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Figure 12.7 plots three variables that can be used to describe Fed behavior. The interest rate is the 3-month Treasury bill rate, which moves closely with the interest rate that the Fed actually controls, which is the federal funds rate. For simplicity, we will take the 3-month Treasury bill rate to be the rate that the Fed controls and we will just call it “the interest rate.” Inflation is the percentage change in the GDP deflator over the previous four quarters. This variable is also plotted in Figure 5.6 on p. 128. Output is the percentage deviation of real GDP from its trend. (Real GDP itself is plotted in Figure 5.4 on p. 127.) It is easier to see fluctuations in real GDP by looking at percentage deviations from its trend. Recall from Chapter 5 that we have called five periods since 1970 “recessionary periods” and two periods “high inflation periods.” These periods are highlighted in Figure 12.7. The recessionary and high inflation periods have considerable overlap in the last half of the 1970s and early 1980s. After 1981, there are no more high inflation periods and three more recessionary periods. There is thus some stagflation in the early part of the period but not in the later part. We know from earlier in this chapter that stagflation is bad news for policy makers. No matter what the Fed does, it will result in a worsening of either output or inflation. Should the Fed raise the interest rate to lessen inflation at a cost of making the output situation (and therefore unemployment) worse, or should it lower the interest rate to help output growth (which will lower unemployment) at a cost of making inflation worse? What did the Fed actually do? You can see from Figure 12.7 that the Fed generally raised the interest rate when inflation was high— even when output was low and unemployment was high. So, the Fed seems to have worried more in this period about inflation than unemployment. The interest rate was very high in the 1979–1983 period even though output was low. Had the Fed not had such high interest rates in this period, the recession would likely have been less severe, but inflation would have been even worse. Paul Volcker, Fed chair at that time, was both hailed as an inflation-fighting hero and pilloried for what was labeled the “Volcker recession.” After inflation got back down to about 4 percent in 1983, the Fed began lowering the interest rate, which helped to increase output
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. The Fed increased the interest rate in 1988 as inflation began to pick up a little and output was strong. The Fed acted aggressively in lowering the interest rate during the 1990–1991 recession and again in the 2001 recession. The Treasury bill rate got below 1 percent in 2003. The Fed then reversed course, and the interest rate rose to nearly 5 percent in 2006. The Fed then reversed course again near the end of 2007 and began lowering the interest rate in an effort to fight a recession that it expected was coming. The recession did come, and the Fed lowered the interest rate to near zero beginning in 2008 IV. The interest rate remained at essentially zero until the end of 2015 when the Fed began raising it gradually. The period between 2008 IV and 2015 IV is the period of the zero interest rate bound discussed M12_CASE3826_13_GE_C12.indd 268 17/04/19 12:27 AM High inflation period Recessionary period Recessionary period Recessionary period Recessionary period CHAPTER 12 Policy Effects and Cost Shocks in the AS/AD Model 269 14 10 22 26 Interest rate Inflation Output 210 1970 I 1975 I 1980 I 1985 I 1990 I 1995 I 2000 I 2005 I 2010 I 2015 I 2017 IV MyLab Economics Real-time data Quarters ▴◂FIGURE 12.7 Output, Inflation, and the Interest Rate 1970 I–2017 IV The Fed generally had high interest rates in the two inflationary periods and low interest rates from the mid1980s on. It aggressively lowered interest rates in the 1990 III–1991 I, 2001 I–2001 III, and 2008 I–2009 II recessions. Between 2008 and 2015 there was a zero lower bound. Output is the percentage deviation of real GDP from its trend. Inflation is the four-quarter average of the percentage change in the GDP deflator. The interest rate is the 3-month Treasury bill rate. previously in this chapter. This period was a “binding situation” period. There was some controversy when the Fed began raising the interest rate at the end of 2015. Output was still considerably below its trend, as can be seen in the figure, and inflation had not picked up much. Some felt that the Fed should have waited until it saw more signs of increased inflation. Fed behavior in the period since 1970 is thus fairly easy to summarize. The Fed generally had high interest rates in the 1970s and early 1980s as it fought inflation. Since 1983, inflation has been low by historical standards, and the
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Fed focused between 1983 and 2008 on trying to smooth fluctuations in output. Between 2008 and 2015 there was a zero lower bound as the Fed focused on trying to increase output. Inflation Targeting MyLab Economics Concept Check Some monetary authorities in the world engage in what is called inflation targeting. If a monetary authority behaves this way, it announces a target value of the inflation rate, usually for a horizon of a year or more, and then it chooses its interest rate values with the aim of keeping the actual inflation rate within some specified band around the target value. For example, the target value might be 2 percent with a band of 1 to 3 percent. Then the monetary authority would try to keep the actual inflation rate between 1 and 3 percent. With a horizon of a year or more, the monetary authority would not expect to keep the inflation rate between 1 and 3 percent each month because there are a number of temporary factors that move the inflation rate around each month (such as weather) over which the monetary authority has no control. But over a year or more, the expectation would be that the inflation rate would be between 1 and 3 percent. India, which had continuing struggles with inflation in recent years, has set an inflation target of 6 percent for 2015–2016, falling to 4 percent by 2017–2018. inflation targeting When a monetary authority chooses its interest rate values with the aim of keeping the inflation rate within some specified band over some specified horizon. M12_CASE3826_13_GE_C12.indd 269 17/04/19 12:27 AM 270 PART III The Core of Macroeconomic Theory There has been much debate about whether inflation targeting is a good idea. It can lower fluctuations in inflation, but possibly at a cost of larger fluctuations in output. When Ben Bernanke was appointed chair of the Fed in 2006, some wondered whether the Fed would move in the direction of inflation targeting. Bernanke had argued in the past in favor of it. There is, however, no evidence that the Fed did this during Bernanke’s tenure as the Fed chair. You can see in Figure 12.7 that the Fed began lowering the interest rate in 2007 in anticipation of a recession, which doesn’t look like inflation targeting. Looking Ahead We have so far said little about employment, unemployment, and the functioning of the labor market in the macroeconomy except to note the central role of sticky wages in the construction of the AS curve. The next chapter will link everything we have done so far to this third
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major market arena—the labor market—and to the problem of unemployment. S U M M A R Y 12.1 FISCAL POLICY EFFECTS p. 261 12.3 SHOCKS TO THE SYSTEM p. 265 1. Increases in government spending (G) and decreases in net taxes (T) shift the AD curve to the right and increase output and the price level. How much each increases depends on where the economy is on the AS curve before the change. 2. If the AS curve is vertical in the long run, then changes in G and T have no effect on output in the long run. 12.2 MONETARY POLICY EFFECTS p. 263 3. Monetary policy is determined by the Fed rule, which in- cludes output, the price level, and the factors in Z. Changes in Z shift the AD curve. 4. The AD curve is flatter the more the Fed weights price stabil- ity relative to output stability. 5. A binding situation is a state of the economy in which the Fed rule calls for a negative interest rate. In this case the best the Fed can do is have a zero interest rate. 6. The AD curve is vertical in a binding situation. 7. Positive cost shocks shift the AS curve to the left, creating cost-push inflation. 8. Positive demand-side shocks shift the AD curve to the right, creating demand-pull inflation. 12.4 MONETARY POLICY SINCE 1970 p. 268 9. The Fed generally had high interest rates in the 1970s and early 1980s as it fought inflation. Since 1983, inflation has been low by historical standards, and the Fed focused between 1983 and 2008 on trying to smooth fluctuations in output. Between 2008 and 2016 there was a zero interest rate bound. 10. Inflation targeting is the case where the monetary authority weights only inflation. It chooses its interest rate value with the aim of keeping the inflation rate within some specified band over some specified horizon binding situation, p. 264 cost-push, or supply-side inflation, p. 267 demand-pull inflation, p. 267 inflation targeting, p. 269 stagflation, p. 265 zero interest rate bound, p. 264 P R O B L E M S All problems are available on MyLab Economics. 12.1 FISCAL POLICY EFFECTS LEARNING OBJECTIVE: Use the AS/AD model to analyze the shortrun and long-run effects of fiscal policy.
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1.1 In February 2010, the Greek government adopted several austerity packages as part of its bailout by the International Monetary Fund. Since then, it has had to reduce tax evasion, impose limits on thirteenth and fourteenth month salaries, increase value-added tax (VAT), and cut pensions. Explain how such measures could precipitate a recession. If you had the power, would you have accepted the austerity measures? MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with. M12_CASE3826_13_GE_C12.indd 270 17/04/19 12:27 AM CHAPTER 12 Policy Effects and Cost Shocks in the AS/AD Model 271 1.2 By using aggregate supply and aggregate demand curves to illustrate your points, discuss the impacts of the following events on the price level and on equilibrium GDP (Y) in the short run: a. A tax cut holding government purchases constant with the economy operating well below full capacity b. An increase in consumer confidence and business optimism with the economy operating at near full capacity 12.2 MONETARY POLICY EFFECTS LEARNING OBJECTIVE: Use the AS/AD model to analyze the shortrun and long-run effects of monetary policy. 2.1 For each of the following scenarios, tell a story and predict the effects on the equilibrium level of aggregate output (Y) and the interest rate (r): a. Faced with a likely recession, country A’s government and central bank decide to act jointly by increasing government expenditure on infrastructure and launching a new bond acquisition program. b. Country B’s government decides to reduce its debt-to- GDP ratio by implementing austerity policies consisting of public spending cuts and tax increases. To alleviate the impact of fiscal policy on output and employment, the central bank increases money supply. c. In country C, growing concerns about the stability of the banking sector lead the central bank to significantly increase the reserve requirement rate. d. Consumer confidence is rapidly increasing in country D, signaling the end of an ongoing recession. The central bank keeps the money supply constant. e. Sluggish demand at home prompts the government in country E to increase public expenditure while the central bank proceeds to sell government securities in an attempt to reduce money supply. 2.2 Paranoia, the largest country in central Antarctica, receives word of an imminent pengu
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in attack. The news causes expectations about the future to be shaken. As a consequence, there is a sharp decline in investment spending plans. a. Explain in detail the effects of such an event on the economy of Paranoia, assuming no response on the part of the central bank or the Treasury (Ms, T, and G all remain constant.) Make sure you discuss the adjustments in the goods market and the money market. b. To counter the fall in investment, the King of Paranoia calls for a proposal to increase government spending. To finance the program, the Chancellor of the Exchequer has proposed three alternative options: (1) Finance the expenditures with an equal increase in taxes (2) Keep tax revenues constant and borrow the money from the public by issuing new government bonds (3) Keep taxes constant and finance expenditures by printing new money Consider the three financing options and rank them from most expansionary to least expansionary. Explain your ranking. 2.3 By late summer 2010, the target federal funds rate was between zero and 0.25 percent. At the same time, “animal spirits” were dormant and there was excess capacity in most industries. That is, businesses were in no mood to build new a plant and equipment because many were not using their already existing capital. Interest rates were at or near zero, and yet investment demand remained quite low. The unemployment rate was 9.6 percent in August 2010. These conditions suggest that monetary policy is likely to be a more effective tool to promote expansion than fiscal policy. Do you agree or disagree? Explain your answer. 2.4 Describe what will happen to the interest rate and ag- gregate output with the implementation of the following policy mixes: a. Expansionary fiscal policy and expansionary monetary policy b. Expansionary fiscal policy and contractionary monetary policy c. Contractionary fiscal policy and expansionary monetary policy d. Contractionary fiscal policy and contractionary monetary policy 2.5 Contractionary policies are designed to slow the economy and reduce inflation by decreasing aggregate demand and aggregate output. Explain why contractionary fiscal policy and contractionary monetary policy have opposite effects on the interest rate despite having the same goal of decreasing aggregate demand and aggregate output. Illustrate your answer with graphs of the money market. 2.6 Explain the effect, if any, that each of the following occurrences should have on the aggregate demand curve. a. The government decreases income tax to encourage consumer spending. b. The central bank reduces the reserve requirement rate. c. A movement
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along the AD curve in an economy causes the price level to decrease. d. Business confidence improves and investment spending increases. e. Production costs are positively affected by a worldwide drop in oil prices. f. The central bank announces a surprise sale of bonds. 2.7 In Japan during the first half of 2000, the Bank of Japan kept interest rates at a near zero level in an attempt to stimulate demand. In addition, the government passed a substantial increase in government expenditure and cut taxes. Slowly, Japanese GDP began to grow with absolutely no sign of an increase in the price level. Illustrate the position of the Japanese economy with aggregate supply and aggregate demand curves. Where on the short-run AS curve was Japan in 2000? 2.8 By using aggregate supply and aggregate demand curves to illustrate your points, discuss the impacts of the following events on the price level and on equilibrium GDP (Y) in the short run: a. An increase in the money supply with the economy operating at near full capacity b. A decrease in taxes and an increase in government spending supported by a cooperative Fed acting to keep output from rising MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with. M12_CASE3826_13_GE_C12.indd 271 17/04/19 12:27 AM 272 PART III The Core of Macroeconomic Theory 2.9 In country A, all wage contracts are indexed to inflation. That is, each month wages are adjusted to reflect increases in the cost of living as reflected in changes in the price level. In country B, there are no cost-of-living adjustments to wages, but the workforce is completely unionized. Unions negotiate three-year contracts. In which country is an expansionary monetary policy likely to have a larger effect on aggregate output? Explain your answer using aggregate supply and aggregate demand curves. 12.3 SHOCKS TO THE SYSTEM LEARNING OBJECTIVE: Explain how economic shocks affect the AS/AD model. 3.1 In mid-2014, the price of oil dropped significantly and reached its lowest in January 2016, when a barrel of Brent oil cost only $28. How would you expect it to impact the aggregate price level and GDP of your country? Illustrate your answer with aggregate demand and supply curves. Would the central bank need to adopt correctional polices? State your recommendation and explain your rationale. 3.
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2 From the following graph, identify the initial equilibrium, the short-run equilibrium, and the long-run equilibrium based on the scenarios below. Explain your answers and identify what happened to the price level and aggregate output. Scenario 1. The economy is initially in long-run equilibrium at point A, and a cost shock causes cost-push inflation. The government reacts by implementing an expansionary fiscal policy. Scenario 2. The economy is initially in long-run equilibrium at point A, and an increase in government purchases causes demand-pull inflation. In the long run, wages respond to the inflation. Scenario 3. The economy is initially in long-run equilibrium at point C, and the federal government implements an increase in corporate taxes and personal income taxes. In the long run, firms and workers adjust to the new price level and costs adjust accordingly. AS (Long run) AS1 (Short run) AS2 (Short run) D C A B AD1 AD2 Y0 Y1 Aggregate output (income), Y Y2 P2 P1 P0 0 Scenario 4. The economy is initially in long-run equilibrium at point C, and energy prices decrease significantly. The government reacts by implementing a contractionary fiscal policy. 3.3 Evaluate the following statement: In the short run, if an economy experiences inflation of 10 percent, the cause of the inflation is unimportant. Whatever the cause, the only important issue the government needs to be concerned with is the 10 percent increase in the price level. 3.4 [Related to the Economics in Practice on p. 266] Use aggregate supply and aggregate demand curves to illustrate the effect the mild monsoon season had on the rice crop in India. Explain what affect this had on the levels of aggregate output and inflation in India. 12.4 MONETARY POLICY SINCE 1970 LEARNING OBJECTIVE: Discuss monetary policy since 1970. 4.1 In 2008, the United Kingdom slipped into a recession. For the next few years, the Bank of England and the British government used monetary and fiscal policies in an attempt to stimulate the economy. Visit www. bankofengland.co.uk and obtain data on interest rates. Do you see evidence of the Bank of England’s action? Also visit www.ukpublicspending.co.uk and obtain data on the total governmental expenditures. Can you tell when various policies were implemented? Use the data to find evidence on whether they were successful in pulling the U.K.
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economy out of recession QUESTION 1 In 2017, the government passed a series of large tax cuts when the economy was at or near full employment. That is, the economy was producing a value of Real GDP close to or equal to Potential GDP. What is the likely consequence of this fiscal policy? QUESTION 2 Since 2014, a number of economies have experienced negative interest rates. This was not even considered possible by most economists before the 2008/2009 Great Recession, but negative rates have appeared in a number of European countries in the past few years. What does this mean for individuals and households that save? MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with. M12_CASE3826_13_GE_C12.indd 272 17/04/19 12:27 AM The Labor Market in the Macroeconomy 13 CHAPTER OUTLINE AND LEARNI NG OBJECTIV ES 13.1 The Labor Market: Basic Concepts p. 274 Define fundamental concepts of the labor market. 13.2 The Classical View of the Labor Market p. 274 Explain the classical view of the labor market. 13.3 Explaining the Existence of Unemployment p. 276 Discuss four reasons for the existence of unemployment. 13.4 Explaining the Existence of Cyclical Unemployment p. 278 Discuss the reasons for the existence of cyclical unemployment. 13.5 The Short- Run Relationship between the Unemployment Rate and Inflation p. 281 Analyze the short-run relationship between unemployment and inflation. 13.6 The Long-Run Aggregate Supply Curve, Potential Output, and the Natural Rate of Unemployment p. 286 Discuss the long-run relationship between unemployment and output. Looking Ahead p. 288 273 In Chapter 7 we described some features of the U.S. labor market and explained how the unemployment rate is measured. In Chapter 11 we considered the labor market briefly in our discussion of the aggregate supply curve. We learned that the labor market is key to understanding how and when government policy can be useful. Sticky wages in the labor market cause the AS curve to be upward sloping and create room for government spending and tax policy to increase aggregate output. If wages are completely flexible and rise every time the price level rises by the same percentage, the AS curve will be vertical and government attempts to stimulate the economy will only lead to price increases. Understanding how wages are set is thus key to macro
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economics. It is also one of the most disputed parts of the field. We begin our discussion with a review of the classical view, which holds that wages always adjust to clear the labor market, that is, to equate the supply of and demand for labor. We then consider what might be wrong with the classical set of assumptions, why the labor market may not always clear, and why unemployment may exist. Finally, we discuss the relationship between inflation and unemployment. As we go through the analysis, it is important to recall why unemployment is one of the three primary concerns of macroeconomics. Go back and reread “The Costs of Unemployment” in Chapter 7 (pp. 155–165). Unemployment imposes heavy costs on society. M13_CASE3826_13_GE_C13.indd 273 17/04/19 4:18 AM 274 PART III The Core of Macroeconomic Theory 13.1 LEARNING OBJECTIVE Define fundamental concepts of the labor market. The Labor Market: Basic Concepts On the first Friday of every month, the Labor Department releases the results of a household survey that provides an estimate of the number of people with a job, the employed (E), as well as the number of people who are looking for work but cannot find a job, the unemployed (U). The labor force (LF) is the number of employed plus unemployed: unemployment rate The ratio of the number of people unemployed to the total number of people in the labor force. The unemployment rate is the number of people unemployed as a percentage of the labor force: LF = E + U unemployment rate = U LF frictional unemployment The portion of unemployment that is due to the normal working of the labor market; used to denote short-run job/skill matching problems. structural unemployment The portion of unemployment that is due to changes in the structure of the economy that result in a significant loss of jobs in certain industries. cyclical unemployment The increase in unemployment that occurs during recessions and depressions. To repeat, to be unemployed, a person must be out of a job and actively looking for work. When a person stops looking for work, he or she is considered out of the labor force and is no longer counted as unemployed. It is important to realize that even if the economy is running at or near full capacity, the unemployment rate will never be zero. The economy is dynamic. Students graduate from schools and training programs; some businesses make profits and grow, whereas others suffer losses and go out of business; people
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move in and out of the labor force and change careers. It takes time for people to find the right job and for employers to match the right worker with the jobs they have. This frictional and structural unemployment is inevitable and in many ways desirable. In this chapter, we are primarily concerned with cyclical unemployment, the increase in unemployment that occurs during recessions and depressions. When the economy contracts, the number of people unemployed and the unemployment rate rise. The United States has experienced several periods of high unemployment. During the Great Depression, the unemployment rate remained high for nearly a decade. In December 1982, more than 12 million people were unemployed, putting the unemployment rate at 10.8 percent. In the recession of 2008– 2009, the unemployment rate rose to more than 10 percent. In one sense, the reason employment falls when the economy experiences a downturn is obvious. When firms cut back on production, they need fewer workers, so people get laid off. Employment tends to fall when aggregate output falls and to rise when aggregate output rises. Nevertheless, a decline in the demand for labor does not necessarily mean that unemployment will rise. If markets work as we described in Chapters 3 and 4, a decline in the demand for labor will initially create an excess supply of labor. As a result, the wage rate should fall until the quantity of labor supplied again equals the quantity of labor demanded, restoring equilibrium in the labor market. Although the equilibrium quantity of labor is lower, at the new wage rate everyone who wants a job will have one. If the quantity of labor demanded and the quantity of labor supplied are brought into equilibrium by rising and falling wage rates, there should be no persistent unemployment above the frictional and structural amount. Labor markets should behave just like output markets described by supply and demand curves. This was the view held by the classical economists who preceded Keynes, and it is still the view of a number of economists. Other economists believe that the labor market is different from other markets and that wage rates adjust only slowly to decreases in the demand for labor. If true, economies can suffer bouts of involuntary unemployment. 13.2 LEARNING OBJECTIVE Explain the classical view of the labor market. The Classical View of the Labor Market The classical view of the labor market is illustrated in Figure 13.1. Classical economists assumed that the wage rate adjusts to equate the quantity demanded with the quantity supplied, thereby implying that unemployment does not exist. If we see people out of work, it just means that they are not interested in working at the going market
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wage for someone with their skills. To see how wage adjustment might take place, we can use the supply and demand curves in Figure 13.1. M13_CASE3826_13_GE_C13.indd 274 17/04/19 4:18 AM CHAPTER 13 The Labor Market in the Macroeconomy 275 labor demand curve A graph that illustrates the amount of labor that firms want to employ at each given wage rate. labor supply curve A graph that illustrates the amount of labor that households want to supply at each given wage rate. Curve D0 is the labor demand curve. Each point on D0 represents the amount of labor firms want to employ at each given wage rate. Each firm’s decision about how much labor to demand is part of its overall profit-maximizing decision. A firm makes a profit by selling output to households. It will hire workers if the value of its output is sufficient to justify the wage that is being paid. Thus, the amount of labor that a firm hires depends on the value of output that workers produce. Figure 13.1 also shows a labor supply curve, labeled S. Each point on the labor supply curve represents the amount of labor households want to supply at each given wage rate. Each household’s decision concerning how much labor to supply is part of the overall consumer choice problem of a household. Each household member looks at the market wage rate, the prices of outputs, and the value of leisure time (including the value of staying at home and working in the yard or raising children) and chooses the amount of labor to supply (if any). A household member not in the labor force has decided that his or her time is more valuable in nonmarket activities. In Figure 13.1 the labor market is initially in equilibrium at W0 and L0. Now consider what classical economists think would happen if there is a decrease in the demand for labor. The demand for labor curve shifts in from D0 to D1. The new demand curve intersects the labor supply curve at L1 and W1. There is a new equilibrium at a lower wage rate, in which fewer people are employed. Note that the fall in the demand for labor has not caused any unemployment. There are fewer people working, but all people interested in working at the wage W1 are in fact employed. The classical economists saw the workings of the labor market—the behavior of labor supply and labor demand—as optimal from the standpoint of both individual households and firms and from the standpoint of
