Archive for August, 2009

Aug 27 2009

Welker’s daily links 08/26/2009

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Aug 26 2009

Inflation: a threat to fear now or a distant concern?

Fidelity Investments – Inflation: A Threat or Not? by Dirk Hofschire

I was surprised to receive an email from the company that manages my personal investments directing me to an article that I would be able to use in class. But this analysis by a vice president of Fidelity Investments offers and excellent, concise examination of the threat posed by inflation in America today. I will use excerpts from the article and present the ideas in a graphical form to help students better understand the situation faced by the US as it struggles to emerge from its deep recession.

Hofschire sets out to answer four questions about inflation:

1. Is inflation accelerating?
2. Why is higher inflation expected?
3. Why hasn’t inflation occurred yet?
4. When will inflation return?
5. How high will inflation go?

1. Is in flation accellerating:

In short, NO.

In June, the U.S. consumer price index (CPI) declined 1.2% (on a year-over-year basis), representing the biggest fall in prices since 1950.1 Much of the decline is attributable to the steep drop in energy prices over the past year, which may reverse itself in the second half of 2009 if crude-oil prices remain near current levels. However, core CPI—which excludes food and energy—was less than 1.8% in June, demonstrating little inflationary pressure in general

A combination of weak aggregate demand and low resource costs for firms has kept price levels down.  While total spending has falling (leftward shift of AD), firms’ costs of production have fallen (rightward shift of AS). Since total output fell we can see that national income (Y) is less in 2009 than in 2008. Since price level has fallen, we can see deflation.

Diagram 1:

25 8 blog post graphs_1

2. Why is higher inflation expected?

With little evidence of economic strength or cost-push inflation today, the concern now is that the monetarist economic view of the world sees inflation clouds on the horizon. The godfather of modern monetarist economic thought, Milton Friedman, once stated, “Inflation is always and everywhere a monetary phenomenon.” What Friedman meant was that money—specifically changes in the supply and use of currency—was the primary driver for changes to price levels in an economy. Friedman informally defined inflation as “too much money chasing too few goods and services.” As a result, an excessive increase in the amount or use of money relative to economic output is the textbook prescription for inflation.

The inflation described above, and feared by Friedman and today’s monetarists is not of the cost-push type, rather the demand-pull variety. As the vast quantities of money injected by the US Fed work their way through the banking system and into the pockets of consumers and the hands of firm managers, eventually demand for America’s goods and services will rise. But in the current recession, the production of those goods and services has stagnated, meaning that once all this money starts getting spent, the competition among buyers for the limited output of producers will drive prices up.

Diagram 2:

25 8 blog post graphs_2

3. Why hasn’t inflation occurred yet?

…there remains considerable downward pressure on prices still in place, due to growing slack in the economy (i.e. underutilized resources, such as labor) and continued deleveraging by consumers and financial firms with heavy debt loads. With the unemployment rate at its highest level in 26 years and consumers saving more and spending less, there is little upward pressure on wages or prices for consumer goods.

Yes, the money supply has increased, which according to our answer to number 2 should lead to inflation. But not if the new money isn’t being spent! Banks with money from the Fed are holding onto their excess reserves instead of loaning them out, due to a prevailing lack of confidence in borrowers ability to repay loans during these hard economic times. If all the money the Central Bank is injecting in the economy is sitting idle, and resources such as labor, land and capital are under-employed, then there is little fear of cost-push nor demand-pull inflation.  Diagram 1 illustrates why inflation hasn’t occured yet.

The excess bank reserves thus represent both the potential for future inflation as well as the explanation for why rapid money growth has yet to create current inflation.

In short, money must be spent to drive inflation up. When households prefer savings to consumption and banks prefer liquidity to risk, inflation is only a distant fear.

4. When will inflation return?

Interestingly, the answer to this question can be summed up as: “hopefully sooner rather than later”. Despite popular belief, some inflation is considered a positive sign of economic growth. Just as deflation is the purveyor of doom and gloom (unemployment, uncertainty, low consumer and investor confidence, credit crunch, etc) inflation is a sign of health returning to the economy (improved confidence, rising employment, looser credit markets, expectations of future growth). Central Bankers like Bernanke will surely be showered with praise, while congressman will be quick to give credit to the fiscal stimulus package.

Whether the pick-up in money velocity leads to significantly higher inflation depends on how quickly the Fed pulls the reins back on the extraordinary credit it is currently providing. In theory, the Fed can take actions to reduce the size of its balance sheet and move back to a more appropriate level of money. In practice, due to the unprecedented expansion in the Fed’s balance sheet, this will be a challenge.

Just as it was the Fed”s and government’s job to get the party started through expansionary monetary and fiscal policies, it is equally important for policymakers to calm the party down should the level of inflation begin to rise.

Diagram 3:

25 8 blog post graphs_3

5. How high will inflation go?

Given the high level of slack (i.e. underutilized resources) likely to remain in the economy during the next two years, there also could be offsetting deflationary pressures lingering in the system. For example, the unemployment rate is expected to rise above 10% and not peak until sometime in 2010. Industrial capacity utilization rates are at their lowest level on record, which means a lot of unused capacity in the manufacturing sector. This slack must tighten considerably before upward pressure is placed on wages and other prices.

