I received the following email today, which gave me a great excuse to write a blog post about monetary policy! My reply to the teacher is below.

Jason,

I hate to bug you, but I have a question. I am a first year AP Econ teacher and I know something is going to come up right away and I want to explain it in the simplest way. “Why can’t the govt. just print more money?” I know the inflation part of it, but when I am reading to look for quality ways of explaining it, I see plenty of information about it, but I can’t grasp it. Principle 9 in Mankiw text states “Prices rise when the govt. prints too much money.” I feel like a dumb kid and I am supposed to teach this!!!!

If you can help, great, if not, I will figure it out.

Thanks,
Teacher

Dear Teacher,

I love your question! It is definitely one of those issues that gets glossed over in most economics textbooks. Or it is assumed that the money supply diagram makes it obvious why excessive monetary growth leads to inflation. But I agree, this is one of those things that for the first couple of years I taught economics, I probably didn’t really understand all that well either! So let me try to break it down in plain English for you. This will be good for me too, cause I always understand things more clearly myself after writing them (which is why writing a textbook is about the best PD I’ve every undertaken!)

So, here it goes:

Printing money and its effect on inflation is a bit more complicated than it sounds. In fact, it is the US treasury that prints money, but it is the Federal Reserve that determines how much money is actually in circulation in the economy. Money printed by the Treasury is distributed to the twelve Federal Reserve banks around the country. The treasury and the government of which it is a part does not have any say on how much money actually gets injected into the economy, as monetary policy decisions are left up to the Federal Reserve.

Traditionally, the Fed has one tool for injecting new money into the economy, a tool known as “open market operations”. (I say traditionally, because in the last three years the Fed has devised numerous new ways to “inject liquidity” into the economy, which I will not get into now). To increase the nation’s money supply, the Fed buys US government bonds on the open market from commercial banks. Commercial banks invest some of American households’ savings into government bonds just like they invest some of our money into individuals and businesses by making loans and charging interest on those loans. Commercial banks will want to buy government bonds if the interest on them rises and will want to sell those bonds when the interest rate falls.

If the Fed want to increase the money supply to stimulate spending in the economy, it will announce an open market purchase of bonds. When the Fed buys bonds, the demand for bonds increases, raising their prices and lowering their effective interest rate. As the interest on government bonds falls as a result of the Fed’s open market operations, banks find them less desirable to hold onto as investments and therefore sell them to the Fed in exchange for, you guessed it, liquid money, fresh off the printing presses!

Remember, the money printed at the Treasury and held at the Fed was NOT part of the money supply, since it is out of reach of private borrowers. But as soon as the Fed buys bonds with that money, it is deposited into commercial banks’ excess reserves and is therefore now in the commercial banking system and therefore part of the money supply. So, “printing money” does not immediately increase the money supply since newly printed money only ends up in the Fed; only once the Fed has undertaken an expansionary monetary policy (an open market bond purchase) does the newly printed money enter the money supply.

Now, commercial banks have just sold their illiquid assets (government bonds) to the Fed in exchange for liquid money. Picture the money market diagram and you will see the money supply increasing.

So the next question is, why does this lead to inflation?

Banks now hold more excess reserves, most of which are kept on reserve at their regional Federal Reserve bank. Reserves held at the Fed do NOT earn interest for the banks, and therefore actually lose value over time as inflation erodes the purchasing power of these idle reserves. Banks, of course, want to invest these reserves to earn interest beyond the rate of inflation and thereby create earn them revenue. In order to attract new borrowers, commercial banks, whose reserves have increased following the Fed’s bond purchase, must offer borrowers a lower interest rate. The increase in the supply of money leads to a decrease in the “price” of money, i.e. the interest rates banks charge borrowers.

So here we see why an increase in the money supply leads to lower interest rates. With greater excess reserves, banks must lower the rate they charge each other (the federal funds rate) and thus the prime rate they charge their most credit-worthy borrowers and all other interest rates in the economy, in order to attract new borrowers and get their idle reserves out there earning interest for the bank.

Lower interest rates create an incentive for firms to invest in new capital since now more investment projects have an expected rate of return equal to or greater than the new lower interest rate. Additionally, the lower rates on savings discourages savings by households and thereby increases the level of household consumption. Households find it cheaper to borrow money to purchase durable goods like cars and it also becomes cheaper to buy new homes or undertake costly home improvements. So we begin to see investment and consumption rise across the economy as the increase in the money supply reduces borrowing costs and decreases the incentive to save. Aggregate demand has started to rise.

Additionally, the lower rate on US government bonds resulting from the Fed’s open market purchase reduces the incentive for foreign investors to save their money in US bonds and in US banks, which are now offering lower interest rates. Falling foreign demand for the dollar causes it to depreciate. A weaker dollar makes US exports more attractive to foreign consumers, so in addition to increased consumption and investment in the US, net exports begin to rise as well, further increasing aggregate demand.

Increasing the money supply (not so much by printing money rather because of the “easy money” policy of the Fed), leads to increased consumption, investment, and net exports, and therefore aggregate demand in the economy. The rising demand among domestic consumers, foreign consumers, and domestic producers for the nation’s output puts upward pressure on prices as the nation’s producers find it hard to keep up with the rising demand. Once consumers start to see prices rising, inflationary expectations will further increase the incentive to buy more now and save less, leading to even more household consumption. Firms see price rises in the future and increase their investment now to meet the expected rises in demand tomorrow.

It does not take much for inflation to accelerate in such an environment. If the the government and the Fed do not slow down the increase in the money supply (STOP THE PRINTING PRESSES!) then soon enough workers will begin demanding higher wages and resource costs will start to increase in all sectors of the economy, causing the nation’s aggregate supply to decline as firms find it harder to cover their rising costs. Now we have both demand-pull AND cost push inflation! The weaker currency also makes imported raw materials more costly to firms, further adding to the inflationary environment. An inflationary spiral is now underway!

Milton Friedman said that “inflation is always and everywhere a monetary phenomenon”. Controlling the rate of growth in the money supply, say the monetarists, will assure that the fluctuations in the business cycle will be mild and periods of dramatic inflation and deflation can be avoided. Stable money growth should lead to stable economic growth. But as soon as we start running the printing presses inflation will not be far behind. On the flip-side, contractionary monetary policies should in theory lead to the exact opposite of what I describe above and cause a deflation. If a central bank were to tighten the money supply too much, interest rates would rise, investment, consumption and net exports would fall, and falling prices would force firms to lay off workers, leading to high unemployment and an economic contraction.

I’ll leave you with one question to ponder (the answer to which would require a much longer article than this one!). If Friedman was right, and increasing the money supply will always and everywhere lead to inflation, then how is it that the monetary base in the United States increased by 142% between 2008 and 2009, yet inflation declined over the same period and fell to as low as -2% in mid-2009? That’s right, the money supply more than doubled, yet the economy went into deflation. Was Friedman missing something in his calculation that monetary growth always leads to price level increases? In other words, is an open market purchase of bonds by the Fed all that is needed to stimulate demand during a recession? Perhaps Friedman, who died in 2006 right before the US entered the Great Recession, would have to re-consider his famous quote if he could see the effect (or lack of effect) of America’s unprecedented monetary growth over the last three years!