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society. If households want more output than is currently being produced, output demand will increase, output prices will rise, the demand for labor will increase, the wage rate will rise, and more workers will be drawn into the labor force. (Some of those who preferred not to be a part of the labor force at the lower wage rate will be lured into the labor force at the higher wage rate.) At equilibrium, prices and wages reflect a trade-off between the value households place on outputs and the value of time spent in leisure and nonmarket work. At equilibrium, the people who are not working have chosen not to work at that market wage. There is always full employment in this sense. The classical economists believed that the market would achieve the optimal result if left to its own devices, and there is nothing the government can do to make things better. e t a r e g a W W0 W1 ◂◂ FIGURE 13.1 The Classical Labor Market Classical economists believe that the labor market always clears. If the demand for labor shifts from D0 to D1, the equilibrium wage will fall from W0 to W1. Anyone who wants a job at W1 will have one. S D0 D1 0 L1 L0 Units of labor MyLab Economics Concept Check M13_CASE3826_13_GE_C13.indd 275 17/04/19 4:18 AM 276 PART III The Core of Macroeconomic Theory The Classical Labor Market and the Aggregate Supply Curve MyLab Economics Concept Check How does the classical view of the labor market relate to the theory of the vertical AS curve we covered in Chapter 11? The classical idea that wages adjust to clear the labor market is consistent with the view that wages respond quickly to price changes. In the absence of sticky wages, the AS curve will be vertical. In this case, monetary and fiscal policy will have no effect on real output. Indeed, in this view, there is no unemployment problem to be solved! The Unemployment Rate and the Classical View MyLab Economics Concept Check If, as the classical economists assumed, the labor market works well, how can we account for the fact that the unemployment rate at times seems high? There seem to be times when millions of people who want jobs at prevailing wage rates cannot find them. How can we reconcile this situation with the classical assumption about the labor market? Some economists answer by arguing that the unemployment rate is not a good measure of whether the labor market is working well. We know the economy is
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dynamic and at any given time some industries are expanding and some are contracting. Consider, for example, a carpenter who is laid off because of a contraction in the construction industry. She had probably developed specific skills related to the construction industry—skills not necessarily useful for jobs in other industries. If she were earning $40,000 per year as a carpenter, she may be able to earn only $30,000 per year in another industry. Will this carpenter take a job at $30,000? There are at least two reasons she may not. First, she may believe that the slump in the construction industry is temporary and that she will soon get her job back. Second, she may mistakenly believe that she can earn more than $30,000 in another industry and will continue to look for a better job. If our carpenter decides to continue looking for a job paying more than $30,000 per year, she will be considered unemployed because she is actively looking for work. This does not necessarily mean that the labor market is not working properly. The carpenter has chosen not to work for a wage of $30,000 per year, but if her value to any firm outside the construction industry is no more than $30,000 per year, we would not expect her to find a job paying more than $30,000. In this case, a positive unemployment rate as measured by the government does not necessarily indicate that the labor market is working poorly. It just tells us that people are slow to adjust their expectations about what they can earn in the labor market. If the degree to which industries are changing in the economy fluctuates over time, there will be more people like our carpenter at some times than at others. This variation will cause the measured unemployment rate to fluctuate. Some economists argue that the measured unemployment rate may sometimes seem high even though the labor market is working well. The quantity of labor supplied at the current wage is equal to the quantity demanded at the current wage. The fact that there are people willing to work at a wage higher than the current wage does not mean that the labor market is not working. Whenever there is an upward-sloping supply curve in a market (as is usually the case in the labor market), the quantity supplied at a price higher than the equilibrium price is always greater than the quantity supplied at the equilibrium price. Economists who view unemployment this way do not see it as a major problem. Yet the haunting images of the bread lines in the 1930s are still with
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us, and many find it difficult to believe everything was optimal when more than 12 million people were counted as unemployed in 2012. There are other views of unemployment, as we will now see. 13.3 LEARNING OBJECTIVE Discuss four reasons for the existence of unemployment. Explaining the Existence of Unemployment We noted previously and in Chapter 7 that some unemployment is frictional or structural. The rest we categorized as cyclical—unemployment that moves up and down with the business cycle. This categorization is, however, a little too simple. Economists have argued that there may be unemployment that is higher than frictional plus structural and yet does not fluctuate much with the business cycle. We turn to these arguments first before considering cyclical unemployment. M13_CASE3826_13_GE_C13.indd 276 17/04/19 4:18 AM CHAPTER 13 The Labor Market in the Macroeconomy 277 Efficiency Wage Theory MyLab Economics Concept Check One argument for unemployment beyond frictional and structural centers on the efficiency wage theory. According to this theory, raising the wage rate can also increase the productivity of workers in the firm. If this is true, then firms may have an incentive to pay wages above the wage at which the quantity of labor supplied is equal to the quantity of labor demanded. The key argument of the efficiency wage theory is that by offering workers a wage in excess of the market wage, the productivity of those workers is increased. Some economists have likened the payment of this higher wage to a gift exchange: Firms pay a wage in excess of the market wage, and in return, workers work harder or more productively than they otherwise would. From the outside the wage looks higher than the market wage but in fact from the firm’s perspective the higher wage is worth it. Empirical studies of labor markets have identified several potential benefits that firms might receive from paying workers more than the market-clearing wage. Among them are lower turnover, improved morale, and reduced “shirking” of work. Under these circumstances, there will be people who want to work at the wage paid by firms and cannot find employment. Indeed, for the efficiency wage theory to operate, it must be the case that the wage offered by firms is above the market wage. It is the gap between the two that motivates workers who do have jobs to outdo themselves. Imperfect Information MyLab Economics Concept Check Thus far we have been assuming that firms know exactly what wage rates they need
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to set to clear the labor market. They may not choose to set their wages at this level, but at least they know what the market-clearing wage is. In practice, however, firms may not have enough information at their disposal to know what the market-clearing wage is. In this case, firms are said to have imperfect information. If firms have imperfect or incomplete information, they may simply set wages wrong—wages that do not clear the labor market. If a firm sets its wages too high, more workers will want to work for that firm than the firm wants to employ, resulting in some potential workers being turned away. The result is, of course, unemployment. One objection to this explanation is that it accounts for the existence of unemployment only in the very short run. As soon as a firm sees that it has made a mistake, why would it not immediately correct its mistake and adjust its wages to the correct market-clearing level? Why would unemployment persist? If the economy were simple, it should take no more than a few months for firms to correct their mistakes, but the economy is complex. Although firms may be aware of their past mistakes and may try to correct them, new events are happening all the time. Because constant change— including a constantly changing equilibrium wage level—is characteristic of the economy, firms may find it hard to adjust wages to the market-clearing level. The labor market is not like the stock market or the market for wheat, where prices are determined in organized exchanges every day. Instead, thousands of firms are setting wages and millions of workers are responding to these wages. It may take considerable time for the market-clearing wages to be determined after they have been disturbed from an equilibrium position. Minimum Wage Laws MyLab Economics Concept Check Minimum wage laws set a floor for wage rates—a minimum hourly rate for any kind of labor. In 2018, the federal minimum wage was $7.25 per hour, although some states had considerably higher rates. If the market-clearing wage for some groups of workers is below this amount, this group will be unemployed. Out-of-school teenagers, who have relatively little job experience, are most likely to be hurt by minimum wage laws. If some teenagers can produce only $6.90 worth of output per hour, no firm would be willing to hire them at a wage of $7.25. To do so would incur a loss of $0.35 per hour. In an unregulated market, these teenagers would be able to
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find work at the marketclearing wage of $6.90 per hour. If the minimum wage laws prevent the wage from falling below $7.25, these workers will not be able to find jobs and they will be unemployed. Others who may be hurt include people with very low skills and some recent immigrants. efficiency wage theory An explanation for unemployment that holds that the productivity of workers increases with the wage rate. If this is so, firms may have an incentive to pay wages above the market-clearing rate. minimum wage laws Laws that set a floor for wage rates— that is, a minimum hourly rate for any kind of labor. M13_CASE3826_13_GE_C13.indd 277 17/04/19 4:18 AM 278 PART III The Core of Macroeconomic Theory 13.4 LEARNING OBJECTIVE Discuss the reasons for the existence of cyclical unemployment. sticky wages The downward rigidity of wages as an explanation for the existence of unemployment. To the extent that minimum wage legislation prevents wages from falling, causing unemployment, it does not provide a challenge to the classical view, but rather an explanation for what happens when the government prevents that market model from working. In the United States the federal minimum wages has not changed in a number of years and most economists view its effect on unemployment at present to be small. Like the theories of the efficiency wage and imperfect information, the existence of government rules on how low wages can fall tell us little about the causes of cyclical unemployment. We turn to this now. Explaining the Existence of Cyclical Unemployment The classical model of wage setting, even in a world of imperfect information and efficiency wages, does not lead us to predict cyclical unemployment. Explaining cyclical unemployment requires us to look to other theories. Key to these theories is explaining why wages might have trouble adjusting downward when economic activity causes firms to seek fewer workers. If wages are sticky in a downward direction, the frictional and structural unemployment that we see in a normal economy will grow in a downturn, and we will experience cyclical unemployment. Sticky Wages MyLab Economics Concept Check Unemployment (above and beyond normal frictional and structural unemployment) occurs because wages are sticky on the downward side. We described this briefly in our building of the AS curve. This situation is illustrated in Figure 13.2, where the equilibrium wage gets stuck at W0 (the original wage) and does not fall to W* when demand decreases from D0 to D1. The result
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is unemployment of the amount L0 − L1, where L0 is the quantity of labor that households want to supply at wage rate W0 and L1 is the amount of labor that firms want to hire at wage rate W0. L0 − L1 is the number of workers who would like to work at W0 but cannot find jobs. The sticky wage explanation of unemployment, however, begs the question: Why are wages sticky, if they are, and why do wages not fall to clear the labor market during periods of high unemployment? Many answers have been proposed, but as yet no one answer has been agreed on. This lack of consensus is one reason macroeconomics has been in a state of flux for so long. The existence of unemployment continues to be a puzzle. Although we will discuss the major theories that economists have proposed to explain why wages may not clear the labor market, we can offer no conclusions. social, or implicit, contracts Unspoken agreements between workers and firms that firms will not cut wages. relative-wage explanation of unemployment An explanation for sticky wages (and therefore unemployment): If workers are concerned about their wages relative to the wages of other workers in other firms and industries, they may be unwilling to accept a wage cut unless they know that all other workers are receiving similar cuts. Social, or Implicit, Contracts One explanation for downwardly sticky wages is that firms enter into social, or implicit, contracts with workers not to cut wages. It seems that extreme events—deep recession, deregulation, or threat of bankruptcy—are necessary for firms to cut wages. Wage cuts did occur in the Great Depression, in the airline industry following deregulation of the industry in the 1980s, and recently when some U.S. manufacturing firms found themselves in danger of bankruptcy from stiff foreign competition. Even then, wage cuts were typically imposed only on new workers, not existing workers, as in the auto industry in 2008– 2009. Broad-based wage cuts are exceptions to the general rule. For reasons that may be more sociological than economic, cutting wages seems close to being a taboo. In one study, Truman Bewley of Yale University surveyed hundreds of managers about why they did not reduce wage rates in downturns. The most common response was that wage cuts hurt worker morale and thus negatively affect worker productivity. Breaking the taboo and cutting wages may be costly in this sense. Firms seem to prefer laying off existing workers to lowering their wages. A related argument, the relative-wage explanation of unemployment, holds that workers are concerned
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about their wages relative to the wages of other workers in other firms and industries and may be unwilling to accept wage cuts unless they know that other workers are receiving similar cuts. Because it is difficult to reassure any one group of workers that all other workers are in the same situation, workers may resist any cut in their wages. There may be an implicit M13_CASE3826_13_GE_C13.indd 278 17/04/19 4:18 AM CHAPTER 13 The Labor Market in the Macroeconomy 279 Evidence on Sticky Wages It should be clear to you from the text the important role the assumption of sticky wages plays in helping to explain both unemployment and the ability of fiscal stimulus in a period of unemployment to increase output and reduce that unemployment. This might lead you to wonder about the evidence of stickiness in the real labor market. Until recently it has been hard to find the right data to answer the question of wage stickiness. After all, we cannot just look at average wages since labor is differentiated. We really want to ask for a set of workers how much wage change each of them experiences over time. A recent paper using a longitudinal survey done by the Census Bureau has done just that.1 The Census Bureau in its Survey of Income and Program Participation (SIPP) followed 39,095 people for periods of 24 to 48 months, interviewing them quarterly about their work and wages. All the workers were hourly workers, making the wage data easier to interpret than that of salaried workers. The data allowed Barattieri et al. to distinguish between wage changes achieved by changing jobs and wage changes within jobs. The period of the survey was 1996–2000. Looking back on the data in Chapter 5 you will see this was a period of low unemployment and high growth, precisely the time we would expect to see wages going up. The researchers found, however, considerable evidence of wage stickiness, especially among those who did not change jobs. They found that the probability of a within-job wage change is between 16 and 21 percent per quarter. This translates into wages that remain unchanged for about a year, which tells us that average wages change much less than average prices. CRITICAL THINKING 1. Why do you think wages are sticky even during high growth periods? 1Alessandro Barattieri, Susanto Basu, and Peter Gottschalk, “Some Evidence on the Importance of Sticky Wages,” American Economic Journal: Macroeconomics, January
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2014, 70–101. understanding between firms and workers that firms will not do anything that would make their workers worse off relative to workers in other firms. Explicit Contracts Many workers—in particular unionized workers—sign 1- to 3-year employment contracts with firms. These contracts stipulate the workers’ wages for each year of the contract. Wages set in this way do not fluctuate with economic conditions, either upward or ◂◂ FIGURE 13.2 Sticky Wages If wages “stick” at W0 instead of falling to the new equilibrium wage of W* following a shift of demand from D0 to D1, the result will be unemployment equal to L0 − L1. Unemployment W0 W* e t a r e g a W New equilibrium wage S D1 D0 0 L1 L* L0 Units of labor MyLab Economics Concept Check M13_CASE3826_13_GE_C13.indd 279 17/04/19 4:18 AM 280 PART III The Core of Macroeconomic Theory How the Sharing Economy Is Transforming the Job Market The last few decades have witnessed prolonged levels of high unemployment across the world. As much as technological advancement has been blamed for many job losses, recent research suggests1 that it has actually helped transform the job market and create more jobs. Digitalization, in particular, has resulted in the birth of the sharing economy, a communitybased shared online market platform built around peer-topeer-based renting, borrowing, swapping, and collaborating of assets, capital, and labor. The sharing economy is a new socioeconomic system whose revenue is estimated to grow from $14 billion in 2014 to $335 billion by 2025. Such a platform allows low income consumers access to items that were previously unaffordable. In the job market, entrepreneurs can access low-cost and high-outreach market platforms to sustain themselves and generate employment. Individuals who are seasonally unemployed can have access to temporary jobs, and those who are structurally unemployed can generate income independently till they acquire the skills needed for permanent employment. Similarly, those in need of flexible working hours can make extra income. In fact, profit can be generated even without employment, such as by sharing a car or renting assets! Apps such as Uber, TaskRabbit, Airbnb, and La Ruche qui dit Oui have given customers access to customized goods and services in this manner. Economist Arun Sundararajan argues2 that since the supply of capital and labor
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comes from decentralized crowds of individuals, the future of exchange is in crowd-based marketplaces rather than by centralized third parties. CRITICAL THINKING 1. What are the labor law reforms that you believe are essential for sustainable employment under the sharing economy model? 1Ian Hathaway and Mark Muro (2016). Tracking the Gig Economy: New Numbers, October 13. Washington, D.C.: Brookings Institution. 2Arun Sundararajan (2016). The Sharing Economy: The End of Employment and the Rise of Crowd-Based Capitalism. Cambridge, MA: The MIT Press. explicit contracts Employment contracts that stipulate workers’ wages, usually for a period of 1 to 3 years. cost-of-living adjustments (COLAs) Contract provisions that tie wages to changes in the cost of living. The greater the inflation rate, the more wages are raised. downward. If the economy slows down and firms demand fewer workers, the wage will not fall. Instead, some workers will be laid off. Although explicit contracts can explain why some wages are sticky, a deeper question must also be considered. Workers and firms surely know at the time a contract is signed that unforeseen events may cause the wages set by the contract to be too high or too low. Why do firms and workers bind themselves in this way? One explanation is that negotiating wages is costly. Negotiations between unions and firms can take a considerable amount of time—time that could be spent producing output—and it would be very costly to negotiate wages weekly or monthly. Contracts are a way of bearing these costs at no more than 1-, 2-, or 3-year intervals. There is a trade-off between the costs of locking workers and firms into contracts for long periods of time and the costs of wage negotiations. The length of contracts that minimizes negotiation costs seems to be (from what we observe in practice) between 1 and 3 years. Some multiyear contracts adjust for unforeseen events by cost-of-living adjustments (COLAs) written into the contract. COLAs tie wages to changes in the cost of living: The greater the rate of inflation, the more wages are raised. COLAs thus protect workers from unexpected inflation, although many COLAs adjust wages by a smaller percentage than the percentage increase in prices. Regarding deflation, few contracts allow for wage cuts in the face of deflation. An Open Question MyLab Economics Concept Check As we have seen, there are many explanations for why we might see unemployment. Some of these explanations focus on why we might
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see levels of unemployment higher than frictional plus structural. Other explanations focus on the reasons for cyclical unemployment. The theories we have just set forth are not necessarily mutually exclusive, and there may be elements of M13_CASE3826_13_GE_C13.indd 280 17/04/19 4:18 AM CHAPTER 13 The Labor Market in the Macroeconomy 281 13.5 LEARNING OBJECTIVE Analyze the short-run relationship between unemployment and inflation. truth in all of them. The aggregate labor market is complicated, and there are no simple answers to why there is unemployment. Much current work in macroeconomics is concerned directly or indirectly with this question, and it is an exciting area of study. Which argument or arguments will win out in the end is an open question. The Short-Run Relationship between the Unemployment Rate and Inflation In Chapter 11 we described the Fed as concerned about both output and the price level. In practice, the Fed typically describes its interests as being unemployment on the one hand and inflation on the other. For example, Janet Yellen, the former Fed chair, gave a speech at the San Francisco Fed on March 27, 2015, in which she said, “Our goal in adjusting the federal funds rate over time will be to achieve and sustain economic conditions close to maximum employment with inflation averaging 2 percent.” Jerome Powell, the current chair, has similarly committed to the joint goal of price stability and employment growth. We are now in a position to connect the Fed interest in output with the unemployment rate and to explore the connection between unemployment and prices. We begin by looking at the relation between aggregate output (income) (Y) and the unemployment rate (U). For an economy to increase aggregate output, firms must hire more labor to produce that output. Thus, more output implies greater employment. An increase in employment means more people working (fewer people unemployed) and a lower unemployment rate. An increase in Y corresponds to a decrease in U. Thus, U and Y are negatively related: When Y rises, the unemployment rate falls, and when Y falls, the unemployment rate rises, all else equal. What about the relationship between aggregate output and the overall price level? The AS curve, reproduced in Figure 13.3, shows the relationship between Y and the overall price level (P). The relationship is a positive one: When P increases, Y increases, and when P decreases, Y decreases. As you will recall from the last chapter, the shape of
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the AS curve is determined by the behavior of firms in reacting to an increase in demand. If aggregate demand shifts to the right and the economy is operating on the nearly flat part of the AS curve—far from capacity— output will increase, but the price level will not change much. However, if the economy is operating on the steep part of the AS curve—close to capacity—an increase in demand will drive up the price level, but output will be constrained by capacity and will not increase much. Now let us put the two pieces together and think about what will happen following an event that leads to an increase in aggregate demand. First, firms experience an unanticipated decline in inventories. They respond by increasing output (Y) and hiring workers—the unemployment rate falls. If the economy is not close to capacity, there will be little increase in the price level. If, however, aggregate demand continues to grow, the ability of the economy to increase output AS ◂◂ FIGURE 13.3 The Aggregate Supply Curve The AS curve shows a positive relationship between the price level (P) and aggregate output (income) (Y). Aggregate output (income), Y MyLab Economics Concept Check M13_CASE3826_13_GE_C13.indd 281 17/04/19 4:18 AM 282 PART III The Core of Macroeconomic Theory ◂▸ FIGURE 13.4 The Relationship Between the Price Level and the Unemployment Rate This curve shows a negative relationship between the price level (P) and the unemployment rate (U). As the unemployment rate declines in response to the economy’s moving closer and closer to capacity output, the price level rises more and more MyLab Economics Concept Check Unemployment rate, U % inflation rate The percentage change in the price level. Phillips Curve A curve showing the relationship between the inflation rate and the unemployment rate. will eventually reach its limit. As aggregate demand shifts farther and farther to the right along the AS curve, the price level increases more and more and output begins to reach its limit. At the point at which the AS curve becomes vertical, output cannot rise any farther. If output cannot grow, the unemployment rate cannot be pushed any lower. There is a negative relationship between the unemployment rate and the price level. As the unemployment rate declines in response to the economy’s moving closer and closer to capacity output, the overall price level rises more and more, as shown in Figure 13.4. The AS curve in Figure 13.3 shows the
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relationship between the price level and aggregate output and thus implicitly between the price level and the unemployment rate, which is depicted in Figure 13.4. In policy formulation and discussions, however, economists have focused less on the relationship between the price level and the unemployment rate than on the relationship between the inflation rate—the percentage change in the price level—and the unemployment rate. Note that the price level and the percentage change in the price level are not the same. The curve describing the relationship between the inflation rate and the unemployment rate, which is shown in Figure 13.5, is called the Phillips Curve, after British economist A. W. Phillips, who first examined it using data for the United Kingdom. Fortunately, the analysis behind the AS curve (and thus the analysis behind the curve in Figure 13.4) will enable us to see both why the Phillips Curve initially looked so appealing as an explanation of the relationship between inflation and the unemployment rate and how more recent history has changed our views of the interpretation of the Phillips Curve. The Phillips Curve: A Historical Perspective MyLab Economics Concept Check In the 1950s and 1960s, the data showed a remarkably smooth relationship between the unemployment rate and the rate of inflation, as Figure 13.6 shows for the 1960s. As you can see, the data points fit fairly closely around a downward-sloping curve; in general, the higher the unemployment rate is, the lower the rate of inflation. The historical data in fact look quite like the hypothetical Phillips Curve in Figure 13.5, which tells us that to lower the inflation rate, we must accept a higher unemployment rate, and to lower the unemployment rate, we must accept a higher rate of inflation. Textbooks written in the 1960s and early 1970s relied on the Phillips Curve as the main explanation of inflation. The story was simple—inflation appeared to respond in a fairly predictable way to changes in the unemployment rate. Policy discussions in the 1960s often revolved around the Phillips Curve. The role of the policy maker, it was thought, was to choose a point on the curve. Conservatives usually argued for choosing a point with a low rate of inflation and were willing to accept a higher unemployment rate in exchange for this. Liberals usually argued for accepting more inflation to keep unemployment at a low level. Life did not turn out to be quite so simple. Data from the 1970s on no longer show the simple negative relationship between the unemployment rate and inflation. Look at Figure 13.7, which graphs the unemployment rate and inflation rate for the
