CH-10-12 Consumption and Investment – Macroeconomics: Understanding the Global Economy : Book Guide

This Document Contains Chapters 10 to 12 INTRODUCTION This is the first of four chapters that focus largely on the business cycle. It is the most theoretical of the four, but outlines a number of models that will be used again later. Time used to absorb these will therefore be well spent. Teaching Tips ALTERNATIVE ROUTES THROUGH THE CHAPTER Since the Keynesian model is introduced largely to be knocked down, it may be worth starting immediately with the permanent income model (which itself could be summarized for a less theoretical course). Since IS-LM analysis is first introduced in this chapter it could be gone through in detail at this stage (See case study) or could wait until the LM curve is outlined in Chapter 13. CHAPTER GUIDE 10.1 The Importance of Consumption. The relationship between US GDP and consumption is shown in the Background Material below. 10.2 The Basic Keynesian Model. An intuitive explanation of the multiplier is shown in the Background Material. It is worth bearing in mind that the multiplier effect was one of the reasons why active demand management policy seemed attractive before the 1980’s. Each dollar spent on fiscal stimulus supposedly added several dollars to GDP. 10.3 The Permanent Income Model. This is a tough section and can be skipped or summarized if required. However, the general ideas here should be familiar from Chapter 10. 10.4 The Importance of Current Income Revisited. The Background Material gives more detail on the UK’s experience of financial liberalization in the 1980’s. 10.5 The Influence of Interest Rates. The possibility that higher interest rates could stimulate consumption is actively discussed in relation to Japan. There, most households have high levels of savings and so the income effect could be large. One member of the Bank of Japan monetary policy committee was convinced of this argument and consistently voted for higher interest rates as a way of helping Japan to recover. However, the other members of the committee did not share Ms. Shinotsuka’s view. 10.6 The Role of Wealth and Capital Gains. Another country where wealth effects (particularly from housing wealth) seem to have been important recently is the UK. CHAPTER 10: CONSUMPTION & INVESTMENT This Document Contains Chapters 10 to 12 Some characteristics of the recent UK experience are brought out in the additional question below. 10.7 Demographic Influences in the Life Cycle Model. Another approach to understanding life cycle effects on consumption is offered in the Background Material - US consumption and World War III. 10.8 Investment and the Capital Stock. This chapter largely focuses exclusively on fixed capital. Inventories are discussed in the Case Study below. 10.9 The Optimal Capital Stock. The Modigliani-Miller theorem states that it makes no difference to the value of the firm how investment is financed, so in theory the source of funds is not important. In practice, the impact of corporate taxation etc. means that Modigliani-Miller does not hold – see Chapter 16. 10.10 Declining Marginal Product of Capital. This section relates back to the material on Chapter 4 10.11 Investment and the Stock Market. Most studies have found a weak, but significant, effect of Q on investment. For example Summers (“Taxation and Corporate Investment: A q-theory approach” Brookings Papers 1:1981) finds that a 10% rise in the stock market increases the ratio of investment to capital stock by 0.009. Cash flow variables have a much stronger effect. 10.12 Cash Flows and Investment. The Background Material shows the relationship between profitability and investment in the US. The importance of cash flow can even be seen within divisions of multi-division firms. Shin and Stulz (NBER © WP 5639) find that within a multi-division firm 1. Investment by the smallest division depends significantly on the cash flow of the other divisions. 2. There is no evidence that divisions in industries with better investment opportunities receive more cash flow. These seemingly inefficient investment policies indicate that a division’s share of the firm’s investment budget is sticky and is related to total cash flow rather than underlying investment opportunities. The authors call this the ‘bureaucratic rigidity hypothesis’. The Background Material gives some results from the Poterba and Summers analysis of Fortune’s survey of firms’ investment planning. 10.13 Building Up the IS curve. More detail on IS-LM analysis is presented in the case study. CASE STUDY: THE IS-LM MODEL Introduction John Hicks developed the IS-LM model in the 1930s as a simple exposition of some of the ideas in Keynes’ seminal General Theory of Employment Interest and Money. It analyses equilibrium in both the goods and money market and is based initially on a fixed price level. It is most easily thought of as an analysis of aggregate demand - bringing in aggregate supply then allows us to drop the assumption of fixed prices. IS-LM has became a staple of macroeconomic analysis ever since Hicks introduced it. However, in recent years its popularity has waned. Robert King has gone so far as to say “the IS-LM model has no greater prospect of being a viable analytical vehicle in the 1990s than the Ford Pinto has of being a sporty reliable car for the 1990s”1. The key weakness is its static approach that ignores important factors such as expectations of the future. Chapter 12 describes this weakness in more detail. The Goods Market: The IS Curve In the case of a closed economy, equilibrium in the goods market is the familiar Y = C+I+G (See Chapter 2) These elements are most simply determined by the following linear equations. C = a +b(Y-T) Consumption is determined by disposable income. b is the marginal propensity to consume (Chapter 13) I = c -d(r) Investment is negatively related to the level of interest rates (Chapter 14) G = G Government spending is fixed –exogenous- in this model (Chapters 10 and 11) T = T Taxation is a fixed lump sum (i.e. not related to income) Given these elements, we arrive at a simple relationship between interest rates and output. It implies that saving must equal investment and since savings is positively related to income and investment is negatively related to interest rates, higher output implies lower interest rates. 1 King(1993) “Will the New Keynesian Macroeconomists Resurrect the IS-LM Model?” Journal of Economic Perspectives 7. The Ford Pinto – Ford’s answer to cheap Japanese imports - went out of production in the 1980s though still has a small but committed fan club. The IS Curve IS Curve Interest rate (r) Output (Y) Algebraically ( ( )) 1 1 a c G bT d r Y b  + + − −     = − The Money Market: The LM Curve Equilibrium in the money market requires that the demand for money equals the supply of money M s = M d Demand for money must equal the exogenous supply (Chapters 12 and 17) M d = e(Y ) − f (r)) Money demand increases with output, decreases with interest rates (Chapters 12 and 17) So r = (e/f)Y – (1/f)M The second equation here is known as the Theory of Liquidity Preference. It shows how greater output increases the need for money in transactions (the transactions demand for money) and how higher interest rates reduce the demand for money relative to interest-bearing assets like bonds (the speculative demand for money). Liquidity preference implies that higher output is associated with higher interest rates (increased transactions demand for money requires a lower speculative demand in order to keep total money demand fixed). The LM curve therefore slopes upwards. The chart below shows overall equilibrium at the intersection of the IS and LM curves. The IS-LM model IS Curve LM Curve Interest rate (r) Output (Y) Or. ( ) M f b de d a c G bT Y b de f       + + − + − +     = 1− + ( / ) (1 ) 1 This model can be used to show the effects of: 1) Expansionary Monetary policy (an increase in Ms). By moving the LM curve out to the right, expansionary monetary policy increases output and lowers interest rates. It increases output by encouraging investment. 