Archive for the 'Recession' Category

Feb 27 2013

Sequestration – a basic economic analysis

Ben Bernanke Lectures Congress on Austerity Economics : The New Yorker

In just two days, the United States will enact a massive contractionary fiscal policy known as the “sequester”, which includes over $1 trillion in federal spending cuts rolled out over the next ten yeas. The imminent sequester (which is defined as “to isolate, or hide away”) is the result of the failure of Democrats and Republicans to agree upon an acceptable combination of spending cuts and tax increases to put the US government on a more sustainable budgetary path (meaning lower national debt in the future). The sequester was never intended to occur, rather it was put in place to force the two parties to come up with a budget compromise that would cause less harm to the economy than the cuts that the sequester will impose.

The $1.2 trillion cut in spending will have several negative effects on the US economy, including 

…up to 2,100 fewer food inspections, 373,000 mentally ill adults and children going without treatment, 70,000 kids being kicked out of preschool, 2,700 schools losing federal funding, about 30,000 teacher layoffs, a reduction in federal law enforcement capacity equivalent to the loss of 1,000 federal agents, 1,000 fewer criminal prosecutions, and the list goes on and on. The chairman of the Joint Chiefs of Staff, Gen. Martin Dempsey, recently said before the Senate Armed Services Committee that sequestration will “make it much harder for us to preserve readiness after more than a decade of fighting in Iraq and Afghanistan.”

The effects on national output and employment in the US economy, which is still recovering from the Great Recession of 2009, will likely be devastating. According to the Federal Reserve Bank Chairman Ben Bernanke,

“Given the still-moderate underlying pace of economic growth, this additional near-term burden on the recovery is significant… Moreover, besides having adverse effects on jobs and incomes, a slower recovery would lead to less actual deficit reduction in the short run.”

Bernanke, a Republican himself, recognizes that any cut in government spending (known as a contractionary fiscal policy) will harm the US economy’s growth potential both in the short-run and the long-run. Bernanke believes that the primary goal of the government right now (and the Central Bank, which he is the head of) should be to promote increased employment to bring the nation’s unemployment rate down (back to its natural rate).

So what is the argument FOR a contractionary fiscal policy? Why would the Democrats and Republicans let this sequestration take place even when America’s leading economic voice is calling for it to be avoided? If you ask many of the Republicans in Washington, D.C., America’s biggest macroeconomic problem is not slow growth or high unemployment, it’s the large national debt. The debt (which is the sum of all of the country’s past budget deficits), has grown to nearly 80% of the nation’s GDP. This means that the nation owes the holders of that debt nearly as much as its total income in a year. If an individual had a debt level this high, that individual would probably have to cut back on his own spending (cut up those credit cards!), to begin paying back that debt; obviously, high personal debt ultimately leads to a decrease in the standard of living of the indebted person as it eventually has to be paid back.

But a nation’s debt is a little different than that of an individual. If the US government cuts back on spending to reduce the debt, the result is rising unemployment, lower incomes, reduced confidence among households and firms, a reduction in economic growth, and possibly, a recession. The goal of reducing the debt could ultimately reduce the national output and income, which could ironically make the debt an even bigger deal than it already is. Let me explain why.

Imagine two countries, Country A and Country G. Country A has a national debt of $12,000 billion dollars. Country G has a national debt of $355 billion dollars. Obviously, Country A’s debt is around 35 times the size of Country G’s. So if I asked you, which of these countries is facing a “debt crisis”, you’d probably say Country A, right? Well, you’d be wrong. Country A is America, and Country G is Greece. So why does Greece’s national debt of $355 billion, which represents 182% of Greece’s GDP of $195 billion, constitute a “crisis”, while America’s debt of $1,200 billion, or just around 80% of its GDP, is simply a cause of concern among one of the country’s political parties? The answer is, it’s not how large a nation’s debt is in dollar terms that matters, rather how large the debt is relative to the country’s GDP. A millionaire could handle a $100,000 debt just fine, while for an individual earning minimum wage, a debt of $100,000 would present a crushing burden that is unlikely ever to be overcome without that individual declaring himself bankrupt.

If the sequestration takes place, America’s GDP may fall, as Bernanke has warned. But its debt will continue to grow (albeit less slowly than it would without the sequester). If the GDP falls while the debt grows, the country’s debt burden actually increases, despite the desired outcome of the sequester, a reduction in debt. In other words, the sequestration will make America more like Greece (the guy on minimum wage) and less like America (the millionaire!).