Over a year has gone by since the 2009 American Recovery and Reinvestment Act (ARRA) was passed and put into action by the Obama Administration. Supporters of the program say that it has been successful, arguing that the economy would be in much worse shape if no stimulus had been introduced at all. In fact, some are arguing that government spending has not been sufficient for a full economic recovery and that more direct government spending is necessary. Economists on the other side argue that the stimulus package has done little for the economy except to delay the inevitable, self correcting forces of the economy needed to pave the road back to recovery. Some actually say that we are in a worse situation now due to the massive increase in government debt which will eventually have to be paid back.

So the question is, are we better off as an economy a year after the stimulus package was introduced? With growth still sluggish and unemployment at 9.5%, many people have begun to question the success of the ARRA. Again, some say the $784 billion was insufficient while others say less regulation and more tax cuts should have been utilized.

In a recent Washington Post article, Neil Irwin argues that the obstacles towards economic growth may not be solved by more stimulus, lower interest rates or tax cuts for corporations. The problem, he claims, is not a lack of funds for investment, but in the uncertainty businesses have in future conditions. He writes:

Corporate profits are soaring. Companies are sitting on billions of dollars of cash. And still, they’ve yet to amp up hiring or make major investments — the missing ingredients for a strong economic recovery. Many Democrats say the economy needs more stimulus. Business lobbyists and their Republican allies say it needs less regulation and lower taxes. But here in the heartland of America, senior executives say neither side’s assessment fits.

They blame their profound caution on their view that U.S. consumers are destined to disappoint for many years. As a result, they say, the economy is unlikely to see the kind of almost unbroken prosperity of the quarter-century that preceded the financial crisis.

With consumers choosing to save or pay off their debts now rather than spend, many businesses find it in their interest to hold off on investments into new capital until consumers begin spending again. With no planned investment and no incentive to hire workers, unemployment stays high and economic growth remains stagnant. With inflation rates low and economists predicting deflation, it makes more sense to hold onto money as it is not losing its value.

So is there a solution? In this situation, expansionary monetary policy through lower interest rates will not have the desired effect as demand for loanable funds is low. As stated in the article:

For large companies such as Illinois Tool Works, the price of borrowed money isn’t the problem. The company had $1.3 billion in cash on its balance sheet at the end of June, up from $743 million at the end of 2008. Lower interest rates wouldn’t make much of a difference, either.

“I could borrow $2 billion tomorrow for 3 1/2 percent,” said Speer. “But what am I going to do with it?””

Other executives claim that an increase in government spending would only provide a temporary fix but have no effect on long term consumer spending.

David Speer is chief executive of the company, which has 60,000 employees worldwide in more than 800 business units and $14 billion in sales. He said an additional burst of fiscal stimulus from Washington might help boost economic growth for a period of months. But that is unlikely to affect his decisions about hiring and expansion, which Speer said are based on expectations for sales over years to come, not just the immediate future. As long as U.S. consumers remain deeply strained, he is unlikely to undertake aggressive expansion.

More fiscal stimulus “might help make things a little better for a couple of quarters, but I’m not sure it would get at the underlying economic issue,” Speer said. “The core question is: How do you get consumers back on their feet. We need growth in a sustainable way, not another Band-Aid.”

Another solution would be for the government to implement supply side measures such as less market regulation and lower corporate taxes. Again, without the much needed consumer spending and confidence, its difficult to say whether or not this will materialize into increased investment and employment.

The rest of the Washington Post article can be read here. Once you’ve read the article, answer discuss the questions below and share your thoughts in a comment on this post.

Discussion Questions:

In the seemingly endless and currently ongoing debate over the role of the government in the macroeconomy, there are two main camps: Those who think the governments of the developed economies have not done enough to get their economies out of recession, and those who think they have already done too much, and therefore need to start rolling back stimulus and reducing deficits.

At the heart of this debate are the two macroeconomic schools of thought, the  Keynesian demand-side theories and the classical, supply-side theories. Two intellectuals have emerged in the last several years representing the two sides of the macroeconomic debate. On the demand-side, representing the Keynesian school of thought, is 2008 Nobel Prize winning economist Paul Krugman. Representing the classical, supply-side school of thought is Harvard economic historian Niall Ferguson. These two have squared off in many forums over the last three years, Krugman arguing for more and continued fiscal stimulus to prop up and increase demand in the economy, Ferguson arguing for smaller deficits, lower taxes and less government spending to increase private sector confidence and thereby supply in the economy.

During our long summer break the two squared off once again in the aftermath of a G20 meeting in which the governments of several major economies from Europe and North America announced plans to begin rolling back the stimulus spending they embarked on throughout 2008 and 2009. The reason for increased “austerity measures” (policies that reduce the budget deficit and slow the growth of national debt), argue global leaders, is to reduce the chances of more countries experiencing debt crises like that experienced in Greece this spring.

International investors realized earlier this year that Greece’s budget deficits were a much larger percentage of its GDP than previously thought, and very quickly decided that Greek government bonds were an unsafe investment. Almost overnight the cost of borrowing in Greece shot up above 20%, bringing investment in the economy to a halt and forcing the government to cut its budget, leading to higher unemployment and reduced social benefits for the people of Greece.  If investors were to look at the growing budget deficits in other developed countries and  then suddenly lose faith in other government’s ability to pay back their debts, then a similar crisis could occur in much larger economies, including the UK, Germany and the United States. Hence these country’s apparent desire to begin reducing deficits and rolling back stimulus spending; measures that may just plunge these economies into an even deeper recession than that which they have experienced over the last two years.

The videos below show the leading intellectuals on both sides of the stimulus/austerity debate presenting their arguments. Below each video are discussion questions to help guide your understanding of their views. Watch the videos and respond to the discussion questions in the comment section below.

Video 1 - Krugman argues for continued stimulus:

Discussion Questions:

Video 2 - Ferguson argues for austerity and “fiscal regime change”:

Discussion Questions:

1. Why does Hayek's "classical" aggregate supply curve always lead to an equilibrium level of national output equal to the full-employment level of
   

    real GDP?

2. The vertical AS curve above is sometimes referred to as the "flexible-wage and flexible-price" model of the macroeconomy. Why must wages and prices be perfectly flexible for this model to be an accurate representation of a nation's economy.
3. Hayek was an advocate for free markets, he felt that government intervention in a nation's economy would only interfere and disrupt the efficient allocation of resources. How does the model above reflect his belief that governments cannot improve a nation's level of output beyond what the free market is able to achieve?
4. Do you believe that the classical model of aggregate supply is representative of the real world? Why or why not? What evidence is there from recent history that the model is or is not accurate?

Figure 2: The Keynesian AD/AS model

1. Based on the model above, which level of aggregate demand corresponds with the macroeconomic goals of "full-employment and stable 
   

   prices"? 

2. Changes in which factors could cause aggregate demand to shift from AD2 to AD3? If AD falls to AD3, what happens to the price level in the economy? What happens to the level of output of goods and services? What happens to employment and unemployment?
3. Sometimes the Keynesian AS model is known as the "sticky-wage and sticky-price model". How does the model reflect the idea that wages are downwardly inflexible, in other words, will not fall even if demand for goods and services fall? For what reasons might wages in an economy be downwardly inflexible (in other words, not fall even as total demand in the economy falls)?
4. How realistic is the Keynsian model of aggregate supply in the real world? 
1. Can you point to any evidence from the last few years that it might be correct (in other words, that a fall in AD will lead to decrease in national output?) Find data on the GDP's of two Western European countries from 2008 and 2009 to support your findings. 
2. Can you point to any evidence from the last few years that the model might be flawed (in other words, that a fall in AD actually does lead to a fall in the price level)? Find data on inflation in the same two Western European countries to examine whether or not wages and prices are completely inflexible downwards as the model suggests.

