Essay Write an essay that discusses major costs of inflation and propose some solutions to these problems. Discuss the role of inflation and inflationary expectations in managerial decision making. Follow APA guidelines for the font, format, references etc. Chapter 12 Unemployment and Inflation Chapter Outline • Unemployment and Inflation: Is There a Trade-Off? • Macroeconomic Policy and the Phillips Curve • The Problem of Unemployment • The Problem of Inflation • Fighting Inflation: The Role of Inflationary Expectations Copyright ©2017 Pearson Education, Inc. All rights reserved. 12-2 Unemployment and Inflation: Is There a Trade-off? • Many people think there is a trade-off between inflation and unemployment – The idea originated in 1958 when A.W. Phillips showed a negative relationship between unemployment and nominal wage growth in Britain – Since then economists have looked at the relationship between unemployment and inflation – In the 1950s and 1960s many nations seemed to have a negative relationship between the two variables – The United States appears to be on one Phillips curve in the 1960s (Fig. 12.1) Copyright ©2017 Pearson Education, Inc. All rights reserved. 12-3 Figure 12.1: The Phillips curve and the U.S. economy during the 1960s Copyright ©2017 Pearson Education, Inc. All rights reserved. 12-4 Unemployment and Inflation: Is There a Trade-off? • Many people think there is a trade-off between inflation and unemployment – This suggested that policymakers could choose the combination of unemployment and inflation they most desired – But the relationship fell apart in the following three decades (Fig. 12.2) – The 1970s were a particularly bad period, with both high inflation and high unemployment, inconsistent with the Phillips curve Copyright ©2017 Pearson Education, Inc. All rights reserved. 12-5 Figure 12.2: Inflation and unemployment in the United States, 1970–2014 Copyright ©2017 Pearson Education, Inc. All rights reserved. 12-6 Unemployment and Inflation: Is There a Trade-off? • The expectations-augmented Phillips curve – Friedman and Phelps: The cyclical unemployment rate (the difference between actual and natural unemployment rates) depends only on unanticipated inflation (the difference between actual and expected inflation) • This theory was made before the Phillips curve began breaking down in the 1970s • It suggests that the relationship between inflation and the unemployment rate isn’t stable Copyright ©2017 Pearson Education, Inc. All rights reserved. 12-7 Unemployment and Inflation: Is There a Trade-off? • The expectations-augmented Phillips curve – How does this work in the extended classical model? • First case: anticipated increase in money supply (Fig. 12.3) – AD shifts up and SRAS shifts up, with no misperceptions – Result: P rises, Y unchanged – Inflation rises with no change in unemployment Copyright ©2017 Pearson Education, Inc. All rights reserved. 12-8 Figure 12.3: Ongoing inflation in the extended classical model Copyright ©2017 Pearson Education, Inc. All rights reserved. 12-9 Unemployment and Inflation: Is There a Trade-off? • The expectations-augmented Phillips curve – How does this work in the extended classical model? • Second case: unanticipated increase in money supply (Fig. 12.4) – AD expected to shift up to AD2,old (money supply expected to rise 10%), but unexpectedly money supply rises 15%, so AD shifts further up to AD2,new – SRAS shifts up based on expected 10% rise in money supply – Result: P rises and Y rises as misperceptions occur – So, higher inflation occurs with lower unemployment – Long run: P rises further, Y declines to full-employment level Copyright ©2017 Pearson Education, Inc. All rights reserved. 12-10 Figure 12.4: Unanticipated inflation in the extended classical model Copyright ©2017 Pearson Education, Inc. All rights reserved. 12-11 Unemployment and Inflation: Is There a Trade-off? • The expectations-augmented Phillips curve (12.1)  =  e − h(u − u ) – When p = pe, u = =u – When p < pe, u < u – When p > pe, u > u Copyright ©2017 Pearson Education, Inc. All rights reserved. 12-12 Unemployment and Inflation: Is There a Trade-off? • The shifting Phillips curve – The short-run Phillips curve shows the relationship between unemployment and inflation for a given expected rate of inflation and natural rate of unemployment – Changes in the expected rate of inflation (Fig. 12.5) Copyright ©2017 Pearson Education, Inc. All rights reserved. 12-13 Figure 12.5: The shifting short-run Phillips curve: an increase in expected inflation Copyright ©2017 Pearson Education, Inc. All rights reserved. 12-14 Unemployment and Inflation: Is There a Trade-off? • The shifting Phillips curve – Changes in the expected rate of inflation (Fig. 12.5) • For a given expected rate of inflation, the short-run Phillips curve shows the trade-off between cyclical unemployment and actual inflation • The short-run Phillips curve is drawn such that p = pe  =when u = u= • Higher expected inflation implies a higher short-run Phillips curve Copyright ©2017 Pearson Education, Inc. All rights reserved. 12-15 Unemployment and Inflation: Is There a Trade-off? • The shifting Phillips curve – Changes in the natural rate of unemployment (Fig. 12.6) • For a given natural rate of unemployment, the short-run Phillips curve shows the trade-off between unemployment and unanticipated inflation • A higher natural rate of unemployment shifts the short-run Phillips curve to the right Copyright ©2017 Pearson Education, Inc. All rights reserved. 12-16 Figure 12.6: The shifting short-run Phillips curve: an increase in the natural unemployment rate Copyright ©2017 Pearson Education, Inc. All rights reserved. 12-17 Unemployment and Inflation: Is There a Trade-off? • Supply shocks and the Phillips curve – A supply shock increases both expected inflation and the natural rate of unemployment • A supply shock in the classical model increases the natural rate of unemployment, because it increases the mismatch between firms and workers • A supply shock in the Keynesian model reduces the marginal product of labor and thus reduces labor demand at the fixed real wage, so the natural unemployment rate rises Copyright ©2017 Pearson Education, Inc. All rights reserved. 