Macroeconomics [2, 2 ed.] 9781948976244, 1948976242

Table of contents :
Cover
Contents
Acknowledgments
Chapter 1: Monetary Policy
Chapter 2: Fiscal Policy
Chapter 3: Managing Aggregate Supply and Aggregate Demand
Chapter 4: Diagnosing the Economy
Chapter 5: The Great Contraction and Its Aftermath
Chapter 6: Lessons from Recent Macroeconomic Policy Making
References
About the Author
Index
Adpage
Backcover

Citation preview

Macroeconomics

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David G. Tuerck

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the book brings the different strands of macroeconomics together into a single approach under which economic agents strive to make rational choices but, while doing so, sometimes misconstrue the data available to them. The result is imbalances between aggregate supply and aggregate demand

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Macroeconomics

that can cause economic contractions. These imbalances may be self-correcting, or they may become long-lived and require government intervention through the exercise of corrective monetary and fiscal policy. Volume I examines economic behavior on the assumption that economic agents correctly interpret the data before them. It thus takes a “micro foundations” approach, under which aggregate supply equals aggregate demand. Volume II allows for the possibility of myopia on the part of economic agents and for the resulting economic malperformance that can result from this myopia. It examines the short-run disparities between aggregate supply and aggregate demand that can result from ill-informed choices of individual economic agents or from a misdiagnosis of economic data by policy makers. It concludes with a review of recent U.S. economic policy. The book aims to correct a good number of misconceptions that bedevil economic policy making—among them the idea that protracted economic contractions necessarily call for increased government spending and lower taxes. It challenges the common understanding that government deficits raise interest rates and “crowd out” private investment. David G. Tuerck is professor of economics at Suffolk University in Boston and president of the Beacon Hill Institute for Public Policy Research. He has held a variety of academic, consulting, and macroeconomics. He has published several books and

free trial, or to order, contact: 

Philip J. Romero and Jeffrey A. Edwards, Editors

approach to the study of macroeconomics. In that respect,

and research positions. His fields of study are public finance

For further information, a

Economics and Public Policy Collection

This book, produced in two volumes, takes an integrative

articles, made dozens of television and radio appearances, published numerous opinion editorials and testified, on three occasions, before the U.S. Congress, as well before several state legislatures.

Economics and Public Policy Collection Philip J. Romero and Jeffrey A. Edwards, Editors ISBN: 978-1-94897-624-4

MACROECONOMICS, VOLUME II

POLICIES BUILT BY LIBRARIANS

Second Edition, Volume II

TUERCK

THE BUSINESS EXPERT PRESS DIGITAL LIBRARIES

Second Edition Volume II

David G. Tuerck

Macroeconomics

Macroeconomics Second Edition Volume II David G. Tuerck

Macroeconomics, Second Edition, Volume II Copyright © Business Expert Press, LLC, 2018. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means—electronic, mechanical, photocopy, recording, or any other except for brief quotations, not to exceed 400 words, without the prior permission of the publisher. First published in 2015 by Business Expert Press, LLC 222 East 46th Street, New York, NY 10017 www.businessexpertpress.com ISBN-13: 978-1-94897-624-4 (paperback) ISBN-13: 978-1-94897-625-1 (e-book) Business Expert Press Economics and Public Policy Collection Collection ISSN: 2163-761X (print) Collection ISSN: 2163-7628 (electronic) Cover and interior design by Exeter Premedia Services Private Ltd., Chennai, India Second edition: 2018 10 9 8 7 6 5 4 3 2 1 Printed in the United States of America.

To the memory of my parents, George and Bertha Tuerck

Abstract Macroeconomics is the study of the economy as a whole and of the work and saving choices of individual economic agents from which macroeconomic activity emerges. This book, produced in two volumes, takes an integrative approach to that topic. It introduces macroeconomics as a study of (1) the long-run, “micro” foundations of macroeconomic analysis and (2) the short-run deviations from long-run equilibrium that are brought about by disparities between aggregate supply and aggregate demand. The first of these is the subject of Volume I, the second, the subject of Volume II. The first chapter of Volume I focuses on the importance of a clear understanding of the difference between long-run and short-run analyses of macroeconomic activity, showing, in particular, how confusion over the effects of government deficits on the economy can arise from failing to distinguish between their short-run and long-run effects. Chapter 2 explains the ­distinction between nominal and real gross domestic product and works through the fundamentals of the National Income and Product Accounts. Chapter 3 lays out a simple model of the work and ­saving choices of individual economic agents, and Chapter 4 generalizes the analysis to a more sophisticated analysis of the consumption/saving ­calculus. Chapter 5 derives the supply and demand for labor and for capital, which represent the principal inputs to aggregate production. Chapter 6 takes up the issue of economic growth and reviews some of the current pessimism relating to U.S. economic growth. Finally, C ­ hapters 7 and 8 examine the micro effects on aggregate economic activity of changes in government tax and spending policy. Volume II begins with a review of monetary policy (Chapter 1) and fiscal policy (Chapter 2) for their impacts on the aggregate economy. Chapter 3 considers at length the distinction between self-correcting and non-self-correcting distortions between aggregate supply and demand. There we review the focus of the Keynesian model on economic downturns brought about by long-lasting excess supply and the focus of the “suppressed inflation model” on long-lasting excess demand. Chapter 4 considers the complexities that arise in diagnosing a decrease in the rate of economic growth that might result from a temporary change in the

viii Abstract

demand for money or that might be a sign of a more long-lasting secular stagnation. The government’s interpretation of this problem will determine whether the growth rate simply adjusts to a new normal or the economy sinks into a protracted downturn. Chapters 5 and 6 examine the Great Contraction of 2007 to 2009 for the lessons that can be learned from it and from recent macroeconomic policy changes.

Keywords aggregate demand, aggregate supply, classical tradition, monetary and fiscal policy, excess demand, excess supply, full employment, individual equilibrium, Laffer curve, natural unemployment rate, non-accelerating inflation rate of unemployment, non-accelerating inflation rate of ­labor-force participation, Phillips curve, potential GDP, steady state of economic growth, structural unemployment, supply side economics

Contents Acknowledgments�����������������������������������������������������������������������������������xi Chapter 1 Monetary Policy�����������������������������������������������������������������1 Chapter 2 Fiscal Policy���������������������������������������������������������������������17 Chapter 3 Managing Aggregate Supply and Aggregate Demand�������41 Chapter 4 Diagnosing the Economy�������������������������������������������������73 Chapter 5 The Great Contraction and Its Aftermath������������������������89 Chapter 6 Lessons from Recent Macroeconomic Policy Making�����105 References�������������������������������������������������������������������������������������������117 About the Author.................................................................................119 Index�������������������������������������������������������������������������������������������������121

Acknowledgments I would like to express my appreciation to a few of the many people to whom I am indebted for help in writing this book and getting it into print. First and foremost, as with the first edition, I want to thank my wife, Prema Popat, without whose encouragement and patience the book would never have seen the light of day. Next, my thanks go to Khang Vinh (Kyle) Doan, my undergraduate assistant, and to Xhulia Kanani and William Burke, both of the Beacon Hill Institute, who helped me by finding and verifying data and by proofing much of the book. Also, and as before, Scott Isenberg, Executive Editor at Business Expert Press, provided both patience and encouragement. Exeter team worked efficiently and diligently with me on proof reading and production. Finally, and again as with the first edition, my thanks to colleague Alison Kelly, whose prodding got me to refocus on this project after many years of hesitation and neglect.

CHAPTER 1

Monetary Policy In Volume I of this book, we ignored the fact that people have a demand for money as well as for the goods that they use their money to buy. But people want to hold money to pay for their day-to-day transactions, and holding money incurs an opportunity cost measured by the return people could receive by using their money to buy interest-earning assets. Let’s call these assets “bonds.” We can begin our discussion of the demand for money with an identity:

MV = PY , (1.1)

where M is the stock of money, V is the turnover rate of money, P is the price level, and Y is real income. In a fiat money system, money, having no intrinsic value, depends for its value entirely on its scarcity, and it is the government that controls the amount of money in existence. In the United States, the Federal Reserve System controls the money supply through purchases and sales of financial instruments, originally shortterm government securities, and nowadays, long-term private securities, for example, mortgages as well. If Y equals $2 million, P equals 1, and M equals $1 million, then V must equal 2, which means that every dollar is spent twice, on average, in the course of a year’s production. Under the principles developed so far in this book, V is some fixed amount and Y is determined by the flow of resources into production and is independent of the level of M. Thus a given percentage change in M would bring about an equal percentage change in P:

%∆M = %∆P,(1.2)

2 Macroeconomics

or

=P  .(1.3) M

According to the reasoning of Volume I, Chapter 5, if the real interest rate r is 5% and if the price level is growing at 4%, then the nominal interest rate R will be 9%. From that chapter, we know that there will be no effect on the real interest rate due to changes in the inflation rate as long as the perceptions of the suppliers of financial capital are aligned with the perceptions of investors and as long as both are aligned with the actual inflation rate. Thus, there will be no effect on real economic activity because of a rise or fall in the inflation rate or, therefore, in the nominal interest rate. But that analysis does not take into account the fact that people have a demand for money and that their demand for money varies with the cost of holding it. Money is the most liquid of all assets. It also offers a zero yield from holding it. Because money pays no interest, the opportunity cost of holding it is R, the nominal interest rate, which, in equilibrium, equals the real interest rate plus the rate of inflation. People have a choice between holding their financial assets in the form of cash and holding them in the form of assets that yield a return, R. People will want to hold more money the greater their real income and the lower the nominal return on income-earning assets. Our Eve in the earlier chapter held only income-earning assets. But she will also want to hold some of her assets in the form of cash. The question is what determines the utility-maximizing mix of cash and income-earning assets. In the forgoing example, nominal income was $2 million, and people held half of it, $1 million, in cash. Now let’s modify our assumption, noted earlier, that V is fixed in value. Let k = 1/V, where k is the fraction of their nominal income that people want to hold in the form of cash. We can specify a demand equation for money, in which the demand for money varies positively with k, P, and Y:

M D = kPY ,(1.4)

and, in equilibrium,

M S = M D .(1.5)



Monetary Policy 3

In equilibrium, the supply of money equals the demand for money, and the demand for money equals kPY. The supply of money, we assume, is determined by the Federal Reserve. The question is how k, P, and Y adjust to bring the demand for money into line with the supply of money, given that the Fed determines the supply of money. Let’s assume, for now, that Y is fixed. That means we are left with the need to consider how P and k adjust to changes in M. In Volume I, Chapter 5, we showed how the nominal interest rate would adjust to changes in expected inflation, but we omitted any consideration of the determinants of expected inflation. Here we provide for a theory of expected inflation by writing:

E = M  , P

(1.6)

 E is= expected  is the growth of the money supply. , inflation and M where P M In Table 1.1, we assume that the nominal interest rate, R, equals the sum of the real rate and expected inflation, per the earlier chapter:



 E. R =r+P 

(1.7)

In Table 1.1, the money supply grows by 5% annually in years 2 through 4 and then grows by 6% from year 5 on (column 2). As a ­consequence of the increased growth of M, expected inflation rises from 5 to 6% (column 4), and the nominal interest rises from 10 to 11% ­(column 6). This induces people to hold a larger share of their assets as bonds and a smaller share as cash. Thus, k falls (we assume) from 50 to 40% (column 9), which is to say that velocity rises from 2 to 2.5. The fall in k, combined with the resulting spike in inflation, brings the demand for money into line with the supply of money (column 10). So far, we don’t allow for any “real” effects (real income remains fixed at $2 million). Money appears to be “neutral” with respect to the “real” economy, which implies that real income, Y, remains fixed. Yet, there is a real effect resulting from the fact that the decision to hold a smaller fraction of an investment portfolio in cash will impose a real cost. That cost is miniscule in comparison to GDP, but it is a cost ­nevertheless. To see why it is a cost, consider a person who is paid $10,000

6%

6%

6%

6

7

8

5%

6%

4

5

$1,461,475

$1,378,750

$1,300,707

$1,227,083

$1,157,625

$1,102,500

$1,050,000

5%

5%

2

3

$1,000,000

MS

ˆ M

t

1

(3)

(2)

(1)

5%

6%

6%

6%

6%

5%

5%

5%

5%

5%

5%

5%

5%

5%

5%

r

ˆE P 5%

(5)

(4)

11%

11%

11%

11%

10%

10%

10%

10%

R

(6)

Table 1.1  Increase in the growth of M causing a rise in R

$2,000,000

$2,000,000

$2,000,000

$2,000,000

$2,000,000

$2,000,000

$2,000,000

$2,000,000

Y

(7)

3,653,687

3,446,875

3,251,769

3,067,706

2,315,250

2,205,000

2,100,000

2,000,000

PY

(8)

40%

40%

40%

40%

50%

50%

50%

50%

k

(9)

$1,461,475

$1,378,750

$1,300,707

$1,227,083

$1,157,625

$1,102,500

$1,050,000

$1,000,000

MD = kPY

(10)

1.83

1.72

1.63

1.53

1.16

1.10

1.05

1.00

P

(11)

6%

6%

6%

33%

5%

5%

5%

ˆ P

(12)

4 Macroeconomics



Monetary Policy 5

on the first of every month. If the nominal interest rate were zero, it would cost nothing to keep the whole amount in cash. Over the course of a month, the person’s average cash balance would be $5,000. His k would equal 0.5 and the velocity of money would be 2. But suppose that the nominal interest rate rises to 5%. Now the cost of keeping money in cash is the 5% return that the person would receive by putting money in bonds. The individual might then decide to keep only half of the $10,000 in cash for the first two weeks of the month, ­putting the other half in bonds for that two-week period. After two weeks, the individual would then convert the bonds he held for the first two weeks into cash to finance his remaining expenditures for that month. His cash balance would then equal only $2,500 (= 0.5 × 0.5 × $10,000), on ­average, over the course of the month. His velocity would equal 4. To continue the example, suppose that the nominal interest rate rose to 10%. The individual might decide to keep only 1/4 of his monthly paycheck in cash, leaving the rest in bonds. He would hold only $1,250 (= 0.5 × 0.5 × 0.5 × $10,000) in cash, on average over the course of the month. His k would fall from 1/4 to 1/8 and his V would rise from 4 to 8. In this last example, the individual puts 3/4 of his paycheck in bonds when he is paid on the first of the month, leaving 1/4 (= $2,500) in his checking account. He spends that amount by the end of the first week and then converts another $2,500 from bonds into cash in order to pay for his second week of expenses, leaving $5,000 in bonds. This continues until the end of the fourth week when he has converted all of his bonds into cash. See Figure 1.1. What this tells us is that a rising nominal interest rate induces the individual to go back and forth from bonds to cash very frequently, an exercise that comes at a cost in terms of the individual’s time and any fees he has to pay to go from cash to bonds and again into cash. Yet there is no compensating rise in the real return if the real interest rate remains unchanged, that is, if the rise in R results only from rising inflation. Essentially, what the individual does is move in and out of cash more frequently in order to protect himself from rising inflation. This is what Table 1.1 illustrates: the fact that if prices are driven by expectations of monetary growth, the only effect of an increase in

6 Macroeconomics M $10,000

$2,500 $1,250

7

14

21

28

Day

Figure 1.1  Example of average cash holdings

the growth of the money supply is to raise the rate of inflation and the ­nominal interest rate, and to impose costs in the form of cash management costs. Expected inflation varies with the observed growth in M. Actual inflation, recorded in column (12) equals the percentage change in the price level, P. P, in turn, equals MV/Y. Now let’s consider another possibility: that P would remain fixed as M rose. In Table 1.2, we consider a one-time rise in M, from $1 million to $1.050 million. Because both P and k are assumed to be fixed, Y must rise to bring the demand for money into line with the supply of money. Another possibility is that the rise in M would cause a fall in R, and therefore r, since prices are assumed to be constant (see Figure 1.2). There we show the demand for money as inversely related to the nominal interest rate. People use their extra cash in part to buy bonds, driving up the price of bonds. Bond yields fall and, with them, R (which is a composite of bond yields).1 The fall in R causes people to feel comfortable holding a larger share of their portfolios and of the incomes in cash. Thus, k rises, and V falls. The fall in R is important, insofar as, with prices fixed, r must equal R and will also, therefore, fall. As we saw in Volume I, Chapter 5, a fall   Suppose a borrower sells a bond for $1,000 that will be redeemed for $1,050 a year later. The yield is 5%. But suppose the bond rises in price to $1,025. A person who buys the bond for $1,050 now gets a yield of 2.4% (= 1,050/1,025 – 1) when the bond matures.

1

$1,050,000

2

5%

$1,000,000

MS

ˆ M

t

1

(3)

(2)

(1)

0%

0%

ˆE P

(4)

Table 1.2  Increase in M causing a rise in Y

5%

5%

r

(5)

5%

5%

R

(6)

$2,100,000

$2,000,000

Y

(7)

$2,100,000

$2,000,000

PY

(8)

50%

50%

k

(9)

$1,050,000

$1,000,000

MD = kPY

(10)

1.00

1.00

P

(11)

0%

ˆ P

(12)

Monetary Policy 7

8 Macroeconomics R

M1S

MS2

5%

1% MD $1,000,000

$1,100,000

M

Figure 1.2  Rise in the money supply

in r reduces the cost of capital, leading to an increase in the capital stock and positive net investment. With the fall in the cost of capital and rise in the capital stock, Y also rises. Tables 1.2 and 1.3 illustrate how the goal of increasing Y motivates the adoption of an expansive monetary policy. In Table 1.2, the increase in the money supply works directly on Y without any change in R. In Table 1.3, the increase in the money supply works on Y through the resulting reduction in r and rise in the capital stock. To summarize: If the money supply rises, as in these examples, people will find themselves involuntarily holding more money than they wish to hold, given k, P, and Y. In the scenario explored in Table 1.1, where Y is assumed to be constant, people try to spend down their new cash holdings and, in the process, drive up the price level. The resulting rise in R induces people to hold a smaller share of their assets in the form of cash, with some resulting increase in the cost of asset management. As k falls, V rises. If P and k are fixed (Table 1.2), then Y must rise to bring people’s demand for cash balances into line with supply. Alternatively (or in addition), R might fall, causing k to rise and through the resulting fall in r, causing Y to rise. Tables 1.2 and 1.3 are descriptive. Finally, it is necessary to consider an autonomous rise in k, which is motivated by perhaps a precaution against an expected fall in Y. Table 1.4 illustrates this possibility. There M and Y are assumed to be constant, so that the effect of the rise in k is a fall in P. Table 1.5 assumes that P is

0%

0%

ˆE P

(4)

$1,000,000

2

0%

$1,000,000

MS

ˆ M

t

1

(3)

(2)

(1)

0%

0%

ˆE P

(4)

Table 1.4  Increase in k and a fall in P

$1,050,000

2

5%

$1,000,000

MS

ˆ M

t

1

(3)

(2)

(1)

Table 1.3  Increase in M causing a fall in R

5%

5%

r

(5)

4%

5%

r

(5)

5%

5%

R

(6)

4%

5%

R

(6)

$2,000,000

$2,000,000

Y

(7)

$2,050,000

$2,000,000

Y

(7)

$1,950,000

$2,000,000

PY

(8)

$2,050,000

$2,000,000

PY

(8)

51%

50%

k

(9)

51%

50%

k

(9)

$1,000,000

$1,000,000

MD = kPY

(10)

$1,050,000

$1,000,000

MD = kPY

(10)

0.98

1.00

P

(11)

1.00

1.00

P

(11)

-3%

ˆ P

(12)

0%

ˆ P

(12)

Monetary Policy 9

0%

0%

ˆE P

(4)

5%

5%

$1,000,000

$1,050,000

5%

2

MS

ˆ M

t

1

(3)

(2)

(1)

0%

0%

ˆE P

(4)

r

(5)

4%

5%

r

(5)

Table 1.6  Increase in M and no change in PY

$1,000,000

2

0%

$1,000,000

MS

ˆ M

t

1

(3)

(2)

(1)

Table 1.5  Increase in k and a fall in Y

4%

5%

R

(6)

5%

5%

R

(6)

$2,000,000

$2,000,000

Y

(7)

$1,950,000

$2,000,000

Y

(7)

$2,000,000

$2,000,000

PY

(8)

$1,950,000

$2,000,000

PY

(8)

53%

50%

k

(9)

51%

50%

k

(9)

$1,050,000

$1,000,000

MD = kPY

(10)

$1,000,000

$1,000,000

MD = kPY

(10)

1.00

1.00

P

(11)

0.98

1.00

P

(11)

0%

ˆ P

(12)

0%

ˆ P

(12)

10 Macroeconomics



Monetary Policy 11

fixed, so that the impact is solely on Y. In this scenario, a precautionary rise in k ends up being a self-fulfilling prophesy. Table 1.6 illustrates still another possibility: that the Fed will increase M to no avail, since k will rise and velocity will fall, thus leaving real GDP unchanged. The rise in M just brings about a rise in k. When M falls, r, P, Y, and k move in a direction the opposite of that illustrated in Tables 1.1 through 1.5. When k falls, the results are the opposite of the ones provided in Tables 1.5 and 1.6. Let’s see how monetary policy has been conducted in recent years. From Figure 1.3, we see that the money supply, defined as “M1” (currency and demand deposits), rose modestly (at an annual rate of 5%) from 1980 to 2009. Then it rose by 22% from the fourth quarter of 2007 to the third quarter of 2009. After rising sharply for several years, velocity fell by 18% from the fourth quarter of 2007 to the third quarter of 2009 (see Figure 1.4). For the same period, the federal funds rate was kept near zero. From this evidence, it is possible to conclude that Federal Reserve policy was only weakly expansive over the course of the Great Contraction.

M1 Money stock 4,000 3,600

Billions of dollars

3,200 2,800 2,400 2,000 4,000 1,200 800 400 0

1985

1990

1995

2000

2005

Shaded areas indicate U.S. recessions

Figure 1.3  M1, 1980–2017 Source: Board of Governors of the Federal Reserve System.

2010

2015 myf.red/g/IRIE

12 Macroeconomics Velocity of M1 money stock 11 10

Ratio

9 8 7 6 5

0

1985

Shaded areas indicate U.S. recessions

1990

1995

2000

2005

Figure 1.4  Velocity of M1, 1980–2017 Source: Board of Governors of the Federal Reserve System.

2010

2015

myf.red/g/hZvj

APPENDIX A

Implications of Tax Policy for Monetary Policy Any change in tax policy has implications for monetary policy. If a cut in the corporate income tax, for example, leads to an increase in real GDP, the Federal Reserve has to consider whether it should accommodate the resulting fall in prices or expand the money supply so as to keep prices from falling. A more complex example would involve the substitution of a tax on consumption for the existing federal income tax. Suppose, in considering this possibility that all income is labor income and that all production goes for either government or personal consumption. Suppose also that all production is pizza production, that pizza sells for $1.00 a slice, and that pizza producers make 1,000 slices. Government collects taxes through an income tax of 20%. So we have

GDP = C + G = $800 + $200 = $1,000.

