Download Exercise: The New Economy

Customized Material for Econ 351 –Fall 2009 Chuderewicz
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Chapter 1: The Money Market and the Federal Reserve
The Fed attempts to fight the business cycle (conducts countercyclical policy) by
influencing the amount of money that is circulating in the economy. The graph of the
federal funds rate (below) will give us a feel for how active the Fed has been in this
regard. Naturally, the Fed attempts to stimulate economic activity, as in fighting the
recession of 2001 (shaded area) by ‘pumping money into the system’ via open market
purchases. Conversely, beginning in June 2004, the Fed did the opposite, as they raised
their target for the federal funds rate 17 times in a row by conducting open market sales..
In the space below, draw a picture of the Fed’s balance sheet and the balance sheet of the
banking sector and allow the Fed to conduct open market purchases (expansionary
monetary policy) as they did throughout 2001.
Note importantly that the Fed is injecting reserves into the banking system – the banks
are selling some of their Government Securities (GS) to the Fed in return, the banks get
(excess) reserves, reserves that can be lent out to the public. Note importantly that the
intuition is as follows: The Fed buys interesting bearing assets from the banking sector
that we call Government Securities and pays for them with non-interest bearing cash
which to a bank, is classified as excess reserves. The banks that receive these excess
reserves would like to get rid of these like a “hot potato.” That is, these reserves earn the
banks zero in terms of interest, and there for, it is very costly to hold these excess
reserves. To get rid of these reserves banks will eventually lower interest rates to
stimulate borrowing activity.
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Shaded Area = 2001 Recession: March - Nov (2001)
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4
2
0
1/01/97
11/01/00
9/01/04
Federal Funds Rate
The Fed conducts open market operations every business day – they guess where reserve
demand is and supply the necessary reserves in hopes of hitting their Federal Funds Rates
target! Sometimes they are wrong. When the federal funds rate is high, then the Fed
underestimated reserve demand – that is, (actual) reserve demand was larger than they
thought it would be. Conversely, if the federal funds rate is lower than target, they
overestimated reserve demand. The Fed guesses what reserve demand will be every
business day, and conducts the appropriate amount of open market operations in hopes of
hitting the FF target as set by the FOMC.
In the space below using the information given, draw a reserve market diagram and
depict what the Fed does every business day in hopes ‘hitting’ the federal fund rate target.
Note that this is actual data from the fall of 2007 and the federal funds rate target is
4.75%.
Oct
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4.77
Oct
9
4.91
Oct
10
4.52
Oct
11
4.75
Summary
The Fed tries to hit the target for the Federal Funds rate every business day by
conducting open market operations – the buying and selling of Government Securities on
the open market. This target is carefully chosen and is set in accordance with the Fed’s
ultimate objectives of full employment, economic growth, and price stability.
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The Discount Rate and Discount Rate Policy
A relatively recent and definitely a major change in the Fed’s discount rate policy:
The articles explain what the discount window is and how the policy regarding the
discount window has changed. Be sure to understand exactly what the change implies for
the upper (intra-day) limit of the federal funds rate.
May 17, 2002
ECONOMY
Fed Proposes a Big Change
In Its Emergency Lending
By GREG IP
Staff Reporter of THE WALL STREET JOURNAL
WASHINGTON -- The Federal Reserve, trying to make its management of interest rates more
effective, is overhauling the way it makes loans to commercial banks through its discount
window.
The changes won't affect the stance of monetary policy. Under the proposed changes, the
discount rate would be significantly higher than it is now but discount window credit would be
granted with far less stringent conditions. This is meant to reduce the stigma and administrative
burden of using the discount window, thus increasing its use.
The discount window used to be an important supplement to open-market operations: It was a
way for the Fed to supply cash to banks and thus maintain its control over interest rates. But it
has fallen into disuse, as banks have become better at managing their cash needs. Furthermore,
because the Fed requires a bank to exhaust alternative sources of funds before granting the bank
discount window credit, banks avoid the discount window for fear of suggesting to the market
that they are in distress.
When the Sept. 11 terrorist attacks disrupted banks' access to the money markets, the Fed
publicly announced the discount window was available in part to remove that stigma. That
week, discount window loans topped $45 billion, a record. They typically fluctuate between $25
million and $300 million.
"There is an alleged stigma to the discount window and we intend to get rid of that," said Fed
Governor Edward Gramlich.
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By boosting use of direct loans to commercial banks, Fed
officials hope they will prevent volatility in the important
federal-funds rate due to temporary shortages of funds. The
federal funds rate is the rate commercial banks charge on
overnight loans to each other. Fed officials also hope to head
off any loss of control over interest rates resulting from
ongoing changes in the bank industry.
The discount rate is now 1.25%, a half-percentage point
beneath the 1.75% federal-funds rate target. Under the
proposal, on which the Fed is seeking comment, the discount
rate would be initially set a full percentage point above the
funds rate target, but that spread could then vary. The Fed
would be able to cut the discount rate quickly in an
emergency.
Furthermore, "primary" discount window credit would be granted to sound banks with few
questions asked and without requiring a bank to first exhaust alternatives. By setting the
discount rate above the funds rate, banks will be discouraged from using it as a routine funding
source. Troubled banks will be eligible for more restrictive "secondary" credit at a discount rate
charged half a percentage point above the primary discount rate.
But when the funds rate spikes above the Fed's intended target, banks are expected to turn to the
discount window -- relieving the pressure on market rates. Such spikes were common in the
early 1990s as hard-pressed banks sought ready cash but avoided the discount window. Today
spikes are more often the result of temporary funding pressures, such as when banks are
dressing up their balance sheets at quarter-end.
But the Fed also wants to prevent interest-rate volatility from rising because of changes in the
bank industry. Banks are required to hold a portion of their deposits on reserve at the Fed, and
the central bank manages interest rates by increasing or decreasing such reserves through open
market operations. In recent years, required reserves have been dropping as money-market
"sweep" accounts, which have no reserve requirements, spread. That trend could eventually
make it harder for the Fed to target interest rates precisely. The new discount-window system
could prevent that from happening.