2) Expansionary fiscal policy (an increase in G or decrease in T). By moving the IS curve to the right, expansionary fiscal policy increases output and raises interest rates (when the money supply is fixed). The IS-LM model and Aggregate Demand Since the simple IS-LM model assumes prices are fixed, it is only limited in its approach. With a flexible price level, the two key equations become M d P = e(Y ) − f (r) Demand for money is in real terms. A doubling in the price level doubles money demand I = d – e(r-π) Investment determined by real interest rates (nominal interest rate ,r ,minus inflation, π) In this framework, overall demand falls as prices rise and so is consistent with a standard aggregate demand curve. CASE STUDY: TAKING STOCK: THE ECONOMIC IMPACT OF INVENTORIES. Introduction Inventories are one of the more problematic areas of economic analysis. They are too small to be worth much attention in their own right, but their extreme volatility makes them one of the key drivers of business cycles. The other problem which they present is that their behavior does not fit most economic models. Inventories and the economy. US Business Inventories as a % of GDP Source: EcoWin 8828384858687889990919293949596979809001 11 12 13 14 15 16 17 18 19 As the chart above shows, inventories make up a small and shrinking share of GDP. Their steady decline is a testament to the success of ‘just in time’ stock control methods. At present, the value of stocks held by producers and retailers only amounts to some 12% of GDP. Given that we are comparing a stock of inventories (the value of all inventories in the economy), with the flow of GDP (how much the economy produces in a year) these numbers are tiny in economic terms. However, anyone studying the business cycle in detail will be acutely interested in their behavior. Changes in stocks (stockbuilding) are one of the key drivers in the business cycle and the extreme volatility in inventory behavior means that this tiny part of the economy has a significant impact on overall GDP. As the chart below shows, taking changes in inventories out of GDP reduces its volatility substantially (in fact, about half of the recent volatility of GDP growth is due to inventories). US GDP growth – with and without inventories GDP Growth (%p.a.) GDP Growth exc. inventories (%.p.a) Source: EcoWin 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 -2 -1 0 1 2 3 4 5 6 7 8 9 Understanding Inventories The standard model of inventory behavior is the production smoothing/buffer stock model. This ostensibly sensible model suggests that inventories are held as a buffer against changes in demand. If marginal production costs are increasing and sales vary over time, then a firm would quite understandably wish to hold some inventories. Even if the changes in demand are forecastable, inventories can help smooth the production cycle; whilst if they are not easily forecastable, inventories are a buffer to satisfy surges in demand and a place to store production if demand slumps. Like many plausible sounding economic theories however, the production smoothing/buffer stock model is completely destroyed by a few hard facts 1) Production is more variable than sales in most industries. So much for production smoothing! 2) Sales and inventory adjustment are normally positively correlated. (i.e. inventories tend to rise when sales rise), if inventories are a buffer they should fall when sales rise. 3) Inventories of finished goods are the smallest and least volatile element of total inventories (the other elements are inventories of unfinished goods and inventories of raw materials). If volatility of demand is the main reason for inventory adjustment, why do stocks of raw materials and unfinished goods vary so much? Surely production requirements are more predictable. The S,s model of inventory behavior To reconcile the three facts above, one needs to turn the production-smoothing/buffer stock model on its head. Whereas the production-smoothing model focused on increasing marginal cost, the S,s model is based on decreasing marginal cost. Take the example of ordering more raw materials for your plant. Is it cheaper to get a van to deliver once a day or a lorry to deliver once a month? The S,s model assumes the latter. If that is the case, then purchasing managers will wait until inventories have almost been exhausted (point s on the chart below) and then build up stocks until the inventory is re-maximized (S on the chart) The (S,s) Model of Inventory Behavior S s s Time Inventory This model can generate production that is more volatile than sales as well as a positive relationship between inventories and sales - provided that the surge in sales sends a firm to its lower trigger point. It can also explain the large stocks of unfinished goods and of raw materials. If the cost of delivering such goods falls and more are delivered at a time, then large inventories are just a way of exploiting reduced delivery costs. Unfortunately, although the (S,s) model seems to fit the facts, it is a very difficult model to apply to the whole economy. For example, how firms will react to a surge in demand depends crucially on how close they are to a trigger point - something that macroeconomists cannot easily ascertain. As a result, aggregate behavior of inventories remains largely obscure – a troubling conclusion given that fluctuations in inventories account for about one half of business cycle fluctuations. Fortunately, since ‘just in time’ management techniques are reducing both the level and volatility of inventories, their impact on GDP is probably declining (see Background Material to Chapter 14) Source: Blinder and Maccini (1991) “Taking Stock: A Critical Assessment of Recent Research on Inventories” Journal of Economic Perspectives vol. 5. Discussion Questions 1) Is the fact that production is more volatile than sales for most industries indicative of bad planning in those industries? 2) Do you think the S,s model is a fair description of how companies manage inventories? Background Material CONSUMPTION AND GDP GROWTH IN THE US US Consumption and GDP Growth GDP growth (% p.a.) Consumption growth (% p.a.) Source: EcoWin 60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 -3 -2 -1 0 1 2 3 4 5 6 7 8 9 As a supplement to Figures 12.3a and b, the chart above shows US GDP and consumption growth. It reveals the expected pattern. The two series move closely together but GDP is slightly more volatile than consumption (as predicted by the permanent income model). The importance of stable and rising consumption for the long 1990’s upswing is clear. THE MULTIPLIER: A DIAGRAMMATIC APPROACH. For students who find the algebra of section 13.2 daunting, a simple exposition of how the multiplier works in practice may help. The diagram below shows the example of an increase in government spending of $100 dollars when the marginal propensity to consume is 0.8 The Multiplier Process (MPC = 0.8) CUMULATIVE GDP INCREASE $100 $180 $244 Road building contractors spend $80 - save $20 Retailers spend $64 - save $16 $500 After all the rounds of spending are complete CUMULATIVE INCREASE IN SAVING $20 $36 $100 Government spends $100 on road- building. FINANCIAL LIBERALIZATION: THE UK EXPERIENCE. The table below outlines the UK experience of financial liberalization in the 1980’s. An important aspect of the UK case (and most other cases) was the interaction between liberalization and asset price inflation. In the UK case, liberalization of the housing market not only allowed individuals to overcome borrowing constraints by using their home as collateral, it also sparked a period of rapid house price inflation that encouraged an even more rapid growth of consumption. The UK Consumer Boom Consumption growth House Price Inflation (real terms in brackets)) Savings Ratio Liberalization Measures 1970’ s 3.2% 15.4 % (3.1%) 10.2% 1979 Exchange controls lifted 1980 -0.1% 20.8 (4.6%) 13.5% ‘corset’ removed 1981 -0.1% 4.8% (-6.4%) 12.6% 1982 1% 1.3% (-7.4%) 11.6% Hire Purchase restrictions removed 1983 4.2% 13.6 % (8.6%) 9.8% 1984 1.6% 9.5% (4.4%) 10.2% 1985 3.5% 8.7% (3.5%) 9.5% Building society access money market 1986 5.4% 14.1 % (9.7%) 8.2% Building society lending controls lifted 1987 5.6% 16.7 % (12.6%) 5.7% 1988 6.7% 25.6 (20.8%) 4.2% 1989 3.5% 19.4 (13.8%) 5.1% The key to the UK consumer boom was the liberalization of the housing market, although the end of hire-purchase restriction (lending for purchase of consumer durables) added to the effect. The liberalization started with the removal of the ‘corset’ on bank lending which allowed banks to enter the mortgage market aggressively (the mortgage market was formerly dominated by building societies – a UK form of thrifts). By 1982, banks were providing over one-third of new mortgage lending. To balance the scales, a number of restrictions on building societies were lifted. First, they were allowed access to money