On February 6 my IB year 2 Economics classes welcomed Dr. Irene Forichi, former Research Officer for Zimbabwe’s Ministry of Agriculture, and former Regional Emergency Agronomist for the Food and Agriculture Organization for Southern Africa. Dr. Forichi spoke with our classes about the role of agricultural productivity in contributing to human development and economic growth in Southern Africa.

For students or teachers who are interested, she delivered an excellent presentation about the agriculture-related obstacles to and strategies for economic development in the Southern Africa Development Community (SADC). Her presentation can be viewed here, or the PowerPoint she presented can be viewed below.

Related posts:

1. IB: Economic development and fertility rates in India
2. Models of Economic Growth and Development
3. Does economic growth = economic development? Not for China’s rural poor…

As we study economic development in year 2 IB Economics, we examine different models for economic growth. Growth in GDP is not the only determinant of economic development, which in order to be measured effectively must account for human welfare determinants such as life expectancy, literacy rates, child mortality rates, distribution of income, and so on. However, it has been shown throughout history that economic growth, or the increase in real output and income, correlates directly with improvements in development factors like those above.

The reason? Increases in national income usually mean at least some levels of improvement in access to basic necessities for the average citizen in a developing country. Also, higher incomes mean more savings, which means greater access to capital for investment by entrepreneurs. More investment leads to greater productivity and rising incomes for those who join the emerging industrial and service sectors that usually accompany economic growth. Furthermore, rising incomes mean more tax revenue for governments, whose spending on public goods like education, health care, and infrastructure result in real improvements in standard of living for not just the emerging upper and middle classes, but the poor as well.

Of course, the following models can be observed to varying degrees among the world’s developing economies today. Some of these models will fail to play out if the institutional and political environment fails to create a stable atmosphere for savings and investment. What you should notice, however, is the underlying importance of savings in all three models. Poor countries suffering from low savings and, even worse, capital flight, are doomed to a cycle of poverty, where funds for investment leading to productivity increases are never made available due to instable institutions like banking and politics. To put a poor country on a path towards economic growth and development, a strategy is needed. Such strategies will be covered in a later post. For now, let’s look at the models:

Harrod-Domar Growth Model:

The model suggests that the economy’s rate of growth depends on:

1. the level of saving
2. the productivity of investment i.e. the capital output ratio

The Harrod-Domar model was developed to help analyse the business cycle. However, it was later adapted to ‘explain’ economic growth. It concluded that:

• Economic growth depends on the amount of labour and capital.
• As LDCs often have an abundant supply of labour it is a lack of physical capital that holds back economic growth and development.
• More physical capital generates economic growth.
• Net investment leads to more capital accumulation, which generates higher output and income.
• Higher income allows higher levels of saving.

Lewis Structural Change (dual-sector) Model:

Many LDCs have dual economies:

• The traditional agricultural sector was assumed to be of a subsistence nature characterised by low productivity, low incomes, low savings and considerable underemployment.
• The industrial sector was assumed to be technologically advanced with high levels of investment operating in an urban environment.

Lewis suggested that the modern industrial sector would attract workers from the rural areas.

• Industrial firms, whether private or publicly owned could offer wages that would guarantee a higher quality of life than remaining in the rural areas could provide.
• Furthermore, as the level of labour productivity was so low in traditional agricultural areas people leaving the rural areas would have virtually no impact on output.
• Indeed, the amount of food available to the remaining villagers would increase as the same amount of food could be shared amongst fewer people. This might generate a surplus which could them be sold generating income.

Those people that moved away from the villages to the towns would earn increased incomes:

• Higher incomes generate more savings.
• Increased savings meant more fund available for investment.
• Increased investment meant more capital and increased productivity in the industrial sector, higher wages, more incentive to move from low productivity agriculture to high productivity industry, the circle continues…

Rostow’s Model – the 5 Stages of Economic Development:

In 1960, the American Economic Historian, WW Rostow suggested that countries passed through five stages of economic development.

According to Rostow development requires substantial investment in capital. For the economies of LDCs to grow the right conditions for such investment would have to be created. If aid is given or foreign direct investment occurs at stage 3 the economy needs to have reached stage 2. If the stage 2 has been reached then injections of investment may lead to rapid growth.

Related posts:

1. Does economic growth = economic development? Not for China’s rural poor…
2. Lesson Plan: Sources of Economic Growth and Development
3. “Fair Trade” coffee and economic development

The most important graph used in Macroeconomics today is almost certainly the Aggregate Demand / Aggregate Supply (AD/AS) model. This graph can be used to illustrate most macroeconomic indicators, including those objectives that policymakers are most interested in achieving:

• Price level stability
• Full employment, and
• Economic growth

source: http://www.beaumontenterprise.com/

 

Related posts:

1. The battle of ideas: Hayek versus Keynes on Aggregate Supply
2. Too much debt or not enough demand? A summary of the debate over America’s fiscal future
3. Keynesian/Classical debate enters the realm of hip hop

The Global Coal Trade’s Complex Calculation : NPR

Sometimes when I read the news, I wonder what it would be like to NOT understand basic economics, and then I realize how much of what goes on around us can be explained by two simple concepts: demand and supply. The NPR story below talks about how the construction of two proposed coal exporting facilities on America’s west coast could, indirectly, lead to a greener future for America. Listen to the story then read on for more analysis:

China, already the world’s largest coal consumer, continues to build new coal burning electricity plants at an alarming rate. Its appetite for the “black gold” has driven the world price up to $100 per ton, as it has demanded increasing quantities from its own coal producers, but also those in other coal rich areas like Australia and the United States.

