Download chap10

CHAPTER 16
Changes in the Macroeconomy and
Changes in Macroeconomic Policy
16-1
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Questions
• How has the structure of the economy
changed over the course of the past
century?
• How has the business cycle changed
over the last century?
• How has economic policy changed
over the past century?
16-2
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Questions
• What are future prospects for
successful management of the
business cycle?
• Why does unemployment in Europe
remain so high?
• Why does growth in Japan remain so
low?
16-3
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Changes in the Macroeconomy
• Over the past century, the structure of
modern industrial economies has
changed
– significant decline in the share of the
labor force engaged in agriculture
– decline in the proportion of the labor
force involved in mining, manufacturing,
and construction
– rise in service-sector employment
16-4
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 16.1 - Occupational Distribution of the
Labor Force
16-5
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Changes in the Macroeconomy
– growth of the government’s social
insurance programs and progressive tax
system
• automatic stabilizers
– broader financial system
• allows households to smooth consumption
spending
• lowers the marginal propensity to consume
and the multiplier
– the creation of the deposit insurance
system
• reduces the number of financial panics
16-6
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Changes in the Macroeconomy
– improvements in labor productivity are
now the result of improvements in the
efficiency of labor (rather than capital
deepening)
• innovations in materials production, materials
handling, and organization
– research and development is now a key
component of investment
16-7
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Changes in the Macroeconomy
• Even with these changes, the U.S.
economy’s business cycle has
continued
– there are some signs that fluctuations in
unemployment have become smaller in
recent years
16-8
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Table 16.1 - Business Cycle Indicators
16-9
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Future Changes
• Consumption
– liquidity constraints will continue to
decline
• the marginal propensity to consume and the
multiplier will grow even smaller over time
16-10
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Future Changes
• Globalization
– international trade will continue to
expand
• increased trade will further lower the
multiplier
• the domestic economy will be less vulnerable
to domestic shocks but more vulnerable to
foreign shocks
– there will also be an increase in the
magnitude of international financial flows
• potential source of financial crisis and
macroeconomic volatility
16-11
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 16.2 - Globalization: Merchandise
Imports as a Share of Total Goods Production
16-12
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Future Changes
• Monetary Policy
– the increase in financial flexibility will
make it somewhat more difficult to
conduct monetary policy
– as more and more different kinds of
financial assets are traded, the supply of
Treasury bills will have less of an effect
on interest rates
16-13
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Future Changes
• Inventories
– improvements in information technology
will improve businesses’ ability to control
their inventories
• mismatches between production and demand
have been a principal source of fluctuations in
employment and output throughout history
• better information technology will reduce this
component of macroeconomic instability
16-14
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Estimating Long-Run
Changes in Cyclical Volatility
• To assess changes in the size of the
overall business cycle, we can
compare the cyclical behavior of real
GDP and unemployment over the
century
– good quality data exists only for the postWorld War II period
– a consistent division of the past century
into recessions and expansions shows
little difference in the size of recession
16-15
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 16.3 - The Great Depression Relative to
Other Business Cycles: U.S. Unemployment
16-16
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Estimating Long-Run
Changes in Cyclical Volatility
• Two conclusions can be drawn about
the changing cyclical variability of the
American economy
– the business cycle during the interwar
period was extraordinarily large
• there were three major contractions during
this period including the Great Depression
– the post-World War II business cycle,
measured relative to the size of the
economy, has been a little smaller than
back before World War I
16-17
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 16.4 - Real GDP Relative to Potential
Output during the Great Depression
16-18
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
How Economic Policy Has
Worked
• The fall in the multiplier, the creation
of automatic stabilizers, and the
increasing power of central banks
have allowed monetary policy to offset
many of the kinds of shocks that
generated pre-Depression business
cycles
– the post-World War II economy has had
fewer small recessions caused by shocks
to the IS and LM curves
16-19
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
How Economic Policy Has
Not Worked
• Economic policy has caused
recessions as well
– the Federal Reserve has engineered a
recession (or has accepted the risk of a
recession) in order to curb inflation at
least four times since World War II
– the post-World War II boom-and-bust
business cycle has been driven by
policies that have allowed rises in
inflation, followed by policies to fight it
16-20
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
How Economic Policy Has
Not Worked
• Why have policy makers found
themselves repeatedly driven to risk
recession in order to fight inflation?