markets effectively increasing the pool of funds available for lending. More importantly, in 1986, a number of further restrictions were lifted which had the effect of allowing them to make general loans using housing as collateral. This measure permitted individuals to access the wealth tied up in the value of their homes and was the key to the subsequent collapse in the savings ratio. The boom was rapid but short-lived. By late 1990, the UK was entering a recession. Source: Muellbauer and Murphy (1990) “Is the UK balance of payments sustainable?” Economic Policy No.11 US CONSUMPTION AND WORLD WAR III An alternative approach to the life cycle hypothesis is to see how life expectancy influences consumption. If life expectancy shortens and intergenerational transfers are ruled out, saving should fall. The chart below shows an estimate of this effect as the US savings ratio shows some relationship to the threat of nuclear war. A survey of the risk of war (“minutes to midnight”) was regularly published in the Bulletin of Atomic Scientists. Fear of Nuclear War and US savings 0 2 4 6 8 10 12 14 1948 1950 1952 1954 1956 1958 1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 5 6 7 8 9 10 11 12 13 14 Minutes to Midnight (LHS) Saving Rate (RHS) Source: Slemrod(1986) “Savings and the fear of nuclear war” Journal of Conflict Resolution Vol. 30 PROFITS AND INVESTMENT The importance of internal resources for investment is highlighted in the chart below. There is a strong (though by no means perfect) correlation between the growth in profits and the growth in investment. If anything, profits are a leading indicator of investment. USA company profits and investment Growth of Non-Residential Investment (% p.a) Growth in Real Corporate post-tax profits (% p.a.) Source: EcoWin 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 -15 -10 -5 0 5 10 15 20 25 30 35 40 HURDLE RATES AND PLANNING HORIZONS FOR US FIRMS In 1990, Fortune magazine asked 1000 CEOs about their hurdle rates (minimum expected profitability) and planning horizons for investment. The results identified an average real hurdle rate of 12.2% - well above the likely cost of borrowing. It also found that about 21% of R&D expenditure was allocated to projects with no expected payoff in the next five years. This was a smaller proportion than both their European and Asian competitors. Survey of US CEO’s attitudes to investment Survey question Resul t Fraction of R&D in long term projects 21.1 % Importance of hurdle rates in capital budgeting (on a scale 0=unimportant, 2= very important) 1.6 Real hurdle Rate 12.2 % Time Horizon relative to own of: US Competitors (on a scale 5=longer, 1=shorter) 2.5 European Competitors(on a scale 5=longer, 1=shorter) 3.2 Asian Competitors (on a scale 1=longer, 1=shorter) 3.8 Investment Horizons Hurdle Rates Source: Poterba and Summers (1995) “A CEO Survey of US Companies Time Horizons and Hurdle Rates” Sloan Management Review vol 37. Additional Questions UK GDP and Consumer spending growth GDP Growth Consumption growth Source: EcoWin 56 58 60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 Percent -5.0 -2.5 0.0 2.5 5.0 7.5 10.0 Question 1) The chart above shows how UK consumer spending grew significantly faster than GDP over the late 1990’s (even more so than in the late 1980’s) what does this imply about a) UK net savings b) future UK consumption. Question 2) what is the most likely cause of the UK’s rapid rise in consumption? Answer 1) a) the saving ratio fell dramatically partly through falling saving and partly through rising debt (see chart) b) Presumably, UK consumer spending may have to slow down below 0% 10% 20% 30% 40% 50% 0-10% 10-30% 30-50% 50-70% 70%+ Share of Firms . % of budget devoted to long-term projects 0% 10% 20% 30% 40% 50% 0-5% 5-10% 10-15% 15-20% 20-25% 25-30% 30-35% Share of Firms . Real Hurdle Rate GDP growth some time in the future in order to return the saving ratio back to its historical average. UK Household saving ratio Source: EcoWin 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 PERCENT 4 5 6 7 8 9 10 11 12 13 Answer 2) Wealth effects – particularly housing wealth Question 3) What is the difference between FDI and buying shares in a foreign firm? Answer 1) FDI is defined as a cross-border investment in which a resident in one economy (the direct investor) acquires a lasting interest in an enterprise in another economy (the direct investment enterprise). The lasting interest implies a long-term relationship between the direct investor and the direct investment enterprise and usually gives the direct investor an effective voice, or the potential for an effective voice, in the management of the direct investment enterprise. By convention, a direct investment is established when the direct investor has acquired 10 percent or more of the ordinary shares or voting power of an enterprise abroad. Answers to Analytical Questions Chapter 10 Consumption and Investment 1. a. The total of income over the remaining 5 periods is 40. The average over the periods is 8. With complete consumption smoothing consumption would be 8 per period. This implies a pattern of consumption, saving and wealth as follows: Period 1 2 3 4 5 Income 4 7 10 19 0 Consumption 8 8 8 8 8 Saving -4 -1 +2 +11 -8 Wealth -4 -5 -3 8 0 b. The average value of income is unchanged with the tax and benefit system and so smoothed consumption is also unchanged. But the pattern of saving is different: Period 1 2 3 4 5 Income 8 8 10 14 0 Consumption 8 8 8 8 8 Saving 0 0 +2 +5 -8 Wealth 0 0 +2 +8 0 2. a. The consumer unable to borrow will find that income is beneath remaining average income in the first 2 periods. As a result they will be forced to consume no more than actual income. From period 3 on they can consume remaining lifetime average earnings. The pattern of savings is therefore: Period 1 2 3 4 5 Income 4 7 10 19 0 Consumption 4 7 9 2/3 9 2/3 9 2/3 Saving 0 0 +1/3 +9 1/3 -9 2/3 Wealth 0 0 +1/3 +9 2/3 0 b. The consumer now finds that the plan to consume average income in each period is feasible since it never requires borrowing – wealth always remains non-negative. The following is a feasible outcome: Period 1 2 3 4 5 Income 8 8 10 14 0 Consumption 8 8 8 8 8 Saving 0 0 +2 +6 -8 Wealth 0 0 +2 +8 0 c. Notice that when there are no borrowing constraints (as in question 1) the change in the timing of income that the tax and benefit system generates is irrelevant. But once we have borrowing restrictions then the smother path of income that the tax and benefit system creates is useful because it allows smooth consumption without borrowing. 3. a. Y = C + I + G thus: Y = 100 + 0.7 x Y + 50 + 120 Y = 270/0.3 = 900 b. Y = C + I + G thus: Y = 130 + 0.7 x Y + 50 + 120 Y = 300/0.3 =1000 c. Y = C + I + G thus: Y = 120 + 0.85 x Y + 50 + 120 Y = 290/0.15 =1933 4. Average income over the 5 periods is 50/5 = 10. Assuming a zero interest rate this is also the level of permanent income. b. Average income becomes 52/5 = 10.4. Consumption rises by 0.4 for a rise in first period income of 2 so the marginal propensity to consume is 0.2 c. Average income becomes 54/5 = 10.8. Consumption rises by 0.8 for a rise in first period income of 2 so the marginal propensity to consume is 0.4 d. Average income becomes 60/5 = 12. Consumption rises by 2 for a rise in first period income of 2 so the marginal propensity to consume is 1.0 Notice that when the rise is income is permanent the propensity to consume becomes unity. 5. a. With 5% interest rates consumption rises by 1 each period. We require that the present value of income equal the present value of consumption. This implies: 4 + 12/(1.05) + 23/(1.05)2 + 16/(1.05)3 = C + (C+1)/(1.05) + (C+2)/(1.05)2 + (C+3)/(1.05)3 + (C+4)/(1.05)4 Where C is first period consumption. Trial and error (using a spreadsheet) shows that the value of first period consumption, C, that satisfies this equations is 9.12 . The pattern of consumption and saving is therefore: Period Income Consumption Saving Wealth 1.00 4.00 9.12 -5.12 -5.12 2.00 12.00 10.12 1.88 -3.50 3.00 23.00 11.12 11.88 8.21 4.00 16.00 12.12 3.88 12.50 5.00 0.00 13.12 -13.12 0.00 Wealth is 1.05 times previous wealth plus current saving b. With 10% interest rates consumption rises by 2 each period. We require that the present value of income equal the present value of consumption. This implies: 4 + 12/(1.10) + 23/(1.10)2 + 16/(1.10)3 = C + (C+2)/(1.10) + (C+4)/(1.10)2 + (C+6)/(1.10)3 + (C+8)/(1.10)4 Where C is first period consumption. Trial and error shows that the value of first period consumption, C, that satisfies this equations is 7.4 . The pattern of consumption and saving is therefore: Period Income Consumption Saving Wealth 1.00 4.00 7.40 -3.40 -3.40 2.00 12.00 9.40 2.60 -1.13 3.00 23.00 11.40 11.60 10.36 4.00 16.00 13.40 2.60 14.00 5.00 0.00 15.40 -15.40 0.00 Wealth is 1.10 times previous wealth plus current saving The substitution effect is powerful – it means that the consumer wants consumption to grow by 2 per period with 10% interest rates as against growth of 1 per period when interest rates are only 5%. First period consumption is significantly lower with higher interest rates to allow a faster rise in consumption over time. Notice that in both cases saving is negative in the first period, when income is low, and the level of wealth is negative for periods one and two. With negative wealth the consumer is borrowing and so the immediate impact of a rise in interest rates is to make the consumer worse off – the income effect is negative. 