However, because of America’s lack of coal transporting and shipping infrastructure, US coal producers have been unable to sell their abundant coal to the Chinese, who are willing to pay 500% the equilibrium price in the US. The US market has remained isolated from the world market, not due to any explicit, government-imposed barriers to trade, rather due to fact that they simply can’t get their coal to the Chinese energy producers who demand it most.

Graphically, this situation can be illustrated as follows:

If the export facilities on the West coast of the US are not constructed, it will remain difficult for US coal producers to sell their output to China at the high price of $100, and the domestic quantity (Q2) will continue to be produced and sold for $20 per ton. But with the new port facilities, US energy producers will now have to compete with Chinese energy producers for American coal, and the US price will be driven up to the world price, since demand now includes thousands of Chinese coal-fired power plants. As the price rises from $20 to $100, the domestic quantity demanded in the US will fall to Q1, as domestic energy producers seek alternative sources of energy, switching instead gas, solar, or wind power.

The irony is that through increasing the ease with which American coal producers can sell their product to China, the US may reduce its own consumption of coal and its emissions of greenhouse gasses. Overall coal production in the US will rise with increased trade, but overall consumption within the US will fall.

Now, this may sound great if you’re the kind of person who thinks only locally. Air pollution will be reduced in the US, health will be improved, our electricity production will be greener and more sustainable. But globally, by making its coal available to China, the US market will contribute to the continued dependence on carbon-intensive energy production, and delay any progress among Chinese energy producers towards a transisttion to greener fuel sources.

The podcast also points out the fact that if the US did undertake the construction of the new coal-exporting facilities, it could be that the current high price of coal will have led to the entrence of several other large coal prodcuing countries into the world market, reducing China’s demand for US coal, reducing the price at which American producers can sell to China and thereby off-setting any domestic environmental benefit that may have resulted from the large decrease in quantity demanded among US producers at the current price of $100 per ton.

The whole conversation about the coal industry is somewhat depressing when the environmental costs of the industry are considered. Another NPR show, Planet Money, ran a story this week about the “gross external damages” caused by the production of coal-powered electricity. They cited a study which found that the damages caused by coal to human health and the environment outweight the benefits enjoyed by society from the generation of cheap electricity by around $10 billion in the United States alone. This means that if the US shut down every coal-powered energy plant in the country immediately, total welfare in the US would increase by $10 billion. There’s no doubt that energy prices would rise, but the gains in human and environmental health would outweight the added costs of electricity generation by $10 billion. If a similar analysis were undertakein in China, I would guess the potential welfare gain of transitioning to alternative energies would be far greater for the Chinese people.

Here’s the chart from Planet Money’s blog showing the net welfare loss of coal-generated electricity and other economic activities in the United States.

*GED = Gross external damages from pollution

Discussion questions:

1. How would the construction of two coal-exporting facilities on America’s West coast ultimately lead to a cleaner environment in the United States? Do you think this prediction is realistic?
2. Who stands to gain the most if the coal-exporting facilities are constructed? Who would suffer? In your opinion, should the facilities be constructed? Why or why not?
3. Interpret the colorful diagram above. What do the green bars represent? What do the yellow and red bars represent? According to the graphic, which type of activity is most harmful to American society? How do you know?
4. True, false, or uncertain. Explain your reasoning. “The burning of coal to make electricity should be completely banned in China, since China is the world’s largest greenhouse gas emitter.”

Related posts:

1. Tit, tat, tariff… China and America’s latest shoving match is underway
2. Supply and demand shifters and the price of pork in China
3. Monopoly prices – to regulate or not to regulate, that is the question!

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 your textbook (Welker’s chapters 11, 12, 13, 14 and 15), 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 that affect each of the four components (this can be found in Welker’s chapter 12) [10 marks]
2. Research and identify the main macroeconomic indicators for your home country. Enter the information you find into THIS ONLINE FORM, and click submit when you’re done.

• From the CIA World Factbook you should be able to discover your country’s main macroeconomic indicators (GDP, GDP per capita, inflation rate
• Using the Eurostat website, you can find out what percentage of your country’s GDP is made up of government spending.
• If you are not from a European country, you may have to do a little more investigation to find the percentage of GDP made up of government spending.

Part 3: The Results : You can view the results of the form by clicking HERE

Discussion Questions:

1. Which of the countries appear to be doing the BEST job of meeting their macroeconomic objectives of low unemployment, low inflation and economic growth?
   
2. Which countries appear to be doing the WORST at meeting their macroeconomic objectives?
3. Which countries have the highest GDP growth rates? What do the highest growth countries have in common? What is different about them?
4. Which countries have the lowest unemployment rates? What do these countries have in common?
5. Which country experienced a recession in 2010? Discuss the possible relationship between economic growth and unemployment?

Related posts:

1. Measuring the Macroeconomic Objectives: in-class activity for AP Macro
2. Lesson plan: Elasticity, exchange rates and the balance of payments – understanding the Marshall Lerner Condition
3. Lesson Plan: Sources of Economic Growth and Development

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:

Click here to view the embedded video.

Discussion Questions:

1. What are the two “profoundly different views of economics” that are being tested as governments begin rolling back the fiscal stimulus packages of the last two years?
2. What are three characteristics of an economy in a “depression” according to Krugman?
3. What is “budget austerity” and why does Krugman think this should not be the first priority of policymakers in the G20 nations?
4. Why is deflation dangerous according to Krugman?
5. What is the additional annual cost to the US government of borrowing and spending an additional trillion dollars now? What is the potential additional benefit of more stimulus?

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

Click here to view the embedded video.

Discussion Questions:

1. Why might the US have to pass spending cuts and tax increases to maintain its “credibility in international bond markets”?
2. Why would fiscal tightening “choke off the recovery”?
3. How is the financial crisis in Europe a warning to the US?
4. How could the “costs” exceed the “benefits” of deficit financed expansionary fiscal policy.
5. Ferguson proposes a new type of policy that “boosts confidence”. Why will expansionary fiscal and monetary policies fail if private sector confidence remains depressed?

