ECN202: Macroeconomics

1960s: End of the Business Cycle?

recessions "are now generally considered fundamentally preventable, like airplane crashes and

hurricanes."

Zenith of Keynesian EconomicsAfter WW II and the Korean War macroeconomics once again was THE issue in a presidential election in 1960. A sitting Vice President was defeated by a relative unknown CATHOLIC promising to get the economy moving. To do that he turned to the rising number of academic scribblers working on turning Keynesian anti-depression economics into anti-recession economics. It was a period of significant developments in macroeconomic theory, and we look at those in this nit. We begin with a more detailed look at consumption and investment spending since Keynesians focused on managing AD, and then we look at the issues of timing and forecasting that were central to effective macro policy. The unit closes with a discussion of the Phillips Curve that symbolized the tradeoff between inflation and unemployment that policy makers must now confront. We open our work with some warnings from Eisenhower as he left office and some headlines from the 1960s.

Eisenhower opens 1960s with a warning

1. “America’s leadership and prestige depend not merely upon our unmatched material progress, riches and military strength, but on how we use our power in the interests of world peace and human betterment.”

2. “In meeting them, whether domestic or foreign, great or small, there is a recurring temptation to feel that some spectacular and costly action could be come the miraculous solution to all current difficulties.”

3. “As we peer into the future, we – you and I, and our government – must avoid the impulse to live for today, plundering, for our own ease and convenience, the precious resources of tomorrow.”

4. Balance “between public and private economy”

In the news: Growth is goodIn the news: Growth is good

1. “Democratic and Republican platform writers have committed their parties, and the nation, presumably, to the goal of more rapid economic growth.” 1960

2. “Kennedy Terms Action to Spur Economic Growth the Major Election Issue” 1962

3. “Economic Growth No Cure-All for Jobless” 1965

4. “The United States apparently moved last year into first place among the leading industrial nations in its rate of economic growth after being near the bottom” 1966”

5. “RECESSION VIEWED AS A 'POSSIBILITY'; Economy Has Not Declined Despite Dip by Indicators, Arthur Burns Declares” 1967

In the news: Unemployment gets noticedIn the news: Unemployment gets noticed

6. “Prof. Paul Samuelson's letter published Nov. 12 illustrates the growing tendency of economists close to the Administration to minimize the unemployment problem.” 1961

7. “ECONOMY ABSORBS TEEN-AGER INFLUX; Unemployment Rate in June Lowest Since Fall of '57” 1965

8. “U.S. Will Change Definitions of Unemployment” 1966

9. “Whether or not a 4 per cent or even higher rate of unemployment is "acceptable," as Secretary David Kennedy would have it, remains to be seen.” 1969

In the news: So does inflationIn the news: So does inflation

10. “PROGRESS NOTED IN INFLATION WAR; Top Economic Aides Doubt Serious Price Rises” 1960

11. “'LITTLE INFLATION' CALLED NO THREAT; Administration Unperturbed at 1-1 % a Year Rise in Consumer Price Index” 1962

12. “Labor Costs Blamed for Inflation” 1965

13. “G.O.P. Dramatizes Inflation as Key Issue; High Cost of Living to Be Stressed in Drive for Votes” 1966

14. “Inflation; It's Mainly Psychological, but Oh How It Hurts!” 1969

In the news: The end of Nirvana?In the news: The end of Nirvana?15. “Advocates of Slower Development Are Gaining

Ground in Latin Nations” 1965

16. “Jobs and Inflation; Truce Is Developing in Debate on When Falling Unemployment Raises Prices” 1966

17. Predictably the rise in unemployment to 4 per cent -- a consequence of efforts to check inflation by fiscal and monetary restraints -- has produced a political outburst” 1969

18. “U.S. JOBLESS RATE ADVANCES TO 4%, HIGHEST SINCE '67; Administration Aides Greet Rise as Sign of Restraint on Boom Spurring Inflation” 1969

19. “Economy; How to Cool It Without the Chill of Recession” 1969

In the news: Trade becomes an issue In the news: Trade becomes an issue 20.“KENNEDY ROUND OF TARIFF TALKS WILL OPEN

TODAY” 196421.“Pastore Urges Efforts by U.S. To Aid Textile-Trade

Balance” 196522.“Nixon Asks For Lower Tariffs” 196923.“Stans Suggests Tax Plan To Help Balance of Trade”

196924.“Morgan Trust Hints Huge Loss For U.S. Payments in

Quarter; BIG LOSS HINTED IN U.S. PAYMENTS” 1969

25.“FOREIGN TEXTILES FOUGHT BY STANS; Secretary, in Italy, Presses for Curbs on Exports” 1969

The Macro Problem: Get the economy moving

The unemployment rate has been trending upward since the end of the Korean War

A call to action

"get the country moving again."