12-18 Unemployment and Inflation: Is There a Trade-off? • Supply shocks and the Phillips curve – So, an adverse supply shock shifts the short-run Phillips curve up and to the right – The short-run Phillips curve will be unstable in periods with many supply shocks Copyright ©2017 Pearson Education, Inc. All rights reserved. 12-19 Unemployment and Inflation: Is There a Trade-off? • The shifting short-run Phillips curve in practice – Why did the original Phillips curve relationship apply to many historical cases? • The original relationship between inflation and unemployment holds up as long as expected inflation and the natural rate of unemployment are approximately constant • This was true in the United States in the 1960s, so the Phillips curve appeared to be stable Copyright ©2017 Pearson Education, Inc. All rights reserved. 12-20 Unemployment and Inflation: Is There a Trade-off? • The shifting Phillips curve in practice – Why did the U.S. Phillips curve disappear after 1970? • Both the expected inflation rate and the natural rate of unemployment varied considerably more in the 1970s than they did in the 1960s • Especially important were the oil price shocks of 1973–1974 and 1979–1980 • Also, the composition of the labor force changed in the 1970s and there were other structural changes in the economy as well, raising the natural rate of unemployment Copyright ©2017 Pearson Education, Inc. All rights reserved. 12-21 Unemployment and Inflation: Is There a Trade-off? • The shifting Phillips curve in practice – Why did the U.S. Phillips curve disappear after 1970? • Monetary policy was expansionary in the 1970s, leading to high and volatile inflation • Plotting unanticipated inflation against cyclical unemployment shows a fairly stable relationship since 1970 (Fig. 12.7) Copyright ©2017 Pearson Education, Inc. All rights reserved. 12-22 Figure 12.7: The expectations-augmented Phillips curve in the United States, 1970–2014 Copyright ©2017 Pearson Education, Inc. All rights reserved. 12-23 Macroeconomic Policy and the Phillips Curve • Can the Phillips curve be exploited by policymakers? Can they choose the optimal combination of unemployment and inflation? – Classical model: NO – Keynesian model: YES, temporarily Copyright ©2017 Pearson Education, Inc. All rights reserved. 12-24 Macroeconomic Policy and the Phillips Curve • Can the Phillips curve be exploited by policymakers? • Classical model: NO – The unemployment rate returns to its natural level quickly, as people’s expectations adjust – So unemployment can change from its natural level only for a very brief time – Also, people catch on to policy games; they have rational expectations and try to anticipate policy changes, so there is no way to fool people systematically Copyright ©2017 Pearson Education, Inc. All rights reserved. 12-25 Macroeconomic Policy and the Phillips Curve • Can the Phillips curve be exploited by policymakers? • Keynesian model: YES, temporarily – The expected rate of inflation in the Phillips curve is the forecast of inflation at the time the oldest sticky prices were set – It takes time for prices and expected prices to adjust, so unemployment may differ from the natural rate for some time Copyright ©2017 Pearson Education, Inc. All rights reserved. 12-26 Macroeconomic Policy and the Phillips Curve • In touch with data and research: The Lucas critique – When the rules of the game change, behavior changes – For example, if batters in baseball were called out after two strikes instead of three, they’d swing more often when they have one strike than they do now – Lucas applied this idea to macroeconomics, arguing that historical relationships between variables won’t hold up if there’s been a major policy change Copyright ©2017 Pearson Education, Inc. All rights reserved. 12-27 Macroeconomic Policy and the Phillips Curve • In touch with data and research: The Lucas critique – The short-run Phillips curve is a good example— it fell apart as soon as policymakers tried to exploit it – Evaluating policy requires an understanding of how behavior will change under the new policy, so both economic theory and empirical analysis are necessary Copyright ©2017 Pearson Education, Inc. All rights reserved. 12-28 Macroeconomic Policy and the Phillips Curve • The long-run Phillips curve – Long run: the u = ufor both Keynesians and classicals • The long-run Phillips curve is vertical, since = u 12.8) when p = pe, then u(Figure Copyright ©2017 Pearson Education, Inc. All rights reserved. 12-29 Figure 12.8: The long-run Phillips curve Copyright ©2017 Pearson Education, Inc. All rights reserved. 12-30 Macroeconomic Policy and the Phillips Curve • The long-run Phillips curve – Changes in the level of money supply have no long-run real effects; changes in the growth rate of money supply have no long-run real effects, either – Even though expansionary policy may reduce unemployment only temporarily, policymakers may want to do so if, for example, timing economic booms right before elections helps them (or their political allies) get reelected Copyright ©2017 Pearson Education, Inc. All rights reserved. 12-31 The Problem of Unemployment • The costs of unemployment – Loss in output from idle resources • Workers lose income • Society pays for unemployment benefits and makes up lost tax revenue • Using Okun’s Law (each percentage point of cyclical unemployment is associated with a loss equal to 2% of full-employment output), if full-employment output is $17 trillion, each percentage point of unemployment sustained for one year costs $340 billion Copyright ©2017 Pearson Education, Inc. All rights reserved. 12-32 The Problem of Unemployment • The costs of unemployment – Personal or psychological cost to workers and their families • Especially important for those with long spells of unemployment – Costs of unemployment may vary across demographic groups Copyright ©2017 Pearson Education, Inc. All rights reserved. 12-33 The Problem of Unemployment • The costs of unemployment – There are some offsetting factors • Unemployment leads to increased job search and acquiring new skills, which may lead to increased future output • Unemployed workers have increased leisure time, though most wouldn’t feel that the increased leisure compensated them for being unemployed Copyright ©2017 Pearson Education, Inc. All rights reserved. 