(A1.1)

Consumers receive $1,000 in before-tax income but must pay $200 to the government in taxes, which the government uses to buy 200 slices of pizza, leaving the remaining 800 for individual consumption. Let’s also put some values to the equation of exchange:

MV= PY = $1,000.

(A1.2)

If the money supply is $500, velocity must be 2, so that the left-hand side of (A1.2) matches up with the right-hand side. Finally, we assume that workers are paid $10 per hour and that they produce 10 slices of pizza for every hour worked. Thus labor income is

LAY = W*L= $10*100= $1,000,

(A1.3)

14 Macroeconomics

so that pizza workers work 100 hours to produce 1,000 slices of pizza. Each worker’s after-tax wage rate is $8 per hour. Now suppose the government decides to replace the income tax with a consumption tax and with the intention of raising enough revenue to continue buying its 200 slices of pizza. The government must impose a tax on consumption that permits it to continue diverting 200 pizza slices from individual to government consumption. But what happens to the price of pizza? Almost everyone would say that the price of pizza will rise by the amount of the sales tax. So if the government wants to be able to buy 20% of the pizza output, the sales tax rate must be 25%. The price of pizza before the sales tax is imposed remains at $1.00. With a 25% sales tax, the price rises to $1.25. Total wages remain at $1,000 and now workers get to put that entire $1,000 in their pockets. But with nominal output now equal to $1,250, that $1,000 buys only 800 ((=$1,000/$1,250) × 1,000) slices, just as before. Government collects $250 (= 0.20 × $1,250) in tax revenue, with which it buys the remaining 200 slices. Because PY now equals $1,250, MV must also equal $1,250. And, if V is constant, it can happen only if government expands M by 25% to $625. Suppose, alternatively, that government does not expand M at all. Then, because V and Y are assumed to remain constant, price can’t change either. Thus, something must happen to wages. Specifically, the wage rate has to fall by 20% to $8 per hour. Recall that there is no income tax now, so hourly take-home pay would also equal $8, just as it did before, under the income tax. Now also the price of pizza, exclusive of the sales tax, falls to $0.80. (If workers receive only $8 per hour to make 10 slices of pizza, the firm can cover the costs of producing those 10 slices by collecting only $0.80 for every slice sold.) If a 25% sales tax is imposed on pizza, the price to the consumer will remain at $1.00 (= 1.25 × $.80). Given that their wages now equal $800, workers can, once again, buy 800 of the 1,000 slices produced. Government collects $.20 in revenue for each slice sold and, given that 1,000 slices are sold, it collects $200 in revenue that it uses to buy 200 slices. So we have two scenarios: (1) Prices rise by 25%, as enabled by a 25% increase in the money supply. Or (2) prices remain constant, as made necessary by the fact that the money supply is kept unchanged, in which



Monetary Policy 15

event wages fall by 20%. More generally, the extent to which the switch from an income to a sales tax results in a rise in the price level depends on the degree to which the Fed wants to “accommodate” the imposition of the sales tax by permitting the money supply to rise. The greater the increase in the money supply, the greater the increase in prices and the smaller the decrease in wages that must take place in order to keep real output from changing. However it turns out, government consumes the same amount of pizza as it did under the income tax. It is necessary to go into this detail in that one approach to tax reform that gets a lot of attention is to junk existing federal taxes in favor of a national sales tax. It is useful to consider the possible implementation of this idea because it presents an example of the interdependence between monetary policy and tax policy, or more generally, between monetary policy and any policy change that would give rise to large-scale adjustments in prices and/or wages. In a sense, in the forgoing example, the Fed has to choose between two, equally problematical ways to adjust to the policy change considered here. If it accommodates the change by permitting prices to rise, it will reduce the real value of government bonds held by the public. If it does not accommodate the change, then it will be necessary for workers to accept nominal wage cuts, which they might resist (to their own detriment). The adoption of a flat tax softens, but does not eliminate, this dilemma. Because a flat tax necessitates an increase in the tax rate on labor income, it would push down after-tax nominal wages unless the Fed accommodated by expanding M and letting the resulting rise in prices bring about the necessary reduction in real after-tax wages. The lesson for the Fed is that if, for example, it aims to keep the inflation rate at a certain level, then it has to consider how changes in tax policy and in other policies require it to take into account how accommodation of those policy changes can affect prices.

CHAPTER 2

Fiscal Policy Macroeconomics was born out of the idea that fiscal policy could be used to stimulate the economy. In this chapter, we consider how decisions on government taxes and spending affect the decisions of individuals to consume and save. In 2016, the current income of federal, state, and local governments in the United States came to $5.313 trillion. Of this amount, $4.980 trillion was raised as tax revenue—the rest from other sources. The government distributed $2.786 trillion in transfer payments, leaving it with $2.527 ­trillion to pay for $2.658 trillion in consumption expenditures, $672 ­billion in interest on government debt, and $62 billion in subsidies. That left a current account deficit of $865 billion, most of which was federal in origin. As shown in Volume I, Chapter 7, the government collects tax revenues by taxing the economic choices of individual residents, in particular the choice of how much to make in wages by offering labor services to employers and how much to make in asset income by offering financial capital to investors. Federal and state income taxes affect those choices of individuals by taking away a part of their wages and asset income. Governments also collect revenues by taxing consumption, such as through the federal excise tax on alcohol and state sales taxes. A federal tax on consumption would, as shown, untax net investment but tax wages. But consumption taxes impose a distortion of their own by making work less attractive relative to leisure. Likewise, means-tested transfer payments affect decisions to work and save, insofar as the individual’s eligibility to receive those payments diminishes with the amount of income he receives. The fact that a tax filer can lose a portion of his earned income tax credit by earning more money, for example, means that the availability of that credit affects his work–leisure calculus.

18 Macroeconomics

In Volume I, Chapter 7, we distinguished between the income and substitution effects of a change in the wage rate brought about by a tax change. If a worker (“Adam”) experiences a rise in his after-tax wage rate because the tax on his wages falls, he will want to substitute work for leisure as the cost of leisure rises (the substitution effect). But he will also want to expand leisure because his after-tax income rises (the income effect). Conversely, if he experiences a decrease in his after-tax wage rate because the tax on his wages rises, he will want to substitute leisure for work as the cost of leisure falls, and he will want to contract leisure because his after-tax income falls. There are likewise income and substitution effects associated with taxes on asset income. If Eve has to pay a tax on interest or dividend income that she receives by saving, then she experiences a reduction in the reward for forgoing current consumption and will, on that account, want to consume more and save less (the substitution effect). At the same time, because the tax makes her poorer, she will want to consume less (the income effect). This reasoning relates to choices about current consumption and saving as affected by current taxes and spending. But government tax and spending decisions affect individual expectations of future income as well as current income and, thus also, individual choices over future as well as current consumption and saving. When the government spends more and, inevitably, taxes more, the individual experiences a reduction in the present value of funds available to finance his current consumption. This exerts an income effect of its own, which has to be considered in assessing the effects of the new spending on individual economic behavior.

Income Effects of Fiscal Policy Changes To examine this income effect, we adopt a convention frequently used— and misused—to measure the effects of changes in fiscal policy on government revenues. This convention assumes that changes in tax burdens and benefit distributions impinge only on people’s disposable income, which is the money left with them after taxes and transfer payments, but that they don’t impinge at all on the relative cost of leisure or consumption. It is as if the government taxes people by sending them bills in the



Fiscal Policy 19

mail without regard to their economic choices, in particular, their choices about earning income or saving for future consumption. The taxpayer gets a bill from government in exactly the same manner as he gets a bill from his credit card company, except that his tax bill bears no relation to how much he spent on consumption. Likewise, government distributes transfer payments by sending out checks unrelated to individual economic choices. This procedure is what a “static” analysis of tax policy implies. In effect, it is assumed that an X-percent increase in the tax rate imposed on some activity will cause an X-percent increase in the revenue collected from taxing that activity and, in the process, have no effect on the individual except to make him poorer. As naïve as it is, that convention is acceptable to the extent that people adjust their consumption and saving choices to the burden that they expect taxes to impose on their current and future incomes. People take into account the current and future taxes they can expect to pay when making their current consumption and saving decisions. Fiscal policy has to do with the effects of government purchase, G, and therefore net taxes, T, on those decisions. When economists use the expression “fiscal policy,” they usually do so with some variation of the Keynesian economic model in mind—a model we have yet to consider but that relies on the assumption that neither tax law nor government spending impinges on the work–leisure or consumption–saving calculus, as worked out in Volume I, Chapters 3 and 4. Keynes centered his analysis on the effects of government tax and spending changes on disposable or after-tax income and on the “propensity” of individuals to consume a certain fraction of their disposable income. This propensity is hard-wired into people’s brains and rules out any notion that it might be in a person’s interest to adjust the fraction of his income allocated to consumption or saving according to his preferences, personal discount rate, or intertemporal elasticity of substitution. In the Keynesian model, a rise in G or a fall in T will increase disposable income and cause consumption to rise as determined by people’s built-in propensity to consume. The assumption about a built-in propensity to consume is at the heart of Keynes’s argument that an increase in government spending will

20 Macroeconomics

expand the economy. Government, according to Keynesian thinking, uses its powers to tax and spend in order to influence aggregate economic activity, particularly, when adjustments in G or T influence consumption through the effects of those changes on disposable income. A matter of particular interest is whether government deficits—budgets in which government spends more than it collects in revenue— positively or negatively affect economic activity. A major concern, as relayed by Alan Blinder several years ago in the Wall Street Journal and as noted in Volume I, Chapter 1, is that government deficits “crowd out” private saving and investment and, by doing so, impose a burden on future generations by leaving them with a shrunken capital stock and a reduced capacity to produce goods for personal consumption. Blinder has raised the same concern more recently in a commentary on the Tax Cuts and Jobs Act, signed into law by President Trump on December 22, 2017 (Blinder 2017). The argument is that, while running a deficit will increase consumption, it might also crowd out investment by pushing up interest rates and by driving private saving away from investment and toward the purchase of bonds that the government issues in order to finance the deficit. Here we will show that increases in G can have this very effect but that any deficit run-up in the process has no bearing on the resulting crowding out. The idea that deficits crowd out investment stems from a variation on the Keynesian model, which is recognized later.

The Effect of Government Taxes on Consumption and Saving Recall the formulas for the present value of consumption and income over the full length of the planning period (which we wrote down for Eve in Chapter 4):

PVc = c1 +

c3 cn c2 + + ... + , (2.1) 2 1 + r (1 + r ) (1 + r )n −1



PV y = y1 +

y3 yn y2 + + ... + , (2.2) 2 1 + r (1 + r ) (1 + r )n −1

ct = vPVy,

(2.3)



Fiscal Policy 21

and savt = yt - vPVy.

(2.4)

Equations (2.1) to (2.4) assume that decisions to consume or save are made on the basis of the individual’s optimization calculus. It is as if the individual decides, first, how much income he wants to make going out to the future and then, second, how much of the present value of that income to allocate to consumption and how much to saving, given r and his personal IES and r. Therefore, the first decision is to decide how much income to receive. The second is to decide how much to consume and save, given the income that the individual will receive. Now we bring taxes into the individual’s optimization calculus. In Volume I, Chapters 3 and 4, there were no taxes or government transfer payments to concern ourselves with, but all that changes now. The individual now pays a tax less any transfer payment from government—a “net tax”—each year over this planning horizon. Let’s designate that net tax as taxt, where the subscript t refers to any year from the current year 1 to the end year n - 1. We then rewrite the individual’s lifetime budget constraint as    PV yat = y1 − tax1 +

y − tax y2 − tax2 y3 − tax3 + + ... + n n −n1 (2.5) 2 1+ r (1 + r ) (1 + r )

or as

PV yat = PV y − PVtax , (2.6)

where PVyat is the present value of future income after net taxes. Thus the individual’s optimization problem is to maximize the present value of lifetime utility subject to

PVc = PV yat . (2.7)

The individual sets current consumption equal to the fraction, v, of the present value of his after-tax income that satisfies his optimization calculus, as worked out in Chapter 4:

ct = vPV yat . (2.8)

22 Macroeconomics

Now, saving is savt = yatt − vPV yat , (2.9)

and the saving rate is

st =



yatt − vPV yat yatt

. (2.10)

Because we want to think only in terms of income effects, it is useful to suppose that government fixes the size of tax for every individual by using some method that ignores how much income the individual chooses to receive. We could pretend that government decides by lottery how much to tax Adam or how big a transfer to provide Eve. It then sends out bills or checks depending on how the lottery turns out for each person. To further simplify the analysis, we could assume that, once the government decides on how to apportion the current year’s T among individual taxpayers, it apportions future taxes and transfers in a similar fashion. If Adam owes the government X% of a given year’s tax revenue or receives Y% of its transfer payments, he will pay or receive the same percentage under different assumptions about the size of T for every future year. Under these assumptions, the total amount of money collected in taxes minus the amount paid out in transfer payments, T, in period t is Tt = ∑ taxt , (2.11)



summed across all individuals for each year t. Now it’s time to reintroduce government purchases G. We denote government purchases for a given year, t, as Gt. Then the present value of government purchases is

PVG = G1 +

G3 Gn G2 + + ... + , (2.12) 2 1 + r (1 + r ) (1 + r )n −1

and the present value of net taxes is

PVT = T1 +

T3 Tn T2 + + ... + . (2.13) 2 1 + r (1 + r ) (1 + r )n −1



Fiscal Policy 23

Government purchases need not match net taxes in any given year, but, we assume, the present value of government purchases must equal the present value of net taxes over the period 1 through n-1, which is to say that PVG = PVT .

(2.14)

This means that, in the long run, government balances its budget or, we could say that, sooner or later, government pays for all its spending through current or future tax levies. Given equations (2.12) and (2.13), we can see that any change in government purchases, ΔG, will cause the present value of government purchases to change and simultaneously require the present value of net taxes to change by the same amount as the change in the present value of government purchases. Let’s denote a change in government purchases in a given year as DGt and a change in net taxes as DTt. The change in the present value of government purchases is

∆PVG = ∆G1 +

∆G3 ∆Gn ∆G2 + + ... + . (2.15) 2 1 + r (1 + r ) (1 + r )n −1

The corresponding change in the present value of net taxes is then

∆PVT = ∆T1 +

∆T3 ∆Tn ∆T2 + + ... + . (2.16) 2 1 + r (1 + r ) (1 + r )n −1

By necessity,

∆PVG = ∆PVT . (2.17)

With all this established, we have to think about what we mean by fiscal policy. The usual meaning is policy regarding government purchases and net taxes in the near term, which, for our purposes, is the current year. Here, we take a longer term view and consider also how government might choose to make a permanent adjustments in its purchases of goods and services. It is useful to imagine a rule that calls for maintenance of the status quo, which is to assume no change in government purchases, unless there would be gains to the economy from making some adjustment,

24 Macroeconomics

temporary or permanent, in those purchases. The question, then, is how a change from that status quo would affect the economy. But what is the “status quo”? The answer depends on what government can and can’t control. We can think of government purchases as an “exogenous” variable affecting the economy: Government expenditures on defense, schools, roads, and so forth depend on what government chooses to provide in the way of services related to those goods. The state of the economy, then, has no effect on G. If government uses the lottery system hypothesized here, then T is exogenous. Government has complete control over both G and T. In reality, both G and T are partly “endogenous”: The size of the actual tax liabilities and actual transfer payments at the individual level, and therefore the size of T at the aggregate level, depend in part on the state of the economy and on how individuals react to changes in the laws relating to the imposition of burdens through taxes and the conferral of benefits through transfer payments. The same goes for G, though to a lesser extent. We ignore this complexity here by adopting the assumption that, over the long run, government simply matches its purchases with sufficient net revenue (revenue left over after transfer payments) to pay for what it spends on goods and services and that it does so without creating any substitution effects on the work–leisure and consumption–saving decisions. So let’s begin by assuming that government has set current period G at some baseline level and then considers making changes in G.

A Permanent Change in Government Purchases Suppose then that government makes a permanent change in its purchases, DG. As n gets very large, equation (2.15) for DPVG becomes ∆PVG = ∆G



1

∆PVG = ∆G + ∆G

1 1 1 + ∆G +  + ∆G . 2 1+ r (1 + r ) (1 + r )n

Multiplying both sides of the equation by



∆PVG

1 + r 1 . r

1 , we get 1+ r

1 1 1 1 . = ∆G + ∆G +  + ∆G 2 1+ r 1+ r (1 + r ) (1 + r )n +1

(2.18)



Fiscal Policy 25

How do individual taxpayers adjust to this change? We know that, because the present value of government purchases must equal the present value of net taxes, the change in the present value of government purchases must be matched by an equal change in the present value of net taxes, so that ∆PVT = ∆G



1+ r (2.19) r

at the aggregate level, and

∆ct = v( ∆PV yat ) (2.20)

at the individual level. We assume that the individual pays taxes equal to some fixed fraction of T. Let’s call that fraction f. Then

∆PV yat = − f ∆PVT = − f ∆G

1+ r . (2.21) r

The government must set the change in each taxpayer’s net payment, tax, for each year over the future so as to satisfy equation (2.19). The individual taxpayer will then adjust his consumption in line with the change in the present value of his after-tax income.

∆ct = v( − f ∆G )

1+ r , (2.22) r

Subtracting, we get



  1  1  ∆PVG 1 − .  = ∆G 1 − n +1   1+ r   (1 + r ) 

Because



1 (1 + r )n +1

is very small, we can ignore that term. Solving,



1+ r  ∆PVG = ∆G  .  r 

26 Macroeconomics

where v = r/(1 + r). Thus,

∆ct = − f ∆G , (2.23)

and

∆savt = f ∆G − ∆taxt . (2.24)

The individual adjusts his consumption to match the change in the present value of his after-tax income, as determined by his lifetime change in taxes, as necessitated, in turn, by the government’s budget constraint. What happens to saving in a given year depends in part on how much the government decides to tax the individual in that year. Suppose, then, that the individual reduces consumption by $100 (which is just his share of the aggregate tax bill for the increased G ) in response to a rise in G, so that Dct = –$100. If the government doesn’t raise the individual’s taxes at all, his saving will rise by $100. Or if the government raises his taxes by $100, his saving will remain constant, as the individual will use money previously spent on personal consumption to pay the new taxes. Note that it doesn’t matter to the individual if the new spending is allocated for a purpose that he can substitute for his c­ onsumption or if the new spending is going to be entirely wasteful. The change in consumption for the economy will be

∆Ct = −v( ∑ ∆PV yat ),

(2.25)

where DPVyat is the aggregate change in the present value of after-tax incomes that results from the change in government purchases and therefore government taxes over the planning period:

∑ ∆PV yat = −∆G

1+ r  . r

(2.26)



Fiscal Policy 27

Again, letting

v=

r ,(2.27) 1+ r

∆Ct = −∆G .(2.28) Now let Yt before the change in G¸ be



Yt = Ct + It + Gt + NXt = Ct + St + Tt.

(2.29)

Or, given our assumption about the equality of net exports and net foreign investment, Yt = Ct + It + Gt + NFIt= Ct + St + Tt.

(2.30)

From equation (2.28) we know that the change in G does not cause a change in Yt. Production that previously went into personal consumption is now allocated to government purchases. It is possible that Yt will change as a result of this reallocation, which we take up later. But for now, let’s assume that

∆Yt = 0 .(2.31)

In this case, there must be a change in (St + Tt ) that just matches the change in Ct. Say, for example, that Ct falls by $1,000. Then (St + Tt  ) must rise by $1,000. If the government keeps taxes constant, so that it increases its deficit by $1,000, saving must rise by $1,000. If it raises taxes by $1,000, saving need not change at all. Or if it raises taxes by $500, saving must rise by $500. The only condition is that the sum of the two changes equal the change in consumption.

A Temporary Change in Government Purchases Now suppose that government purchases change only in year t. For each taxpayer,

∆PV yat = − f ∆Gt , (2.32)

28 Macroeconomics

since ∆PVT = ∆Gt . (2.33)

Now

∆ct = −vf ∆Gt , (2.34)

and

∆savt = vf ∆Gt − ∆taxt . (2.35)



What happens at the aggregate level depends on the size of DG. Because ∆Ct = −v ∆Gt , (2.36)



∆Ct = −



r ∆Gt . (2.37) 1+ r

Then ∆St =



r ∆Gt − ∆Tt , (2.38) 1+ r

and

∆Yt = ∆Gt (1 − v ) + ∆I t + ∆NFI t . (2.39) Thus also, if DYt = 0,



∆I t + ∆NFI t = −∆Gt (1 − v ).(2.40)

The sum of DIt and DNFIt must equal the negative of DGt(1 - v). (It + NXt  ) must fall if Gt rises and rise if Gt falls. Thus, if r = 5% and if Gt rises by $1,000, It + NFIt must fall by $952.38. If Gt falls by $1,000, It + NFIt must rise by $952.38. If Gt rises, there is crowding out of investment. If it falls, there is crowding in of investment. Note that this result is



Fiscal Policy 29

independent of the extent to which the change in Gt is accompanied by a rise in the deficit or surplus. What happens to saving? Referring to equation (2.38), suppose that DGt = $1,000 and that the government finances the increase in government purchases by imposing $1,000 more in taxes in period t. In this case, the existing deficit does not change. If r = 5%, taxpayers will reduce their saving by $952.38 in order to free up the revenue to pay the new taxes. They will pay the remaining $47.62 in taxes out of funds diverted from current consumption. They will reduce their consumption by $47.62 in year t and in every year in the future, rather than endure paying the $1,000 in new taxes all at once in period t. Now suppose the government does not raise taxes at all, thus adding $1,000 to the deficit. Saving will rise by $47.62. The government will raise the $1,000 it needs to pay for the increase in Gt by selling $1,000 in bonds. Taxpayers will divert $952.38 in current saving from the purchase of bonds and other financial instruments issued by private sector entities to the purchase of the new government bonds. They will combine that $952.38 with the $47.62 that they free up by reducing consumption to buy the $1,000 in bonds the government will issue to finance the deficit. As before, consumption falls by only $47.62 a year as consumers spread the impact of the new government spending over their future. What this proves is that it doesn’t matter if government adjusts net taxes to match a temporary increase in government purchases. There will be a crowding out of investment but only because government increases purchases temporarily, not permanently, thus inducing taxpayers to spread the resulting hit to their income over their future. The interest rate r will rise in the process. If the government raises taxes to match a temporary increase in purchases, r will rise as aggregate saving falls. Likewise, if it engages in deficit financing, r will rise as savers replace existing saving instruments with the purchase of the bonds issued by government to pay for the new spending. Figure 2.1 charts government purchases as a fraction of GDP against gross investment as a fraction of GDP from 1935 to 2016. It shows a substantial crowding out of gross investment during World War II and during the fiscal stimulus of 2009–10. Figure 2.2 shows that the temporary spending was financed largely by government borrowing.