6. Y = C + I + G C = 120 + 0.7 x Y – 10 x r Y = 120 + 0.7 x Y - 10 x r + 50 + 120 Y = (290 – 10 x r ) / 0.3 For various levels of r the value of Y is then: r 1 2 3 4 5 6 7 8 9 10 Y 933 900 867 833 800 767 733 700 667 633 7. The user cost of capital is p x ( r.(1-t) +  ) where p is the price of the van; r is the interest rate, t is the corporate tax rate and  is the rate of depreciation. In this case p = $50,000; r = 0.12; t = 0.3 and  is (50,000-30,000) / 50,000 = 0.4. Plugging these values into the formula we have that the user cost of the van is $24,200. 8. The extra revenue for each further 10 vans is easily calculated as: Number of vans Marginal revenue for 10 more vans marginal revenue per van 10 $300,000 $30,000 20 $270,000 $27,000 30 $270,000 $27,000 40 $160,000 $16,000 50 $150,000 $15,000 The third column is a rough estimate of marginal revenue per van. We cannot know exactly what marginal revenue per van is since we only have the information to give us marginal value for an extra 10 vans; the third column is a measure of the average marginal revenue of 10 vans. The user cost of a van is $24,200. From the table we see that having 30 vans still generates a marginal revenue in excess of the user cost. The extra 10 vans that take us from 30 to 40 does not cover the cost. So the optimal strategy is to hire about 30 extra vans. 9. Tobin’s q is the ratio of the market value of the company to the replacement cost of its assets (or capital). If we just focus on its tangible assets the value of q is: $ 540 million / ( $100 million + $120 million + $300 million ) = 1.038 q is about 4% above unity. This deviation of q from unity could reflect several things: a. The company is overvalued on the equity market. b. The company is fairly valued and has an incentive to buy more assets since their value is about 4% above purchase price. c. The company is fairly valued – its existing assets are worth about 4% more than the replacement of those assets. However buying more assets is not profitable because the marginal increase in firm value may be no higher than the extra cost of the assets. In other words 1.038 measures average q (of existing assets) while the marginal q (of new assets) may be no higher than 1, and could be lower. d. The 3.8% surplus of market value to the replacement cost of the assets may reflect the distinctive value of the assets when they are owned and operated by this company. This intangible benefit could reflect the good reputation of the firm. That reputation, in turn, could reflect a perception that the small scale of the operation ensures personal service and means that the skilled owners continue to know and care about all their customers. A substantial increase in output could undermine that perception and reduce the value of the firm. This would be an example of a low marginal value of investment. On the other hand if expansion does not dilute the value of a good reputation the firm could increase its value by about 4% more than the cost of the extra tangible assets it needs to buy. Then marginal q would be greater than 1 and applying the benefits of the good reputation to more capital makes good sense. INTRODUCTION This chapter moves on from analyzing the individual elements of demand to looking at business cycles as aggregate phenomena. Although the chapter is looking at broad themes, the Case Study below on US economic indicators can be used to analyze the current state of the business cycle in the US. The main aim of the chapter is to characterize business cycles - focusing on what causes them and their welfare implications. Teaching Tips ALTERNATIVE ROUTES THROUGH THE CHAPTER This chapter has a clear logical structure (from ‘what do business cycles look like’ to ‘how can we explain them’) which is worth following. An alternative approach would be to start with the question “Is the business cycle dead?” and to draw on both historical evidence and theory to arrive at a negative conclusion – even though cycles may be becoming less pronounced for developed countries. CHAPTER GUIDE 11.1 What is a Business Cycle? The calculation of output gaps ranges from the simplistic (fitting a time trend through GDP and naming the difference between trend and actual the ‘output gap’), to the detailed (based on an estimated production function). Output gaps published by the OECD in their Economic Outlook are based on the production function approach. This entails evaluating potential labor and capital supply and TFP. 11.2 Measuring the Business Cycle. Although the performance of the Japanese economy over the last decade is sometimes called a depression, output has actually risen on average by just over 1% p.a. since 1992 Another term often heard alongside recession is ‘stagflation’. Stagflation is usually defined as a period of low or negative growth and high or rising inflation (stagnant output and rising inflation). 11.3 Characterizing Business Cycles. Higher GDP volatility in developing countries is largely related to their less diversified economies. As a result, they are subject to extreme sectoral shocks (e.g. poor harvests or rapid changes in their terms of trade). The Background Material looks at GDP and terms of trade volatility for the major groupings in the world economy. 11.4 Business Cycles as Aggregate Fluctuations. The link between inflation, unemployment and the business cycle will be dealt with in detail in Chapter 16’s discussion of the Phillips Curve. CHAPTER 11: BUSINESS CYCLES 11.5 Have Business Cycles Changed? The lengthening of expansions is evinced by the fact that the US upswing which began in March 1991 and persisted into 2001 is the longest on record. The previous longest expansion was 106 months between February 1961 and December 1969. Although the evidence of a reduction in business cycle volatility from the pre-1950’s period is open to question, the evidence for a fall in business cycle volatility in the 1980s and ‘90s as compared with the 1960s to ‘80s is stronger (see Background Material). 11.6 Are Business Cycles Bad? As well as the negative impact of volatility, many argue that hysteresis effects are important. A deep recession will cause firms to scrap capital that would be productive during an upturn simply because no one will buy it. Similarly, a deep recession will create long term unemployment that erodes human capital (see Chapter 8). 11.7 The Frisch-Slutsky Paradigm. A demonstration of thick market effects is shown in the Background Material where a clear cyclical pattern can be seen in US new home sales. 11.8 Aggregate Demand and Aggregate Supply. US survey results on price stickiness are also contained in the Background Material. 