As a result of this downward pressure on wages, which remain the largest expense for corporations, it would appear a 1970s-style, double-digit inflation outburst remains unlikely in the short to medium term. Average weekly earnings for U.S. workers rose more than 7% annually during the period from 1975-1981 in which consumer price inflation averaged more than 9% and peaked at 14% in 1980.5 It is hard to foresee wage gains of that magnitude reinforcing inflation pressures during the next couple of years.

The 1970′s was a period of high inflation in the US, caused primarily by higher costs for firms rather than increasing demand for output. This “cost-push” inflation is unlikely to occur in today’s climate due to the high levels of unemployment and under-employment of labor, land and capital resources. This does not mean inflation won’t happen, just that it’s unlikely to look like the cost-push variety of the 1970′s.

Diagram 4:

25 8 blog post graphs_4

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Aug 26 2009

Welker’s daily links 08/25/2009

  • One response to the current crisis has been a rise in the popularity of behavioural economics, which examines the psychological and emotional factors behind transactions. These models drop the assumption of the rational actor yet implicitly keep the same model of economic rationality at their heart. We may diverge from the path of rationality for all sorts of psychological reasons but only because emotion, Keynes’s famous “animal spirits”, clouds our judgment.

    tags: economics, rational behavior, markets

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Aug 23 2009

Rational behavior, opportunity cost, marginal analysis – An intro to the Economic way of thinking

Freakonomics – Laid-Back Labor – New York Times

If you’ve spent much time on this blog, you know that I’m a fan of the boys at Freakonomics, the book that so aptly applies economic theory to the seemingly benign happenings of everyday life. In the article above the Freakonomists examine the difference between labor and leisure. I thought this article did a good job of introducing some of the basic concepts behind how economists think about the world.

As this year’s AP students begin to delve into the world of economics, one of the early topics they study will be the concept of humans as rational beings engaged in the constant pursuit of utility (the economist’s word for happiness). According to our text, “Economics assumes that human behavior reflects ‘rational self-interest.’ Individuals look for and pursue opportunities to increase their utility.”

If, as economists say, the purpose of life it the pursuit of utility, then presumably work is only a tedious but necessary means to an end, which we assume to be leisure. So why, as pointed out in the article above, do so many people willingly choose to spend so much time and money doing things like cooking, knitting, gardening, working in the yard, and other tasks that appear to be work, when they could easily pay others to do these menial chores for them, thus giving them more time for leisure? As the authors say, “Isn’t it puzzling that so many middle-aged Americans are spending so much of their time and money performing menial labors when they don’t have to?”

Where exists the line between work and leisure? This seems like an apt question to explore from an economic perspective. Here’s the author’s view:

“Economists have been trying for decades to measure how much leisure time people have and how they spend it, but there has been precious little consensus. This is in part because it’s hard to say what constitutes leisure and in part because measurements of leisure over the years have not been very consistent.http://www.rideau-info.com/canal/images/locks/mowing.jpg

Economists typically separate our daily activities into three categories: market work (which produces income), home production (unpaid chores) and pure leisure. How, then, are we to categorize knitting, gardening and cooking? While preparing meals at home can certainly be much cheaper than dining out and therefore viewed as home production, what about the ‘cooking for fun’ factor?”

Why a professional (let’s say a lawyer) who spends 50 hours a week in his office, earning somewhere in the range of $100 an hour for his labor, would choose to spend two hours mowing his lawn on a Saturday, rather than hiring the neighbor boy to do it for him, truly poses an economic paradox.

Let’s see why: If this man’s labor is worth $100 and hour, then we can calculate the opportunity cost of mowing his own lawn as $200 plus the value to this man of the leisure he could have enjoyed by not mowing his lawn. The man probably could have hired the neighbor boy to mow his lawn for $20, which would have then freed him up to pursue his own leisure activities (reading, working out, watching a movie, etc.) during those two hours, and compared to the $200 value of his own labor the $20 seems like a bargain. So is a lawyer who mows his own lawn acting irrationally?

It would seem the line separating leisure from work has blurred in modern times. A hundred years ago an activity such as sewing or caring for a lawn would certainly have been viewed as work, but today the behavior of millions of Americans would indicate otherwise. As a science rooted in the belief that humans are rational pursuers of their own happiness and leisure, the paradox of the lawn mowing lawyer poses several interesting questions for students of economics.

Discussion Questions:

According to chapter one of our text (McConnell and Brue’s Economics, 17th Edition), “Purposeful (rational) behavior does not assume that people and institutions are immune from faulty logic and therefore are perfect decision makers. They sometimes make mistakes.”

  1. Is the lawyer who mows his own lawn defying a fundamental rule of economics, that people act rationally? Is he making a mistake by not hiring the neighbor boy to do it for him?
  2. What is meant by opportunity cost? Give an example of a decision you have made recently that involved an opportunity cost.
  3. How is the lawyer’s decision whether or not to mow his lawn rooted in marginal analysis? Describe a choice you’ve made recently that involved marginal analysis.

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Aug 18 2009

Welker’s daily links 08/17/2009

  • Investor’s Business Daily would like you to believe that Obamacare would turn America into Britain — or, rather, a dystopian fantasy version of Britain. The screamers on talk radio and Fox News would have you believe that the plan is to turn America into the Soviet Union. But the truth is that the plans on the table would, roughly speaking, turn America into Switzerland — which may be occupied by lederhosen-wearing holey-cheese eaters, but wasn’t a socialist hellhole the last time I looked.

    tags: economics

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