three Revolutions in Macroeconomic Thought It is the 1930s. Many people have begun to wonder if the United States will ever escape the Great Depression’s cruel grip. Forecasts that prosperity lies just around the corner take on a hollow ring. The collapse seems to defy the logic of the dominant economic view—that economies should be able to reach full employment through a process of selfcorrection. The old ideas of macroeconomics do not seem to work, and it is not clear what new ideas should replace them. In Britain, Cambridge University economist John Maynard Keynes is struggling with ideas that he thinks will stand the conventional wisdom on its head. He is confident that he has found the key not only to understanding the Great Depression but also to correcting it. It is the 1960s. Most economists believe that Keynes’s ideas best explain fluctuations in economic activity. The tools Keynes suggested have won widespread acceptance among governments all over the world; the application of expansionary fiscal policy in the United States appears to have been a spectacular success. But economist Milton Friedman of the University of Chicago continues to fight a lonely battle against what has become the Keynesian orthodoxy. He argues that money, not fiscal policy, is what affects aggregate demand. He insists not only that fiscal policy cannot work, but that monetary policy should not be used to move the economy back to its potential output. He counsels a policy of steady money growth, leaving the economy to adjust to long-run equilibrium on its own. It is 1970. The economy has just taken a startling turn: Real GDP has fallen, but inflation has remained
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high. A young economist at Carnegie–Mellon University, Robert E. Lucas, Jr., finds this a paradox, one that he thinks cannot be explained by Keynes’s theory. Along with several other economists, he begins work on a radically new approach to macroeconomic thought, one that will challenge Keynes’s view head-on. Lucas and his colleagues suggest a world in which self-correction is swift, 685 Chapter 17 A Brief History of Macroeconomic Thought and Policy rational choices by individuals generally cancel the impact of fiscal and monetary policies, and stabilization efforts are likely to slow economic growth. John Maynard Keynes, Milton Friedman, and Robert E. Lucas, Jr., each helped to establish a major school of macroeconomic thought. Although their ideas clashed sharply, and although there remains considerable disagreement among economists about a variety of issues, a broad consensus among economists concerning macroeconomic policy seemed to emerge in the 1980s, 1990s, and early 2000s. The Great Recession and the financial crisis in the late 2000s, though, set off another round of controversy. In this chapter we will examine the macroeconomic developments of six decades: the 1930s, 1960s, 1970s, 1980s, 1990s, and 2000s. We will use the aggregate demand–aggregate supply model to explain macroeconomic changes during these periods, and we will see how the three major economic schools were affected by these events. We will also see how these schools of thought affected macroeconomic policy. Finally, we will see how the evolution of macroeconomic thought and policy influenced how economists design policy prescriptions for dealing with the recession that began in late 2007, which turned out to be the largest since the Great Depression. In examining the ideas of these schools, we will incorporate concepts such as the potential output and the natural level of employment. While such terms had not been introduced when some of the major schools of thought first emerged, we will use them when they capture the ideas economists were presenting. 686 Chapter 17 A Brief History of Macroeconomic Thought and Policy 17.1 The Great Depression and Keynesian Economics. 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
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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.David C. Wheelock, “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. 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 17.1 "The Depression and the Recessionary Gap" 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. 687 Chapter 17 A Brief History of Macroeconomic Thought and Policy Figure 17.1 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 economics1 is the body of macro
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economic 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 1. The body of macroeconomic thought, associated primarily with 19th-century British economist David Ricardo, that focused on the long run and on the forces that determine and produce growth in an economy’s potential output. 17.1 The Great Depression and Keynesian Economics 688 Chapter 17 A Brief History of Macroeconomic Thought and Policy 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. 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
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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 economics2 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. 2. The body of macroeconomic thought that asserts that changes in aggregate demand can create gaps between the actual and potential levels of output, and that such gaps can be prolonged. It stresses the use of fiscal and monetary policy to close such gaps. 17.1 The Great Depression and Keynesian Economics 689 Chapter 17 A Brief History of Macroeconomic Thought and Policy 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 17.1 "The Depression and the Recessionary Gap", 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.