1. How does the above model represent a compromise between Keynes' and Hayek's view of aggregate supply?
2. Why are there two aggregate supply curves? What is the difference between the two?
3. What happens in the SHORT-RUN when AD falls from AD2 to AD3 to the price level and output? What will happen in the long-run? In macroeconomics, the short-run is known as the "fixed-wage period" and the long-run the "flexible-wage period". The main factor that can shift the SRAS curve is the level of wages in the economy (in other words, a change in wages will shift the SRAS). How does this help explain the adjustment from the short-run equilibrium and the long-run equilibrium following a fall in AD?
4. What happens in the SHORT-RUN when AD increases from AD2 to AD1? What will happen in the long-run? How does the long-run flexibility of wages explain why output always seems to return to its full employment level of output in the long-run?
5. What does the model above indicate about the possible need for government intervention to help an economy achieve its macroeconomic goals of full-employment and price level stability in the short-run? 

Directions: Macroeconomics is an area of study with precise goals attached to it. Macroeconomists generally agree that there are three primary goals towards which policies should be used to try and achieve:

• Full employment of the nation’s resources, including labor, land and capital.
• Price level stability, meaning a low (generally between 2% and 4%) inflation rates
• Economic growth, meaning a year on year increase in the nation’s output of goods and services and the average income of the nation’s people.

Understanding the indicators used in macroeconomics to measure the success in these three areas is important. In the activity that follows, you will research, define, and explain the various types of inflation, unemployment and economic growth. You will also research and record examples of these indicators from several countries. Finally, you will investigate your OWN country, and determine what precisely makes up the total amount of economic activity in your country.

Part 1: Using your notes and Welker’s Unit 3.1 study guide, answer the following questions. Most of the country data you are asked to find can be found in the CIA World Factbook.

1. Identify the four components of a nation’s aggregate demand and briefly explain two factors [10 mark]
2. Research and identify the percentage of your own country’s GDP each of the four types of spending account for (as a percentage of total GDP). Enter your findings into THIS ONLINE FORM [5 marks]:
3. When you’ve completed the form for your own country, VISIT THE RESULTS PAGE and analyze the data with your classmates.

John Maynard Keynes was an economist whose opinions have shaped government policies throughout the 20^th century. Joseph Sternberg of the Wall Street Journal explained an interesting link this week, between Keynesian policies and the fate of bankrupted Japan Airlines.

Keynesian policies suggest that during a period of depressed economic growth, a chronic lack of the demand is a core problem that couldn’t be solved with supply side policies. Instead he advocated for demand stimulus packages including infrastructure developments.

The Japanese economy has experienced a turbulent past. Throughout the 1960’s, 70’s and 80’s the level for GDP grew at impressive rates, but growth began to slow in the 1990’s due to the effects of an asset bubble. An asset bubble was caused by an abundance of cheap credit caused by exceptionally low interest rates. This lead to the prices of shares, houses and land rising very quickly as buyers speculated and outbid each other. The government responded by sharply raising interest rates in 1989, which crushed the bubble and stalled the economy.  Depressed wealth caused spending to stall, and the Japanese thrift and savings culture to return.

In the 1990’s the government attempted to stimulate the economy but this was largely unsuccessful. The result was low real growth (compared to the past), zero percent interest rates set by the Central Bank and a deflationary spiral. Politicians used a variety of policies, including Keynesian ideas to boost aggregate demand.

During the economic boom, the development of the aviation industry was an important pillar of the countries infrastructure development as Joseph Sternberg of the Wall Street Journal explains.

Starting in the 1960s, successive governments concocted aviation plans focused on building new airports. Perhaps this was justifiable back then, when Japan was an Asian tiger economy with a growing population. But in 1964, even before the bulk of the airport construction, the bullet train appeared. At that point, and especially as the shinkasen high-speed-rail network developed, it might have been prudent to ask whether air would invariably be the most efficient way to connect domestic destinations.

Unfortunately, by then the airport boom had taken on a life of its own. During the lost decade of the 1990s, airport construction popped up in many stimulus plans. National and local politicians, not to mention the politically powerful construction lobby, wanted to put an airport in every prefecture. And ordinary airports wouldn’t do. Because Japan’s relatively small flat surface area is in such high demand, one airport after another was built on reclaimed land in the middle of the ocean at enormous expense. Despite periodic public fulminations about out-of-control costs, in practice “expensive” seemed to be viewed as a net positive.

Boosters touted airports as creators of short-term construction jobs and longer-term boons to their areas. This airport binge has continued right up to today. Japan’s 98th airport opened last year: Shizuoka-Mt. Fuji, roughly 50 miles from the famous mountain. California, with a larger land area, has around one-third as many airports in regular commercial service, with another 35 or so “reliever airports” to handle business jets and general aviation.

The author reflects on the cost of the Keynesian stimulus. Whilst in the short term, development of the airport network provided jobs and helped the construction industry; in the long term the projects have created an inefficient and expensive transport network. Japan Airlines has been forced to offer flights from each of these 98 regional airports, often paying high landing charges, and operating flights at below capacity. Overtime this pressure may have caused Japan Airlines to slide into bankruptcy.  Perhaps this is a unique one off case, but the author predicts some interesting links to current developments in China.

Lest anyone think this is a uniquely Japanese problem, consider all the other places in the world currently undergoing their own Keynesian infrastructure booms—and especially China. For instance, a new high-speed rail line is due to connect Beijing to a station an inconvenient 45 minutes from the downtown commercial center of Guangzhou in southern China. The train will take somewhat less than eight hours to connect cities reachable in under three by air. Will enough passengers ever make that trek for the train to operate in the black?

Discussion Questions:

1. Why does John Maynard Keynes suggest that demand stimulus is an appropriate response, for a country stuck in a deep recession, with depressed demand?
2. If central bank interest rates are very close to zero, what other policies could the government use to stimulate growth?
3. How could supply side policies actually make the recession worse in Japan?
4. Outline the advantages and disadvantages of demand-side policies used in Japan.

Econstories.tv – A new resource for Econ teachers and students, from Russ Roberts and John Papola

The long awaited rap video from George Mason University’s Russ Roberts featuring the theories of John Maynard Keynes and F. A. Hayek has been released at last!

We’ve heard some decent Econ raps before (remember “Demand, Supply” by Rhythm, Rhyme, Results?) But this song covers all bases in the predominant macroeconomic schools of thought. Keynes and Hayek are brought back to life and their theories pitted against one another in an all out liquor fueled debate on the streets of New York City.

The video was just released this week. It is packed full of theory from the Classical, supply-side school of macroeconomics (represented by Hayek) and the demand-side school (represented, of course, by Keynes). The video includes cameos from Fed chairman Ben Bernanke and Treasury Secretary Tim Geithner, whose role as bartenders filling Keynes glass reflects their role in the real economy at keeping the money supply and government spending at high levels, fueling economic booms and the eventual busts that result.