12-34 The Problem of Unemployment • The long-term behavior of the unemployment rate – The changing natural rate • How do we calculate the natural rate of unemployment? • CBO’s estimates: about 5.5% in 2015, somewhat higher than it was in the early 2000s but somewhat lower than its value in the late 1970s Copyright ©2017 Pearson Education, Inc. All rights reserved. 12-35 The Problem of Unemployment • The long-term behavior of the unemployment rate – The changing natural rate • In the 1980s and 1990s, demographic forces reduced the natural rate of unemployment (Fig. 12.9) – The proportion of the labor force aged 16–24 years fell from 25% in 1980 to 16% in 1998 and to 13% in 2015 – Research by Shimer showed this is the main reason for the fall in the natural rate of unemployment Copyright ©2017 Pearson Education, Inc. All rights reserved. 12-36 Figure 12.9: Actual and natural unemployment rates in the United States, 1960–2014 Copyright ©2017 Pearson Education, Inc. All rights reserved. 12-37 The Problem of Unemployment • The long-term behavior of the unemployment rate – The changing natural rate • Some economists think the natural rate of unemployment was 4.5% or even lower in the 1990s and 2000s – The labor market became more efficient at matching workers and jobs, reducing frictional and structural unemployment – Temporary help agencies became prominent, helping the matching process and reducing the natural rate of unemployment Copyright ©2017 Pearson Education, Inc. All rights reserved. 12-38 The Problem of Unemployment • The long-term behavior of the unemployment rate – The changing natural rate • Increased labor productivity may increase the natural rate of unemployment – If increases in real wages lag changes in productivity, firms hire more workers and the natural rate of unemployment will decline temporarily – Ball and Mankiw found evidence supporting this hypothesis in the 1990s Copyright ©2017 Pearson Education, Inc. All rights reserved. 12-39 The Problem of Unemployment • The long-term behavior of the unemployment rate – Measuring the natural rate of unemployment • Policymakers need a measure of the natural rate of unemployment to use the unemployment rate for setting policy • Economists disagree about how to measure the natural rate of unemployment and the CBO has often revised its measure Copyright ©2017 Pearson Education, Inc. All rights reserved. 12-40 The Problem of Unemployment • The long-term behavior of the unemployment rate – Measuring the natural rate of unemployment • Staiger, Stock, and Watson found that the natural rate cannot be measured precisely with econometric methods, as the confidence interval is very large Copyright ©2017 Pearson Education, Inc. All rights reserved. 12-41 The Problem of Unemployment • The long-term behavior of the unemployment rate – Measuring the natural rate of unemployment • What should policymakers do in response to uncertainty about the natural rate of unemployment? – They may wish to be less aggressive with policy than they would be if they knew the natural rate more precisely – Research (Orphanides–Williams) suggests that the rise of inflation in the 1970s can be blamed on bad estimates of the natural rate Copyright ©2017 Pearson Education, Inc. All rights reserved. 12-42 The Problem of Inflation • The costs of inflation – Perfectly anticipated inflation • No effects if all prices and wages keep up with inflation • Even returns on assets may rise exactly with inflation • Shoe-leather costs: People spend resources to economize on currency holdings; the estimated cost of 10% inflation is 0.3% of GNP • Menu costs: the costs of changing prices (but technology may mitigate this somewhat) Copyright ©2017 Pearson Education, Inc. All rights reserved. 12-43 The Problem of Inflation • The costs of inflation – Unanticipated inflation (p – pe) • Realized real returns differ from expected real returns – – – – Expected r ==i – pe Actual r ==i – p Actual r differs from expected r by pe – p Numerical example: i = 6%, pe = 4%, so expected r = 2%; if p ==6%, actual r == 0%; ifp = 2%, actual r == 4% Copyright ©2017 Pearson Education, Inc. All rights reserved. 12-44 The Problem of Inflation • The costs of inflation – Unanticipated inflation (p – pe) • Similar effect on wages and salaries • Result: transfer of wealth – From lenders to borrowers when p > pe – From borrowers to lenders when p < pe • So people want to avoid risk of unanticipated inflation – They spend resources to forecast inflation Copyright ©2017 Pearson Education, Inc. All rights reserved. 12-45 The Problem of Inflation • The costs of inflation – Unanticipated inflation (p – pe) • Loss of valuable signals provided by prices – Confusion over changes in aggregate prices vs. changes in relative prices – People expend resources to extract correct signals from prices Copyright ©2017 Pearson Education, Inc. All rights reserved. 12-46 The Problem of Inflation • In touch with data and research: Indexed contracts – People could use indexed contracts to avoid the risk of transferring wealth because of unanticipated inflation – Most U.S. financial contracts are not indexed, with the exception of some long-term contracts like adjustable-rate mortgages and inflation-indexed bonds issued by the U.S. Treasury beginning in 1997 – Many U.S. labor contracts are indexed by COLAs (cost-of-living adjustments) – Indexed contracts are more prevalent in countries with high inflation Copyright ©2017 Pearson Education, Inc. All rights reserved. 12-47 The Problem of Inflation • The costs of inflation – The costs of hyperinflation • Hyperinflation is a very high, sustained inflation (for example, 50% or more per month) – Hungary in August 1945 had inflation of 19,800% per month – Zimbabwe had annual rates of inflation of 1017% in 2006, 10,453% in 2007, and 55.6 billion percent in 2008, before dropping to 6.5% in 2009 Copyright ©2017 Pearson Education, Inc. All rights reserved. 