Write to Greg Ip at [email protected]
Updated May 17, 2002 8:53 p.m. EDT
Copyright 2002 Dow Jones & Company, Inc. All Rights Reserved
Printing, distribution, and use of this material is governed by your Subscription
agreement and Copyright laws.
For information about subscribing go to http://www.wsj.com
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From Url: http://www.frbsf.org/education/activities/drecon/2004/0409.html
Ask Dr. Econ
I find definitions of the federal funds rate stating that it can be both
above and below the discount rate. Which is correct? (September 2004)
Great question! The correct answer depends on the time period. Since January
2003, when the Federal Reserve System implemented a “penalty” discount rate
policy, the discount rate has been about 1 percentage point, or 100 basis points,
above the effective (market) federal funds rate. The fed funds rate is the interest
rate that depository institutions—banks, savings and loans, and credit unions—
charge each other for overnight loans. The discount rate is the interest rate that
Federal Reserve Banks charge when they make collateralized loans—usually
overnight—to depository institutions.
The federal funds market
The fed funds rate and the discount rate are two of the tools the Federal Reserve
uses to set U.S. monetary policy. Let’s start by describing the more important of
these two short-term interest rates—the fed funds rate.
First, you should know that depository institutions are required by the Federal
Reserve to keep a certain amount of their deposits as required reserves, in the
form of vault cash or as electronic funds in reserve accounts with the Fed.1 Over
the course of each day, as banks pay out and receive funds, they may end up
with more (or fewer) funds than they need to meet their reserve requirement
target. Banks with excess funds typically lend them overnight to other banks that
are short on funds, rather than leaving those funds in their non-interest bearing
reserve accounts at the Fed or as idle vault cash.
This interbank market is known as the federal funds market and the effective
interest rate on daily transactions in this market is known as the federal funds
rate. As of September 2004, U.S. commercial banks reported about $360 billion
in daily average interbank loans, mostly federal funds loans—so you can see this
is a very important market for banks to make short-term adjustments to their
funding.
The Federal Reserve Bank of San Francisco publication, U.S. Monetary Policy:
An Introduction describes how the fed funds market works:
The interest rate on the overnight borrowing of reserves is called the federal
funds rate or simply the "funds rate." It adjusts to balance the supply of and
demand for reserves. For example, if the supply of reserves in the fed funds
market is greater than the demand, then the funds rate falls, and if the supply of
reserves is less than the demand, the funds rate rises.
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Monetary policy and the fed funds rate
For monetary policy purposes, the Federal Reserve sets a target for the federal
funds rate and maintains that target interest rate by buying and selling U.S.
Treasury securities. When the Fed buys securities, bank reserves rise, and the
fed funds rate tends to fall. When the Fed sells securities, bank reserves fall, and
the fed funds rate tends to rise. Buying and selling securities, or open market
operations, is the Fed’s primary tool for implementing monetary policy.
Borrowing from the Fed’s Discount Window
Additionally, banks may borrow funds directly from the discount window at their
District Federal Reserve Bank to meet their reserve requirements. The discount
rate is the interest rate that banks pay on this type of collateralized loan. On a
daily average basis in September 2004, borrowing at the discount window
averaged only $335 million a day, a tiny fraction of the $360 billion daily
average for interbank loans during that month.
The following quote from the U.S. Monetary Policy: An Introduction, describes
how the discount window works and the discount rate is set:
The Boards of Directors of the Reserve Banks set these rates, subject to the
review and determination of the Federal Reserve Board… Since January 2003,
the discount rate has been set 100 basis points above the funds rate target,
though the difference between the two rates could vary in principle. Setting the
discount rate higher than the funds rate is designed to keep banks from turning to
this source before they have exhausted other less expensive alternatives. At the
same time, the (relatively) easy availability of reserves at this rate effectively
places a ceiling on the funds rate.
Historical comparison: Which rate was higher?
Historically the federal funds rate has been both above and below the discount
rate, although until 2003 the funds rate typically was above the discount rate.
Until January 2003, it was possible for the effective fed funds rate to fall below
the discount rate on occasion; however, normally the funds rate exceeded the
discount rate. This relationship can be seen in the Chart 1, which plots both the
interest rates and the difference between the two rates. The effective fed funds
rate (in black) and the discount rate (in yellow before 2003 and red after 2002)
compare the level of interest rates—note that since the January 2003 change in
discount window policy the discount rate has exceeded the fed funds rate.
The line centered on zero in the chart is the difference between the two interest
rates; it is calculated as the fed funds rate less the discount rate. Before 2003,
the line showing the difference between the two interest rates (shown in orange)
indicates that the funds rate typically was above the discount rate by a small
margin. However, since the change to a “penalty” discount rate policy in January
2003, the funds rate (shown in pink) has been consistently below the discount
rate.
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Chart 1
Endnotes
1A bank’s reserve requirement is determined by a percentage the amount of deposits a
bank has, so each bank’s reserve requirement is different. For current reserve
requirements, please see Reserve Requirements of Depository Institutions at:
http://www.federalreserve.gov/monetarypolicy/reservereq.htm.
References
Instruments of the Money Market. (1998) Federal Reserve Bank of Richmond.
http://www.rich.frb.org/pubs/instruments/
Selected Interest Rates (H.15 Release). Board of Governors of the Federal Reserve
System. http://www.federalreserve.gov/releases/
U.S. Monetary Policy: An Introduction. (2004) Federal Reserve Bank of San Francisco.
http://www.frbsf.org/publications/federalreserve/monetary/index.html
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In the space below, draw a reserve market diagram and depict how the relatively new
discount rate policy effectively puts and upper bound on the federal funds rate.
Connecting the market for overnight reserves to the
money market
Our objective is to understand both sides of the money market – money supply where the
Fed plays a major role and money demand.