Rather than working towards debt reduction, as the mainstream of the Republican party advocates, Ben Bernanke would prefer the federal government focus on policies that reduce unemployment. Unemployment, defined as “the state of actively seeking a job, but being unable to find one”, has several negative effects on individuals and the economy as a whole. Here’s Bernanke explaining to the US Congress the consequences of unemployment:

High unemployment has substantial costs, including not only the hardship faced by the unemployed and their families, but also the harm done to the vitality and productive potential of our economy as a whole. Lengthy periods of unemployment and underemployment can erode workers’ skills and attachment to the labor force or prevent young people from gaining skills and experience in the first place—developments that could significantly reduce their productivity and earnings in the longer term. The loss of output and earnings associated with high unemployment also reduces government revenues and increases spending, thereby leading to larger deficits and higher levels of debt.

Many economists believe that America’s huge national debt (in dollar terms) is really not all that bad when compared to its even huger GDP. A nation’s debt really only becomes a problem when that nation, like an individual burdened with a high level of personal debt, is forced to reduce its spending and begin paying that debt off. A nation can maintain a high level of debt as long as it can continue to borrow more money to pay off its past debt. And in the current global economy, no nation can borrow money more easily than the United States of America.

The cost of borrowing money is the interest rate that must be paid on loans made to an individual or government. At present, the US government can borrow money at very low interest rates (it pays between 1% and 3% on most of the government bonds it issues). This fact indicates that America’s debt, while it is a primary concern of the Republican party, is not a major concern among those to whom the US government owes money, nor to those who may lend it money in the near future.

The tradeoff America faces as it enters this period of sequestration, government spending cuts, and the resulting reduction in aggregate demand, income, output and employment, is one between future debt and future prosperity. The sequester may reduce the level of debt in the future, but it will also increase the debt burden (as Bernanke explained). In exchange for a smaller dollar value of its debt, America may have to accept  increased unemployment and a slower recovery from the Great Recession, which together will make the US less competitive, reduce standards of living, and make it more difficult for future generations to enjoy the quality of life experienced by their parents and grandparents.

Discussion Questions:

  1. What is the Unemployment Rate in the United States today? What is thought to be the US’s “natural rate of unemployment” How is unemployment measured (simply state the formula)?
  2. Based on America’s current unemployment rate, where would you expect the US to be on its business cycle? Draw a business cycle model and indicate where the US is most likely to be.
  3. Based on America’s current unemployment rate, where do you think current US equilibrium output is compared to full employment output? Draw an AD/AS model and indicate the likely equilibrium the US is currently experiencing.
  4. If you were in charge of fiscal policy, identify two possible policy recommendations that the US should consider given its current level of unemployment. Explain how each would impact the level of unemployment in the economy.
  5. Assume the marginal propensity to consume in the United States is 0.6, and the government decides to cut military and domestic spending by $85 billion. Calculate the effect this will have on America’s GDP.
  6. On the business cycle and AD/AS diagram you drew above, show the effect of the $85 billion spending cut.
  7. Explain how the spending cut will will impact the level of unemployment in the economy.
  8. Discuss with your table the wisdom of the $85 billion spending cut described above.

