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ECN202: Macroeconomics 1960s: End of the Business Cycle? recessions "are now generally considered fundamentally preventable, like airplane crashes and hurricanes." Zenith of Keynesian Economics After WW II and the Korean War macroeconomics once again was THE issue in a presidential election in 1960. A sitting Vice President was defeated by a relative unknown CATHOLIC promising to get the economy moving. To do that he turned to the rising number of academic scribblers working on turning Keynesian anti-depression economics into anti-recession economics. It was a period of significant developments in macroeconomic theory, and we look at those in this nit. We begin with a more detailed look at consumption and investment spending since Keynesians focused on managing AD, and then we look at the issues of timing and forecasting that were central to effective macro policy. The unit closes with a discussion of the Phillips Curve that symbolized the tradeoff between inflation and unemployment that policy makers must now confront. We open our work with some warnings from Eisenhower as he left office and some headlines from the 1960s. Eisenhower opens 1960s with a warning 1. “America’s leadership and prestige depend not merely upon our unmatched material progress, riches and military strength, but on how we use our power in the interests of world peace and human betterment.” 2. “In meeting them, whether domestic or foreign, great or small, there is a recurring temptation to feel that some spectacular and costly action could be come the miraculous solution to all current difficulties.” 3. “As we peer into the future, we – you and I, and our government – must avoid the impulse to live for today, plundering, for our own ease and convenience, the precious resources of tomorrow.” 4. Balance “between public and private economy” In the news: Growth is good 1. “Democratic and Republican platform writers have committed their parties, and the nation, presumably, to the goal of more rapid economic growth.” 1960 2. “Kennedy Terms Action to Spur Economic Growth the Major Election Issue” 1962 3. “Economic Growth No Cure-All for Jobless” 1965 4. “The United States apparently moved last year into first place among the leading industrial nations in its rate of economic growth after being near the bottom” 1966” 5. “RECESSION VIEWED AS A 'POSSIBILITY'; Economy Has Not Declined Despite Dip by Indicators, Arthur Burns Declares” 1967 In the news: Unemployment gets noticed 6. “Prof. Paul Samuelson's letter published Nov. 12 illustrates the growing tendency of economists close to the Administration to minimize the unemployment problem.” 1961 7. “ECONOMY ABSORBS TEEN-AGER INFLUX; Unemployment Rate in June Lowest Since Fall of '57” 1965 8. “U.S. Will Change Definitions of Unemployment” 1966 9. “Whether or not a 4 per cent or even higher rate of unemployment is "acceptable," as Secretary David Kennedy would have it, remains to be seen.” 1969 In the news: So does inflation 10. “PROGRESS NOTED IN INFLATION WAR; Top Economic Aides Doubt Serious Price Rises” 1960 11. “'LITTLE INFLATION' CALLED NO THREAT; Administration Unperturbed at 1-1 % a Year Rise in Consumer Price Index” 1962 12. “Labor Costs Blamed for Inflation” 1965 13. “G.O.P. Dramatizes Inflation as Key Issue; High Cost of Living to Be Stressed in Drive for Votes” 1966 14. “Inflation; It's Mainly Psychological, but Oh How It Hurts!” 1969 In the news: The end of Nirvana? 15. “Advocates of Slower Development Are Gaining Ground in Latin Nations” 1965 16. “Jobs and Inflation; Truce Is Developing in Debate on When Falling Unemployment Raises Prices” 1966 17. Predictably the rise in unemployment to 4 per cent -- a consequence of efforts to check inflation by fiscal and monetary restraints -- has produced a political outburst” 1969 18. “U.S. JOBLESS RATE ADVANCES TO 4%, HIGHEST SINCE '67; Administration Aides Greet Rise as Sign of Restraint on Boom Spurring Inflation” 1969 19. “Economy; How to Cool It Without the Chill of Recession” 1969 In the news: Trade becomes an issue 20.“KENNEDY ROUND OF TARIFF TALKS WILL OPEN TODAY” 1964 21.“Pastore Urges Efforts by U.S. To Aid Textile-Trade Balance” 1965 22.“Nixon Asks For Lower Tariffs” 1969 23.“Stans Suggests Tax Plan To Help Balance of Trade” 1969 24.“Morgan Trust Hints Huge Loss For U.S. Payments in Quarter; BIG LOSS HINTED IN U.S. PAYMENTS” 1969 25.“FOREIGN TEXTILES FOUGHT BY STANS; Secretary, in Italy, Presses for Curbs on Exports” 1969 The Macro Problem: Get the economy moving Unemployment Rate 16 The unemployment rate has been trending upward since the end of the Korean War 12 8 4 0 1940 1945 1950 1955 1960 A call to action "get the country moving again." 