We begin with a world with two assets – money and bonds. More generally, we
want to define money as a non-interest bearing asset that is used for transaction purposes
(transactions money). Bonds on the other hand are less liquid, interest bearing, and
cannot be used directly for transactional purposes. Jumping forward, these points are
important in determining money demand – for example, if interest rates are very high,
then you will hold more bonds since it is so ‘costly’ to hold money. Naturally, low
interest rates mean that the costs of holding money are low so you tend to hold more
money . These are important issues in terms of money demand – but we will do money
supply first.
Money Supply
When we think of money supply, we think of the Fed: Doesn’t the Fed control
the money supply?? Sort of – let’s be precise and say that the Fed has a lot of influence
over the money supply – in particular, M1, which is the monetary aggregate that includes
the most liquid assets: Cash (Currency) and Demand Deposits (Checking accounts). M1
also includes travelers’ checks. There other major monetary aggregate is M2 which is a
broader measure of money that includes all of M1 plus some small time savings deposits
(i.e., M2 includes assets that are less liquid than M1). The Fed used to measure and
monitor M3 which was even broader than M2, but discontinued it measurement in
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March, 2006, arguing that the costs of collecting the data exceeds the benefits of
collecting the data.1
The purpose of the few equations below is for you to understand that the Fed has
imperfect control of the money supply due to changes in household and bank behavior
that influences the money multiplier and in turn, influences the money supply. We will
use the great depression as an example to drive home this point. We will also mention
Y2K in this context.
Money Supply
Define money as above:
1) M = C + D where C = currency (cash) and D = demand deposits (checking accounts)
The Fed has pretty darn good control over what is referred to as the monetary base (MB)
(also referred to as high powered money since changes in MB due to open market
operations result in high powered effects, via the money multiplier, on the money
supply). Define MB as follows with C = currency as before, TR equals total reserves, a
combination of required reserves (RR) and excess reserves (ER).
2) MB = C + TR
Divide 1) by 2)
3) M/MB = (C + D)/(C + TR)
Now a “trick” – divide the numerator and denominator of the RHS (right hand side) of 3)
by D
4) M/MB = (C /D+ D/D)/(C/D + TR/D)
Let’s do a few things to 4) – a) get MB on RHS, b) D/D = 1, and c) TR = RR + ER
5) M = [(C /D+ 1)/(C/D + RR/D + ER/D)] MB
The term in brackets is referred to as the money multiplier, which is a little
different than what you saw in principles. Equation 5) implies that the money multiplier
is influenced by household behavior via C/D, which is determined by us. C/D is simply
the currency to deposit ratio. For example, if you typically carry $100 in cash and you
have $1000 in a demand deposit, then your C/D is 0.1. Think about what happened to
C/D during Y2K.
A quote from the website of the Federal Reserve Board of Governors: “ M3 does not appear to convey
any additional information about economic activity that is not already embodied in M2 and has not played a
role in the monetary policy process for many years. Consequently, the Board judged that the costs of
collecting the underlying data and publishing M3 outweigh the benefits.”
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Equation 5) also implies that bank behavior influences the money multiplier via
ER/D. Even though banks tend to get rid of excess reserves (ER) since they earn zero
interest, sometimes they hold on to them. What do you think banks were doing during
Y2K? Probably holding a lot of ER to meet the liquidity needs of their customers (they
anticipated significant withdrawals)!
The last player that has influence over the money multiplier is the Fed themselves
via RR/D which is simply the reserve requirement ratio (this is what you were supposed
to learn in principles). Note that if we let C/D and ER/D equal zero, the money multiplier
collapses to 1/(RR/D) which is the ‘simple’ money multiplier that you may or may not
have learned about in principles.
Specifics on the money multiplier: If C/D, ER/D, or RR/D go up, then the
multiplier falls. This is important, because if MB remains constant, the money supply
will fall along with the multiplier. We will now use an example that is a simplified
version of what happened during the great depression.
Graphical Analysis, connecting the reserve market to the money market.
Initial Conditions
Let C/D = .2 , RR/D = .1 and ER/D = 0
Money Multiplier = (.2 +1)/ (.2 + .1 + 0) = 4
What does this mean?
A couple things: first, suppose the MB is $ 100 billion ; M = $ 400 billion
Second, a 10 billion dollar open market purchase will result in a $40 billion increase in
the money supply (remember high powered money!) See the two graphs below.
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MB
MB’
i
i
100
110
Ms
Ms’
400
440
MB
M
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The Great Depression – an Example
The Fed is blamed by some for causing the great depression or at the very least, failing to
respond appropriately as in they should of conducted more open market purchases! Of
course hindsight is 20/20.
What will a bank run do to C/D ratios?
So C/D rose dramatically as people were trying to get their cash – remember, there was
no FDIC insurance back then.
ER/D also rose for two reasons – one, banks were keeping ER to meet the liquidity needs
of their customers and two, had no one to lend to – banks are reluctant to make loans in
such a dismal environment (i.e., the default risk of the borrower is naturally high in such
a dismal environment).
Ironically, RR/D went up as well. The Fed was young, less than 20 years in existence
and felt that raising the required reserve ratio would make banks more sound as well as
giving the public more confidence so that they would not run on banks – in hindsight,
raising the required reserve ratio was a mistake!
All three components of money multiplier rose during the great depression – impact on
money multiplier?
Recall Money Multiplier equals:
[(C /D+ 1)/(C/D + RR/D + ER/D)]
Initially, let C/D = .2 , RR/D = .1 , and ER/D = 0
With numbers:
[(.2+ 1)/(.2 + .1 + 0)] = 4
Now account for changes in C/D, RR/D, ER/D
Let C/D up to .5, RR/D up to .2, ER/D up to .3
[(.5+ 1)/(.5 + .2 + .3] = 1.5
NEW Multiplier = 1.5
With numbers – before the great depression
M = ( 4 ) MB
If MB = $ 100 billion ; M = $ 400 billion
Now great depression hits and the multiplier falls to 1.5
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MB still at $100 billion – M = 150 billion
Now the Fed isn’t blind – they buy $ 100 billion in Gov Securities, increasing MB by
$100 billion – Money Supply up to $300 billion (1.5 times $200 billion) – still a 25%
drop from where it was initially.