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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 17.1 The Great Depression and Keynesian Economics 690 Chapter 17 A Brief History of Macroeconomic Thought and Policy 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. 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 17.2 Aggregate Demand and Short-Run Aggregate Supply: 1929–1933 Figure 17.2 "Aggregate Demand and Short-Run Aggregate Supply: 1929–1933" 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
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recessionary gap ever recorded in the United States. We know that the shortrun 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. 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. 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. 17.1 The Great Depression and Keynesian Economics 691 Chapter 17 A Brief History of Macroeconomic Thought and Policy 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.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. As Figure 17.3 "World War II Ends the Great Depression" 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. Figure 17.3 World War II Ends the Great Depression Increased U.S. government purchases,
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prompted by the beginning of World War II, ended the Great Depression. By 1942, increasing aggregate demand had pushed real GDP beyond potential output. 17.1 The Great Depression and Keynesian Economics 692 Chapter 17 A Brief History of Macroeconomic Thought and Policy 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 • 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. T R Y I T! 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. 17.1 The Great Depression and Keynesian Economics 693 Chapter 17 A Brief History of Macroeconomic Thought and Policy Case in Point: Early Views on Stickiness 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 18th- and 19th-century economists developed theoretical arguments suggesting that changes in aggregate
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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 17.1 The Great Depression and Keynesian Economics 694 Chapter 17 A Brief History of Macroeconomic Thought and Policy 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.” Hume’s argument implies sticky prices; some prices are slower to respond to the increase in the money supply than others. Economists of the 18th and 19th century 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.
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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. 17.1 The Great Depression and Keynesian Economics 695 Chapter 17 A Brief History of Macroeconomic Thought and Policy 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. 17.1 The Great Depression and Keynesian Economics 696 Chapter 17 A Brief History of Macroeconomic Thought and Policy 17.2 Keynesian Economics in the 1960s and 1970s. 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
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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, 697 Chapter 17 A Brief History of Macroeconomic Thought and Policy 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 17.4 "The Two Faces of Expansionary Policy in the 1960s", 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. Figure 17.4 The Two Faces of Expansionary Policy in the 1960s 17.2 Keynesian Economics in the 1960s and 1970s 698 Chapter 17 A Brief History of Macroeconomic Thought and Policy Expansionary fiscal and monetary policy early in the 1960s (Panel [a]) closed a recessionary gap, but continued expansionary policy created an inflationary gap
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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 17.4 "The Two Faces of Expansionary Policy in the 1960s". 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 17.4 "The Two Faces of Expansionary Policy in the 1960s" 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. 17.2 Keynesian Economics in the 1960
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s and 1970s 699 Chapter 17 A Brief History of Macroeconomic Thought and Policy 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 selfcorrection delivered it. Figure 17.5 "The Economy Closes an Inflationary Gap" 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. 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. Figure 17.5 The Economy Closes an Inflationary Gap 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. 17.2 Keynesian Economics in the 1960s and 1970s 700 Chapter 17 A Brief History of Macroeconomic Thought and Policy The administration dealt
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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 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. 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
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well as in the long run. They argued that fiscal policy had no effect on the 17.2 Keynesian Economics in the 1960s and 1970s 701 Chapter 17 A Brief History of Macroeconomic Thought and Policy economy. Their “money rules” doctrine led to the name monetarists. The monetarist school3 holds that changes in the money supply are the primary cause of changes in nominal GDP. 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 self-correction 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
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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 3. The body of macroeconomic thought that holds that changes in the money supply are the primary cause of changes in nominal GDP. 17.2 Keynesian Economics in the 1960s and 1970s 702 Chapter 17 A Brief History of Macroeconomic Thought and Policy 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 17.6 "M2 and Nominal GDP, 1960–1980" 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 17.6 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. 17.2 Keynesian Economics in the 1960s and 1970s 703 Chapter 17 A Brief History of Macroeconomic Thought and Policy 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