30 Macroeconomics

50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% 1930

1940

1950

1960

1970

1980

G/GDP

1990

2000

2010

2020

2030

Gross I/GDP

Figure 2.1  Crowding out of gross investment Source: U.S. Bureau of Economic Analysis.

0.30 0.25 0.20 0.15 0.10 0.05 1935 1938 1941 1944 1947 1950 1953 1956 1959 1962 1965 1968 1971 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013 2016

0.00 −0.05 −0.10 Deficit/GDP

Gross I/GDP

Figure 2.2  U.S. deficits and gross investment Source: U.S. Bureau of Economic Analysis and Office of Management and Budget.

A Change in Taxes Now suppose that the government decides to change aggregate taxes by the amount DTt. If DTt is negative, which means the government cuts taxes (and/or increases transfer payments), it must sell bonds matching the amount DTt and must service the bonds over periods 2 through n, raising taxes in increments as DTt+1, DTt+3, …, DTn-1, in order to satisfy equation (2.17). By assumption,

∆PVG = 0. (2.41)



Fiscal Policy 31

As a result, ∆PVT = 0, (2.42)

and, at the taxpayer level,

 ∆taxt +1 ∆taxt + 2 ∆taxn  ∆taxt = −  + + ... +  . (2.43) 2 (1 + r ) (1 + r )n −1   1+ r

Thus,

∆PV yat = 0,(2.44)

and

∆ct = v ∆PVatlay = 0. (2.45)

Because

∆savt = ∆ct − ∆taxt , (2.46)



∆savt = −∆taxt . (2.47) Hence, also, ∆Ct = 0, (2.48)

and

∆St = −∆Tt . (2.49) Saving simply adjusts to the change in taxes.

Setting Tax Rates Here we tie in the analysis from previous chapters where we recognize that actual taxes are imposed on choices about economic activity—choices about working, consuming, and saving. Government does not send out bills as credit card companies do but collects revenue by taxing certain activities (e.g., earning income) or certain asset holdings (e.g., holding

32 Macroeconomics

property). Nor does it typically send out checks to individuals as bonuses for being good citizens. Rather, it sends out checks to individuals that operate mainly as rewards for not earning income. The question is how do we amend the foregoing analysis to consider this reality? In reality, when the government decides to spend more on purchases or transfer payments, it must eventually recalibrate existing tax rules to raise the amount of revenue needed to finance the new spending (recognizing that it might spread out the process of raising this revenue over a long period of time, so that interim deficits may result). That process must take into account also how the expenditure of the taxes raised will affect individual choices, depending in part on whether taxpayers consider the expenditure to be “useful” or whether eligibility for a transfer payment depends on those choices. We have already worked through this consideration in Volume I, Chapter 7. If government just randomly sent out bills to pay for what it spent (as assumed in the preceding analysis), none of this would matter. ­People would simply adjust their consumption accordingly, as described ­previously. But because it collects revenue by taxing choices, it will, as we have seen, affect those choices. Suppose, for example, that government commits to a stream of new spending on facilities like the Minute Clinics mentioned in Volume I, Chapter 8 and that it decides to raise the revenue by enacting a permanent surcharge on labor income. The surcharge will have to be set in a way that recognizes the opposing consequences of the income and substitution effects. The strength of the income effect will vary inversely with the value of the new government clinics to consumers. Consumers will not feel that the tax made them poorer if the new clinics provide services comparable to or better than the CVS clinics that the new clinics displace. The tax rate will have to be set high enough to compensate for the negative effect on revenue of the taxpayer’s inclination to substitute leisure for work but there will be little or no sacrifice of leisure to compensate for the burden of the new tax on income. In effect, consumers will simply pay government for a service for which it previously paid a private provider and, to that extent, suffer no loss in utility. In reality, of course, it wouldn’t simply be a matter of the quality of the government clinic’s services versus those provided by CVS. Because the use of private sector clinics requires co-payments and becomes reflected



Fiscal Policy 33

in insurance rates, there exists a rationing mechanism for their use. If the government just opens the doors of its new clinics and treats people free of charge, the clinics are likely to be overused and, ultimately, become costlier. On the other hand, as some would argue, the government clinics could operate more cheaply by eliminating the need for an insurance company and, perhaps, by extracting other cost savings. But let’s not get buried in a discussion of socialized versus free-market health care. Let’s just assume that people who previously went to CVS for care now just go to the new “US Care” clinics with no loss in services. They simply, in effect, send money to government that they previously sent to CVS and to their insurance providers, but experience no income effect or on, that account, an incentive to work more. There will remain only a substitution effect and the resulting incentive to work less, along with the resulting necessity of setting the tax rate high enough to overcome the loss in revenue owed to the reduction in work effort. The result is a strong negative effect on work effort, labor income, and GDP. Whether the new spending ends up being good or bad for the economy would depend on the trade-off between whatever efficiencies the government clinics could provide and the negative effect on GDP of the new tax. We can suppose conversely that the new spending is entirely wasteful. Then taxpayers send money to the government that would have gone to personal consumption and do so entirely as a sacrifice. The income effect at least partly offsets the substitution effect, reducing the tax rate increase needed to finance the new spending. The effect on labor income and GDP is small inasmuch as the reduction in work effort is small, but consumers suffer a reduction in utility as they sacrifice personal consumption for wasteful spending. However, as these effects work themselves out, individuals will want to reduce their consumption permanently by the amount of the new spending. Insofar as the new spending provides a perfect substitute for consumption on some good (clinics), consumers get “free” what they used to pay for and reduce their personal expenditures on private clinics accordingly. Insofar as the new spending is wasteful, they will want to spread the burden of providing tax dollars to fund a wasteful expenditure evenly over their lifetimes. Next, suppose again that government undertakes a once-and-for-all increase in purchases. Because individuals will want to spread the tax

34 Macroeconomics

burden necessitated by this increase over their lifetimes, they will either reduce their saving (if the spending is financed by new taxes) or reallocate their existing saving to the purchases of government bonds (if the spending is financed by borrowing). Either way, r will rise and, with it the cost of capital, causing investment to fall. A further collateral effect is that the supply of labor will rise in response to the rise in r. Correspondingly, wage rates will fall, and GDP will rise. Ultimately, also, the increase in G, though temporary, will give rise to higher taxes, with the same substitution and income effects that are associated with higher taxes, which are made necessary by a permanent rise in G. Finally, government can choose to reduce T, by either reducing tax rates or by loosening the eligibility requirements for transfer payments, or both. A reduction in tax rates encourages people to substitute work for leisure, because of the substitution effect, and to substitute leisure for work, because of the income effect. A reduction in T ultimately means a reduction in G. If the reduction in G means the elimination of government programs that provide useful alternatives to private consumption, the income effect will be weak and the reduction in tax revenue brought about by the reduction in tax rates will be greater than if the programs were wasteful. The effect of loosening the eligibility requirements for transfer payments on revenues depends on the new benefits provided and on any increase in tax rates (with all the corresponding collateral effects) that is necessitated by the loosening of requirements. As it turns out, government consumption expenditures amount to about 50 percent of total government revenues. This means that about 50 percent of tax revenues go to providing services that taxpayers would otherwise have to obtain from the private sector. A ­disproportionate burden of federal income taxes is borne by only about half of tax­payers. The top 50 percent of income earners pay 93 percent of all federal income taxes. The income effect of federal tax rates must therefore be high and the tax rates needed to raise the requisite revenue correspondingly low. People continue to work in order to provide for personal consumption as taxes imposed to pay for defense and the social safety net rise, blunting the inclination to increase leisure as the price of leisure falls. Another way of putting it is that government takes advantage of people’s demand for personal consumption in order to finance defense and social benefits.



Fiscal Policy 35

Fiscal Policy as a Stimulus Tool Chapter 3 of this volume shows how government can manipulate fiscal policy to restore the economy to full employment. This role for fiscal policy presents itself when the economy suffers long-lasting excess supply or excess demand. Excess supply manifests itself as a condition brought about by a failure of prices and nominal wages to fall in tandem with a fall in demand. Excess demand manifests itself as a condition brought about by a failure of prices and wages to rise in tandem with a rise in demand. The required response by government to a condition involving excess supply is to increase government purchases and transfer payments and to reduce tax collections. The required response to a condition involving excess demand is to reduce government purchases and transfer payments and to increase tax collections. We go into detail in Chapter 3 of this volume.

The Budgetary Baseline Now we need to refine what we mean when we refer to changes in government revenue and expenditures. There exists some baseline expectation of government spending and tax revenue, going forward. This expectation reflects both the assumed state of the economy and the statutes governing expenditures and taxes. The statutes governing expenditures and taxes have the effect of causing T to rise when the economy is expanding and to fall when the economy is contracting. T rises in an expanding economy as tax revenues rise and transfer payments fall. It falls in a contacting economy as tax revenues fall and transfer payments rise. The baseline projection for federal government revenue and expenditures for 2018 to 2027, as offered by the Congressional Budget Office, is provided in Table 2.1 (Congressional Budget Office 2017, p. 13). Projected revenues and expenditures vary with assumed changes in the economy. For its report, the CBO assumed that real GDP would grow by 2.0 percent in 2018, by 1.5 percent in 2019 to 2020, and by 1.9 percent in 2021 to 2027. In the foregoing discussion, an assumed ΔG or ΔT is intended to reflect a change in statutory provisions that determine spending and revenue, given existing assumptions about the state of the economy. Thus, any assumed change in T or G over the future would mean a change in the baseline assumptions behind Table 2.1. Because

36 Macroeconomics

the government cannot simply decree a change in taxes or expenditures without considering the effects of a statutory change on the economy, it would be necessary to consider how any proposed change in tax or spending legislation would affect the baseline assumptions about GDP growth. When federal officials “score” new spending legislation, they do not account for the future tax changes that will be eventually needed because of that legislation, unless the tax changes are included in the legislation. Table 2.1 therefore reflects CBO’s assumptions about current (June 2017) law and future economic conditions. It makes no provision for changes in tax law needed to pay for the projected expenditures. While, under our assumptions, the government need not raise taxes enough to set the present value of revenue equal to the present value of expenditures in a 12-year frame, it must plan to do so within some time frame (50 years? 100 years?) in order to assure people buying government bonds that they will be paid. Thus, the current scoring mechanism is misleading in that it recognizes no limit to government’s ability to borrow. If the government’s ability to borrow were unlimited, no one would expect the government to pay its bills and no one would lend money to the government to finance its deficits. Policymakers, pundits, and politicians often claim, in effect, that the real gauge of the ability of government to pay its bills is the fraction of GDP accounted for by the deficit. Table 2.1 provides the projected deficits as a fraction of GDP. This table should be comforting, in that it has the deficit as percentage of GDP only slightly higher for 2027 than for 2017. What that means is that, given the assumptions relating to the growth of GDP over that period, the capacity of the economy to absorb the deficits implicit in budgeted spending plans will be about the same in nine years as it is now (2018). It does not, however, eliminate the eventual necessity of those tax increases or, therefore, of future government surpluses needed to pay the federal debt. What are the chances that government will, in fact, impose the needed new taxes, given that it chooses to spend more? Figure 2.3 traces the history of the federal deficit as a fraction of GDP since 1929. There we see that the deficit exceeded 25 percent of GDP during World War II and came to about 10 percent during the Great Recession that marked

3,687 4,475 789

3,531

4,194

663

2.8

Total Revenue

Total Expenditures

Deficit

Deficit as a % of GDP

3.3

2019

2018

Year

3.6

775

4,628

3,853

2020

4.0

879

4,891

4,011

2021

4.5

1,027

5,205

4,178

2022

4.4

1,057

5,419

4,361

2023

Fiscal Years 2018 to 2027 ($ billions)

Table 2.1  CBO baseline projections of federal revenue and expenditures

4.3

1,083

5,628

4,545

2024

4.7

1,225

5,967

4,742

2025

5.0

1,352

6,300

4,948

2026

5.2

1,463

6,621

5,158

2027

Fiscal Policy 37

38 Macroeconomics

the Obama presidency. The CBO, as we have seen, projects deficits in the 3 to 5 percent range over the next several years. What about federal debt? The total amount of debt owed by the U.S. government at the end of 2016 was $19.539 trillion. This figure is not meaningful, however, insofar as a substantial portion—$5.372 trillion— is owed by the government to itself, i.e., to government trust funds like Social Security. Social Security trust fund administrators use taxes (“contributions”) paid into the fund to pay benefits and to “buy” government bonds in amounts equal to the excess of Social Security “contributions” over payments. In this process, the trust fund has acquired over $5 trillion in what it reports as assets. As Social Security payouts rise, it will begin to spend down these assets in order to cover the difference between payouts and revenues from Social Security taxes. To say that assets held by government trust funds represent government debt in any meaningful sense is, however, nonsense. Suppose that you have a mortgage on your house and that you keep a cookie jar where you put your spare change to pay for a night out for dinner. The mortgage you owe on your house is debt. So is the money you take out of the cookie jar to meet an occasional expense debt too? Maybe you “borrow” $25 from the cookie jar to pay your baby sitter. You can leave a note for $25 in the cookie jar as a reminder to repay your dinner account, but that $25 is not a debt. It is money you owe yourself, unlike the money you owe your mortgage holder. Federal Surplus or Deficit [-] as a Percent of Gross Domestic Product 5

Percent of GDP

0 −5 −10 −15 −20 −25 −30

1930

1940

Shaded areas indicate U.S. recessions

1950

1960

1970

1980

1990

2000

2010

myf.red/g/fVqK

Figure 2.3  Federal surplus or deficit (−) as a percent of GDP Source: Federal Reserve Bank of St. Louis.



Fiscal Policy 39

That is why, in talking about the burden of the debt, it is necessary to consider only that portion of federal debt that is owed the public and not government itself. That portion of the debt came to $14.167 billion at the end of 2016. Figure 2.4 traces federal debt owned by the public from 1939 to 2016 as a fraction of GDP. The debt as a fraction of GDP was an all-time high of about 105 percent during World War II, fell to a low of slightly more than 20 percent in the 1970s and then shot up again, largely as a result of the Great Contraction. Figure 2.5 tracks interest on the federal debt as a fraction of GDP. Both figures reflect the temporary run-up in government expenditures during the Great Contraction. Gross Federal Debt Held by the Public as Percent of Gross Domestic Product 110 100

Percent of GDP

90 80 70 60 50 40 30 20

1940

1950

Shaded areas indicate U.S. recessions

1960

1970

1980

1990

2000

2010

myf.red/g/fVly

Figure 2.4  U.S. debt as a percent of GDP 1939 to 2016 Source: Federal Reserve Bank of St. Louis.

Interest on Federal Debt/GDP 6.0% 5.0% 4.0% 3.0% 2.0% 1.0%

2014

2008 2011

2005

2002

1999

1996

1993

1990

1984 1987

1981

1978

1975

1972

1969

1966

1963

1960

1954 1957

1951

1948

1945

1942

1939

0.0%

Figure 2.5  Interest on U.S. debt as a percent of GDP 1939 to 2016 Source: Federal Reserve Bank of St. Louis.

CHAPTER 3

Managing Aggregate Supply and Aggregate Demand Chapter 5 of Volume I lays out the conditions under which the market for labor clears: Firms hire labor up to the point where the marginal product of labor equals the real wage rate. Workers, in turn, expand their provision of labor until the marginal rate of substitution of leisure for labor income equals the after-tax real wage rate. This brings about an outcome called “full employment.” Corresponding to this state is full-employment GDP or potential GDP. We can take full employment to be a condition in which the number of job openings just equals the number of workers who want jobs. This does not mean that everyone who wants to work has a job. Unemployment will never be zero. There will always be some openings that temporarily go unfilled and therefore some workers who temporarily go jobless. One type of unemployment is “frictional unemployment,” that is, unemployment that exists because some workers are between jobs or because they just entered the labor force and are searching for a job that meets their expectations. Another, more problematical, type of unemployment is “structural unemployment,” that is, unemployment that exists because unemployed workers’ skills do not match the requirements of the jobs that are open. The best way to characterize unemployment that exists when there is “full employment” is to contrast it with unemployment that is attributable to imbalance between aggregate demand and aggregate supply of labor. In the Keynesian model such unemployment is called “involuntary,” in the sense that workers want to take jobs but can’t induce employers to open up job opportunities at any wage at which they might be willing to work. In the “suppressed inflation” model, which is about to be considered, the problem will be that employers can’t get workers to take a job at any wage they might offer.

42 Macroeconomics

In the “classical” model, the market for labor automatically clears through real-wage adjustments in the event of temporary imbalances between supply and demand. If the real wage rises above the equilibrium level, the resulting excess supply of labor will cause it to fall until equilibrium is restored. If it falls below the equilibrium level, the resulting excess demand for labor will cause it to rise again until equilibrium is restored. Keynes wanted to revise economics to account for the fact that the economy could fall into a non-self-correcting state of low employment. Keynes was right about one thing concerning the Great Depression, which was the worst period of low employment in U.S. history: Real wage adjustments of the kind needed to restore “full employment” either did not occur or were not working, and the result was a long-lasting state of affairs in which there was an excess supply of both goods and labor. There is a question of what to call such a state of affairs. It could be seen as a disequilibrium, since it is characterized by an imbalance between supply and demand. Here it will be considered an “equilibrium,” though certainly one not to be wished for. During the Great Depression and until World War II, the United States suffered a long period of low employment. A low-employment “equilibrium” is therefore an economic state that is not self-correcting. The long-run/short-run dichotomy is meant to recognize a distinction between an equilibrium in which aggregate supply equals aggregate demand and an equilibrium in which it does not. Keynes taught a generation of economists to believe that a low-employment equilibrium would always be one in which there was excess supply: The aggregate supply of labor would exceed the aggregate demand for labor, and the aggregate supply of goods would exceed the aggregate demand for goods. One purpose of this chapter is to show that a low-employment equilibrium can just as well be characterized by excess demand. In this shortrun equilibrium, the aggregate demand for labor exceeds the aggregate supply of labor, and the aggregate demand for goods exceeds the aggregate supply of goods. As mentioned earlier, the name ordinarily given to this rarely considered condition is suppressed inflation, usually associated with episodes in which countries impose price controls or “forced savings” measures on their citizens. In this chapter, we will see how this condition would arise



Managing Aggregate Supply and Aggregate Demand 43

from a failure of nominal wages and prices to rise in tandem with an increase in aggregate demand, that is, from upward stickiness of nominal wages and prices. Keynesian unemployment occurs when there is a downward “stickiness” of nominal wages and prices, which in turn creates an excess supply of labor and goods. Conversely, suppressed inflation occurs when there is an upward stickiness of nominal wages and prices, which in turn creates an excess demand for labor and goods. Either condition creates a case for government intervention in the form of discretionary monetary or fiscal policy. It is just that, of the two, the first is by far the most familiar, as the scenario that became the most recognized interpretation of Keynes’s General Theory. Also the two conditions call for opposite responses from government. Keynesian unemployment calls for expansive monetary and fiscal policy. Suppressed inflation calls for contractive monetary and fiscal policy.

Aggregate Supply and Demand in the Classical Model In the classical model, in which the aggregate supply of labor equals the aggregate demand for labor, there are exactly as many employment opportunities as there are age-eligible people who want to be employed. (More specifically, the number of hours of labor time that employers want to fill with workers is exactly equal to the number of hours of labor time that age-eligible people want to supply.) As pointed out previously, it is important not to infer that, in the classical case, every hour of time offered by workers is in fact filled with an hour of employment or that every hour of time demanded by employers is filled with an hour of work. Mismatches between supply and demand can still occur because of “frictional” or “structural” imbalances. But the number of work opportunities just matches the number of work hours available to fill those opportunities. The analysis begins with the assumption that people hold their wealth in the form of cash. Recall Table 1.1 in Chapter 1 of this volume where cash balances M started out at $1,000,000 and then rose, first by 5% a year and then by 6%. Let’s assume that there is $1 million in circulation and that P = 1. Then the real money supply is

44 Macroeconomics

M $1, 000, 000 = = $1, 000, 000. (3.1) 1 P



Now we need a few assumptions about labor and goods. To make life as easy as possible, let’s assume that there is one good, pizza, which sells for $1 a slice. Let’s also assume that workers receive a nominal wage of $10 per hour. Finally, let’s set the price level P equal to the price of a slice of pizza. The worker’s real wage w is his nominal wage W divided by P: w = W/P = $10/1 = $10.

(3.2)

In other words, the worker is rewarded the equivalent of 10 slices of pizza for every hour of work. Now what happens to that $1 million that people have in their pockets? Well, they use it to buy pizza. How much do they spend? That depends on the velocity of money. Suppose that the velocity V is 2, which implies that the average dollar turns over twice in a year. Thus, nominal income equals

ψ = PY = 1 × $2, 000, 000 = $2, 000, 000,(3.3)

which means that people buy $2,000,000 worth of pizza slices and make $2,000,000 producing them. This is the same y that we called nominal GDP in Chapter 2. Real income equals Y = y/P = $2,000,000/1 = $2,000,000,

(3.4)

which reflects the fact that people produce and buy 2,000,000 pizza slices a year. We can recast these numbers in terms of the “quantity theory” equation:

MV = PY.(3.5)

or, in the example,

$1,000,000 × 2 = 1 × $2,000,000.

(3.6)



Managing Aggregate Supply and Aggregate Demand 45

So far, all we have is a string of identities illustrated with hypothetical values of the variables involved. Now we can introduce theoretical content by writing down the equation seen earlier:

M = kPY,(3.7)

where k is the inverse of the velocity of money and assumed to be constant. As pointed out, we can think of the left hand-side of (3.7) as representing the supply of nominal cash balances and the right-hand side as representing the demand for nominal cash balances. Rewriting (3.6) to conform to this format, we get

$1,000,000 = 1/2(1 × $2,000,000).

(3.8)

The left-hand side of this equation tells us that people have $1,000,000 in cash at their disposal. The right-hand side says that people want to hold exactly that much in cash. Supply equals demand. Now suppose that the government reduces the money supply by 50% from $1 million to $500,000. If the left-hand side of (3.7) falls by 50%, so must the right-hand side. If k is constant, then P and Y must adjust in such a way as to restore balance between supply and demand. For the time being, before the right-hand side adjusts, assume that the supply of nominal cash balances is less than the demand for nominal cash balances:

M < kPY.(3.9)

Because consumers find themselves with only half as much in nominal balances as they did before, they try to rebuild those balances in order to bring their money holdings, on the left-hand side of the equation, back into line with their demand for money holdings, on the right-hand side of the equation. But because the only way that they can accomplish this is by spending less on goods supplied by each other, something has to give on the right-hand side. Assuming that k is constant, that “something” must be a fall in P, a fall in Y, or some combination of the two. In the classical case, the adjustment consists entirely of a fall in P. As M falls by 50%, P falls by 50% and balance between the two sides is restored.