Stay tuned to this blog for more feedback on the video, including some graphical analysis and discussion questions for Macro teachers to use in class!

Keynes vs. Hayek: Late Economists Hip-Hop Legacy | PBS NewsHour | Dec. 16, 2009 | PBS.

A major theme of both the AP and IB Economics courses is the long-running debate between the Keynesian, demand-side theories of macroeconomic policy and those of the Classical, supply-side school. Today’s “Great Recession” has revived this debate, which itself dates back to the Great Depression of the 1930′s, when an Englishman and an Austrian could be found at the ideological centers of two different philosophies of the role government should play in the macroeconomy.

John Maynard Keynes and Friedrich Hayek were close friends whose views on government’s role differed greatly. Hayek was a classical, laissez faire libertarian who believed that any intervention by government in a nation’s economy disrupted the efficient functioning of the free market and threatened to stifle private enterprise. Keynes, the father, of course, of modern Keynesian economics, believed that free markets left unchecked were vulnerable to the volotile animal spirits of investors and speculators whose often irrational behaviors could create externalities such as unemployment and credit crunches, thereby harming society as a whole.

Paul Solman of PBS (who I recently met at an Economics teachers conference in Washington DC) interviews a modern Keynesian, Robert Skidelsky (Keynes’ biographer) and a neo-classical economist, Russ Roberts (who I also recently met in Richmond, VA).

YouTube - Chinas empty city – 10 Nov 09.

My buddy living in Shanghai posted this video to his Facebook profile today. It demonstrates how misaligned incentives in China lead local government officials to launch massive government infrastructure projects, all with the goal of meeting the growth targets handed down from Beijing.

Building roads to nowhere and cities that stand empty certainly creates jobs and new spending by the workers employed in their construction, so in that regard at least one goal of such projects is achieved. But whether or not all growth is good growth depends on whether efficiency in the economy is increase or decreased as a result of the growth strategies used.

Hundreds of billions of dollars worth of resources in China are currently being allocated by the government in Beijing towards massive public works projects such as this sparkling new city in remote Inner Mongolia. But it seems that government plans don’t always fall in line with the wishes of the nation’s people. A wise man once said, “build it… and they will come.” Apparently in China, that’s not always true.

I happen to have traveled in Inner Mongolia a few years ago with a group of students from my school in Shanghai. It was a sad thing in my opinion to witness the rampant development of the once pristine and culturally rich Inner Mongolian steppes. Ethnic Mongolians had been put on large reservations (not unlike the Native American people 150 years ago) and turned into tourist attractions. The cities were populated almost entirely with ethnic Han Chinese, there for the purpose of building more new cities, mining raw materials, and selling them to the rest of China’s industries.

Fiscal policy (the use of government spending and taxes to stimulate or reduce the overall level of demand in an economy) is a powerful tool for achieving the macroeconomic goals of full-employment, economic growth and price level stability. When used effectively, government spending can also improve efficiency in an economy by allocating society’s scarce resources towards socially and economically valuable projects. In China, it appears, the government’s incentives are aimed more towards pleasing the higher ups and continuing to inflate the speculative  bubble in real estate that has almost certainly formed, rather than pursuing socially desirable and allocatively efficient projects that actually help the Chinese people. Damn shame!

Discussion Questions:

1. What type of fiscal policy is the government in China pursuing? Expansionary or contractionary? What is the difference?
2. Why is government spending sometimes less efficient than private sector spending?
3. What would have been an alternative policy to allocating over $220 billion of public money into infrastructure projects that may have resulted in a more efficient allocation of China’s resources than projects such as the “empty city” in the video above?

This article was originally posted on September 19, 2007

FT.com / Asia-Pacific / China – China freezes government-set prices

Here’s a great article for both AP and IB students to pay attention to. The Chinese government is responding to rising prices at home by resorting to some good old fashioned “iron fist” measures, namely price controls on a wide range of products. For the rest of this year, prices on certain goods and services will not be permitted to rise, OR ELSE! (what? we don’t want to know!)

China has begun to enforce a freeze on all government-controlled prices in a sign of the central government’s alarm about rising popular anger over inflation, now at the highest rate in over a decade.The order freezes a vast array of prices still under the control of governments in China, ranging from oil, electricity and water, to the cost of parking and park entrance fees.

I find the following statement interesting:

“Any unauthorised price rises are strictly forbidden…and in principle, there will be no new price-raising measures this year,” the ministries’ announcement said. (italics added)

How strange is it that the government’s announcement pointed out that the freeze on prices is only in principle? Could this be the government’s attempt to placate a public that’s grown angry at their weakening purchasing power? Does this mean that if prices actually do go up, the government can just say, “Hey, at least we tried!” Looks like the old communist mentality has softened a bit in the era of market reforms!

So what’s the source of all these rising prices? Well, food plays a big role, thanks to a couple of factors:

The sharp spike in inflation is largely due to higher food prices, because of a shortage of pigs after a disease killed millions late last year and earlier in 2007, and the rising cost of feed, a global
phenomenon.

The China of today is very different from that of 20 or 30 years ago, when the government played a much larger role in the economy. Unleashing the beast of the free market in the early 80′s may have meant the government would have to loosen its grip in situations such as today’s inflation, and let the free market adjust on its own.

Economists said the price freeze is the kind of administrative measure redolent of China’s former planned economy, but it may be less effective in China today.

“They will not be able to control the price of everything,” said Chen Xingdong, of BNP Parisbas in Beijing.

Perhaps that’s for the better.

Discussion Questions:

1. Why might the government’s price controls actually make the matter worse for the average Chinese?
2. If the government were to take a “laissez faire” approach to the problems faced by China, how might the free market resolve them on its own? Any ideas?

 Podcast: China's Inflation and Consumer Spending: Download

Economic Growth Yet to Hit Job Market – washingtonpost.com

In AP and IB Economics, we understand the importance of macroeconomics to policymakers, whose primary macroeconomic goal is growth. Economic Growth, defined as an increase in a nation’s total output of goods and service (and therefore the national income), is desidred not only for the sake of growth itself (producing more stuff requires more resources, and may not necessarily make the average citizen better off), rather growth is needed in order to achieve full-employment of a nation’s labor force.

Growth is good. This tenet of economics is rooted in two basic observations: 1. Growth leads to an improvement in the average standard living of a nation’s people, and 2. Growth is needed to employ the growing workforce of a nation experiencing population growth and immigration.

America’s work force is a diverse group of people of all skill levels. 150 million strong, the nation’s workforce requires a healthy national economy with strong investment and consumption to maintain enough jobs to keep unemployment low.   In the last two years, however, the prospect of employment in America has diminished as the number of people out of work has grown to nearly 15 million.

Involuntary unemployment is perhaps the most serious cost of an economic slowdown. A willing and able worker (or 15 million of them!), skilled in mind and body, unable to find prouductive work, represents a monumental failure of a nation’s economy. Policies aimed at promoting growth are in fact aimed at creating employment.

The costs of unemployment affect not only the unlucky  individuals who have have lost their job. Social costs include increased crime and poverty, psychological costs include stress, anxiety, loss of self-image and depression. The economic costs are myriad. Unemployed workers become dependent on the rest of society for support, in one way or another. Benefits for the unemployed payed by the government require greater budget deficits or increased tax burden on the employed. The large pool of jobless citizens seeking work puts downward pressure on the wages of those still working, as employers find it difficult to keep paying high wages while demand for their products has fallen and millions of job seekers are willing to work for less.