Related posts:

1. Will the stimulus package “crowd-out” private investment and reduce long-run growth potential in America?
2. The almighty bond market: Niall Ferguson’s concerns about the US deficit explained
3. How big is the government spending multiplier in America? Well, it depends on which economist you ask…

Harvard Economist Niall Ferguson appeared on CNN’s GPS with Fareed Zakaria over the weekend. Ferguson has stood out among mainstream economists lately in his opposition to the US fiscal stimulus package, an $880 billion experiment in expansionary Keynesian policy. While economists like Paul Krugman argue that Obama’s plan is not big enough to fill America’s “recessionary gap”, Ferguson warns that the long-run effects of current and future US budget deficits could lead the US towards economic collapse. This blog post will attempt to explain Ferguson’s views in a way that high school economics students can understand.

Government spending in the US is projected to exceed tax revenues by $1.9 trillion this year, and trillions more over the next four years. An excess of spending beyond tax revenue is known as a budget deficit, and must be paid for by government borrowing. Where does the government get the funds to finance its deficits? The bond market. The core of Ferguson’s concerns about the future stability of the United States economy is the situation in the market for US government bonds. According to Ferguson:

One consequence of this crisis has been an enormous explosion in government borrowing, and the US federal deficit… is going to be equivelant to 1.9 trillion dollars this year alone, which is equivelant to nearly 13% of GDP… this is an excessively large deficit, it can’t all be attributed to stimulus, and there’s a problem. The problem is that the bond market… is staring at an incoming tidal wave of new issuance… so the price of 10-year treasuries, the standard benchmark government bond… has taken quite a tumble in the past year, so long-term interest rates, as a result, have gone up by quite a lot. That poses a problem, since part of the project in the mind of Federal Reserve Chairman Ben Bernanke is to keep interest rates down“

There’s a lot of information in Ferguson’s statements above. To better understand him, some graphs could come in handy. Below is a graphical representation of the US bond market, which is where the US government supplies bonds, which are purchased by the public, commercial banks, and foreigners. Keep in mind, the demanders of US bonds are the lenders to the US government, which is the borrower. The price of a bond represents the amount the government receives from its lenders from the issuance of a new bond certificate. The yield on a bond represents the interest the lender receives from the government. The lower the price of a bond, the higher the yield, the more attractive bonds are to investors. Additionally, the lower the price of bonds, the greater the yield, thus the greater the amount of interest the US government must pay to attract new lenders.

Ferguson says that the price of US bonds has “taken a tumble”. The increase of supply has lowered bond prices, increasing their attractiveness to investors who earn higher interest on the now cheaper bonds. Below we can see the impact of an increase in the quantity demanded for government bonds on the market for private investment.

Financial crowding-out can occur as a result of deficit financed government spending as the nation’s financial resources are diverted out of the private sector and into the public sector. Granted, during a recession the demand for loanable funds from firms for private investment may be so low that there is no crowding out, as explained by Paul Krugman here.

But crowding out is not Ferguson’s only concern. The increase in interest rates caused by the US government’s issuance of new bonds could lead to a decrease in private investment in the US economy, inhibiting the nation’s long-run growth potential. But the bigger concern is one of America’s long-run economic stability. If the Obama administration does not put forth a viable plan for balancing its budget very soon, the demand for US government bonds could fall, which would further excacerbate the crowding-out effect, and eliminate the country’s ability to finance its government activities. In other words, such a loss of faith could plunge the United States into bankruptcy.

Fareed Zakaria asks Ferguson:

“Is it fair to say that this bad news, the fact that we can’t sell our debt as cheaply as we thought, overshadows all the good news that seems to be coming?”

Ferguson’s reply:

The green shoots that are out there (referring to the phrase economists and politicians have been using to describe the signs of recovery in the US economy) seem like tiny little weeds in the garden, and what’s coming in terms of the fiscal crisis in the United States is a far bigger and far worse story.

Finally Fareed asks the question everyone wants to know:”What the hell do we do?”

Ferguson:

One thing that can be done very quickly is for the president to give a speech to the American people and to the world explaining how the administration proposes to achieve stabilization of American public finance… the administration doesn’t have that long a honeymoon period, it has very little time in which it can introduce the American public to some harsh realities, particularly about entitlements and how much they are going to cost. If a signal could be sent really soon to the effect that the administration is serious about fiscal stabilization and isn’t planning on borrowing another $10 trillion between now and the end of the decade, then just conceivably markets could be reassured.

Ferguson is saying that only if the Obama administration begins taking serious steps towards balancing the US government’s budget can it hope to stave off an eventual loss of faith among America’s creditors (and thus a fall in demand for US bonds). It will be a while before tax revenues are high enough to finance the US budget. But if the country does not begin working towards such an end immediately, it may find itself unable to raise the funds to pay for such public goods as infrastructure, education, health care, national defense, medical research, as well as the wages of the millions of government employees. In other words, the US government could be bankrupt, and its downfall could mean the end of American economic power.

The power of the bond market should not be underestimated. America’s very future depends on continued faith in its financial stability and fiscal responsibility.

Discussion Questions:

1. Why do you think the US government has such a huge budget deficit this year? ($1.9 trillion) Previously, the largest budget deficit on record was only around $400 billion.
2. How does the issuance of new bonds by the US government lead to less money being available to private households and firms?
3. Do you think investors will ever totally lose faith in US government bonds? Why or why not?
4. In what way is the government’s huge budget deficit a “tax on teenagers”? In other words, how will today’s teenagers end up suffering because of the federal budget deficit?

