Archive for the 'Consumption' Category

May 09 2008

Exactly what does inflation measure?

All of Inflation’s Little Parts – The New York Times

This is really cool… The Bureau of Labor Statistics releases monthly data on prices to let Americans know just how much inflation affects their livelihoods. The Consumer Price Index, which is studied in both AP and IB Economics, consists of a “basket of goods”, that when bundled together represent the “typical” American consumer’s expenditures. The CPI is broken into a few broad categories:

  • Health care
  • Apparel
  • Housing
  • Education/communication
  • Recreation
  • Food/beverages
  • Transportation
  • Miscellaneous

Here’s the cool part, though… within each broad category the BLS tracks the prices of dozens of specific categories, around 200 to be precise. Each of these is then broken down into individual products, around 84,000 in total! The task of tracking the prices of 84,000 individual goods and services every month is daunting, and just thinking about the tedium of this job makes me glad I’m a teacher!

The New York Times has assembled what can only be described as a mosaic of consumption, organizing the 200 specific CPI categories into what looks like an ornate stained-glass window, in which the size of each piece of glass represents the percentage of Americans’ income that go towards each specific category. Some of the categories represented in this mosaic include items such as:

  • Oils and peanut butter (0.1%)
  • Gasoline (5.2%)
  • Garbage collection (0.3%)
  • Internet (0.3%)
  • Nursing homes (0.1%)
  • New cars and trucks (4.6%)
  • DVDs (0.2%)

This graphic is a great tool for teaching and understanding the Consumer Price Index, not to mention a beautiful pattern for any stained-glass artist looking for inspiration!

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Apr 18 2008

From the Help Desk: Long-run vs. short-run economic growth, consupmtion and investment…

*Click on the graphs to see full-size versions

The following message was submitted through the AP/IB Econ Help Desk:


An AP Macro Question: Comes from the recently published AP Practice Exam

An increase in which of the following is most likely to promote economic growth?

A. Consumption Spending
B. Investment Tax Credits
C The natural rate of unemployment
D The trade deficit
E Real Interest Rates.

The answer is B, and I understand the economic principles of why that would promote economic growth, but what I can’t answer for my students is why A, Consumption Spending wouldn’t work. I know that consumption spending makes up part of the demand in aggregate demand, but I can’t help but think that an increase in it, would promote economic growth.

Thanks, “Econ Teacher”

For what it’s worth, here is my reply:

Hello “Econ Teacher”,

That’s a good question. I would explain to my students that in the short-run, an increase in AD alone will lead to some growth, but would be accompanied by inflation, since AS does not shift out when consumption increases. However, an investment tax credit will result in REAL long-run economic growth (by real I mean nominal GDP will increase while the price level remains stable), since it encourages investment. Investment is a determinant of AD, just like consumption, so AD will shift out, but it is also a determinant of AS, since firms are investing in capital. Increase the quantity or the quality of capital, and labor becomes more productive. Greater productivity shifts out AS, leading to growth AND stable prices.

Economic growth is defined, in terms of the AD/AS model, as an outward shift of both AD and AS. Increases in consumption will increase AD, but this will lead to inflation, and in the long run, workers will demand higher wages, increasing the costs of production and shifting AS leftward, returning the economy to the full employment level of output at an even higher price level, i.e. no economic growth occurs (see graph to the right). Investment, however, encouraged through a tax credit, will have positive demand and supply side effects, resulting in real economic growth and stable prices (see graph below)

Hope that helps!

Jason Welker>>>

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Mar 12 2008

Helicopter Ben and Monetary Policy: the cartoon version!

Monetary Policy

Much hoopla is made over the US Federal Reserve’s power to affect markets through its injections of liquidity into the economy. These days, the Fed appears to have some new tricks up its sleeve, but still uses its traditionally dominant tool of Open Market Operations to affect the Federal Funds rate, and thus the interest rates that commercial banks charge borrowers financing consumption and investment.

The power of monetary policy lies in the fact that spending stimulus can be achieved without running the risk of crowding-out, wherein expansionary fiscal policy drives up interest rates, potentially off-setting any increases in aggregate demand by triggering declines in consumption and investment due to increased borrowing costs.The whole aim of expansionary monetary policy, on the other hand, is to drive interest down by increasing the reserves held by commercial banks.

The cartoon above illustrates the process that leads to lower interest rates and greater spending when the Fed undertakes expansionary open market operations. Government bonds (the blue bills above) are held as assets by both commercial banks and the public. These are illiquid, meaning they cannot be spent. In order to stimulate new spending, the Fed can take some of its reserves of money (the green bills), and buy bonds from the public and banks.

Banks receive cash from the Fed, which increases their excess reserves. Further, the public will deposit the checks they receive from the Fed into their banks, increasing checkable deposits, which add to both the banks’ required reserves and excess reserves. The result is banks now have new liquidity that they want desperately to lend out in order to earn interest (remember, banks rarely want to hold onto their excess reserves, because inflation will erode the value of any money that’s not earning interest!).

When banks’ reserves increase, due to their growing checkable deposits and the inflow of cash from the Fed’s purchase of bonds, the supply of “federal funds” shifts down, lowering the interest rates that banks charge one another for overnight loans. These are loans that banks often give and receive in order to meet their reserve requirements at the end of a business day.

For example: If Bank A has finds at the end of the day that it has received more deposits than withdrawals, and it now has $1m more in its reserves than it is required to have, it wants to lend that money out as soon as possible to earn interest on it. Bank B, it just so happens, received more withdrawals than it did deposits during the day, and is $1m short of its required reserves at day’s end. Bank B can borrow Bank A’s excess reserves in order to meet its reserve requirement. Bank A will not lend it for free, however, and the rate it charges is called the “federal funds” rate, since banks’ reserves are held predominantly by their district’s Federal Reserve Bank.Federal Funds market

When the Fed buys bonds, all banks experience an increase in their reserves, meaning the supply of federal funds shifts out (or down in the graph above), lowering the “price” of federal funds, i.e. the federal funds rate. Lower interest rates on overnight loans will encourage banks to be more generous in their lending activity, allowing them to lower the prime interest rate (the rate they charge their most credit-worthy borrowers), which in turn should have a downward effect on all other interest rates.

Expansionary monetary policy involves the buying of government bonds on from the public and commercial banks by the Federal Reserve Bank. The result of this buying of bonds is an increase in the money supply, a decrease in real interest rates, and hopefully the stimulus of aggregate demand through new consumption and investment. Unlike expansionary fiscal policy (such as the stimulus package announced by Congress last month), crowding-out should not occur. Ideally, lowering the federal funds rate will lead to lower interest rates across the economy as a whole.

This, however, does not always transpire. In a future post, we’ll discuss why, and look at what the Fed is experimenting with today to stimulate investment and consumption, in response to the apparent failure of open market operations at providing the needed stimulus.

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Mar 09 2008

Unemployment and inflation: understanding the Fed’s balancing act

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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Mar 06 2008

Walking the fine line between good growth and bad growth in China / 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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