The families and friends to whom unemployed workers turn for help find their already stretched incomes spread even thinner. Without steady incomes, the unemployed consume less, putting further strain on an already depressed economy. Deflation can result from unemployment, which can lead to futher layoffs by pessimistic firms, excacerbating the situation and plunging the economy into what’s known as a deflationary spiral.

For all the reasons above, policymakers strive to promote growth. When monetary policy fails to incite spending, the government must pick up the slack, hence the stimulus package so discussed in America today. China’s stimulus of over $500 billion (twice that of the US, as a percentage of its GDP) has had a positive effect on both GDP and the job market.

Employment levels in China began to recover over the past three months in the latest evidence of the rapid rebound in the economy from the international financial crisis as a result of heavy public investment.

Yin Weimin, China’s labour minister, said there had been a modest increase in the number of jobs in the economy during June, July and August, reversing the sharp slump in employment which began last October.

America’s stimlus has also begun to restore growth, but the rise in employment has so far not occured:

Despite an emerging economic expansion, businesses were sufficiently skittish about the future that the job market continued its long, steep decline in August, according to a new government report Friday. The unemployment rate rose to 9.7 percent, from 9.4 percent, as employers shed jobs for the 20th straight month, the Labor Department said.

“Our clients tell us they will not hire in anticipation

of a recovery, but will wait until they see it,” said Jonas Prising, an executive vice president at Manpower, the giant employment services firm. “In a normal recession, people would now start to feel more comfortable and start hiring, but nobody is doing that today. They’ll do it when they see real orders and real business.”

The “silver lining” of the latest unemployment figures is hardly encouraging. The rise in unemployment is not as sharp as over most of the last year. In other words, workers are definitely worse off, but not as badly as they could have been if things were as dismal as they were earlier this year.

While the unemployment rate, as seen on the graph to the right, has risen almost every month since August of 2008, the rate at which the rate has increased has begun to slow. In other words, the economy is probably close to “bottoming out”.

The tally of lost jobs now stands at 6.9 million since the beginning of the recession in December 2007. But the rate of job losses has been declining, if haltingly, since winter. The 216,000 jobs eliminated in August is down from 276,000 cut in July and a peak of 741,000 lost in January.

Here’s what I find most interesting from in the current data. The unemployment rate’s recent rise may actually be a sign that the economy is beginning to recover. Recovery means growth in output, which should mean less unemployment. However, if workers who have been unemployed for a long time, and have therefore stop seeking employment suddenly feel more optimistic about the prospects of getting a job and begin seeking work again, then the nation’s unemployment rate actually rises! How’s that for “silver lining”? The 216,000 additional people added to the list of unemployed may have already been out of work but since they were notactively seeking employment they were not included in last month’s data.

The tricky thing about macroeconomic policy is this:  Monetary and fiscal policies can put billions of dollars into the nation’s banks and households’ and firms’ pockets through tax breaks, government bailouts, subsidies, infrastructure spending and “troubled asset swaps”… but all the money and income in the world will not lead the nation towards full-employment unless the nation’s consumers and producers feel confident. I teach my students that national income is made up of the sum of wages, interest, rent and profit; its spending consists of consumption, investment, government spending and net exports… but without the “big C” of confidence, expansionary policies aimed at increasing employment will come to nought. Confidence, according to John Maynard Keynes, is an animal spirit, a trait of humans beyond the assumption of rational behavior. Until confidence is restored, America’s output and employment levels will remain low.

This is a follow up to a recent post to this blog, Hey, what are you Laffing at? The relationship between tax rate and tax revenue

The unbearable lightness of being Martin Feldstein | Free exchange | Economist.com

Supply-side economics, advocated by most Republican politicians, including presidential candidate John McCain, places great emphasis on the idea that investment is the main engine of economic growth, price level stability, and low unemployment. To encourage firms to invest, government should play a minimal role in the economy; taxes should be sufficiently low to incentivize firms to invest, while at the same time government spending should be reduced to avoid crowding-out of private investment.

Without a healthy level of investment, a country’s capital stock wears out and is not replaced, raising costs of production and shifting short-run (and maybe even long-run) aggregate supply leftward. If investment remains sufficiently low, over time an economy’s output could even begin to shrink.

In the article below, The Economist’s Free Exchange explores the relationship between tax rates and long-run economic growth. The Economist takes the position of “supply-siders” who study the impact of tax rates on the level of output. The idea of supply-side economics is that lower taxes encourage more investment and thus higher growth rates.

Here’s the gist of the supply-side argument:

Our baseline specification suggests that an exogenous tax increase of one percent of GDP lowers real GDP by roughly three percent.

On the other hand…

…we find that a tax cut of one percent of GDP increases real output by approximately three percent over the next three years.

In the case of the Laffer Curve, which shows the relationship between tax rates and tax revenue, the article concludes that:

Tax cuts don’t exactly “pay for themselves”, but they also don’t diminish revenue after about two years. That is, after about two years, the government receives revenues equal to what it would have received at the higher rate, but taxpayers enjoy a lower burden. It is an important advance to discover that because cuts do lead to an immediate dip in revenue, they often inspire offsetting tax increases that retard the growth effect of the origina cut. Nevertheless, the effect of cuts on output is generally strong enough to bring revenue back to where it would have been otherwise.

Supply-side economics, folks. Understanding the effects of fiscal and monetary policies on not only aggregate demand, but on aggregate supply (both short-run and long-run) is a crucial skill in  answering AP free response questions.

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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:

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:

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:

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:

The Fed should focus on deflation | The greater of two evils | The Economist

Deflation: a decrease in the general price level of goods and services of an economy. Sounds great, right? Lower prices mean the purchasing power of our income increases, making the “average” person richer! On the surface, it could be concluded that deflation may actually be a good thing. And in some cases, it is!

If prices of goods are falling because of major technological advances (think of the price of cell phones and laptop computers over the last 20 years) or because of massive improvements in the productivity of labor and capital (think of the price of manufactured consumer goods during the Industrial Revolution), then deflation could be considered a sign of healthy economic growth. Put in terms an IB or AP Economics student should understand, a fall in prices caused by an increase in a nation’s aggregate supply is good, since it is accompanied by greater levels of employment and higher real incomes. But if the fall in prices is caused by a decline in spending in the economy (in other words, by a decrease in aggregate demand), the consequences can be catastrophic.

It just so happens that the United States, Great Britain, and my own home of Switzerland are all faced with demand-deficient deflation at this very moment. I’ll allow the Economist to elaborate:

…With unemployment nearing 9% (in the United States), economic output is further below the economy’s potential than at any time since 1982. This gap is likely to widen. House prices are not part of America’s inflation index but their decline is forcing households to reduce debt , which could subdue economic growth for years. As workers compete for scarce jobs and firms underbid each other for sales, wages and prices will come under pressure.