2 responses so far

Nov 06 2012

A closer look at the crowding-out effect

To spend or not to spend. That is the question. In order to determine whether or not a government should increase its budget deficit in order to stimulate economic activity in its economy, it is important to determine whether said deficit spending will lead to a net increase in the nation’s GDP or a net decrease in GDP. Obviously, if increasing the debt to pay for a government spending package leads to lower aggregate demand in the economy, then it should not be undertaken. However, if a deficit-financed spending package leads to an overall increase in output and national income, it may be justified.
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To understand the circumstances under which a government stimulus package will increase or decrease overall output in the economy, we must compare two competing possible impacts of a government stimulus. The multiplier effect of government spending refers to a theory which says that any increase in government spending will lead to further increases in private spending, as households enjoy more income and thus consume more and firms, which earn more revenues due to the government’s increased spending, make new capital investments, contributing to the stimulus provided by government and leading to an overall increase in GDP that exceeds the increase in government spending.
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The crowding-out effect, on the other hand, refers to the theory that any increase in government spending, when financed by a larger deficit, will lead to a net decrease in private expenditures, as firms and households face higher interest rates due to the governments’ intervention in private financial markets. Government spending will crowd out private spending, thus any increase in spending will be off-set by a decrease in private spending, possibly even reducing overall income in the nation.
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This post will focus on the second of these effects, and attempt to explain the circumstances under which crowding-out is likely to occur, and those under which it is unlikely to occur.
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Deficit-financed government spending refers to any policy that increases government expenditures without increasing taxes, or one that reduces taxes without reducing government expenditures. In either case, a government must increase the amount of borrowing it does to pay for the policy, which means governments must borrow from the private sector by issuing new debt in the form of government bonds.
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When a government must borrow to spend, it has to attract lenders somehow, which may require the government to offer higher rates of return on its bonds. The impact this has on the supply of private savings, which refers to the funds available in commercial banks for lending and borrowing in the private sector, will be negative. In other words, the supply of loanable funds in the private sector will decrease.
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The graph below shows the market for loanable funds in a nation. The supply curve represents all households and other savers who put their money in private banks, in which they earn a certain interest rate on their savings. The demand for loanable funds represents private borrowers in the nation, who demand funds for investments in capital and technology (firms) and durable goods and real estate investments (households). The demand for loanable funds is inversely related to the real interest rate in the economy, since higher borrowing costs mean less demand for funds to pay for investment and consumption.
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When a government needs to borrow money to pay for its deficit, private savers (represented by Slf above) will find lending money to the government more attractive than saving in private banks, since the relative interest rate on government bonds is likely to rise. This should reduce the supply of loanable funds in the private sector, making them more scarce and driving up borrowing costs to households and firms. This can be seen below:
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In the illustration above, a government’s deficit spending crowds-out private spending, as firms and households find higher interest rates less attractive and thus demand less funds for investment and consumption. Private expenditures fall from Qe to Q1; therefore any increase in economic output resulting from the increase in government spending may be off-set by the fall in private spending. Crowding-out has occurred.
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Another way to view the crowding-out effect is to think about the impact of increased government borrowing on the demand for loanable funds. Demand represents all borrowers in an economy: households, firms and the government. An increase in public debt requires the government to borrow funds from the private sector, so as the supply of loanable funds fall, the demand will also increase, although not from the private sector, rather from the government. The effect this has can be seen below:
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In the graph above, both the reduced supply of loanable funds resulting from private savers lending more to the government and the increased demand for loanable funds resulting form the government’s borrowing from the private sector combine to drive the equilibrium interest rate up to IR2. The private quantity demanded now falls from Qe to Qp, while the total amount of funds demanded (from the private sector and the government  now is only Qp+g. This illustration thus shows how an increase in government borrowing crowds out private spending but also leads to an overall decrease in the amount of investment in the economy.
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Based on the two graphs above, a deficit-financed government spending package will definitely crowd-out private spending to some extent, and in the case of the second graph will even lead to a decrease in overall expenditures in the economy. This analysis could be used to argue against government spending as a way to stimulate economic activity. But this analysis makes some assumptions that may not always be true about a nation’s economy, namely that the equilibrium level of private investment demand and the supply of loanable funds occurs at a positive real interest rate. There are two possibilities that may mean the crowding-out effect does not occur. They are:
  • If the private demand for loanable funds is extraordinarily low, or
  • If the private supply of loanable funds is extraordinarily high.
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When might these conditions be met? The answer is, during a deep recession. In a recession, household confidence is low, therefore private consumption is low and savings rates tend to rise, increasing the supply of funds in private banks. Also, firms’ expectations about the future tend to be weak, as low inflation or deflation make it unlikely that investments in new capital will provide high rates of return. Home sales are down and consumption of durable goods (which households often finance with borrowing) is depressed. Essentially, during a recession, private demand from borrowers is low and private supply from households is high. If the economy is weak enough, the loanable funds market may even exhibit an equilibrium interest rate that is negative. This could be shown as follows:
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Notice that due to the exceedingly low demand and high supply of loanable funds, 0% acts as a price floor in the market. In other words, since interest rates cannot fall below 0%, there will be an excess supply of funds available to the private sector. Such a scenario is known as a liquidity trap. The level of private investment will be very low at only Qd. Banks cannot loan out all their excess reserves, and even though borrowing money is practically free, borrowers aren’t willing to take the risk to invest in capital or assets that may have negative rates of return, a prospect that is not unlikely during a recession.
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So what happens when government deficit spends during a “liquidity trap”, as seen above? First of all, the government need not offer a very high rate to borrow in such an economy. Private interest rates will be close to zero, so even a 0.1% return on government bonds will attract lenders. So the supply of loanable funds may decrease, and demand may increase, but crowding-out will not occur because there is almost no private investment spending to crowd out! Here’s what happens:
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Here we see the same shifts in demand and supply for loanable funds as we saw in our first graph, except now there is no increase in the interest rate resulting from the government’s entrance into the market. Since private interest rates stay at 0%, the private quantity of funds demanded for investment remains the same (Qp), while the increased government borrowing leads to an increase in overall spending in the economy from Qp to Qp+g. Rather than crowding-out private spending, the increase in government spending has no impact on households and firms, and leads to a net increase in overall spending in the economy.
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If the government spends its borrowed funds wisely, it is possible that private spending could be crowded-in, which means that the boost to total output resulting from the fiscal stimulus may increase firm and household confidence and shift the private demand for loanable funds outwards, increasing the level of private investment and consumption, further stimulating economic activity.
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So what have we shown? We have seen that in a healthy economy, in which households and firms are eager to borrow money to finance their spending, and in which savings rates are not exceedingly high, government borrowing may drive up private interest rates and crowd-out private spending. But during a deep recession, in which consumer spending is depressed and firms are not investing due to uncertainty and savings rates are higher than what is historically normal, an increase in government spending financed by a deficit will have little or no impact on the level of private investment and consumption. In such a case, governments can borrow cheaply (at just above 0%), and increase the overall level of demand in the economy without harming the private sector.
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Crowding-out is a valid economic theory, but its likelihood of occurring must be evaluated by considering the actual level of output and employment in the economy. In a deflationary setting, in which savings is high and private spending is low, government may have the opportunity to boost demand and stimulate growth without driving up borrowing costs in the private sector and decreasing the level of household and firm expenditures.