46 Macroeconomics

The nominal wage rate must also fall, however. Because P has fallen by 50%, the real wage would double if the nominal wage did not also fall by 50%. There is no logical reason why workers would not accept the required cut in their nominal wages. If fully informed, workers would understand that if they were unwilling to accept this wage cut, employers would be compelled to reduce the amount of labor time employed. They would also understand that, with the price of a slice of pizza now at $0.50, they could accept a 50% decrease in their nominal wage and still be paid, in effect, 10 slices of pizza per hour of work. In the classical case, therefore, a change in M brings about a proportionate change in P and W in the same direction and leaves the real wage rate and real output unchanged. We can encapsulate some of this information in a single graph by thinking of the left-hand side of equation (3.5) as the level of aggregate demand (AD). See Figure 3.1. The AD curve represents aggregate demand and the LRAS curve longrun aggregate supply. If MV rises, aggregate demand rises. If MV falls, aggregate demand falls. For a given level of MV, then, the AD curve shows the different combinations of P and Y that will satisfy equation (3.5). The aggregate demand curve then becomes a rectangular hyperbola, in that the product of the vertical axis variable and the horizontal axis variable is always the same and equal to MV. Here, the LRAS supply curve is vertical to indicate that that level of output is constant for any level of aggregate demand.

P

B

LRAS

X AD

0

A

Figure 3.1  Long-run equilibrium price and output

Y



Managing Aggregate Supply and Aggregate Demand 47

To see how it works, let a rise in M bring about a rise in aggregate demand, from AD1 to AD2 in Figure 3.2. The AD curve shifts up and P rises in proportion to M, from OB to OC. There is no change in Y if M alone rises and V remains constant. Temporarily,

M > kPY.(3.10)

Because k and Y are constant, P must rise in proportion to M. The economy moves from point X to point W. This is the process illustrated in Chapter 1, Table 1.1, of this volume. Alternatively, if M falls, and with it AD, temporarily:

M < kPY.(3.11)

P falls in proportion to M from OB to OD, and the economy shifts from point X to point Z as the aggregate demand curve shifts down the LRAS curve from AD1 to AD3. The reality is that the seamless adjustments to changes in M assumed in the classical model are in fact just simplifying assumptions that work well for considerations of the long run but seldom apply in the short run. The fact that information about observed changes in demand is often imperfect means that there can be maladjustments to these changes. The question, then, is whether those maladjustments are short-lived or protracted. It is to this question that we turn next. P

LRAS

C

W

B

X

D

Z

AD2 AD1 AD3

A

Figure 3.2  Shifts in AD along the LRAS curve

Y

48 Macroeconomics

Short-Lived, Self-Correcting Maladjustments: Worker Myopia For output to be independent of the level of aggregate demand, both prices and wages must adjust instantaneously in proportion to changes in AD. But what if prices and/or wages do not adjust in this way? What sort of maladjustments might occur and what processes will work toward their correction? Macroeconomists use the expression money illusion to connote a blind refusal by workers to recognize that what matters is their real wage, not their nominal wage. If workers suffer from this kind of myopia, they will refuse to take wage cuts in the face of falling prices, even if they know that by refusing to do so, they will cause the cost of labor to rise and force their employers into resorting to layoffs. Likewise, they will hesitate to demand wage increases in the face of rising prices, even if they know that by failing to do so, they may end up working longer hours for a lower real wage. It is possible to consider the problem of price and/or wage rigidity, however, without assuming unwillingness on the part of workers to realize that their real wages are what matter. Assume the existence of multiple pizza shops selling different brands of pizza. As before, the government reduces the money supply and pizza consumers cut back on their purchases unless and until store owners cut their prices. In this process, suppose the local Domino’s franchise tells its workers that they have to accept 50% wage cuts but not to worry since the general price level is also falling by 50%. They will continue to get their ten pizza slices per hour of work in compensation if they are willing to accept the wage cuts. The workers are, however, skeptical. They have heard rumors that Pizza Hut has improved its product and that the reason Domino’s is losing customers is due to competition from Pizza Hut. They conclude that there is no change in monetary policy, but rather an increase in competition from Pizza Hut. The falloff in demand for Domino’s pizzas could be a localized shift in consumer demand from Domino’s to Pizza Hut. Workers see only what is in front of them, not the broader picture. Meanwhile, Pizza Hut workers arrive at a similar conclusion when they are told that they have to accept a wage cut. They likewise refuse to go along with this wage cut, suggesting that this attitude is uniform



Managing Aggregate Supply and Aggregate Demand 49

for all pizza workers. Each worker reasons that he would rather see what other workers do before he takes it on faith that all he has to do is accept a lower wage in order to keep his job, and at the same time make the same real wage as before. This general refusal to take nominal wage cuts is not based on a failure of workers to understand that it is their real wages that matter, but rather a misperception about the underlying cause of a falloff in demand for whatever product their employer is selling. The result is that when aggregate demand falls, so does Y. In Figure 3.3, the downward shift in AD moves the economy from point X to point W along the short-run aggregate supply curve 1 (SRAS1). Prices fall from OB to OC, but wages do not fall in proportion. This leads to a reduction in quantity of labor supplied and a reduction in output from OA to OE, along SRAS1. Prices do not fall in proportion to the fall in M since the fall in Y in and of itself reduces the demand for money. Yet, the percentage fall in prices exceeds the percentage fall in nominal wages for reasons explained. The result is that the cost of labor, equal to W/P, rises, and employers eliminate some workers and in the process, reduce output. The reduction in output can end up being a short-lived phenomenon. All that is needed is for the Domino’s and Pizza Hut workers to realize that their refusal to accept wage cuts was based on a misunderstanding about why their employers’ business was falling off. Once workers P

LRAS SRAS1 SRAS2

B C D

X

W

Z

AD1 AD2

0

E

A

Y

Figure 3.3  Decrease in AD and increase in SRAS with worker myopia

50 Macroeconomics

understand what really happened, they will accept the necessary nominal wage cuts. With workers accepting wage cuts, short-run supply will rise, which implies it will shift from SRAS1 to SRAS2, which intersects the LRAS curve at Z. Output will return to OA, where, as before, AD equals LRAS, and prices will fall to OD. There can be misperceptions also about the cause of a rise in demand. Suppose the monetary authorities increase M, which causes aggregate demand to rise. Pizza buyers will line up in front of pizza shops demanding more pizza, and pizza sellers will ask their workers to put in longer hours to accommodate the rise in demand. Because consumers find themselves with increased nominal cash balances, they try to spend those balances in order to bring their holdings of nominal balances, on the left-hand side of (3.10), back into line with their demand for nominal balances, on the right-hand side of (3.10). But because the only way they can accomplish this is by spending more on goods supplied by each other, something has to give. Given that k is constant, that “something” must cause a rise in P, a rise in Y, or some combination of the two. In the classical case, the adjustment consists of a rise in P and a proportionate rise in W. If M rises by 50%, and P and W rise by 50%, the balance between the supply of money and the demand for money is restored. Suppose, however, that W does not rise in proportion to P. Because P has risen by 50%, the real wage would be cut by 1/3 if the nominal wage did not also rise by 50%. With pizza now priced at $1.50 per slice, workers should be unwilling to work at current levels unless their nominal wage rate rose by enough (from $10 to $15 per hour) so that they continued to earn a real wage of ten pizza slices per hour. Employers, for their part, should be willing to offer this pay increase since they can also raise their prices by 50%. Production should remain unchanged. Suppose, however, that Domino’s workers are reluctant to demand a 50% wage increase since they believe that the increase in demand for Domino’s pizzas reflects a shift in consumer demand from other pizza brands to Domino’s. If these workers think that the rise in the price of Domino’s pizza is limited to that brand, then they might perceive a lessthan-50% wage increase as a rise in their real wage. They might also then be willing to put in more hours of work, with the result that Domino’s



Managing Aggregate Supply and Aggregate Demand 51 P

LRAS

SRAS2 SRAS1

Z

D C B

W X AD2 AD1

0

A

E

Y

Figure 3.4  Increase in AD and decrease in SRAS with worker myopia

would produce more pizza. Given that all pizza employers experience this reluctance on the part of their workers to demand higher wages, production will rise. Now consider Figure 3.4. The rise in AD causes the economy to move out along SRAS1, from point X to point W, with the result that Y expands from OA to OE and prices rise from OB to OC. Output expands because workers provide more of their services on the false assumption that the nominal wage increases being offered to them are high enough, relative to the rise in P to permit their real wages to rise. Prices rise but their rise is mitigated by the fact that the demand for money rises with the rise in Y. Again, wages are stickier than prices, with the result that real wages fall. This state of affairs may last only briefly, however. Once the workers realize that their nominal wages have risen less than in proportion to P, they pull back on their services. The short-run average supply curve shifts from SRAS1 to SRAS2. As Y falls back to OA, prices rise to OD, and the economy now adjusts to point Z.

Short-Lived, Self-Correcting Maladjustments: Employer Myopia Now let’s consider the consequences for the economy of employer myopia, as it can surface after a change in aggregate demand. Suppose again that

52 Macroeconomics

the money supply rises and this time suppose that employers are reluctant to raise wages in proportion to prices. Perhaps the Domino’s manager wrongly believes that the increase in demand for his pizzas has resulted from the success of the Domino’s chain in its efforts to market a better pizza. The manager might not think it necessary to pay his workers more since what he is observing is not a general increase in the demand for pizza but a localized shift from his competitors’ stores to his. But then the Pizza Hut manager, acting on the same unfounded supposition, also refuses to raise nominal wages, as do all the other store managers, with the result that workers, facing a reduction in their real wage in the face of an expected general rise in the price of pizza, decide to withhold their services. This in turn causes store managers to cut back on production, which reduces the supply of pizza. Figure 3.5 provides an illustration. The rise in demand moves the economy from point X to point W on SRAS1. Prices rise from OB to OC and output falls from OA to OE, the reason being that employers refuse to offer wage increases in proportion to the rise in prices. The rise in prices is more than proportionate to the rise in M since output falls. Again, wages are stickier than prices but this time it’s because of an unwillingness on the part of employers to match the rise in prices with higher wages. The consequent unwillingness of workers to put in as many hours as they did before causes output to fall. P

C D

LRAS

W

Z

B

X

AD2 AD1 SRAS2 SRAS1

0

E

A

Y

Figure 3.5  Increase in AD and increase in SRAS with employer myopia



Managing Aggregate Supply and Aggregate Demand 53

This scenario resembles what is called “repressed” (or suppressed) inflation in the macroeconomics literature. “One of the most striking characteristics of repressed inflation is that the demand for labor at the price paid for labor is always greater than the supply, since that price [paid for labor] is below equilibrium”1 (Charlesworth 1956, p. 26). In the modern economy, there are few price controls (except, notably, for the health care sector), but limitations on the wage incentives to supply labor are entirely possible. Suppose that there is a government-engineered increase in aggregate demand that takes place simultaneously with a government-engineered increase in taxes on goods, wages and capital income. Aggregate demand would rise, and the supply of goods and labor would fall, inducing people to allocate their increased disposable income to saving. In the pizza example, the underemployment brought about by repressed wages will be short-lived, however, if employers quickly realize their mistake and offer wage increases commensurate with the rise in prices. As employers offer higher wages, short-run aggregate supply will shift to the right from SRAS1 to SRAS2 in Figure 3.5. In response to the rise in output, prices will fall from OC to OD, equilibrium will shift to point Z, and output will return to its long-run, full-employment level OA. We would get the reverse of this case if aggregate demand fell and if employers were reluctant, for parallel reasons, to reduce the wages they pay, in line with falling prices. Perhaps the employer believes that the fall in demand is localized to his own pizza brand and he cannot expect his employees to take wage cuts as demand falls off. This turn of events is illustrated in Figure 3.6. Aggregate demand falls, shifting the economy from point X to point W along SRAS1. Prices fall from OB to OC. Even though aggregate demand has fallen, the reluctance of employers to cut wages in tandem with falling prices causes workers to offer more of their services and causes output to rise temporarily from OA to OE.   This differs from the Barro and Grossman’s interpretation of what they called “suppressed inflation.” They point out that the supply of labor could fall even if the real wage rate stayed constant and only because the price of goods was prevented from rising (Barro and Grossman 1974).

1

54 Macroeconomics P

LRAS

X

B D C

Z

W

AD1 AD2 SRAS1 SRAS2

0

A

E

Y

Figure 3.6  Decrease in AD and decrease in SRAS with employer myopia

Once employers realize that their reluctance to cut wages is unwarranted, they will cut wages in tandem with the fall in prices. Short-run aggregate supply will shift from SRAS1 to SRAS2, prices will rise to OD and output will return to its long-run equilibrium level as the economy adjusts to point Z. In this section and the one before, the general presumption in favor of relative wage “stickiness” was brought about by worker or employer myopia. In both the sections, wages lag behind prices until either workers or employers are able to see their error and make the needed correction. The logic here flows from the fact that when people find themselves holding more money (or less money), than they wish to hold, they will collectively attempt to bring their actual moneyholding in line with their desired moneyholding, the effect of which is to cause aggregate demand to rise (or fall). Whether that leads to a temporary rise (or fall) in output depends on the ability of workers and employers to see what is afoot: That there is an economywide rise—or fall—in aggregate demand. Workers and employers must then diagnose what the change in demand means to their particular part of the economy. It is the possible lag between when workers and employers feel the impact of the change in aggregate demand and when they determine that the impact was in fact attributable to a change in aggregate demand that causes the maladjustment.



Managing Aggregate Supply and Aggregate Demand 55

The maladjustments considered in the prior two sections were shown to be self-correcting. Let’s now identify the appropriate policy responses to Keynesian unemployment and repressed-inflation unemployment, when those conditions are not self-correcting.

Protracted Maladjustments: Keynesian Scenario In the prior two sections we saw two scenarios in which output could fall below the full-employment level. In the first, aggregate demand fell, and workers refused to accept wage cuts commensurate with falling prices. In the second, aggregate demand rose, and employers refused to offer wage hikes commensurate with rising prices. In both instances we saw how corrective shifts in short-run aggregate supply could move the economy back to full employment without government intervention. Here we consider how a fall in output owing to wage and price rigidities could lead to a protracted period of economic underperformance. Let’s return to the case of worker myopia. Figure 3.3 illustrates the effects of an unwillingness by workers to take wage cuts. At first, this wage rigidity causes output to fall as the reduction in M causes aggregate demand to fall. Then, however, as workers discover their mistake and signal their readiness to take wage cuts, short-run aggregate supply rises until output returns to its full-employment level. Consider, however, the possibility that as workers take time to figure out their mistake and signal their readiness to take wage cuts, aggregate demand will fall yet again owing to the layoffs that the original reduction in aggregate demand brought about. Employers, having laid off some of their workers, experience an additional fall in demand owing to the fact that the laid-off workers have no income to buy their goods. Now let’s add another factor. The fall in M necessitates wage cuts, but it necessitates price cuts as well. We saw that in the example, noted earlier, of a 50% reduction in M, which, when combined with a 50% reduction in P and W, leaves output unchanged. It would not be enough only for workers to accept nominal wage cuts, but employers must also cut their prices, so that pizza sales remain unchanged in the face of lower money balances. That is, both P and W must fall. If they do not fall in tandem, employers will have to lay off at least some of their workers.

56 Macroeconomics

And that would not be the end of it. If there is no proportionate cut in P and W, individual employers will experience a loss of business, not just because their prices are too high but also because other employers have laid off workers, whose demand for consumer goods falls. There is the first reduction in aggregate demand resulting from wage and price rigidity but then also a second reduction owing to the layoffs that result from the first round of layoffs. This next reduction in aggregate demand will bring about yet another reduction in the work force, and then yet another, and so forth until the resulting shrinkage in output reaches some limit. This is the Keynesian multiplier at work. This is also what we might call a depression scenario— an economic downturn of unusual length and severity. It is important, incidentally, to realize that worker myopia need not be the only factor leading to this result. Minimum wage laws make it difficult for employers to cut nominal wages, as do labor contracts. Unions often seem more willing to let employers lay off workers than to accept wage cuts. What distinguishes this scenario from the one illustrated in Figure 3.3 is that the needed wage cuts take too long to head off a multiple round of job cuts, for which no automatic correction remains possible. The Keynesian solution: Expansive fiscal and/or monetary policy. To see how this remedy works, let’s write down the expenditureapproach formula for GDP:

Y = C + I + G + NX,(3.12)

where C is consumption, I is gross private domestic investment, G is government purchases and NX is net exports. Where Keynesian low employment prevails, supply exceeds demand, which means that goods are going unsold, factories are operating below capacity and workers cannot find jobs. In this state of affairs, the demand side of the market determines how much will be produced, the degree to which production capacity will be utilized and the number of workers who will be hired (more exactly, the amount of labor time that will be used). With Keynesian unemployment, consumers are unable to convert their labor time into goods. Factory owners are unable to convert their



Managing Aggregate Supply and Aggregate Demand 57

production into sales and are thus unwilling to invest in new capacity or even to maintain existing capacity. Store owners cannot convert their inventories into sales. Gross private domestic investment is low and net private domestic investment may be negative, as the existing capacity is allowed to depreciate. Consumers are constrained from buying goods due to lack of demand for their labor services. Factory owners are constrained from buying capital goods, and store owners are constrained from building inventories by virtue of the lack of demand for their goods. In this state of affairs, the assumptions of the classical model no longer apply. In particular, people can no longer decide how to allocate their time between work and leisure and their current income between consumption and saving on the assumption that they can provide as much of their labor services as they choose to employers at the current wage rate. Because people are constrained to provide fewer such services than they would wish, they are left in a state of affairs in which the reward for giving up another hour of leisure, that is, the real wage rate, is greater than the amount of labor income with which they would have to be compensated in order willingly to give up that hour of leisure:

MRSLeLay < w.(3.13)

The reason why the worker doesn’t sacrifice leisure and expand work is because work is not to be found. This leaves him with less disposable income than he would have had in classical equilibrium and, with less income at his disposal, he is less willing to consume. In an earlier discussion, we saw that a temporary decrease in income would lead to only a small decrease in consumption and that, conversely, a temporary increase in income would lead to only a small increase in consumption. Here things are different: The worker has less labor income and therefore enjoys less consumption than he would prefer and, as a result, any increase of disposable income would have a substantial effect on his consumption, which in turn would provide a needed “injection” into the economy. In the same earlier discussion, we saw that people make saving decisions according to the utility that they attach to current and future consumption and their preference for current utility over future utility. Saving

58 Macroeconomics

is the willful postponement of consumption to the future, and, as such, frees up resources to be allocated to investment. In the Keynesian model, saving reduces the size of the injection brought about by an increase in disposable income, however, that increase is brought about. Saving (and imports) create a “leakage” out of the economic system that reduces the simulative effect of an increase in income. In this analysis, with labor in excess supply, consumption depends on the quantity of labor that gets hired: C = CD(L),(3.14) and the quantity of labor that gets hired is the quantity demanded, which depends on disposable income:

L = LD(Y - T  ).(3.15)

A second behavioral relationship is between investment and the real interest rate. Keynes saw investment as a function of the real interest rate:

I = I(r),(3.16)

where a fall in r brings about a rise in I. The representation of the demand for investment as a function of the real interest rate is another departure from the classical model, in which the demand for capital is a function of the real interest rate. In the Keynesian system, the ability of the monetary authorities to reduce the real interest rate provides a portal through which government can inject new demand into the economic system through increased investment. It is necessary to recognize how government deficits can lead to a rise in r and therefore fall in I. This is what Alan Blinder’s comments, quoted in Chapter 1, were about. But this would not be, as he argued, a longrun phenomenon, but rather a short-run, Keynesian phenomenon. In the long run, it is not deficits but unexpected increases in government spending that can lead to the crowding out of investment, as explained the Chapter 8 of Volume I. The ability to expand Y rests on the opportunity that the monetary authorities have in a time of low-employment equilibrium to push down



Managing Aggregate Supply and Aggregate Demand 59

the nominal interest rate R through monetary expansion. Return to the ­Cambridge equation,

M = kPY.(3.17)

In the classical model and under full employment, an increase M will bring not about an increase in Y. But suppose that PY (nominal GDP) does not rise in tandem with M. Temporarily, again,

M > kPY.(3.18)

Something has to give, but what will it be? The answer is that k must rise, which implies that velocity must fall. The mechanism needed to get velocity to fall is through a decrease in the nominal interest rate, which will cause the demand for money to rise, bringing the right-hand side of (3.18) into line with the left-hand side. We can construct a demand function for money that provides the necessary linkage between an expansion in M and a fall in R. This is the scenario illustrated in Table 1.3 of Chapter 1 of this volume. Monetary policy can also affect net exports through changes brought about in the real interest rate and in the exchange rate. Under flexible exchange rates, an increase in the money supply will have a limited effect on I, insofar as any departure of the home-country interest rate from the global interest rate will be self-correcting. When the monetary authorities push down the interest rate by expanding M, capital flows out of the home country into other countries, which means NFI rises. As investors move funds from dollars into other currencies, the dollar depreciates. The resulting rise in ε will cause exports to rise and imports to fall. We can then write an equation for net exports NX, expressed as a function of e:

NX = NX(e).(3.19)

Now returning to equation (3.12) and recognizing that production is determined on the demand side of the market, we can write

.(3.20) Y = C  LD (Y − T )  + I D (r ) + G D + NX D (ε )   D

(

)

60 Macroeconomics

We see that there is a behavioral relationship between C D and LD and between LD and Y – T. When we combine these relationships into a single expression we get

b=

∆C D ∆LD ∆C D .(3.21) = ∆LD ∆(Y − T ) ∆(Y − T )

The change in C D that results from another dollar of disposable income equals the change in C D, which results from the provision of an additional unit of labor multiplied by the change in the amount of labor demanded per dollar change in disposable income. The coefficient b is what Keynes called the marginal propensity to consume or MPC. Frequently, economists specify equation (3.20) as D D D   Y = a + b(Y − T ) + I (r ) + G + NX (ε ), which becomes, (3.22)



Y =

1 [ a − bT + I D (r ) + G D + NX D (ε )]. (3.23) 1−b

Suppose the government wants to engineer a certain change in Y D in order to move production closer to its full-employment level. Then it can use the equation 1   ∆I D ∆NX D dY = dr + d ε  (3.24) a − b(dT ) + dG D +  1−b  ∆r ∆ε  to determine the desired combination of monetary and fiscal policy for achieving the desired change in Y. The expression 1/(1 - b) is the Keynesian demand multiplier, which tells us how much Y will change for every dollar change in the bracketed term on the right-hand side of equation (3.24). We can think of the bracketed items as representing the policy instruments available to government for manipulating aggregate demand. The government can bring about changes in Y through its ability to control T, G, r, and e. Changes in these variables bring about changes in Y through the Keynesian multiplier.2   Note that the MPC and the multiplier will get smaller as Y rises. This is because changes in Y require changes in L, and Y rises at a decreasing rate as L rises. Additional units of labor will provide additional dollars of disposable income and therefore additional dollars of consumption, but the additional consumption that results from the provision of additional units of labor will decline as the amount of labor hired expands. 2



Managing Aggregate Supply and Aggregate Demand 61

A couple of examples will be helpful. Let’s assume that the MPC = 0.5 and that the government decides to buy $1 million more worth of Patriot missiles from the Raytheon Corporation in Massachusetts. That creates another $1 million in output right off the bat. This purchase by government requires Raytheon to hire additional labor for which it pays the $1 million, which in turn leads to the expenditure of 50% of that amount on goods by the newly hired workers. Given that the MPC = 0.5, these workers spend $0.5 million at local businesses for food, furniture, and other items. That adds another $0.5 million to output. Local stores have to hire additional labor to provide those goods, and the providers of that labor in turn spend $0.25 million (= 0.5 × $0.5 million) on goods, adding another $0.25 million to output. And so forth. The entire process can be laid out as follows: dY = dG D (1 + b + b 2 + b 3 +  + b n )



= $1 million(1 + 0.5 + 0.52 + 0.53 +  + 0.5n )  = $2 million.