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in the 1970s. 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 economics4. 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 4. The approach to macroeconomic analysis built from an analysis of individual maximizing choices and emphasizing wage and price flexibility. 17.2 Keynesian Economics in the 1960s and 1970s 704 Chapter 17 A Brief History of Macroeconomic Thought and Policy 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
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, 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 hypothesis5, 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 17.7 "Contractionary Monetary Policy: With and Without Rational Expectations". Suppose the economy is initially in equilibrium at point 1 in Panel (a). Real GDP equals its potential output, YP. Now suppose a reduction in the money supply causes aggregate demand to fall to AD2. In our model, the solution moves to point 2; the price level falls to P2, and real GDP falls to Y2. There is a recessionary gap. In the long run, the short-run aggregate supply curve shifts to SRAS2, the price level falls to P3, and the economy returns to its potential output at point 3. 5. Individuals form expectations about the future based on the information available to them, and they act on those expectations. 17.2 Keynesian Economics in the 1960s and 1970s 705 Chapter 17 A Brief History of Macroeconomic Thought and Policy Figure 17.7 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 AD2. Panel (a) shows the kind of response we have studied up to this point; real GDP falls to Y2 in period (2); the recessionary gap is closed in the long run by falling nominal wages that cause an increase in shortrun 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
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a reduction in the price level but no change in real GDP; the solution moves from (1) to (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 P3. They adjust their expectations accordingly. Workers agree to lower nominal wages, and the short-run aggregate supply curve shifts to SRAS2. This occurs as aggregate demand falls. As suggested in Panel (b), the price level falls to P3, and output remains at potential. The solution moves from (1) to (2) with no loss in real GDP. 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 17.2 Keynesian Economics in the 1960s and 1970s 706 Chapter 17 A Brief History of Macroeconomic Thought and Policy 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
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. 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 Keynesian Economics in the 1960s and 1970s 707 Chapter 17 A Brief History of Macroeconomic Thought and Policy • 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. T R Y I T! 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. 17.2 Keynesian Economics in the 1960s and 1970s 708 Chapter 17 A Brief History of Macroeconomic Thought and Policy Case in Point: Tough Medicine Is Hard to Stomach: Macroeconomic Policy in the
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1960s 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. 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. 17.2 Keynesian Economics in the 1960s and 1970s 709 Chapter 17 A Brief History of Macroeconomic Thought and Policy 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 supplyside troubles in the next decade Even with an inflationary gap, it is possible to pursue expansionary
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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. 17.2 Keynesian Economics in the 1960s and 1970s 710 Chapter 17 A Brief History of Macroeconomic Thought and Policy 17.3 Macroeconomics for the 21st Century. 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. Following the recession that ended in 1982, the last two decades of the 20th century and the early years of the 21st century have sometimes been referred to as the Great Moderation. Yes, there were recessions, but they were fairly mild and shortlived. Prematurely, economists began to pat themselves on the backs for having tamed the business cycle. There was a sense that macroeconomic theory and policy had helped with this improved performance. The ideas associated with macroeconomic theory and policy incorporated elements of Keynesian economics, monetarism, and new classical economics. All three schools of macroeconomic thought contributed to the development of a new school of macroeconomic thought: the new Keynesian school. New Keynesian economics6 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. 711 6. A body of macroeconomic thought that stresses the stickiness
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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 run and in the short run. Chapter 17 A Brief History of Macroeconomic Thought and Policy 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 20th century. Public opinion polls in 1979 consistently showed that most people regarded inflation as the leading problem facing the nation. Figure 17.8 The Fed’s Fight Against 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 shortrun aggregate supply curve, and the economy suffered a recession in 1980. Inflation remained high. Figure 17.8 "The Fed’s Fight Against Inflation" shows how the combined shifts in aggregate
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demand and short-run aggregate supply produced a reduction in real GDP and an increase in the price level. 17.3 Macroeconomics for the 21st Century 712 Chapter 17 A Brief History of Macroeconomic Thought and Policy 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, up to that point, 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. 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. 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
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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. 17.3 Macroeconomics for the 21st Century 713 Chapter 17 A Brief History of Macroeconomic Thought and Policy 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 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