11.9 So What Causes Business Cycles? As shown in the Background Material, developing countries tend to be more prone to terms of trade shocks (as well as poor harvests etc.). These are aggregate supply shocks. CASE STUDY: MONITORING THE BUSINESS CYCLE. A Guide to US Economic Indicators Importanc e Frequency Available Volatility Comments Initial Unemployment Claims  Weekly Every Thursday for the week ending previous Saturday Moderate The first hint we receive about the economy for any given month. A leading indicator that helps predict payroll employment Car/Truck Sales  Monthly 1-3 business days after end of month Moderate Another early indicator. This sector is quite sensitive to the business cycle National Association of Purchasing Management (NAPM) survey  Monthly First business day of the month Moderate A survey of manufacturing optimism. Supposedly forward-looking but can give bad signals Payroll employment (non-farm payrolls)  Monthly First Friday of the month Moderate First complete picture of the economy. Includes total (non- farm) employment, earnings and unemployment. Producer Price Index (PPI)  Monthly 9th-16th of the month Moderate First inflation indicator of the month, can be a leading indicator of CPI inflation Retail Sales  Monthly 11-14th of the month High Key indicator of consumer spending, but can be subject to large revisions Industrial Production  Monthly 14th-17th of the month Low Complete picture of manufacturing, but is predictable using other indicators Consumer Sentiment (University of Michigan)  Monthly Preliminary 13-20th Final: two weeks later Moderate One of three consumer sentiment measures. Can be a leading indicator of consumer spending Housing Starts/ Building Permits  Monthly 16th-20th of the month Moderate Key indicator of a highly cyclical sector. Can be volatile in winter months Consumer Price Index (CPI)  Monthly 15th-21st of the month Moderate Most important inflation measure. Core CPI strips out more volatile elements Durable Good Orders  Monthly 22nd-28th of the month High Potential leading indicator of the manufacturing sector but volatile and subject to revision Personal Income and Consumption Expenditures  Monthly 22nd-31st of the month Moderate First complete sighting of consumer spending Index of Leading Indicators  Monthly Last Business day of the month Low A compilation of other indicator that are supposed to be leading indicators of the business cycle New Home Sales  Monthly 28th- 4th of following month Moderate Similar in role to housing starts Construction Spending  Monthly 1st business day of the month for two months prior High 20% of GDP but revisions can be enormous Merchandise Trade  Monthly 9th-16th of the month Moderate Trade increasingly important part of GDP GDP  Quarterly Advance Estimate: 21st- 30th of month Preliminary estimate second month Revised Estimate: third month Moderate The ‘bottom line’ that all other indicators are helping us predict. Source: Slifer and Carnes (1995) “By the Numbers” Published by International Financial Press Discussion Questions 1) Look at the recent indicators for the US, what do they imply about the current state of the US business cycle? 2) Look at financial markets reaction to a recent big indicator (e.g. payrolls).Does the reaction make sense? Background Material Have a look at the OECD’s Business Cycle Clock to see a visualization of business cycles and economic indicators http://stats.oecd.org/mei/bcc/default.html Additional Questions Question 1) Do you think output volatility is greater in developed or developing countries? What reason might there be for any differences? Answer 1) The chart below shows how output volatility is over twice as high in developing countries. Terms of trade volatility is a major cause of that difference. The Terms of trade are the ratio of export prices to import prices and are far more volatile for developing countries whose exports are usually dominated by a few commodities. Some studies suggest that about half of GDP volatility is due to terms of trade movements. GDP growth Volatility and Terms of Trade Volatility (Standard Deviations in %, un-weighted country averages) 0% 2% 4% 6% 8% 10% 12% 14% High Income Low- and Middle Income East Asia and Pacific South Asia Middle East and North Africa Latin America and Caribbean Sub- Saharan Africa GDP Terms of Trade Source: World Bank Question 3) Think about the pricing behavior of US Firms. How often do they change prices? How quickly do prices respond to changes in market conditions ( such as higher demand or rising costs). What factors do you think might explain any price stickiness? Answer 3) The following tables show the results of a US survey of price setting. As well as the frequency of price reviews, respondents were asked to rank the determinants of price stickiness. Survey of Prices and Costs of 200 US Firms Pricing Policy Median Number of price changes a year 1.4 Mean Lag (months) before adjusting price to: Demand Increase 2.9 Demand Decrease 2.9 Cost Increase 2.8 Cost Decrease 3.3 Percent of firms which Report annual price reviews 45% Have non-trivial costs of adjusting prices 43% Costs Percent of firms that can estimate costs at least moderately well 87% Mean percentage of costs which are fixed 44% Percentage of firms for which marginal costs are Increasing 11% Constant 48% Decreasing 41% Reasons for Price Stickiness (1=totally unimportant, 4=very important) 12 Theories of price stickiness Mean Score Coordination Failure: Firms hold back on price changes waiting for other firms to go first 2.77 Cost-based Pricing: Price rises delayed until costs rise, delays cumulate through production process 2.66 Nonprice competition: firms vary nonprice elements such as delivery lags, service or quality 2.58 Implicit Contracts: Firms tacitly agree to stabilize prices 2.40 Nominal Contracts: Prices are fixed by contract 2.11 Costly Price Adjustment: Firms incur costs in changing prices 1.89 Procyclical Elasticity: Demand curves become less elastic as they move in (loyal customers remain) 1.85 Pricing Points: Certain prices (like $9.99) have a psychological significance 1.76 Constant Marginal Cost: Marginal cost is flat, markups are constant 1.57 Inventories: Firms vary inventory rather than price 1.56 Hierarchy: Internal bureaucracy slows down decisions 1.41 Judging Quality by Price: Firms fear that price cuts will be seen as a reduction in quality 1.33 Source: Blinder, Canetti, Lebow and Rudd (1998) “Asking About Prices” Russell Sage Foundation, New York Answers to Analytical Questions Chapter 11 Business Cycles 1. A simple straight line trend estimate based on the initial data yields the following measures of the output gap: If the initial estimate of year 11 data is used as the end point to generate the trend the estimated output gaps look like this: The new estimate of the output gap for year 10 is +0.05. An alternative strategy would be to assume that year 10 output was on trend and that in year 11 output was 0.5 below trend. If the revised estimate for year 11 output of 12 is assumed to be on trend the revised estimates are: The trend path of output is now much higher and as a result output is estimated as being below trend for much of the 11 year period. Rather than assume that year 11 output is on trend, which implies a significant negative output gap for most of the 11 year period, a more plausible assumption would be that year 11 output is significantly above trend. But there is no way of being sure that this is the right assumption to make. 2. With today’s output gap, Yt given by: Yt = 0.9 Yt-1 - 0.9 Yt-2 And Y0 = Y1 = 0 The output gap for the three cases are shown in table 1. Clearly once we have shocks we generate persistent business cycles (paths 2 and 3). With no further shocks the cycles would damp out. The duration of the business cycle is not affected by the magnitude of the shock (compare paths 2 and 3) but the amplitude of the cycle is. d. Table 2 shows the path of output under three different models of the output gap. Column 1 shows the model: Yt = 0.5 Yt-1 - 0.5 Yt-2 Column 2 shows the model: Period 1 2 3 4 5 6 7 8 9 10 Trend 1 2 3 4 5 6 7 8 9 10 Output 1 1.2 2.8 4.3 5.2 6.1 6.7 7.4 8.9 10 Output Gap 0 -0.8 -0.2 +0.3 +0.2 +0.1 -0.3 -0.6 -0.1 0 Period 1 2 3 4 5 6 7 8 9 10 11 Trend 1 1.95 2.9 3.85 4.8 5.75 6.7 7.65 8.6 9.55 10.5 Output 1 1.2 2.8 4.3 5.2 6.1 6.7 7.4 8.9 10 10.5 Output Gap 0 -0.75 -0.1 +0.45 +0.4 +0.35 0 -0.25 +0.3 +0.05 0 Period 1 2 3 4 5 6 7 8 9 10 11 Trend 1 2.1 3.2 4.3 5.4 6.5 7.6 8.7 9.8 10.9 12 Output 1 1.2 2.8 4.3 5.2 6.1 6.7 7.4 8.9 10 12 Output Gap 0 -0.9 -0.4 0 -0.2 -0.4 -0.9 -1.3 -0.9 -0.9 0 Yt = 0.1 Yt-1 - 0.1 Yt-2 Column 3 shows the model: Yt = Yt-1 - Yt-2 In each case we have a shock of 1 in year 2. The larger in absolute size are the coefficients on lagged output gaps the more persistent are business cycle fluctuations. When the coefficients are 0.1 and – 0.1 the impact of a unit shock in year 2 is negligible by year 7 (path 2). But when the coefficients are +1 and –1 the impact of the shock does not die out at all (path 3). a. Table 3 shows the path of the output gap when the coefficients on lagged output gaps are +0.1 and –0.1 and when the pattern of shocks is given by the recurring series 1,1,1, -1,-1,-1. With very damped impacts of past shocks the propagation mechanism is relatively weak here and the current level of the output gap is dominated by the impact of the contemporary shock. But