(3.25)

Voila! By spending an additional $1 million, the government creates $2 million in new output and with it the new jobs that became needed in order to make this new output possible. Equation (3.25) provides the long way of calculating the effect on output. The shorter way is to take advantage of the formula presented in equation (3.24) to get

dY =

1 1 $1 million = $2 million.(3.26) dG D = 1−b 1 − 0.5

There are other policy instruments available to government. An alternative strategy would be to cut taxes, thus “putting money in people’s pockets.” Now suppose that, instead of purchasing goods or services, the government cuts taxes by $1 million or, equivalently, sends out checks to individuals for this amount. A tax cut of $1 million does not immediately “inject” $1 million into the economy. The reason is that taxpayers save 50% of that amount. They spend only the remaining 50%. But, again, we are not finished, because there are the same unemployed workers who will be put to work as taxpayers spend that 50% of their tax cut. And so forth. The process can be

62 Macroeconomics

laid out as follows (keeping in mind that a tax cut means that the change in taxes dT is negative): dY = −dT (b + b 2 + b 3 + .... + b n )  

= $1 million(0.5 + 0.52 + 0.53 + .... + 0.5n ) = $1 million .(3.27) The short-cut solution is



dY =

−b −0.5 dT = ( −$1 million) = $1 million .(3.28) 1 − 0.5 1−b

This illustrates the use of the policy instruments available to the fiscal authorities. For the monetary authorities, in the Keynesian system, the trick is to take advantage of the stickiness of prices and the opportunity that presents to increase investment and net exports through expansive monetary policy. A change dr in the real interest rate through monetary expansion leads to an increase in investment. Suppose r is reduced from 3% to 1%. If investment rises by $100 for every percentage point fall in r ∆I , then the reduction in r brings about a $200 rise in = $100), (that is, if ∆r investment, and through the multiplier, a $400 rise in output. It is necessary also, in analyzing the role of r in this process, to consider how an expansion in the economy brought about by a rise in G or a cut in T can itself influence r. Recall that the demand for money depends not only on the interest rate but also the level of real income. If the government uses fiscal policy successfully to expand Y, the demand for money will rise. Because, under these assumptions, as the supply of money remains fixed, something has to rise in order to bring the demand for money back in line with the existing supply of money. That something is the interest rate. The interest rate will be under pressure to rise as Y expands, and a rise in the interest rate will cause investment to fall, thus dampening the positive effect of an expansive fiscal policy on output. Given the sensitivity of international capital flows to variations in the interest rate, the effectiveness of fiscal policy might be quite limited. An upward push on the home-country interest rate will cause capital to flow into the home country and put pressure on the dollar to appreciate (i.e., for ε to fall). This will in turn cause NX D to fall and, with it, Y, bringing the demand for money back into line with the supply of money.



Managing Aggregate Supply and Aggregate Demand 63 Y Z′

B′

W

LD Y2

Z

B

0

Y1

X

A

A′

L

Figure 3.7  Increase in government spending: Keynesian case

Also important are the channels through which monetary policy works. In a closed economy, reduction in r, orchestrated through a rise in M, will cause investment and therefore output to rise. In an open economy, however, a reduction in r can be only temporary since it will spur an outflow of capital. Then, as mentioned, it is this outflow of capital that causes output to rise as the home currency depreciates and exports rise. Now let’s illustrate graphically how government can use fiscal policy in a closed economy to expand Y and L.3 See Figure 3.7, where the failure of the wage rate to adjust to a downward shift in aggregate demand has resulted in a quasi-permanent below-full-employment equilibrium at point X. The LD and Y curves show the different combinations of labor and income that satisfy equations (3.15) and (3.20), respectively, with the economy resting at point X on curves LD and Y. We imagine that G takes one value along curve Y1 and a higher value along curve Y2. The LD curve shows the different quantities of labor that firms will demand for given levels of output that they can sell. The Y curves show the different amounts of goods that firms can sell for different amounts of labor that are employed. At point X, OA workers have found jobs and firms have been able to find buyers for OB units of production. Point X represents an equilibrium,

  The following exposition is based on Barro and Grossman (1976) and Heijdra and Ploeg (2002).

3

64 Macroeconomics

insofar as OB represents just enough in product sales to make it necessary to employ OA units of labor, and OA represents just enough employment to find buyers for OB units of output. But, we assume, point X also represents a below-full-employment equilibrium. If OA′ represents full-employment output, there is a case for government to intervene by increasing purchases by XZ (= dG). This causes the Y curve to shift up by XZ, so that the economy now finds itself on Y2 and at a new equilibrium W. Employment increases to OA′ and production to OB′. Note that in an open economy and under flexible exchange rates, this process is likely to reverse itself as the rise in G and consequent rise in Y cause the demand for money and interest rates to rise. The resulting appreciation of the dollar will cause the Y D curve to shift downward, causing Y to fall back to OB and L to fall back to OA.4 On the other hand, the government could bring about a permanent rise in production and employment through expansive monetary policy. The rise in M puts downward pressure on r and thus increases NFI until the resulting depreciation of the dollar causes net exports to rise and r to return to its previous level. Monetary policy is more effective than fiscal policy for bringing about an expansion of output under integrated global financial markets and flexible exchange rates.

Protracted Maladjustments: Suppressed Inflation Scenario Now let’s turn to a scenario in which aggregate demand for goods and labor exceeds aggregate supply. This could occur because of employer myopia, as discussed previously, where employers refuse to provide wage hikes in the face of rising prices, and employees, as a result, withdraw from the labor force. It could also occur because government price controls prevent firms from raising prices, thus causing them to reduce

  Fiscal policy would be effective for expanding aggregate demand in an open economy and under fixed exchange rates. The expansion in output and the resulting rise in R would put pressure on the dollar to appreciate, forcing the monetary authorities to expand the money supply and thus to expand output.

4



Managing Aggregate Supply and Aggregate Demand 65

production. In this version of excess demand, workers withdraw from the labor force, not only because of employer myopia but also because of the price rigidities that block increases in prices. The usual example involves the expansion of government in wartime and the price controls that government typically imposes in response to the inflationary pressures that, as a result, arise (Charlesworth 1956). Let’s explore a case brought about by monetary expansion. If M rises by 50%, then W and P must also rise by 50%. P must rise in order to ration out the supply goods among buyers who now have larger cash balances and W must rise to prevent the worker’s real wage from falling. If both do not rise in tandem, the economy falls into a low-employment equilibrium parallel to the low-employment equilibrium experienced in the Keynesian case, the difference being that here the supply of goods and labor falls. Government can address this problem by instituting policies aimed at contracting aggregate demand. The conditions described here are the opposite of the Keynesian case. In the Keynesian case, an expansive monetary or fiscal policy is aimed at pulling aggregate demand up into line with aggregate supply. In the suppressed inflation case, a contractive monetary or fiscal policy is aimed pulling aggregate supply up into line with aggregate demand. In the Keynesian case, an expansion of G, I, or NX causes the demand for goods and labor to rise, thus causing the excess supply of goods and labor to fall. But here the problem is excess demand, not excess supply. Every dollar of production that goes toward the production of capital goods, government goods, and net exports is a dollar less that goes toward the production of consumer goods. We can write

C  S = Y - [I(r) + G + NX(e)],(3.29)

whereby the quantity of consumer goods supplied equals production of all goods minus the production of capital goods, government goods, and net exports. Also, the amount of labor used in production equals the amount of labor supplied by workers, which is a function of the consumer goods available for them to buy and the taxes they have to pay.

LS = LS(C S, T  ).(3.30)

66 Macroeconomics

Labor supply varies positively with C and T. It varies positively with C because a greater abundance of consumer goods makes it more worthwhile for workers to sacrifice leisure for labor income. It varies positively with T because higher taxes make workers feel poorer and thus more inclined to work. Here we assume that taxes take the form of lump-sum taxes—taxes that the individual must pay irrespective of his work–leisure and his consumption–saving choices. In effect the government sends the individual a bill, which when paid, leaves him free of any additional tax liability. In short, the tax is imposed in such a way as to have only an income effect—to make the individual feel poorer and therefore to induce him to contract leisure and expand work. Not that this is a reasonable policy option. The analysis, however, does make it clear that in an excess demand scenario, the idea of “putting money in people’s pockets” is just the opposite of what is needed. In this analysis, production depends on how much labor workers are willing to supply:

Y = Y(LS ).(3.31) Substituting equation (3.30) into equation (3.31), we get



Y = Y [LS(C S,T  )].(3.32)

Production depends on the quantity of labor supplied, which, in turn, depends on the quantity of consumption goods supplied and taxes, both of which affect the quantity of labor supplied positively. Now substitute equation (3.29) into equation (3.32) to get

Y = Y  LS [Y − ( I (r ) + G + NX (ε )),T ] .(3.33)

We see that a decrease in I, G, and NX leads to an increase in the production of consumer goods, which leads to an increase in the supply of labor, which then leads to an increase in production. We can specify these relationships as follows: Let

c=

∆Y , (3.34) ∆LS



Managing Aggregate Supply and Aggregate Demand 67

which equals the change in the supply of production per unit change in the supply of labor, d=



∆LS , (3.35) ∆C S

which equals the change in the supply of labor per unit change in consumption, and e=



∆LS , (3.36) ∆T

which equals the change in labor supply per unit change in taxes. Then we can combine these parameters to get

f =

∆Y ∆LS ∆Y = , (3.37) S S ∆L ∆C ∆C S

which equals the change in the supply of goods per unit change in consumption, and

g=

∆Y ∆LS ∆Y = , (3.38) ∆LS ∆T ∆T

which equals the change in the supply of goods per unit change in taxes. Now suppose that government decides to increase output by reducing spending (keeping in mind that dG is assumed to be negative) and/or increasing taxes. Then

dY S = f (dY S − dG ) + g (dT ), (3.39)



dY S (1 − f ) = − f (dG ) + g (dT ), and (3.40)



dY S =

1 [− f (dG ) + g (dT )]. (3.41) 1− f

We can give the coefficient f its own name. Let’s call it the marginal propensity to produce (MPP), by which we mean the increase in production that will take place because workers get another dollar of consumption goods.

68 Macroeconomics

f for every dollar that government pur1− f f chases are reduced. We can think of the coefficient as the output 1− f supply multiplier that applies to decreases in aggregate demand. Simig larly, production will rise by for every dollar that tax burdens are 1− f increased. Suppose that the MPP equals 0.9. Then a $1 million reduction in government spending will lead to an increase of $9 million in production. First, the $1 million in reduced government purchases frees up resources that flow into the production of consumer goods, permitting consumers to buy $1 million more in goods. So far, there is no effect on production: The government has, by its action, simply caused producers to replace $1 million of government goods with $1 million of consumer goods. Now, however, consumers, seeing $1 million in new consumer goods on store shelves, provide more labor time to employers, enough to induce the production of an additional $0.9 million in goods, which in turn, causes consumers to provide more labor time and production to rise by $0.81 million (= 0.9 × 0.9 × $1 million). And so forth. Output supply expands as a geometric progression (similar to the expansion of output demand in the Keynesian case): Production will rise by

  dY = $1 million (0.9 + 0.92 + 0.93 +  + 0.9n ) = $9 million .(3.42) Alternatively, we can use equation (3.41) to solve for the change in Y. Given that dT = 0,    dY =

−f  −0.9  (dG ) =   ( −$1 million) = $9 million. (3.43) 1− f  1 − 0.9 

We can infer that a $1 million reduction in I or NX brought about by an increase in r or appreciation of the exchange rate would yield the same result. To figure out the effect of a tax increase, we would have to know the value of g, the increase in output per unit rise in taxes. Suppose that g = 0.5, and that there is a $1 million increase in taxes. Workers, feeling



Managing Aggregate Supply and Aggregate Demand 69

poorer, expand their labor time by enough to bring about $0.5 million in new production. Given that f = 0.9, the resulting increase in production then leads to $0.45 million in further new production, then to another $0.405 million, and so on. Ultimately, production rises by dY = 0.5 × $1 million (1 + 0.9 + 0.92 + 0.93 +  + 0.9n ) = $5 million,  (3.44) which we can calculate using equation (3.43) as follows:     dY = dT

g  0.5  = $1 million   = $5 million .(3.45) 1− f  1 − 0.9 

These results are the opposite of what we found for the Keynesian scenario. In that case, the corrective for low employment lay in expansive monetary and fiscal policy. In this case, it lies in contractive monetary and fiscal policy. We illustrate this in Figure 3.8. This time we have an LS curve, representing equation (3.30), which shows the different quantities of labor that workers will be willing to supply, given the amount of goods that are available to them to consume. And we have a Y curve, representing equation (3.33), which shows the different amounts of production that will be forthcoming, given the quantity of labor that workers are willing to provide to employers. Point X represents an equilibrium, insofar as Y

L1S

LS2 Y

B′

Z′

B

W

X Z

0

A

A′

L

Figure 3.8  Decrease in government spending: repressed wages case

70 Macroeconomics

OB represents just enough in output to make it worthwhile for workers to apply OA units of their effort to production, and OA represents just enough employment to make it possible for firms to produce the quantity OB. Now suppose that point X, where the L1S curve intersects the Y curve, represents a below-full-employment equilibrium. Government intervenes by reducing government purchases by dG (=XZ). This causes the LS curve to shift down by XZ, so that the economy now finds itself on LS2 and at a new equilibrium point W. Employment increases to OA′ and production to OB′. The reduction in government purchases causes the LS line to shift down as workers see that they can get more consumer goods by working more. This results in the provision of more labor services, causing the excess demand for labor services to fall. As more labor services are provided, income rises and, with it, the production of consumer goods, leading workers to provide even more labor services, in a reverse of the process described earlier where we posited an increase in government purchases. This leads to an expansion of output equal to Z′X. The multiplier is Z′Z/ZX. As before, however, we have to consider what an increase in output means for interest rates. In this instance, a contractive fiscal policy will cause Y to rise and with it the demand for money and (temporarily) the nominal interest rate. The higher interest rate will bring about some combination of reduced investment and net exports, further increasing the volume of goods available to consumers and further increasing output and employment. A contractive monetary policy will push up the interest rate (again temporarily) and cause some combination of reduced investment and net exports, again increasing employment and output.

Summing Up When there is an excess supply of goods and labor, workers can’t find as many jobs—and their employers can’t sell as much in goods—as they could if prices and wages were adjusting as in the classical case. When there is excess demand for goods and labor, employers can’t find as many



Managing Aggregate Supply and Aggregate Demand 71

workers and workers can’t find as much in goods as they could if prices and wages were adjusting as in the classical case. The existence of either excess supply or excess demand in the labor and goods markets will therefore cause employment and production to fall below some “normal,” market-clearing level. But which is the cause? Excess supply or excess demand? The tradition, ever since Keynes, has been to cite the cause as excess supply. As we see, however, the existence of a low-employment equilibrium can just as well happen because supply has fallen short of demand. An economic downturn may reflect the fact that supply does not necessarily create its own demand but it may also reflect the fact that demand does not necessarily create its own supply. Blinder puts the debate over economic policy as between supply-siders on one side and Keynesians on the other. That, however, is not the correct debate. The correct debate begins by recognizing that there is low output and low employment and therefore an unwanted state of affairs attributable to either general excess supply or general excess demand. If it is excess supply, then Blinder is right: The cure is larger deficits combined with continued monetary expansion. But if it is excess demand, then those prescriptions will worsen the problem and are, in fact, the opposite of what is needed. The following chapter takes up the task of correctly diagnosing the problem as either excess supply or excess demand. As we will see, that task is often a difficult one to perform.

CHAPTER 4

Diagnosing the Economy In this chapter we review the problem faced by government in adjusting monetary and fiscal policy to the underlying conditions relating to the labor market and the growth of real GDP. There are, to be sure, many goals to which macroeconomic policies can, and should, be applied. Among them are price stability, economic growth, exchange rate s­ tability, and some measure of equity, among others. Here we focus on the p ­ roblem of calibrating monetary and fiscal policy to keep real GDP at its full-­ employment level.1 Consider Figure 4.1, also seen in the previous chapter. In Volume I, we considered how tax policy affects the point at which the LRAS line cuts the horizontal axis, shown as point A in Figure 4.1. Reductions in tax rates and welfare benefits (and generally, the elimination of government-imposed distortions in the price system) shift the LRAS curve to the right. The opposite policies shift it to the left. In Chapter 3 of this volume we reviewed the circumstances under which actual output, Y, deviates from full-employment output, YFE . In the short run, a rise or fall in aggregate demand can cause actual Y to exceed or fall below YFE . What happens to Y depends on whether workers or employers misread the change in aggregate demand as an event localized to their particular portion of the market, when in fact it is an economywide event. If there is myopia, wages will lag behind prices in adjusting to a fall or rise in aggregate demand, causing Y to fall temporarily below, or temporarily rise above, YFE . If Y is below YFE , the problem will be self-correcting if workers or employers come to understand that what they saw as a localized change   Although all the discussion is in terms of monetary policy, every point made in the upcoming text concerning the use of monetary policy can be generalized to encompass fiscal policy as well.

1

74 Macroeconomics P

LRAS

X

B

AD

0

A

Y

Figure 4.1  Long-run equilibrium price and output

in demand is, in fact, an economywide change. It will be self-correcting if caught early enough. It will not be self-correcting if it leads to an irreversible shrinkage in employment opportunities or worker availability. If aggregate demand falls and if wages do not both fall by the same rate as prices, the layoffs that result will bring about a spiraling reduction in demand for goods and labor. If aggregate demand rises and if wages don’t rise by the same rate as prices, the worker departures from the labor force that result will bring about a spiraling reduction in the supply of goods and labor. This means that policymakers have three problems to solve. The first is whether and how to eliminate distortions in the price system that reduce YFE . The second is to determine whether at any time Y has fallen below YFE and, if so, whether the fall is self-correcting or (quasi) permanent. Then if that problem is not self-correcting, the third problem is deciding how to use the policy instruments at its disposal to increase or to decrease aggregate demand. Neither workers nor employers have a monopoly on their inclination to misdiagnose a change in aggregate demand. Government can as well misdiagnose a fall in output and employment and, when it does, it might provide a remedy opposite of what is called for. The most likely misdiagnosis, given the Keynesian bias that runs through policy making and analysis, is to misinterpret a fall in aggregate supply as a fall in aggregate demand. The government might, for example, offer more generous social benefits to correct a problem aggravated by an increase in social benefits.



Diagnosing the Economy 75

In this chapter, we generalize conclusions of the preceding chapter to account for how policymakers adjust their actions to changes in the growth of real GDP and to labor market indicators, particularly the unemployment rate. Let’s assume that the policy goal is to increase YFE to the degree that is politically feasible and then to keep Y as closely aligned with YFE as possible. We begin again with the equation,

M = kPY.

(4.1)

Now let’s think of how we have to adjust this equality to reflect growth in each of the variables. We can write   %∆M = %∆K + %∆P + %∆Y , or, to simplify the notation, (4.2)

 = k + P  + Y , (4.3) M

which implies that the percentage change in M will, by necessity, equal the percentage change in k plus the percentage change in P plus the percentage change in Y. There must be a match between the growth of the supply of money (the left-hand side of the equation) and the growth of the demand for money (the right-hand side of the equation). The ques , given the sensitivity of tion for monetary policy is how to calibrate M     K , P and Y to M . Chapter 1 of this volume outlined the options available to the Federal Reserve System policy in addressing this problem. If k is constant, we can interpret the equation to say that a change in the growth of M requires a commensurate change in the growth of PY. Let’s use the symbol Y normal to represent the normal growth rate of real GDP, Y. We saw in Volume I, Chapter 6 that there would be some normal growth of Y in an economy where the growth of Y just matches the growth of the number of workers, L (assuming that Z is constant). Say, for example, that we expect L to grow by 3% annually, so that expected Y = Y normal = 3%. Now let’s also suppose that there is some targeted infla targeted = 2%. Then, in order to maintain full employment, the tion rate, P  must be 2% so that the real wage growth of the nominal wage rate W

76 Macroeconomics

rate remains constant. This assumes that the volume of labor services, L, is growing in tandem with Y, so that there is no change in labor productivity Y/L. Given that k is zero, we can use equation (4.3) to solve for the required growth in M:

 required = Y normal + P  targeted = 3% + 2% = 5%. (4.4) M

By this logic (and assuming that k is constant), the required annual growth of the money supply equals the normal annual growth of real GDP (which for many years in the United States, was about 3%) plus the targeted rate of inflation. If Y = Y normal , real GDP (Y) equals the full-employment real GDP, YEF. The size of L depends on the unemployment rate, UR¸ and the labor force participation rate, LFPR: If Y = Y normal , everyone in the age-eligible population who wants to work will be in the labor force. Everyone in the labor force will have a job except for temporary mismatches owing to “frictional” or “structural” factors. When Y = Y normal , the resulting unemployment rate is called the natural rate of unemployment or, more descriptively, the nonaccelerating inflation rate of unemployment (or NAIRU ). This is the rate of unemployment that exists when nominal wages are changing in tandem with prices so as to maintain equality between Y = Y normal . The unemployment rate falls below the NAIRU when prices rise faster than wages and when workers expand their work effort even though their real wages are falling. We can coin an analogous term to represent the rate of labor force participation when wages are changing at the same rate as prices. Let’s call that rate the nonaccelerating inflation rate of labor-force participation or NAPR (ugly, true, but not much worse than NAIRU   ). NAPR is the labor-force participation rate that exists when nominal wages are changing at the same rate as prices and when they are both changing just fast enough to keep Y = Y normal . The labor-force participation rate  below P  > 0 and falls below the NAPR when myopic employers keep W when people leave the labor force as a result. Full employment is the level of employment that exists when the unemployment rate and the labor-force participation rate are both at



Diagnosing the Economy 77

their “natural” or “nonaccelerating” levels. Such unemployment, if it exists, is frictional or structural in nature but not the result of any imbalance between aggregate supply and demand.