1960 Presidential Election An incredibly close election 1964 Presidential Election What happens when you nominate a fringe candidate and what happened in the South to have them shift from solid Democrat to solid Republican? The Solution: again Keynes’ theory If it could cure a depression imagine what is could do for a recession The solution: in theory recessions "are now generally considered fundamentally preventable, like airplane crashes and hurricanes.” Arthur Okun, president Johnson's economic advisor Aggregate Demand “Rules” Aggregate demand is central to Keynes’ view, so let’s look at it. First we look at consumption spending (C) that is important because it is HUGE and because it is stable and may be managed. In this period newer theories of consumption surfaced including the permanent income and life cycle theories that altered how we looked at C. What we spend on has also changed since the mid 1970s with the declining importance of nondurables. Investment spending is important because it has a supply-side effect – if we invest in more factories and machines our workers become more productive and this increases our productive capacity. This make investment a favorite target of discretionary fiscal policy. Consumption • • • • BIG STABLE MANAGEABLE (relationship to disposable income) Theories (MPC?) – Keynes – Permanent income hypothesis (wealth) – Life-cycle model Personal income & consumption expenditures 12,000 C 10,000 Very strong relationship between income and consumption 8,000 6,000 4,000 2,000 Y 0 0 2,000 4,000 6,000 8,000 10,000 12,000 14,000 Components of Consumption 50 40 You can see where more of our money is going – and how durable spending is the most volatile Services 30 Durables 20 Nondurables 10 0 1960 1970 1980 1990 2000 2010 Personal saving rate: US What happened to the savings rate after 1980 and was that a good thing, and what happened to the rate since the mid 2000s? And how do we get Americans to save more? What is so different about China from the US – and why do American policy officials what could be done to decrease the savings of the Chinese people? Saving Investment The savings glut. Controversy guaranteed. Council of Foreign Relations How do we change savings behavior? You have all had microeconomics so this should be an easy question. If we try to alter behavior we need to look at why people do what they do and then try to alter the incentives to alter their behavior. In the US the problem is that there are very low incentives to save – either people do not have to save or it is very easy to access funs, while in China there is a need to save or it is difficult to access funds. Here are a few possible options for altering the savings patterns. How do we get Americans to spend less? Make it easier to save 1. Financial deregulation 2. National savings plan (SS example) Make it more rewarding to save 1. Tax policies 1. Sales / consumption tax rate 2. Interest income tax rate How do we get the Chinese to spend more? Make saving less attractive 1. Expand public pension system 2. Expand public health care system 3. Unionization 4. Urbanization (rural to urban) 5. Industrialization (agriculture to manufacturing) Make it easier to spend 1. Expansion of credit Wealth Effect One of the implications of the expanded theory of consumption spending was the acknowledgement of a wealth effect. Consumption spending ( C ) depends on wealth as well as income, and there is a marginal propensity to spend wealth (MPC). [MPC = DC / D W] Research has shown the following estimates of their values. –MPC for wealth in homes = .09 –MPC for wealth in stocks = .04 Based on this try this: what would be the impact on C of a $5 trillion decline in housing values in the Great Recession? Shiller-Case Home Price Index 5.0 4.5 A BIG hit in housing values 4.0 3.5 -$5T*.09 = -$450 billion = decline in C SF 3.0 BOST CH 2.5 LV MI 2.0 DC TAMPA 1.5 1.0 0.5 0.0 1985 1990 1995 2000 2005 2010 A lost decade = or two? A BIG hit in stock market values in Japan A huge hit in real estate values in Japan Investment • • • • SMALL / UNSTABLE SUPPLY-SIDE EFFECT MANAGEABLE? LEADING INDICATOR The Challenge of fine tuning an economy In the next few graphs you will see the problem of fine tuning in a world without instantaneous change and the potential solutions. The goal is to flatten out those recessions and the problem is that because of lags the impact may not be felt until after the problem disappeared so it may actually worsen the cycle. One “solution” is to build in automatic stabilizers like unemployment benefits so as the economy slides into a recession the unemployment benefits increase and this additional income is spent. The second option is to forecast the problem and use preemptive policies such as a tax cut before a recession happens. Fine tuning: A timing problem? 18 GDP We want to avoid the recession that begins in 1975 16 14 A 12 Too much too late 10 1. Recognition lag 8 2. Discussion lag 6 3. Action lag 4 R A Monetary Fiscal 2 0 1960 D 1965 1970 1975 1980 1985 1990 1995 2000 2005 One possible solution? Automatic stabilizers = autopilot Automatic stabilizer reduces changes in AD 1. Income tax 2. Unemployment benefits 18 GDP 16 14 Income rises 12 rise Taxes Spending rises slower 10 8 Income falls Taxes fall Spending falls slower 6 4 2 0 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 Another possible solution? Preemptive Discretionary policies 18 We want to avoid the recession that begins in 1975 GDP 16 Just right, just in time 14 12 A 10 1. Recognition lag 8 2. Discussion lag 6 3. Action lag 4 2 0 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 Fine-tuning requirement: Forecasting ability This was a time when we saw an increase interest in forecasting – a perfect storm of sorts – that increased demand for forecasts at the same time as that we had what we needed – computers to analyze the macro numbers now being produced regularly, a theory on how to manage the economy, and liberals in power who believed in managing. Here we look briefly at three techniques. , so here we look at some techniques. Also when you are forecasting be sure that the variables you choose matches the time horizon. All time series can be decomposed into seasonal, cyclical, and trends and the influences on each of these is likely to be different. On the next slide you will see a few of my “favorite” forecasts. The forecasting track record? 