if the coefficients on past output gaps were larger the propagation of past shocks would matter more. Table 1 Table 2 Table 3: Output Gaps year path 1 path 2 path 3 0.00 0.00 0.00 0.00 1.00 0.00 0.00 0.00 2.00 0.00 1.00 2.00 3.00 0.00 0.90 1.80 4.00 0.00 -0.09 -0.18 5.00 0.00 -0.89 -1.78 6.00 0.00 -0.72 -1.44 7.00 0.00 0.15 0.31 8.00 0.00 0.79 1.57 9.00 0.00 0.57 1.14 10.00 0.00 -0.19 -0.39 11.00 0.00 -0.69 -1.38 12.00 0.00 -0.44 -0.89 13.00 0.00 0.22 0.44 14.00 0.00 0.60 1.20 15.00 0.00 0.34 0.68 16.00 0.00 -0.23 -0.46 17.00 0.00 -0.51 -1.03 18.00 0.00 -0.25 -0.51 19.00 0.00 0.23 0.47 20.00 0.00 0.44 0.88 Output Gaps year path 1 path 2 path 3 0.00 0.00 0.00 0.00 1.00 0.00 0.00 0.00 2.00 1.00 1.00 1.00 3.00 0.50 0.10 1.00 4.00 -0.25 -0.09 0.00 5.00 -0.38 -0.02 -1.00 6.00 -0.06 0.01 -1.00 7.00 0.16 0.00 0.00 8.00 0.11 0.00 1.00 9.00 -0.02 0.00 1.00 10.00 -0.07 0.00 0.00 11.00 -0.02 0.00 -1.00 12.00 0.02 0.00 -1.00 13.00 0.02 0.00 0.00 14.00 0.00 0.00 1.00 15.00 -0.01 0.00 1.00 16.00 -0.01 0.00 0.00 17.00 0.00 0.00 -1.00 18.00 0.00 0.00 -1.00 19.00 0.00 0.00 0.00 20.00 0.00 0.00 1.00 Output Gaps year path 1 0.00 0.00 1.00 0.00 2.00 1.00 3.00 1.10 4.00 1.01 5.00 -1.01 6.00 -1.20 7.00 -1.02 8.00 1.02 9.00 1.20 10.00 1.02 11.00 -1.02 12.00 -1.20 13.00 -1.02 14.00 1.02 15.00 1.20 16.00 1.02 17.00 -1.02 18.00 -1.20 19.00 -1.02 20.00 1.02 3. In figure 11.11a the labor supply curve is very steep; labor is very inelastic with respect to the real wage. Over the business cycle employment and output tend to move a good deal and real wages move relatively little. Shifts in labor demand around a steep labor supply curve that moves only a little will generate small changes in employment and output and large changes in real wages. To account for typical business cycle fluctuations we require the labor supply curve to move a good deal and for labor demand to move with it. This will generate shifts in quantities (output and employment) but small changes in real wages. Figure 1 illustrates. As labor supply shifts from LS0 to LS1 demand rises from LD0 to LD1 creating a large change in employment and a small change in wages. One factor which might generate simultaneous shifts in labor demand and supply in the same direction are movements in tax rates. Reductions in taxes , especially in labor taxes, might move the labor supply curve to the right and increase the demand for labor as aggregate demand rises. Neither effect is, however, entirely obvious: labor supply might react little, or indeed perversely, to tax changes and Ricardian equivalence suggests demand effects might be limited. Figure 1: Wages employment LD0 LS0 LS2 LS1 LD1 LD2 4. Figure 2 shows the impact of an oil price shock which moves the supply curve from AS0 to AS1. Figure 2: Prices Output and prices are initially at point a. The hike in oil prices simultaneously drives up domestic prices and reduces output. We move to point b. If the government responds to the fall in output by boosting demand, so demand increases from AD0 to AD1, then output moves up in the short run and prices are driven even higher. We move to point c. Rising prices of domestic output have now reduced the relative increase in oil prices – potentially wiping it out. If oil producers respond and increase oil prices the process begins again. If oil producers succeed in raising the real price of oil domestic output will decline. Ultimately profits and real wages will be lower and unemployment likely to be higher. Real incomes will be lower and consumer confidence probably lower. But the process can be drawn out and so long as the domestic government tries to offset the impact of higher fuel costs by boosting demand employment, profits and can be preserved at their original levels, but only at the cost of ever rising prices. 5. a. If the other industry does not invest the better strategy is to follow suit and not invest. This strategy generates a profit of $1 billion as opposed to a loss of $1 billion. b. If the other industry does invest the better strategy is to follow suit and to invest. This strategy generates a profit of $5 billion as opposed to only $2 billion if investment is not undertaken. c. Both optimism (a belief that the other firm will invest) and pessimism (a belief that the other firm will not invest) are self-fulfilling. Switches in the degree of optimism can mean that the economy moves from a persistent slump to a persistent boom. d. If an investment subsidy of $3 billion is offered to each industry then it becomes worthwhile investing even if the other industry does not invest. The profit from investing even if the other industry does not invest is $2 billion, including the subsidy. So each industry might as well invest. This means that each industry will make a profit of $8 billion, including the subsidy. The subsidy ensures we avoid the poor outcome of no investment. The subsidy is a transfer - which in itself is not a real cost to society. Of course if the subsidy requires taxes to be higher and this creates distortions then real costs are incurred. That might be a cost worth paying to ensure that joint industry profits are $10 billion (before the subsidy). AD0 c a b AS1 AS0 output AD1 INTRODUCTION This chapter is a natural introduction to Chapter 13 (Monetary Policy) and in a shorter course can be combined with it. The key difference between the two is that this chapter looks at long run issues and highlights the classical dichotomy between the real and nominal economy. Chapter 13 looks at short run, business cycle issues where the dichotomy does not hold. Although much of the material is theoretical and technical, this is a relatively easy chapter to communicate and discussions of the costs of inflation and hyperinflation usually work well. Teaching Tips ALTERNATIVE ROUTES THROUGH THE CHAPTER Opening the lecture with a discussion of hyperinflation should generate interest and lead on naturally to the quantity theory and inflation tax. This is a particularly good route for a shorter course where the history, measurement and costs of inflation have been dropped or compressed. CHAPTER GUIDE 12.1 Rising Prices. As with most chapters, the opening section is designed mainly to set the scene and encourage discussion. The historical episodes will help in explaining the theoretical issues discussed later on. For example, the long history of prices in Figures 1 to 3 gives some useful background on the gold standard (see Case Study on the Wizard of Oz.). More recent history can be used to introduce the distinction between supply and demand shocks. 12.2 Measuring Inflation. The distinction between CPI and the GDP deflator is key here as it links back into Chapter 2. See Background Material for more on mis-measurement. 12.3 The Costs of Inflation and the Dangers of Deflation. There is, of course, a huge and largely inconclusive literature on the costs of inflation but the idea that they are small but significant is a useful one to leave with students whilst the Barro study gives some useful concrete numbers. 12.4 The Nature of Money. Money is legal tender since a law has been passed saying that a creditor cannot refuse payment in the form of cash though he can legally refuse payment in bricks – or anything else that is not legal tender. 12.5 The Money Supply. A discussion of Divisia Money helps illustrate two principal themes of this section - the concept of liquidity and the arbitrary nature of broad money definitions. In it simplest form, Divisia money is a weighted measure of broad money where relative rates of return are used as weights. The idea is that forms of money that offer low rates CHAPTER 12: MONEY AND PRICES of return must offer high liquidity or people would not hold them. For example, notes and coins get the highest weight in a Divisia index since they offer no interest. Whilst theoretically superior to conventional broad money measures, Divisia money has not proved popular (Data and further information on Divisia for the US is available on the Federal Reserve Bank of St Louis Web Site, www.stls.frb.org). 12.6 How Banks Make Money - The Money Multiplier. As well as the technicalities of the money multiplier, the main distinction to be brought out in this section is between reserve money and broad money since these concepts are used in later sections and chapters. The chart of the Japanese money multiplier (see Background Material) can be used to illustrate that the multiplier is not fixed and to bring in current issues such as the poor performance of the Japanese banking sector. 