6 responses so far

Aug 16 2011

Too much debt or not enough demand? A summary of the debate over America’s fiscal future

As yet another school year begins, we once again find ourselves returning to an atmosphere of economic uncertainty, sluggish growth, and heated debate over how to return the economies of the United States and Europe back onto a growth trajectory. In the last couple of weeks alone the US government has barely avoided a default on its national debt, ratings agencies have downgraded US government bonds, global stock markets have tumbled, confidence in the Eurozone has been pummeled over fears of larger than expected deficits in Italy and Greece, and the US dollar has reached historic lows against currencies such as the Swiss Franc and the Japanese Yen.

What are we to make of all this turmoil? I will not pretend I can offer a clear explanation to all this chaos, but I can offer here a little summary of the big debate over one of the issues above: the debate over the US national debt and what the US should be doing right now to assure future economic and financial stability.

There are basically two sides to this debate, one we will refer to as the “demand-side” and one we will call the “supply-side”. On the demand-side you have economists like Paul Krugman, and in Washington the left wing of the Democratic party, who believe that America’s biggest problem is a lack of aggregate demand.

Supply-siders, on the other hand, are worried more about the US national debt, which currently stands around 98% of US GDP, and the budget deficit, which this year is around $1.5 trillion, or 10% of GDP. Every dollar spent by the US government beyond what it collects in taxes, argue the supply-siders, must be borrowed, and the cost of borrowing is the interest the government (i.e. taxpayers) have to pay to those buying government bonds. The larger the deficit, the larger the debt burden and the more that must be paid in interest on this debt. Furthermore, increased debt leads to greater uncertainty about the future and the expectation that taxes will have to be raised sometime down the road, thus creating an environment in which firms and households will postpone spending, prolonging the period of economic slump.

The demand-siders, however, believe that debt is only a problem if it grows more rapidly than national income, and in the US right now income growth is almost zero, meaning that the growing debt will pose a greater threat over time due to the slow growth in income. Think of it this way, if I owe you $98 and I only earn $100, then that $98 is a BIG DEAL. But if my income increases to $110 and my debt grows to $100, that is not as big a deal. Yes, I owe you more money, but I am also earning more money, so the debt burden has actually decreased.