So far, expectations of inflation remain stable: that sentiment is itself a welcome bulwark against deflation. But pay freezes and wage cuts may soon change people’s minds. In one poll, more than a third of respondents said they or someone in their household had suffered a cut in pay or hours…

Does this matter? If prices are falling because of advancing productivity, as at the end of the 19th century, it is a sign of progress, not economic collapse. Today, though, deflation is more likely to resemble the malign 1930s sort than that earlier benign variety, because demand is weak and households and firms are burdened by debt. In deflation the nominal value of debts remains fixed even as nominal wages, prices and profits fall. Real debt burdens therefore rise, causing borrowers to cut spending to service their debts or to default. That undermines the financial system and deepens the recession.

From 1929 to 1933 prices fell by 27%. This time central banks are on the case. In America, Britain, Japan and Switzerland they have pushed short-term interest rates to, or close to, zero…

…inflation is easier to put right than deflation. A central bank can raise interest rates as high as it wants to suppress inflation, but it cannot cut nominal rates below zero… In the worst case, rising debts and defaults depress growth, poisoning the economy by deepening deflation and pressing real interest rates higher….Given the choice, erring on the side of inflation would be less catastrophic than erring on the side of deflation.

Discussion Questions:

1. Deflation poses several threats to an economy that is otherwise fundamentally healthy, such as the United States’. What are some the threats posed by deflation?
2. The expectation of future deflation can have as equally devastating effect. Why is this?
3. What evidence does the article put forth that an economy experiencing deflation may eventually “self-correct”, meaning return to the full employment level of output in the long-run?
4. Why don’t governments and central banks just sit back and let the economy self-correct? In other words, why are fiscal and monetary policies being used so aggressively by the US, Great Britain and Switzerland during this economic crisis?

Deflation or Inflation:Watch the video below, see if gives you any clues as to the causes and effects of deflation. What do you think John Maynard Keynes would say in response to the deflationary fears expressed in the Economist article?

Economic View – A Dose of Skepticism on Government Spending – NYTimes.com

We all understand that fiscal stimulus is one of the tools that governments can use to increase the level of economic activity during a recession. The fiscal medicine can be delivered in one of two ways. The government can tweak the tax systems to boost incentives to spend and work or it can increase government spending. One tool that we can use to evaluate the merits of these two policies is to compare the relative multipliers that relate to government spending and taxation.

The multiplier is the key component of Keynesian theory and shows the possibility of a given increase in injections, e.g. government spending, investment and exports, increasing aggregate demand by more than the initial value. This logic fits with our understanding of the circular flow where say increased government spending will lead to increased derived demand for other products, and increased demand for labour. Workers will spend additional wages on other products which leads to further increases in aggregate demand. This flow on effect can be diluted by withdrawals from the system such as taxation or savings.

Greg Mankiw wrote an excellent analysis of this issue in the New York Times in Janurary. “A dose of skepticism on government spending”

An essential skill for IB and AP Economics students is to be able to evaluate the effectiveness of Keynesian  demand-side policies as well as classical supply-side policies, both fiscal and monetary. An understanding of multipliers can improve a student’s ability to evaluate fiscal policy. Greg writes:

“Economics textbooks, including Mr. Samuelson’s and my own more recent contribution, teach that each dollar of government spending can increase the nation’s gross domestic product by more than a dollar. When higher government spending increases G.D.P., consumers respond to the extra income they earn by spending more themselves. Higher consumer spending expands aggregate demand further, raising the G.D.P. yet again. And so on. This positive feedback loop is called the multiplier effect.

In practice, however, the multiplier for government spending is not very large. The best evidence comes from a recent study by Valerie A. Ramey, an economist at the University of California, San Diego. Based on the United States’ historical record, Professor Ramey estimates that each dollar of government spending increases the G.D.P. by only 1.4 dollars. So, by doing the math, we find that when the G.D.P. expands, less than a third of the increase takes the form of private consumption and investment.”

This low multiplier effect implies that any government spending must be used in an effective manner where it will increase the long-term productivity of the country. During a “jobs think-tank” recently in New Zealand, a media release announced an idea of the government spending a vast sum of money to develop a walking track from one end of the country to the other. Would this lead to increased tourism? How much money would these hiking visitors spend? Would it create more jobs?

Should we therefore expect that tax cuts will lead to a greater increase in GDP through the feedback loop compared to government spending? Well, we have to remember that not all tax cuts will be spent immediately, according to the marginal propensity to consume. In a recession some workers will be pessimistic about the future and save the money. Will tax cuts compensate workers who are working shorter hours? Greg suggests that tax cuts might actually be more potent than government spending according to current research.

“Textbook Keynesian theory says that tax cuts are less potent than spending increases for stimulating an economy. When the government spends a dollar, the dollar is spent. When the government gives a household a dollar back in taxes, the dollar might be saved, which does not add to aggregate demand.

The evidence, however, is hard to square with the theory. A recent study by Christina D. Romer and David H. Romer, then economists at the University of California, Berkeley, finds that a dollar of tax cuts raises the G.D.P. by about $3. According to the Romers, the multiplier for tax cuts is more than twice what Professor Ramey finds for spending increases.

Why this is so remains a puzzle. One can easily conjecture about what the textbook theory leaves out, but it will take more research to sort things out. And whether these results based on historical data apply to our current extraordinary circumstances is open to debate.”

So the current research indicates that one-dollar of tax cuts can increase G.D.P by $3 compared to an additional dollar of government spending increasing GDP by $1.40. But why is there such a large difference? Is this related to the arguments about the efficiency of increased government spending? The verdict is still out and we may need to wait till the next global recession to find out.

Below is a picture of the aptly named Bridge to Nowhere located in the central North Island of New Zealand. It was built by the government in a spending splurge in the 1936 to open up land in the area. The land is now no longer fertile or accessible and all access to the area is cut off except for this concrete relic. The area is now popular with trampers.

Discussion Questions:

1. How do economists calculate the multiplier?
2. What are leakages from the circular flow that reduce the multiplier effect?
3. Explain the link between the accelerator model and the multiplier.
4. What would multipliers for other injections such as export receipts or investment look like? Would they be higher or lower than multipliers for taxation or government spending?
5. Evaluate the effectiveness of fiscal stimulus to increase the level of economic activity.

Why Are Large Companies Losing More Jobs Than Small Ones? – TIME

This is a fascinating, short article from TIME. Before reading it, see if you can answer the multiple choice question below:

Q: Why do small companies lay off proportionately fewer workers during a recession than large companies?

A) Because small firms are less likely to be in the industries hardest hit by a recession (such as manufacturing)?
B) Because small firms are less focused on maintaining profits to satisfy greedy shareholders?
C) Because small companies are able to hang on to employees and even hire new ones during a recession because of all the talent being laid off by big firms.

Still thinking? Well, it’s likely that all three are true to some extent. But it’s the third one that seems most intriguing as a student of economics. Here’s what the article says:

…small companies hire disproportionately more early on in an economic recovery because it’s easy for these firms to find good workers while unemployment is still high—and easy for workers to come across small companies since there are so many of them. Once the economy is chugging along at full-steam and the labor market is tight, larger companies regain the advantage, since they’re likely able to offer more money—and poach from smaller outfits.

Seems pretty straight forward, right? Sure, but the fact that small firms are likely to hire when unemployment is high supports one side in a long-running economic debate over the economy’s ability to “self-correct” in times of recession.

As any student of Macroeconomics learns early on, there are two dominant theories of macroeconomics, both which are represented in the aggregate demand/aggregate supply diagram that we learn and use in AP and IB Economics.