12.7 Seigniorage and the Inflation Tax. Further data on seigniorage is shown in the Background Material below. 12.8 Hyperinflation. A simple Seigniorage Laffer Curve is shown in the Background Material. Dollarization is a good example of how the Laffer curve works in practice. The curve also shows why hyperinflations tend to be relatively short-lived since revenue quickly dries up. Germany’s notorious post-WW1 hyperinflation only lasted 26 months, but the average monthly inflation rate of 322% meant that the price level was 10,200,000,000 times higher by the end. It was ended by the introduction of the Retenmark = 1012 old marks and a new Central Bank. 12.9 Monetarism and the Quantity Theory of Money. This is one of the key topics of the chapter. It recurs in Chapter 17 and it worthy of emphasis. Consider highlighting the triviality of the Fisher Identity by replacing M with something else (e.g. number of MBAs) and showing that the definition of V means that the identity always holds. This example exposes the importance of causation in economics. It is very easy to stray into money targeting in this section. Decide early therefore how you want to link this chapter with Chapter 13. TABLE & CHART TIPS Figure 12.2. The volatility of prices pre-1930 (Figure 12.2) seems to contradict Figure 12.9 (low inflation related to low volatility). The reason, of course, is that the monetary regime – the gold standard – resulted in price fluctuations related to changes in the supply of gold. Table 12.7. It may be worth discussing the high inflation/hyperinflations that occurred after the breakup of the Soviet Union (1993-4). This was partly due to the ruble zone system in which each country had the right to print its own currency and use rubles for trade. Thus, a free rider problem was created as Gresham’s Law suggests. Rapid printing of local currencies caused rubles to migrate to other countries and contribute to inflation there. CASE STUDY:THE WIZARD OF OZ AND THE QUANTITY THEORY OF MONEY Although the subject of some controversy, many economic historians believe that the Wizard of Oz is an allegory on the bimetallist debate that occurred in the US at the end of the 19th century. Historical Background In the early 1890’s, the supply of gold began to dry up. As a result, the US money supply began to shrink and prices to fall. At the same time, unemployment began to rise (Chapter 16 discusses the short term relationship between inflation and output). See table below. The US Economy 1890-1900 Year Price Level (1869=10 0) Money Stock ($ bill.) Reserve money ($ bill.) Real Income ($ bill, 1869 prices) Unemploy ment % of labour force Ratio of gold to silver price 1890 70 3.92 1.39 16.82 4.0 19.8 1891 69 4.08 1.461 17.506 5.4 20.9 1892 66 4.43 1.533 19.117 3.0 23.6 1893 68 4.26 1.561 18.373 11.7 26.4 1894 64 4.28 1.582 17.259 18.4 32.8 1895 63 4.43 1.499 19.248 13.7 31.7 1896 61 4.35 1.451 18.758 14.4 30.8 1897 61 4.64 1.554 20.563 14.5 34.6 1898 63 5.26 1.682 20.924 12.4 35.5 1899 65 6.09 1.812 23.353 6.5 39.6 1900 68 6.60 1.954 24.121 5.0 38.6 Source: Rockoff (1990) As a result, a populist movement - led by the democratic presidential candidate William Jennings Bryan - advocated the return to a bimetallic standard (silver dollars had been abolished in 1873) at the ratio of 16 to 1. This meant that the currency could be backed by either gold or silver and that the official rate of exchange between the two would be 16oz. of silver for 1oz. of gold. Since the prevailing market price of gold and silver suggested a conversion rate closer to 30, this would have resulted in a huge inflow of silver into the US (as people traded in their silver for a more valuable amount of gold) thus boosting the US money supply. The tendency for the cheaper silver to drive out gold is an example of Gresham’s Law – bad money drives out good. The law dates back to Henry VIII’s debasement of the currency (he ordered lead to be inserted into gold coins and the gold so recovered given to him). Consequently, pure gold coins ceased circulating (and were hoarded) and only debased coins were used as money. Gresham’s Law meant that critics of bimetallism argued that a true bimetallic standard was almost impossible. If gold was more valuable than the official conversion rate implied, only silver currency would circulate. If silver were more valuable, only gold would circulate. Only if the bullion price and the conversion rate were identical could both circulate together. Proponents countered by saying that the US was large enough to influence the conversion rate (i.e.purchases of silver for US circulation would drive up the price and so validate the conversion rate). As it turned out, William Jennings Bryan lost the election and the bimetallic standard was not introduced. However, the supply of gold began to increase independently and so ended the deflation. What about the Wizard of Oz? The Wizard of Oz is full of gold and silver images (the yellow brick road, Dorothy’s silver slippers – changed to ruby in the film version in order show off the wonders of Technicolor). Economic historians have done an impressive job of interpreting the cast of characters Dramatis Personae Dorothy – America Toto – The Prohibition Party (teetotalers) supporters of the bimetallist cause The Cowardly Lion – William Jennings Bryan (A great orator but cowardly because he dropped the bimetallist cause after the election). The Scarecrow – The Western Farmer The Tin Man – The Urban Worker The Wicked Witch of the West – President McKinley The Wicked Witch of the East – Grover Cleveland (pro-gold democrat defeated by Bryan in the 1896 convention) The Good Witches of the North and South – New England and Southern support for the bimetallists The Wizard of Oz – Marcus Hanna, a key adviser to McKinley The Munchkins – Citizens of the East Plot Summary After acquiring the silver slippers from the dead wicked witch of the east, Dorothy sets off to the Emerald City (Washington DC) down the yellow brick road. After meeting her new companions (The Cowardly Lion, Scarecrow and Tin Man), they face various challenges that prove their worth - including the mysterious poppy field in which the Cowardly Lion falls asleep - (Bryan was easily distracted onto the issue of anti-imperialism – represented by the opium poppies). After arriving at the Emerald City, the Wizard of Oz enlists them to confront the Wicked Witch of the West but they are captured. The Wicked Witch of the West steals one of the silver slippers from Dorothy (McKinley did not rule out a bimetallic standard completely but argued that it must occur through an international agreement – an agreement that was very unlikely). Dorothy then pours a bucket of water over her which kills the witch (water to cure the drought facing western farmers or, arguably, a symbol for inflation). After discovering that the wizard cannot help her, Dorothy meets the Good Witch of the South who tells her she need only click the heels of her silver slippers together three times in order to get home. Source: Rockoff (1990) “The Wizard of Oz as a monetary allegory” Journal of Political Economy Vol. 98, no. 4, pp 739-760 Discussion Questions 1) Do you agree that Bryan’s bimetallist proposal would have been a good policy for the US? 2) If you had to recast the wizard of Oz today. Who would be the Wizard (Alan Greenspan?) and other characters? Background Material INFLATION MIS-MEASUREMENT: CROSS COUNTRY EVIDENCE Inflation mis-measurement in major economies Country Overstatement of Inflation (% p.a.) Point Estimate Range USA 1.1% 0.8%-1.6% Germany 0.75% 0.5%-1.5% Japan 0.9% 0.35%-2% UK - 0.35%-0.8% Canada 0.5% - Sources: - [Boskin Commission] (1996), Hoffmann (1998) Bundesbank Discussion Paper, Shiratsuka (1999) Bank of Japan Monetary and Economic Studies, Cunningham (1996) Bank of England Working Paper No. 47, Crawford (1998) Bank of Canada Spring Review THE BOSKIN COMMISSION IN THE US The US Senate Advisory Commission to study the consumer price index (The Boskin Commission) found that US inflation was probably overstated by 1.1%. One recommendation suggested was that social security which had been indexed to inflation should move to a CPI minus 1.1% formula. It was calculated that such a move would reduce the federal deficit by almost $1.7 billion by 2008 (with increasingly large reductions from then on). The AARP (American Association of Retired People) quickly hit back noting that this formula would make the average 65 year old retired couple almost $40,000 worse off over their