In order to get US income to grow, say the demand-siders, continued fiscal and monetary stimulus are needed. With the debt deal struck two weeks ago, however, the US government has vowed to slash future spending by $2.4 trillion, effectively doing the opposite of what the demand-siders would like to see happen, pursuing fiscal contraction rather than expansion. As government spending grows less in the future than it otherwise would have, employment will fall and incomes will grow more slowly, or worse, the US will enter a second recession, meaning even lower incomes in the future, causing a the debt burden to grow.

Now let’s consider the supply-side argument. The supply-siders argue that America’s biggest problem is not the lack of demand, rather it is the debt itself. Every borrowed dollar spent by the goverment, say the supply-siders, is a dollar taken out of the private sector’s pocket. As government spending continues to grow faster than tax receipts, the government must borrow more and more from the private sector, and in order to attract lenders, interest on government bonds must be raised. Higher interest paid on government debt leads to a flow of funds into the public sector and away from the private sector, causing borrowing costs to rise for everyone else. In IB and AP Economics, this phenomenon is known as  the crowding-out effect: Public sector borrowing crowds out private sector investment, slowing growth and leading to less overall demand in the economy.

Additionally, argue the supply-siders, the increase in debt required for further stimulus will only lead to the expectation among households and firms of future increases in tax rates, which will be necessary to pay down the higher level of debt sometime in the future. The expectation of future tax hikes will be enough to discourage current consumption and investment, so despite the increase in government spending now, the fall in private sector confidence will mean less investment and consumption, so aggregate demand may not even grow if we do borrow and spend today!

This debate is not a new one. The demand-side / supply-side battle has raged for nearly a century, going back to the Great Depression when the prevailing economic view was that the cause of the global economic crisis was unbalanced budgets and too much foreign competition. In the early 30′s governments around the world cut spending, raised taxes and erected new barriers to trade in order to try and fix their economic woes. The result was a deepening of the depression and a lost decade of economic activity, culminating in a World War that led to a massive increase in demand and a return to full employment. Let’s hope that this time around the same won’t be necessary to end our global economic woes.

Recently, CNN’s Fareed Zakaria had two of the leading voices in this economic debate on his show to share their views on what is needed to bring the US and the world out of its economic slump. Princeton’s Paul Krugman, a proud Keynesian, spoke for the demand-side, while Harvard’s Kenneth Rogoff represented the supply-side. Watch the interview below (up to 24:40), read my notes summarizing the two side’s arguments, and answer the questions that follow.

Summary of Krugman’s argument:

  • Despite the downgrade by Standard & Poor’s (a ratings agency) there appears to be strong demand for US government bonds right now, meaning really low borrowing costs (interest rates) for the US government.
  • This means investors are not afraid of what S&P is telling them to be afraid of, and are more than happy to lend money to the US government at low interest rates.
  • Investors are fleeing from equities (stocks in companies), and buying US bonds because US debt is the safest asset out there. The market is saying that the downgrade may lead to more contractionary policies, hurting the real economy. Investors are afraid of contractionary fiscal policy, so are sending a message to Washington that it should spend more now.
  • The really scary thing is the prospect of another Great Depression.
  • Can fiscal stimulus succeed in an environment of large amounts of debt held by the private sector? YES, says Krugman, the government can sustain spending to maintain employment and output, which leads to income growth and makes it easier for the private sector to pay down their debt.
  • With 9% unemployment and historically high levels of long-term unemployment, we should be addressing the employment problem first. We should throw everything we can at increasing employment and incomes.
  • Is there some upper limit to the national debt? Krugman says the deficit and debt are high, but we must consider costs versus benefits: The US can borrow money and repay in constant dollars (inflation adjusted) less than it borrowed. There must be projects the federal government could undertake with at least a constant rate of return that could get workers employed. If the world wants to buy US bonds, let’s borrow now and invest for the future!
  • If we discovered that space aliens were about to attack and we needed a massive military buildup to protect ourselves from invasion, inflation and budget deficits would be a secondary concern to that and the recession would be over in 18 months.
  • We have so many hypothetical risks (inflation, bond market panic, crowding out, etc…) that we are afraid to tackle the actual challenge that is happening (unemployment, deflation, etc..) and we are destroying a lot of lives to protect ourselves from these “phantom threats”.
  • The thing that’s holding us back right now in the US is private sector debt. Yes we won’t have a self-sustaining recovery until private sector debt comes down, at least relative to incomes. Therefore we need policies that make income grow, which will reduce the burden of private debt.
  • The idea that we cannot do anything to grow until private debt comes down on its own is flawed… increase income, decrease debt burden!
  • Things that we have no evidence for that are supposed to be dangerous are not a good reason not to pursue income growth policies.
  • When it comes down to it, there just isn’t enough spending in the economy!