The Phillips Curve Consider now a scenario in which the growth of the money supply rises so that, temporarily,

 > k + P  + Y . (4.5) M

If the economy is at full employment and if prices and wages rise  lags at the same rate as M, Y will equal to Y normal . But suppose that W  , causing the cost of labor to fall. Suppose also that myopic behind P workers, confusing the rise in nominal wages with a rise in real wages, expand their work effort. Then Y will temporarily rise above Y normal , and the unemployment rate will fall below the NAIRU. Laurence Ball and N. Gregory Mankiw say that “there is wide agreement about the fundamental insight that monetary fluctuations push inflation and unemployment in opposite directions. That is, society faces a tradeoff, at least in the short run, between inflation and unemployment” (Ball and Mankiw 2002, p. 116). This relationship is known as the Phillips curve, as shown in Figure 4.2. There we draw a short-run Phillips curve (SRPC1) that intersects the long run Phillips curve (LRPC) at point X where the unemployment rate is OC and equal to the NAIRU. If aggregate demand rises, the inflation rate rises, in this example, from OA to OB, causing the unemployment rate to fall to OD and the economy to move up the short-run Phillips curve to point Y. Because workers are myopic, the labor-force participation rate rises. The number of workers, L, rises but only temporarily. In the long run, as workers overcome their myopia and demand wage increases commensurate with the existing rate of inflation, the short-run Phillips curve shifts to SRPC2, which intersects the LRPC at point Z. The actual unemployment rate returns to the NAIRU and L returns to the level consistent with the NAIRU.

78 Macroeconomics P

B

LRPC

Y

Z X

A

SRPC2 SRPC1

0

D

C

UR

Figure 4.2  Shifts in the short-run Phillips curve

The Labor-Force Participation Rate Curve Now let’s consider how a rise in the growth of money supply could cause a short-run fall in L. To illustrate this possibility, assume myopia on the part of employers and draw two short-run labor-force participation rate curves, SRPRC1 and SRPRC2, in Figure 4.3. SRPRC1 intersects the longrun labor force participation rate curve (LRPRC) at point X, where the labor-force participation rate, OC, equals the nonaccelerating inflation rate of labor-force participation, NAPR. The rise in the inflation rate from OA to OB causes the labor-force  lags behind P  , causing the econparticipation rate to fall to OD as W omy to move up the SRPRC1 to point Y. In the long run, as employers overcome their myopia and grant wage increases commensurate with the existing rate of inflation, the SRPRC shifts up to SRPRC2, which now intersects the LRPRC at point Z, and the actual labor-force participation rate returns to the NAPR, and L rises back to its previous level. There is a close connection between the unemployment rate and the labor-force participation rate. In the short run, what happens to  rises depends on whether workers are more myopic or less L when M myopic than employers. If they are more myopic, the unemployment rate will fall. If they are less myopic, the labor-force participation rate will fall.



Diagnosing the Economy 79 P

B

LRPRC

Y

Z X

A

SRPRC2 SRPRC1

0

D

LFPR

C

Figure 4.3  Shifts in the short-run labor-force participation rate curve

The unemployment rate is defined as

UR =

LF − L , (4.6) LF

where LF is the number of people in the civilian population 16 or older who are either working or looking for work and L the number of people who have work. The labor-force participation rate is

LFPR =

LF , (4.7) POP16

where POP16 is the size of the civilian population 16 or older. We can use equations (4.6) and (4.7) to solve for the number of workers:

L = LFPR × POP16 (1 − UR ). (4.8)

It is important not to interpret a fall in the UR, taken alone, to mean that the economy is improving. A fall in the UR causes L to rise, as does a rise in the LFPR, but the same forces that cause the UR to fall can also cause the LFPR to fall. Finally, the result is not just a matter of who is more myopic. Both employed and unemployed workers may leave the labor force as they succumb to the lure of safety-net benefits, as considered in Volume I, Chapter 8.

80 Macroeconomics

Misdiagnosing Changes in Real GDP Growth Just as Y can remain stuck below YFE if the required price and wage adjustments do not take place, Y can get stuck below Y normal . Once the economy remains in a prolonged slump, recovery may require government intervention in the form of increased or decreased aggregate demand, whichever corrective is called for. In a Keynesian slump, the appropriate intervention is an increase in aggregate demand relative to supply. In a suppressed-inflation slump, the appropriate intervention is a decrease in aggregate demand relative to supply. The question arises, though, just how the government knows what kind of slump the economy is suffering. The question is the length of time over which Y is less than Y normal and the amount by which Y normal exceeds Y . Some would denote a long-lived excess of Y normal over Y as secular stagnation. An unemployment rate persistently greater than the NAIRU is a symptom of a secular stagnation as is a labor-force participation rate persistently less than the NAPR.2 But in any slump, it is likely to be true that both problems will exist—a high unemployment rate and a low labor-force participation rate. It is possible to address both problems—high unemployment and low labor-force participation—through policies aimed at removing disincentives to work and/or to create jobs. Such policies shift the LRS curve to the right, increase YFE, increase Y normal , reduce the NAIRU, and increase the NAPR. The problem here lies in discerning whether a fall in Y is temporary or  = 5%, Y = Y normal = 3%, permanent. Return to the example in which M  k = 0 and P targeted = 2%. Now suppose that the actual growth in M temporarily falls from 5% to 4%. Then

 = 4% < k + P  + Y = 5%. (4.9) M

 and assuming that k remains unchanged at zero, Given the fall in M   must fall by 1 percentage point in order to keep Y from both P and W   Note that the economy can suffer from suppressed inflation even if prices are rising faster than nominal wages. Suppressed inflation exists if prices and wages are not rising as fast as aggregate demand.

2



Diagnosing the Economy 81

falling. This is just a dynamic version of the case in which we implicitly assumed that YFE was constant. The only difference is that now it is not a once-and-for-all proportionate fall in W and P that is needed, but a proportionate fall in their growth (again, from 2% to 1%). If this did not occur, then the economy could ratchet itself into a slump, as described here. The policy remedy would be as before—an expansion of government purchases or the money supply to pull the economy back to its normal growth curve. We can present a parallel example of “suppressed inflation.” Suppose that the growth in M temporarily rises from 5% to 6%. To close the gap, the growth of P (currently 2%) must rise by 1 percentage point, to 3%. And, likewise, in order to keep the real wage rate from falling, the growth of W (also currently 2%) must rise by 1 percentage point to 3%. ­Otherwise, employers will put fewer goods on their shelves and workers will withdraw from the labor force. Casting the discussion in terms of growth rates brings to light the complexities that arise in diagnosing a case of high unemployment or low labor-force participation. First, the growth of the money supply is not tightly controlled from some command post at the Federal Reserve. Controlling the money supply requires answering questions about what definition of the money supply to use, about how tightly the Fed can control the money supply through asset purchases and sales, and about what kind of assets the Fed will choose to buy and sell in conducting its policy. Second, the growth path of YFE changes with innovation booms, Middle East wars, elections, and so forth. Finally, controlling inflation involves the choice of price indexes, distinctions between actual and “core” inflation (goods excluding food and energy), and the need to anticipate and correct for the numerous forces at work in the economy, outside the orbit of monetary and fiscal policy, that cause growth rates to fluctuate unpredictably. The problem is that it might be hard to tell whether any developing  and problem of long-term underemployment results from a failure of P  to adjust downward or upward. We cannot assume that there is a W failure of these indicators to adjust downward because of an ill-advised  . Or that a failure to adjust upward results from an ill-­ decrease in M  . Rather, the problem of fine-tuning monetary advised increase in M

82 Macroeconomics

 relative to observed changes in ­ olicy has to do with the behavior of M p Y , which actually means the behavior of k, a point made in Chapter 1 of this volume.  fixed at 5% and Suppose that the monetary authorities are keeping M  fixed at 2% but that Y unexpectedly falls from 3% to zero, which leads P to, temporarily, at least

Y = 0%. (4.10)  remains unchanged, which is to say, Assume that M



 = 5%.(4.11) M Now recall that, at the moment before Y fell,



 = 2%.(4.12) k + P The question then is whether it continues to be true that



Y normal = 3%, (4.13)

so that what we see in equation (4.10) is just an anomaly, or whether it is now true that

Y normal = 0%. (4.14)

Ultimately the economy will adjust in such a way as to satisfy equation (4.3). If policymakers see equation (4.13) as still true, they might interpret the fall in Y as having resulted from a temporary rise in the demand for money relative to the supply of money, as manifested by a rise in k . Were that the case, employers and workers should (i.e., “should” from their own self-interested point of view) agree to bring about propor and W  . (Note that k is the rate at which people are tionate decreases in P increasing the fraction of their real income that they want to hold as cash, so that a rise in k brings about a rise in the demand for money relative to the supply and the need for the growth of prices and wages to fall.) If



Diagnosing the Economy 83

these adjustments do not occur and if Y fails to return to the old normal, then the appropriate policy response, so it would appear, would be to  until Y returns to normal, if it ever does. increase M Suppose, however, that this is a misdiagnosis, which means for some reason now Y normal = 0%, and k did not rise. That means that the growth of the supply of money must ultimately fall relative to the growth of the demand for money. In order to restore equality between the growth of the supply and the growth of the demand for money, the monetary authori from 5 to 2%, or bring  to rise from 2 to 5%, cut M ties must permit P  rises, W  must rise in about some combination of the two. Then also, if P  tandem with P .  rises and if W  does not keep pace with P  , the stage will be If P set for a suppressed-inflation scenario. The economy can sink into a “supply-side” downturn in which Y falls below the new (and lower) ­normal Y . In this case Y would become negative. Why? Again, because, barring a reduction in monetary growth, nominal wages must rise in proportion to prices in order to keep workers from wanting to cut back on their labor services. We are back to the situation in which pizza shop managers generally refuse to grant wage increases to their workers, not understanding in this instance, that, despite the shrinkage in business that took place because of the downturn in Y normal , the demand for pizza is growing faster than the supply (this is because the growth of M exceeds the growth of Y     ). While the idea of acceding to wage demands in a slumping economy seems perverse, doing so is in fact necessary here to keep workers on the job, given that workers correctly understand that the underlying upward  will otherwise cause their real wages to fall. Now if workers pressure on P do not get faster raises, they will pull out of their jobs and production will slump even further. The further slump in production will lead workers to pull back still more as the availability of consumer goods (pizzas) further shrinks, and so on. At this point, monetary and fiscal contraction becomes an even more pressing policy imperative. The trick is to determine whether an observed decline in Y is attributable to some shift in preferences such as a rise in k or whether it is attributable to a decrease in Y normal itself. If it is the former and if the decline is long-lasting, then the correct remedy is a governmentally engineered

84 Macroeconomics

 . If it is the latter, increase in aggregate demand through an increase in M  and W  rise then it is necessary to see how prices and wages adjust. If P in tandem, then the economy will slump to its new normal without further, unnecessary decline in output growth. If they do not rise in tandem, then the economy will slump even below its new normal until a government-engineered contraction in aggregate demand is implemented.

What Is the Correct Monetary Rule? The money supply of the United States fell by 30% during the Great Depression. Real GDP fell by 26% from its peak in 1929 to its trough in 1932. Much of the decline in the money supply was the result of people pulling their money out of banks as they panicked over bank closings. But the Fed arguably allowed the decline in the money supply to take place, with the result that real GDP fell by more than it would have fallen, had the monetary contraction not taken place. The record of the Fed since the Great Depression has been spotty. Perhaps the period for which the Fed is most highly regarded for its conduct of monetary policy was during the “Great Moderation” of (about) 1985 to 2005, so dubbed by John Taylor because of the simultaneous low inflation, low unemployment, and high GDP growth that characterized that period. According to the “Taylor rule,” the Federal Reserve should keep the short-term nominal interest rate at a level that satisfies the equation

 + g  Y − Y FE  + h P −P TAR + r , (4.15) R=P  Y  FE

(

)

where R is the short-term nominal interest rate, Y is actual real GDP, TAR is the tar is the actual inflation rate, P YFE is potential real GDP, P geted inflation rate, and r is the natural rate of interest, that is, the rate that equilibrates saving and investment. In an early paper on this topic, TAR at 0.02 and r at 0.02 Taylor proposed setting g at 0.5, h at 0.5, P (Taylor 1998). According to one report, the Taylor rule “correctly predicted the decisions of the Federal Open Market Committee 85 percent of the time up



Diagnosing the Economy 85

until 2008” (Lowenstein).3 This assessment applies to the actions of the committee during the tenure of Alan Greenspan, who served as chairman of the Federal Reserve Board over most of the Great Moderation. Although the Fed did not formally adopt the Taylor rule as the instrument for guiding monetary policy, it nevertheless gave the rule great importance in making monetary policy decisions. Taylor himself has stressed the importance of rule-based, as opposed to discretionary, policy making. The Great Moderation, he has argued, testifies to superiority of rules-based monetary policy over “interventionism.” The Taylor rule, as mentioned, became the dominant rule of that period. However, monetary policy went off the rails in the 2000s. Between 2003 and 2005, the Federal Reserve held interest rates far below the levels that would have been suggested by monetary policy rules that had guided the Fed’s actions the previous two decades....the Fed’s public statements during that time—which asserted that interest rates would be low for a “prolonged period” and would rise at a “measured pace”—are evidence that this was an intentional departure from the policies of the 1980s and 1990s (Taylor 2013, pp. 34–35). Taylor testifies to the extraordinary lengths to which the U.S. government went over the course of the following “Great Contraction” to rescue the economy through expansionist monetary and fiscal policies. This was as opposed to his recommended return to the rule-based policy that the Fed had implemented during the previous Great Moderation. According to Taylor, monetary policy was overly expansionist over the entire period 2003 to 2009. Taylor’s assessment of the conduct of monetary policy during that period is at odds, however, with an alternative line of thinking. To understand this line of thinking, it is necessary to recognize the fact that any Fed   The Federal Reserve Open Market Committee is the policy arm of the Federal Reserve System, consisting of the seven members of the board of governors plus five presidents of the regional Federal Reserve Banks.

3

86 Macroeconomics

policy aimed at controlling interest rates invites the creation of disparities between the Fed-mandated interest rate and the natural interest rate. The natural interest rate is the r that equilibrates the supply and demand for capital, as derived in Volume I, Chapter 5. In that chapter, we allowed that the nominal interest rate R would diverge from the real  rose above or fell below zero. Table 1.1 in rate r as the rate of inflation P  to the rate Chapter 1 of this volume fleshes out that analysis by tying P of monetary expansion or contraction. In that chapter, we expanded the analysis to consider how increases or decreases in the money supply can affect real GDP either directly by inducing people to adjust their spending to changes in the money supply or indirectly by influencing nominal interest rates. The Taylor rule calls for a policy of using the Fed’s control over the money supply to fix R at whatever rate achieves the wanted balance between the goal of closing the GDP gap (the gap between actual and full-employment GDP) and the goal of bringing the actual inflation rate into line with the targeted rate. The Taylor rule operates by finding the ideal point on the short-run Phillips curve. An alternative rule would aim strictly at closing the GDP gap. If the Phillips curve is vertical, as it must be in the long run, then the alternative rule would be to adjust the money supply to bring actual GDP into line with potential, full-employment GDP and then, once the GDP gap is closed, to bring the rate of monetary expansion into line with the growth of real GDP and the percentage change in velocity. In his presidential address to the American Economic Association, Milton Friedman reiterated his long-standing argument that the Fed should adopt a monetary rule—not an interest rate rule. “The first requirement,” he said, is that the monetary authority should guide itself by magnitudes it can control, not by ones that it cannot control. If, as the authority has often done, it takes interest rates or the current unemployment percentage as the immediate criterion of policy, it will be like a space vehicle that has taken a fix on the wrong star. No matter how sensitive and sophisticated its guiding apparatus, the space vehicle will go astray (Friedman 1968, pp. 14–15).



Diagnosing the Economy 87

The correct monetary rule, argued Friedman, would specify “a steady rate of growth in a monetary total.” That would be “something like a 3 to 5 per cent per year rate of growth in currency plus all commercial bank deposits [M1] or a slightly lower rate of growth in currency plus demand deposits only” (Friedman 1968, p. 16). The average annual growth of M1 over the period 1980 to 2017 was , 5.9%. For the same period, Y = 2.6% and V = -0.8%. Solving for P

 = 5.9% − 0.8% − 2.6% = 2.5%,.(4.17) P

If 2.6% is the new normal growth rate of real GDP and if 2.5% is the targeted inflation rate, then we can conclude that, going forward, the Fed should adopt the “Friedman rule” and set the annual growth of M1 at 5.9%.

CHAPTER 5

The Great Contraction and Its Aftermath From December 2007 to June 2009, the United States went through the “Great Contraction,” so named because of the severity of the financial crisis by which it was precipitated and the severe contraction in GDP and employment that resulted over the period following its onset. In this chapter, we consider the history of the Great Contraction some 11 years since it began. We discuss the current state of the U.S. economy in this context because of the fact that the effects of the Great Contraction and of the policies adopted to ameliorate it continue to influence the ­economy today.

Origins of the Contraction The crisis resulted from the collapse of housing prices and the resulting losses experienced by holders of subprime mortgages. The S&P CaseShiller 20-City Home Price index fell by 34% from its peak in April 2006 to its bottom in January 2012. See Figure 5.1. The delinquency rate on residential mortgages went from 2.08% in the first quarter of 2007 to 11.53% in the first quarter of 2010. By the third quarter of 2017 it had fallen to 3.63%. See Figure 5.2. The rapid rise of the delinquency rate led to the rapid descent toward bankruptcy of financial institutions that held trillions of dollars in mortgage-backed securities. By January 2009, Bank of America had acquired Merrill Lynch and JP Morgan Chase had acquired Bear Sterns. Both Merrill Lynch and Bear Sterns had been driven close to bankruptcy by the mortgage crisis. Lehman Brothers went bankrupt because it couldn’t find a buyer. The Dow-Jones Industrial Average fell by 32% from November 4, 2008 to March 9, 2009.

90 Macroeconomics S&P/Case-Shiller 20-City Composite Home Price Index 220

Index Jan 2000=100

200 180 160 140 120 100

2002

Shaded areas indicate U.S. recessions

2004

2006

2008

2010

2012

2014

2016

myf.red/g/iTBW

Figure 5.1  The case-shiller 20-city composite home price index (2000–2017) Source: S&P Dow Jones Indices and Federal Reserve Bank of St. Louis. Delinquency Rate on Single-Family Residential Mortgages, Booked in Domestic Offices, All Commercial Banks

12.5

Percent

10.0

7.5

5.0

2.5

0.0

2002

Shaded areas indicate U.S. recessions

2004

2006

2008

2010

2012

2014

2016 myf.red/g/iTys

Figure 5.2  The delinquency rate on single-family residential mortgages (2000–2017) Source: The Board of Governors of the Federal Reserve System and Federal Reserve Bank of St. Louis.

The United States sank into a recession. Real GDP fell by 3.9% from the fourth quarter of 2007 to the third quarter of 2009. See Figure 5.3. Real GDP grew by 3.4% per year over the 25-year period from 1982 to 2007 but by only 2.2% per year from 2009 to 2017. See Figure 5.3. This suggests that the present economy has still not fully improved to match the pre-Contraction economy. Employment fell by 6.2% from the last quarter of 2007 to third quarter of 2009. See Figure 5.4. Employment grew at an average annual rate of 1.8% from 1982 to 2007 and of 1.6% from 2009 to 2017.

The Great Contraction and Its Aftermath 91 Real Gross Domestic Product

Billions of chained 2009 dollars

18,000 17,000 16,000 15,000 14,000 13,000 12,000

2002

Shaded areas indicate U.S. recessions

2004

2006

2008

2010

2012

2014

2016

myf.red/g/ihhf

Figure 5.3  Real GDP (2000–2017) Source: U.S. Bureau of Economic Analysis and Federal Reserve Bank of St. Louis.

All Employees: Total Nonfarm Payrolls 150,000

Thousands of persons

140,000 130,000 120,000 110,000 100,000 90,000 80,000

1985

Shaded areas indicate U.S. recessions

1990

1995

2000

2005

2010

2015

myf.red/g/jagf

Figure 5.4  Employment (1980–2017) Source: U.S. Bureau of Labor Statistics and the Federal Reserve Bank of St. Louis.

Intervention by the Federal Reserve The federal government intervened with numerous emergency measures over the course of the Great Contraction. In October 2008, Congress passed and the president signed the Emergency Economic Stabilization Act, which created the Troubled Asset Relief Program (TARP) and authorized the U.S. Treasury to buy up to $700 billion (later reduced to $475 billion) in troubled assets. TARP funds were spent for the ­purpose of ­stabilizing the U.S. auto industry, shoring up credit markets, providing mortgage relief, and rescuing the insurance company American

92 Macroeconomics

International Group from bankruptcy, along with numerous major banks, including Morgan Stanley and Goldman Sachs. Following tradition, the Fed brought down the Federal Funds rate (the rate on overnight loans between banks) from 5.25% in June 2007 to just above 0% in October 2008, where it remained until June 2017. In tandem with these interventions, the Fed undertook a policy of “quantitative easing” through a policy of buying long-term assets and, as part of its strategy, focusing on assets in markets in particular need of rescue. Thus, on November 25, 2008, the Federal Reserve kicked off what became known as “QE1,” under which it announced its intention to purchase $500 billion in mortgaged-back securities and $100 billion in debt held by Fannie May and Freddie Mac, which had suffered huge losses because of the subprime crisis. The Fed then followed with another round of asset purchases in March 2009. After a hiatus of several months, the Fed initiated QE2 with the purchase of $600 billion in U.S. Treasuries. QE3 followed in late 2012 with a promise to buy $40 to $85 billion per month in mortgage-backed securities. On June 19, 2013, the chairman of the Fed announced a plan to scale back these purchases, thus beginning an era of planned or expected “tapering.” Altogether, under quantitative easing, Fed assets rose from $1.211 trillion in September 2008 to $4.453 trillion in September 2017. See Figure 5.5. In September 2017 the Fed announced a policy of gradually selling off its assets. All Federal Reserve Banks: Total Assests 4,800,000 4,400,000

Millions of dollars

4,000,000 3,600,000 3,200,000 2,800,000 2,400,000 2,000,000 1,600,000 1,200,000 800,000 400,000

2004

Shaded areas indicate U.S. recessions

2006

2008

2010

2012

2014

2016

2018

myf.red/g/i5bu

Figure 5.5  Federal reserve assets (December 2002 to January 2018) Source: The Board of Governors of the Federal Reserve System and Federal Reserve Bank of St. Louis.