To learn more about the power of the bond market, watch Niall Ferguson’s documentary, The Ascent of Money. The section on the bond market can be viewed here:

Related posts:

1. A must read for AP Macro teachers: Paul Krugman explains why deficit spending during a recession does NOT cause crowding-out
2. Sample IB Economics Internal Assessment Commentary – Understanding the ECB’s bond-purchasing program
3. To continue stimulus or to pursue austerity, that is the question

Help Wanted: Why That Sign’s Bad – BusinessWeek

This week’s cover story in Business Week magazine tells an interesting story about unemployment in America. Listen to the podcast or follow the link above to read more of this story:

Surprising statistic: In the midst of the worst recession in a generation or more, with 13 million people unemployed, there are approximately 3 million jobs that employers are actively recruiting for but so far have been unable to fill. That’s more job openings than the entire population of Mississippi.

Sound like good news? It’s not. Instead, it’s evidence of an emerging structural shift in the U.S. economy that has created serious mismatches between workers and employers. People thrown out of shrinking sectors such as construction, finance, and retail lack the skills and training for openings in growing fields including education, accounting, health care, and government. At the same time, the worst housing bust in decades has left the unemployed frozen in place. They can’t move to get work because they can’t sell their homes.

In IB and AP Economics we teach that there are three types of unemployment an economy may experience, ranked roughly in order from the least undesirable to the most undesirable (from a macroeconomic perspective):

• Frictional unemployment: This accounts for people who are “in between jobs” or fresh out of college looking for their first jobs.
• Structural unemployment: This is caused by the changing structure of an economy. As America’s manufacturing sector shrinks and its education and health care sectors grown, those whose skills lie in manufacturing become structurally unemployed.
• Cyclical unemployment: This is also called “demand-deficient” unemployment because it is caused by a fall in aggregate demand or overall spending in the economy.

America today is clearly experiencing all three types, but due to the particular circumstances of the recession, the American worker is finding it it harder than ever to match his skills with an appropriate job. Below are some of the industries with the most and the fewest job openings today:

Most openings:

• Education
• Health care
• Government
• Energy (such as wind, oil, natural gas)
• “Analytics” (i.e. business data analysis by firms such as IBM)

Fewest openings:

• Construction
• Manufacturing

Unfortunately for the large numbers of unemployed construction and factory workers, the kinds of skills required to work in the fields with the most job openings are prohibitively different from those learned in their previous industries. In addition to a mismatch of skills between the industries in which jobs are being lost and those in which labor is in demand, there is also a geographic mismatch in the labor market. Below are the states with the least and the most job openings:

Most job vacancies (states with large energy sectors: oil, natural gas and windmills)

• North Dakota
• Wyoming

Least job vacancies (states with large manufacturing and construction sectors)

• North Carolina
• California
• Michigan

Historically, the geographic factor has not posed an issue to American workers, and when jobs opened up in one part of the country, Americans would pack up and move where necessary to find work. Today, however, with the collapse of house prices, more and more Americans find themselves stuck with a house they can’t sell in a part of the country where they can’t find a job.

To paraphrase the podcast above, “the US in danger of looking like Europe. The European job market has been described as ‘sclerotic’; people don’t respond to want ads because of the generous long-term unemployment benefits offered by European governments. Europeans have historically been geographically immobile due to nationalist ties to their home countries.” Today, the US job market reflects some of the same “sclerosis” as that of Europe.

America is facing the perfect storm of unemployment. At the same time that the economy is undergoing its most significant structural change since the Industrial Revolution brought millions of American workers from the farm fields into factories, it is facing the most significant decline in private sector spending (consumption, investment and exports) since the great depression. Put this together with the relative immobility of the American worker caused by the housing crisis, and unemployment has climbed to its highest level in three decades.

This interesting story ends with a glimmer of hope for the American worker:

To fight this sclerosis, the White House is using $3.5 billion of the stimulus for training, while boosting support for community colleges. Classes for factory workers seeking entry-level health-care careers have shown some success.

The truth is, displaced workers may have to move down a few rungs as they switch careers because their skills are irrelevant in their new roles… Many laid-off Wall Street financial engineers still haven’t absorbed that, says Fred Wilson, a partner in Union Square Ventures, a New York venture capital firm. “For them to take a job that pays a lot less, they have to make a meaningful change in their lifestyle. And that is an issue.”

Employers need to bend as well, recognizing that the candidates they’re seeking may not exist. Mark Mehler, co-founder of CareerXRoads, a staffing strategy consulting firm in Kendall Park, N.J., tells employers: “You’re hiring potential….You’ve got to train them.”

A mismatch of work and workers is never a good thing. But smart policy—combined with realism on the part of employers and job seekers—can minimize the disruption.

Discussion Questions:

1. In what way may structural unemployment be a sign of a healthy economy, rather than a sick one?
2. Part of the Obama stimulus package includes increased benefits for unemployed Americans. How may this pose an obstacle to reducing unemployment in America?
3. Historically, the natural rate of unemployment in most European economies has been higher than that of the United States. Why is this?
4. Do you think America’s NRU will return to its historic level (4-6%) when the economy eventually recovers from the current crisis? Why or why not?

Related posts:

1. Some good news for Swiss businesses and workers during hard economic times
2. Exports, good – Imports, ALSO GOOD!
3. Will the economy self-correct?

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 (In macroeconomics): The period of time over which wages and prices are relatively inflexible. A fall in aggregate demand will lead to unemployment and recession in the short-run. Due to the inability of the nation's producers to reduce wages paid to worker, they must lay workers off to reduce costs as demand falls.');" onmouseout="tooltip.hide();">short-run and long-run macroeconomic effects of the House Stimulus Package.

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.