So the Fed pumped up the Monetary Base via open market purchases – but it was not
enough to offset the dramatic fall in the money multiplier – they should have been
easier!!
The lesson here is that the Fed has incomplete control over the money supply and in order
to have better control, they better try to figure out what determines C/D and ER/D ratios.
In normal times, these are pretty stable so that ‘normally,’ the Fed has pretty good control
over the money supply (M1).
In terms of graphs – in the reserve market, reserve supply doubled to $200 billion but in
the money market, Ms shifted to the left!
A few comments:
We have FDIC insurance now so bank runs are unlikely. The closest thing to a bank run
was the environment during Y2K. People didn’t trust computers and grabbed cash
instead. This was foreseeable, so the Fed, to offset the fall in the multiplier, should buy
lots of bonds thereby injecting lots of reserves into the system. Did they? Not exactly –
they used the discount window instead. They essentially told banks that you could
borrow all you need from us, the Fed, without worrying about the standard implicit cost
from borrowing from the Fed. Normally, banks are unwilling to borrow from the Fed
since borrowing from the Fed sends up a ‘red flag’ and increases the probability of being
audited by the Fed, something a bank certainly avoids. As a result, banks normally
would rather borrow off of other banks via the federal funds market. But during Y2k
they accepted the Feds offer and Y2k came and wend without incident.
Money Demand
The other half of the money market - money demand
There are two main determinants of money demand
First – real income – if your real income goes up you will live a better life and in order to
live a better life you consume more and in order to consume more you need to hold more
money. Graphically, an increase in real income (economic growth) shifts the money
demand curve to the right.
Second – the (opportunity) cost of holding money is the interest foregone by holding the
non-interest bearing money. The higher the interest rate, the higher the cost of holding
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money so the less money you will hold. This idea gives us a negatively sloped money
demand as shown below.
i
6
A
B
4
Md (Y,PS)
400
440
M
For example, when rates are 6 percent, people hold 400 in money balances – quite costly
to hold money. An extreme case may help bring the point home – suppose for a second
that rates are 100% - how much money would you hold, a meals worth? Now suppose
rates are zero, how much money would you hold? Get the idea?
The variables in parentheses are shift variables – as noted before, a higher real income
means more transactions and more transactions require people to hold more money. The
PS term is included and stands for portfolio shocks – think again about Y2K. People
wanted to hold more money not because of lower interest rates or a change in real income
– they just wanted to readjust their portfolios due to Y2K. This would be depicted as a
rightward shift in money demand.
Note: In reality, it is next to impossible to clearly distinguish between real shocks to
money demand where money demand shifts due to changes in the real economy and
nominal or portfolio shocks to money demand where economic agents alter the
composition of the assets. From a monetary policy perspective, this distinction is critical.
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PRACTICE PROBLEMS
An ‘old’ Homework Assignment
PLEASE BE AS NEAT AS POSSIBLE
Pretend you are in charge of conducting monetary policy.
Initial Conditions
rr/D= .10
C = 400 b
D = 1200 b
ER = 10
M=C+D
1)
a) Calculate the MB.
b) Calculate the money multiplier.
c) What is the money supply (use MS = m x MB)?
Please show all work
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2) If Rd = 300 – 40 iff, given the information above, what is the market clearing federal
funds rate?
Draw a reserve market diagram depicting exactly what is going on here! Label the
equilibrium point as point A.
3) Suppose that the ff rate that clears the market in 2) above happens to be the federal
funds target that policy makers are happy with (i.e., they feel it’s in line with hitting their
ultimate objectives). If you were in charge of the operational aspect of the desk, that is, if
you were in charge of “hitting” the fed funds target, what must you do on a daily basis?
Be very specific!
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4) Suppose that due to whatever reason, reserve demand changes and you forecast the
reserve demand to now be Rd = 250 – 40 iff
a) In order to keep the fed funds at target, what must the open market desk do? Be
specific and show this development in your picture above (label the new equilibrium as
point B).
b) Suppose the alternative, that the open market desk does nothing different, that is, they
hold the amount of reserves constant (the fed holds the money stock). What happens in
the reserve market? What is the market clearing fed funds rate now? Label this
development, that is, the new equilibrium as point C.
5) Let’s move on to the money market now.
a) Suppose the money demand function is given by:
Md = 2211 – 100i
What is the market clearing interest rate in the money market?
Show all work
b) Draw a money market diagram and label this initial equilibrium as point A.
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Consistent with the shock to reserve demand, money demand also decreases. The “new”
money demand curve is now:
Md = 2011 – 100i
c) If the desk acts as they did in part 4) a), to keep the fed funds rate at target, what
would be the new market clearing interest in the money market? Show these
developments on your money market diagram and label this equilibrium as point B.
d) Now suppose the desk “Holds the money Stock,” what would be the market clearing
interest rate now? Label this equilibrium as point C.
e) Since you are the captain of the ship, how would you make your decision on whether
or not to conduct any open market operations? That is, tell me a nice detailed story as to
what goes into making this decision. There is a lot to discuss!
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ANOTHER PROBLEM
Initial Conditions
rr/D= .05
C = 200 b
D = 800 b
ER = 10
M=C+D
a) (3 points)
a) Calculate the MB.
b) Calculate the money multiplier.
c) What is the money supply (use mm x MB to calculate this)?
Show work
b) (3 points) If Rd = 290 – 60 iff, given the information above, what is the market
clearing federal funds rate?
Show work
(4 points for correct diagram) Draw a reserve market diagram depicting exactly what is
going on here! Label the equilibrium point as point A.