The Great Contraction and Its Aftermath 93

What does recent experience with monetary policy teach us? John Taylor lays blame for the crisis that took place beginning in 2007 on the Fed for pushing interest rates too low. But if monetary growth, rather than interest rates, is the correct predictor of output and inflation, then the onset of the crisis cannot be blamed on low interest rates. Monetary growth over the period 2003 to 2005 was slightly lower than it was over the entire length of the Great Moderation. Robert Hetzel of the Federal Reserve Bank of Richmond recognizes this fact. “Leaving aside the housing sector, a review of macroeconomic variables reveals no evidence that monetary policy was expansive during the recovery from the 2000–2001 recession” (Hetzel 2012, p. 190). What effect did the Fed have? The received view is that the downturn was exceptionally steep and the recovery exceptionally slow despite the lengths that the Fed went to conduct an expansionist monetary policy. If expansionist means setting the Federal Funds rate close to zero and accumulating trillions of dollars in assets, then, indeed, the policy was expansionist. But by another measure, monetary policy was contractive. It is worth quoting Hetzel at length on this possibility: Policy makers misdiagnosed the cause of the recession. The fact that lending declined despite massive government intervention into credit markets indicated that the decline in bank lending arose not as a cause but as a response to the recession, which produced both a decline in the demand for loans and an increase in the riskiness of lending. In their efforts to stimulate the economy, policy makers would have been better served by concentrating on maintaining significant growth in money as an instrument for maintaining growth in the dollar expenditure of the public rather than on reviving financial intermediation (Hetzel 2012, p. 298).

The ARRA As an additional rescue effort, Congress passed the American Recovery and Reinvestment Act (ARRA) in February 2009. When the act was under consideration, congressional researchers estimated that it would cause budget deficits to rise by $787 billion over the period FY 2009–19.

94 Macroeconomics

In a report of February 12, 2012, the Congressional Budget Office (CBO) revised the estimate to $831 billion. “More than 90 percent of ARRA’s budgetary impact was realized by the end of December 2011” (Congressional Budget Office 2012a). By the end of the first quarter of 2013, the impact had reached $787 billion. Figure 5.6 shows the amount spent (in billions of dollars at annual rates) by calendar quarter from the first quarter of 2009 to the first quarter of 2013. The percentage changes in spending for the major programs were as follows: • Government investment expenditures: 5.4% • Capital transfers (including grants for infrastructure and green energy projects): 10.0% • Subsidies (includes subsidies for section 8 housing and for use of renewable energy): 2.3% • Grants-in-aid to state and local government (includes grants for Medicaid and education): 29.8% • Social benefits (includes SNAP benefits [previously “food stamps”] and extensions of unemployment benefits): 24.7% • Government consumption expenditures: 5.4% • Tax cuts (including a “Make Work Pay” tax credit and ­deductions for on business equipment): 25.7% In a report on the ARRA, the Congressional Budget Office provided high and low estimates of the act’s economic effects on real GDP and 400 350 300

Gov't inv. exp.

250

Capital transfers

200

Subsidies

150

Grants-in-aid

100

Social benefits

50

Gov't con. exp.

0

Tax cuts

20

09 20 .1 09 . 20 2 09 20 .3 09 20 .4 10 20 .1 10 . 20 2 10 20 .3 10 20 .4 11 . 20 1 11 20 .2 11 20 .3 11 . 20 4 12 . 20 1 12 20 .2 12 20 .3 12 . 20 4 13 .1

−50

Figure 5.6  Stimulus expenditures by type ($ billions seasonally adjusted at annual rates) Source: U.S. Bureau of Economic Analysis.

The Great Contraction and Its Aftermath 95

employment. Table 5.1 provides the average of these estimates for the years 2009 to 2013 (Congressional Budget Office 2012a). The CBO reports that it used various economic models and historical data to guide its estimate of the way in which output and employment are affected by increases in outlays and reductions in revenues under ARRA. CBO’s assessment is that different elements of ARRA (such as ­particular types of tax cuts, transfer payments, and government purchases) have had different effects on economic output per dollar of higher spending or lower tax receipts. Multiplying estimates of those per-dollar effects by the dollar amounts of each element of ARRA yields an estimate of the law’s total impact on output (Congressional Budget Office 2012a, p. 4). The estimates of “per-dollar effects” are Keynesian multipliers, which CBO determined to run from a low of 0.2 for “extension of first-time home buyer credit” to 2.5 for “purchases of goods and services by the federal government” (Congressional Budget Office 2012a). John Taylor has argued that the effects of ARRA were negligible. In a statistical analysis of the act, he found that “the temporary stimulus payments had a very small effect on consumption and that this effect is not statistically significantly different from zero.” He found that “the Keynesian multiplier for transfer payments or temporary tax rebates was not significantly different from zero for the kind of stimulus programs enacted in the 2000s” (Taylor, Undated). Table 5.1  CBO estimates of the economic effects of the ARRA Year

Increase in real GDP(%)

Increase in number of workers (millions)

2009

1.10

0.55

2010

2.40

2.0

2011

1.35

1.50

2012

0.45

0.65

2013

0.25

0.30

Source: Congressional Budget Office.

96 Macroeconomics

Taylor reflects upon the fact that government purchases amounted to a small share of ARRA spending (and a negligible share of GDP), compared to grants and aid to state and local government. While the CBO reports that these grants increased GDP by $.40 to $2.20 for every dollar spent, Taylor concludes that the grants principally had the effect of encouraging the state and local governments receiving them to increase saving. Thus, “the ARRA had no effect on the sum of purchases and other expenditures” (Taylor, Undated, p. 15). In a subsequent article, Taylor reported that there was a sharp increase in rebate payments in 2008. The rebates brought about an equally sharp increase in disposable income but had no effect on consumption. He observes that “these results are consistent with the permanent income theory or life-cycle theory of consumption” (Taylor 2009, p. 552). Based on his review of this experience, he could “see no empirical rationale for a revival of discretionary countercyclical fiscal policy” (Taylor 2009, p. 553). Another indication of the ineffectiveness of the expansionary policies adopted by the United States is the increase in the saving rate that took place in tandem with those efforts. One study observes that “in the United States, for example, the increase in household saving since 2007 was generally sharper than after any other postwar recession…and the personal saving rate has remained well above its pre-crisis value for the past five years” (Carroll, Slacalek, and Sommer 2012, p. 4). Matthew D. Shapiro and Joel Slemrod studied the effects of a stimulus measure adopted in 2001, when the federal government sent tax rebate checks of up to $300 for single individuals and up to $600 for households. According to their findings, only 21.8 percent of households reported that the tax rebate would lead them to mostly increase spending. There was no evidence that the spending rate was higher for low-income households. The aggregate data in 2001 show a spike in the saving rate precisely at the same time the tax rebates were mailed in July, August, and September 2001 (Shapiro and Slemrod 2003, p. 381). In another study Shapiro and Slemrod concluded that “because of the low spending propensity, the rebates in 2008 provided low ‘bang for the

The Great Contraction and Its Aftermath 97

buck’ as economic stimulus” (Shapiro and Slemrod 2009, p. 379). These findings are consistent with Taylor’s findings regarding the ineffectiveness of the ARRA to stimulate spending and the importance of the permanent income hypothesis in explaining the meek results. Figures 5.7 and 5.8 show the surge in saving that began with the onset of the recession. From this evidence, it is possible to argue that the multiplier effects of the stimulus were so small that the government might well have not bothered at all to undertake discretionary countercyclical policies. But it is equally possible to argue that, because those effects were Personal Saving as a Percentage of Disposable Personal Income 12.5

Percent

10.0

7.5

5.0

2.5

0.0

1985

Shaded areas indicate U.S. recessions

1990

1995

2000

2005

2010

2015

myf.red/g/i5cr

Figure 5.7  Personal saving as a percentage of disposable personal income (1980–2017) Source: U.S. Bureau of Economic Analysis and Federal Reserve Bank of St. Louis.

Net Private Saving 1,800 1,600

Billions of dollars

1,400 1,200 1,000 800 600 400 200

2002

Shaded areas indicate U.S. recessions

2004

2006

2008

2010

2012

2014

Figure 5.8  Net private saving (2000–2017) Source: U.S. Bureau of Economic Analysis and Federal Reserve Bank of St. Louis.

2016

myf.red/g/jahO

98 Macroeconomics

so small, the government should have been all the more aggressive in adopting its expansionary efforts.

Decomposing the Employment Effects In order to examine more closely the contrasting analyses offered by the CBO and by John Taylor, it is useful to decompose the decline in employment over the course of the recession into the contribution of the unemployment rate and the labor-force participation rate. The unemployment rate reached its Contraction high of 10.0% in October 2009 and fell to 4.1% in February 2018. See Figure 5.9. It reached 10.8% in November 1982 during the 1981–1982 recession. The unemployment rate plus the rate of marginally attached workers fell from to 17.1% in October 2009 to 8.2% in January 2018. See Figure 5.10. Although the unemployment rate is the headline number, the strength of the recovery lies as much in the willingness of workers to enter the labor force as it does on the fraction of the labor force that is employed. Thus, it is important to see how the labor-force participation rate has fared over the course of the contraction and the subsequent recovery. See Figure 5.11. The labor-force participation rate hit a postwar high of 67.3% in January 2000, after which it went into a steady decline, which accelerated Civilian Unemployment Rate 11 10 9 Percent

8 7 6 5 4 3

1985

Shaded areas indicate U.S. recessions

1990

1995

2000

2005

2010

Figure 5.9  Unemployment rate (2000–2017) Source: U.S. Bureau of Labor Statistics and Federal Reserve Bank of St. Louis.

2015

myf.red/g/i5gw

The Great Contraction and Its Aftermath 99 Total unemployed, plus all marginally attached workers plus total employed part time for economic reasons

17.5

Percent

15.0

12.5

10.0

7.5

5.0

1996

1998

Shaded areas indicate U.S. recessions

2000

2002

2004

2006

2008

2010

2012

2014

2016

2018

myf.red/g/i8SW

Figure 5.10  Unemployment rate + Rate of marginally attached workers (January 1994 to January 2018) Source: U.S. Bureau of Labor Statistics and Federal Reserve Bank of St. Louis. Civilian Labor Force Participation Rate 68 67 66

Percent

65 64 63 62 61 60 59

1975

1980

Shaded areas indicate U.S. recessions

1985

1990

1995

2000

2005

2010

2015 myf.red/g/hlfV

Figure 5.11  Labor force participation rate (1970–2017) Source: U.S. Bureau of Labor Statistics and Federal Reserve Bank of St. Louis.

during the period 2007 to 2009. It fell to its postwar low of 62.3% in September 2015, more than six years after the recession ended. See Figure 5.11. From equation (4.8) of the previous chapter, we can write

L = LFPR × (1 − UR ). (5.1) POP16

The ratio of the number of persons employed to the civilian population 16 or older, L/POP16, combines the unemployment rate and the labor-force participation rate into a single measure. See Figure 5.12.

100 Macroeconomics Civilian Employment to Population Ratio 65 64 63

Percent

62 61 60 59 58 57

1985

Shaded areas indicate U.S. recessions

1990

1995

2000

2005

2010

2015 myf.red/g/jaiU

Figure 5.12  Civilian employment to population ratio (1980–2017) Source: U.S. Bureau of Labor Statistics, Federal Reserve Bank of St. Louis.

The employment-population rate reached its postwar high of 64.7% in April 2000 and then began to fall. It fell precipitously from 62.7% in December 2007 to 58.3% in December 2010, and rose to 60.1% in December 2017. One factor contributing to the decline in the labor-force participation rate is the retirement of baby boomers, who are now leaving the labor force at, so it is claimed, a rate of 10,000 per day (Metcalf 2017). In order to abstract from this phenomenon, we can chart the ratio of employment to the number of working-age residents. We do that in Figure 5.13, which reports the number of workers as a fraction of the population aged 15 to 64. In that graph, we see that the worker–population ratio reached a high of 74.27% in February 2000 and then started to fall. The rate was 71.55% at the start of the recession in December 2007 and 67.82% at the end in June 2009. It was recorded at 70.29% in December 2017, still below the December 2007 number. From Figures 5.12 and 5.13, it appears that the Great Contraction simply accelerated a decline in the supply of labor relative to population that set in in 2000. Although the numbers have improved since December 2007, they are still far below the levels reached in 2000. One might wonder if this is a sign of the secular stagnation discussed in Volume I. Another is the slowdown in the growth of real GDP. Real GDP grew at an average annual rate of 3.5% from 1948 to 2005. It grew at an average annual rate of 1.5% from 2005 to 2017. See Figure 5.14.

The Great Contraction and Its Aftermath 101 Employment Rate: Aged 15-64: All Persons for the United States

75 74 73

Percent

72 71 70 69 68 67 66 65

1995

1990

1985

Shaded areas indicate U.S. recessions

2000

2005

2010

2015

myf.red/g/janM

Figure 5.13  Employment rate: aged 15–64 (1980–2017) Source: Organization for Economic Co-operation and Development, Employment Rate: Aged 15–64: All Persons for the United States [LREM64TTUSM156S], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/LREM64TTUSM156S, March 21, 2018.

Real Gross Domestic Product 18,000 Billions of chained 2009 dollars

16,000 14,000 12,000 10,000 8,000 6,000 4,000 2,000 0

1950

1960

1970

1980

1990

2000

Shaded areas indicate U.S. recessions

2010 myf.red/g/i1vl

Figure 5.14  Real GDP (1948–2017) Source: U.S. Bureau of Economic Analysis and Federal Reserve Bank of St. Louis.

The Congressional Budget office predicts that potential real GDP will grow at an average annual rate of 1.7% from 2005 to 2027. See Figure 5.15. The actual average annual growth of real GDP from 2005 to 2017 was 1.5%, close to the predicted rate for potential real GDP. Figure 5.16 charts potential real GDP for two scenarios: the CBO’s “slow growth” scenario and another scenario that assumes the growth rate was normal for the economy for the period 1948 to 2005. Should potential

102 Macroeconomics Real Potential Gross Domestic Product Real Gross Domestic Product

17,600 Billions of chained 2009 dollars

17,200 16,800 16,400 16,000 15,600 15,200 14,800 14,400 14,000

2006

2008

2010

Shaded areas indicate U.S. recessions

2012

2014

2016 myf.red/g/i6m9

Figure 5.15  Actual and potential real GDP (2005–2027; in billions of dollars) Source: The Congressional Budget Office, Federal Reserve Bank of St. Louis and U.S. Bureau of Economic Analysis.

2005-01-01 2006-02-01 2007-03-01 2008-04-01 2009-05-01 2010-06-01 2011-07-01 2012-08-01 2013-09-01 2014-10-01 2015-11-01 2016-12-01 2018-01-01 2019-02-01 2020-03-01 2021-04-01 2022-05-01 2023-06-01 2024-07-01 2025-08-01 2026-09-01 2027-10-01

35,000 30,000 25,000 20,000 15,000 10,000 5,000 -

Potential GDP, Slow Growth

Potential GDP, Normal Growth

Figure 5.16  Potential real GDP: Slow and normal growth $ billions Source: The Congressional Budget Office, Federal Reserve Bank of St. Louis and U.S. Bureau of Economic Analysis and author’s calculation.

real GDP expand at the normal rate (3.5%), it would be $10 trillion higher in 2027 than it would be if it grew at the slow, CBO rate. In the foregoing, we considered the CBO’s assessment of the ARRA and John Taylor’s critique of that assessment. While there can be no doubting the depth of the recession, there is strong evidence that the recovery was exceptionally tepid. The question is whether this fact is rooted in the nature of the downturn or in choice of a bad policy mix by government. The argument that the fault lies in the nature of the downturn has well-known defenders. Carmen Reinhart and Kenneth Rogoff famously



The Great Contraction and Its Aftermath 103

Percent change from start of recovery

Compare Recoveries

Compare Recessions

1948

12 10

Recovery from 1981 recession

8

1953

Recovery from 2001 recession

1957 1960 1969 1973

6

1980

Recovery from 2007–2009 recession

4

1981 1990

2

2001 2007*

0 0

1

2 3 4 5 6

7 8

9 10 11 12 13 14 15 16 17 18 19 20

Recovery

Quarters from start of recovery 1948

1953

1957

1960

1969

1973

1980

1981

*Start of the recovery for the 2007 recession is june 2009 (the second quarter). Source: Federal reserve bank of minneap...

1990

2001

2007

Updated february 28 2014

Figure 5.17  Change in U.S. output: Recoveries

Percent change from start of recovery

Compare Recoveries

Compare Recessions

1948

6

1953

5 Recovery from 1981 recession

4

1957

Recovery from 2007 recession

1960 1969

3

1973

2

1980

1

1981 Recovery from 2001 recession

0

1990 2001

−1

2007*

−2 0

3

6 9 12 15 18 21 24 27 30 33 36 39 42 45 48 51 54 57 60

Recovery

Months from start of recovery 1948

1953

1957

1960

1969

1973

1980

1981

1990

*Start of the recovery for the 2007 recession is june 2009 Source: Federal reserve bank of minneap...

2001

2007

Updated march 7 2014

Figure 5.18  Change in U.S. employment: Recoveries

argue that “banking crises tend to be protracted affairs.” Their take on the evidence is that severe postwar financial crises “have had a deep and lasting effect on asset prices, output, and employment” (Reinhart and Rogoff

104 Macroeconomics

2009, pp. 238, 289). This finding has led to claims that the U.S. economy is recovering comparatively well from the 2007–2009 recession, considering that it resulted from a financial crisis. See, for example, Rampell and Dewan (2014). However, Michael Bordo and Joseph Haubrich draw a distinction between (1) the length and depth of recessions caused by financial crises and (2) the speed with which countries recover from those crises (Bordo and Haubrich 2012). There is agreement that recessions caused by financial crises are longer and deeper than other recessions. But, as Bordo writes in an opinion editorial published in the Wall Street Journal, data going back to the 1880s show that recoveries from financial crises have exhibited average growth rates of 8.0% while recoveries from other recessions have exhibited average growth rates of 6.9% (Bordo 2012). Economists at the Federal Reserve Bank of Minneapolis examined the 11 recessions that took place in the United States since World War II and found that the recovery from the 2007–2009 recession was weak—in some instances, exceptionally weak—compared to the other 10. The recovery, as measured by the percentage change in real GDP, is weaker than for the other 10 recoveries. The recovery, as measured by percentage change in employment, has been weaker than it was for nine of the other 10 recoveries (the recession of 2001 being the exception) (Federal Reserve Bank of Minneapolis 2014). Figures 5.17 and 5.18 contrast the recoveries from the 1981, 2001, and 2007–2009 recessions. The question then is whether the Great Contraction was so unique that it justifies pessimism about future growth or whether the policies adopted in fighting it were simply misplaced. If the policy regimen was, in fact, inappropriate or inadequate for the task faced by Congress and the Fed, then the basis for pessimism about future growth seems to disappear, unless the same wrongheaded policies continue to be employed.

CHAPTER 6

Lessons from Recent Macroeconomic Policy Making A core argument of this book is that there are both long-run and shortrun causes of low-employment equilibrium. The long-run causes are distortions in the price system that reduce aggregate supply. The shortrun causes are price and wage rigidities that bring about distortions in aggregate demand and aggregate supply, sometimes leading to a need for corrective stabilization policies by government. In this chapter, we will see how the long-run causes can frustrate the short-run stabilization policies. Traditionally, in macroeconomic policy analysis (and as evidenced by opinion editorials by Alan Blinder, much quoted in the previous chapters), macroeconomists see the distinction between the long run and the short run as a distinction between supply and demand: In the long run, the problem is inadequate supply. In the short run, the problem is inadequate demand and therefore excess supply. This is in accord with the received view of prolonged economic contractions, which proposes that the task of the government is to engineer just the right increase in aggregate demand while avoiding “too much” inflation. Yet, if we look back to the Barro and Grossman book of 1976 and other writings, we see that the short-run problem could just as well reflect the existence of excess demand as it could excess supply (Barro and Grossman 1976). Barro and Grossman give full shrift to the argument that a decrease in aggregate demand can lead to a Keynesian-type contraction, if prices and nominal wages don’t adjust downward in tandem with the fall in aggregate demand. Their unorthodox point was that the economy could just as well contract because of an increase in aggregate demand combined with a failure of prices and wages to rise in tandem.

106 Macroeconomics

Barro and Grossman imply that that when the economy contracts, it is necessary to determine whether the contraction is a matter of excess supply or excess demand in order to determine what kind of monetary and fiscal policy—expansive or contractive—is called for. It further implies that, just as government should run deficits and an expansive monetary policy to address the problem of short-run excess supply, it should run surpluses and a contractive monetary policy to address the problem of short-run excess demand. These considerations are largely ignored despite the fact that the suppressed inflation scenario is exactly parallel to the Keynesian scenario. The problem of short-run macroeconomic stabilization is in part the problem of teasing out the cause of the contraction before figuring out just how to intervene. The problem is even more complicated than that. Suppose that the initial cause of a contraction is a fall in aggregate demand but that the government overshoots in its efforts to expand aggregate demand. We can imagine a sequence of expansive monetary and fiscal measures that at some point go too far—pushing up prices but also pushing down the supply of labor because of lagging nominal wages, with the result that the economy shifts into a state of excess demand and suppressed inflation. Likewise, if the cause of the contraction is an increase in aggregate demand, government can overshoot in its efforts to increase aggregate supply, pushing down prices but also pushing down the demand for labor because of lagging nominal wage cuts, with the result that the economy shifts into a state of excess supply and Keynesian unemployment. The preceding chapter raised one further issue: Suppose that the government attempts to alleviate a downturn by adopting counter measures and that, by doing so, worsens the downturn it is trying to alleviate. How do policymakers take into account the effects of distortions in the price system on their ability to alleviate a downturn through macroeconomic stabilization policies?