1. “Brain work will cause women to go bald” Berlin professor 1914 2. "Who the hell wants to hear actors talk?" H. M. Warner,1927 3. “The Japanese don’t make anything the people in the US would want.” (Secretary of State John Foster Dulles in 1954 4. "And for the tourist who really wants to get away from it all, safaris in Vietnam." Newsweek's 1963 prediction of popular holidays for the late 1960s. 5. "Rail travel at high speeds is not possible because passengers, unable to breathe, would die of asphyxia." Dionysius Lardner, 1828 6. "I think there is a world market for maybe five computers." Thomas Watson, chairman of IBM 1943 7. "1930 will be a splendid year for employment." Department of Labor in 1929 Forecasting basics: seasonal patterns • Seasonal (big summer) • Cyclical • Trend • Match timeframe with factors Forecasting basics: Develop a forecast of company . Year 1995 1996 1997 1998 1999 2000 2001 --2007 2008 2009 2010 2011 2012 2013 2014 2015 sales over the next five years Sales (units) 9073 9287 9853 10094 10500 11321 12216 --15057 15951 18120 Itzibitzi Sales 20,000 18,000 16,000 14,000 12,000 10,000 8,000 6,000 1995 2000 2005 2010 2015 Time-series analysis “The ruler” Actual and Estimated Sales error 20,000 18,000 S = a + b S-1 Actual Estimated 16,000 14,000 Sales today depend upon sales last year 12,000 10,000 8,000 6,000 1995 2000 2005 2010 Oil price forecast – look to past sales for guide to future 2015 Econometric analysis error “The relationship” Actual and Estimated Sales 20000 error Actual S = a + b*P 18000 16000 S = -3299 + .546*P Estimated 14000 12000 10000 Sales depend upon 8000 1995 2000 2005 2010 2015 price so with price forecast we have oil demand Oil price forecast – look to past for relationships forecast Barometric analysis Turning points “The experts” Leading indicators 16.00 Lead time 14.00 12.00 If you are forecasting, how do you predict turning points? 10.00 8.00 6.00 You want something that turns before your variable so when it turns you know what is coming. 4.00 2.00 0.00 1950 1960 1970 1980 1990 2000 Lead time RI Index of Leading Indicators 1. Manufacturing employment 2. Retail & wholesale employment 3. Index of Providence Help-Wanted Ads 4. Passenger traffic at Green 5. Newport Bridge Tokens 6. Single-family housing permits 7. RI Industrial kilowatt hours 8. National average for weekly unemployment claims 9. National vendor delivery performance An example of a leading indicator Sotheby’s stock rises in booms but seems to fall before other indicators of macro decline Derek Thompson, “The Art of Bubbles: How Sotheby's Predicts the World Economy,” Atlantic Monthly, Apr 5, 2011 Another problem!! Inflation “arrives” in the late 1960s Inflation rate 7% 6% 5% 4% 3% 2% 1% 0% 1960 1962 1964 1966 1968 1970 The inflation-unemployment tradeoff By the late 1960s inflation was a problem facing Keynesians who began to look into the work of an economist, William Phillips, who a decade earlier had identified a negative relationship between inflation and wage growth: wages tended to rise faster when the unemployment rate was lower because workers had more bargaining power. If wages grew faster than prices would rise faster, so we got the Phillips Curve. This became seen as a possibility line of sorts where policies could move us along the Phillips Curve, so you should be able to see where Republicans and Democrats would differ in terms of their goals. If you used expansionary fiscal policy you would increase AD and this would increase GDP (lower unemployment) and increase prices. This was not great, so liberals looked to policies to shift the curve inward. Phillips’ Evidence Where would Republicans want to move the economy and where would Democrats want to go – A or B? •A •B Republicans care about inflation so they choose B, while Democrats care about unemployment so they would choose A AS-AD & Phillips Curve? AS-AD 18 Phillips Curve 18 Increase AD Price level 16 Inflation 16 rate AS 14 14 12 12 10 10 8 8 AD2 6 4 * 6 * Initial situation 4 AD1 2 0 1960 New situation 1965 1970 1975 1980 1985 1990 1995 2000 GDP 2005 2 0 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 Unemployment rate Policy choices: Move curve – or move on curve? 18 Same inflation – lower u 18 i i 16 Expansionary policy Monetary Fiscal 16 14 14 Job training Job information 12 12 10 10 8 8 6 6 B 4 B A A 4 2 0 1960 Less U and more inflation 2 1965 1970 1975 1980 1985 1990 1995 2000 u 2005 0 1960 1965 1970 1975 1980 1985 1990 1995 u 2000 2005 Summary of 1960s policy activism Keynesian economics: anti recession version • Economic Theory – John Maynard Keynes P • Key concept – Multiplier • DY/DG = 1/(1-MPC) • “New” AS –AD model – Upward sloping AS • Implications – Inflation-unemployment trade off – Temporary policies have limited value Q