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c) (2 points) Suppose that the ff rate that clears the market in 2) above happens to be the
federal funds target that policy makers are happy with (i.e., they feel it’s in line with
hitting their ultimate objectives). If you were in charge of the operational aspect of the
desk, that is, if you were in charge of “hitting” the fed funds target, what must you do on
a daily basis? Be very specific!
d) Suppose that due to whatever reason, you forecast the reserve demand to be:
Rd = 300 – 60 iff
e) (2 points) In order to keep the fed funds at target, what must the open market desk do?
Be specific and show this development in your picture above (label the new equilibrium
as point B). In fed language, this is referred to as accommodating the shock to reserve
demand.
Show work
f) (2 points) Suppose the alternative, that the open market desk does nothing different,
that is they hold the amount of reserves constant (“the fed holds the money stock”). What
happens in the reserve market? What is the market clearing fed funds rate now? Label
this development, that is, the new equilibrium as point C.
Show work
Let’s move on to the money market now.
Suppose the money demand function is given by :
Md = 1500 – 100i
g) (2 points) What is the market clearing interest rate in the money market?
Show all work
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h) (4 points for correct diagram) Draw a money market diagram (use space below) and
label this initial equilibrium as point A.
Consistent with the shock to reserve demand, money demand also increases. The “new”
money demand curve is now:
Md = 1600 – 100i
i) ( 2 points) If the desk acts as they did in part e), to keep the fed funds rate at target,
what would be the new market clearing interest in the money market. Show these
developments on your money market diagram and label this equilibrium as point B.
Show work:
j) (2 points) Now suppose the desk “Holds the money Stock,” what would be the market
clearing interest rate now? Label this equilibrium as point C.
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Chapter 2: Financial Markets: Part 1
To truly understand financial markets and ‘talk the talk,’ you will be required to
understand a plethora of jargon. Remember, I am here to answer all your questions, so
don’t be shy. The last thing we need is for you to not to understand something because of
jargon. Before getting started, it would be helpful to think of financial markets as a giant
poker game where it is ‘dealer’s choice’ and you are the dealer. There are many different
poker games out there and when you start playing, everybody has an equal chance of
winning, that is, it is a fair game. Financial markets are similar in that there are many
bets one can make and everyone has the same chance as winning (making a capital gain)
and losing (suffer a capital loss). Another way to state this is that there is no free money
to be made in financial markets and we will get much deeper into this phenomenon a
little later in the course.2
Glass half full or empty (Bulls vs. Bears).
As mentioned above, there are many bets you can make in the financial markets.3 Before
deciding on what particular bet to make, you essentially need to decide if you are
optimistic (Bullish) or pessimistic (Bearish) as it pertains to the ‘chosen’ asset’s price.
Bulls make money when prices rise and lose when prices fall. Conversely, bears make
money when prices fall and lose money when prices rise. After you establish whether
your are bullish or bearish, you can chose any of the ‘games’ or ‘bets’ that follow, always
remembering, a) there is no free money out there and 2) different bets have varying
amounts of risked attached to them.
Stocks: Long vs. Short
A US Common stock represents partial equity in the company whose name it bears.
Going long, that is, buying and holding shares of stock is probably the simplest (and most
familiar) investment one could make. The idea is to buy (relatively) low and sell high,
reaping what is referred to as a capital gain. Mutual funds are primarily comprised of
long positions in common stock. In taking a long position, the investor is betting
(hoping) that the stock price (or stock market index) will rise.
2
For those of you familiar with finance, this concept is known as the efficient market theory.
When state the word financial markets, we are typically referring to three very large markets:1) the Bond
market; 2) the Stock (equity) market, and 3) the Foreign Exchange market.
3
23
Example: Use the space below: Taking a long position (buying 10 shares) in IBM
stock:
In contrast to going long, an investor can go “short” on a stock and therefore benefit if the
relevant stock price falls (A bearish position). Shorting a stock involves borrowing
shares from a creditor (e.g., JP Morgan) and selling them immediately. The key to
understanding how shorting stocks works is to recognize that your debt is in stocks and
not cash. For example, if I short one hundred shares of IBM stock, I borrow 100 shares
of stock from a creditor and it is 100 shares of stock that I owe my creditor (excluding
transactions fees)4. The idea is that once the price has fallen, I can buy the (borrowed)
shares back for less money than I received when I sold them. Thus, if the stock does fall
you pocket the difference. If the stock price rises instead and stays relatively high, then
you will (eventually) be forced to buy the stock back at a higher price than you sold it for
and will thus suffer a capital loss.
Example: Use the space below: Shorting IBM stock (shorting 10 shares):
In one sense, shorting a stock is more risky than going long because it exposes the
investor to the possibility of larger losses. For example, if I short shares of a small
biotech company which then announces a drug approval by the FDA tripling its share
price, I will lose 200% overnight.5 Conversely, the worst-case scenario with long
investments is a loss of 100%, such as occurred when Enron announced accounting
scandals and its stock price went to zero.
Throughout this course, we will typically ‘assume away’ transactions costs in our numerical calculations
and analyses.
5
For example, If I short 100 shares when the price is $10 and the price subsequently rises (triples) to $30, it
would cost me $3000 (buying 100 shares at $30 and returning them to my creditor) to close my position.
The initial value of my ‘investment’ was $1000 (100 shares times $10) so the loss is 200% (($1000 $3000)/$1000) x 100. You will be required to calculate rates of return throughout this course.
4
24
Long vs. Short positions on Bonds
Throughout the semester, we will constantly exploit the inverse relationship between the
price of bonds and the yield or interest rate on bonds.
Do the “Chud Bond” Example in the space below emphasizing this inverse
relationship between the price of bonds and the interest rate on bonds (an Asian
financial crisis example).