The two models below represent the two opposing views of macroeconomics. First we see the Keynesian model, which shows that when overall demand in an economy falls, unemployment increases drastically and output tanks, plunging the economy into a deep recession. This is primarily because of the “inflexible” nature of wages, meaning that even when unemployment rises, workers are unwilling to accept lower wages and firms therefore are unwilling to hire more workers.

According to Keynesians, the only way to get the economy out of the recession is by increasing overall demand through heavy doses of government spending (case in point, the $775 billion stimulus in the US).

Next is the Classical AD/AS model with a vertical long-run aggregate supply curve. The implication of the vertical AS curve is that regardless of the level of overall demand in the economy, output will always return to the full-employment level, and thus unemployment will always return to its natural level. The major assumption underlying the Classical model is that wages are in fact flexible in times of recession. As unemployment rises, workers will accept lower wages since they’d rather be making less than making nothing at all. As wages fall firms will begin hiring more workers, increasing overall output and decreasing unemployment until full-employment output is restored.

The implication of the model on the right is that government is NOT needed to get the economy out of a recession, because it will self-correct due to the new hiring and production by firms in response to falling wages in the labor market.

The reason this article stood out to me was that it seems to offer some evidence in support of the flexible-wage, Classical model of macroeconomic self-correction. There has been surprisingly little talk among news anchors, pundits and politicians about the likelihood of the US or ANY economy suffering in the global slowdown “self-correcting” as the Classical model would suggest it should. But the fact that small businesses are less likely to lay off workers in a recession and more likely to begin hiring them due to the large number of workers being laid of by big companies offers at least an inkling of evidence in support of the Classical model of flexible wages and macroeconomic self-correction.

Discussion Questions:

1. Why is laying off workers the first thing big companies do when faced with falling demand for their products? Why don’t they shut down factories instead?
2. What pressures does a publicly traded company (one that sells stocks to investors) face in times of recession that a small, privately owned business does not?
3. When the global recession is finally over, do you think more people or fewer people will be working for small companies (less than 50 people) than before the recession? What would you rather work for, a small firm or a large one? Why?

FT.com / China / Economy & Trade – Downturn drives expat exodus from Shanghai

Having recently moved from Shanghai to Zurich myself, I was interested to see this headline in today’s Financial Times.

Korean companies are shipping workers home, cutting off school fees and repatriating wives and children without their menfolk to cut costs. They are the first large wave of expatriates to have begun leaving China’s financial capital as a result of the global economic crisis but their departure raises the prospect of a broader exodus of foreigners who may take investment, skills and job creation opportunities with them.

The press officer of the Korean consulate in Shanghai could not answer questions about the exodus of her countrymen – because her post had just been abolished and she was being sent back to Korea…

Japanese relocation companies, meanwhile, say there has been a marked rise in Japanese families returning home from Shanghai compared with last year and they expect the pace to pick up further during the traditional peak relocation months of March and April.

As Korean and Japanese families pack up and leave Shanghai, the impact is likely to be felt at international schools catering to the expat community in Eastern China. Koreans made up around 15% of the students at Shanghai American School, while other schools in the city had even larger numbers of Japanese and Korean students. In Beijing the exodus is also underway:

The pain has not been limited to Shanghai. A parent with children enrolled in an expensive Beijing international school says most of her daughters’ Korean classmates have left the school almost overnight.

This story reminds me of my own experience as an international school student in the late 1990′s, when the Asian financial crisis plunged Korea’s economy into deep recession. At the time, 30% of my school in Malaysia were Korean students, and in one semester over half of them packed up and moved back to Korea. In one year enrollment at the International School of Kuala Lumpur’s high school fell from 600 students to 420!

One reason the Korean and Japanese economies are struggling is that they are heavily dependent on exports to the rest of the world. With incomes falling and unemployment rising among their trading partners, the effect is amplified in Japan and Korea by significant falls in aggregate demand and GDP due to lower net exports, investment and consumption in the Japanese economy.

According to this article in the FT, the current fall in exports in Japan is the worst in 50 years.

Japanese exports fell 45.7 per cent in January, eclipsing a 35 per cent drop in December and big declines last month for Taiwan and South Korea.

The slide in exports was the steepest since 1957 and highlighted the severe impact of the global slowdown on demand for Japanese products ranging from cars to heavy machinery and electronics. Exports to the US fell 52.9 per cent and those to China were down 45.1 per cent .

Falling demand has forced manufacturers such as Toyota and Sony to cut production and jobs. It has reinforced concerns the economy will suffer another quarter of falling output. Gross domestic product shrank 3.3 per cent in the last three months of 2008, the largest fall in 35 years.

The diagram below provides a graphical representation of the impact of falling exports on Japan’s economy.

Discussion questions:

1. Some economists believe that recessions are a crisis of confidence. What do they mean by that and how does the situation in Japan seen above reflect this theory?
2. What is the multiplier effect and how does the fall spending on Japanese exports by the rest of the world result in an even greater fall in Japan’s GDP?
3. If you were the manager of a Japanese firm facing falling demand from international customers and you had to cut costs, what costs would  you cut in the short-run to remain competitive? What about in the long-run, assuming demand for your products remained weak?

CBO Director’s Blog » Macroeconomic Effects of the Senate Stimulus Legislation

The February 9th edition of the excellent NPR show, Planet Money reported on a letter sent from the director of the Congressional Budget Office to the Senate, forecasting the short-run and long-run macroeconomic effects of the House Stimulus Package.

 Crowding-out and the Stimulus Package [1:23m]: Play Now | Play in Popup | Download

It turns out the director of the CBO has his own blog on which he published his letter to the Senate. Here are some highlights:

CBO estimates that the Senate legislation would raise output by between 1.4 percent and 4.1 percent by the fourth quarter of 2009; by between 1.2 percent and 3.6 percent by the fourth quarter of 2010; and by between 0.4 percent and 1.2 percent by the fourth quarter of 2011. CBO estimates that the legislation would raise employment by 0.9 million to 2.5 million at the end of 2009; 1.3 million to 3.9 million at the end of 2010; and 0.6 million to 1.9 million at the end of 2011…

Most of the budgetary effects of the Senate legislation would occur over the next few years. Even if the fiscal stimulus persisted, however, the short-run effects on output that operate by increasing demand for goods and services would eventually fade away. In the long run, the economy produces close to its potential output on average, and that potential level is determined by the stock of productive capital, the supply of labor, and productivity. Short-run stimulative policies can affect long-run output by influencing those three factors, although such effects would generally be smaller than the short-run impact of those policies on demand.

In contrast to its positive near-term macroeconomic effects, the Senate legislation would reduce output slightly in the long run, CBO estimates, as would other similar proposals. The principal channel for this effect is that the legislation would result in an increase in government debt.  To the extent that people hold their wealth in the form of government bonds rather than in a form that can be used to finance private investment, the increased government debt would tend to “crowd out” private investment—thus reducing the stock of private capital and the long-term potential output of the economy.

The negative effect of crowding out could be offset somewhat by a positive long-term effect on the economy of some provisions—such as funding for infrastructure spending, education programs, and investment incentives, which might increase economic output in the long run. CBO estimated that such provisions account for roughly one-quarter of the legislation’s budgetary cost. Including the effects of both crowding out of private investment (which would reduce output in the long run) and possibly productive government investment (which could increase output), CBO estimates that by 2019 the Senate legislation would reduce GDP by 0.1 percent to 0.3 percent on net.