12-48 The Problem of Inflation • The costs of inflation – The costs of hyperinflation • There are large shoe-leather costs, as people minimize cash balances • People spend many resources getting rid of money as fast as possible • Tax collections fall, as people pay taxes with money whose value has declined sharply • Prices become worthless as signals, so markets become inefficient Copyright ©2017 Pearson Education, Inc. All rights reserved. 12-49 The Problem of Inflation • Can Inflation Be Too Low? – Should central banks be concerned about low inflation rates or even deflation (negative rates of inflation?) – Low inflation can be harmful • Borrowers are hurt by unexpectedly low inflation, as in the 1930s, when deflation led to severe financial distress • Anticipated deflation also has costs, such as the increase in real wages if nominal wages are sticky, leading to lower employment • Understanding relative prices can also be difficult in a deflationary environment Copyright ©2017 Pearson Education, Inc. All rights reserved. 12-50 The Problem of Inflation • Can Inflation Be Too Low? – Nominal interest rates cannot generally fall below zero, so under deflation, real interest rates cannot be very low • So, a central bank’s ability to reduce real interest rates to combat a recession is limited • For example, if deflation occurs at a rate of 2% (that is, the inflation rate is negative 2%), the lowest real interest rate possible occurs when the nominal interest rate is 0%, in which case the real interest rate is 2% • However, if inflation were positive 2%, the central bank could achieve a real interest rate of negative 2% Copyright ©2017 Pearson Education, Inc. All rights reserved. 12-51 The Problem of Inflation • Can Inflation Be Too Low? – What inflation rate should central banks aim for? • Many central banks target inflation around 2% • An inflation rate around 2% keeps the costs of inflation fairly low • But an inflation rate of 2% is high enough that there is only a small risk that the economy will suffer from deflation • In addition, inflation measures are biased up, so 2% measured inflation means that true inflation is somewhat lower Copyright ©2017 Pearson Education, Inc. All rights reserved. 12-52 Fighting Inflation: The Role of Inflationary Expectations • If rapid money growth causes inflation, why do central banks allow the money supply to grow rapidly? – Developing or war-torn countries may not be able to raise taxes or borrow, so they print money to finance spending – Industrialized countries may try to use expansionary monetary policy to fight recessions, then not tighten monetary policy enough later Copyright ©2017 Pearson Education, Inc. All rights reserved. 12-53 Fighting Inflation: The Role of Inflationary Expectations • Disinflation is a reduction in the rate of inflation – But disinflations may lead to recessions – An unexpected reduction in inflation leads to a rise in unemployment along the Phillips curve • The costs of disinflation could be reduced if expected inflation fell at the same time actual inflation fell Copyright ©2017 Pearson Education, Inc. All rights reserved. 12-54 Fighting Inflation: The Role of Inflationary Expectations • Rapid versus gradual disinflation – The classical prescription for disinflation is cold turkey—a rapid and decisive reduction in money growth • Proponents argue that the economy will adjust fairly quickly, with low costs of adjustment, if the policy is announced well in advance Copyright ©2017 Pearson Education, Inc. All rights reserved. 12-55 Fighting Inflation: The Role of Inflationary Expectations • Keynesians disagree with rapid disinflation – Price stickiness due to menu costs and wage stickiness due to labor contracts make adjustment slow – Cold turkey disinflation would cause a major recession – The strategy might fail to alter inflation expectations, because if the costs of the policy are high (because the economy goes into recession), the government will reverse the policy Copyright ©2017 Pearson Education, Inc. All rights reserved. 12-56 Fighting Inflation: The Role of Inflationary Expectations • The Keynesian prescription for disinflation is gradualism – A gradual approach gives prices and wages time to adjust to the disinflation – Such a strategy will be politically sustainable because the costs are low Copyright ©2017 Pearson Education, Inc. All rights reserved. 12-57 Fighting Inflation: The Role of Inflationary Expectations • In touch with data and research: The sacrifice ratio – When unanticipated tight monetary and fiscal policies are used to reduce inflation, they reduce output and employment for a time, a cost that must be weighed against the benefits of lower inflation Copyright ©2017 Pearson Education, Inc. All rights reserved. 12-58 Fighting Inflation: The Role of Inflationary Expectations • In touch with data and research: The sacrifice ratio – Economists use the sacrifice ratio as a measure of the costs • The sacrifice ratio is the number of percentage points of output lost in reducing inflation by one percentage point • Ball’s study: U.S. inflation fell by 8.83 percentage points in the early 1980s, with a loss in output of 16.18 percent of the nation’s potential output • Sacrifice ratio = 16.18/8.83 = 1.832 Copyright ©2017 Pearson Education, Inc. All rights reserved. 12-59 Fighting Inflation: The Role of Inflationary Expectations • In touch with data and research: The sacrifice ratio – Ball studied the sacrifice ratios for many different disinflations around the world in the 1960s, 1970s, and 1980s • The sacrifice ratios varied substantially across countries, from less than 1 to almost 3 • One factor affecting the sacrifice ratio is the flexibility of the labor market – Countries with slow wage adjustment (for example, because of heavy government regulation of the labor market) have higher sacrifice ratios • Ball also found a lower sacrifice ratio from cold turkey disinflation than from gradualism Copyright ©2017 Pearson Education, Inc. All rights reserved. 12-60 Fighting Inflation: The Role of Inflationary Expectations • In touch with data and research: The sacrifice ratio Ball’s results should be interpreted with caution, since it isn’t easy to calculate the loss of output and because supply shocks can distort the calculation of the sacrifice ratio Copyright ©2017 Pearson Education, Inc. All rights reserved. 