You would take a long position on bonds if you expect prices to go up, same reasoning as
in stocks (above). Saying the same thing a little differently, you would take a long
position on bonds if you expect lower interest rates in the future. As we will see
throughout the semester, expected Federal Reserve policy (i.e., what the Fed may or may
not do in the future) plays a critical role in the determination of bond prices and thus
interest rates. Investors are constantly looking for clues that will aid them in this regard
and naturally, the continuous stream of incoming economic data is scrutinized for
possible clues. For example, if the CPI (consumer price index) report came out and
suggested major inflationary pressures that were not expected prior to the report, then
investors would immediately expect the Fed to be more hawkish in the future, and thus,
interest rates would be expected to be higher in the future.6 Exploiting the inverse
relationship between bond prices and interest rates, the previous statement can be stated
as “due to the CPI report, investors expect lower bond prices in the future and thus,
investors who currently have a short position in bonds will be the winners while those
investors who have a long position will be the losers. We will be evaluating the impact
of NEWS on the asset markets throughout the semester with NEWS being defined as the
“unexpected!” For example, if the consumer price index is expected to rise by .2% and
the actual number is .2%, then there is no NEWS since expectations were exactly correct.
Naturally, expectations are usually not correct so NEWS is virtually an everyday
experience.
6
Hawkish refers to the Fed aggressively fighting inflation by raising interest rates to slow down aggregate
demand. The opposite of hawkish is dovish and refers to the Fed being soft on inflation. An inflation dove
typically worries more about employment and economic growth and less about inflation; the opposite can
be said about an inflation hawk. These terms will be used throughout the semester, especially when we
consider the Fed’s loss function and the Taylor rule.
25
Long vs. Short positions on Foreign Exchange
If you go long on the dollar, that means you are hoping the dollar gets stronger relative to
the currency that you chose or a basket of currencies as in a dollar index. For example, if
I go long on the dollar relative to the Euro, then I will profit if the dollar get stronger
relative to the Euro and lose money if the dollar weakens relative to the Euro. If you
think the dollar is going to weaken, then you should take a short position on the dollar.
Example: In the space below, do an example of taking a long position on the euro vs.
the US dollar.
The currency market is probably the hardest to predict of the three asset markets and we
will keep an ‘eye’ on the currency markets throughout the semester.
Options
Options are contracts giving the owner the right to buy (call option) or the right to sell
(put option) shares of stock at a predetermined (strike) price. One call option typically
gives the owner the right to buy 100 shares of the underlying security for the strike price
stated on the contract. Buying calls is considered bullish because you profit when the
underlying stock price rises. A call option is “in the money” when the strike price is
below the (current) spot price. In such a case, the price at which you can buy the stock,
i.e., the strike price, is less than the price that you can sell the stock, the spot price, so
exercising the option would be profitable.
Example: Use the space below to do an IBM example on calls (a long position;
bullish).
26
A put option is the exact opposite (and is thus bearish) and gives the owner the right to
sell the underlying security at the strike price. Put options are in the money when the
spot price is below the strike price. In this case, the owner could exercise the put by
buying the stock at the relatively low spot price and selling the stock at the strike price,
since this is exactly what a put option allows you to do.
Example: Use the space below to do an IBM example on puts (a short position;
bearish).
Option prices are quoted in premium-per-share. The premium is the price you pay for the
option contract. Recall that an option contract allows you to buy or sell a specified
quantity of an asset during a specified time period (i.e., they expire). To find the actual
cost of an option (excluding fees and other possible transactions costs), multiply the
quoted premium by 100. We will discuss the specific factors that determine option
premiums during class. We will also understand why options are typically not exercised,
they are bought and sold much like shares of stock or bonds. The example problem on
options that follows will help us understand this entire paragraph.
Futures
A futures contract is an obligation to deliver or receive a financial asset or commodity on
a predetermined date for a stated price.7 Futures contracts exist for everything from pork
bellies to interest rates. Futures contracts are generally preferred to forward contracts
because they are standardized and for the most part, more liquid. Interest rate futures are
always denominated by a face value of $100,000; other commodities have standardized
qualities as well. Futures are often used as a hedge (insurance) against unwanted price
movements. For example, a farmer who produces wheat would want to insure against a
low price at harvest time by selling wheat futures to lock in a price for his/her wheat. By
selling a wheat futures contract, the farmer is obligated to deliver a specified quantity of
wheat at a specified future time.8 When the wheat is harvested, he/she must deliver it at
the price as described by the futures contract. In much the same way, a baker who uses
wheat can ensure against a high price at harvest time by purchasing wheat futures, thus
locking in a price for this vital input. In this sense, the baker is hedging (insuring) against
a high price of wheat at harvest time. As you can see, there is a ‘natural market’ that
develops here; The farmer insuring against low prices at harvest time, and a baker
insuring against high prices at harvest time.
7
One major difference between options and futures is that futures contract require you to close your
position where as options do not (i.e., options can expire without any action between the buyer and seller).
8
As in at harvest time. In the real world, the standardized quantity for a futures wheat contract is 5,000
bushels!
27
Speculators operate in the futures market as well tending to improve the liquidity to the
futures market. We will discuss speculators in the futures market when we do the
problem that follows.
To trade futures, an investor must keep approximately 10% of the value of the contract in
his account as margin. Futures accounts are marked to market daily meaning that if
your account falls below margin, you must add funds to the account immediately.
Conversely, if you make money, cash is added to your account at the close of trading
each day. This property of the futures market give accountants headaches and as a result,
the relatively new futures options markets has blossomed.
Futures contacts are very risky, since you can place a very large bet for a relatively small
amount of money. If there are significant changes in the value of your futures contract,
the the gains/losses can easily exceed 100% in a short period of time.
Futures Options
A futures option is simply the option to buy (a call) or sell (a put) a specified quantity of
commodity at a predetermined price by the expiration date. These options trade on
exchanges just like regular stocks or options and their prices, therefore, are marketdetermined. Advantages of futures options over futures are:
a) Futures options preserve the possibility of profits while limiting potential losses to the
price of the option. That is, the most you can lose is what you paid for the option
(referred to as the premium).
b) Futures options do not require daily settlement via a margin account and thus are
much easier to handle from an accounting standpoint.