– in the late 1940s, the Federal Reserve
kept interest rates low to reduce the cost
of the national debt
– in the 1960s and 1970s, inflation was
allowed to accelerate for a number of
possible reasons
• memory of the Great Depression
• mistaken economic theories
• political business cycle considerations
16-21
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Great Depression
• The speed and magnitude of the
economy’s collapse during the first
stages of the Great Depression was
unprecedented
– from 1929 to 1933, real GDP fell by
almost 40 percent
– by 1932, real investment spending was
less than one-ninth of what it had been in
1929
– by 1933, unemployment had reached 25
percent
16-22
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 16.5 - Movement along the IS Curve:
The Great Contraction, 1929-1932
16-23
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Great Depression
• Investment and real GDP fell so
quickly because of an extraordinary
rise in real interest rates
– real interest rates increased from 4 to
nearly 13 percent from 1929 to 1931
– after 1932, investment spending
remained low even though real interest
rates returned to more normal values
• businesses put off expanding their capacity
• baseline investment (I0) fell
16-24
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Great Depression
• The cause of high real interest rates
was rapid deflation
– falling production, employment, and
demand led to steep declines in prices
• But there must have been an initial
shock to cause the start of the
downward spiral that was the Great
Depression
16-25
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 16.6 - Real and Nominal
Interest Rates and the Inflation Rate
in the Great Depression
16-26
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Great Depression
• Economists have proposed many
candidates for the shock that
triggered the Great Depression
– the stock market crash of 1929
– the availability of consumer credit in the
1920s that led to a boom in consumption
spending and then came to a natural end
– recognition of excessive residential
investment that led to a decline in
baseline investment
– an increase in interest rates in 1928
16-27
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Great Depression
• Economists have reached a consensus
that sufficiently aggressive monetary
policy could have stemmed the
deflation and thus ended the Great
Depression much earlier
– massive federal deficits funded by
printing money coupled with aggressive
open market purchases could have
produced inflation
• real interest rates would not have risen and
investment spending would have been less
affected
16-28
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Great Depression
• In addition to reducing real GDP
through higher real interest rates,
deflation also redistributes wealth
from debtors to creditors
– businesses that are heavily in debt find
that they cannot pay and go bankrupt
– financial institutions that have loaned to
these business find that their loans are
worthless and go bankrupt as well
• more than one-third of U.S. banks failed
during the first years of the Great Depression
16-29
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Stabilization
• If we divide the post-World War II era
into two periods with the breakpoint
chosen at the end of the Volcker
disinflation in the early 1980s, the
pre-1984 years show much more
business cycle volatility than do the
post-1984 years
– there have not been many shocks or any
truly large shocks to the economy
– maybe lessons have truly been learned
from the 1960s and 1970s
16-30
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
High European
Unemployment
• Unemployment rates in western
Europe at the end of the 1990s are
close to those achieved in the U.S.
during the Great Depression
– until the end of the 1970s, the
unemployment rate in western Europe
had been lower than that in the U.S.