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period from 1970 to 2017. The points in Figure 13.7 show no particular relationship between inflation and the unemployment rate. M13_CASE3826_13_GE_C13.indd 282 17/04/19 4:18 AM CHAPTER 13 The Labor Market in the Macroeconomy 283 MyLab Economics Concept Check ◂◂ FIGURE 13.5 The Phillips Curve The Phillips Curve shows the relationship between the inflation rate and the unemployment rate.0 5.0 4.0 3.0 2.0 1. fl ( ◂◂ FIGURE 13.6 Unemployment and Inflation, 1960–1969 During the 1960s, there seemed to be an obvious tradeoff between inflation and unemployment. Policy debates during the period revolved around this apparent trade-off. Source: U.S Bureau of Labor Statistics. ◂◂ FIGURE 13.7 Unemployment and Inflation, 1970–2017 From the 1970s on, it became clear that the relationship between unemployment and inflation was anything but simple. Source: U.S Bureau of Labor Statistics. Unemployment rate, U % MyLab Economics Concept Check ’69 ’68 ’67 ’66 ’65 ’60 ’63 ’64 ’62 ’61 0 1.0 2.0 3.0 5.0 4.0 Unemployment rate, U 6.0 7. ( % 13.0 12.0 11.0 10.0 9.0 8.0 7.0 6.0 5.0 4.0 3.0 2.0 1.0 0 –1.0 MyLab Economics Real-time data ’80 ’79 ’74 ’81 ’75 ’11 ’78 ’77 ’76 ’84 ’90 ’88 ’08 ’91 ’73 ’71 ’70 ’89 ’05 ’00 ’96 ’06 ’72 ’87 ’85 ’04 ’92 ’07 ’01 ’99 ’98 ’95 ’97 ’94 ’03 ’02 ’14 ’93 ’86 ’13 ’12 ’82 ’83 ’10 ’09 0 1.0 2.0 3.0 4.0 5.0 6.0 7.0 8.0 9.0 10.0 11.0 12.0
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13.0 % Unemployment rate, U M13_CASE3826_13_GE_C13.indd 283 17/04/19 4:18 AM 284 PART III The Core of Macroeconomic Theory Aggregate Supply and Aggregate Demand Analysis and the Phillips Curve MyLab Economics Concept Check How can we explain the stability of the Phillips Curve in the 1950s and 1960s and the lack of stability after that? To answer, we need to return to AS/AD analysis. If the AD curve shifts from year to year but the AS curve does not, the values of P and Y each year will lie along the AS curve (Figure 13.8(a)). The shifting AD curve creates a set of AS/AD intersections that trace out the AS curve. (Try doing this yourself on a graph of the AS and AD curves.) The plot of the relationship between P and Y will be upward sloping in this case. Correspondingly, the plot of the relationship between the unemployment rate (which decreases with increased output) and the rate of inflation will be a curve that slopes downward. In other words, if the new equilibrium data reflect a stable AS curve and a shifting AD curve, we would expect to see a negative relationship between the unemployment rate and the inflation rate, just as we see in Figure 13.6 for the 1960s. However, the relationship between the unemployment rate and the inflation rate will look different if the AS curve shifts from year to year, perhaps from a change in oil prices, but the AD curve does not move. A leftward shift of the AS curve with the AD curve stable will cause an increase in the price level (P) and a decrease in aggregate output (Y) (Figure 13.8(b)). When the AS curve shifts to the left, the economy experiences both inflation and an increase in the unemployment rate (because decreased output means increased unemployment). In other words, if the AS curve is shifting from year to year, we would expect to see a positive relationship between the unemployment rate and the inflation rate. If both the AS and the AD curves are shifting simultaneously, however, there is no systematic relationship between P and Y (Figure 13.8(c)) and thus no systematic relationship between the unemployment rate and the inflation rate. One explanation for the change in the Phillips Curve between the 1960s and later periods is that both the AS and the AD curves appear to be shifting in the later periods—both shifts from the supply side and shifts from the demand side. This can be seen
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by examining a key cost variable: the price of imports. The Role of Import Prices We discussed in the previous chapter that one of the main factors that causes the AS curve to shift are changes in energy prices, particularly the price of oil. Because the United States imports much of its oil, the price index of U.S. imports is highly correlated with the (world) price of oil. As a result, a change in the U.S. import price index, which we will call “the price of imports,” shifts the AS curve. The price of imports is plotted in Figure 13.9 for the 1960 I–2017 IV period. As you can see, the price of imports changed very little between 1960 and 1970. There were no large shifts in the AS curve in the 1960s due to changes in the price of imports. There were also no other large changes in input prices in the 1960s, so overall the AS curve shifted very little during the decade. The main variation in the 1960s was in aggregate demand, so the shifting AD curve traced out points along the AS curve. MyLab Economics Concept Check P2 P1 P0 AS AD2 AD1 AD0 P2 P1 P0 AS2 AS1 AS0 AD P, l e v e l P2 P1 e c i r P0 P AS2 AS1 AS0 AD2 AD1 AD0 0 Y0 Y1 Y2 0 Y2 Y1 Y0 0 Y1 Y0 Y2 Aggregate output (income), Y Aggregate output (income), Y Aggregate output (income), Y a. AD shifts with no AS shifts trace out the AS curve (a positive relationship between P and Y). b. AS shifts with no AD shifts trace out the AD curve (a negative relationship between P and Y). c. If both AD and AS are shifting, there is no systematic relationship between P and Y. ▴◂FIGURE 13.8 Changes in the Price Level and Aggregate Output Depend on Shifts in Both Aggregate Demand and Aggregate Supply M13_CASE3826_13_GE_C13.indd 284 17/04/19 4:18 AM CHAPTER 13 The Labor Market in the Macroeconomy 285 1.2 1 0.8 0.6 0.4 0. 1960 I 1965 I 1970 I 1975 I 1980 I 1985 I 1990 I 1995 I 2000 I 2005 I 2010 I 2015 I 2017 IV Quarters MyLab Economics Real-time data
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▴◂FIGURE 13.9 The Price of Imports, 1960 I–2017 IV The price of imports changed very little in the 1960s and early 1970s. It increased substantially in 1974 and again in 1979–1980. Between 1981 and 2002, the price of imports changed very little. It generally rose between 2003 and 2008, fell somewhat in late 2008 and early 2009, rose slightly in 2011 and then remained flat. Figure 13.9 also shows that the price of imports increased considerably in the 1970s. This rise led to large shifts in the AS curve during the decade, but the AD curve was also shifting throughout the 1970s. With both curves shifting, the data points for P and Y were scattered all over the graph and the observed relationship between P and Y was not at all systematic. This story about import prices and the AS and AD curves in the 1960s and 1970s carries over to the Phillips Curve. The Phillips Curve was stable in the 1960s because the primary source of variation in the economy was demand, not costs. In the 1970s, both demand and costs were varying so no obvious relationship between the unemployment rate and the inflation rate was apparent. To some extent, what is remarkable about the Phillips Curve is not that it was not smooth after the 1960s, but that it ever was smooth. Expectations and the Phillips Curve MyLab Economics Concept Check Another reason the Phillips Curve is not stable concerns expectations. We saw in Chapter 12 that if a firm expects other firms to raise their prices, the firm may raise the price of its own product. If all firms are behaving this way, prices will rise because they are expected to rise. In this sense, expectations are self-fulfilling. Similarly, if inflation is expected to be high in the future, negotiated wages are likely to be higher than if inflation is expected to be low. Wage inflation is thus affected by expectations of future price inflation. Because wages are input costs, prices rise as firms respond to the higher wage costs. Price expectations that affect wage contracts eventually affect prices themselves. If the rate of inflation depends on expectations, the Phillips Curve will shift as expectations change. For example, if inflationary expectations increase, the result will be an increase in the rate of inflation even though the unemployment rate may not have changed. In this case, the Phillips Curve will shift to the right. If inflationary expectations decrease, the Phillips Curve will shift to the left—there will be less inflation at any given level of the unemployment rate. It so happened that
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inflationary expectations were quite stable in the 1950s and 1960s. The inflation rate was moderate during most of this period, and people expected it to remain moderate. With inflationary expectations not changing very much, there were no major shifts of the Phillips Curve, a situation that helps explain its stability during the period. Near the end of the 1960s, inflationary expectations began to increase, primarily in response to the actual increase in inflation that was occurring because of the tight economy caused by the Vietnam War. Inflationary expectations increased even further in the 1970s as a result of large oil price increases. These changing expectations led to shifts of the Phillips Curve and are another reason the curve was not stable during the 1970s. Inflation and Aggregate Demand MyLab Economics Concept Check It is important to realize that the fact that the historical data since the 1970s do not trace out a smooth downward-sloping Phillips curve does not mean that aggregate demand has no effect on inflation. It simply means that inflation is affected by more than just aggregate demand. If, M13_CASE3826_13_GE_C13.indd 285 17/04/19 4:18 AM 286 PART III The Core of Macroeconomic Theory 13.6 LEARNING OBJECTIVE Discuss the long-run relationship between unemployment and output. say, inflation is also affected by cost variables like the price of imports, there will be no stable relationship between just inflation and aggregate demand unless the cost variables are not changing. Similarly, if the unemployment rate is taken to be a measure of aggregate demand, where inflation depends on both the unemployment rate and cost variables, there will be no stable Phillips Curve unless the cost variables are not changing. Therefore, the unemployment rate can have an important effect on inflation even though this will not be evident from a plot of inflation against the unemployment rate—that is, from the Phillips Curve. The Long-Run Aggregate Supply Curve, Potential Output, and the Natural Rate of Unemployment Thus far we have been discussing the relationship between inflation and unemployment, looking at the short-run AS and AD curves. We turn now to look at the long run, focusing on the connection between output and unemployment. Recall from Chapter 11 that many economists believe that in the long run, the AS curve is vertical. We have illustrated this case in Figure 13.10. Assume that the initial equilibrium is at the intersection of AD0 and the long-run aggregate supply curve. Now consider a shift of the aggregate demand curve from AD0 to
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AD1. If wages are sticky and lag prices, in the short run, aggregate output will rise from Y0 to Y1. (This is a movement along the short-run AS curve AS0.) In the longer run, wages catch up. For example, next year’s labor contracts may make up for the fact that wage increases did not keep up with the cost of living this year. If wages catch up in the longer run, the AS curve will shift from AS0 to AS1 and drive aggregate output back to Y0. If wages ultimately rise by exactly the same percentage as output prices, firms will produce the same level of output as they did before the increase in aggregate demand. As we indicated in Chapter 11, Y0 is sometimes called potential output. Aggregate output can be pushed above Y0 in the short run. When aggregate output exceeds Y0, however, there is upward pressure on input prices and costs. The unemployment rate is already quite low, firms are beginning to encounter the limits of their plant capacities, and so on. At levels of aggregate output above Y0, costs will rise, the AS curve will shift to the left, and the price level will rise. Thus, potential output is the level of aggregate output that can be sustained in the long run without inflation. AS/AD AS (Long run) AS1 (Short run) AS0 (Short run) AD1 AD0 P2 P1 P0 % Long-Run Phillips Curve U* % 0 Y0 Y1 Aggregate output (income), Y MyLab Economics Concept Check Unemployment rate, U ▴◂FIGURE 13.10 The Long-Run Phillips Curve: The Natural Rate of Unemployment If the AS curve is vertical in the long run, so is the Phillips Curve. In the long run, the Phillips Curve corresponds to the natural rate of unemployment—that is, the unemployment rate that is consistent with the notion of a fixed long-run output at potential output. U* is the natural rate of unemployment. M13_CASE3826_13_GE_C13.indd 286 17/04/19 4:18 AM CHAPTER 13 The Labor Market in the Macroeconomy 287 This story is directly related to the Phillips Curve. Those who believe that the AS curve is vertical in the long run at potential output also believe that the Phillips Curve is vertical in the long run at some natural rate of unemployment. Changes in aggregate demand—including increases in government spending—increase prices, but do
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not change employment. Recall from Chapter 7 that the natural rate of unemployment refers to unemployment that occurs as a normal part of the functioning of the economy. It is sometimes taken as the sum of frictional unemployment and structural unemployment. The logic behind the vertical Phillips Curve is that whenever the unemployment rate is pushed below the natural rate, wages begin to rise, thus pushing up costs. This leads to a lower level of output, which pushes the unemployment rate back up to the natural rate. At the natural rate, the economy can be considered to be at full employment. The Nonaccelerating Inflation Rate of Unemployment (NAIRU) MyLab Economics Concept Check In Figure 13.10, the long-run vertical Phillips Curve is a graph with the inflation rate on the vertical axis and the unemployment rate on the horizontal axis. The natural rate of unemployment is U*. In the long run, with a long-run vertical Phillips Curve, the actual unemployment rate moves to U* because of the natural workings of the economy. Another graph of interest is Figure 13.11, which plots the change in the inflation rate on the vertical axis and the unemployment rate on the horizontal axis. Many economists believe that the relationship between the change in the inflation rate and the unemployment rate is as depicted by the PP curve in the figure. The value of the unemployment rate where the PP curve crosses zero is called the nonaccelerating inflation rate of unemployment (NAIRU). If the actual unemployment rate is below the NAIRU, the change in the inflation rate will be positive. As depicted in the figure, at U1, the change in the inflation rate is 1. Conversely, if the actual unemployment rate is above the NAIRU, the change in the inflation rate is negative: At U2, the change is −1. Consider what happens if the unemployment rate decreases from the NAIRU to U1 and stays at U1 for many periods. Assume also that the inflation rate at the NAIRU is 2 percent. Then in the first period the inflation rate will increase from 2 percent to 3 percent. The inflation rate does not, however, just stay at the higher 3 percent value. In the next period, the inflation rate will increase from 3 percent to 4 percent and so on. The price level will be accelerating—that is, the change in the inflation rate will be positive—when the actual unemployment rate is below the NAIRU. Conversely, the price level will be decelerating—that is, the change in the inflation
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rate will be negative—when the actual unemployment rate is above the NAIRU.1 natural rate of unemployment The unemployment that occurs as a normal part of the functioning of the economy. Sometimes taken as the sum of frictional unemployment and structural unemployment. NAIRU The nonaccelerating inflation rate of unemployment. % 1 0 - MyLab Economics Concept Check ◂◂ FIGURE 13.11 The NAIRU Diagram At an unemployment rate below the NAIRU, the price level is accelerating (positive changes in the inflation rate); at an unemployment rate above the NAIRU, the price level is decelerating (negative changes in the inflation rate). Only when the unemployment rate is equal to the NAIRU is the price level changing at a constant rate (no change in the inflation rate). U1 NAIRU U2 Unemployment rate, U PP % 1The NAIRU is actually misnamed. It is the price level that is accelerating or decelerating, not the inflation rate, when the actual unemployment rate differs from the NAIRU. The inflation rate is not accelerating or decelerating, but simply changing by the same amount each period. The namers of the NAIRU forgot their physics. M13_CASE3826_13_GE_C13.indd 287 17/04/19 4:18 AM 288 PART III The Core of Macroeconomic Theory The PP curve in Figure 13.11 is like the AS curve in Figure 13.3—the same factors that shift the AS curve, such as cost shocks, can also shift the PP curve. Figure 11.2 on p. 246 summarizes the various factors that can cause the AS curve to shift, and these are also relevant for the PP curve. A favorable shift for the PP curve is to the left because the PP curve crosses zero at a lower unemployment rate, indicating that the NAIRU is lower. Some have argued that one possible recent source of favorable shifts is increased foreign competition, which may have kept wage costs and other input costs down. Before about 1995, proponents of the NAIRU theory argued that the value of the NAIRU in the United States was around 6 percent. By the end of 1995, the unemployment rate declined to 5.6 percent, and by 2000, the unemployment rate was down to 3.8 percent. At the end of 2017 it was 4.1 percent. If the NAIRU had been 6 percent, one should have seen a continuing increase in the inflation rate
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beginning about 1995. In fact, the 1995 to 2000 period saw slightly declining inflation. Not only did inflation not continually increase, it did not even increase once to a new, higher value and then stay there. As the unemployment rate declined during this period, proponents of the NAIRU lowered their estimates of it, more or less in line with the actual fall in the unemployment rate. This recalibration can be justified by arguing that there have been continuing favorable shifts of the PP curve, such as possible increased foreign competition. Critics, however, have argued that this procedure is close to making the NAIRU theory vacuous. Can the theory really be tested if the estimate of the NAIRU is changed whenever it is not consistent with the data? How trustworthy is the appeal to favorable shifts? The 2015–2017 period also saw declining unemployment rates with no increase in the inflation rate, further evidence against the NAIRU theory. Looking Ahead This chapter concludes our basic analysis of how the macroeconomy works. In the preceding six chapters, we have examined how households and firms behave in the three market arenas—the goods market, the money market, and the labor market. We have seen how aggregate output (income), the interest rate, and the price level are determined in the economy, and we have examined the relationship between two of the most important macroeconomic variables, the inflation rate and the unemployment rate. In Chapter 14, we use everything we have learned up to this point to examine a number of important policy issues. S U M M A R Y 13.1 THE LABOR MARKET: BASIC CONCEPTS p. 274 1. Because the economy is dynamic, frictional and structural unemployment are inevitable and in some ways desirable. Times of cyclical unemployment are of concern to macroeconomic policy makers. 2. In general, employment tends to fall when aggregate output falls and rise when aggregate output rises. 13.2 THE CLASSICAL VIEW OF THE LABOR MARKET p. 274 3. Classical economists believe that the interaction of supply and demand in the labor market brings about equilibrium and that unemployment (beyond the frictional and structural amounts) does not exist. 4. The classical view of the labor market is consistent with the theory of a vertical aggregate supply curve. 5. Some economists argue that the unemployment rate is not an accurate indicator of whether the labor market is working properly. Unemployed people who are considered part of the labor force may be offered jobs but may be unwilling to take those jobs at the offered salaries
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. Some of the unemployed may have chosen not to work, but this result does not mean that the labor market has malfunctioned. 13.3 EXPLAINING THE EXISTENCE OF UNEMPLOYMENT p. 276 6. Efficiency wage theory holds that the productivity of workers increases with the wage rate. If this is true, firms may have an incentive to pay wages above the wage at which the quantity of labor supplied is equal to the quantity of labor demanded. At all wages above the equilibrium, there will be an excess supply of labor and therefore unemployment. 7. If firms are operating with incomplete or imperfect informa- tion, they may not know what the market-clearing wage is. As a result, they may set their wages incorrectly and bring about unemployment. Because the economy is so complex, it may take considerable time for firms to correct these mistakes. MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with. M13_CASE3826_13_GE_C13.indd 288 17/04/19 4:18 AM CHAPTER 13 The Labor Market in the Macroeconomy 289 8. Minimum wage laws, which set a floor for wage rates, are 12. The Phillips Curve represents the relationship between the one factor contributing to unemployment of teenagers and very low-skilled workers. If the market-clearing wage for some groups of workers is below the minimum wage, some members of this group will be unemployed. 13.4 EXPLAINING THE EXISTENCE OF CYCLICAL UNEMPLOYMENT p. 278 9. If wages are sticky downward, cyclical unemployment may result. Downwardly sticky wages may be brought about by social (implicit) or explicit contracts not to cut wages. If the equilibrium wage rate falls but wages are prevented from falling also, the result will be unemployment. 13.5 THE SHORT-RUN RELATIONSHIP BETWEEN THE UNEMPLOYMENT RATE AND INFLATION p. 281 10. There is a negative relationship between the unemployment rate (U) and aggregate output (income) (Y): When Y rises, U falls. When Y falls, U rises. 11. The relationship between the unemployment rate and the price level is negative: As the unemployment rate declines and the economy moves closer to capacity, the price level rises more and more. inflation rate and
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the unemployment rate. During the 1950s and 1960s, this relationship was stable and there seemed to be a predictable trade-off between inflation and unemployment. As a result of import price increases (which led to shifts in aggregate supply), the relationship between the inflation rate and the unemployment rate was erratic in the 1970s. Inflation depends on more than just the unemployment rate. 13.6 THE LONG-RUN AGGREGATE SUPPLY CURVE, POTENTIAL OUTPUT, AND THE NATURAL RATE OF UNEMPLOYMENT p. 286 13. Those who believe that the AS curve is vertical in the long run also believe that the Phillips Curve is vertical in the long run at the natural rate of unemployment. The natural rate is generally the sum of the frictional and structural rates. If the Phillips Curve is vertical in the long run, then there is a limit to how low government policy can push the unemployment rate without setting off inflation. 14. The NAIRU theory says that the price level will accelerate when the unemployment rate is below the NAIRU and decelerate when the unemployment rate is above the NAIRU cost-of-living adjustments (COLAs), p. 280 cyclical unemployment, p. 274 efficiency wage theory, p. 277 explicit contracts, p. 280 frictional unemployment, p. 274 inflation rate, p. 282 labor demand curve, p. 275 labor supply curve, p. 275 minimum wage laws, p. 277 NAIRU, p. 287 natural rate of unemployment, p. 287 Phillips Curve, p. 282 relative-wage explanation of unemployment, p. 278 social, or implicit, contracts, p. 278 sticky wages, p. 278 structural unemployment, p. 274 unemployment rate, p. 274 P R O B L E M S All problems are available on MyLab Economics. 13.1 THE LABOR MARKET: BASIC CONCEPTS c. Retraining programs for workers who need to learn new LEARNING OBJECTIVE: Define fundamental concepts of the labor market. 1.1 The following policies have at times been advocated for coping with unemployment. Briefly explain how each might work and explain which type or types of unemployment (frictional, structural, or cyclical) each policy is designed to alter. a. A computer list of job openings and a service that matches employees with job vacancies (sometimes called an “economic dating service”) b. Lower minimum wage for teenagers skills to find employment
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d. Public employment for people without jobs e. Improved information about available jobs and current wage rates f. The president’s going on nationwide TV and attempting to convince firms and workers that the inflation rate next year will be low 1.2 How will the following affect labor force participation rates, labor supply, and unemployment in your country? a. The government steps up public funding for nurseries. b. A growing majority of the young and well-educated pop- ulation is leaving the country. MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with. M13_CASE3826_13_GE_C13.indd 289 17/04/19 4:18 AM 290 PART III The Core of Macroeconomic Theory c. Firms are taking advantage of looser lay-off regulations while increasing the volume of paid overtime work. d. The government tightens rules for obtaining permanent residence, causing a decline in the number of immigrants coming into the country. e. The government shortens the maximum period one is entitled to unemployment benefits. 13.2 THE CLASSICAL VIEW OF THE LABOR MARKET LEARNING OBJECTIVE: Explain the classical view of the labor market. 2.1 Using a supply and demand graph for the labor market, explain the classical view that the economy will remain at full employment, even with a decrease in the demand for labor. How will this labor market graph change in the absence of sticky wages? 13.3 EXPLAINING THE EXISTENCE OF UNEMPLOYMENT LEARNING OBJECTIVE: Discuss four reasons for the existence of unemployment. 3.1 In 2019, the country of Cheeseling was suffering from a period of high unemployment. The new president, Chad Cheddar, appointed Merry Parmesan as his chief economist. Ms. Parmesan and her staff estimated these supply and demand curves for labor from data obtained from the secretary of labor, Sore Mozzarella: QD = 190 - 6W QS = 10W - 18 where Q is the quantity of labor supplied/demanded and W is the wage rate in strings, the currency of Cheeseling. a. What is the equilibrium wage? How many workers are employed? b. Assume that Sore Mozzarella wants to introduce a law that says that no worker shall be paid less than 16 strings per hour. Estimate the
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quantity of labor supplied and the number of unemployed. c. How can you justify this minimum wage for the economy of Cheeseling? 3.2 Country X came out of a prolonged recessional period a few years ago, thanks to a vigorous fiscal stimulus by the government. The country’s economy had resumed growing two years ago, reaching a solid pace of growth of more than 2.5 percent last year. Yet, unemployment levels, which increased fast during the recession, are still stuck at a high level (around 10 percent), and do not show any signs of falling. Which of the following factors do you think contributed to this, and why? a. Wages are sticky which represents an obstacle for employ- ment in growing firms. b. Employment and unemployment are always lagging indi- cators in response to changes in economic growth. c. People are out of a job for too long and, in turn, have dif- ficulties in returning to work. d. The recession has led to the replacement of old sectors with new ones, boosting structural unemployment at a time when cyclical unemployment is decreasing. e. The recession has led firms to be much more cautious with their hiring strategies–preferring to rely on overwork to cope with increasing demand. f. The fiscal stimulus has crowded out private investment spending that has been the main source of reductions in unemployment. Choose two of these statements and write a short essay. Use data to support your claims. 13.4 EXPLAINING THE EXISTENCE OF CYCLICAL UNEMPLOYMENT LEARNING OBJECTIVE: Discuss the reasons for the existence of cyclical unemployment. 4.1 Economists and politicians have long debated the extent to which unemployment benefits affect the duration of unemployment. The table on the following page represents unemployment and unemployment benefit data for five high-income countries. The unemployment rate and the duration of unemployment benefits for each of these countries are shown for 2007, prior to the recession of 2008–2009, for 2010, the first full year following the end of the recession, and for June 2017, eight years after the end of the recession. As the data shows, three of these countries extended the duration of unemployment benefits as a result of the recession and two of those countries have since reduced the extended duration. The data for 2007, 2010, and 2017 show a positive relationship between the duration of unemployment benefits and the unemployment rate. Discuss whether you believe the length of time in which a person can receive unemployment benefits directly affects the