12-61 Fighting Inflation: The Role of Inflationary Expectations • Wage and price controls – Pro: Controls would hold down inflation, thus lowering expected inflation and reducing the costs of disinflation – Con: Controls lead to shortages and inefficiency; once controls are lifted, prices will rise again Copyright ©2017 Pearson Education, Inc. All rights reserved. 12-62 Fighting Inflation: The Role of Inflationary Expectations • Wage and price controls – The outcome of wage and price controls may depend on what happens with fiscal and monetary policy • If policies remain expansionary, people will expect renewed inflation when the controls are lifted • If tight policies are pursued, expected inflation may decline – The Nixon wage-price controls from August 1971 to April 1974 led to shortages in many products; the controls reduced inflation when they were in effect, but prices returned to where they would have been soon after the controls were lifted Copyright ©2017 Pearson Education, Inc. All rights reserved. 12-63 Fighting Inflation: The Role of Inflationary Expectations • Credibility and reputation – Key determinant of the costs of disinflation: how quickly expected inflation adjusts – This depends on credibility of disinflation policy; if people believe the government and if the government carries through with its policy, expected inflation should drop rapidly – Credibility can be enhanced if the government gets a reputation for carrying out its promises – Also, having a strong and independent central bank that is committed to low inflation provides credibility Copyright ©2017 Pearson Education, Inc. All rights reserved. 12-64 Fighting Inflation: The Role of Inflationary Expectations • The U.S. disinflation of the 1980s and 1990s – Fed chairmen Volcker and Greenspan gradually reduced the inflation rate in the 1980s and 1990s • They sought to eliminate inflation as a source of economic instability • They wanted people to be confident that inflation would never be very high again Copyright ©2017 Pearson Education, Inc. All rights reserved. 12-65 Fighting Inflation: The Role of Inflationary Expectations • The U.S. disinflation of the 1980s and 1990s – To judge the Fed’s success, we look at inflation expectations (Fig. 12.10) • Inflation expectations were erratic before 1990 • Inflation expectations fell gradually from 1990 to 1998 and have been stable since then Copyright ©2017 Pearson Education, Inc. All rights reserved. 12-66 Figure 12.10: Expected inflation rate 1971Q1–2015Q2 Copyright ©2017 Pearson Education, Inc. All rights reserved. 12-67 Fighting Inflation: The Role of Inflationary Expectations • The U.S. disinflation of the 1980s and 1990s – Inflation expectations were slow to decline initially (in the late 1970s and early 1980s) because Volcker and the Fed lacked credibility – But as inflation continued to fall, the Fed’s credibility increased, and inflation expectations declined gradually – To solidify those expectations, the Fed declared a 2% long-run inflation target in 2012 Copyright ©2017 Pearson Education, Inc. All rights reserved. 12-68 Copyright ©2017 Pearson Education, Inc. All rights reserved. 12-69 Chapter 4 Consumption, Saving, and Investment Chapter Outline • Consumption and Saving • Investment • Goods Market Equilibrium Copyright ©2017 Pearson Education, Inc. All rights reserved. 4-2 Consumption and Saving • The importance of consumption and saving – Desired consumption: consumption amount desired by households – Desired national saving: level of national saving when consumption is at its desired level: Sd = Y – C d – G (4.1) Copyright ©2017 Pearson Education, Inc. All rights reserved. 4-3 Consumption and Saving • The consumption and saving decision of an individual – A person can consume less than current income (saving is positive) – A person can consume more than current income (saving is negative) Copyright ©2017 Pearson Education, Inc. All rights reserved. 4-4 Consumption and Saving • The consumption and saving decision of an individual – Trade-off between current consumption and future consumption • The price of 1 unit of current consumption is 1 + r units of future consumption, where r is the real interest rate • Consumption-smoothing motive: the desire to have a relatively even pattern of consumption over time Copyright ©2017 Pearson Education, Inc. All rights reserved. 4-5 Consumption and Saving • Effect of changes in current income – Increase in current income: both consumption and saving increase (vice versa for decrease in current income) – Marginal propensity to consume (MPC) = fraction of additional current income consumed in current period; between 0 and 1 – Aggregate level: when current income (Y) rises, Cd rises, but not by as much as Y, so Sd rises Copyright ©2017 Pearson Education, Inc. All rights reserved. 4-6 Consumption and Saving • Effect of changes in expected future income – Higher expected future income leads to more consumption today, so saving falls Copyright ©2017 Pearson Education, Inc. All rights reserved. 4-7 Consumption and Saving • Application: consumer sentiment and forecasts of consumer spending – Do consumer sentiment indexes help economists forecast consumer spending? – Data do not seem to give much warning before recessions (Fig. 4.1) Copyright ©2017 Pearson Education, Inc. All rights reserved. 4-8 Figure 4.1: Consumer Sentiment, 1978Q1 to 2015Q1 Copyright ©2017 Pearson Education, Inc. All rights reserved. 4-9 Consumption and Saving • Application: consumer sentiment and forecasts of consumer spending – Data on consumer spending are correlated with data on consumer confidence (Fig. 4.2) Copyright ©2017 Pearson Education, Inc. All rights reserved. 4-10 Figure 4.2: Consumer sentiment and consumption spending growth, 1978Q1–2015Q1 Copyright ©2017 Pearson Education, Inc. All rights reserved. 4-11 Consumption and Saving • Application: consumer sentiment and forecasts of consumer spending – Data on consumer spending are correlated with data on consumer confidence (Fig. 4.2) – But formal statistical analysis shows that data on consumer confidence do not improve forecasts of consumer spending based on real-time data Copyright ©2017 Pearson Education, Inc. All rights reserved. 4-12 Consumption and Saving • Effect of changes in wealth – Increase in wealth raises current consumption, so lowers current saving Copyright ©2017 Pearson Education, Inc. All rights reserved. 