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. 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 17.3 Macroeconomics for the 21st Century 714 Chapter 17 A Brief History of Macroeconomic Thought and Policy 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 was 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 was 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 17.6 "M2 and Nominal GDP, 1960–1980". 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 17.9 "M2 and Nominal GDP, 1980–2011". It shows the same two variables, M2 and nominal GDP, from
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the 1980s through 2011. The tidy relationship between the two seems to have vanished. What happened? 17.3 Macroeconomics for the 21st Century 715 Chapter 17 A Brief History of Macroeconomic Thought and Policy Figure 17.9 M2 and Nominal GDP, 1980–2011 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 17.3 Macroeconomics for the 21st Century 716 Chapter 17 A Brief History of Macroeconomic Thought and Policy 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
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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 deficitfinanced 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. Similarly, doubts about Keynesian economics raised by the events of the 1970s led Keynesians to modify and strengthen their approach. 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 17.3 Macroeconomics for the 21st Century 717 Chapter 17 A Brief History of Macroeconomic Thought and Policy 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.Dan Fuller and Doris Geide-Stevenson, “Consensus among Economists: Revisited,” Journal of Economic Education 34, no. 4 (Fall 2003): 369–87. Just as the new Keynesian approach appears to have won support among most economists, it has become dominant in terms of macroeconomic
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policy. In the United States, the Great Recession was fought using traditional monetary and fiscal policies, while other policies were used concurrently to deal with the financial crisis that occurred at the same time. Did the experience of the 2007–2009 recession affect economists’ views concerning macroeconomic policy? One source for gauging possible changes in the opinions of economists is the twice-yearly survey of economic policy among the National Association for Business Economics (NABE).National Association for Business Economics, Economic Policy Surveys, March 2009 and August 2010, available at http://www.nabe.com. 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 the middle of 2012. Concerning fiscal policy, there was less agreement. Still, according to the survey taken at the time the 2009 fiscal stimulus was being debated, 22% characterized it as “about right,” another third found it too restrictive, and only one third found it too stimulative. In the August 2010 survey, 39% thought fiscal policy “about right,” 24% found it too restrictive, and 37% found it too stimulative. Also, nearly 75% ranked promotion of economic growth as more important than deficit reduction, roughly two thirds supported the extension of unemployment benefits, and 60% agreed that awarding states with federal assistance funds from the 2009 stimulus package was appropriate. Taken together, the new Keynesian approach still seems to reflect the dominant opinion. Is the Great Moderation Over? As did the Great Depression of the 1930s, the Great Recession of the late 2000s generated great fear. Even though it officially ended in the middle of 2009, the state of the economy was the major issue over which the 2012 U.S. presidential election was fought, as the two major political parties offered their competing visions. Unemployment was still high, the housing sector had still not recovered, and the European debt situation loomed in the background. Another lurking question was whether the experience of the recent deep recession, the related financial crisis, and the slow recovery from them would become the new “normal” or whether macroeconomic performance would return to being less volatile. 17.3 Macroeconomics for the 21st Century 718 Chapter 17 A Brief History of Macroeconomic Thought and Policy Economist Todd Clark at the Federal Reserve Bank of Kansas attempted to answer this question.Todd E. Clark, “Is the Great Moderation Over? An
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Empirical Analysis,” Federal Reserve Bank of Kansas City Economic Review 94, no. 4 (Fourth Quarter 2009): 5–42. He first looked at the various explanations for the lower volatility of the U.S. economy during the 25-year period that preceded the Great Recession. Three broad reasons were given: structural changes, improved monetary policy, and good luck. While there is disagreement in the literature as to the relative importance of each of these, Clark argues that there is no reason to assume that the first two explanations for moderation will not continue to have moderating influences. For example, one positive structural change has been better inventory management, and he sees no reason why firms should become less able in the future to manage their inventories using the newly developed techniques. Similarly, in the future, monetary authorities should be able to continue to make the better decisions that they made during the Great Moderation. The element that can vary is luck. During the Great Moderation, the economy experienced fewer serious shocks. For example, oil prices were fairly stable. In contrast, during the recent recession, the price of oil rose from $54 per barrel in January 2007 to $134 per barrel in June 2008. The bursting of the housing price bubble and the ensuing crisis in financial markets was another major shock contributing to the depth and length of the recent recession. Clark says, “Accordingly, once the crisis subsides and the period of very bad luck passes, macroeconomic volatility will likely decline. In the future, the permanence of structural change and improved monetary policy that occurred in years past should ensure that low volatility is the norm.”Ibid., 27. Let’s hope that he is correct • 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. 17.3 Macroeconomics for the 21st Century 719 Chapter 17 A Brief History of Macroeconomic Thought and Policy T R Y I T! 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