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unemployment rate, and whether your answer applies to 2007, 2010, and 2017. Look up the unemployment rates in each of the five countries. Discuss whether a positive relationship still exists between the duration of unemployment benefits and the unemployment rate, and whether you believe the extension of unemployment benefits in three of those countries played a role in their current unemployment rates. MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with. M13_CASE3826_13_GE_C13.indd 290 17/04/19 4:18 AM CHAPTER 13 The Labor Market in the Macroeconomy 291 Country Canada France Great Britain Japan United States 2007 Unemployment Rate Unemployment Benefits Duration, 2007 2010 Unemployment Rate Unemployment Benefits Duration, 2010 June 2017 Unemployment Rate Unemployment Benefits Duration, 2017 6.4% 8.7% 5.3% 3.9% 4.6% 50 weeks 52 weeks 26 weeks 13 weeks 26 weeks 7.1% 9.4% 7.9% 4.7% 9.6% 50 weeks 104 weeks 26 weeks 21 weeks 99 weeks 6.5% 9.4% 4.3% 2.8% 4.4% 45 weeks 104 weeks 26 weeks 13 weeks 26 weeks 4.2 [Related to the Economics in Practice on p. 280] The Economics in Practice box states that job applicants who have been unemployed for a long period of time have a more difficult time getting job interviews than do those applicants who have been unemployed for a shorter time period. Go to www.bls.gov and do a search for “Table A-12: Unemployed persons by duration of unemployment.” Look at the seasonally adjusted data for the current month and for the same month in the previous year. What happened to the “number of unemployed” and the “percent distribution” over that year for those who were unemployed 15 to 26 weeks and for those who were unemployed 27 weeks and over? Does this data seem to support the findings in the Economics in Practice? Explain. 4.3 In which if the following situations will you be best off, and in which will you be worst off, in terms of your real wage? Explain your answer. a. You are offered a 5 percent wage increase and the inflation rate for the year turns out to be 7 percent. b. You are offered a 1 percent wage increase and the inflation rate
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for the year turns out to be −2 percent. c. You are offered a 12 percent wage increase and the infla- tion rate for the year turns out to be 16 percent. d. You are offered a 6 percent wage increase and the inflation rate for the year turns out to be 6 percent. e. You are offered a 7 percent wage increase and the inflation rate for the year turns out to be 3 percent. 4.4 How might social, or implicit, contracts result in sticky wages? Use a labor market graph to show the effect of social contracts on wages and on unemployment if the economy enters a recession. 4.5 [Related to the Economics in Practice on p. 279] The Economics in Practice discusses data gathered from 1996– 2010, a period of low unemployment and high growth. The years 2016–2018 have also been described as a period of low unemployment and high growth. Search news sources such as Bloomberg, the New York Times, and Forbes, as well as the Bureau of labor Statistics, for information regarding wages during this period. Did wages appear to be sticky from 2016–2018, as they did from 1996–2000? Briefly explain. 13.5 THE SHORT-RUN RELATIONSHIP BETWEEN THE UNEMPLOYMENT RATE AND INFLATION LEARNING OBJECTIVE: Analyze the short-run relationship between unemployment and inflation. 5.1 In March 2018, the unemployment rate in the Czech Republic was at 3.7 percent, the third lowest in the European Union. At the same time, the country experienced an average inflation rate of 2.45 percent. Can you explain the trade-off between inflation and unemployment? What factors might improve this trade-off? 5.2 Obtain monthly data on the unemployment rate and the inflation rate for the last two years. (This data can be found at www.bls.gov or in a recent issue of the Survey of Current Business or in the Monthly Labor Review or Employment and Earnings, all published by the government and available in many college libraries.) a. What trends do you observe? Can you explain what you see using aggregate supply and aggregate demand curves? b. Plot the 24 monthly rates on a graph with the unemploy- ment rate measured on the x-axis and the inflation rate on the y-axis. Is there evidence of a trade-off between these two variables? Provide an explanation. 5.3 Suppose the relationship between the inflation rate and the unemployment rate, depicted by the Phillips Curve,
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was stable. Does this mean that neighboring countries such as Germany and France are likely to have the same trade-off between unemployment and inflation? Explain your answer. 13.6 THE LONG-RUN AGGREGATE SUPPLY CURVE, POTENTIAL OUTPUT, AND THE NATURAL RATE OF UNEMPLOYMENT LEARNING OBJECTIVE: Discuss the long-run relationship between unemployment and output. 6.1 Obtain data on average hourly wages of production work- ers and the unemployment rate for the manufacturing sector in your country. How have these two sets of data evolved recently? To what extent do you think the changes in the unemployment rate have affected the changes in average wages? Provide an explanation QUESTION 1 When an unemployed individual gives up looking for work and leaves the labor force, she is no longer considered unemployed. What happens to the unemployment rate as a result? Does this mean that the unemployment rate understates or overstates the problem of joblessness? QUESTION 2 According to the Efficiency Wage Theory, employers occasionally pay workers more than the equilibrium wage in the market in order to increase productivity. Explain how this would lead to reduced turnover. MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with. M13_CASE3826_13_GE_C13.indd 291 17/04/19 4:18 AM P ART IV FURTHER MACROECONOMICS ISSUES 14 Financial Crises, Stabilization, and Deficits CHAPTER OUTLINE AND LEARNING OBJECTIVES 14.1 The Stock Market, the Housing Market, and Financial Crises p. 293 Discuss the effects of historical fluctuations in stock and housing prices on the economy. 14.2 Time Lags Regarding Monetary and Fiscal Policy p. 299 Explain the purpose of stabilization policies and differentiate between three types of time lags. 14.3 Government Deficit Issues p. 303 Discuss the effects of government deficits and deficit targeting. 292292 We have seen in the last several chapters the way in which the government can use fiscal and monetary policies to affect the economy. Yet, if you look back at Figure 5.5 on page 128 you can see that the unemployment rate still fluctuates widely. What accounts for these large fluctuations? Why can’t policymakers do a better job of controlling the economy? This chapter covers a number of
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topics, but they are all concerned at least indirectly with trying to help answer this question. In the next section we will consider the stock market and the housing market. Both of these markets have important effects on the economy through a household wealth effect. When stock prices or housing prices rise, household wealth rises, and households respond to this by consuming more. Economic models do a reasonably good job of estimating the effects of a wealth change on consumption, but they do a poor job of predicting the stock price and housing price changes that create that wealth change in the first place. Stock prices and housing prices are asset prices, and changes in these prices are, for the most part, unpredictable. Neither policymakers nor anyone else in the economy have the ability to predict how the stock and housing markets will behave in the future. This is then the first problem that policymakers face. If stock and housing prices are unpredictable, the best that policymakers can do is to try to react quickly to these changes once they occur. In this section we will also describe the way in which large unpredictable changes in these asset prices can lead to “financial crises” and what policymakers can and cannot do about them. A second problem policymakers confront in stabilizing the economy is getting the timing right, which we cover in the second section of this chapter. We will see that there is a danger of overreacting to changes in the economy—making the fluctuations in the economy even worse than they otherwise would be. The third section of this chapter discusses government deficit issues. We learned at the end of Chapter 9 that it is important to distinguish between cyclical deficits and structural deficits. One expects that the government will run a deficit in a recession since tax revenue is down because of the sluggish economy and spending may be up as the government tries to stimulate the economy. If at full employment the government is still running a deficit, this part of the deficit is described as a structural deficit. In 2018 many countries, including the United States, faced serious structural deficit problems. Many countries in the European Union struggled to meet the structural deficit targets set by the European Commission. We discuss various problems that may arise if a government runs large deficits year after year, including the possibility of a financial crisis. We will also look at some of the historical ways that have been used to control deficits in the United States. M14_CASE3826_13_GE_C14.indd 292 17/04/19 4:19 AM CHAPTER 14 Financial Crises, Stabilization, and Deficits
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293 The Stock Market, the Housing Market, and Financial Crises Introductory macroeconomic textbooks written before 1990 could largely ignore the stock and housing markets. The effects of these markets on the macroeconomy were small enough to be put aside in introductory discussions. In the 1990s this changed. The boom in the U.S. economy in the late 1990s and the subsequent recession owed a good deal to the rise and later fall in the stock market in that period. Similarly, in the period after 2000, the rise and later fall in housing prices contributed to cycles in the real economy. Now even introductory macroeconomics courses must spend some time looking at these two markets. We first turn to some background material on the stock market. 14.1 LEARNING OBJECTIVE Discuss the effects of historical fluctuations in stock and housing prices on the economy. Stocks and Bonds MyLab Economics Concept Check It will be useful to begin by briefly discussing the three main ways in which firms borrow or raise money to finance their investments. How do firms use financial markets in practice? When a firm wants to make a large purchase to build a new factory or buy machines, it often cannot pay for the purchase out of its own funds. In this case, it must “finance” the investment. One way to do this is to borrow from a bank. The bank loans the money to the firm, the firm uses the money to buy the factory or machine, and the firm pays back the loan (with interest) to the bank over time. Another possible way for a firm to borrow money is for the firm to issue a bond. If you buy a bond from a firm, you are making a loan to the firm. Bonds were discussed in Chapter 10 in our discussion of U.S. Treasury securities. We noted in that chapter that a bond is a promise to pay a fixed coupon periodically during the term of the bond and then to repay the full amount of the bond at the end of its term. Bonds issued by firms are called corporate bonds and are part of a firm’s debt. A third way for a firm to finance an investment is for it to issue additional shares of stock. Just as with bonds, typically only corporations have the ability to issue stock. When a firm issues new shares of stock, it does not add to its debt. Instead, it brings in additional owners of the firm, owners who agree to supply it with funds. Such owners are treated differently than bondholders, who are owed the amount they have
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loaned. Shares in a firm are also called the equity of the firm. A share of common stock is a certificate that represents the ownership of a share of a business, almost always a corporation. In some cases, firms pay a portion of their annual profits directly to their shareholders in the form of a dividend. For example, Waste Management is one of the largest firms in the business of managing garbage, with a market value of $35.3 billion. Its shares are owned by many individuals, mutual funds, foundations, and pensions, including Vanguard, BlackRock, and the Gates Foundation. In 2018, Waste Management had gross profits of $5.4 billion and paid out 38 percent of its earning in dividend. The remainder was retained for firm investments. Stockholders who own stocks that increase in value earn what are called capital gains. Realized capital gains (or losses) are increases (or decreases) in the value of assets, including stocks that households receive when they actually sell those assets. The government considers realized capital gains net of losses to be income, although their treatment under the tax code has been complex and subject to change every few years. The total return that an owner of a share of stock receives is the sum of the dividends received and the capital gain or loss. Determining the Price of a Stock MyLab Economics Concept Check What determines the price of a stock? If a share of stock is selling for $25, why is someone willing to pay that much for it? As we have noted, when you buy a share of stock, you own part of the firm. If a firm is making profits, it may be paying dividends to its shareholders. If it is not paying dividends but is making profits, people may expect that it will pay dividends stock A certificate that certifies ownership of a certain portion of a firm. capital gain An increase in the value of an asset. realized capital gain The gain that occurs when the owner of an asset actually sells it for more than he or she paid for it. M14_CASE3826_13_GE_C14.indd 293 17/04/19 4:19 AM 294 PART IV Further Macroeconomics Issues in the future. Microsoft, for example, only began paying dividends in 2003 as it entered a more mature phase of its business. Apple began paying dividends in 2012. Most utilities like Con Edison always pay dividends. Dividends are important in thinking about stocks because dividends are the form in which shareholders receive income from the firm. So one thing that
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is likely to affect the price of a stock is what people expect its future dividends will be. The larger the expected future dividends, the higher the current stock price, other things being equal. Another important consideration in thinking about the price of a stock is when the dividends are expected to begin to be paid. A $2-per-share dividend stream that is expected to start four years from now is worth less than a $2-per-share dividend that starts next year. In other words, the farther into the future the dividend is expected to be paid, the more it will be “discounted.” The amount by which expected future dividends are discounted depends on the interest rate. The higher the interest rate, the more expected future dividends will be discounted. If the interest rate is 10 percent, I can invest $100 today and receive $110 a year from now. I am thus willing to pay $100 today to someone who will pay me $110 in a year. If instead, the interest rate were only 5 percent, I would be willing to pay $104.76 today to receive $110 a year from now because the alternative of $104.76 today at a 5 percent interest rate also yields $110.00 at the end of the year. I am thus willing to pay more for the promise of $110 a year from now when the interest rate is lower. In other words, I “discount” the $110 less when the interest rate is lower. When investors buy a bond, that bond comes with a fixed coupon. When investors buy a stock, they can look at the current and past dividends, but there is no guarantee that future dividends will be the same. Dividends are voted each year by the board of a company, and in difficult times a board may decide to reduce or even eliminate dividends. So dividend payments come with a risk and that risk affects the stock price. In 2017, General Electric, a large, well diversified firm hit hard times in a number of its businesses and cut its dividend in half. The stock price soon followed. People prefer certain outcomes to uncertain ones for the same expected values. For example, I prefer a certain $50 over a bet in which there is a 50 percent chance I will get $100 and a 50 percent chance I will get nothing, even though the expected value of the two deals are equal. The same reasoning holds for future dividends. If, say, I expect dividends for both firms A and B to be $2
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per share next year but firm B has a much wider range of possibilities (is riskier), I will prefer firm A. Put another way, I will “discount” firm B’s expected future dividends more than firm A’s because the outcome for firm B is more uncertain. In the case of General Electric, the stock price fell both because the dividend payment fell and because stockholders lost faith in the company’s ability to keep paying even the new dividend. Risks had increased. We can thus say that the price of a stock should equal the discounted value of its expected future dividends, where the discount factors depend on the interest rate and risk. If for some reason (say, a positive surprise news announcement from the firm) we expect a firm to increase its future dividends, this should lead to an increase in the price of the stock. If there is a surprise fall in the interest rate, this decrease should also lead to a stock price increase. Finally, if the perceived risk of a firm falls, this perception should increase the firm’s stock price. Some stock analysts talk about the possibility of stock market “bubbles.” Given the preceding discussion, what might a bubble be? Assume that given your expectations about the future dividends of a firm and given the discount rate, you value the firm’s stock at $20 per share. Is there any case in which you would pay more than $20 for a share? We noted previously that the total return to an owner of a share of stock includes any capital gains that come from selling the stock. If the stock is currently selling for $25, which is above your value of $20, but you think that the stock will rise to $30 in the next few months, you might buy it now in anticipation of selling it later for a higher price and reap these capital gains. If others have similar views, the price of the stock may be driven up. In this case, what counts is not the discounted value of expected future dividends, but rather your view of what others will pay for the stock in the future. You will recall we suggested that stock prices cannot be predicted. Sometimes stocks rise and give their owners capital gains, while other times they fall and there are capital losses. One way to define a bubble is M14_CASE3826_13_GE_C14.indd 294 17/04/19 4:19 AM CHAPTER 14 Financial Crises, Stabilization, and Def
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icits 295 a time in which everyone expects that everyone else expects that stock prices in general will be driven up. This expectation of general price appreciation itself fuels the market as people come to expect capital gains as part of the return on their investments. When a firm’s stock price has risen rapidly, it is difficult to know whether the reason is that people have increased their expectations of the firm’s future dividends or that there is a bubble. You should see that holding stock under these circumstances is also risky. Some have compared stock ownership in a bubble to the game of musical chairs: You don’t want to be the one holding the stock when the music stops! The Stock Market Since 1948 MyLab Economics Concept Check Most investors are interested in following the fortunes of individual firms. Macroeconomists, tracking the connection between stocks and overall levels of economic activity, need instead a measure of the stock market in general. There are several indices available. If you follow the stock market at all, you know that much attention is paid to two stock price indices: the Dow Jones Industrial Average and the NASDAQ Composite. From a macroeconomic perspective, however, these two indices cover too small a sample of firms. One would like an index that includes firms whose total market value is close to the market value of all firms in the economy. For this purpose a much better measure is the Standard and Poor’s 500 stock price index, called the S&P 500. This index includes most of the larger companies in the economy by market value. The S&P 500 index is plotted in Figure 14.1 for 1948 I–2017 IV. What perhaps stands out most in this plot is the huge increase in the index between 1995 and 2000. Between December 31, 1994, and March 31, 2000, the S&P 500 index rose 226 percent, an annual rate of increase of 25 percent. This is by far the largest stock market boom in U.S. history, completely dominating the boom of the 1920s. Remember that we are talking about the S&P 500 index, which includes most of the firms in the U.S. economy by market value. We are not talking about just a few dot-com companies. The entire stock market went up 25 percent per year five years! This boom added roughly $14 trillion to household wealth, about $2.5 trillion per year.1 What caused this boom? You can see from Figure 12.7 that interest rates did not change much in the last half of the
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1990s, so the boom cannot be explained by any large fall in interest rates. Perhaps profits rose substantially during this period, and this growth led to a large increase in expected future dividends? We know from the preceding discussion that if expected Dow Jones Industrial Average An index based on the stock prices of 30 actively traded large companies. It is the oldest and most widely followed index of stock market performance. NASDAQ Composite An index based on the stock prices of more than 5,000 companies traded on the NASDAQ Stock Market. The NASDAQ market takes its name from the National Association of Securities Dealers Automated Quotation System. Standard and Poor’s 500 (S&P 500) An index based on the stock prices of 500 of the largest firms by market value. 2700.0 1215.0 405.0 135.0 45.0 15.0 1950 I 1955 I 1960 I 1965 I 1970 I 1975 I 1980 I 1985 I 1990 I 1995 I 2000 I 2005 I 2010 I 2015 I 2017 IV MyLab Economics Rea-time data Quarter ▴ FIGURE 14.1 The S&P 500 Stock Price Index, 1948 I–2017 IV The scale is the log scale. 1It is worth noting that S&P changes the firms that are in its index as firms either prosper or fade. This selection tells us that the index will overestimate actual stock market gains as a result of survivor bias. M14_CASE3826_13_GE_C14.indd 295 17/04/19 4:19 AM 296 PART IV Further Macroeconomics Issues t n e c r e P 0.08 0.07 0.06 0.05 0.04 0.03 1950 I 1955 I 1960 I 1965 I 1970 I 1975 I 1980 I 1985 I 1990 I 1995 I 2000 I 2005 I 2010 I 2015 I 2017 IV MyLab Economics Real-time data Quarter ▴ FIGURE 14.2 Ratio of After-Tax Profits to GDP, 1948 I–2017 IV future dividends increase, stock prices should increase. Figure 14.2 plots for 1948 I–2017 IV the ratio of after-tax profits to GDP. It is clear from the figure that nothing unusual happened to profits in the last half of the 1990s. The share of after-tax profits in GDP rose from the middle of 1995 to the middle of 1997, but then generally fell after that through 2000. Thus, there does not appear to be any surge of profits that would have led people to expect much higher future dividends
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. It could be that the perceived riskiness of stocks fell in the last half of the 1990s. This change would have led to smaller discount rates for stocks and thus, other things being equal, to higher stock prices. Although this possibility cannot be completely ruled out, there is no strong independent evidence that perceived riskiness fell. The stock market boom is thus a puzzle, and many people speculate that it was simply a bubble. For some reason, stock prices started rising rapidly in 1995 and people expected that other people expected that prices would continue to rise. This led stock prices to rise further, thus fulfilling the expectations, which led to expectations of further increases, and so on. Bubble believers note that once stock prices started falling in 2000, they fell a great deal. It is not the case that stock prices just leveled out in 2000; they fell rapidly. People of the bubble view argue that this was simply the bubble bursting. Robert Shiller, a Yale Nobel Laureate, referred to this period as one of “irrational exuberance.” The first problem then for the stability of the macroeconomy is the large and seemingly unpredictable swings in the stock market. As we will see, these swings induce behavior changes by households and firms that affect the real economy. Before we explore this link, however, we turn to a second volatile series: housing prices. Housing Prices Since 1952 MyLab Economics Concept Check Figure 14.3 plots the relative price of housing for 1952 I–2017 IV. The plotted figure is the ratio of an index of housing prices to the GDP deflator. When this ratio is rising, it means that housing prices are rising faster than the overall price level, and vice versa when the ratio is falling. The plot in Figure 14.3 is remarkable. Housing prices grew roughly in line with the overall price level until about 2000. The increase between 2000 and 2006 was then huge, followed by an equivalent fall between 2006 and 2009. Between 2000 I and 2006 I the value of housing wealth increased by about $13 trillion, roughly $500 billion per quarter. Between 2006 II and 2009 I the fall in the value of housing wealth was about $7 trillion, more than $600 billion per quarter. Once again, it is hard to find a cogent reason for this based on the use value of housing. Rental prices, for example, did not rise and fall in this way. M14_CASE3826_13_GE_C14.indd 296 17/04/19 4:19
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AM CHAPTER 14 Financial Crises, Stabilization, and Deficits 297 o i t a R 2.2 2.0 1.8 1.6 1.4 1.2 1.0 0.8 1955 I 1960 I 1965 I 1970 I 1975 I 1980 I 1985 I 1990 I 1995 I 2000 I 2005 I 2010 I 2015 I 2017 IV Quarter MyLab Economics Real-time data ▴ FIGURE 14.3 Ratio of a Housing Price Index to the GDP Deflator, 1952 I–2017 IV Household Wealth Effects on the Economy MyLab Economics Concept Check We see that both the stock market and the housing market have periods of large unpredictable ups and downs. How are these swings felt in the real economy? We know from earlier that one of the factors that affects consumption expenditures is wealth. Other things being equal, the more wealth a family has, the more it spends. Much of the fluctuation in household wealth in the recent past is because of fluctuations in stock prices and housing prices. When housing and stock values rise, households feel richer and they spend more. As a rough rule of thumb, a $1.00 change in the value of wealth (either stocks or housing) leads to about a $0.03 to $0.04 change in consumer spending per year. With unpredictable wealth changes, we end up with unpredictable consumption changes and thus unpredictable changes in GDP. An increase in stock prices may also increase investment. If a firm is considering an investment project, one way in which it can finance the project is to issue additional shares of stock. The higher the price of the firm’s stock, the more money it can get per additional share issued. A firm is thus likely to undertake more investment projects the higher its stock price. The cost of an investment project in terms of shares of stock is smaller the higher the price of the stock. This is the way a stock market boom may increase investment and a stock market contraction may decrease investment. Stock price changes affect a firm’s cost of capital. Financial Crises and the 2008 Bailout MyLab Economics Concept Check It is clear that the stock market boom in the last half of the 1990s contributed to the strong economy in that period and that the contraction in the stock market after that contributed to the 2000–2001 recession. It is also clear that the boom in housing prices in the 2000–2005 period contributed to the expansion that followed the 2000–2001 recession and that the collapse of housing prices between 2006 and 2009 contributed to the 2008–2009