Related posts:

1. Fiscal Stimulus package passes in Congress – here comes $170 billion, America!
2. From the Help Desk: Long-run vs. short-run economic growth, consupmtion and investment…
3. Walking the fine line between good growth and bad growth in China

I love this discussion between John Stewart and former director of the National Economics Council Lawrence Lindsey. Stewart pitches his own version of a fiscal stimulus package to the economist, and is surprised when Lindsey agrees with the plan.

I find Lindsey’s suggestion that a stimulus package should include subsidized mortgage rates to home owners fascinating. According to Lindsey, a homeowner with a $200,000 mortgage paying 6% interest on his loan would save $4,000 per year on interest payments if the government accommodated a refinanced rate of 4%. Millions of Americans currently struggling to meet all of their monthly debt obligations while continuing to put food on the table and participate in the consumer economy would benefit from such a scheme. In its current form, Obama’s stimulus package with its $150 billion or so in tax cuts will only put approximately $500 per year for two years into taxpayers’ pockets.

As a homeowner paying a 6% mortgage myself, I can personally say I’d prefer $4,000 in savings on my annual interest payments for the next 23 years (the time remaining on my mortgage) than I would $1000 in cash over the next two years. The mortgage relief plan would result in nearly $100,000 less in interest payments, freeing that income up to be spent on goods and services and contributing to real job creation.

And check out last night’s “moment of Zen”. While Obama’s stimulus package is not quite $1 trillion, it is darn close. Senator Mitch McConnell puts the vast size of the spending bill into perspective for us:

Related posts:

1. Obama’s stimulus is “the first real test of Keynesian economic policy”
2. Fiscal stimulus, the Swiss way
3. Fiscal Stimulus package passes in Congress – here comes $170 billion, America!

How Does the Stock Market Effect The Economy? | Economics Blog

Well, a few things… Generally, the fluctuations of the stock market do not necessarily bode ill for the whole economy. Likewise, global fluctuations of stock markets does not mean there is a recession on the horizon. In fact, an old adage says that “stock markets have predicted ten out of the last three recessions.” In other words, a slump in global markets does not always precipitate a slump in the world’s economy. Here’s some impacts the market crashes of the last few days may have, however, explained nicely by Richard Pettinger, an economics teacher in the UK:

Economic Effects of Stock Market

1. Wealth Effect: The first impact is that people with shares will see a fall in their wealth. If the fall is significant it will affect their financial outlook. If they are losing money on shares they will be more hesitant to spend money; this can contribute to a fall in consumer spending. However, the effect should not be given too much importance. Often people who buy shares are prepared to lose money; their spending patterns are usually independent of share prices, especially for short term losses.

2. Effect on Pensions: Anybody with a private pension or investment trust will be affected by the stock market, at least indirectly. Pension funds invest a significant part of their funds on the stock market. Therefore, if there is a serious fall in share prices, it reduces the value of pension funds. This means that future pension payouts will be lower. If share prices fall too much, pension funds can struggle to meet their promises. The important thing is the long term movements in the share prices. If share prices fall for a long time then it will definitely affect pension funds and future payouts.

3. Confidence: Often share price movements are reflections of what is happening in the economy. E.g. recent falls are based on fears of a US recession and global slowdown. However, the stock market itself can affect consumer confidence. Bad headlines of falling share prices are another factor which discourage people from spending. On its own it may not have much effect, but combined with falling house prices, share prices can be a discouraging factor.

4. Investment: Falling share prices can hamper firms ability to raise finance on the stock market. Firms who are expanding and wish to borrow often do so by issuing more shares – it provides a low cost way of borrowing more money. However, with falling share prices it becomes much more difficult.

Related posts:

1. Advice from an economic oracle – buy American stocks now!
2. Unemployment and inflation: understanding the Fed’s balancing act
3. Will the stimulus package “crowd-out” private investment and reduce long-run growth potential in America?

FT.com / Columnists / Wolfgang Munchau – Inflation and the lessons of the 1970s

It seem that everyone’s speculating about the US economy today. Recession or no recession, that is the question. The economy has even surpassed the Iraq War as the number one issue in the US presidential race! John McCain, who has publicly admitted that economics is not his strong suit, may just find himself in trouble in a general election where the most important concern among voters is the economic situation.

So what IS that situation, anyway? Is the US in a recession? In other words, has real gross domestic, or total output in the US economy, actually declined over the last six months? Technically, the answer is no. My fellow blogger, Steve Latter, explains this clearly here. What is true, on the other hand, is that the current situation shares many similarities to the global economic slowdown that did occur in the 1970s.

In 1973 OPEC, the newly formed oil cartel consisting at the time of only Arab states, reduced its output of oil and cut off exports to the United States in response to US support of Israel in the Yom Kippur War, in which the Israelis officially occupied the Palestinian territories of the West Bank and Gaza and seized the Golan Heights from the sovereign nation of Syria. To punish the US for its position on this conflict, OPEC cut off supplies of oil to the west, driving gas and energy prices upwards by 70%, triggering a supply shock characterized by a decline in total output and an increase in both unemployment and inflation, a phenomenon known as stagflation: a macroeconomic policy maker’s worst nightmare.

Recently the world has seen a similar (albeit of a different cause) rise in the price of oil and energy prices. Today the rise in energy prices is driven primarily by rising demand, rather than reduced supply (since the 1970s the OPEC cartel has grown to include many non-Arab nations, making it harder to achieve collusion to restrict output and drive up oil prices). Global demand for oil has risen steadily, driven ever higher due to rapid growth in China and other developing nations, and exacerbated by the falling value of the dollar, the currency in which oil prices are denominated.

The supply shocks of today have combined with falling aggregate demand in the US due to weak consumer spending to slow real growth rates to nearlry 0%. So technically, the US has avoided a recession, but the effect on American workers and consumers may be just as painful as the real recession of the 1970s. In order to prevent the “r” word from becoming a reality today, central banks (including the US Fed) have eased money supplies, lowering interest rates, fueling even greater increases in the price level.