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, consider both the short-run and the long-run effects. 17.3 Macroeconomics for the 21st Century 720 Chapter 17 A Brief History of Macroeconomic Thought and Policy Case in Point: Steering on a Difficult Course 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 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 17.3 Macroeconomics for the 21st Century 721 Chapter 17 A Brief History of Macroeconomic Thought and Policy 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
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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 was already in the ditch. The Fed decided on a “no holds barred” approach. It 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. Continuing on smaller expansionary fiscal policy begun under President George W. Bush, the Obama administration for its part advocated and Congress passed a massive spending and tax relief package of more than $800 billion. Besides the members of his economic team, many economists seem to be on board in using 17.3 Macroeconomics for the 21st Century 722 Chapter 17 A Brief History of Macroeconomic Thought and Policy 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
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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 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. As discussed elsewhere in this text, the controversy persists. But the fact that a variety of expansionary policies were used to ease the recession and spur the recovery is not in doubt. 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. 17.3 Macroeconomics for the 21st Century 723 Chapter 17 A Brief History of Macroeconomic Thought and Policy 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 Y2. 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. 17.3 Macroeconomics for the 21st Century 724 Chapter 17 A Brief History of Macroeconomic Thought and Policy 17.4 Review and Practice 725 Chapter 17 A Brief History of Macroeconomic Thought and Policy 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
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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 expansionary 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. 17.4 Review and Practice 726 Chapter 17 A Brief History of Macroeconomic Thought and Policy P R O B L E M S 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
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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? 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? 2. 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. 6. 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. 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? 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? 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? 8. 7. 17.4 Review and Practice 727 Chapter 17 A Brief History of Macroeconomic Thought and Policy 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. a. The price level rises sharply while real GDP falls. b. The price level and real GDP rise. c. The price level falls while real GDP rises
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. d. 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. a. Oil prices rise b. The Fed sells bonds c. Government purchases increase d. Federal taxes increase e. The government slashes transfer payment spending f. 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. 17.4 Review and Practice 728 Chapter 18 Inequality, Poverty, and Discrimination Start Up: Occupy Wall Street and the World It all began September 17, 2011, with a march by thousands of demonstrators unhappy with all sorts of things about the United States—the distribution of income, with rallying cries on behalf of the 99%; “greed” on Wall Street; the bailout of many banks; capitalism in general; and a variety of other perceived ills, from hostility to certain nonfinancial companies such as Walmart and Starbucks to calls for the United States to pull out of military operations around the world and to abolish the Federal Reserve Bank. The symbol of the movement became the occupation of a small park in the neighborhood of Wall Street—Zuccotti Park. Two months later, the park continued to be jammed with demonstrators using it as a campground, after which New York City Mayor Michael Bloomberg shut it down as a place for overnight lodging. Well before then, the “Occupy Wall Street” movement had become a national phenomenon and then an international phenomenon. The Economist in mid-October reported demonstrations in more than 900 cities and in more than 80 countries. The demonstrators generally rejected the entire concept of making specific demands, preferring instead to protest in support of an ill-defined, but clearly compelling, message—whatever that message might have been. Who were the demonstrators? Douglas Schoen, who once worked as a pollster for President Bill Clinton, had his survey firm interview about 200 protesters occupying Zuccotti Park in mid-October of 2011 about their views. According to Schoen's survey, the Zuccotti Park demonstrators were committed to a
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radical redistribution of income and sharp increases in government regulation of the economy, with 98% of them supporting civil disobedience to further their aims and 31% advocating violent measures to achieve their goals. A Pew survey at about the same time found Americans divided in their opinion about the “Occupy Wall Street” movement, with nearly 40% in support and about 35% opposed. At the same time, support and opposition for the Tea Party were running 32% in favor and 44% opposed.