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recession. This is just the household wealth effect at work combined in the case of stock prices with an effect on the investment spending of firms. The recession of 2008–2009 was also characterized by some observers as a period of financial crisis. Although there is no precise definition of a financial crisis, most financial writers identify financial crises as periods in which the financial institutions that facilitate the movement of capital across households and firms cease to work smoothly. In a financial crisis, macroeconomic problems caused by the wealth effect of a falling stock market or housing market are accentuated. Many people consider the large fall in housing prices that began at the end of 2006 to have led to the financial crisis of 2008–2009. We discussed briefly in Chapter 10 some of the reasons for this fall in housing prices. Lax government regulations led to excessive risk taking during the housing boom, with many people taking out mortgages that could only be sustained if housing prices kept rising. People bought houses expecting capital gains from those houses once they sold. The problem was exacerbated by low “teaser-rate” mortgage loans in which people paid very low interest M14_CASE3826_13_GE_C14.indd 297 17/04/19 4:19 AM 298 PART IV Further Macroeconomics Issues Predicting an Economy’s Future Policymakers and economists depend on economic forecasting models to predict the duration and magnitude of changes in the business cycle. These models rely on a large set of measurable economics factors, known as leading indicators, to try and provide an estimate of the future performance of GDP growth, unemployment, and inflation over a one, two, or three-year horizon. These indicators include (a) output variables such as changes in the components of GDP, capital formation, industrial production, manufacturing new orders, new credit lines, and building permits; (b) unemployment claims, job additions, wages, and labor productivity indicators; and (c) indicators of future inflation such as housing prices and producer prices. Lately, stock prices and stock market indices are also being included in the list. Does the intricacy of economic forecasting models lead to accurate forecasts? Unfortunately, no. Economists are often criticized for the unreliability of forecasting models in predicting recessions, even ones as severely damaging as the Great Depression in the 1930s and the financial crisis of 2008–2009. Some recessions are difficult to anticipate because of sudden and severe shocks and political crises, but in many cases economists are unable to read signs of an impending economic slowdown. What are these
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models missing? A study by the Federal Reserve Bank of New York (FRBNY)1 compares the forecasting models used by two major central banks, the Fed and the European Central Bank (ECB), and concludes that the main shortcomings of their models are poor assumptions and misunderstanding of the asset market boom that preceded the meltdowns. The economists at the Fed failed to account for the overvaluation of house prices and the rapid growth of new forms of mortgage finance. Both central banks failed to allocate sufficient weight to the powerful spillover effects between the financial system and the real economy. Another serious flaw was the dependence on historical figures to forecast trends, which led to unreliable predictions. A solution to account for multiple possibilities and assess each outcome is the behavioral economic model. This model takes into consideration consumer behavior and uses a scenario-driven approach, which generates a number of “what if?” scenarios that illustrate the sensitivity of economic aggregates to changes in economic conditions and macroeconomic policies. Since the two largest recessions in modern history originated in the financial sector, central banks have started using stress testing scenarios, which are “what if?” analysis to test the impact of shocks and various economic assumptions on the financial sector and the economy at large. Finally, while forecasting is an inexact science because it depends, to a great extent, on events that cannot be foreseen, social conditions could be a good prediction of impending recessions. For example, studies in the United States and the United Kingdom2 reveal that lower levels of pregnancy and higher rates of divorce usually precede economic slowdowns. It might be worthwhile for economists and policymakers to pay attention to social trends to predict economic trends! CRITICAL THINKING 1. What other factors and indicators can be included to refine economic forecasting models? 1Lucia Alessi, Eric Ghysels, Luca Onorante, Richard Peach, and Simon Potter (2014). “Central Bank Macroeconomic Forecasting during the Global Financial Crisis: The European Central Bank and Federal Reserve Bank of New York Experiences,” Federal Reserve Bank of New York Staff Reports, Staff Report No. 680, July 2014. 2Gemma Tetlow (2018). “Economists urged to use fertility to predict recessions,” The Economist, February 26. rates for the first few years of home ownership. Once housing prices started to fall, the possibility of capital gains from a house sale lessened and it became clear that many households would not be able to afford their homes once
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teaser rates expired. With no prospect of a profitable house sale and higher mortgage interest rates, many people defaulted on those mortgages. As a result, the value of the securities backed by these mortgages dropped sharply. Many large financial institutions were involved either directly in the mortgage market or in the market for mortgage-backed securities, and they began to experience financial trouble. With the exception of Lehman Brothers, which M14_CASE3826_13_GE_C14.indd 298 17/04/19 4:19 AM CHAPTER 14 Financial Crises, Stabilization, and Deficits 299 went bankrupt, most of the large financial institutions were bailed out by the federal government— a $700 billion bailout bill that was passed in October 2008. These institutions included Goldman Sachs, Citigroup, Morgan Stanley, J.P. Morgan Chase, and A.I.G. The government provided capital to these firms to ease their financial difficulties. The Federal Reserve also participated in the bailout, buying huge amounts of mortgage-backed securities. We saw in Chapter 10 that in mid-April 2018, the Fed held about $1,754 billion in mortgage-backed securities, many of which it purchased in 2008 and 2009. Many other countries had similar issues with their own financial institutions, in part because many of them had purchased U.S. mortgage-backed securities as an investment. What would have happened had the U.S. government not bailed out the large financial institutions? This is a matter of debate among economists and politicians, but some effects are clear. Absent intervention, the negative wealth effect would have been larger. Some of the financial institutions would have gone bankrupt, which would have wiped out their bondholders. Many of these bonds are held by the household sector, so household wealth would have fallen from the loss in the value of the bonds. The fall in overall stock prices would also likely have been larger, thus contributing to the negative wealth effect. The government bailout thus reduced the fall in wealth that took place during this period. Some people also argue that lending to businesses would have been lower had there been no bailout. This would have forced businesses to cut investment, thereby contributing to the contraction in aggregate demand. It is not clear how important this effect is since, as seen in Chapter 10, much of the Fed’s purchase of mortgagebacked securities ended up as excess reserves in banks, not as increased loans. It is important to distinguish between the stimulus measures the government took to fight the 2008–2009 recession, which were
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tax cuts and spending increases, and the bailout activity, which was direct help to financial institutions to keep them from failing. Putting aside the stimulus measures, was the bailout a good idea? On the positive side, it lessened the negative wealth effect and possibly led to more loans to businesses. Also, much of the lending to the financial institutions has or will be repaid; so the final total cost will be less than $700 billion. On the negative side, there were political and social costs. Many of the people who benefited from the bailout were wealthy—certainly wealthier than average. The bond holders of financial institutions tend to come from the top end of the income distribution. Many people noted that expenditures bailing out the financial institutions that made bad loans dwarfed expenditures to help home owners who took out those bad loans. Also, the jobs in the financial institutions that were saved were mostly jobs of high-income earners. People who will pay for the bailout in the long run are the U.S. taxpayers, who are on average less wealthy than those who benefited from the bailout. The bailout thus likely had, or at least was perceived by many to have had, bad income distribution consequences, which put a strain on the body politic. We have seen how difficult it is to predict changes in asset prices like stock and housing prices, and we have also seen how much impact these changes can have on the real economy. But many have noted that while the government may not be able to predict asset bubbles, it does influence those fluctuations through other policies. In the case of housing, at least some of the fuel driving the bubble was likely lax credit standards, credit standards controlled in part by government agencies. Recent asset bubbles also may have reflected risk taking by financial institutions, risk behavior that is also under the control of government agencies. The substantial macroeconomic costs of the most recent recession stimulated numerous calls for regulatory reform in the financial market. In 2010 a financial regulation bill, known as the Dodd-Frank bill, was passed to try to tighten up financial regulations in the hope of preventing a recurrence of the 2008–2009 financial crisis. In the late spring of 2018, Congress voted to ease some of the Dodd-Frank rules for smaller banks and credit unions. Time Lags Regarding Monetary and Fiscal Policy We have so far seen that the unpredictability of asset-price changes is difficult for policymakers to deal with. At best, policymakers can only react to these changes. The goal of stabilization policy is to smooth out fluctuation in GDP as much as possible. Consider
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the two possible time paths for aggregate output (income) (Y) shown in Figure 14.4. Path A (the dark blue line) represents GDP 14.2 LEARNING OBJECTIVE Explain the purpose of stabilization policies and differentiate between three types of time lags. M14_CASE3826_13_GE_C14.indd 299 17/04/19 4:19 AM 300 PART IV Further Macroeconomics Issues ▸ FIGURE 14.4 Two Possible Time Paths for GDP Path A is less stable—it varies more over time—than path B. Other things being equal, society prefers path B to path A. P D G B A stabilization policy Describes both monetary and fiscal policy, the goals of which are to smooth out fluctuations in output and employment and to keep prices as stable as possible. time lags Delays in the economy’s response to stabilization policies. Time MyLab Economics Concept Check absent stabilization policies by the government; Path B (the light blue line) shows the smoother path that stabilization policy aims to produce. Stabilization policy is also concerned with the stability of prices. Here the goal is not to prevent the overall price level from rising at all, but instead to achieve an inflation rate that is as close as possible to a target rate of about 2 percent given the government’s other goals of high and stable levels of output and employment. Stabilization goals are not easy to achieve, particularly in the light of various kinds of time lags, or delays in the response of the economy to stabilization policies. Economists generally recognize three kinds of time lags: recognition lags, implementation lags, and response lags. Figure 14.5 shows timing problems a government may face when trying to stabilize the economy. Suppose the economy reaches a peak and begins to slide into recession at point A (at time t0). Given the need to collect and process economic data, policymakers do not observe the decline in GDP until it has sunk to point B (at time t1). By the time they have begun to stimulate the economy (point C, time t2), the recession is well advanced and the economy has almost bottomed out. When the policies finally begin to take effect (point D, time t3), the economy is already on its road to recovery. The policies push the economy to point E’—a much greater fluctuation than point E, which is where the economy would have been without the stabilization policy. Sometime after point
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D, policymakers may begin to realize that the economy is expanding too quickly. By the time they have implemented contractionary policies and the policies have made their effects felt, the economy is starting to weaken. The contractionary policies therefore end up pushing GDP to point F’ instead of point F. Because of the various time lags, the expansionary policies that should have been instituted at time t0 do not begin to have an effect until time t3, when they are no longer needed. The light blue line in Figure 14.5 shows how the economy behaves as a result of the “stabilization” policies. ▸ FIGURE 14.5 Possible Stabilization Timing Problems Attempts to stabilize the economy can prove destabilizing because of time lags. An expansionary policy that should have begun to take effect at point A does not actually begin to have an impact until point D, when the economy is already on an upswing. Hence, the policy pushes the economy to points E’ and F’ (instead of points E and F). Income varies more widely than it would have if no policy had been implemented. E' E P D G A B D C t0 t1 t2 t3 t4 F F' t5 Time MyLab Economics Concept Check M14_CASE3826_13_GE_C14.indd 300 17/04/19 4:19 AM CHAPTER 14 Financial Crises, Stabilization, and Deficits 301 The dark blue line shows the time path of GDP if the economy had been allowed to run its course and no stabilization policies had been attempted. In this case, stabilization policy makes income more erratic, not less—the policy results in a peak income of E’ as opposed to E and a trough income of F’ instead of F. Critics of stabilization policy argue that the situation in Figure 14.5 is typical of the interaction between the government and the rest of the economy. This claim is not necessarily true. We need to know more about the nature of the various kinds of lags before deciding whether stabilization policy is good or bad. Recognition Lags MyLab Economics Concept Check It takes time for policymakers to recognize a boom or a slump. Many important data—those from the national income and product accounts, for example—are available only quarterly. It usually takes several weeks to compile and prepare even the preliminary estimates for these figures. If the economy goes into a slump on January 1, the recession may not be
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detected until the data for the first quarter are available at the end of April. Moreover, the early national income and product accounts data are only preliminary, based on an incomplete compilation of the various data sources. These estimates can, and often do, change as better data become available. (For example, when the Bureau of Economic Analysis first announced the results for the fourth quarter of 2012, it indicated that the economy had negative growth, –0.1%. This announcement was at the end of January 2013. At the end of February the growth rate was revised to plus 0.1%. Then at the end of March it was further revised to plus 0.4%.) This situation makes the interpretation of the initial estimates difficult, and recognition lags result. Recognition lag also kicks in on the upside of the cycle as the economy recovers from slow growth in response to government policy. When has the government done enough to stimulate the economy and when will further efforts lead to over stimulation? Janet Yellen, former chair of the Fed, spoke of exactly this concern as she contemplated changing the Fed’s easy monetary policy in the spring of 2015 in a speech in San Francisco. “We need to keep in mind the wellestablished fact that the full effects of monetary policy are felt only after long lags. This means that policymakers cannot wait until they have achieved their objectives to begin adjusting policy. I would not consider it prudent to postpone the onset of normalization until we have reached, or are on the verge of reaching, our inflation objective. Doing so would create too great a risk of significantly overshooting both our objectives of maximum sustainable employment and 2 percent inflation, potentially undermining economic growth and employment if the FOMC is subsequently forced to tighten policy markedly or abruptly.” Implementation Lags MyLab Economics Concept Check The problems that lags pose for stabilization policy do not end once economists and policymakers recognize that the economy is in a boom or a slump. Even if everyone knows that the economy needs to be stimulated or reined in, it takes time to put the desired policy into effect, especially for actions that involve fiscal policy. Implementation lags result. Each year Congress decides on the federal government’s budget for the coming year. The tax laws and spending programs embodied in this budget are hard to change once they are in place. If it becomes clear that the economy is entering a recession and is in need of a fiscal stimulus during the middle of the year, there is a limited amount that can be done. Until Congress authorizes more
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spending or a cut in taxes, changes in fiscal policy are not possible.2 Monetary policy is less subject to the kinds of restrictions that slow down changes in fiscal policy. As we saw in Chapter 10, the Fed’s current tool for changing the interest rate is to change the rate it pays on bank reserves. This change can be made very quickly, and there is in effect no implementation lag once the decision has been made to make the change. 2Do not forget, however, about the existence of automatic stabilizers (Chapter 9). Many programs contain built-in countercyclical features that expand spending or cut tax collections automatically (without the need for congressional or executive action) during a recession. recognition lag The time it takes for policymakers to recognize the existence of a boom or a slump. implementation lag The time it takes to put the desired policy into effect once economists and policymakers recognize that the economy is in a boom or a slump. M14_CASE3826_13_GE_C14.indd 301 17/04/19 4:19 AM 302 PART IV Further Macroeconomics Issues response lag The time that it takes for the economy to adjust to the new conditions after a new policy is implemented; the lag that occurs because of the operation of the economy itself. Response Lags MyLab Economics Concept Check Even after a macroeconomic problem has been recognized and the appropriate corrective policies have been implemented, there are response lags—the time that it takes for the economy to adjust to the new conditions after a new policy is implemented; lags that occur because of the operation of the economy itself. Even after the government has formulated a policy and put it into place, the economy takes time to adjust to the new conditions. Although monetary policy can be adjusted and implemented more quickly than fiscal policy, it takes longer to make its effect felt on the economy because of response lags. What is most important is the total lag between the time a problem first occurs and the time the corrective policies are felt. Response Lags for Fiscal Policy One way to think about the response lag in fiscal policy is through the government spending multiplier. This multiplier measures the change in GDP caused by a given change in government spending or net taxes. It takes time for the multiplier to reach its full value. The result is a lag between the time a fiscal policy action is initiated and the time the full change in GDP is realized. The reason for the response lag in fiscal policy—the delay in the multiplier process—is simple. During the first few months
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after an increase in government spending or a tax cut, there is not enough time for the firms or individuals who benefit directly from the extra government spending or the tax cut to increase their own spending. Neither individuals nor firms revise their spending plans instantaneously. Until they can make those revisions, the increase in government spending does not stimulate extra private spending. Changes in government purchases are a component of aggregate expenditure. When G rises, aggregate expenditure increases directly; when G falls, aggregate expenditure decreases directly. When personal taxes are changed, however, an additional step intervenes, giving rise to another lag. Suppose a tax cut has lowered personal income taxes across the board. Each household must decide what portion of its tax cut to spend and what portion to save. This decision is the extra step. Before the tax cut gets translated into extra spending, households must take the step of increasing their spending, which usually takes some time. With a business tax cut, there is a further complication. Firms must decide what to do with their added after-tax profits. If they pay out their added profits to households as dividends, the result is the same as with a personal tax cut. Households must decide whether to spend or to save the extra funds. Firms may also retain their added profits and use them for investment, but investment is a component of aggregate expenditure that requires planning and time. In practice, it takes about a year for a change in taxes or in government spending to have its full effect on the economy. This response lag means that if we increase spending to counteract a recession today, the full effects will not be felt for 12 months. By that time, the state of the economy might be different. Response Lags for Monetary Policy Monetary policy works by changing interest rates—assuming that interest rates are not at the zero lower bound—which then changes planned investment. Interest rates can also affect consumption spending, as we discuss further in Chapter 15. For now, it is enough to know that lower interest rates usually stimulate consumption spending and that higher interest rates decrease consumption spending. The response of consumption and investment to interest rate changes takes time. Even if interest rates were to rise by 5 percent overnight, firms would not immediately decrease their investment purchases. Firms generally make their investment plans several years in advance. If General Motors (GM) wants to respond to an increase in interest rates by investing less, it will take time—perhaps up to a year—for the firm to come up with plans to scrap some of its investment projects. The response lags for monetary
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policy are even longer than response lags for fiscal policy. When government spending changes, there is a direct change in the sales of firms, which would sell more as a result of an increase in government purchases. When interest rates change, however, the sales of firms do not change until households change their consumption spending and/or firms change their investment spending. It takes time for households and firms to respond to interest rate changes. In this sense, interest rate changes are like tax-rate changes. The resulting change in firms’ sales must wait for households and firms to change their purchases of goods. M14_CASE3826_13_GE_C14.indd 302 17/04/19 4:19 AM CHAPTER 14 Financial Crises, Stabilization, and Deficits 303 Summary MyLab Economics Concept Check Stabilization is thus not easily achieved even if there are no surprise asset-price changes. It takes time for policymakers to recognize the existence of a problem, more time for them to implement a solution, and yet more time for firms and households to respond to the stabilization policies taken. Monetary policy can be adjusted more quickly and easily than taxes or government spending, making it a useful instrument in stabilizing the economy. However, because the economy’s response to monetary changes is probably slower than its response to changes in fiscal policy, tax and spending changes may also play a useful role in macroeconomic management. Government Deficit Issues If a government is trying to stimulate the economy through tax cuts or spending increases, this, other things being equal, will increase the government deficit. One thus expects deficits in recessions—cyclical deficits. These deficits are temporary and do not impose any long-run problems, especially if modest surpluses are run when there is full employment. If, however, at full employment the deficit—the structural deficit—is still large, this can have negative long-run consequences. Figure 9.6 shows that the U.S. government deficit as a percentage of GDP rose rapidly beginning in 2008. In 2009 the deficit as a percentage of GDP was about 9 percent. This is huge, but most of it was cyclical because of the sharp recession. Earlier, in 2005–2007, there was roughly full employment, and during this period the deficit was about 2 percent of GDP, which we can think of as a structural deficit given that it occurred in a full employment period. By the end of 2017, with the economy essentially at full employment, the deficit was at 3.
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7 percent of GDP. At that point, the deficit was almost all structural. The large deficits beginning in 2008 led to a large rise in the ratio of the federal government debt to GDP. Figure 9.7 in Chapter 9 shows that the ratio peaked at the end of 2012, where it was about 70 percent. (This is up from about 46 percent in 2007.) Since 2012 the ratio has remained large. At the end of 2017 it was about 69 percent. One concern about a rising debt-to-GDP ratio for a country is that at some point investors may begin to perceive that the bonds the country is selling to finance its deficits are now riskier. This will increase the interest rate that the country must pay on its bonds, which will add further to the deficit as interest payments rise. This may in turn force the country to drastically cut spending or increase taxes, which may have large negative effects on the economy. Deficit Targeting MyLab Economics Concept Check Debates about deficits have been around for a long time. In the 1980s the U.S. government was spending much more than it was receiving in taxes. In response to the large deficits, in 1986 the U.S. Congress passed and President Reagan signed the Gramm-Rudman-Hollings Act (named for its three congressional sponsors), referred to as GRH. It is interesting to look back on this in the context of the current deficit problem. GRH set a target for reducing the federal deficit by a set amount each year. As Figure 14.6 shows, the deficit was to decline by $36 billion per year between 1987 and 1991, with a deficit of zero slated for fiscal year 1991. What was interesting about the GRH legislation was that the targets were not merely guidelines. If Congress, through its decisions about taxes and spending programs, produced a budget with a deficit larger than the targeted amount, GRH called for automatic spending cuts. The cuts were divided proportionately among most federal spending programs so that a program that made up 5 percent of total spending was to endure a cut equal to 5 percent of the total spending cut.3 3Programs such as Social Security were exempt from cuts or were treated differently. Interest payments on the federal debt were also immune from cuts. 14.3 LEARNING OBJECTIVE Discuss the effects of government deficits and deficit targeting. Gramm-Rudman-Hollings Act Passed by the U.S. Congress and signed by President Reagan in 1986, this law set out to reduce the
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federal deficit by $36 billion per year, with a deficit of zero slated for 1991. M14_CASE3826_13_GE_C14.indd 303 17/04/19 4:19 AM 304 PART IV Further Macroeconomics Issues ▸ FIGURE 14.6 Deficit Reduction Targets under Gramm-RudmanHollings The GRH legislation, passed in 1986, set out to lower the federal deficit by $36 billion per year. If the plan had worked, a zero deficit would have been achieved by 1991. MyLab Economics Concept Check ) 150 $125 $100 $75 $50 $25 $0 $144 $108 $72 $36 1987 1988 1989 Fiscal year 1990 1991 In 1986, the U.S. Supreme Court declared part of the GRH bill unconstitutional. In effect, the Court said that Congress would have to approve the “automatic” spending cuts before they could take place. The law was changed in 1986 to meet the Supreme Court ruling and again in 1987, when new targets were established. The new targets had the deficit reaching zero in 1993 instead of 1991. The targets were revised again in 1991, when the year to achieve a zero deficit was changed from 1993 to 1996. In practice, these targets never came close to being achieved. As time wore on, even the revised targets became completely unrealistic, and by the end of the 1980s, the GRH legislation was not taken seriously. Although the GRH legislation is history, it is useful to consider the stabilization consequences of deficit targeting. What if deficit targeting is taken seriously? In the spring of 2018 House Republicans again offered up a balanced budget amendment for a vote, although it failed to get the two thirds majority vote needed to pass. Balanced budget rules require that the government not run a deficit ever. Is this good policy? The answer is probably not. We will now show how deficit targeting can make the economy more unstable. In a world with no deficit targeting, Congress and the president make decisions each year about how much to spend and how much to tax. The federal government deficit is a result of these decisions and the state of the economy. However, with deficit targeting, the size of the deficit is set in advance. Taxes and government spending must be adjusted to produce the required deficit, or in the case of a balanced budget world, no deficit. In this situation, the deficit is no longer a consequence of the tax and spending decisions. Instead, taxes and spending become a consequence of the deficit decision.