1960 Presidential Election

An incredibly close election

1964 Presidential ElectionWhat happens when you nominate a fringe candidate - and what happened in the South to have them shift from solid Democrat to solid Republican?

The Solution: again

Keynes’ theory

If it could cure a depressionimagine what is could do for

a recession

The solution: in theory

recessions "are now generally considered fundamentally preventable, like airplane crashes and hurricanes.” Arthur Okun, president Johnson's economic advisor

Aggregate Demand “Rules”

Aggregate demand is central to Keynes’ view, so let’s look at it. First we look at consumption spending (C) that is important because it is HUGE and because it is stable and may be managed. In this period newer theories of consumption surfaced including the permanent income and life cycle theories that altered how we looked at C. What we spend on has also changed since the mid 1970s with the declining importance of nondurables. Investment spending is important because it has a supply-side effect – if we invest in more factories and machines our workers become more productive and this increases our productive capacity. This make investment a favorite target of discretionary fiscal policy.

• BIG• STABLE• MANAGEABLE (relationship to disposable income)• Theories (MPC?)

– Keynes – Permanent income hypothesis (wealth)– Life-cycle model

Consumption

You can see where more of our money is going – and how durable spending is the most volatile

Personal saving rate: US

What happened to the savings rate after 1980 and was that a good thing, and what happened to the rate since the mid 2000s?And how do we get Americans to save more?

The savings glut. Controversy guaranteed. Council of Foreign Relations

Saving

Investment

What is so different about China from the US – and why do American policy officials what could be done to decrease the savings of the Chinese people?

How do we change savings behavior?

You have all had microeconomics so this should be an easy question. If we try to alter behavior we need to look at why people do what they do and then try to alter the incentives to alter their behavior. In the US the problem is that there are very low incentives to save – either people do not have to save or it is very easy to access funs, while in China there is a need to save or it is difficult to access funds. Here are a few possible options for altering the savings patterns.

How do we get Americans to spend less?

Make it easier to save1. Financial deregulation2. National savings plan (SS example)

Make it more rewarding to save1. Tax policies

1. Sales / consumption tax rate2. Interest income tax rate

How do we get the Chinese to spend more?

Make saving less attractive1. Expand public pension system2. Expand public health care system3. Unionization4. Urbanization (rural to urban)5. Industrialization (agriculture to manufacturing)

Make it easier to spend1. Expansion of credit

Wealth Effect

One of the implications of the expanded theory of consumption spending was the acknowledgement of a wealth effect. Consumption spending ( C ) depends on wealth as well as income, and there is a marginal propensity to spend wealth (MPC). [MPC = DC / D W] Research has shown the following estimates of their values.

–MPC for wealth in homes = .09–MPC for wealth in stocks = .04

Based on this try this: what would be the impact on C of a $5 trillion decline in housing values in the Great Recession?

A BIG hit in housing values

-$5T*.09 = -$450 billion = decline in C

A lost decade = or two?A BIG hit in stock market values in Japan

A huge hit in real estate values in Japan

• SMALL / UNSTABLE• SUPPLY-SIDE EFFECT• MANAGEABLE?• LEADING INDICATOR

Investment

The Challenge of fine tuning an economyThe Challenge of fine tuning an economyIn the next few graphs you will see the problem of fine tuning in a world without instantaneous change and the potential solutions. The goal is to flatten out those recessions and the problem is that because of lags the impact may not be felt until after the problem disappeared so it may actually worsen the cycle. One “solution” is to build in automatic stabilizers like unemployment benefits so as the economy slides into a recession the unemployment benefits increase and this additional income is spent. The second option is to forecast the problem and use preemptive policies such as a tax cut before a recession happens.

Fine tuning: A timing problem?