Summary of Rogoff’s argument:

  • The downgrade was well justified, and the reason for the demand for treasuries is that they look good compared to the other options right now.
  • There is a panic going on as investors adjust to lower growth expectations, due to lack of leadership in the US and Europe.
  • This is not a classical recession, rather a “Great Contraction”: Recessions are periodic, but a financial crisis like this is unusual, this is the 2nd Great Contraction since the Depresssion. It’s not output and employment, but credit and housing which are contracting, due to the “debt overhang”.
  • If you look at a contraction, it can take up to 4 or 5 years just to get back where you started.
  • This is not a double dip recession, because we never left the first one.
  • Rogoff thinks continued fiscal stimulus would worsen the debt overhang because it leads to the expectation of future tax increases, thus causing firms and households increased uncertainty and reduces future growth.
  • If we used our credit to help facilitate a plan to bring down the mortgage debt (debt held by the private sector), Rogoff would consider that a better option than spending on employment and output. Fix the debt problem, and spending will resume.
  • Rogoff thinks we should not assume that interest rates of US debt will last indefinitely. Infrastructure spending, if well spent, is great, but he is suspicious whether the government is able to target its spending so efficiently to make borrowing the money worthwhile.
  • Rogoff thinks if government invests in productive projects, stimulus is a good idea, but “digging ditches” will not fix the economy.
  • Until we get the debt levels down, we cannot get back to robust growth.
  • It’s because of the government’s debt that the private sector is worried about where the country’s going. If we increase the debt to finance more stimulus, there will be more uncertainty, higher interest rates, possibly inflation, and prolonged stagnation in output and incomes.
  • When it comes down to it, there is just too much debt in the economy!

Discussion Question:

  1. What is the fundamental difference between the two arguments being debated above? Both agree that the national debt is a problem, but where do the two economists differ on how to deal with the debt?
  2. The issues of “digging ditches and filling them in” comes up in the discussion. What is the context of this metaphor? What are the two economists views on the effectiveness of such projects?
  3. Following the debate, Fareed Zakaria talks about the reaction in China to S&P’s downgrade of US debt. What does he think about the popular demands in China for the government to pull out of the market for US government bonds?
  4. Explain what Zakaria means when he describes the relationship between the US and China as “Mutually Assured Destruction (MAD)”.
  5. Should the US government pursue a second stimulus and directly try to stimulate employment and income? Or should it continue down the path to austerity, cutting government programs to try and balance its budget?

20 responses so far

Sep 23 2010

The magical recession proof bunny

Chocolate Sales: A Sweet Spot in the Recession – TIME

Living in Switzerland, I find an article featuring a local business from the town my school is in irresistible, particularly when it appear in TIME magazine. Lindt chocolate, the company featured in this article, manufactures its delicate treats right down the hill from the ZIS campus, which means that when the wind is just right, you can just catch the scent of fresh, creamy chocolate wafting up the hillside while walking to campus.

Lindt, as well as its global competitors in the chocolate business, is enjoying surge in demand even while countless other industries are forced to cut back production, lay off workers, and close their factory doors. From TIME:

While the credit crisis has slowed down sales of everything from cars to organic groceries, people seem happy to keep shelling out for chocolate. Last year, as the global recession was gaining ground, Swiss chocolate makers bucked the trend with record sales — nearly 185,000 tons, an increase of 2% over 2007, sold domestically and in 140 export markets…

“Switzerland’s image sells well abroad, and nothing says ‘Switzerland’ more than chocolate,” says Stephane Garelli, director of the World Competitiveness Center at the Institute of Management Development (IMD) in Lausanne, predicting that this comfort food will continue to sweeten the sour economy for months to come…

“Now that people don’t have a new television or a new car,” he noted, “they eat a bit more chocolate.”