Pulling It All Together Chapter 3 in this volume shows that a temporary mismatch between aggregate supply and demand might correct itself without the need for



Lessons from Recent Macroeconomic Policy Making 107

government intervention. The underlying wage rigidities can arise from an inclination on the part of employers or workers to interpret a rise or fall in aggregate demand as one that affects only their particular businesses or jobs rather than the broader economy. Rigidities can arise also from business and labor practices that limit wage and price flexibility. These practices include reluctance on the part of firms to change menu prices in the face of fluctuations in demand, up or down. Long-term labor contracts limit the ability of workers and firms to adjust wages to current realities. Both management and labor appear to favor layoffs over wage cuts in responding to decreases in demand. Government-induced distortions in the price system provide another source of wage and price rigidity. Minimum wage laws reduce the demand for labor and, as a result, reduce long-run aggregate supply. But they have an additional effect: If there is a decrease in aggregate demand, the same laws impede the downward wage adjustments needed to avoid a short-run excess-supply scenario. So do any number of laws that have similar effects, among them prevailing wage laws for construction workers and “equalpay-for-equal work” laws intended to protect minorities and women. The traditional explanation for the emergence of an excess demand scenario is wartime wage and price controls. But there can be other causes. Safety-net laws of the kind documented by Casey Mulligan and taxes on labor income slow the rise in net wages needed to avoid an excess-demand scenario in the face of a rise in aggregate demand relative to supply. Whatever the cause, times of economic contraction often bring about political pressure for more generous safety-net benefits and increases in the minimum wage. Because contractions are generally seen as Keynesian in nature, such measures are considered helpful because they “put money in people’s pockets” and thus spur consumption. Missing from this logic is an understanding of the obstacles the same measures pose for economic correction. One purpose of an expansive monetary and fiscal policy is to correct for excess supply by simultaneously expanding consumer demand and raising prices. Raising prices relative to wages makes labor cheaper, and increases the demand for labor. Raising the minimum wage makes this more difficult. While raising the minimum wage makes it more difficult for government to get firms to create more jobs, raising the safety-net replacement

108 Macroeconomics

Table 6.1  Policy options Problem Corrective Measure

Excess supply

Excess demand

Expansive government policy

Contractive Government Policy

Restraint in raising the replacement rate, tax rates, and the minimum wage

rate makes it harder for firms to find people who want to take the new jobs that the government’s expansionist policies are intended to create. Thus, it is counterproductive to raise either the replacement rate or the minimum wage during a contraction. In the long run, it is equally counterproductive to raise the minimum wage, the replacement rate, and tax rates as doing so reduces long-run aggregate supply. In the event that a contraction is manifested by an excess demand for labor, raising the replacement rate simply causes a further shrinkage in labor supply and a further widening of the gap between aggregate supply and demand. If the government raises the minimum wage in an excess-supply scenario, it will reduce the downward flexibility of wages needed to avoid a spiraling decline in employment. Thus government can confound its efforts to reverse a short-run contraction by yielding to political pressure to impede the flexibility of prices and wages, whatever the nature and cause of that contraction. As mentioned, politicians usually want to increase the replacement rate and the minimum wage when dealing with a contraction. A country that does not increase the replacement rate or the minimum wage is therefore suppressing a politically driven impulse to undermine its intended goal of economic correction, whatever stabilization policy it might have undertaken to achieve that goal. It is exercising restraint of a kind that will help facilitate the correction. Table 6.1 provides a taxonomy of policy responses based on the foregoing points.

What Does It Add Up To? We noted earlier that positive replacement rates reduce long-run supply of labor and minimum wage laws reduce the long-run demand for labor.



Lessons from Recent Macroeconomic Policy Making 109

The United States appears to have expanded government spending too slowly and in a fashion that brought about little improvement in GDP growth during the Great Contraction. One article sums it all up in the title: “The Net Fiscal Expenditure Stimulus in the U.S., 2008–9: Less than What You Might Think, and Less than the Fiscal Stimuli of Most OECD Countries.” The article argues that “the aggregate fiscal expenditure stimulus in the United States, properly adjusted for the declining fiscal expenditure of the 50 states, was close to zero in 2009” (Aizenman and Pasricha 2011, p. 1). This mirrors the finding of John Taylor noted in Chapter 5 (Taylor, Undated). At the same time that the United States was conducting an anemic effort to engage in fiscal expansion, it registered increases in the replacement rate and the minimum wage. These developments substantially neutralized whatever expansive effects the increased spending and other policy efforts were exerting. It is fair to say that, if expansive monetary and fiscal policies were called for during the contraction, then government spending, as defined here, represents only a narrow component of the full range of policy options utilized by countries experiencing a growth slowdown. It is beyond the scope of this book to attempt a full accounting of the comparative effectiveness of the policy options actually utilized. Yet, it is possible to conclude that monetary policy in the United States did not contribute to the aimed-for expansive efforts by government. This possibility has been emphasized repeatedly by economist William A. Barnett. According to Barnett, the Fed has suffered from two problems over recent decades: (1) its adoption of interest rate targets, instead of money supply targets and (2) the techniques it has used for measuring the money supply—techniques that are too narrow and that have caused the Fed unwittingly to alternate between overly contractive and overly expansive money-supply policies, especially since the early 1980s (Barnett 2012). Steven H. Hanke echoes Barnett’s argument. He sums up his argument in another article with a suggestive title: “It’s the money supply, stupid.” Hanke argues that the Fed’s money supply measurement technique is misleading because it fails to recognize the distinction between “private money” (which is produced outside of the Fed and which consists of assets of varying liquidity such as Treasury bills and commercial paper)

110 Macroeconomics

and “public money” (which is also called “Fed money” and which consists of bank reserves and currency). The problem is that, while the Fed is focused on interest rate targets and on public money, private money, which is much more important in magnitude than public money, has behaved in a way contrary to the Fed’s stated goals. According to Hanke, this led to perverse policies during the contraction: It is clear that while Fed-produced money has exploded, privately-produced money has imploded. The net result is a level of broad money that is way below where it would have been if broad money would have followed a trend rate of growth. The post-crisis monetary policy mix has brought about a massive opening of the public money-supply spigots, and a significant tightening of those in the private sector. Since the private portion of the broad money supply in the U.S. is now five and a half times larger than the public portion, the result has been a decrease in the money supply since the Lehman Brothers collapse. So, when it comes to money in the U.S., policy has been, on balance, contractionary—not expansionary. This is bad news, since monetary policy dominates fiscal policy. The problem was not confined to the United States. “The picture for the Eurozone, absent Germany, looks very similar to that of the U.S.,” says Hanke (Hanke 2012).

Short Circuits and the Philosophy of Macroeconomic Causation In an article published in 1965, philosopher J. L. McKie asked what condition we would expect an event to satisfy if we were to think of that event as causing a result. His answer was that, if the event can be deemed to be “an insufficient but necessary part of a condition which is itself unnecessary but sufficient for the result,” then, he said, “it is often a condition… that we have in mind” as the cause of some result. Thus, he coined the “INUS” condition for causality. As an example, McKie considered the possibility that investigators would determine that a short circuit was the cause of a house fire. What



Lessons from Recent Macroeconomic Policy Making 111

is obvious is that a short circuit, in and of itself, would be insufficient to cause a fire. The investigators are not saying that the short-circuit was a sufficient condition for this house’s catching fire; for if the short-circuit had occurred, but there had been no inflammable material nearby, the fire would not have broken out, and even given both the short-circuit and the inflammable material, the fire would not have occurred if, say, there had been an efficient automatic sprinkler at just the right spot. Far from being a condition both necessary and sufficient for the fire, the short-circuit was, and is known to the experts to have been, neither necessary nor sufficient for it. “In what sense, then,” asked McKie is it said to have caused the fire? The answer is that, although the short circuit was insufficient to cause the fire, it was nevertheless necessary as part of a general set of circumstances (presence of inflammable material, absence of a sprinkler) that were, in their entirety, sufficient for the result. But these circumstances were also unnecessary: A fire could be caused by an entirely different combination of circumstances (e.g., “lightning striking a barn where straw is stored”) (McKie 1965, pp. 245, 250). In an article titled, “Econometrics as Observation,” economist Kevin Hoover cites the INUS condition as relevant to the discussion of the effectiveness of “policy interventions.” A proposed cause of some macroeconomic result should satisfy the INUS condition if it is to be legitimately designated a cause of that result (Hoover 2008, pp. 298–99). It is just that if any one proposed cause does satisfy the INUS condition, there might well be other causes that would satisfy that condition. As pointed out, it seems safe to say that an increase of government spending of at least 2.50% per year was part of an INUS condition for recovery. It was not a sufficient condition. It had to be accompanied by restraint in raising the replacement rate and the minimum wage. Nor was

112 Macroeconomics

it, even if accompanied by such restraint, necessary: A genuinely expansive monetary regimen might have worked just as well or better. And then there is an entirely different interpretation of what caused the U.S. recovery to be so poor: Perhaps the dramatic increase in the replacement rate so shrank the supply of labor that it brought about a state of excess demand for which an expansive monetary and fiscal policy was exactly the wrong prescription. At the conclusion of Chapter 4, we considered a scenario in which a fall in the normal growth of real GDP would require either a contraction in the growth of the money supply or a proportionate rise in prices and wages in order to restore equilibrium. Failing one or the other, the decrease in the growth of real GDP could be all the more pronounced. This too presents itself as another INUS explanation for the behavior of the U.S. economy over recent years. The broad lesson is that, given an economic contraction, governments have a choice between numerous competing policy options, all of which must be weighed in terms of their combined effect on the economy. As a policy line, macroeconomic stabilization of any sort must be conducted with a view toward how government policies affecting market incentives will either reinforce or undermine the stabilization efforts under way. The performance of the economy at the macro level depends on the ability of the decentralized price system to coordinate billions of decisions concerning the allocation of time between work and leisure and of current income between consumption and saving. Government policies as they affect these decisions should be calibrated to be as welfare-enhancing as possible, recognizing that such policies, though well intended, can be the opposite of what is called for—this because of the possibility of misdiagnosis of some underlying problem. There are some principles of macroeconomic policy making that are well grounded in both theory and evidence. One is that government policies (notably, tax policies) that narrow the wedge between before-tax and after-tax wage rates and between the before-tax and after-tax return to saving are welfare-enhancing. Policies that narrow that wedge reduce the cost of labor and capital and thereby induce firms to hire more of both. They likewise induce workers to work more and savers to save more and thus, on that account as well, expand work and the availability of financial capital.



Lessons from Recent Macroeconomic Policy Making 113

There is, in the debate over taxes, the question of just how effective tax-rate reductions are for expanding work and saving (and therefore investment). If the income effects of cutting tax rates are strong, then the result might be only a small increase in work and saving. Paradoxically, the income effect of a cut in tax rates will be smaller the more useful the government program that must be sacrificed because of the loss in tax revenue. Proposals to untax net investment and to recoup the lost revenue by raising taxes on labor income offer a promising approach to tax reform for the very reason that they minimize revenue losses and therefore the income effects that would diminish the expansive effects of untaxing net investment. In times of protracted low employment, government faces the unenviable task of coming up with the correct diagnosis of what caused the problem. If the cause is excess supply, then the correct response is monetary and fiscal expansion. If it is excess demand, the correct response is monetary and fiscal contraction. When there is excess supply, there is a need to increase demand. That argues for government as Santa Claus (lower tax burdens and more spending all around!). But when there is excess demand, there is a need to increase supply. That argues for government as Scrooge (higher tax burdens and less spending all around—no Christmas holiday for you, Cratchet!). We began Volume I of this book by citing an opinion editorial by Alan Blinder as an example of how badly economists have been missing this point. The short-run, low-employment problem does not call automatically for government policies aimed at expanding aggregate demand. Rather, it calls for a diagnosis aimed at determining whether government should increase aggregate demand relative to aggregate supply or to increase aggregate supply relative to aggregate demand. “Supply-side” policies can be as germane in the short run as in the long run. The recent U.S. recession provides an object lesson in the importance of these distinctions. The safety-net expansion considered by Casey Mulligan shrank the supply of labor, causing the long-run aggregate supply curve for aggregate output to move to the left and perhaps also reduced economic growth to a new, lower “normal.” Even had there been no recession, output and employment would have gone down as a

114 Macroeconomics

result of this policy. But there was a recession, and from the evidence, the safety-­net expansion further shrank the supply of labor. This became a determining factor in causing the recession to be as deep as it was and the recovery to be as slow as it has been. We have seen that an increase in the saving rate will increase output per capita. But it will not put output per capita on a growth path. For output per capita to grow steadily, there must be steady growth in the Z mentioned in Volume I, Chapter 6. And this Z stands for, not just technology, but for all the factors—the quality of the country’s legal system, confidence in government and in government policies, a strong system of property rights—that businesses need in order to invest their capital. That need calls for a renewed emphasis on economic growth as a policy goal and on the kind of policies that are likely to bring it about. A renewed emphasis on economic growth will not eliminate economic contractions. Stabilization policies will continue to be an important part of the government’s policy arsenal. What we have learned from the preceding chapters is that it is no easy matter to identify the correct stabilization policy to apply. The correct policy may be either expansive or contractive, depending on how the wages and prices have failed to adjust in tandem with each other. And what would otherwise be the correct stabilization policy might fail if undermined by government policies that limit wage–price flexibility. The standard argument is that macroeconomic policy requires policymakers to walk a fine line between full employment and price stability. The goal, according to this argument, is to orchestrate just the right expansion in monetary and fiscal policy, to the end of nudging the economy back to full employment without threatening inflation. We have found that the problem is more complicated than that. For one thing, we have seen how a contraction could occur because prices and wages are not rising as they should in order to restore balance between aggregate supply and demand. We saw in Chapters 3 and 4 that a Keynesian slump manifests itself directly in an increase in the unemployment rate and that a suppressed-­ inflation slump manifests itself in a decrease in the labor-force participation rate. This illustrates the problem of diagnosing a slump and identifying the appropriate policy response.



Lessons from Recent Macroeconomic Policy Making 115

All we can hope to do is to group different strands of policy into different categories of causes—INUS causes—without any sure way to determine which category of causes best fits the facts. In macroeconomics, it’s not a choice between a short circuit or a lightning strike in determining the cause of a fire. More than likely, there will be a short circuit as well as a lightning strike to consider in sorting things out. So it is not just that policymakers have to walk a fine line. It is also that the line is blurred and constantly shifting. The only policy line that seems to be as clear in the short run as in the long run is the one that minimizes distortions in the price system created by taxes, welfare benefits, minimum wage laws, and the like. Sustained real GDP growth requires price and wage flexibility of the kind that will permit the economy to avoid long-lasting, deep contractions of the kind just experienced. Absent such contractions, the task of achieving price stability is reduced to one of bringing about the correct rate of monetary growth. When a contraction occurs, the task becomes one of choosing between policy options that include contractive monetary and fiscal policy. And whatever option is called for, its successful implementation requires attention to price and wage rigidities introduced by government that can undermine the effectiveness of any stabilization policy in moving the economy back to full employment. The task of macroeconomic stabilization, to use one last metaphor, is akin to that faced by the sailor passing through a narrow channel who has to tack just enough in either direction in order to avoid the dangers on both sides. That great sailor Odysseus tied himself to the mast in order to resist the call of the sirens, who would have lured him and his crew to their demise. What policymakers who put a high value on economic growth must do is avoid the siren call of redistributionist measures that make their task of tacking between the rocks more difficult.

References Aizenman, J., and G. Pasricha. June 1, 2011. The Net Fiscal Expenditure Stimulus in the U.S., 2008–9: Less than What You Might Think, and Less than the Fiscal Stimuli of Most OECD Countries, 2011 ed. Ball, L., and N.G. Mankiw. 2002. “The NAIRU in Theory and Practice.” Journal of Economic Perspectives 16, no. 4, pp. 115–36. Barnett, W.A. 2012. Getting It Wrong: How Faulty Monetary Statistics Undermine the Fed, the Financial System, and the Economy. MIT Press. Barro, R.J., and H.I. Grossman. 1974. “Suppressed Inflation and the Supply Multiplier.” The Review of Economic Studies 41, no. 1, pp. 87–104. Barro, R.J., and H.I. Grossman. 1976. Money, Employment and Inflation. Cambridge Books. Blinder, A.S. December 27, 2017. “Almost Everything is Wrong with the New Tax Law.” Wall Street Journal. Bordo, M. September 27, 2012. “Financial Recessions Don’t Lead to Weak Recoveries.” Wall Street Journal. Bordo, M.D., and J.G. Haubrich. June 2012. “Deep Recessions, Fast Recoveries, and Financial Crises: Evidence from the American Record.” Working Paper 12–14. Carroll, C., J. Slacalek, and M. Sommer. 2012. “Dissecting Saving Dynamics: Measuring Wealth, Precautionary, and Credit Effects.” IMF Working Papers, (WP/12/219). Washington, DC. Charlesworth, H.K. 1956. The Economics of Repressed Inflation. London: Routledge. Congressional Budget Office. 2012a. Estimated Impact of the American Recovery and Reinvestment Act on Employment and Economic Output from October 2011 Through December 2011. Washington DC: Congressional Budget Office. Federal Reserve Bank of Minneapolis. 2014. “The Recession and the Recovery in Perspective.” Retrieved from https://minneapolisfed.org/publications_ papers/studies/recession_perspective/ Friedman, M. 1968. “The Role of Monetary Policy.” American Economic Review, LVIII. Hanke, S. 2012. “It’s the Money Supply, Stupid.” Retrieved from http:// realclearmarkets.com/blog/It%27s The Money Supply%2C Stupid%2C July 2012%5B1%5D.pdf Heijdra, B.J., and F.V.D. Ploeg. 2002. Foundations of Modern Macroeconomics. Oxford: Oxford University Press.

118 References

Hetzel, R.L. 2012. The Great Recession: Market Failure or Policy Failure? Cambridge, UK: Cambridge University Press. Hoover, K.D. 2008. “Econometrics as Observation: The Lucas Critique and the Nature of Econometric Inference.” In The Philosophy of Economics: An Anthology, ed. D.M. Hausman, 3rd ed. Cambridge: Cambridge University Press. McKie, J.L. 1965. “Causes and Conditions.” American Philosophical Quarterly 2, no. 4, pp. 245–64. Metcalf, M. 2017. “Boomers Are Retiring Rapidly: Are Successors Prepared?” Forbes. Retrieved from https://forbes.com/sites/forbescoachescouncil/2017/ 06/28/boomers-are-retiring-rapidly-are-successors-prepared/ - 316132344472 Rampell, C., and S. Dewan. 2014. “Study Suggests Recovery in U.S. Is Relatively Vita.” Retrieved from http://cnbc.com/id/101312687 Reinhart, C.M., and K.S. Rogoff. 2009. This Time is Different. Princeton: Princeton University Press. Shapiro, M.D., and J. Slemrod. 2003. “Consumer Response to Tax Rebates.” American Economic Review 93, no. 1, pp. 381–96. Shapiro, M.D., and J. Slemrod. 2009. “Did the 2008 Tax Rebates Stimulate Spending?” American Economic Review 99, no. 2, pp. 374–79. Taylor, J.B. 2009. “The Lack of an Empirical Rationale for a Revival of Discretionary Fiscal Policy.” American Economic Review Papers & Proceedings 99, no. 2, pp. 550–55. Taylor, J.B. 2013. First Principles: Five Keys to Restoring America’s Prosperity. W.W. Norton & Company. Taylor, J.B. Undated. An Empirical Analysis of the Revival of Fiscal Activism in the 2000s. Discussion Paper, (10-031). Stanford University.

About the Author David G. Tuerck is professor of economics at Suffolk University in ­Boston and president of the Beacon Hill Institute for Public Policy Research. He has held a variety of academic, consulting, and research positions. His fields of study are public finance and macroeconomics. He  has published several books and articles, made dozens of television and radio a­ ppearances, published numerous opinion editorials and testified, on three occasions, before the U.S. Congress, as well before several state legislatures.

Index aggregate demand, 41–43 in classical model, 43–47 employer myopia, 51–55 Keynesian model, 55–64 suppressed inflation case, 64–70 worker myopia, 48–51 aggregate supply, 41–43 in classical model, 43–47 employer myopia, 51–55 Keynesian model, 55–64 suppressed inflation case, 64–70 worker myopia, 48–51 American Recovery and Reinvestment Act (ARRA), 93–98 average cash holdings, 5, 6 Barnett, William A., 109 Barro, R. J., 53n1, 105–106 Blinder, Alan, 20, 58, 105 Bordo, Michael, 104 budgetary baseline, 35–39 budget constraint, 21 Cambridge equation, 59 classical model, 43–47 Congressional Budget Office (CBO), 35–38, 94–96 consumption and saving, taxes on, 20–24 contraction, 89–91 cost of capital, 7–8, 34 demand for money, 1–3 demand multiplier, 60 economy diagnosis, 73–77 GDP growth, 80–84 labor force participation rate curve, 78–79 monetary policy, 84–87

Phillips curve, 77–78 elasticity, 19 The Emergency Economic Stabilization Act, 91–92 employer myopia, 51–55 employment effects, 98–104 excess demand, 35, 42, 43, 65, 66, 70–71, 105–108, 112–113 excess supply, 35, 42, 43, 58, 65, 71, 105–108, 113 federal government intervention, 91–93 Federal Reserve System, 1, 3 Fed-mandated interest rate, 85–86 fiscal policy, 17–18, 35 budgetary baseline, 35–39 change in taxes, 30–31 consumption and saving, taxes on, 20–24 government purchases, 24–30 income effects of, 18–20 tax rates, 31–34 full employment, 76–77 GDP growth, 80–84 government purchases, 22–30 “Great Contraction” American Recovery and Reinvestment Act, 93–98 employment effects, 98–104 federal government intervention, 91–93 origins, 89–91 Greenspan, Alan, 85 Grossman, H . I., 53n1, 105–106 Hanke, Steven H., 109–110 Haubrich, Joseph, 104 Hetzel, Robert, 93

122 Index

income effects, 18–20, 22, 32–34, 66, 113 intertemporal elasticity of substitution, 19 INUS condition, 110–112, 115 Keynesian model, 19–20, 41–43, 55–64 labor force participation rate (LFPR), 78, 79 long-run labor force participation rate curve (LRPRC), 78 long run Phillips curve (LRPC), 77 Mac, Freddie, 92 McKie, J. L., 110–111 macroeconomic policy analysis, 105–106 causation, 110–115 contraction, 106–108 and fiscal policies, 108–110 maladjustments employer myopia, 51–55 Keynesian model, 55–64 worker myopia, 48–51 marginal product, 41 marginal propensity to consume (MPC), 60 marginal propensity to produce (MPP), 67 marginal rate of substitution, 41 May, Fannie, 92 monetary policy, 1–12, 84–87 implications of tax policy, 13–15 money supply, 6, 8 Mulligan, Casey, 107, 113 natural interest rate, 85–86 natural unemployment rate, 76 nominal interest rate, 2–5 non-accelerating inflation rate of labor-force participation (NAPR), 76, 78, 80 non-accelerating inflation rate of unemployment (NAIRU), 76, 77, 80, 117

opportunity cost, 1, 2 permanent income hypothesis, 97 Phillips curve, 77–78, 86 potential GDP, 41, 102 protracted maladjustments Keynesian model, 55–64 suppressed inflation case, 64–70 “quantity theory” equation, 44 real GDP growth, 80–84 Reinhart, Carmen, 102–103 replacement rate, 107–109, 111–112 repressed inflation, 52–53 Rogoff, Kenneth, 102–103 secular stagnation, 80, 100 self-correcting maladjustments, 48–55 Shapiro, Matthew D., 96–97 short-lived phenomenon, 47, 48–50, 53 Slemrod, Joel, 96–97 Social Security trust fund, 38 structural unemployment, 41 substitution effect, 18, 24, 32–34 supply multiplier, 68 supply side economics, 83, 113 “suppressed inflation,” 81 suppressed inflation case, 64–70 taxes change in, 30–31 on consumption and saving, 20–24 tax policy, implications of, 13–15 tax rates, 31–34 Taylor, John, 93, 95, 98, 109 “Taylor rule,” 84–86 Troubled Asset Relief Program (TARP), 91–92 unemployment rate, 79 wage laws, 107 Wall Street Journal (Bordo), 104 worker myopia, 48–51

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