The fascinating thing about this letter from the Congressional Budget Office to the Senate is that it mentions so many of the Macroeconomic principles we teach in both AP and IB Economics.

• The nation’s potential output (PPC) is “determined by the stock of productive capital, the supply of labor, and productivity”.
  
• Fiscal stimulus’ effects, while possibly significant in the short-run, may result in less long-run growth due to “crowding-out” of private investment as the public puts its savings into government debt and takes it out of the market for loanable funds.
• A stimulus package should be made up of “funding for infrastructure spending, education programs, and investment incentives, which might increase economic output in the long run.” The negative effects of crowding-out could be offset through responsible government spending.

I find this letter to be surprisingly positive. The short-run forecast seems optimistic: as much as 3.6% GDP growth and as many as 3.9 million new jobs by the end of 2010. The negative growth effects of the stimulus resulting from increased government debt and the subsequent “crowding-out” of private investment are not predicted to set in until 2019.

I always tell my students that humans are “short-run creatures living in a long-run world”. I have to admit, this short-run creature is inclined to think that a stimulus package that puts nearly 4 million people to work and turns the US Economy back onto a path towards growth within two years is probably worth the long-run risk of sluggish growth ten years down the road due to the decline in private investment resulting from the debt-financed spending today.

This letter from the CBO also seems to address a debate recently undertaken in the AP Economics teacher email list: whether deficit-financed government spending affects the supply of or the demand for loanable funds in the economy.

To the extent that people hold their wealth in the form of government bonds rather than in a form that can be used to finance private investment, the increased government debt would tend to “crowd out” private investment—thus reducing the stock of private capital and the long-term potential output of the economy.

This passage from the director’s letter indicates that it is the supply, not the demand for loanable funds that shifts, driving up real interest rates in the economy. Savers will take their money out of banks and other lending institutions and put it in government bonds, reducing the amount of capital available for private investment. This can be illustrated as a leftward shift of the supply of loanable funds.

Discussion questions:

1. In evaluating the use of expansionary fiscal policy, we learn in IB Economics that the crowding-out of private investment will reduce the expansionary effect of increased government spending. Is crowding-out a problem during a recession? Why or why not?
2. Discuss the following statement: “In order to finance its budget deficit, the US government must borrow from the private sector.” How does the government borrow from the American people?
3. Will fiscal stimulus in the short-run lead to increased growth or decreased growth in the long-run? Discuss.

Does the Economy Self-Correct? – Welker’s Wikinomics Page

The debate in Washington over Obama’s fiscal stimulus package, which has now been re-written by both the House and the Senate, is ultimately one of the validity of orthodox economic theories. By voting for a nearly $1 trillion government spending bill, the Obama administration and Congress are clearly taking the position that an economy in recession will either not be able to correct itself, or will take too long to self-correct, thus the government is needed to accellerate the recovery process.

Washington’s stimulus package presents students and teachers of economics with an all too rare opportunity to put to the test the two competing hypotheses of macroeconomics: the Demand-side Theory versus the Supply-side Theory.

At the core of the long-running macroeconomic debate is the simple question, “Does the economy self-correct in times of recession?” The supply-side theory, attributed to the “classical” economists dating back to Adam Smith and David Ricardo, argues that the answer to this question is YES. The rationale between this laissez faire approach to macroeconomics is the following:

1. Falling demand in an economy means less output by firms, forcing them to lay off workers.
2. As inventories build up due to their inability to sell their output, firms will be forced to lower their prices, putting downward pressure on the price level in the economy (deflation).
3. High unemployment and falling prices eventually lead to workers in the economy being willing to accept lower wages.
4. Weak demand for commodities such as oil and minerals put downward pressure on raw material and energy prices faced by firms.
5. Falling wages and raw material prices mean more potential for profits for firms in various enterprises, even as overall demand in the economy is weak. Firms begin hiring workers at lower wages, and increase production to take advantage of lower input costs. Overall supply of goods and services in the economy begins to increase due to lower costs faced by firms in all sectors.
6. The downward spiral caused by weak aggregate demand, rising unemployment, falling prices for output, falling wages and commodity prices, is eventually reversed and turns into an upward spiral as firms hire more workers, employ more resources, creating more income and spending, moving the economy towards recovery and economic growth.

The supply-side theory of self-correction (so called because recovery results due to an outward shift of aggregate supply) outlined above depends on the downward flexibility of wages. If wages do NOT fall, as some demand-siders propose, then the idea that firms will eventually begin to hire more workers is busted, and unemployment will only continue to increase as overall demand remains weak.

Today, there is some evidence that wages in the United States may in fact be downwardly flexible.

GM Slashing 10,000 White-Collar Jobs, Cutting Pay – washingtonpost.com

…the base pay of higher-level U.S. executives will be lowered by 10 percent, while other salaried employees will face cuts of between 3 and 7 percent.

General Motors employees are beginning to accept lower wages. Rising unemployment, especially in the white collar sector, mean that the number of highly educated and skilled American workers unable to find work will grow as corporate layoffs continue.

A “shovel-ready” stimulus package from Washington may indeed help to “create or save” 3 million jobs, as Obama claims, but it is the self-correcting nature of markets due to flexible commodity prices and wages that will ultimately contribute to a recovery of the US economy. As prices of commodities fall, combined with lower wages for white collar workers and deflation in the overall economy, firms will find it profitable to begin employing resources at their lower costs, putting people back to work, stimulating spending through market forces.

Fiscal stimulus may accellerate the recovery process, but the threat it poses is the same threat posed by all forms of government intervention in the free market: that the nearly trillion dollars will go towards satisfying the priorities of politicians rather than the wants and needs of society as a whole, resulting in a misallocation of the nation’s resources towards goods, services, and infrastructure projects that are chosen by legislators, not the market itself. Stimulus is needed, but only the right kind. The recognition by politicians and the media that markets may also self-correct is also needed. News like GM’s wage cuts may sound dire, but the underlying implication of falling wages may be a sign that the US economy is already on the path to recovery, even before Washington has spent a single dollar on stimlus.

On my way to work this morning I listened to the latest episode of WEBZ Chicago Public Radio’s excellent show This American Life. The theme of this week’s radio show was “the New Boss”. America’s new boss, Barack Obama, has embarked on an ambitious experiment aimed at rescuing the American economy from the most severe recession it has seen since the Great Depression. The economic theory behind Obama’s nearly $1 trillion economic stimulus package was developed by a man we have all heard of in our AP and IB Economics classes, but probably know little about in a historical sense.

The clip from This American Life that I have included below presents a fascinating examination of Keynes’ life and times, and puts his theory into perspective in the history of macroeconomics of the last century. We learn that Keynesian theory has not been truly put to the test, and that Obama’s $830 billion stimulus package is the first real test of Keynesianism.

 Keynes.mp3: Play Now | Play in Popup | Download

The clip is a bit long, but it is definitely worth listening to if you are a student or teacher of economics. I know that when I come teo Macroeconomics and Fiscal Policy in my course this spring, I will have my kids listen to and discuss the podcast below. If you’re teaching or learning Macro now, feel free to listen and leave comments about your impressions of the story here.