“Not Quite Together,” Economist, October 22, 2011; Douglas Schoen, “Polling the Occupy Wall Street Crowd,” Wall Street Journal Online, October 18, 2011; “Public Divided Over Occupy Wall Street Movement,” Pew Charitable Trust Pew Research Center for the 729 Chapter 18 Inequality, Poverty, and Discrimination People & the Press, http://www.people-press.org/2011/10/24/public-divided-overoccupy-wall-street-movement/. Whatever the makeup of the groups demonstrating throughout the world, they clearly brought the issues examined in this chapter—poverty, discrimination, and the distribution of income—to the forefront of public attention. It was not obvious why inequality and related complaints had suddenly become an important issue. As we will see on this chapter, inequality in the U.S. distribution of income had begun increasing in 1967; it has continued to rise ever since. At about the same time as the movement was in the news, the poverty rate in the United States reached its highest level since 1993. The number of people below the U.S. poverty line in 2010—an annual income of $22,314 for a family of four—rose to 15.1% of the population. The number of people considered to be below the poverty level rose to 46.2 million, the highest number ever recorded in the history of the United States. Those statistics came more than four decades after President Lyndon B. Johnson stood before the Congress of the United States to make his first State of the Union address in 1964 to declare a new kind of war, a War on Poverty. “This administration today here and now declares unconditional war on poverty in America,” the President said. “Our aim is not only to relieve the symptoms of poverty but to cure it; and, above, all, to prevent it.” In the United States that year, 35.1 million people, about 22% of the population, were
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, by the official definition, poor. The President’s plan included stepped-up federal aid to low-income people, an expanded health-care program for the poor, new housing subsidies, expanded federal aid to education, and job training programs. The proposal became law later that same year. More than four decades and trillions of dollars in federal antipoverty spending later, the nation seems to have made little progress toward the President’s goal. In this chapter, we shall also explore the problem of discrimination. Being at the lower end of the income distribution and being poor are more prevalent among racial minorities and among women than among white males. To a degree, this situation may reflect discrimination. We shall investigate the economics of discrimination and its consequences for the victims and for the economy. We shall also assess efforts by the public sector to eliminate discrimination. Questions of fairness often accompany discussions of income inequality, poverty, and discrimination. Answering them ultimately involves value judgments; they are normative questions, not positive ones. You must decide for yourself if a particular distribution of income is fair or if society has made adequate progress toward 730 Chapter 18 Inequality, Poverty, and Discrimination reducing poverty or discrimination. The material in this chapter will not answer those questions for you; rather, in order for you to have a more informed basis for making your own value judgments, it will shed light on what economists have learned about these issues through study and testing of hypotheses. 731 Chapter 18 Inequality, Poverty, and Discrimination 18.1 Income Inequality. 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. According to the Congressional Budget Office, between 1979 and 2007, real average household income—taking into account government transfers and federal taxes—rose 62%. For the top 1% of the population, it grew 275%. For others in the top 20% of the population, it grew 65%. For the 60% of the population in the middle, it grew a bit under 40% and for the 20% of the population at the lowest end of the income distribution, it grew about 18%.Congressional Budget Office, “Trends in the Distribution of Household Income Between 1979 and 2007,” October 2011, http://www.cbo.gov/ftpdocs/124xx/doc
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12485/10-25-HouseholdIncome.pdf. 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 substantially over the last half century. A recent study undertaken at the Georgetown University Center on Education and the Workforce concluded that people with a bachelor’s degree earn 84% more over a lifetime than do people who are high school graduates only. That college premium is up from 75% in 1999.Anthony P. Carnevale, Stephen J. Rose, and Ban Cheah, The College Payoff: Education, Occupation, and Lifetime Earnings, Georgetown University Center on Education and the Workforce: 2011, http://cew.georgetown.edu/collegepayoff. Moreover, education is not an equal opportunity employer. A student from a family in the upper end of the income distribution is much more likely to get a college degree than a student whose family is in the lower end of the income distribution. 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. 732 Chapter 18 Inequality, Poverty, and Discrimination 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
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share of income going to the top 5% of households. Income distribution data can be presented graphically using a Lorenz curve1, 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 18.1 "The Distribution of U.S. Income, 1968 and 2010". 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% income and a vertical line up the righthand 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 1. A curve that shows cumulative shares of income received by individuals or groups. 18.1 Income Inequality 733 Chapter 18 Inequality, Poverty, and Discrimination bowed out the curve, the less equal the distribution. We see in Figure 18.1 "The Distribution of U.S. Income, 1968 and 2010" that the Lorenz curve for the United States became more bowed out between 1968 and 2010. Figure 18.1 The Distribution of U.S. Income, 1968 and 2010 The distribution of income among households in the United States became more unequal from 1968 to 2010. 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 2010 was more bowed out than was the curve for 1968. (Mean income adjusted for inflation and reported in 2010 dollars; percentages