…the global weighted average inflation rate will be 5.4 per cent this year, while the global money market interest rate is currently only 4.3 per cent. This means that global short-term real interest rates are negative – at a time when inflation is rapidly accelerating. As monetary policy has been excessively accommodating for more than a decade, inflationary pressures have built up in the global economy.

Central bankers like Ben Bernanke have to make tough decisions sometimes, weighing the trade-off between unemployment and inflation, and determining their monetary policies based on whatever they deem to be the “lesser of two evils”. Rising energy prices have forced firms to cut either cut back their production and raise the price of their products, both actions that result in less overall spending and output in the economy. Falling house prices have led consumers to cut back their own spending, further reducing demand for firms’ output. These factors have all pushed the unemployment rate from around 4.8% a year ago to 5.1% today, which combined with an estimated additional 3-5% of American workers having dropped out of the workforce, (referred to by the Department of Labor as “discouraged workers”) paints a pretty ugly picture of the reality for the American worker today.

The harsh reality of the weak labor market has led Mr. Bernanke and the Fed to pursue an expansionary monetary policy aimed at avoiding further increases in the unemployment rate and decreases in the GDP growth rate. Expansionary monetary policy means lower interest rates, with the goal being increased consumption and investment, both factors that could worsen the inflation problem already experienced thanks to the global supply shock. Evidence indicates that the inflation problem, even in the US where slow growth usually leads to lower price levels, is not going away:

In the US, a survey-based measure of inflationary expectations recently showed an increase to more than 5 per cent. I would estimate there are now several hundred basis points of difference between the current Fed funds rate and an interest rate that would be consistent with price stability in the medium term.

…meaning the Fed, in its attempt to avoid recession and rising unemployment, has created a condition where real interest rates are actually negative, a highly inflationary condition. All this wouldn’t be so bad if wages in the US were rising along with the price level. This however, does not appear to be happening:

The main difference between the situation in the 1970s and now is today’s absence of wage inflation, which explains why absolute inflation rates are a little more moderate. I guess this is probably because of some combination of deregulated labour markets and globalisation. But the lack of wage-push inflation is not necessarily good news. Falling real wages mean falling disposable income and tighter credit conditions mean less borrowing for consumption.

Rising prices for energy, transportation and food have put American households in a tough situation. In the past, periods of inflation have often been characterized by rising wages, meaning the full brunt of nominal price level increases was not entirely born by the American worker. Today, on the other hand, a recession has thus far been avoided, but the combination of record numbers of “discouraged workers”, rising unemployment and inflation may make the pain of our current economic situation just as real as recessions of the past.

In the words of billionaire investor and economic sage Warren Buffett just today:

“I believe that we are already in a recession… Perhaps not in the sense as defined by economists. … But people are already feeling the effects of a recession.”

“It will be deeper and longer than what many think,” he added.

Discussion Questions:

1. What is the difference between nominal and real GDP? Which must decline in order for the economy to be in a recession?
2. What impact do rising energy prices have on the behavior of individual firms?
3. Why are low interest rates likely to make the inflation problem even worse?

Related posts:

1. Unemployment and inflation: understanding the Fed’s balancing act
2. Doom and gloom in the headlines as US economy teters on edge of recession…
3. Stagflation – a blast from the past could mean trouble for US economy

FT.com / Asia-Pacific / China – Weak dollar troubles Beijing

Inflation, with its erosive effects on wealth and income, has plagued China at increasing rates since mid-2007. In February it reached an annualized rate of 8.7%, threatening to undermine China’s GDP growth rate, which has been predicted in the 8% range for this year.

As we have discussed in our our AP Econ class here in Shanghai, China’s inflation is caused by a combination of demand and supply-side factors. On the demand-side, a growing middle class has driven consumer spending to record levels recently, surpassing investment as the largest component of China’s GDP in 2007. Of course, as always, high inflation (thus low real interest rates), optimism about rising consumption in the future, and a comparative advantage in labor-intensive manufacturing (albeit a diminishing one as wages continue to rise) all combine to keep investment extremely high. Furthermore, cheap exports have helped keep demand for China’s output from abroad strong. The combination of increasing consumption, strong investment, and its trade surplus have resulted in demand-pull inflation.

On the supply-side, China has encountered additional inflationary pressures of late. Rising energy prices (mostly due to coal and oil shortages) combined with record rises in food prices (24% increase in the last year), have driven costs to firms up, shifting the aggregate supply curve leftward, further fueling inflation.

Knowing the damaging effects inflation has on income and wealth, it might be assumed that Beijing would place the utmost emphasis on taming the country’s rising prices. This, however,is not at the top of the government’s macroeconomic goals, according to premier Wen Jiabao:

On the issue of whether he would sacrifice economic output to bring down inflation, at the risk of increasing unemployment, Mr Wen indicated that growth re­mained the overarching priority. “We must ensure that our economy will grow…in order to ensure employment,” he said. “China is a developing country with 1.3bn people. We have to maintain a certain degree of fast economic growth to provide enough jobs.

”He said China needed to add about 10m jobs a year for the next five years, a lower figure than in the past when the aim was growth of 15m-20m jobs a year.

The tradeoff between inflation and unemployment to which Mr. Wen refers is a text book example of the challenges faced by macroeconomic policymakers everywhere. This trade-off is illustrated in the Phillips Curve model, which shows that in the (In macroeconomics): The period of time over which wages and prices are relatively inflexible. A fall in aggregate demand will lead to unemployment and recession in the short-run. Due to the inability of the nation's producers to reduce wages paid to worker, they must lay workers off to reduce costs as demand falls.');" onmouseout="tooltip.hide();">short-run, there exists an inverse relationship between the price level and the unemployment rate.