While futures expose investors to virtually infinite risk, the most one can lose with the
purchase of a futures option is the cost of that option (i.e., the premium). As with stock
options, if the contract is not “in the money,” the contract will not be exercised and no
additional losses will be incurred.
28
Terms to be familiar with (not in any particular order):
1. Options – calls, puts.
2. Derivatives – what does this term mean and why?
3. Shorting stocks and short covering.
4. Long vs. Short positions.
5. NEWS.
6. Futures.
7. Closing your position.
8. Hedging vs Speculating
9. Bulls vs. Bears.
10. Exercise.
11. In the money.
12. Rally (apply to all three of the asset markets).
13. Spot price.
14. Zero Sum game.
15. Strike price.
16. Expiration date.
17. Futures options.
18. Determination of option premium.
19. Covered vs. Naked calls/puts.
20. Writing options.
21. Risk.
22. Expected return.
23. Liquidity.
Practice Questions
1. a) Suppose you bought (took a long position) 10 shares of IBM stock at a (previous)
spot price of $100 and the current IBM spot price is $95. If you closed your position,
how much money would you make/lose (assume away all transactions costs)? Show al
work.
b) Suppose alternatively that you took a short position by shorting 10 shares of IBM
(assume same price change as in 1. a) above. How much money would you make/lose if
you closed your position (cover your short)? Explain in detail and show all work.
29
c) Given either position, what would determine whether or not you would close your
position? Again, explain in detail.
2. Previous HW assignment from Spring 2006
(15 points total) Use the following 3 tables to answer the questions that follow. In this
example, you are bearish on Best Buy (BBY). We are going to examine and compare
two bearish bets. We assume away all transactions costs and as always, use the ‘last sale’
column, i.e., the premium for your calculations.
TABLE 1
BBY
46.20 -4.16
Sep 13, 2005 @ 10:29 ET (Data 20 Minutes Delayed)
Bid N/A Ask N/A Size N/AxN/A Vol 8587300
Calls
Last
Sale
05 Sep 43.375 (BXJ IU-E)
4.40
05 Sep 45.00 (BBY II-E)
1.55
05 Sep 46.625 (BXJ IV-E)
0.55
05 Sep 47.50 (BBY IW-E)
0.25
05 Oct 42.50 (BBY JV-E)
05 Oct 45.00 (BBY JI-E)
Net
Vol
Open
Int
Puts
Last
Sale
2.95
0
3119
05 Sep 43.375 (BXJ UU-E)
0.10
1.55
86
826
05 Sep 45.00 (BBY UI-E)
0.35
0.50
83
5966
05 Sep 46.625 (BXJ UV-E)
0.85
0.25
266
6145
05 Sep 47.50 (BBY UW-E)
1.50
27
05 Oct 42.50 (BBY VV-E)
813
05 Oct 45.00 (BBY VI-E)
1382
8526
Bid
Ask
pc
2.80
-3.65
1.40
-3.65
0.45
-3.15
0.15
6.90
pc
4.30
4.50
0
2.80
-1.60
2.50
2.60
40
05 Oct 47.50 (BBY JW-E)
1.25
-2.95
1.20
1.30
205
05 Oct 50.00 (BBY JJ-E)
0.50
-2.05
0.50
0.55
109
Net
Vol
Open
Int
0.15
0
9902
0.40
761
9084
1.00
81
5637
1.60
441
5594
0.70
14
1311
1.40
216
1834
2.45
2.60
65
4461
4.20
4.40
42
1127
Bid
Ask
pc
0.10
+0.15
0.30
+0.45
0.90
+0.95
1.50
0.60
+0.20
0.60
1.25
+0.45
1.30
05 Oct 47.50 (BBY VW-E)
2.50
+1.20
05 Oct 50.00 (BBY VJ-E)
4.10
+1.95
TABLE 2
BBY
45.29 -5.07
Sep 13, 2005 @ 15:11 ET (Data 20 Minutes Delayed)
Bid N/A Ask N/A Size N/AxN/A Vol 24252700
Calls
Last
Sale
Net
Bid
Ask
Vol
Open
Int
Puts
Last
Sale
Net
Bid
Ask
Vol
Open
Int
05 Sep 43.375 (BXJ IU-E)
2.10
-2.30
2.00
2.10
376
3119
05 Sep 43.375 (BXJ UU-E)
0.15
+0.05
0.10
0.20
765
9902
05 Sep 45.00 (BBY II-E)
0.85
-4.35
0.75
0.85
955
826
05 Sep 45.00 (BBY UI-E)
0.50
+0.30
0.45
0.50
1388
9084
05 Sep 46.625 (BXJ IV-E)
0.20
-4.00
0.15
0.20
267
5966
05 Sep 46.625 (BXJ UV-E)
1.35
+0.95
1.45
1.55
247
5637
05 Sep 47.50 (BBY IW-E)
0.10
-3.30
0.05
0.10
275
6145
05 Sep 47.50 (BBY UW-E)
2.10
+1.55
2.20
2.30
678
5594
05 Oct 42.50 (BBY JV-E)
3.50
-3.40
3.60
3.80
5
27
05 Oct 42.50 (BBY VV-E)
0.75
+0.35
0.75
0.85
103
1311
05 Oct 45.00 (BBY JI-E)
2.00
-2.40
1.95
2.05
326
813
05 Oct 45.00 (BBY VI-E)
1.65
+0.85
1.65
1.70
383
1834
05 Oct 47.50 (BBY JW-E)
0.95
-3.25
0.90
0.95
1021
1382
05 Oct 47.50 (BBY VW-E)
2.90
+1.60
3.00
3.10
148
4461
05 Oct 50.00 (BBY JJ-E)
0.35
-2.20
0.35
0.40
458
8526
05 Oct 50.00 (BBY VJ-E)
4.70
+2.55
4.90
5.10
185
1127
30
TABLE 3
BBY
Oct 01, 2005 @ 07:22 ET (Data 20 Minutes Delayed)
43.53 +0.49
Bid N/A Ask N/A Size N/AxN/A Vol 3075600
Calls
Last
Open
Net Bid Ask Vol
Puts
Sale
Int
Last
Open
Net Bid Ask Vol
Sale
Int
05 Oct 40.00 (BBY JH-E)
4.10 +1.35 3.70 3.90 105 1004 05 Oct 40.00 (BBY VH-E)
0.30
05 Oct 42.50 (BBY JV-E)
1.65 +0.50 1.75 1.85
0.60 -0.65 0.60 0.70 128 8718
05 Oct 45.00 (BBY JI-E)
0.70 +0.40 0.50 0.60 313 7907 05 Oct 45.00 (BBY VI-E)
8 6866 05 Oct 42.50 (BBY VV-E)
pc 0.15 0.25
0 7023
1.85 -0.75 1.85 1.95 22 4167
05 Oct 47.50 (BBY JW-E) 0.15
-- 0.10 0.15 303 5847 05 Oct 47.50 (BBY VW-E) 3.50 -1.00 3.90 4.10 26 4036
05 Nov 40.00 (BBY KH-E) 4.00
pc 4.30 4.50
0 3579 05 Nov 40.00 (BBY WH-E) 0.55 -0.45 0.60 0.70 10 875
05 Nov 42.50 (BBY KV-E) 2.80 +0.80 2.55 2.65 45 4400 05 Nov 42.50 (BBY WV-E) 1.25 -0.40 1.30 1.40 65 685