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What difference does it make whether Congress chooses a target deficit and adjusts government spending and taxes to achieve that target or decides how much to spend and tax and lets the deficit adjust itself? The difference may be substantial. Consider a leftward shift of the AD curve caused by some negative demand shock. A negative demand shock is something that causes a negative shift in consumption or investment schedules or that leads to a decrease in U.S. exports. We know that a leftward shift of the AD curve lowers aggregate output (income), which causes the government deficit to increase. In a world without deficit targeting, the increase in the deficit during contractions provides an automatic stabilizer for the economy. (Review Chapter 9 if this point is hazy.) The contraction-induced decrease in tax revenues and increase in transfer payments tend to reduce the fall in after-tax income and consumer spending because of the negative demand shock. Thus, the decrease in aggregate output (income) caused by the negative demand shock is lessened somewhat by the growth of the deficit [Figure 14.7(a)]. In a world with deficit targeting, the deficit is not allowed to rise. Some combination of tax increases and government spending cuts would be needed to offset what would have otherwise been an increase in the deficit. We know that increases in taxes or cuts in spending are contractionary in themselves. The contraction in the economy will therefore be larger than it would have been without deficit targeting because the initial effect of the negative demand shock is worsened by the rise in taxes or the cut in government spending required to keep the deficit from rising. As Figure 14.7(b) shows, deficit targeting acts as an automatic destabilizer. It requires taxes to be raised and government spending to be cut during a contraction. This reinforces, rather than counteracts, the shock that started the contraction. automatic stabilizer Revenue and expenditure items in the federal budget that automatically change with the state of the economy in such a way as to stabilize GDP. automatic destabilizer Revenue and expenditure items in the federal budget that automatically change with the state of the economy in such a way as to destabilize GDP. M14_CASE3826_13_GE_C14.indd 304 17/04/19 4:19 AM CHAPTER 14 Financial Crises, Stabilization, and Deficits 305 a. Without Deficit Targeting MyLab Economics Concept Check Positive boost to demand reduces the shock (automatic stabilizers) Negative demand shock Income falls Tax revenues drop; transfers increase Deficit increases ◂ FIGURE
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14.7 Deficit Targeting as an Automatic Destabilizer Deficit targeting changes the way the economy responds to negative demand shocks because it does not allow the deficit to increase. The result is a smaller deficit but a larger decline in income than would have otherwise occurred. b. With Deficit Targeting Negative demand shock Income falls Tax revenues drop; transfers increase Deficit increases Second negative demand shock reinforces first shock and worsens the contraction Tax rates raised or spending cut to reach deficit target (automatic destabilizer) Deficit targeting thus has undesirable macroeconomic consequences. It requires cuts in spending or increases in taxes at times when the economy is already experiencing problems. This drawback does not mean, of course, that a government should ignore structural deficit problems. Locking in spending cuts or tax increases during periods of negative demand shocks is not a good way to manage the economy. Moving forward, policymakers around the globe will have to devise other methods to control growing structural deficits. S U M M A R Y 14.1 THE STOCK MARKET, THE HOUSING MARKET, AND FINANCIAL CRISES p. 293 in housing prices beginning in 2006 led to the recession and financial crisis of 2008–2009. 1. A firm can finance an investment project by borrowing from banks, by issuing bonds, or by issuing new shares of its stock. People who own shares of stock own a fraction of the firm. 2. The price of a stock should equal the discounted value of its expected future dividends, where the discount factors depend on the interest rate and risk. 3. A bubble exists when the price of a stock exceeds the dis- counted value of its expected future dividends. In this case what matters is what people expect that other people expect about how much the stock can be sold for in the future. 4. The largest stock market boom in U.S. history occurred between 1995 and 2000, when the S&P 500 index rose by 25 percent per year. The boom added $14 trillion to household wealth. 5. Why there was a stock market boom in 1995–2000 appears to be a puzzle. There was nothing unusual about earnings that would predict such a boom. Many people believe that the boom was merely a bubble. 6. Housing prices rose rapidly between 2000 and 2006 and fell rapidly between 2006 and 2009. Many consider that the fall 7. Changes in stock prices and housing prices change household wealth, which affects consumption and thus the real economy. Changes in stock and housing prices are largely unpredictable, which makes many fluctuations in the economy
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unpredictable. 14.2 TIME LAGS REGARDING MONETARY AND FISCAL POLICY p. 299 8. Stabilization policy describes both fiscal and monetary policies, the goals of which are to smooth out fluctuations in output and employment and to keep prices as stable as possible. Stabilization goals are not necessarily easy to achieve because of the existence of certain time lags, or delays in the response of the economy to macroeconomic policies. 9. A recognition lag is the time it takes for policymakers to recognize the existence of a boom or a slump. An implementation lag is the time it takes to put the desired policy into effect once economists and policymakers recognize that the economy is in a boom or a slump. A response lag is the time it takes for the economy to adjust to the new conditions after a new policy is implemented—in other words, a lag that MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with. M14_CASE3826_13_GE_C14.indd 305 17/04/19 4:19 AM 306 PART IV Further Macroeconomics Issues occurs because of the operation of the economy itself. In general, monetary policy can be implemented more rapidly than fiscal policy but fiscal policy generally has a shorter response lag than monetary policy. 11. In 1986 Congress passed and President Reagan signed the Gramm-Rudman-Hollings Act (GRH), which set deficit targets for each year. The aim was to reduce the large structural deficit that existed. 14.3 GOVERNMENT DEFICIT ISSUES p. 303 10. The U.S. debt-to-GDP ratio has remained high since 2012, and it is projected to increase substantially beyond 2017. 12. Deficit-targeting measures that call for automatic spending cuts to eliminate or reduce the deficit, like the GRH legislation, may have the effect of destabilizing the economy automatic destabilizers, p. 304 automatic stabilizers, p. 304 capital gain, p. 293 Dow Jones Industrial Average, p. 295 Gramm-Rudman-Hollings Act, p. 303 implementation lag, p. 301 NASDAQ Composite, p. 295 realized capital gain, p. 293 recognition lag, p. 301 response lag, p. 302 stabilization policy, p. 300 Standard and Poor’s 500 (S&P 500),
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p. 295 stock, p. 293 time lags, p. 300 P R O B L E M S All problems are available on MyLab Economics. 14.1 THE STOCK MARKET, THE HOUSING MARKET, AND FINANCIAL CRISES LEARNING OBJECTIVE: Discuss the effects of historical fluctuations in stock and housing prices on the economy. 1.1 In July 2009, the S&P 500 index was at 1,000. a. What is the S&P 500 index? b. Where is the S&P today? c. If you had invested $10,000 in July2009 and your investments had increased in value by the same percentage as the S&P 500 index had increased, how much would you have today? d. Assume that the total stock market holdings of the household sector were about $20 trillion and that the entire stock market went up/down by the same percentage as the S&P. Evidence suggests that the “wealth effect” of stock market holdings on consumer spending is about 4 percent of wealth annually. How much additional or reduced spending would you expect to see as a result of the stock market moves since July 2009? Assuming a multiplier of two and a GDP of $18,000 billion, how much additional/ less GDP would you predict for next year if all of this was true? 1.2 During 1997, stock markets in Asia collapsed. Hong Kong’s was down nearly 30 percent, Thailand’s was down 62 percent, and Malaysia’s was down 60 percent. Japan and Korea experienced big drops as well. What impacts would these events have on the economies of the countries themselves? Explain your answer. In what ways would you have expected these events to influence the U.S. economy? How might the spending of Asians on American goods be affected? What about Americans who have invested in these countries? 14.2 TIME LAGS REGARDING MONETARY AND FISCAL POLICY LEARNING OBJECTIVE: Explain the purpose of stabilization policies and differentiate between three types of time lags. 2.1 In January 2013, the Treaty on Stability, Coordination and Governance in the Economic and Monetary Union (TSCG), also referred to as the Fiscal Stability Treaty, came into effect in the European Union. According to this treaty, the budgets of the nation states have to be in balance or in surplus, otherwise certain automatic correction mechanisms come into force. For countries with debt over 60 percent
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of GDP, the treaty outlines the ratio by which their debt has to decrease annually. Why do you think this treaty was adopted and why do you think that expansionary fiscal policies were not pursued rather? 2.2 Explain why stabilization policy may be difficult to carry out. How is it possible that stabilization policies can actually be destabilizing? 2.3 [Related to the Economics in Practice on p. 298] The Economics in Practice states that since recessions can be hard to forecast, the recognition lag can be long, as was the case with the recession of 2008–2009. Assuming that the recognition lag with regards to this recession was the same for both federal government and Federal Reserve MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with. M14_CASE3826_13_GE_C14.indd 306 17/04/19 4:19 AM policymakers, explain which type of policy, fiscal or monetary, should have been the quickest to take effect in the economy and with which of these policies should the economy have most rapidly adjusted to the newly implemented conditions. 14.3 GOVERNMENT DEFICIT ISSUES LEARNING OBJECTIVE: Discuss the effects of government deficits and deficit targeting. 3.1 Explain why the government deficit rises as the economy contracts and why the government deficit falls when the economy expands. 3.2 You are given the following information about the econ- omy in 2019 (all in billions of dollars): Consumption function: Taxes: Investment function: Disposable income: Government spending: Equilibrium: Hint: Deficit is D = G - T = G - C = 100 + T = - 150 + 1 I = 60 Yd = Y - T G = 80 Y = C + I + G.25 * Y 1 - 150 +.8 * Yd.25 * Y 2 2. a. Find equilibrium income. Show that the government budget deficit (the difference between government spending and tax revenues) is $5 billion. 2 4 1 3 b. Congress passes the Foghorn-Leghorn (F-L) amendment, which requires that the deficit be zero this year. If the budget adopted by Congress has a deficit that is larger than zero, the deficit target must be met by cutting spending. Suppose spending is cut by $5 billion (to $75 billion). What is the new value for
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equilibrium GDP? What is the new deficit? Explain carefully why the deficit is not zero. CHAPTER 14 Financial Crises, Stabilization, and Deficits 307 c. Suppose the F-L amendment was not in effect and planned investment falls to I = 55. What is the new value of GDP? What is the new government budget deficit? What happens to GDP if the F-L amendment is in effect and spending is cut to reach the deficit target? (Hint: Spending must be cut by $21.666 billion to balance the budget.) 3.3 In the wake of the 2007–2008 crisis, and especially in 2010–2012, the eurozone underwent severe strains on its government bond markets. Although no European country has defaulted (yet) on its bonds, several countries have had to resort to exceptional measures, in part financed by the European Central Bank, to overcome the crisis. Do some research to find information on any two countries that are most affected by the European debt crisis and explain how this might have happened. Find the most recent data on the interest rates these countries pay for their bonds and how these rates compare to those for bonds by the German treasury. 3.4 Suppose the government decides to decrease spending and increase taxes to reduce public deficit. Is it possible for the central bank to adopt measures that will offset the impact of the new fiscal policy on aggregate output? How? 3.5 If the government implements a spending and tax policy in which it promises to neither increase nor decrease spending and taxes, is it still possible for the budget deficit to increase or decrease? Explain. 3.6 In the United Kingdom, the Office for Budget Responsibility (OBR) is in charge of, among other things, the publications of economic forecast concerning the country’s fiscal deficits. In November 2016, the OBR forecast a public sector net borrowing of 3.5 percent of GDP for 2016–2017. Go to the OBR website and look up the current forecast. How has it changed since 2016? What are some of the reasons for this change QUESTION 1 As indicated in Figure 14.3, housing prices have risen substantially over the past few years. The composition of buyers (based on credit scores and median household incomes), however, is different from the composition of buyers in 2006. How does the composition of buyers affect the severity of a potential housing market bust? QUESTION 2 Deficit targeting could lead to the wrong type of fiscal policies being enacted during a recession. How is this so? MyLab Economics
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Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with. M14_CASE3826_13_GE_C14.indd 307 17/04/19 4:19 AM Household and Firm Behavior in the Macroeconomy: A Further Look1 15 CHAPTER OUTLI NE AND LEARNING OBJECTIVES 15.1 Households: Consumption and Labor Supply Decisions p. 309 Describe factors that affect household consumption and labor supply decisions. 15.2 Firms: Investment and Employment Decisions p. 317 Describe factors that affect the investment and employment decisions of firms. 15.3 Productivity and the Business Cycle p. 322 Explain why productivity is procyclical. 15.4 The ShortRun Relationship between Output and Unemployment p. 323 Describe the short-run relationship between output and unemployment. 15.5 The Size of the Multiplier p. 324 Identify factors that affect multiplier size. In Chapters 8 through 14, we considered the interactions of households, firms, and the government in the goods, money, and labor markets. In these chapters, we assumed that household consumption (C) depends only on income and that firms’ planned investment (I) depends only on the interest rate. In this chapter, we present a more realistic picture of the influences on households’ consumption and labor supply decisions and on firms’ investment and employment decisions. We use the insights developed here to then analyze a richer set of macroeconomic issues. 308308 1This chapter is somewhat more advanced, but it contains a lot of interesting information! M15_CASE3826_13_GE_C15.indd 308 17/04/19 4:20 AM CHAPTER 15 Household and Firm Behavior in the Macroeconomy: A Further Look 309 Households: Consumption and Labor Supply Decisions For most of our analysis so far, we have been assuming that consumption depends simply on income. Although this is a useful starting point, and income is in fact the most important determinant of consumption, it is not the only thing that determines household consumption decisions. We need to consider other theories of consumption to build a more realistic description of household behavior. 15.1 LEARNING OBJECTIVE Describe factors that affect household consumption and labor supply decisions. The Life-Cycle Theory of Consumption MyLab Economics Concept Check Most people make consumption decisions based not only on current income but also
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on what they expect to earn later in life. Many of you, as young college students, are consuming more than you currently earn as you anticipate future earnings, whereas a number of your instructors are consuming less than they currently earn as they save for retirement without labor earnings. The model of consumption that is based on the idea that people track lifetime income when they make consumption decisions is called the life-cycle theory of consumption. The lifetime income and consumption pattern of a representative individual is shown in Figure 15.1. As you can see, this person has a low income during the first part of her life, high income in the middle, and low income again in retirement. Her income in retirement is not zero because she has income from sources other than her own labor—Social Security payments, interest and dividends, and so on. The consumption path as drawn in Figure 15.1 is constant over the person’s life. This is an extreme assumption, but it illustrates the point that the path of consumption over a lifetime is likely to be more stable than the path of income. We consume an amount greater than our incomes during our early working careers. We do so by borrowing against future income by taking out a car loan, a mortgage to buy a house, or a loan to pay for college. This debt is repaid when our incomes have risen and we can afford to use some of our income to pay off past borrowing without substantially lowering our consumption. The reverse is true for our retirement years. Here, too, our incomes are low. We can save up a “nest egg” that allows us to maintain an acceptable standard of living during retirement because we consume less than we earn during our prime working years. Fluctuations in wealth are also an important component of the life-cycle story. Many young households borrow in anticipation of higher income in the future. Some households actually have negative wealth—the value of their assets is less than the debts they owe. A household in its prime working years saves to pay off debts and to build up assets for its later years, when income typically goes down. Households whose assets are greater than the debts they owe have positive wealth. With its wage earners retired, a household consumes its accumulated wealth. Generally speaking, wealth starts out negative, turns positive, and then approaches zero near the end of life. Wealth, therefore, is intimately linked to the cumulative saving and dissaving behavior of households. life-cycle theory of consumption A theory of household consumption: Households make lifetime consumption decisions based on their
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expectations of lifetime income. Saving Income Consumption Borrowing Spending accumulated savings ◂◂ FIGURE 15.1 Life-Cycle Theory of Consumption In their early working years, people consume more than they earn. This is also true in the retirement years. In between, people save (consume less than they earn) to pay off debts from borrowing and to accumulate savings for retirement. 20 30 40 50 Age 60 70 80 MyLab Economics Concept Check M15_CASE3826_13_GE_C15.indd 309 17/04/19 4:20 AM 310 PART IV Further Macroeconomics Issues permanent income The average level of a person’s expected future income stream. The key difference between the Keynesian theory of consumption and the life-cycle theory is that the life-cycle theory suggests that consumption and saving decisions are likely to be based not only on current income but also on expectations of future income. The consumption behavior of households immediately following World War II clearly supports the life-cycle story. Just after the war ended, income fell as wage earners moved out of war-related work. However, consumption spending did not fall commensurately, as Keynesian theory would predict. People expected to find jobs in other sectors eventually, and they did not adjust their consumption spending to the temporarily lower incomes they were earning in the meantime. The term permanent income is sometimes used to refer to the average level of a person’s expected future income stream. If you expect your income will be high in the future (even though it may not be high now), your permanent income is said to be high. With this concept, we can sum up the life-cycle theory by saying that current consumption decisions are likely to be based on permanent income instead of current income.2 This means that policy changes such as tax-rate changes are likely to have more of an effect on household behavior if they are expected to be permanent instead of temporary. One-time tax rebates such as we saw in the United States in 2001 and 2008 provide an interesting test of the permanent income hypothesis. In both cases, the tax rebate was a one-time stimulus. In 2008, for example, the tax rebate was $300 to $600 for individual tax payers eligible for the rebate. How much would we expect this rebate to influence consumption? The simple Keynesian model that we introduced previously in this text would just apply the marginal propensity to consume to the $600. If the marginal propensity to consume is 0.8, we would
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expect the $600 to generate $480 in incremental spending per rebate. The permanent income hypothesis instead looks at the $600 in the context of an individual’s permanent income. As a fraction of one’s lifetime income, $600 is a modest number, and we would thus expect individuals to increase their spending only modestly in response to the rebate. Research on the 2001 tax rebate by Matthew Shapiro and Joel Slemrod, based on surveys of consumers, suggested that most people planned to use their rebates to lower debt, rather than increase spending. This is consistent with the life-cycle model. Although the life-cycle model enriches our understanding of the consumption behavior of households, the analysis is still missing something. What is missing is the other main decision of households: the labor supply decision. The Labor Supply Decision MyLab Economics Concept Check The size of the labor force in an economy is of obvious importance. A growing labor force is one of the ways in which national income/output can be expanded, and the larger the percentage of people who work, the higher the potential output per capita. So far we have said little about what determines the size of the labor force. Of course, demographics are a key element; the number of children born in 2018 will go a long way toward determining the potential number of 20-year-old workers in 2038. In addition, immigration, both legal and illegal, plays a role. Behavior also plays a role. Households make decisions about whether to work and how much to work. These decisions are closely tied to consumption decisions because for most households, the bulk of their spending is financed out of wages and salaries. Households make consumption and labor supply decisions simultaneously. Consumption cannot be considered separately from labor supply because it is precisely by selling your labor that you earn income to pay for your consumption. As we discussed in Chapter 3, the alternative to supplying your labor in exchange for a wage or a salary is leisure or other nonmarket activities. Nonmarket activities include raising a child, going to school, keeping a house, or—in a developing economy—working as a subsistence farmer. What determines the quantity of labor supplied by a household? Among the list of factors are the wage rate, prices, wealth, and nonlabor income. 2The pioneering work on this topic was done by Milton Friedman, A Theory of the Consumption Function (Princeton, NJ: Princeton University Press, 1957). In the mid-1960s, Franco Modigliani did closely related work that
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included the formulation of the life-cycle theory. M15_CASE3826_13_GE_C15.indd 310 17/04/19 4:20 AM CHAPTER 15 Household and Firm Behavior in the Macroeconomy: A Further Look 311 The Wage Rate A changing wage rate can affect labor supply, but whether the effect is positive or negative is ambiguous. An increase in the wage rate affects a household in two ways. First, work becomes more attractive relative to leisure and other nonmarket activities. The opportunity cost of leisure is higher because every hour spent in leisure now requires giving up a higher wage. As a result, you would expect that a higher wage would lead to a larger quantity of labor supplied—a larger workforce. This is called the substitution effect of a wage rate increase. On the other hand, household members who work are clearly better off after a wage rate increase. By working the same number of hours as they did before, they will earn more income. If we assume that leisure is a normal good, people with higher income will spend some of it on leisure by working less. This is the income effect of a wage rate increase. When wage rates rise, the substitution effect suggests that people will work more, whereas the income effect suggests that they will work less. The ultimate effect depends on which separate effect is more powerful. The data suggest that the substitution effect seems to win in most cases. That is, higher wage rates usually lead to a larger labor supply and lower wage rates usually lead to a lower labor supply. Prices Prices also play a major role in the consumption/labor supply decision. In our discussions of the possible effects of an increase in the wage rate, we have been assuming that the prices of goods and services do not rise at the same time. If the wage rate and all other prices rise simultaneously, the story is different. To make things clear, we need to distinguish between the nominal wage rate and the real wage rate. The nominal wage rate is the wage rate in current dollars. When we adjust the nominal wage rate for changes in the price level, we obtain the real wage rate. The real wage rate measures the amount that wages can buy in terms of goods and services. Workers do not care about their nominal wage—they care about the purchasing power of this wage—the real wage. Suppose skilled workers in Indianapolis were paid a wage rate of $20 per hour in 2017. Now suppose their wage rate rose to $22 in 2018, a 10 percent increase. If the prices
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of goods and services were the same in 2018 as they were in 2017, the real wage rate would have increased by 10 percent. An hour of work in 2018 ($22) buys 10 percent more than an hour of work in 2017 ($20). What if the prices of all goods and services also increased by 10 percent between 2017 and 2018? The purchasing power of an hour’s wages has not changed. The real wage rate has not increased at all. In 2018, $22 bought the same quantity of goods and services that $20 bought in 2017. To measure the real wage rate, we adjust the nominal wage rate with a price index. As we saw in Chapter 7, there are several such indices that we might use, including the consumer price index and the GDP price deflator.3 We can now apply what we have learned from the life-cycle theory to our wage/price story. Recall that the life-cycle theory says that people look ahead in making their decisions. Translated to real wage rates, this idea says that households look at expected future real wage rates as well as the current real wage rate in making their current consumption and labor supply decisions. Consider, for example, medical students who expect that their real wage rate will be higher in the future. This expectation obviously has an effect on current decisions about things like how much to buy and whether to take a part-time job. Wealth and Nonlabor Income Life-cycle theory implies that wealth fluctuates over the life cycle. Households accumulate wealth during their working years to pay off debts accumulated when they were young and to support themselves in retirement. This role of wealth is clear, but the existence of wealth poses another question. Consider two households that are at the same stage in their life cycle and have similar expectations about future wage rates, prices, and so on. They expect to live the same length of time, and both plan to leave the same amount to their children. They differ only in their wealth. Due to a past inheritance, household one has more wealth than household two. Which household is likely to have a higher consumption path for the rest of its life? Household one is because it has more wealth to spread out over the rest of 3To calculate the real wage rate, we divide the nominal wage rate by the price index. Suppose the wage rate rose from $10 per hour in 1998 to $18 per hour in 2010 and the price level rose 50 percent during the same period. Using 1998 as the base year, the price index would be 1.00
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in 1998 and 1.50 in 2010. The real wage rate is W/P, where W is the nominal wage rate and P is the price level. Using 1998 as the base year, the real wage rate is $10 in 1998 ($10.00/1.00) and $12 in 2010 ($18.00/1.50). nominal wage rate The wage rate in current dollars. real wage rate The amount the nominal wage rate can buy in terms of goods and services. M15_CASE3826_13_GE_C15.indd 311 17/04/19 4:20 AM 312 PART IV Further Macroeconomics Issues nonlabor, or nonwage, income Any income received from sources other than working—inheritances, interest, dividends, transfer payments, and so on. its life. Holding everything else constant (including the stage in the life cycle), the more wealth a household has, the more it will consume both now and in the future. Now consider a household that has a sudden unexpected increase in wealth, perhaps an inheritance from a distant relative. How will the household’s consumption pattern be affected? Few spend the entire inheritance all at once. Most households will increase consumption both now and in the future, spending the inheritance over the course of the rest of their lives. An increase in wealth can also be looked on as an increase in nonlabor income. Nonlabor, or nonwage, income is income received from sources other than working— inheritances, interest, dividends, and transfer payments, such as welfare payments and Social Security payments. As with wealth, an unexpected increase in nonlabor income will have a positive effect on a household’s consumption. What about the effect of an increase in wealth or nonlabor income on labor supply? We already know that an increase in income results in an increase in the consumption of normal goods, including leisure. Therefore, an unexpected increase in wealth or nonlabor income results in an increase in consumption and an increase in leisure. With leisure increasing, labor supply must fall. So an unexpected increase in wealth or nonlabor income leads to a decrease in labor supply. This point should be obvious. If you suddenly win a million dollars in the state lottery or make a killing in the stock market, you will probably work less in the future than you otherwise would have. Interest Rate Effects on Consumption MyLab Economics Concept Check Recall from the last few chapters that the interest rate affects a firm’s investment decision