lifetime. Furthermore, the average individual, 10 years from retirement, would need to save an extra $214 a month to make up the shortfall. In the end, the CPI minus 1.1% idea was dropped, but changes to the calculation of CPI since the Boskin Commission have knocked about 0.5% p.a. off measured CPI. FURTHER DATA ON SEIGNIORAGE Average Annual Rates of Seigniorage (1971-1990) Country Seigniorage % of GDP Seigniorage % Gov. Spending Country Seigniorage % of GDP Seigniorage % Gov. Spending USA 0.43 1.96 Philippines 1.23 8.96 Canada 0.44 2.01 El Salvador 1.53 10.89 UK 0.47 1.28 Nigeria 1.57 11.12 France 0.55 1.39 India 1.72 11.82 Switzerland 0.62 6.74 Ecuador 2.17 15.81 Cameroon 0.64 3.38 Greece 3.13 10.51 S. Africa 0.65 2.53 Ghana 3.31 22.01 Germany 0.69 2.35 Turkey 3.58 15.20 Burundi 0.85 6.12 Bolivia 3.81 19.76 Japan 0.96 5.62 Peru 4.99 28.23 Thailand 1.09 6.30 Argentina 9.73 62.00 Source: Click (1990) "Seigniorage in a Cross-section of Countries" Journal of Money Credit and Banking: 30(2) pp 154-71 Additional Questions Question 1) Look at the chart below, describe what this implies about the Japanese Banking system in recent years? Japanese Money Multiplier Source: EcoWin 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 6 7 8 9 10 11 12 13 14 Note: M2+CD’s divided by monetary base. Data not seasonally adjusted Answer 1) The chart below shows the money multiplier for Japan – broad money as a multiple of base money. Two features stand out. First, the multiplier is very seasonal with cash demand surging around holiday periods. Second, the multiplier has been drifting down over the 1990s due to the problems of the banking system and 0% interest rates. This encourages people to hold more cash themselves thus leaving less of the total stock of cash in the banking system, and also means that banks are happy to hold considerable amounts of cash in their vaults. Question 2) look at the charts of Indonesian money supply growth and inflation and Bulgarian money supply growth and inflation. What do they tell you about the relationship between the money and inflation? Indonesia: Money and Inflation MONEY GROWTH INFLATION Source: EcoWin 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 Percent 0 10 20 30 40 50 60 70 Bulgarian Money and Inflation inflation M0 growth Source: EcoWin 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 Percent 0 100 200 300 400 500 600 700 800 900 1000 1100 1200 Answer 2) The Indonesian chart shows how the relationship between money growth and inflation is not always that reliable at low rates of inflation, though it shows up strongly at higher rates of inflation. The Bulgarian Chart reinforces the second point – it is not possible to have very high inflation without high money growth as well. Question 3 )a) the official definition of hyperinflation is inflation of 50% or above at a monthly rate (i.e. prices rising by at least 50% a month). What is that at an annual rate? b) One of the highest monthly rates of inflation recorded was 30,000% in the German hyperinflation. What annual rate of inflation would that translate to? Answer 3) Monthly Rate Equivalent Annual rate 1% 12.7% 5% 79.6% 10% 213.8% 50% 12,874.6% 100% 409,500% 1000% 313,842,837,672,000% 10,000% 112,682,503,013,000,000,000,000,000% 30,000% 55,309,272,631,100,000,000,000,000,000,000% Answers to Analytical Questions Chapter 12 Money and Prices 1. Let the value of the £ note be 1 in 1661. Subsequent values in equivalent spending power are equal to the price level in 1661 relative to the current price level. Thus the real value of the bank note in each year are: 1661 (109/109) = 1.00 1691 (109/83) = 1.31 1891 (109/81) = 1.35 1919 (109/231) = 0.47 1946 (109/208) = 0.52 1975 (109/1103) = 0.10 2000 (109/5350) = 0.02 2. a. The nominal rate is approximately equal to the real rate (2%) plus expected inflation (5%) which is 7%. A more accurate formula is ( 1+nominal rate) = (1+expected inflation) x (1+ real rate). This generates a nominal rate of 0.071, or 7.1%: b. If actual inflation turns out to be 10% the ex-post real rate will be 7% - 10% = -3%. The gainers are those who borrowed at a nominal rate of 7% because the higher than expected inflation has eroded the real value of the debt below what was considered likely. The losers are those with savings paying 7% when inflation is at 10% and whose real savings have fallen by about 3%. c. If the after tax real rate needs to be 2% when expected inflation is 5% and the tax rate is 50% we need the nominal rate, r, to satisfy the equation: r x (1-0.5) – 5% = 2% which implies r = 14%. If inflation turns out to be 10% The after tax, ex-post real rate is once again 5% lower at about –3%. If the nominal rate were to rise enough to compensate for high inflation the rate would need to rise to 24% with a 50% tax rate. 3. a. With a 5% reserve requirement and $100 million in the vaults the bank would be able to sustain total lending of $2000 million, so that the 5% reserve requirement on that stock of lending would be $100 million. b. Assume that real estate loans are considered unusually risky, and that other loans continue to require a 5% reserve requirement. The bank will have a reserve requirement of $25 million on the $50 million of real estate loans. This leaves $75 million in cash in the vaults. That amount is equal to the reserve requirement on non-real estate lending of $1500. Thus overall lending would be $1550 million. If all loans are to real estate companies the $100 of cash can only support lending of $200million with a 50% reserve requirement. 4. Money demand is: 150,000 – (% inflation)3 Revenue raised by the inflation tax is: inflation x (150,000 – (% inflation)3 ) The following table shows revenue raised at various inflation rates: From the table it appears that an inflation rate of around 33% maximises the inflation tax. We can get an exact answer by maximising the value of the inflation tax with respect to inflation. The inflation tax is: (inflation/100) x (150,000 – (% inflation)3 To maximise we take the first derivative with respect to inflation and set it to zero. This implies: (1/100) x (150,000 - 4 inflation3 ) = 0 which means inflation = (150,000/4)1/3 solving this equation generates a revenue maximising inflation rate of 33.47%. Inflation % Money Inflation demand Tax 1 149999 1499.99 2 149992 2999.84 3 149973 4499.19 4 149936 5997.44 5 149875 7493.75 6 149784 8987.04 7 149657 10475.99 8 149488 11959.04 9 149271 13434.39 10 149000 14900 11 148669 16353.59 12 148272 17792.64 13 147803 19214.39 14 147256 20615.84 15 146625 21993.75 16 145904 23344.64 17 145087 24664.79 18 144168 25950.24 19 143141 27196.79 20 142000 28400 21 140739 29555.19 22 139352 30657.44 23 137833 31701.59 24 136176 32682.24 25 134375 33593.75 26 132424 34430.24 27 130317 35185.59 28 128048 35853.44 29 125611 36427.19 30 123000 36900 31 120209 37264.79 32 117232 37514.24 33 114063 37640.79 34 110696 37636.64 35 107125 37493.75 36 103344 37203.84 37 99347 36758.39 38 95128 36148.64 39 90681 35365.59 40 86000 34400 41 81079 33242.39 42 75912 31883.04 43 70493 30311.99 44 64816 28519.04 45 58875 26493.75 46 52664 24225.44 47 46177 21703.19 48 39408 18915.84 49 32351 15851.99 50 25000 12500 5. a. With no change in velocity we require the money supply to grow by the growth of real GDP plus the inflation rate. With a forecast for real GDP growth of 2.5% and a 2% inflation target we require a money supply growth of 4.5%. b. The quantity equation says that M x V = P x T We require the right hand side to grow by about 4.5% (T, real GDP, grows by 2.5% and we aim for P , prices, to grow by 2%). V, velocity, is growing by 3%. This only leaves room for M, the money supply, to grow by about 1.5% to ensure the left hand side of the quantity equation rises by 4.5%. c. We proceed step by step. The quantity theory implies: %growth in M + %growth in V = %growth in P + %growth in T This means that: %inflation = %growth in M + %growth in V - %growth in GDP Denote the interest rate by r From the information we have we know the following: % Growth in M = 5.5 – (r – 4) % Growth in V = 0.25 x (r – 4 ) % Growth in GDP = 2.5 – 0.5 x (r - 4) Putting these bits of information together we have: Inflation = 5.5 – (r – 4) + 0.25 x (r – 4 ) – 2.5 + 0.5 x (r – 4) We require inflation to be 2 Thus: 2 = 5.5 – (r – 4) + 0.25 x (r – 4 ) – 2.5 + 0.5 x (r – 4) So: (r – 4) x { 0.75 – 1} = 2 – 5.5 + 2.5 (r – 4) = -0.5/-0.25 = 2.0 Thus r = 6% Solution Manual for Macroeconomics: Understanding the Global Economy David Miles, Andrew Scott, Francis Breedon 9781119995715