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do not sum to 100% due to rounding.) Sources: Carmen DeNavas-Walt, Bernadette D. Proctor, and Jessica C. Smith, U.S. Census Bureau, Current Population Reports, P60-239, Income, Poverty, and Health Insurance Coverage in the United States: 2010, U.S. Government Printing Office, Washington, DC, 2011, Table A-3; U.S. Census Bureau, Current Population Survey, 2010 Annual Social and Economic Supplement, Table HINC-05. The degree of inequality is often measured with a Gini coefficient2, 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 more unequal distributions. The Census Bureau reported that the Gini coefficient was 0.359 in 1968 and 0.457 in 2010.Carmen DeNavas-Walt, Bernadette D. Proctor, and Jessica C. Smith, U.S. Census Bureau, Current Population Reports, P60-239, Income, Poverty, and Health Insurance Coverage in the United States: 2010, U.S. Government Printing Office, Washington, DC, 2011. Mobility and Income Distribution 2. A measure of inequality expressed as the ratio of the area between the Lorenz curve and a 45° line and the total area under the 45° line. 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 18.1 Income Inequality 734 Chapter 18 Inequality, Poverty, and Discrimination point in time, as was done in Figure 18.1 "The Distribution of U.S. Income, 1968 and 2010". 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,
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which simply take a snapshot of incomes at a particular time. Based on the University of Michigan’s data, Federal Reserve Bank of Boston economist Katharine Bradbury compared mobility over the decades through 2005. She concluded that on most mobility measures, family income mobility was significantly lower in the 1990s and early 2000s than in earlier periods. Moreover, when families move out of a quintile, they move less. Finally, she notes that for the recent decades moving across quintiles has become harder to achieve precisely because of the increased income inequality.Katharine Bradbury, “Trends in U.S. Family Income Mobility, 1969–2006,” Federal Reserve Bank of Boston Working Paper no. 11-10, October 20, 2011. 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 2010, the median income of families headed by married couples was 2.5 times that of families headed by women without a spouse. The percentage of families headed by women with no spouse present has nearly 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. 18.1 Income Inequality 735 Chapter 18 Inequality, Poverty, and Discrimination 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 highschool-trained workers. 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-
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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. 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 Reagan tax cuts introduced in 1981 and the Bush tax cuts introduced in 2001, 2002, and 2003. An analysis of the Bush tax cuts by the Tax Foundation combines the three Bush tax cuts and assumes they occurred in 2003. Table 18.1 "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. 18.1 Income Inequality 736 Chapter 18 Inequality, Poverty, and Discrimination Table 18.1 Income Tax Liability Before and After the Bush Tax Cuts Quintile Share of income tax liability before tax cuts Share of income tax liability after tax cuts Share of total tax relief First quintile Second quintile Third quintile Fourth quintile Top quintile 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 two-thirds 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
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Facts, August 24, 2004. Tax cuts under George W. Bush were widely criticized as being tilted unfairly toward the rich. And certainly, Table 18.1 "Income Tax Liability Before and After the Bush Tax Cuts" shows that the share of total tax relief received by the first four quintiles was modest, while those in the top quintile garnered more than two-thirds of the total benefits of the three tax cuts. Looking at the second and third columns of the table, however, gives a different perspective. 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. Further, we see that each of the first four quintiles paid a very small share of income taxes before and after the tax cuts, while those in the top quintile ended up shouldering more than 80% of the total income tax burden. We saw in Figure 18.1 "The Distribution of U.S. Income, 1968 and 2010" that those in the top quintile received just over half of total income. After the Bush tax cuts, they paid 81% of income taxes. 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 18.1 Income Inequality 737 Chapter 18 Inequality, Poverty, and Discrimination 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. For example, quintiles of households do not contain the same number of people. Rea Hederman of the Heritage Foundation, a conservative think tank, notes that the top 20% of households contains about 25% of the population. Starting in 2006, the Census Bureau report began calculating a measure called “equivalence-adjusted income” to take into account family size. The Gini coefficient for 2010 using this adjustment fell slightly from 0.469 to 0.457. The trend over time in the two Gini coefficients is similar. Two other flaws pointed out by Mr. Hederman are that taxes and benefits from noncash programs that help the poor are not included. While some Census studies attempt to take these into account and report lower inequality, other studies do not receive
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as much attention as the main Census annual report.Rea S. Hederman, Jr., “Census Report Adds New Twist to Income Inequality Data,” Heritage Foundation, Policy Research and Analysis, No. 1592, August 29, 2007. Even studies that look at incomes over a decade may not capture lifetime income. For example, people in retirement may have a low income but their consumption may be bolstered by drawing on their savings. Younger people may be borrowing to go to school, buy a house, or for other things. The annual income approach of the Census data does not capture this and even the ten-year look in the mobility study mentioned above is too short a period. This suggests that more precise measurements may provide more insight into explaining inequality. 18.1 Income Inequality 738 Chapter 18 Inequality, Poverty, and Discrimination • 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 curve 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 40 years. • The degree of mobility up and down the distribution of income appears to have declined in recent years. • 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. T R Y I T! 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? 18.1 Income Inequality 739 Chapter 18 Inequality, Poverty, and Discrimination Case in Point: Attitudes and Inequality © 2010 Jupiterimages Corporation In a fascinating examination of attitudes in the United States and in continental Western Europe, economists Alberto Alesina of Harvard University and GeorgeMarios 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