4-13 Consumption and Saving • Effect of changes in real interest rate – Increased real interest rate has two opposing effects • Substitution effect: Positive effect on saving, since rate of return is higher; greater reward for saving elicits more saving • Income effect – For a saver: Negative effect on saving, since it takes less saving to obtain a given amount in the future (target saving) – For a borrower: Positive effect on saving, since the higher real interest rate means a loss of wealth • Empirical studies have mixed results; probably a slight increase in aggregate saving Copyright ©2017 Pearson Education, Inc. All rights reserved. 4-14 Consumption and Saving • Effect of changes in real interest rate – Taxes and the real return to saving • Expected real after-tax interest rate: ra-t = (1 – t)i –pe Copyright ©2017 Pearson Education, Inc. All rights reserved. (4.2) 4-15 Table 4.1: Calculating After-Tax Interest Rates Copyright ©2017 Pearson Education, Inc. All rights reserved. 4-16 Consumption and Saving • In touch with data and research: interest rates – Discusses different interest rates, default risk, term structure (yield curve), and tax status – Since interest rates often move together, we frequently refer to “the” interest rate – Yield curve: relationship between life of a bond and the interest rate it pays Copyright ©2017 Pearson Education, Inc. All rights reserved. 4-17 In Touch With Data And Research: Yield Curve Copyright ©2017 Pearson Education, Inc. All rights reserved. 4-18 Consumption and Saving • Fiscal policy – Affects desired consumption through changes in current and expected future income – Directly affects desired national saving, Sd = Y – C d – G Copyright ©2017 Pearson Education, Inc. All rights reserved. 4-19 Consumption and Saving • Fiscal policy – Government purchases (temporary increase) • Higher G financed by higher current taxes reduces after-tax income, lowering desired consumption • Even true if financed by higher future taxes, if people realize how future incomes are affected • Since Cd declines less than G rises, national saving (Sd = Y – Cd – G) declines • So government purchases reduce both desired consumption and desired national saving Copyright ©2017 Pearson Education, Inc. All rights reserved. 4-20 Consumption and Saving • Fiscal policy – Taxes • Lump-sum tax cut today, financed by higher future taxes • Decline in future income may offset increase in current income; desired consumption could rise or fall Copyright ©2017 Pearson Education, Inc. All rights reserved. 4-21 Consumption and Saving • Fiscal policy – Taxes • Ricardian equivalence proposition – If future income loss exactly offsets current income gain, no change in consumption – Tax change affects only the timing of taxes, not their ultimate amount (present value) – In practice, people may not see that future taxes will rise if taxes are cut today; then a tax cut leads to increased desired consumption and reduced desired national saving Copyright ©2017 Pearson Education, Inc. All rights reserved. 4-22 Consumption and Saving • Application: How consumers respond to tax rebates – The government provided tax rebates in recessions of 2001 and 2007-2009, hoping to stimulate the economy – Research by Shapiro and Slemrod suggests that consumers did not increase spending much in 2001, when the government provided a similar tax rebate – New research by Agarwal, Liu, and Souleles finds that even though consumers originally saved much of the tax rebate, later they increased spending and increased their credit-card debt Copyright ©2017 Pearson Education, Inc. All rights reserved. 4-23 Consumption and Saving • Application: How consumers respond to tax rebates – The new research comes from credit-card payments, purchases, and debt over time – People getting the tax rebates initially made additional payments on their credit cards, paying down their balances; but after nine months they had increased their purchases and had more credit-card debt than before the tax rebate Copyright ©2017 Pearson Education, Inc. All rights reserved. 4-24 Consumption and Saving • Application: How consumers respond to tax rebates – Younger people, who were more likely to face binding borrowing constraints, increased their purchases on credit cards the most of any group in response to the tax rebate – People with high credit limits also tended to pay off more of their balances and spent less, as they were less likely to face binding borrowing constraints and behaved more in the manner suggested by Ricardian equivalence Copyright ©2017 Pearson Education, Inc. All rights reserved. 4-25 Consumption and Saving • Application: How consumers respond to tax rebates – New evidence on the tax rebates in 2008 and 2009 was provided in a research paper by Parker et al. • Consumers spent 50%-90% of the tax rebates • Inconsistent with Ricardian equivalence Copyright ©2017 Pearson Education, Inc. All rights reserved. 4-26 Summary 5: Determinants of Desired National Saving Copyright ©2017 Pearson Education, Inc. All rights reserved. 4-27 Investment • Why is investment important? – Investment fluctuates sharply over the business cycle, so we need to understand investment to understand the business cycle – Investment plays a crucial role in economic growth Copyright ©2017 Pearson Education, Inc. All rights reserved. 4-28 Investment • The desired capital stock – Desired capital stock is the amount of capital that allows firms to earn the largest expected profit – Desired capital stock depends on costs and benefits of additional capital – Since investment becomes capital stock with a lag, the benefit of investment is the future marginal product of capital (MPKf) Copyright ©2017 Pearson Education, Inc. All rights reserved. 4-29 Investment • The desired capital stock – The user cost of capital • Example of Kyle’s Bakery: cost of capital, depreciation rate, and expected real interest rate • User cost of capital = real cost of using a unit of capital for a specified period of time = real interest cost + depreciation uc = rpK + dpK = (r + d)pK Copyright ©2017 Pearson Education, Inc. All rights reserved. (4.3) 4-30 Investment • The desired capital stock – Determining the desired capital stock (Fig. 4.3) Copyright ©2017 Pearson Education, Inc. All rights reserved. 