– after the 1970s, western European
unemployment rose during recessions,
but did not fall during expansions
16-31
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 16.7 - European Unemployment
16-32
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
High European
Unemployment
• In the U.S., it is possible to explain
the comovements of unemployment
and inflation from 1960 to 2000 using
the standard Phillips curve
– movements in the expected rate of
inflation reflect changes in the economic
policy environment
– movements in the natural rate of
unemployment are relatively small and
can be linked to plausible factors
16-33
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
High European
Unemployment
• In western Europe, the accelerationist
Phillips curve never fit the historical
experience very well
– each policy episode from 1970 on
seemed to shift the Phillips curve further
out and to further raise the natural rate
of unemployment
16-34
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
High European
Unemployment
• The dominant view expressed in
Europe in the early 1990s was that
high European unemployment was the
result of labor market rigidities
– this would mean that high unemployment
is an equilibrium, because it is not caused
by a deficiency of aggregate demand
• But the rigidities in the European
labor market were stronger in the
1960s
– the unemployment rate was lower
16-35
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
High European
Unemployment
• Many economists see the western
European situation as reversible
– have central bankers and governments
shift to a more expansionary monetary
policy
• as demand rises, people will find the natural
rate of unemployment is falling
• the decline in the natural rate will create
further increases in demand and further
declines in the natural rate
– begin reducing and eliminating labormarket rigidities
16-36
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Japanese Stagnation
• The Japanese stock market and real
estate market rose far and fast in the
1980s
• Eventually, the market turned and
both the real estate and stock
markets collapsed
– many businesses and banks were
bankrupted
– no one was willing to lend money
• investment spending was depressed
16-37
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Japanese Stagnation
• The Japanese economy has fallen into
a decade of economic stagnation
– growth has been almost zero
– unemployment has risen to high levels
– the IS curve has shifted far left
– even extremely low nominal interest
rates have not been enough to boost
investment and aggregate demand
16-38
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 16.8 - The Japanese Bubble Economy:
Before, during, and after
16-39
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Japanese Stagnation
• What should policy makers do?
– have the government run a substantial
deficit
– have the central bank push the interest
rate it charges close to zero
– deliberately try to engineer moderate
inflation
• makes the alternative to investment spending
more risky
16-40
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Moral Hazard
• In a financial crisis, the flow of funds
through financial markets will slow to
a trickle and the IS curve will shift far
and fast to the left
– the government needs to close down and
liquidate those organizations that are
fundamentally bankrupt
– the government needs to lend money to
organizations that would be solvent if
production and demand were at normal
levels
16-41
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Moral Hazard
• Government support is necessary to
prevent a deep meltdown of the entire
financial system
• But government assistance must be
offered on terms unpleasant enough
and expensive enough that no one
wishes to get in a situation in which
they need to draw on it
– they need to prevent moral hazard
16-42
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Ultimate Lesson
• In many ways, it seems to be very
hard to learn the lessons of history
• The future of economic policy seems
likely to be similar to the past
– gross mistakes will be made
– historical analogies will be misapplied
– economists and other observers will find
major policy mistakes made by
governments and central banks to be
inexcusable (after the fact)
16-43
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Summary
• The structure of the economy has
undergone mammoth changes over
the past century, yet these changes
appear to have had relatively little
impact on the size of the business
cycle
• Stabilization policy as we know it was
impossible a hundred years ago
– it is performed routinely and aggressively
since
16-44
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Summary
• Since World War II, stabilization policy
has had some successes and failures
– its principal failure has been that it has
generated policy-induced recessions to
fight inflation
• these policy-reduced recessions have kept
policy from successfully stabilizing the
economy to a greater degree
• In the past two decades, stabilization
policy in the U.S. has been very
successful
16-45
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Summary
• Certainly from the U.S. perspective
there is every reason to be optimistic
about the future of macroeconomic
policy and of the macroeconomy
• From a European perspective, there is
less reason to be optimistic
– European governments and central banks
have not learned how to deal with their
high levels of unemployment
16-46
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Summary
• From a Japanese perspective, there is
less reason to be optimistic
– the Japanese government has not
learned how to deal with its financial
meltdown
16-47
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Summary
• Even from a U.S. perspective, it
seems hard to learn the lesson that
good economic policy during an
economic crisis is not a matter of
clinging to one principle, but of
balancing off the conflicting
requirements of several valid
principles
16-48
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.