In his words above, Mr. Wen demonstrates Beijing’s preference in the trade-off between inflation and unemployment: He’ll take inflation… Here’s why.

In case you haven’t heard, China is not a democracy. Nor is it a, ehem, “free” country. According to Alan Greenspan in his book “The Age of Turbulence”, democracy and freedom of speech act as “safety valves” in Western countries; in other words, in times of economic or political unrest, the right to gather in the streets, the right to vent frustrations through a free press and the opportunity to advocate political and economic change through the various media, all combine to prevent violent and revolutionary uprisings when times get tough economically.

Take the US for example. Times are certainly tough right now. Inflation’s approaching 4-5%, while nominal growth has nearly stagnated. Unemployment, while it has technically fallen recently, in reality has risen as hundreds of thousands of workers have given up searching for work. The bursting of the housing bubble represents one of the most massive losses of wealth in recent history. A weak dollar has meant that even cheap imports don’t seem so cheap anymore. Throw in the desperate war in Iraq, the nuclear threat from Iran, rising food prices, $110 oil and an incredibly unpopular national leader, and by some measures the country would appear ripe for revolution. However, a revolution is about the least likely thing to occur in America, because it enjoys the “safety valve” of democracy. Rather than overthrowing their government, Americans have the right to go to the pole and vote for a new one, which in all likelihood will occur this November when it seems either Barrack or Hillary stand the greatest chance and winning the White House.

Now let’s look at China. The picture’s not quite so gloomy for the Chinese right now. Yes, inflation is high, as in the US. But unlike America, China is still growing at a very healthy pace, unemployment is probably still below its natural level, the real estate markets in China’s cities are still booming, meaning the middle class residents there are experiencing leaps and bounds in terms of personal wealth. Demand for its exports remains strong, and ever more poor Chinese are finding jobs in high paying factories across the country. Investments in capital, infrastructure and education point towards a bright future of continued growth for the foreseeable future.

But wait, 8.4% is something to worry about, especially when we take into account the 24% increase in food prices. Shouldn’t Wen and Beijing be taking drastic steps to reign in this high rate of inflation? In short, NO, they shouldn’t. Because as can be seen in the Phillips Curve, to reduce inflation could result in another, far more serious problem for Beijing; rising unemployment.

It appears that Beijing’s greatest fear is a population out of work. Its goal of creating 10 million new jobs is ambitious, but in the eye’s of the government, necessary. The Chinese people do not enjoy the “safety valve” of democracy through which economic frustrations and hardships can be channeled were the country to experience a slowdown in growth and an increase in unemployment. The last time the economy faced high inflation AND high unemployment, students, workers, soldiers and tanks all gathered for an afternoon of urban warfare under Mao’s somber gaze in Beijing. To avoid such massive revolutionary movements in the future, Beijing must do all it can to insure job creation continues and growth remains strong, even if the trade-off is record high inflation.

This one passage spoken by Wen Jiabao, China’s premier, tells a vivid story about the reality of Communist dictatorship in China. Sound economic policy may go on the back burner in times of political uncertainty. Price controls, such as those on petrol in Shanghai (speaking of, the long lines at gas stations are back!), were a microeconomic example of bad economics; Beijings hesitance to seriously tackle inflation is a macroeconomic example. Holding on to power seems to be more important than stabilizing prices, at least for now.

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Related posts:

1. Facts and the Phillips Curve: new evidence of the short-run trade-off between unemployment and inflation
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Job losses worst in five years – Mar. 7, 2008

The news late last week out of Washington was not what the White House was hoping for only a couple of weeks after the passing of a fiscal stimulus package meant to achieve exactly the opposite of what has happened. The US Labor Department released its latest numbers on employment on Friday:

There was a net loss of 63,000 jobs, which is the biggest decline since March 2003 and weaker than the revised 22,000 jobs lost in January. Economists had forecast a gain of 25,000 jobs…

“Based on today’s Employment Report, if we are not in a recession, it is a darned good imitation of one,” said Kevin Giddis, managing director of fixed income at Morgan Keegan.

So with a net loss of jobs, it may seem weird to hear that unemployment has actually fallen from 4.9% to 4.8%. How is this possible? In this case lower unemployment may indicate an even worse reality for the American economy:

The unemployment rate fell because of an increase of 450,000 people whom the government no longer counts as being part of the labor force for a variety of factors, such as that they are not currently looking for work. That drop in the size of the labor force allowed for the modest decline in unemployment, even as the household survey showed 255,000 fewer Americans with jobs than in January.

Discouraged workers point to a deep pessimism underlying households and workers in America, indicating that if we’re not already in a recession, it is only a matter of time. With the apparent failure of fiscal policy at achieving any immediate turnaround in consumer confidence, all eye’s are now on the Fed, America’s central bank, to see how Ben Bernanke will respond to the latest round of bad news.

“Even the silver lining of a falling unemployment rate has a little rust,” said Rich Yamarone, director of economic research at Argus Research. He predicted that the central bank will cut rates by a half percentage point at both its March meeting and again on April 30.

But Yamarone and some other experts questioned whether additional Fed cuts would do much to improve the employment outlook.

“We’re not in a crisis because the cost of borrowing is too high, it’s because people are afraid of lending,” said Dan Alpert, managing director of Westwood Capital, referring to the ongoing credit crunch. “At the end of the day, the Fed cuts don’t really solve the problems. They’ve already cut allot; if jobs continue to decline in face of further interest rate cuts, it’s prima facie evidence cuts aren’t effective.”

But few experts were ready to suggest the Fed would stop cutting rates at this point, given the problems in the economy and financial markets.

“The Fed has to do what it can to provide remedy and not scare the market as well,” said Mike Materasso, a senior portfolio manager at Franklin Templeton.