4-31 Figure 4.3: Determination of the desired capital stock Copyright ©2017 Pearson Education, Inc. All rights reserved. 4-32 Investment • The desired capital stock – Desired capital stock is the level of capital stock at which MPKf = uc – MPKf falls as K rises due to diminishing marginal productivity – uc doesn’t vary with K, so is a horizontal line Copyright ©2017 Pearson Education, Inc. All rights reserved. 4-33 Investment • The desired capital stock – If MPKf > uc, profits rise as K is added (marginal benefits > marginal costs) – If MPKf  uc, profits rise as K is reduced (marginal benefits < marginal costs) – Profits are maximized where MPKf = uc Copyright ©2017 Pearson Education, Inc. All rights reserved. 4-34 Investment • Changes in the desired capital stock – Factors that shift the MPKf curve or change the user cost of capital cause the desired capital stock to change – These factors are changes in the real interest rate, depreciation rate, price of capital, or technological changes that affect the MPKf (Fig. 4.4 shows effect of change in uc; Fig. 4.5 shows effect of change in MPKf) Copyright ©2017 Pearson Education, Inc. All rights reserved. 4-35 Figure 4.4: A decline in the real interest rate raises the desired capital stock Copyright ©2017 Pearson Education, Inc. All rights reserved. 4-36 Figure 4.5: An increase in the expected future MPK raises the desired capital stock Copyright ©2017 Pearson Education, Inc. All rights reserved. 4-37 Investment • Changes in the desired capital stock – Taxes and the desired capital stock • With taxes, the return to capital is only (1 – t) MPKf • A firm chooses its desired capital stock so that the return equals the user cost, so (1 – t)MPKf = uc, which means: MPKf = uc/(1 – t) = (r + d)pK/(1 – t) Copyright ©2017 Pearson Education, Inc. All rights reserved. (4.4) 4-38 Investment • Changes in the desired capital stock – Taxes and the desired capital stock • Tax-adjusted user cost of capital is uc/(1 – t) • An increase in t raises the tax-adjusted user cost and reduces the desired capital stock Copyright ©2017 Pearson Education, Inc. All rights reserved. 4-39 Investment • Changes in the desired capital stock – Taxes and the desired capital stock • In reality, there are complications to the tax-adjusted user cost – We assumed that firm revenues were taxed • In reality, profits, not revenues, are taxed • So depreciation allowances reduce the tax paid by firms, because they reduce profits – Investment tax credits reduce taxes when firms make new investments Copyright ©2017 Pearson Education, Inc. All rights reserved. 4-40 Investment • Changes in the desired capital stock – Taxes and the desired capital stock • In reality, there are complications to the tax-adjusted user cost – Summary measure: the effective tax rate—the tax rate on firm revenue that would have the same effect on the desired capital stock as do the actual provisions of the tax code – Table 4.2 shows effective tax rates for many different countries Copyright ©2017 Pearson Education, Inc. All rights reserved. 4-41 Table 4.2: Effective Tax Rate on Capital, 2013 Copyright ©2017 Pearson Education, Inc. All rights reserved. 4-42 Investment • Application: measuring the effects of taxes on investment – Do changes in the tax rate have a significant effect on investment? – A 1994 study by Cummins, Hubbard, and Hassett found that after major tax reforms, investment responded strongly; elasticity about –0.66 (of investment to user cost of capital) Copyright ©2017 Pearson Education, Inc. All rights reserved. 4-43 Investment • From the desired capital stock to investment – The capital stock changes from two opposing channels • New capital increases the capital stock; this is gross investment • The capital stock depreciates, which reduces the capital stock Copyright ©2017 Pearson Education, Inc. All rights reserved. 4-44 Investment • From the desired capital stock to investment – Net investment = gross investment (I) minus depreciation: Kt+1 – Kt = It – dKt (4.5) where net investment equals the change in the capital stock – Fig. 4.6 shows gross and net investment for the United States Copyright ©2017 Pearson Education, Inc. All rights reserved. 4-45 Figure 4.6: Gross and net investment, 1929–2014 Copyright ©2017 Pearson Education, Inc. All rights reserved. 4-46 Investment • From the desired capital stock to investment – Rewriting (4.5) gives It = Kt+1 – Kt + dKt – If firms can change their capital stocks in one period, then the desired capital stock (K*) = Kt+1 – So It = K* – Kt + dKt (4.6) Copyright ©2017 Pearson Education, Inc. All rights reserved. 4-47 Investment • From the desired capital stock to investment – Thus investment has two parts • Desired net increase in the capital stock over the year (K* – Kt) • Investment needed to replace depreciated capital (dKt) Copyright ©2017 Pearson Education, Inc. All rights reserved. 4-48 Investment • From the desired capital stock to investment – Lags and investment • Some capital can be constructed easily, but other capital may take years to put in place • So investment needed to reach the desired capital stock may be spread out over several years Copyright ©2017 Pearson Education, Inc. All rights reserved. 4-49 Investment • In touch with data and research: investment and the stock market – Firms change investment in the same direction as the stock market: Tobin’s q theory of investment – If market value > replacement cost, then firm should invest more – Tobin’s q = capital’s market value divided by its replacement cost • If q < 1, don’t invest • If q > 1, invest more Copyright ©2017 Pearson Education, Inc. All rights reserved. 4-50 Investment • In touch with data and research: investment and the stock market – Stock price times number of shares equals firm’s market value, which equals value of firm’s capital • Formula: q = V/(pKK), where V is stock market value of firm, K is firm’s capital, pK is price of new capital • So pKK is the replacement cost of firm’s capital stock • Stock market boom raises V, causing q to rise, increasing investment Copyright ©2017 Pearson Education, Inc. All rights reserved. 