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. A higher interest rate leads to a lower level of planned investment and vice versa. This was a key link between the money market and the goods market, and it was the channel through which monetary policy had an impact on planned aggregate expenditure. We can now expand on this link: The interest rate also affects household behavior. Consider the effect of a fall in the interest rate on consumption. A fall in the interest rate lowers the reward to saving. If the interest rate falls from 10 percent to 5 percent, you earn 5 cents instead of 10 cents per year on every dollar saved. This means that the opportunity cost of spending a dollar today (instead of saving it and consuming it plus the interest income a year from now) has fallen. You will substitute toward current consumption and away from future consumption when the interest rate falls: You consume more today and save less. A rise in the interest rate leads you to consume less today and save more. This effect is called the substitution effect. There is also an income effect of an interest rate change on consumption. If a household has positive wealth and is earning interest on that wealth, a fall in the interest rate leads to a fall in interest income. This is a decrease in its nonlabor income, which, as we just saw, has a negative effect on consumption. For households with positive wealth, the income effect works in the opposite direction from the substitution effect. On the other hand, if a household is a debtor and is paying interest on its debt, a fall in the interest rate will lead to a fall in interest payments. The household is better off in this case and will consume more. In this case, the income and substitution effects work in the same direction. The total household sector in the United States has positive wealth, and so in the aggregate, the income and substitution effects work in the opposite direction. Government Effects on Consumption and Labor Supply: Taxes and Transfers MyLab Economics Concept Check The government influences household behavior mainly through income tax rates and transfer payments. When the government raises income tax rates, after-tax real wages decrease, lowering consumption. When the government lowers income tax rates, after-tax real wages increase, raising consumption. A change in income tax rates also affects labor supply. If the substitution effect dominates, as we are generally assuming, an increase in income tax rates, which lowers after-tax wages, will lower labor supply. A decrease in income tax rates will increase labor supply. There is much debate about the size of these effects. If the labor elastic
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ity is very high, raising rates could substantially M15_CASE3826_13_GE_C15.indd 312 17/04/19 4:20 AM CHAPTER 15 Household and Firm Behavior in the Macroeconomy: A Further Look 313 TABLE 15.1 The Effects of Government on Household Consumption and Labor Supply Income Tax Rates Transfer Payments Increase Negative Negative* Decrease Positive Positive* Increase Positive Negative Decrease Negative Positive Effect on consumption Effect on labor supply *If the substitution effect dominates. Note: The effects are larger if they are expected to be permanent instead of temporary. reduce economic activity and even lead to a reduction in aggregate tax revenue. A recent review article, however, suggests that labor supply is relatively inelastic to changes in the marginal tax rate, indicating that increasing tax rates somewhat would likely increase total tax revenues.4 Transfer payments are payments such as Social Security benefits, veterans’ benefits, and general assistance to the needy. An increase in transfer payments is an increase in nonlabor income, which we have seen has a positive effect on consumption and a negative effect on labor supply. Increases in transfer payments thus increase consumption and decrease labor supply, whereas decreases in transfer payments decrease consumption and increase labor supply. Table 15.1 summarizes these results. A Possible Employment Constraint on Households MyLab Economics Concept Check Our discussion of the labor supply decision has so far proceeded as if households were free to choose how much to work each period. If a member of a household wants to work an additional five hours a week at the current wage rate, we have assumed that the person can work five hours more—that work is available. If someone who has not been working decides to work at the current wage rate, we have assumed that the person can find a job. There are times when these assumptions do not hold and individuals are constrained in the hours they can work. A household constrained from working as much as it would like at the current wage rate faces a different decision from the decision facing a household that can work as much as it wants. The work decision of the former household is, in effect, forced on it. The household works as much as it can—a certain number of hours per week or perhaps none at all—but this amount is less than the household would choose to work at the current wage rate if it could find more work. The amount that a household would like to work at the current wage rate if it could find the work is called its unconstrained supply of labor. The amount that
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the household actually works in a given period at current wage rates is called its constrained supply of labor. A household’s constrained supply of labor is not a variable over which it has any control. The amount of labor the household supplies is imposed on it from the outside by the workings of the economy. Under these conditions, we do not expect changes in tax rates, for example, to influence labor supply behavior in the way we see in unconstrained markets. However, the household’s consumption is under its control. We know that the less a household works—that is, the smaller the household’s constrained supply of labor is—the lower its consumption will be. Constraints on the supply of labor are an important determinant of consumption. Interestingly, some of the recent changes in the nature of the labor market with the rise in flexible-hour jobs like Uber, Lyft, Task Rabbit, and the like may have relaxed constraints on labor supply choice for some people. Keynesian Theory Revisited Recall the Keynesian theory that current income determines current consumption. We now know the consumption decision is made jointly with the labor supply decision and the two depend on the real wage rate. It is incorrect to think that consumption depends only on income, at least when there is full employment. However, if there is unemployment, and labor supply is constrained on the upside, Keynes is closer to being correct because 4Emmanuel Saez, Joel Slemrod and Seth Giertz, “The elasticity of taxable income with respect to marginal tax rates: A critical review,” Journal of Economic Literature, March 2012 3–50. unconstrained supply of labor The amount a household would like to work within a given period at the current wage rate if it could find the work. constrained supply of labor The amount a household actually works in a given period at the current wage rate. M15_CASE3826_13_GE_C15.indd 313 17/04/19 4:20 AM 314 PART IV Further Macroeconomics Issues the level of income (at least workers’ income) depends exclusively on the employment decisions made by firms and not on household decisions. In this case, it is income that affects consumption, not the wage rate. For this reason Keynesian theory is considered to pertain to periods of unemployment. It was, of course, precisely during such a period that the theory was developed. A Summary of Household Behavior MyLab Economics Concept Check This completes our discussion of household behavior in the
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macroeconomy. Household consumption depends on more than current income. Households determine consumption and labor supply simultaneously, and they look ahead in making their decisions. The following factors affect household consumption and labor supply decisions: ■■ Current and expected future real wage rates ■■ Initial value of wealth ■■ Current and expected future nonlabor income ■■ Interest rates ■■ Current and expected future tax rates and transfer payments If households are constrained in their labor supply decisions, income is directly determined by firms’ hiring decisions. In this case, the Keynesian focus on consumption as a function of income alone has more power. The Household Sector Since 1970 MyLab Economics Concept Check To better understand household behavior, we will examine how some of the aggregate household variables have changed over time. We will discuss the period 1970 I–2017 IV. (Remember, Roman numerals refer to quarters, that is, 1970 I means the first quarter of 1970.) Within this span, there have been five recessionary periods: 1974 I–1975 I, 1980 II–1982 IV, 1990 III–1991 I, 2001 I–2001 III, and 2008 I–2009 II. How did the household variables behave during each period? Consumption Data on the total consumption of the household sector are in the national income accounts. As we saw in Table 6.2, personal consumption expenditures accounted for 69.1 percent of GDP in 2017. The three basic categories of consumption expenditures are services, nondurable goods, and durable goods. Figure 15.2 plots the data for consumption expenditures on services and nondurable goods combined and for consumption expenditures on durable goods. The variables are in real terms. You can see that expenditures on services and nondurable goods are “smoother” over time 10,800 9,800 8,800 7,800 6,800 5,800 4,800 3,800 Recessionary period (1974 I– 1975 I) Recessionary period (1980 II– 1982 IV) Recessionary period (2008 I– 2009 II) Recessionary period (1990 III– 1991 I) Recessionary period (2001 I– 2001 III) Services and nondurable goods (left scale) Durable goods (right scale) 1800 1700 1600 1500 1400 1300 1200 1100 1000 900 800 700 600 500 400 300 200 ◂▸ FIGURE 15.2 Consumption Expenditures, 1970 I–2017 IV Over time, expenditures on services and nondurable goods are “smoother” than expenditures on durable goods. 2,800 1970 I 1980 I MyLab Economics Real-time
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data 1975 I 1985 I 1990 I 1995 I Quarters 2000 I 2005 I 2010 I 100 2015 I 2017 IV M15_CASE3826_13_GE_C15.indd 314 17/04/19 4:20 AM CHAPTER 15 Household and Firm Behavior in the Macroeconomy: A Further Look 315 Measuring Housing Price Changes We have suggested in the text that the rapid rise in housing prices in the period from 2000 to 2006 and the subsequent rapid fall of those prices after 2006 may have played a role in the 2008–2009 recession. There has been a good deal of work in economics tracing the links between what has been called the housing bubble and that recession, particularly on the bursting of the bubble on bank stability. But how do we measure housing price changes? After all, houses are all different. Measuring price changes in houses is much harder than measuring price changes in oil, or even price changes in milk or cans of tuna fish. One possibility is to look at changes in the average price of a house in a city over time. However, if in year one mostly modest split-levels change hands, while in year two most of the houses sold are McMansions, then changes in the average price will not do a very good job of capturing housing price inflation. An alternative is to try to standardize the house type, say looking at the change in the average price of a four-bedroom house in an area over time. This is better, but still leaves one with a lot of heterogeneity. In fact, one of the authors of this text, Karl Case, working with Robert Shiller, a behavioral finance economist, developed an index (aptly named the Case-Shiller index) that neatly solves the problem that houses are all different. The Case-Shiller index looks only at houses that have sold multiple times and asks the question: How much does an identical house sell for now versus that same house in the past? The index, developed first in Boston, is now computed for a number of large housing areas. In fact, the index itself is commonly reported on the financial pages and shows housing price changes for 10-city and 20-city bundles. So what does the Case-Shiller index tell us about the present? From 1996 to 2006, the Case-Shiller index increased by 125 percent, only to fall by 38 percent from 2006 to 2011. 2012 and early 2013 looked much better, with an annual increase of 7.3 percent in the 10-city index and 8
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.1 percent for the 20-city index as of April 2013. CRITICAL THINKING 1. Who, other than macroeconomists, might be inter- ested in the Case-Shiller index? than expenditures on durable goods. For example, the decrease in expenditures on services and nondurable goods was much smaller during the five recessionary periods than the decrease in expenditures on durable goods. Why do expenditures on durables fluctuate more than expenditures on services and nondurables? When times are bad, people can postpone the purchase of durable goods, which they do. It follows that expenditures on these goods change the most. When times are tough, you do not have to have a new car or a new smartphone; you can make do with your old Chevy or iPhone until things get better. When your income falls, it is not as easy to postpone the service costs of day care or health care. Nondurables fall into an intermediate category, with some items (such as new clothes) easier to postpone than others (such as food). Housing Investment Another important expenditure of the household sector is housing investment (purchases of new housing), plotted in Figure 15.3. Housing investment is the most easily postponable of all household expenditures, and it has large fluctuations. The fluctuations are remarkable between 2003 and 2010. Housing investment rose rapidly between 2003 and 2005 and then came crashing down. As discussed in Chapter 14, much of this was driven by a huge increase and then decrease in housing prices. Labor Supply As we noted in Chapters 7 and 13, a person is considered a part of the labor force when he or she is working or has been actively looking for work in the past few weeks. The ratio of the labor force to the total working-age population—those 16 and over—is the labor force participation rate. M15_CASE3826_13_GE_C15.indd 315 17/04/19 4:20 AM Recessionary period (1974 I– 1975 I) Recessionary period (1980 II– 1982 IV) Recessionary period (1990 III– 1991 I) Recessionary period (2001 I– 2001 III) Recessionary period (2008 I– 2009 II) 316 PART IV Further Macroeconomics Issues ◂▸ FIGURE 15.3 Housing Investment of the Household Sector, 1970 I–2017 IV Housing investment fell during the five recessionary periods since 1970. Like expenditures for durable goods, expenditures for housing investment are postponable 770 720 670 620 570 520 470 420
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370 320 270 220 170 1970 I 1980 I MyLab Economics Real-time data 1975 I 1985 I 1990 I 1995 I 2000 I 2005 I 2010 I 2015 I 2017 IV Quarters It is informative to divide the labor force into three categories: males 25 to 54, females 25 to 54, and all others 16 and over. Ages 25 to 54 are sometimes called “prime” ages, presuming that a person is in the prime of working life during these ages. The participation rates for these three groups are plotted in Figure 15.4. As the figure shows, most men of prime age are in the labor force, although the participation rate has fallen since 1970—from 0.961 in 1970 I to 0.888 in 2017 IV. (A rate of 0.888 means that 88.8 percent of prime-age men were in the labor force.) The participation rate for prime-age women, on the other hand, rose dramatically between 1970 and 1990—from 0.501 in 1970 I to 0.741 in 1990 I. Although economic factors account for some of this increase, a change in social attitudes and preferences probably explains much of the increase. Since 1990, the participation rate for prime-age women has changed very little. In 2017 IV, it was 0.752, still considerably below the 0.888 rate for prime-age men. Figure 15.4 also shows the participation rate for all individuals 16 and over except prime-age men and women. This rate has some cyclical features—it tends to fall in recessions and to rise or fall less during expansions. These features reveal the operation of the discouraged-worker effect, discussed in Chapter 7. During recessions, some people get discouraged about ever finding a job. They stop looking and are then not considered a part of the labor force. During expansions, people become encouraged again. Once they begin looking for jobs, they are again considered a part of the labor force. Prime-age women and men are likely to be fairly attached to the labor force, thus the discouraged-worker effect for them is quite small. ◂▸ FIGURE 15.4 Labor Force Participation Rates for Men 25 to 54, Women 25 to 54, and All Others 16 and Over, 1970 I–2017 IV Since 1970, the labor force participation rate for prime-age men has been decreasing slightly. The rate for prime-age women has been increasing dramatically. The rate for all others 16 and over has been declining since 1979 and shows a tendency to fall during rec
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essions (the discouragedworker effect). Recessionary period (1974 I– 1975 I) Recessionary period (1980 II– 1982 IV) Recessionary period (1990 III– 1991 I) Men 25–54 Recessionary period (2001 I– 2001 III) Recessionary period (2008 I– 2009 II) Women 25–54 All others 16 and over 1.00 0.95 0.90 0.85 0.80 0.75 0.70 0.65 0.60 0.55 0.50.45 0.40 1970 I 1975 I 1980 I 1985 I 1990 I 1995 I 2000 I 2005 I 2010 I 2015 I 2017 IV MyLab Economics Real-time data Quarters M15_CASE3826_13_GE_C15.indd 316 17/04/19 4:20 AM CHAPTER 15 Household and Firm Behavior in the Macroeconomy: A Further Look 317 15.2 LEARNING OBJECTIVE Describe factors that affect the investment and employment decisions of firms. Firms: Investment and Employment Decisions Having taken a closer look at the behavior of households in the macroeconomy, we now look more closely at the behavior of firms—the other major decision-making unit in the economy. In discussing firm behavior previously, we assumed that planned investment depends only on the interest rate. However, there are several other determinants of planned investment. We now discuss them and the factors that affect firms’ employment decisions. Once again, microeconomic theory can help us gain some insight into the working of the macroeconomy. In a market economy, firms determine which goods and services are available to consumers today and which will be available in the future, how many workers are needed for what kinds of jobs, and how much investment will be undertaken. Stated in macroeconomic terms, the decisions of firms, taken together, determine output, labor demand, and investment. Expectations and Animal Spirits MyLab Economics Concept Check Time is a key factor in investment decisions. Capital has a life that typically extends over many years. A developer who decides to build an office tower is making an investment that will be around (barring earthquakes, floods, or tornadoes) for several decades. In deciding where to build a plant, a manufacturing firm is committing a large amount of resources to purchase capital that will presumably yield services over a long time. Furthermore, the decision to build a plant or to purchase large equipment must often be made years before the actual project is completed. Whereas the acquisition of a small business computer
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may take only a few days, the planning process for downtown developments in large U.S. cities has been known to take decades. For these reasons, investment decisions require looking into the future and forming expectations about it. In forming their expectations, firms consider numerous factors. At a minimum, they gather information about the demand for their specific products, about what their competitors are planning, and about the macroeconomy’s overall health. A firm is not likely to increase its production capacity if it does not expect to sell more of its product in the future. Hilton will not put up a new hotel if it does not expect to fill the rooms at a profitable rate. Ford will not build a new plant if it expects the economy to enter a long recession. Forecasting the future is fraught with dangers. Many events cannot be foreseen. Investments are therefore always made with imperfect knowledge. Keynes pointed this out in 1936: The outstanding fact is the extreme precariousness of the basis of knowledge on which our estimates of prospective yield have to be made. Our knowledge of the factors which will govern the yield of an investment some years hence is usually very slight and often negligible. If we speak frankly, we have to admit that our basis of knowledge for estimating the yield ten years hence of a railway, a copper mine, a textile factory, the goodwill of a patent medicine, an Atlantic liner, a building in the City of London amounts to little and sometimes nothing. Keynes concludes from this line of thought that much investment activity depends on psy- chology and on what he calls the animal spirits of entrepreneurs: Our decisions can only be taken as a result of animal spirits. In estimating the prospects of investment, we must have regard, therefore, to nerves and hysteria and even the digestions and reactions to the weather of those upon whose spontaneous activity it largely depends.5 animal spirits of entrepreneurs A term coined by Keynes to describe investors’ feelings. 5John Maynard Keynes, The General Theory of Employment, Interest, and Money (1936), First Harbinger Ed. (New York: Harcourt Brace Jovanovich, 1964), pp. 149, 152. M15_CASE3826_13_GE_C15.indd 317 17/04/19 4:20 AM 318 PART IV Further Macroeconomics Issues Expectations about the future are, as Keynes points out, subject to great uncertainty, they may change often. Thus, animal spirits help to make investment a volatile component of gross domestic product (GDP).
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George Akerlof and Robert Shiller, two Nobel Laureates who work in the area of behavioral macroeconomics, have emphasized the role of animal spirits in driving volatility in the modern economy.6 The Accelerator Effect Keynes’ reference to animal spirits suggest that expectations play a role in determining the level of planned investment spending. At any interest rate, the level of investment is likely to be higher if businesses are optimistic and lower if they are pessimistic. A key question is then what determines expectations? One possibility is that expectations are optimistic when aggregate output (Y) is rising and pessimistic when aggregate output is falling. At any given level of the interest rate, expectations may be more optimistic and planned investment higher when output is growing rapidly than when it is growing slowly or falling. It is easy to see why this might be so. When firms expect future prospects to be good, they may plan now to add productive capacity, and one indicator of future prospects is the current growth rate. If this is the case, the result will be what is called an accelerator effect. If aggregate output (income) (Y) is rising, investment will increase even though the level of Y may be low. Higher investment spending leads to an added increase in output, further “accelerating” the growth of aggregate output. If Y is falling, expectations are dampened and investment spending will be cut even though the level of Y may be high, accelerating the decline. Excess Labor and Excess Capital Effects MyLab Economics Concept Check In our simple model of the macroeconomy, to produce more output the firms in the economy need to hire more labor and capital. In practice, firms appear at times to hold what we will call excess labor and/or excess capital. A firm holds excess labor (or capital) if it can reduce the amount of labor it employs (or capital it holds) and still produce the same amount of output. The possibility that large numbers of firms may at times be holding excess labor or capital complicates our story of the investment-output relationship. Why might a firm want to employ more workers or have more capital on hand than it needs? Both labor and capital are costly—a firm has to pay wages to its workers, and it forgoes interest on funds tied up in machinery or buildings. Why would a firm want to incur costs that do not yield revenue? To see why, suppose a firm suffers a sudden and large decrease in sales, but it expects the lower sales level to last only a few months, after
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which it believes sales will pick up again. In this case, the firm is likely to lower production in response to the sales change to avoid too large an increase in its stock of inventories. This decrease in production means that the firm could get rid of some workers and some machines because it needs less labor and less capital to produce the now-lower level of output. However, things are not that simple. Decreasing its workforce and capital stock quickly can be costly for a firm. Abrupt cuts in the workforce hurt worker morale and may increase personnel administration costs, and abrupt reductions in capital stock may be disadvantageous because of the difficulty of selling used machines. These types of costs are sometimes called adjustment costs because they are the costs of adjusting to the new level of output. There are also adjustment costs to increasing output. For example, it is usually costly to recruit and train new workers. Adjustment costs may be large enough that a firm chooses not to decrease its workforce and capital stock when production falls. The firm may at times choose to have more labor and capital on hand than it needs to produce its current amount of output simply because getting rid of them is more costly than keeping them and the firm expects it will need the workers in the near future. In practice, excess labor takes the form of workers not working at their normal level of activity. Some of this excess labor may receive new training so that productivity will be higher when production picks up again, and some of the excess labor may take the form of maintenance. 6George Akerlof and Robert Shiller, Animal Spirits: How human psychology Drives the Economy, and Why it Matters for Global Capitalism, Princeton University Press, Princeton NJ, 2010. accelerator effect The tendency for investment to increase when aggregate output increases and to decrease when aggregate output decreases, accelerating the growth or decline of output. excess labor, excess capital Labor and capital that are not needed to produce the firm’s current level of output. adjustment costs The costs that a firm incurs when it changes its production level— for example, the administration costs of laying off employees or the training costs of hiring new workers. M15_CASE3826_13_GE_C15.indd 318 17/04/19 4:20 AM CHAPTER 15 Household and Firm Behavior in the Macroeconomy: A Further Look 319 The existence of excess labor and capital at any given moment is likely to affect future employment and investment decisions. Suppose a firm already has excess labor and capital as a result of a fall in
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its sales and production. When production picks up again, the firm will not need to hire as many new workers or acquire as much new capital as it would otherwise. The more excess capital a firm already has, the less likely it is to invest in new capital in the future. The more excess labor it has, the less likely it is to hire new workers in the future. As you can see, predicting what happens as an economy recovers is made more complicated if in a down period many firms hold excess inputs. Inventory Investment MyLab Economics Concept Check We now turn to a brief discussion of the inventory investment decision. Inventory investment is the change in the stock of inventories. Although inventory investment is another way in which a firm adds to its capital stock, the inventory investment decision is quite different from the plantand-equipment investment decision. inventory investment The change in the stock of inventories. The Role of Inventories Recall the distinction between a firm’s sales and its output. If a firm can hold goods in inventory, which is usually the case unless the good is perishable or unless the firm produces services, then within a given period, it can sell a quantity of goods that differs from the quantity of goods it produces during that period. When a firm sells more than it produces, its stock of inventories decreases; when it sells less than it produces, its stock of inventories increases. Stock of inventories (end of period) = Stock of inventories (beginning of period) + Production - Sales If a firm starts a period with 100 umbrellas in inventory, produces 15 umbrellas during the period, and sells 10 umbrellas in this same interval, it will have 105 umbrellas (100 + 15 - 10) in inventory at the end of the period. A change in the stock of inventories is actually investment because inventories are counted as part of a firm’s capital stock. In our example, inventory investment during the period is a positive number, 5 umbrellas (105 - 100). When the number of goods produced is less than the number of goods sold, such as 5 produced and 10 sold, inventory investment is negative. The Optimal Inventory Policy We can now consider firms’ inventory decisions. Firms are concerned with what they are going to sell and produce in the future as well as what they are selling and producing currently. At each point in time, a firm has some idea of how much it is going to sell in the current period and in future periods
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. Given these expectations and its knowledge of how much of its goods it already has in stock, a firm must decide how much to produce in the current period. Inventories are costly to a firm because they take up space and they tie up funds that could be earning interest. However, if a firm’s stock of inventories gets too low, the firm may have difficulty meeting the demand for its product, especially if demand increases unexpectedly. The firm may lose sales. The point between too low and too high a stock of inventory is called the desired, or optimal, level of inventories. This is the level at which the extra cost (in lost sales) from decreasing inventories by a small amount is just equal to the extra gain (in interest revenue and decreased storage costs). A firm that had no costs other than inventory costs would always aim to produce in a period exactly the volume of goods necessary to make its stock of inventories at the end of the period equal to the desired stock. If the stock of inventory fell lower than desired, the firm would produce more than it expected to sell to bring the stock up. If the stock of inventory grew above the desired level, the firm would produce less than it expected to sell to reduce the stock. There are other costs to running a firm besides inventory costs. In particular, large and abrupt changes in production can be costly because it is often disruptive to change a production process geared to a certain rate of output. If production is to be increased, there may be adjustment costs for hiring more labor and increasing the capital stock. If production is to be decreased, there may be adjustment costs in laying off workers and decreasing the capital stock. desired, or optimal, level of inventories The level of inventory at which the extra cost (in lost sales) from lowering inventories by a small amount is just equal to the extra gain (in interest revenue and decreased storage costs). M15_CASE3826_13_GE_C15.indd 319 17/04/19 4:20 AM 320 PART IV Further Macroeconomics Issues Holding inventories and changing production levels are both costly, thus firms face a tradeoff between them. A firm is likely to smooth its production path relative to its sales path because of adjustment costs. This means that a firm is likely to have its production fluctuate less than its sales, with changes in inventories to absorb the difference each period. However, because there are incentives not to stray too far from the optimal level of inventories, fluctuations