Central bankers face difficult decisions in times like these. While unemployment and falling growth rates pose significant problems to the American economy, the third macroeconomic evil is certainly in the minds of policymakers when deciding how to deal with the first two: inflation.

In order to lower interest rates, the Fed first has to implement expansionary monetary policy. In other words, the central bank must increase America’s money supply. How does it do this, exactly? Most commonly, the Fed uses open market operations, which is a fancy way of saying the Fed buys and sells government securities (treasury notes, bonds, etc…) on the bond market. When the Fed wishes to lower interest rates, it must inject new money into the economy, which it does by buying government bonds from the holders of those securities; namely, the public.

American banks, households, and firms, as well as foreigners all hold government debt. When the Fed wants to expand the money supply, it simply starts buying these debt securities back from the public. The increase in demand for securities drives up their prices, encouraging holders of the debt to sell their securities to the Fed, for which they receive money in exchange. In effect, the public exchanges illiquid (unspendable) debt certificates for liquid money. Now consumers have more money in their pockets to spend, firms have more to invest, and banks have more to loan out to borrowers who want to spend and invest. How do banks get rid of their new liquidity? Yep, they lower their interest rates.

In a nutshell, that’s how monetary policy works. To combat a recession and rising unemployment, the Fed simply buys bonds on the open market, injecting liquidity into the economy, which should result in more borrowing and more spending, shifting aggregate demand out, leading to growth and rising employment.

But what about that third evil, inflation? Won’t more spending lead to demand pull inflation? Usually this is not a major concern in times of a slowdown, since rising unemployment indicates the economy is producing below its full employment level of output. Expanding aggregate demand should result in increased output and stable prices. Today, however, Americans are facing other inflationary pressures, including a historically weak dollar (meaning imported goods and raw materials are more expensive than ever), and skyrocketing food and energy prices due to rising global demand for such commodities.

This all makes the job of monetary policy exceptionally challenging for Mr. Bernanke and his colleagues at the Fed. Expand the money supply too much (i.e. lower interest rates too much) and you risk accellerating inflation. Keep rates too high, and we can expect even worse employment and output numbers in the next few months.

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Related posts:

1. The Federal Reserve and the tradeoff between unemployment and inflation
2. You can’t always get what you want… the tradeoff between unemployment and inflation
3. Facts and the Phillips Curve: new evidence of the short-run trade-off between unemployment and inflation

FT.com / Asia-Pacific / China – China to focus on curbing inflation

Growth – the ultimate macroeconomic policy goal. Growth leads to improvements in material well-being; by definition it means more output per person. Growth also enriches society in other ways: more tax revenue for governments means more to spend on public goods like education, health care, and infrastructure, which all contribute to development of human capital, standard of living, and productivity. But is there such a thing as too much of a good thing? When it comes to growth in China, that may be the case.

According to Chinese premier Wen Jiabao:

“The primary task for macro­economic regulation this year is to prevent fast economic growth from becoming overheated growth…”

So, fast growth is good, but overheated growth is bad?

I once had a Jeep Wrangler that when I drove it across the country, anytime it hit 70 mph it started to overheat… is that the kind of overheating China’s economy is experiencing? Well, kind of, yes.

The reason my Jeep would overheat was that the pistons in the engine had to move so rapidly to keep the engine going at enough RPMs that the friction created overwhelmed the engine’s ability to properly cool itself. In China, the pistons can be compared to the manufacturing industry and agricultural sectors, which last year were stretched to their limits to meet not only rising demand from foreigners for China’s output, but record levels of domestic demand as well.

For the first time last year, China’s domestic consumption made up a larger component of the country’s GDP than investment. Returning to our metaphor, the engine was forced to work harder than usual, but I hadn’t spent enough to maintain the engine, so it was not properly lubed and tuned for the stress of long-distance travel. Maintenance on an engine is important, otherwise it will wear out and overheat while driving at high speeds over long distances. Likewise, investment in new capital is vital for an economy to keep from overheating as it grows at high rates over long periods of time.

Rising consumption and exports, without a corresponding increase in investment, means capital depreciates too quickly to meet Chinese and the world’s demand for output. In terms of our macroeconomic model, AD shifts out more rapidly than AS, causing inflation:

“the premier said the political priority was to tame consumer price inflation, which hit an 11-year high of 7.1 per cent in January.”

Rising consumption and net exports puts upward pressure on prices in China. To worsen matters, food prices have experienced record increases in the last year, making the matter especially hard for China’s urban poor, separated from the farmland and its produce as they are.

Investment, while an expenditure itself, tends not to contribute to inflation (as might be thought, since it shifts AD outward), but mitigate it, due to the supply-side effect attributable to the increase in capital and productivity that it creates. To combat rising food prices in China, Mr. Wen plans to encourage investment in the agricultural sector through targeted government intervention:

The government would expand agricultural commodity production, strictly control industrial grain use, establish an early-warning system to monitor supply and demand, and strengthen “market oversight” and “price inspections”, he said.

Subsidies for the poor would be increased and provincial governors and mayors held directly responsible for ensuring basic food supplies, said Mr Wen.

Overall China’s picture is looking rather rosy, it would appear. While 7.1% inflation is certainly something to fear, it seems to be manageable in the context of a global slowdown in income growth, and the corresponding decrease in demand for Chinese exports that implies. Combined with a strengthening RMB, China can look forward to a slower rate of growth in 2008, (“a now routine annual ‘target’ of 8 percent expansion in [GDP]“). The trick for the government is to foster investment and productivity growth in the agricultural sector to keep food prices down in the face of growing demand for meat products among China’s middle class.

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1. “China Chokes”: A look at the effects of China’s massive economic growth
2. Could a US recession be good for China?
3. China: formerly the world’s factory, now a nation of consumers…