4-51 Investment • In touch with data and research: investment and the stock market – Data show general tendency of investment to rise when stock market rises; but relationship isn’t strong because many other things change at the same time (Figure 4.7) – This theory is similar to text discussion • Higher MPKf increases future earnings of firm, so V rises • A falling real interest rate also raises V as people buy stocks instead of bonds • A decrease in the cost of capital, pK, raises q Copyright ©2017 Pearson Education, Inc. All rights reserved. 4-52 Figure 4.7: Investment and Tobin’s q, 1987Q1–2014Q4 Copyright ©2017 Pearson Education, Inc. All rights reserved. 4-53 Investment • Investment in inventories and housing – Marginal product of capital and user cost also apply, as with equipment and structures Copyright ©2017 Pearson Education, Inc. All rights reserved. 4-54 Summary 6: Determinants of Desired Investment Copyright ©2017 Pearson Education, Inc. All rights reserved. 4-55 Goods Market Equilibrium • The real interest rate adjusts to bring the goods market into equilibrium – Y = Cd + Id + G (4.7) • Goods Market Equilibrium condition – Differs from income-expenditure identity, as goods market equilibrium condition need not hold; undesired goods may be produced, so goods market won’t be in equilibrium Copyright ©2017 Pearson Education, Inc. All rights reserved. 4-56 Goods Market Equilibrium • Alternative representation: since • Sd = Y – Cd – G, • Sd = Id (4.8) Copyright ©2017 Pearson Education, Inc. All rights reserved. 4-57 Goods Market Equilibrium • The saving-investment diagram • Plot Sd vs. Id (Key Diagram 3; text Fig. 4.8) Copyright ©2017 Pearson Education, Inc. All rights reserved. 4-58 Figure 4.8: Goods market equilibrium Copyright ©2017 Pearson Education, Inc. All rights reserved. 4-59 Goods Market Equilibrium • The saving-investment diagram – Equilibrium where Sd = Id – How to reach equilibrium? Adjustment of r – See text example (Table 4.3) Copyright ©2017 Pearson Education, Inc. All rights reserved. 4-60 Table 4.3: Components of Aggregate Demand for Goods (An Example) Copyright ©2017 Pearson Education, Inc. All rights reserved. 4-61 Goods Market Equilibrium • Shifts of the saving curve – Saving curve shifts right due to a rise in current output, a fall in expected future output, a fall in wealth, a fall in government purchases, a rise in taxes (unless Ricardian equivalence holds, in which case tax changes have no effect) – Example: Temporary increase in government purchases shifts S left – Result of lower savings: higher r, causing crowding out of I (Fig. 4.8) Copyright ©2017 Pearson Education, Inc. All rights reserved. 4-62 Figure 4.9: A decline in desired saving Copyright ©2017 Pearson Education, Inc. All rights reserved. 4-63 Goods Market Equilibrium • Shifts of the investment curve – Investment curve shifts right due to a fall in the effective tax rate or a rise in expected future marginal productivity of capital – Result of increased investment: higher r, higher S and I (Fig. 4.9) Copyright ©2017 Pearson Education, Inc. All rights reserved. 4-64 Figure 4.10: An increase in desired investment Copyright ©2017 Pearson Education, Inc. All rights reserved. 4-65 Goods Market Equilibrium • Application: macroeconomic consequences of the boom and bust in stock prices – Sharp changes in stock prices affect consumption spending (a wealth effect) and capital investment (via Tobin’s q) – Data in Fig. 4.11 Copyright ©2017 Pearson Education, Inc. All rights reserved. 4-66 Figure 4.11: Real U.S. stock prices and the ratio of consumption to GDP, 1987Q1 to 2015Q1 Copyright ©2017 Pearson Education, Inc. All rights reserved. 4-67 Goods Market Equilibrium • The boom and bust in stock prices – Consumption and the 1987 crash • When the stock market crashed in 1987, wealth declined by about $1 trillion • Consumption fell somewhat less than might be expected, and it wasn’t enough to cause a recession • There was a temporary decline in confidence about the future, but it was quickly reversed • The small response may have been because there had been a large run-up in stock prices between December 1986 and August 1987, so the crash mostly erased this run-up Copyright ©2017 Pearson Education, Inc. All rights reserved. 4-68 Goods Market Equilibrium • The boom and bust in stock prices – Consumption and the rise in stock market wealth in the 1990s • Stock prices more than tripled in real terms • But consumption was not strongly affected by the runup in stock prices Copyright ©2017 Pearson Education, Inc. All rights reserved. 4-69 Goods Market Equilibrium • The boom and bust in stock prices – Consumption and the decline in stock prices in the early 2000s • In the early 2000s, wealth in stocks declined by about $5 trillion • But consumption spending increased as a share of GDP in that period Copyright ©2017 Pearson Education, Inc. All rights reserved. 4-70 Goods Market Equilibrium • The boom and bust in stock prices – Investment and the declines in the stock market in the 2000s • Investment and Tobin’s q were correlated in 2000 and 2008, when the stock market fell sharply • Investment tended to lag the decline in the stock market, reflecting lags in the process of making investment decisions Copyright ©2017 Pearson Education, Inc. All rights reserved. 4-71 Goods Market Equilibrium • The boom and bust in stock prices – The financial crisis of 2008 • Stock prices plunged in fall 2008 and early 2009, and home prices fell sharply as well, leading to a large decline in household net wealth • Despite the decline in wealth, the ratio of consumption to GDP did not decline much Copyright ©2017 Pearson Education, Inc. All rights reserved. 4-72 Goods Market Equilibrium • The boom and bust in stock prices – Investment and Tobin’s q • Investment and Tobin’s q were not closely correlated following the 1987 crash in stock prices • But the relationship has been tighter in the 1990s and early 2000s, as theory suggests (Fig. 4.11) Copyright ©2017 Pearson Education, Inc. All rights reserved. 4-73 Key Diagram 3: The saving–investment diagram Copyright ©2017 Pearson Education, Inc. All rights reserved. 4-74 Copyright ©2017 Pearson Education, Inc. All rights reserved. 4-75
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