“Chocolate is one of the more recession-resilient food sectors,” says Dean Best, executive director of Just-Food, a U.K.-based news and information website for the global food industry. “With consumers eating out less and eating at home more, there is evidence that they are still allowing themselves the occasional indulgence — and chocolate is a relatively inexpensive indulgence.”

But the question of why there is no meltdown in the chocolate business may be more a matter of psychology than economics. “There is well-documented evidence going back to Freud, showing that in times of anxiety and uncertainty, when people need a boost, they turn to chocolate,” says Garelli of the IMD. “That’s why when the economy is bad, chocolate is still selling well.”

Which goes to show that chocolate is more than a candy treat — it’s real food for the soul.

So does this mean chocolate is an inferior good, or one for which demand increases as incomes fall? I doubt many Swiss chocolate producers would consider their product inferior, but perhaps it does fit the definition.

On the other hand, perhaps the reason demand for chocolate increases during a recession has more to do with the substitution effect than the income effect. As people eat out less, they consume fewer expensive deserts at restaurants and instead fill their shopping baskets with more affordable dessert options for the home. I can say from experience that this is the case for myself.

Living in Switzerland, I find myself rarely going out to eat at restaurants, an activity reserved for special occasions in this country where a steak can set you back 75 dollars. Instead, I eat at home almost every night, and nothing is more appealing to me, especially during hard economic times, than a bar of delicious chocolate after a home cooked meal. Demand for chocolate may rise during recessions simply because the demand for one of its substitutes (restaurant desserts) falls.

Discussion questions:

  1. Do you think chocolate is an inferior good or a normal good? What’s the difference? What types of goods do YOU consome more of when you find yourself faced with a tighter budget?
  2. Does economics have a good explanation for the above situation? The article mentions Freud, a pioneer in  the field of psychology; do humans’ economic behavior always appear rational?
  3. If chocolate were an inferior good, what would happen to chocolate sales when the global economy finally turns around and incomes start increasing? What do you think will happen to chocolate sales when the economy starts imrpoving? Explain.

28 responses so far

May 05 2010

Facts and the Phillips Curve: new evidence of the short-run trade-off between unemployment and inflation

Introduction: The following is a selection of a chapter from my new Economics textbook project, the Pearson Baccalaureate Economics text, which will be available to IB Economics teacher for the 2011-2013 school year.

It should be noted that the original Phillips Curve theory did not distinguish between the short-run and the long-run. In fact, the original Phillips Curve itself was a long-run model demonstrating a trade-off between unemployment and changes in the wage rate over a span of 52 years in the United Kingdom.

Up until the early 1970s, the Phillips Curve was treated as a generally accurate demonstration of the relationship between two important macroeconomic indicators. Throughout the 60′s data for the United States showed in most cases that increases in unemployment corresponded with lower inflation rates, and vis versa.

Year 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969
UR 5.5 6.7 5.5 5.7 5.3 4.5 3.8 3.6 3.5 3.7
IR 1.46 1.07 1.2 1.24 1.28 1.59 3.01 2.78 4.27 5.46

As can be seen above, between almost every year of the decade a fall in the inflation rate corresponded with a rise in unemployment. The only exceptions were between 1962 and 1963, when both unemployment and inflation increased slightly, and between 1968 and 1969, when again both variables increased. Phillips’ theory of the trade-off between unemployment and inflation was generally supported throughout most of the decade, as the downward slope of the line in the graph above demonstrates.

Beginning in 1970, however, data for the US began to point to a flaw in the Phillips curve theory. Throughout the decade, both unemployment and inflation rose in the US, as oil exporters in the Middle Ease, united under the Oil Producing and Exporting Countries (OPEC) cartel, placed embargoes on oil exports to the US in retaliation for America’s support of Israel in a war against its Arab neighbors. The resulting supply shock in the US led to energy and petrol shortages and rising costs for US firms, forcing businesses to reduce costs by laying off workers, while simultaneously raising output prices. Several other macroeconomic variables contributed to rising unemployment and inflation in the late 1970s, including the return of tens of thousands of troops from the Vietnam War who entered the labor market and found themselves unemployed as firms reduced output in the face of rising energy costs. The Phillips Curve for the 1970s told a somewhat different story about inflation and unemployment than that of the 1960s.