GDP We want to avoid the recession that begins in 1975

A

1. Recognition lag

2. Discussion lag

3. Action lag

Too much too late

R D A MonetaryFiscal

One possible solution? Automatic stabilizers = autopilot

GDPAutomatic stabilizer reduces changes in AD1. Income tax2. Unemployment benefits

Income risesTaxes riseSpending rises slower

Income fallsTaxes fallSpending falls slower

Another possible solution? Preemptive Discretionary policies

GDPWe want to avoid the recession that begins in 1975

A1. Recognition lag

2. Discussion lag

3. Action lag

Just right, just in time

Fine-tuning requirement: Forecasting ability

This was a time when we saw an increase interest in forecasting – a perfect storm of sorts – that increased demand for forecasts at the same time as that we had what we needed – computers to analyze the macro numbers now being produced regularly, a theory on how to manage the economy, and liberals in power who believed in managing. Here we look briefly at three techniques. , so here we look at some techniques. Also when you are forecasting be sure that the variables you choose matches the time horizon. All time series can be decomposed into seasonal, cyclical, and trends and the influences on each of these is likely to be different. On the next slide you will see a few of my “favorite” forecasts.

The forecasting track record?

1. “Brain work will cause women to go bald” Berlin professor 1914

2. "Who the hell wants to hear actors talk?" H. M. Warner,1927

3. “The Japanese don’t make anything the people in the US would want.” (Secretary of State John Foster Dulles in 1954 

4. "And for the tourist who really wants to get away from it all, safaris in Vietnam." Newsweek's 1963 prediction of popular holidays for the late 1960s.

5. "Rail travel at high speeds is not possible because passengers, unable to breathe, would die of asphyxia."  Dionysius Lardner, 1828

6. "I think there is a world market for maybe five computers." Thomas Watson, chairman of IBM 1943

7. "1930 will be a splendid year for employment."  Department of Labor in 1929

Forecasting basics: seasonal patterns

• Seasonal(big summer)

• Cyclical• Trend

• Match time-frame with factors

Forecasting basics: Develop a forecast of company sales over the next five years

.

YearSales (units)

1995 90731996 92871997 98531998 100941999 105002000 113212001 12216

--- ---2007 150572008 159512009 18120201020112012201320142015

Time-series analysis

“The ruler”

S = a + b S-1

Sales today depend upon sales last year

Oil price forecast – look to past sales for guide to future

error

ActualEstimated

Econometric analysis

“The relationship”

S = a + b*P

S = -3299 + .546*P

Sales depend upon price so with price forecast we have oil demand forecast

error

Oil price forecast – look to past for relationships

error

Barometric analysis

“The experts”

Leading indicators

If you are forecasting, how do you predict turning points?

You want something that turns before your variable so when it turns you know what is coming.

Turning points

Lead time

Lead time

RI Index of Leading Indicators

1. Manufacturing employment

2. Retail & wholesale employment

3. Index of Providence Help-Wanted Ads

4. Passenger traffic at Green

5. Newport Bridge Tokens

6. Single-family housing permits

7. RI Industrial kilowatt hours

8. National average for weekly unemployment claims

9. National vendor delivery performance

An example of a leading indicator

Derek Thompson, “The Art of Bubbles: How Sotheby's Predicts the World Economy,” Atlantic Monthly, Apr 5, 2011

Sotheby’s stock rises in booms but seems to fall before other indicators of macro decline

Another problem!!Inflation “arrives” in the late 1960s

The inflation-unemployment tradeoff

By the late 1960s inflation was a problem facing Keynesians who began to look into the work of an economist, William Phillips, who a decade earlier had identified a negative relationship between inflation and wage growth: wages tended to rise faster when the unemployment rate was lower because workers had more bargaining power. If wages grew faster than prices would rise faster, so we got the Phillips Curve. This became seen as a possibility line of sorts where policies could move us along the Phillips Curve, so you should be able to see where Republicans and Democrats would differ in terms of their goals. If you used expansionary fiscal policy you would increase AD and this would increase GDP (lower unemployment) and increase prices. This was not great, so liberals looked to policies to shift the curve inward.

Phillips’ Evidence

Where would Republicans want to move the economy and where would Democrats want to go – A or B?

• A

• B

Republicans care about inflation so they choose B, while Democrats care about unemployment so they would choose A

AS-AD & Phillips Curve?

AS-AD Phillips CurvePricelevel

GDP

AD1

ASInflationrate

Unemploymentrate

*

Initialsituation

Increase AD

*New situation

AD2

Policy choices:Move curve – or move on curve?

i

u

i

u

AA

B

Job trainingJob information

B

Expansionary policyMonetaryFiscal

Same inflation – lower u Less U and more inflation

Summary of 1960s policy activism

Keynesian economics: anti recession version

• Economic Theory– John Maynard Keynes

• Key concept– Multiplier

• Y/G = 1/(1-MPC)

• “New” AS –AD model– Upward sloping AS

• Implications– Inflation-unemployment trade

off– Temporary policies have

limited value

P

Q