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in production are not eliminated completely. Production is still likely to fluctuate, just not as much as sales fluctuate. Two other points need to be made here. First, if a firm’s stock of inventories is unusually or unexpectedly high, as a result of unexpected shortfalls in sales, the firm is likely to produce less in the future than it otherwise would have to decrease its high stock of inventories. In this way, unexpected inventories also influence current production levels. An unexpectedly high stock of inventories will have a negative effect on production in the future, and an unexpectedly low stock will have a positive effect on production in the future. We have seen that lower than expected past sales will influence optimal production as firms seek to reduce unplanned inventories. Future sales expectations also have an effect on inventory policy and on production. If a firm expects its sales to be high in the future, it will adjust its planned production path accordingly, recognizing that a higher level of sales also requires a higher level of inventories to support those sales. Production is likely to depend on expectations of the future so animal spirits may play a role. If firms become more optimistic about the future, they are likely to produce more now as they build up inventories in anticipation of increased future sales. Keynes’s view that animal spirits affect investment is also likely to pertain to output. A Summary of Firm Behavior MyLab Economics Concept Check The following factors affect firms’ investment and employment decisions: ■■ Firms’ expectations of future output ■■ Wage rate and cost of capital (The interest rate is an important component of the cost of capital.) ■■ Amount of excess labor and excess capital on hand The most important points to remember about the relationship among production, sales, and inventory investment are ■■ Inventory investment—that is, the change in the stock of inventories—equals production minus sales. ■■ An unexpected increase in the stock of inventories has a negative effect on future production. ■■ Current production depends on expected future sales. The Firm Sector Since 1970 MyLab Economics Concept Check To close our discussion of firm behavior, we now examine some aggregate investment and employment variables for the period 1970 I–2017 IV. We will see the way in which our expanded model of firm behavior helps us to understand patterns in those data. Plant-and-Equipment Investment Plant-and-equipment investment by the firm sector is plotted in Figure 15.5. Investment fared poorly in the five recessionary periods after 1970. This observation is
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consistent with the observation that investment depends in part on output. An examination of the plot of real GDP in Figure 20.4 and the plot of investment in Figure 15.5 shows that investment generally does poorly when GDP does poorly and that investment generally does well when GDP does well. Figure 15.5 also shows that investment fluctuates greatly. This is not surprising. The animal spirits of entrepreneurs are likely to be volatile, and if animal spirits affect investment, it follows that investment too will be volatile. Despite the volatility of plant-and-equipment investment, however, it is still true that housing investment fluctuates more than plant-and-equipment investment (as you can see by comparing Figures 15.3 and 15.5). Plant and equipment investment is not the most volatile component of GDP. M15_CASE3826_13_GE_C15.indd 320 17/04/19 4:20 AM CHAPTER 15 Household and Firm Behavior in the Macroeconomy: A Further Look 321 Recessionary period (1974 I– 1975 I) Recessionary period (1980 II– 1982 IV) Recessionary period (1990 III– 1991 I) Recessionary period (2008 I– 2009 II) ◂◂ FIGURE 15.5 Plant and Equipment Investment of the Firm Sector, 1970 I–2017 IV Overall, plant and equipment investment declined in the five recessionary periods since 1970. Recessionary period (2001 I– 2001 III) 1975 I 1980 I 1985 I 1990 I 1995 I Quarters 2000 I 2005 I 2017 IV MyLab Economics Real-time data 2015 I 2010 2000 1900 1800 1700 1600 1500 1400 1300 1200 1100 1000 900 800 700 600 500 400 300 1970 I Recessionary period (1974 I– 1975 I) Recessionary period (1980 II– 1982 IV) Recessionary period (2008 I– 2009 II) Recessionary period (1990 III– 1991 I) Recessionary period (2001 I– 2001 III) 140 130 120 110 100 90 80 ◂◂ FIGURE 15.6 Employment in the Firm Sector, 1970 I–2017 IV Growth in employment was generally negative in the five recessions the U.S. economy has experienced since 1970. 70 1970 I 1975 I 1980 I 1985 I 1990 I 1995 I 2000 I Quarters 2005 I 2010 I 2017 IV MyLab Economics Real-time data 2015 I Employment Employment in the firm sector is plotted in Figure 15.6, which shows that employment fell in all five recessionary periods. This is consistent with the theory that employment depends in part on
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output. Otherwise, employment has grown over time in response to the growing economy. Employment in the firm sector rose from 72.5 million in 1970 I to 132.5 million in 2007 IV (before the recession of 2008–2009). During the 2008–2009 recession, employment fell by 9.5 million—from 132.5 million in 2007 IV to 123.0 million in 2009 IV. You can see from the figure that employment has recovered fairly slowly since 2009. Inventory Investment Recall that inventory investment is the difference between the level of output and the level of sales. Recall also that some inventory investment is usually unplanned. This occurs when the actual level of sales is different from the expected level of sales. Inventory investment of the firm sector is plotted in Figure 15.7. Also plotted in this figure is the ratio of the stock of inventories to the level of sales—the inventory-to-sales ratio. The figure shows that inventory investment is volatile—more volatile than housing investment and plant and equipment investment. Some of this volatility is undoubtedly as a result of the unplanned component of inventory investment, which is likely to fluctuate greatly from one period to the next. When the inventory-to-sales ratio is high, the actual stock of inventories is likely to be larger than the desired stock. In such a case, firms have overestimated demand and produced too much relative to sales and they are likely to want to produce less in the future to draw down their stock. M15_CASE3826_13_GE_C15.indd 321 17/04/19 4:20 AM 322 PART IV Further Macroeconomics Issues ◂▸ FIGURE 15.7 Inventory Investment of the Firm Sector and the Inventory-to-Sales Ratio, 1970 I–2017 IV The inventory-to-sales ratio is the ratio of the firm sector’s stock of inventories to the level of sales. Inventory investment is volatile. 120 90 60 30 0 230 260 290 2120 2150 2180 Inventory investment (left scale) Recessionary period (1974 I– 1975 I) Recessionary period (1980 II– 1982 IV) Recessionary period (1990 III– 1991 I) Recessionary period (2008 I– 2009 II) Recessionary period (2001 I– 2001 III) Inventory/sales ratio (right scale) 0.21 0.20 0.19 0.18 0.17 0.16 0.15 15.3 LEARNING OBJECTIVE Explain why productivity is pro
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cyclical. productivity, or labor productivity Output per worker hour. 2210 1970 I 1975 I 1980 I 1985 I 1990 I MyLab Economics Real-time data 1995 I Quarters 2000 I 2005 I 2010 I 2015 I 0.14 2017 IV You can find several examples of this trend in Figure 15.7—the clearest occurred during the 1974–1975 period. At the end of 1974, the stock of inventories was high relative to sales, an indication that firms probably had undesired inventories at the end of 1974. In 1975, firms worked off these undesired inventories by producing less than they sold. Thus, inventory investment was low in 1975. The year 1975 is clearly a year in which output would have been higher had the stock of inventories at the beginning of the year not been so high. There were large declines in inventory investment in the recessions of 2001 and 2008–2009. On average, the inventory-to-sales ratio has been declining over time, evidence that firms are becoming more efficient in their management of inventory stocks. Firms are becoming more efficient in the sense of being able (other things equal) to hold smaller and smaller stocks of inventories relative to sales. Productivity and the Business Cycle We can now use what we have just learned about firm behavior to analyze movements in productivity. Productivity, sometimes called labor productivity, is defined as output per worker hour. If output is Y and the number of hours worked in the economy is H, productivity is Y/H. Simply stated, productivity measures how much output an average worker produces per hour. Productivity fluctuates over the business cycle, tending to rise during expansions and fall during contractions. See Figure 7.2 for a plot of productivity for 1952 I–2017 IV. You can see from this figure that productivity fluctuates around a positive trend. The fact that firms at times hold excess labor explains why productivity fluctuates in the same direction as output. Figure 15.8 shows the pattern of employment and output over time for a hypothetical economy. Employment does not fluctuate as much as output over the business cycle. It is precisely this pattern that leads to higher productivity during periods of high output and lower productivity during periods of low output. During expansions in the economy, output rises by a larger percentage than employment and the ratio of output to workers rises. During downswings, output falls faster than employment and the ratio of output to workers falls. The existence of excess labor when the economy is in a slump means that productivity as measured by
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the ratio Y/H tends to fall at such times. Does this trend mean that labor is in some sense “less productive” during recessions than before? Not really: It means only that firms choose to employ more labor than would be profit-maximizing. For this reason, some workers are in effect idle some of the time even though they are considered employed. They are not less productive in the sense of having less potential to produce output; they are merely not working part of the time that they are counted as working. M15_CASE3826_13_GE_C15.indd 322 17/04/19 4:20 AM CHAPTER 15 Household and Firm Behavior in the Macroeconomy: A Further Look 323 ◂◂ FIGURE 15.8 Employment and Output over the Business Cycle In general, employment does not fluctuate as much as output over the business cycle. As a result, measured productivity (the output-to-labor ratio) tends to rise during expansionary periods and decline during contractionary periods. 15.4 LEARNING OBJECTIVE Describe the short-run relationship between output and unemployment. Okun’s Law The theory, put forth by Arthur Okun, that in the short run the unemployment rate decreases about 1 percentage point for every 3 percent increase in real GDP. Later research and data have shown that the relationship between output and unemployment is not as stable as Okun’s “Law” predicts. Aggregate output Employment Time MyLab Economics Concept Check The Short-Run Relationship between Output and Unemployment We can also use what we have learned about household and firm behavior to analyze the relationship between output and unemployment. When we discussed the connections between the AS/AD diagram and the Phillips Curve in Chapter 14, we mentioned that output (Y) and the unemployment rate (U) are inversely related. When output rises, the unemployment rate falls, and when output falls, the unemployment rate rises. At one time, it was believed that the shortrun relationship between the two variables was fairly stable. Okun’s Law (after U.S. economist Arthur Okun, who first studied the relationship) stated that in the short run the unemployment rate decreased about 1 percentage point for every 3 percent increase in real GDP. As with the Phillips Curve, Okun’s Law has not turned out to be a “law.” The economy is far too complex for there to be such a simple and stable relationship between
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two macroeconomic variables. Although the short-run relationship between output and the unemployment rate is not the simple relationship Okun believed, it is true that a 1 percent increase in output tends to correspond to a less than 1 percentage point decrease in the unemployment rate in the short run. In other words, there are a number of “slippages” between changes in output and changes in the unemployment rate. The first slippage is between the change in output and the change in the number of jobs in the economy. When output increases by 1 percent, the number of jobs does not tend to rise by 1 percent in the short run. There are two reasons for this. First, a firm is likely to meet some of the increase in output by increasing the number of hours worked per job. Instead of having the labor force work 40 hours per week, the firm may pay overtime and have the labor force work 42 hours per week. Second, if a firm is holding excess labor at the time of the output increase, at least part of the increase in output can come from putting the excess labor back to work. For both reasons, the number of jobs is likely to rise by a smaller percentage than the increase in output. The second slippage is between the change in the number of jobs and the change in the number of people employed. If you have two jobs, you are counted twice in the job data but only once in the persons-employed data. Because some people have two jobs, there are more jobs than there are people employed. When the number of jobs increases, some of the new jobs are filled by people who already have one job (instead of by people who are unemployed). This means that the increase in the number of people employed is less than the increase in the number of jobs. This is a slippage between output and the unemployment rate because the unemployment rate is calculated from data on the number of people employed, not the number of jobs. The third slippage concerns the response of the labor force to an increase in output. Let E denote the number of people employed, let L denote the number of people in the labor force, and let u denote the unemployment rate. In these terms, the unemployment rate is The unemployment rate is one minus the employment rate, E/L. u = 1 - E/L M15_CASE3826_13_GE_C15.indd 323 17/04/19 4:20 AM 324 PART IV Further Macroeconomics Issues discouraged-worker
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effect The decline in the measured unemployment rate that results when people who want to work but cannot find work grow discouraged and stop looking, dropping out of the ranks of the unemployed and the labor force. When we discussed how the unemployment rate is measured in Chapter 7, we introduced the discouraged-worker effect. A discouraged worker is one who would like a job but has stopped looking because the prospects seem so bleak. When output increases, job prospects begin to look better and some people who had stopped looking for work begin looking again. When they do, they are once again counted as part of the labor force. The labor force increases when output increases because discouraged workers are moving back into the labor force. This is another reason the unemployment rate does not fall as much as might be expected when output increases. These three slippages show that the link from changes in output to changes in the unemployment rate is complicated. All three combine to make the change in the unemployment rate less than the percentage change in output in the short run. They also show that the relationship between changes in output and changes in the unemployment rate is not likely to be stable. The size of the first slippage, for example, depends on how much excess labor is being held at the time of the output increase, and the size of the third slippage depends on what else is affecting the labor force (such as changes in real wage rates) at the time of the output increase. The relationship between output and unemployment depends on the state of the economy at the time of the output change. 15.5 LEARNING OBJECTIVE Identify factors that affect multiplier size. The Size of the Multiplier We can finally bring together the material in this chapter and in previous chapters to consider the size of the multiplier. We mentioned in Chapter 8 that much of the analysis we would do after deriving the simple multiplier would have the effect of decreasing the size of the multiplier. We can now summarize why. 1. There are automatic stabilizers. We saw in the Appendix to Chapter 9 that if taxes are not a fixed amount but instead depend on income (which is surely the case in practice), the size of the multiplier is decreased. When the economy expands and income increases, the amount of taxes collected increases. The rise in taxes acts to offset some of the expansion (thus, a smaller multiplier). When the economy contracts and income decreases, the amount of taxes collected decreases. This decrease in taxes helps to lessen the contraction. Some transfer payments also respond to the state of the economy and act
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as automatic stabilizers, lowering the value of the multiplier. Unemployment benefits are the best example of transfer payments that increase during contractions and decrease during expansions. 2. There is the interest rate. We saw in Chapter 11 that in normal times the Fed increases the interest rate as output increases, which decreases planned investment. The increase in output from a government spending increase is thus smaller than if the interest rate did not rise because of the crowding out of planned investment. As we saw previously in this chapter, increases in the interest rate also have a negative effect on consumption. Consumption is also crowded out in the same way that planned investment is, and this effect lowers the value of the multiplier even further. 3. There is the response of the price level. We also saw in Chapter 11 that some of the effect of an expansionary policy is to increase the price level. The multiplier is smaller because of this price response. The multiplier is particularly small when the economy is on the steep part of the AS curve, where most of the effect of an expansionary policy is to increase prices. 4. There are excess capital and excess labor. When firms are holding excess labor and capital, part of any output increase can come from putting the excess labor and capital back to work instead of increasing employment and investment. This lowers the value of the multiplier because (1) investment increases less than it would have if there were no excess capital and (2) consumption increases less than it would have if employment (and thus household income) had increased more. 5. There are inventories. Part of any initial increase in sales can come from drawing down inventories instead of increasing output. To the extent that firms draw down their inventories in the short run, the value of the multiplier is lower because output does not respond as quickly to demand changes. 6. There are people’s expectations about the future. People look ahead, and they respond less to temporary changes than to permanent changes. The multiplier effects for policy changes perceived to be temporary are smaller than those for policy changes perceived to be permanent. M15_CASE3826_13_GE_C15.indd 324 17/04/19 4:20 AM CHAPTER 15 Household and Firm Behavior in the Macroeconomy: A Further Look 325 Estimating Multipliers: The Mafia Link Estimating the size of the multiplier is difficult because it is hard to sort out the many things that are likely to be changing when a government decides to increase its spending. However, a recent
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paper found a novel way to sort out the various effects. We have focused on the national multiplier. How much does national GDP rise when the national government increases spending? Economists and policy makers are also interested in the effects of stimuli at the local or regional level. In general we expect these multipliers to be less than national multipliers: If the governor of New York increases government spending in the state, some of that increase will likely spill over to New Jersey and other states. But exactly how big are these multipliers in practice? Several economists working with Italian data had a novel approach to estimating regional multipliers in Italy.1 In the 1990s the Italian national government passed a law to try to control Mafia–led corruption in local governments. The law stated that when Mafia involvement was found in the city council in an area, all elected officials would be fired, to be replaced by three commissioners appointed by the national government. This change in decision making had a large effect on reducing public spending in the area as a result of the disruption. On average, replacement of the council members reduced spending by 20 percent. Since the Mafia’s involvement varied considerably by region for historical reasons, this law had differential effects across regions, and those regional differences could be used to identify the size of the local multiplier. The results? Regional multipliers in the range of 1.5 to 2. Interestingly, work in the United States at the state level found similar magnitudes for the multiplier, using quite different methods.2 CRITICAL THINKING 1. Multipliers also vary across countries. What factors do you think determine these differences? 1Antonio Acconcia, Giancarlo Corsetti, and Savero Sivenenlli, “Mafia and Public Spending: Evidence on the Fiscal Multiplier from a Quasi Experiment,” American Economic Review, July 2014, 2185–2209. 2Emi Nakamura and Jon Steinnson, “Fiscal Stimulus in a Monetary Union: Evidence form U.S. States,” American Economic Review, 2014, 753–792. The Size of the Multiplier in Practice In practice, the multiplier probably has a value of around 2.0. Its size also depends on how long ago the spending increase began. For example, in the first quarter of an increase in government spending, the multiplier is likely below 1.0 since some of the increased sales comes out of inventories. The multiplier then rises over time, likely reaching a peak
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after about a year. One of the main points to remember here is that if the government is contemplating a monetary or fiscal policy change, the response of the economy to the change is not likely to be large and quick. It takes time for the full effects to be felt, and in the final analysis, the effects are much smaller than the simple multiplier we discussed in Chapter 8 would lead one to believe. A good way to review much of the material since Chapter 8 is to make sure you clearly understand how the value of the multiplier is affected by each of the additions to the simple model in Chapter 8. We have come a long way since then, and this review may help you to put all the pieces together. S U M M A R Y 15.1 HOUSEHOLDS: CONSUMPTION AND LABOR SUPPLY DECISIONS p. 309 1. The life-cycle theory of consumption says that households make lifetime consumption decisions based on their expectations of lifetime income. Generally, households consume an amount less than their incomes during their prime working years and an amount greater than their incomes during their early working years and after they have retired. 2. Households make consumption and labor supply decisions simultaneously. Consumption cannot be considered separately from labor supply because it is precisely by selling your labor that you earn the income that makes consumption possible. 3. There is a trade-off between the goods and services that wage income will buy and leisure or other nonmarket activities. The wage rate is the key variable that determines how a household responds to this trade-off. M15_CASE3826_13_GE_C15.indd 325 17/04/19 4:20 AM 326 PART IV Further Macroeconomics Issues 4. Changes in the wage rate have both an income effect and a substitution effect. The evidence suggests that the substitution effect seems to dominate for most people, which means that the aggregate labor supply responds positively to an increase in the wage rate. 5. Consumption increases when the wage rate increases. 6. The nominal wage rate is the wage rate in current dollars. The real wage rate is the amount the nominal wage can buy in terms of goods and services. Households look at expected future real wage rates as well as the current real wage rate in making their consumption and labor supply decisions. 7. Holding all else constant (including the stage in the life cycle), the more wealth a household has, the more it will consume both now and in the future. 8. An unexpected increase in nonlabor income
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(any income re- ceived from sources other than working, such as inheritances, interest, and dividends) will have a positive effect on a household’s consumption and will lead to a decrease in labor supply. 9. The interest rate also affects consumption, although the di- rection of the total effect depends on the relative sizes of the income and substitution effects. There is some evidence that the income effect is larger now than it used to be, making monetary policy less effective than it used to be. 10. The government influences household behavior mainly through income tax rates and transfer payments. If the substitution effect dominates, an increase in tax rates lowers after-tax income, decreases consumption, and decreases the labor supply; a decrease in tax rates raises after-tax income, increases consumption, and increases labor supply. Increases in transfer payments increase consumption and decrease labor supply; decreases in transfer payments decrease consumption and increase labor supply. 11. During times of unemployment, households’ labor supply may be constrained. Households may want to work a certain number of hours at current wage rates but may not be allowed to do so by firms. In this case, the level of income (at least workers’ income) depends exclusively on the employment decisions made by firms. Households consume less if they are constrained from working. 15.2 FIRMS: INVESTMENT AND EMPLOYMENT DECISIONS p. 317 12. Expectations affect investment and employment decisions. Keynes used the term animal spirits of entrepreneurs to refer to investors’ feelings. 13. At any level of the interest rate, expectations are likely to be more optimistic and planned investment is likely to be higher when output is growing rapidly than when it is growing slowly or falling. The result is an accelerator effect that can cause the economy to expand more rapidly during an expansion and contract more quickly during a recession. 14. Excess labor and capital are labor and capital not needed to produce a firm’s current level of output. Holding excess labor and capital may be more efficient than laying off workers or selling used equipment. The more excess capital a firm has, the less likely it is to invest in new capital in the future. The more excess labor it has, the less likely it is to hire new workers in the future. 15. Holding inventories is costly to a firm because they take up space and they tie up funds that could be earning interest. Not holding inventories can cause a firm to lose sales if demand increases. The desired, or optimal, level of
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inventories is the level at which the extra cost (in lost sales) from lowering inventories by a small amount is equal to the extra gain (in interest revenue and decreased storage costs). 16. An unexpected increase in inventories has a negative effect on future production, and an unexpected decrease in inventories has a positive effect on future production. 17. The level of a firm’s planned production path depends on the level of its expected future sales path. If a firm’s expectations of its future sales path decrease, the firm is likely to decrease the level of its planned production path, including its actual production in the current period. 15.3 PRODUCTIVITY AND THE BUSINESS CYCLE p. 322 18. Productivity, or labor productivity, is output per worker hour— the amount of output produced by an average worker in one hour. Productivity fluctuates over the business cycle, tending to rise during expansions and fall during contractions. That workers are less productive during contractions does not mean that they have less potential to produce output; it means that excess labor exists and that workers are not working at their capacity. 15.4 THE SHORT-RUN RELATIONSHIP BETWEEN OUTPUT AND UNEMPLOYMENT p. 323 19. There is a negative relationship between output and unemployment: When output (Y) rises, the unemployment rate (U) falls, and when output falls, the unemployment rate rises. Okun’s Law states that in the short run the unemployment rate decreases about 1 percentage point for every 3 percent increase in GDP. Okun’s Law is not a “law”—the economy is too complex for there to be a stable relationship between two macroeconomic variables. In general, the relationship between output and unemployment depends on the state of the economy at the time of the output change. 15.5 THE SIZE OF THE MULTIPLIER p. 324 20. There are several reasons why the actual value of the multiplier is smaller than the size that would be expected from the simple multiplier model: (1) Automatic stabilizers help to offset contractions or limit expansions. (2) When government spending increases, the increased interest rate crowds out planned investment and consumption spending. (3) Expansionary policies increase the price level. (4) Firms sometimes hold excess capital and excess labor. (5) Firms may meet increased demand by drawing down inventories instead of increasing output. (6) Households and firms change their behavior
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less when they expect changes to be temporary instead of permanent. 21. In practice, the size of the multiplier at its peak is about 2. MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with. M15_CASE3826_13_GE_C15.indd 326 17/04/19 4:20 AM CHAPTER 15 Household and Firm Behavior in the Macroeconomy: A Further Look 327 accelerator effect, p. 318 adjustment costs, p. 318 animal spirits of entrepreneurs, p. 317 constrained supply of labor, p. 313 desired, or optimal, level of inventories, p. 319 discouraged-worker effect, p. 324 excess labor, excess capital, p. 318 inventory investment, p. 319 life-cycle theory of consumption, p. 309 nominal wage rate, p. 311 nonlabor, or nonwage, income, p. 312 Okun’s Law, p. 323 permanent income, p. 310 productivity, or labor productivity, p. 322 real wage rate, p. 311 unconstrained supply of labor, p. 313 P R O B L E M S All problems are available on MyLab Economics. 15.1 HOUSEHOLDS: CONSUMPTION AND LABOR SUPPLY DECISIONS LEARNING OBJECTIVE: Describe factors that affect household consumption and labor supply decisions. 1.1 In June 2018, the Federal Reserve Bank raised interest rates for the seventh time in three years, and signaled that two additional rate hikes would take place by the end of the year. a. What direct effects do higher interest rates have on house- hold and firm behavior? b. One of the consequences of higher interest rates is that the value of existing bonds (both corporate bonds and government bonds) will fall. Explain why higher interest rates would decrease the value of existing fixed-rate bonds held by the public. c. Some economists argue that the wealth effect of higher interest rates on consumption is as important as the direct effect of higher interest rates on investment. Explain what economists mean by “wealth effects on consumption” and illustrate with AS/AD curves. 1.2 The personal income tax rate in Spain stands at 45 percent as of 2018. The tax rate averaged a 47.92 percent from 1995 until 2018, reaching an all-time high of 56 percent in 1996 and a record low of 43
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