Year 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979
UR 4.9 5.9 5.6 4.9 5.6 8.5 7.7 7.1 6.1 5.8
IR 5.84 4.3 3.27 6.16 11.03 9.2 5.75 6.5 7.62 11.22

Between 1973 and 1974, both the unemployment rate and the inflation rate increased significantly, and even as unemployment increased by almost 3% between 1974 and 1975, the inflation rate fell by less than 2% but still remained at nearly 10%. Unlike the 1960s, the 1970s was a decade of both high unemployment AND high inflation. By the end of the decade, unemployment was at approximately the same level as it was in 1963 (5.8%) but inflation was nearly 10 times higher (11.22% in 1979 versus just 1.24% in 1963). The Phillips Curve theory was apparently busted, as the seemingly random scattering of data in the graph above points to no discernible trade-off between unemployment and inflation throughout the 1970s.

Several prominent economists in the 1970s, including Nobel Laureate Milton Friedman, revived the classical view of the macroeconomy which held that policies aimed at managing aggregate demand would ultimately be unsuccessful at decreasing unemployment in the long-run, since a nation’s output and employment would always return to the full-employment level regardless of the level of demand in the economy. Friedman, whose theory of the macroeconomy would come to be known as monetarism, believed that changes in the money supply would lead to inflation or deflation, but no change in unemployment in the long-run. Monetary policy and its effects on aggregate demand and aggregate supply will be explored in more depth in a later chapter in this book. The basic premise of the monetarists, however, was that in order to maintain stable prices and low unemployment, the nation’s money supply should be allowed to grow at a steady rate, corresponding with the desired level of economic growth. Any increase in the money supply aimed at stimulating spending and aggregate demand would result in an increase in inflationary expectations, an increase in nominal wages, and a leftward shift of aggregate supply, resulting only in higher inflation and no change in real output and employment. Therefore, monetary rules were needed to assure that policymakers would not manipulate the supply of money to try and stimulate or contract the level of aggregate demand in the economy.

By the late 1970s, our current interpretation of the Phillips’ theory as including both a short-run and a long-run model became widely adopted. The short-run Phillips Curve may accurately illustrate the trade-off between unemployment and inflation observed in the period of time over which wages and prices are relatively inflexible in a nation’s economy. For instance, during the twelve month period between July 2008 and June 2009, the level of consumption and investment in the US fell as the economy slipped into recession. Unemployment rose and inflation decreased and eventually became negative in the final three months of the period. The graph below shows the relationship between unemployment and inflation during the onset of the recession in 2008 and 2009.

A clear trade-off appears to have existed in the twelve month period above. At the time of writing, it is yet to be seen whether the unemployment rate will return to its pre-recession level in the United States. Although in the short-run it seems likely that the downward sloping Phillips Curve holds some truth, a look at a longer period of time for the same country tells a different story. The graph below shows the unemployment / inflation relationship during the twelve years leading up to the onset of recession in 2008.

Looking at data for a longer period of time shows that even as inflation fluctuated between 0.5% and 4%, US unemployment remained in a relatively narrow range of between 4% and 6%. Year on year unemployment and inflation often increased together, while at other times demonstrated an inverse relationship as Phillips’ theory predicts it should. The narrow range of unemployment portrayed in the data above is evidence that the Long-run Phillips curve for the US between 1997 and 1998 was more like a vertical line than a downward sloping one. It appears that during the period above the natural rate of unemployment for the United States was around 5%; meaning that even as AD increased and decreased in the short-run, the level unemployment remained relatively steady around the natural rate of 5% in the long-run.

The 1970′s represented a turning point in the mainstream economic analysis of the relationship between inflation and unemployment. Demand-management policies by governments may be effective at fine-tuning an economy’s employment level and price level in the short-run, but as data from the 1970′s and early 2000s shows, in the long-run a nation’s level of unemployment tends to be independent of the inflation rate, and is likely to remain around the natural rate of unemployment once wages and prices have adjusted to fluctuations in aggregate demand. In response to supply shocks such as the oil shortages of the 1970′s, both inflation and unemployment may increase at the same time, calling into question the validity of the original Phillips Curve relationship. Despite the breakdown in the relationship between unemployment and inflation in the long-run, the evidence from the recession of 2008 and 2009 seems to support the theory that an economy in which aggregate demand is falling will experience a short-run trade-off between the rate of inflation and the rate of unemployment.

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