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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. 18.1 Income Inequality 740 Chapter 18 Inequality, Poverty, and Discrimination 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 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. 18.1 Income Inequality 741 Chapter 18 Inequality, Poverty, and Discrimination The Lorenz curve showing the distribution of income after taxes and benefits
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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. 18.1 Income Inequality 742 Chapter 18 Inequality, Poverty, and Discrimination 18.2 The Economics of Poverty. 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. 3. Income test that sets a specific income level and defines a person as poor if his or her income falls below that level. These two approaches represent two bases on which poverty is defined. The first is an absolute income test3, which sets a specific income level and defines a person as 743 Chapter 18 Inequality, Poverty, and Discrimination poor if his or her income falls below that level. The second is a relative income test4, in which people whose incomes fall at the bottom of the income distribution
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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 2010, any U.S. household with an annual income below $20,000 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 line5. In 2010 the poverty line for a family of four was an income of $22,314. Figure 18.2 "Weighted Average Poverty Thresholds in 2010, by Size of Family" shows the poverty line for various family sizes. Figure 18.2 Weighted Average Poverty Thresholds in 2010, by Size of Family 4. Income test in which people whose incomes fall at the bottom of the income distribution are considered poor. 5. Amount of annual income below which the federal government defines a household as poor. 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, P60-239, Income, Poverty, and Health Insurance Coverage in the United States: 2010, U.S. Government Printing Office, Washington, D.C., 2011; p. 61. 18.2 The Economics of Poverty 744 Chapter 18 Inequality, Poverty, and Discrimination 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 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.
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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 oneseventh 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. In addition, the U.S. Census Bureau and the Bureau of Labor Statistics have begun working on more broad-based alternative measures of poverty. The new Supplemental Poverty Measure is based on expenses for food, clothing, shelter, and utilities; adjusts for geographic differences; adds in various in-kind benefits such as school lunches, housing subsidies, and energy assistance; includes tax credits; and then subtracts out taxes, work expenses, and out-of-pocket medical expenses.Kathleen Short, U.S. Census Bureau, Current Population Reports P60-241, Supplemental Poverty Measure: 2010, U.S. Government Printing Office, Washington, DC, November 2011. The percentage of the population that falls below the poverty line is called the poverty rate6. Figure 18.3 "The Poverty Rate in the United States, 1959–2010" shows both the number of people and the percentage of the population that fell below the poverty line each year since 1959. 6. The percentage of the population that falls below the poverty line. 18.2 The Economics of Poverty 745 Chapter 18 Inequality, Poverty, and Discrimination Figure 18.3 The Poverty Rate in the United States, 1959–2010 The curve shows the percentage of people who lived in households that fell below the poverty line in each year from 1959 to 2010. The poverty rate fell through the 1960s and since has been hovering between about 12% and 15%. It tends to rise during recessions. Source: DeNavas-Walt, Carmen, Bernadette D. Proctor, and Jessica Smith, U.S. Census Bureau, Current Population Reports P60-239, Income, Poverty, and Health Insurance Coverage in the United States: 2010, U.S. Government Printing Office, Washington DC, 2011; Figure 4,
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p. 14. 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, people defined as poor 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, based on data from 2005 to 2009, 42% of poor households in the United States owned their own homes, nearly 75% owned a car, and 64% have cable or satellite TV. Over 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.Robert Rector and Rachel Sheffield, “Understanding Poverty in the United States: Surprising Facts about America’s Poor,” Heritage Foundation, Policy Research & Analysis, No. 2607, September 13, 2011. We often think of poverty as meaning that poor people are unable to purchase adequate food. Yet, according to Department of Agriculture surveys, 83% of poor 18.2 The Economics of Poverty 746 Chapter 18 Inequality, Poverty, and Discrimination people report that they have adequate food and 96% of poor parents report that their children are never hungry because they cannot afford food. 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
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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 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 18.4 "The Demographics of Poverty in the United States, 2010" shows poverty rates for various groups and for the population as a whole in 2010. What does it tell us? 18.2 The Economics of Poverty 747 Chapter 18 Inequality, Poverty, and Discrimination 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 4.7%. 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 about nine 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 2010 for whites (non-Hispanic origin) was less than half that for Hispanics or of blacks. 6. The poverty rate
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