05 Nov 45.00 (BBY KI-E) 1.45 +0.30 1.25 1.40 25 3203 05 Nov 45.00 (BBY WI-E) 2.30 -0.65 2.50 2.60 64 330
05 Nov 47.50 (BBY KW-E) 0.60 +0.15 0.50 0.60
8 1059 05 Nov 47.50 (BBY WW-E) 4.20 -0.90 4.20 4.40 28
11
It is Sept 13 at 10:29 am (TABLE 1). You are thinking that Best Buy is going down due
to hurricane related stuff including high oil prices. You have $2,500 to play the game and
you are going to spend it all on BBY put options. You are looking at Oct 45 puts and Oct
47.50 puts.
a) (2 points) Why the difference in the premiums on these two options (use Table 1)? Be
specific.
b) (2 points) Suppose you decided to use the entire $2,500 to purchase the Oct 45 puts.
How many put options could you buy and what would they collectively, give you the
right to do (we are still using Table 1)?
c) (3 points) It is now October 1 (Table 3) and you decided to sell your Oct 45 puts.
What is your profit/loss? What is your rate of return? Please show all your calculations.
31
d) (2 points) Instead of purchasing the Oct 45 puts you decide to use all $2,500 to
purchase the October 47.50 puts (again, on Sept 13 at 10:29 am – Table 1). How many
Oct 47.50 puts could you buy and what would they, collectively, give you the right to do?
e) (2 points) It is now October 1 (Table 3) and you decided to sell your October 47.50
puts. What is your profit/loss and your rate of return? Please show all your calculations.
f) (2 points) Given that your profit / loss is different depending on your choice of puts,
which selection of put options gave you a higher return (i.e., compare part c) with part
e))?
g) (2 points) Now consider Table 2. Since hindsight is 20 / 20, would it have been better
in terms of profits and/or returns if you would have sold your options later on September
13 (Table 2) rather than waiting until 10/1 (Table 3)? Why or why not, explain.
32
3. Previous HW assignment from Spring 2006
(15 points total) Suppose you are a weaver and you need 10,000 pounds of cotton to
make handkerchiefs. Harvest time is six months from now and you want to lock in a
price per lb now via a futures contract. Suppose you can make an agreement, that is,
enter into a futures contract for 10,000 lbs with a cotton farmer with an agreed upon price
of $1.00 lb (which happens to be the current spot price).
a) (2 points) Explain the terminology of the transaction – that is, what exactly are you
doing and why: what is the farmer doing and why?
b) (2 points) Now suppose, due to a trade war and a great growing season, cotton prices
plunge to 50 cents ($0.50) per pound at harvest time. Who looks smart for acquiring the
futures contract, the cotton farmer or the weaver? Explain.
c) (3 points) Now, let’s assume that they are both speculators. Plot the profit function
(futures profit functions) for the speculator cotton farmer (in one graph) and the
speculator weaver (in another graph). Locate the profit or loss for each with a label of
point A (where the price equals $0.50). Please use the space below for your diagram.
33
d) (3 points) Now assume that instead that the speculators play the futures options
market. In particular, the speculator cotton farmer buys a futures options put for 10,000
lbs of cotton for $1000 (strike price = $1.00 lb) and the speculator weaver buys a futures
options call for 10,000 lbs of cotton for $1000 (strike price = $1.00 lb). Assume that the
price per pound plunges to 50 cents ($0.50) as before and that the futures options expire
at harvest time. Add the futures option profit function for each speculator to your diagram
above. Locate the profit or loss for both players in the futures options game as point B.
Be sure to label your diagram with all the specific numbers that apply. Which option is
“in the money?”
e) (4 points) Are these results consistent with a zero sum game (hint, there are four
players here)? Explain.
34
Chapter 3: Financial Markets: Part 2
Portfolio Allocation and the demand for assets
There are three main determinants of asset pricing:
1) Expected return: The higher the expected return of the asset, all else constant, the
higher the price of the asset. Naturally, we will discuss at length the factors that
influence the expected return of the asset(s) throughout the course. I do want to
mention at this point how important expectations and changes in expectations are in
terms of determining not only asset prices, but also, aggregate economic activity.
Asset price = f (Rete) :
+
{stated as “the asset price is a positive (+) function (f) of it’s expected return (Rete), all
else constant}
2) Liquidity: Liquidity is an attractive quality in any asset and a highly liquid asset has
three qualities: 1) it is easy (low cost) to convert the asset into money where money is
defined as transactions money; 2) it can be converted to money quickly and 3) the
amount that it is converted to is representative of its fundamental value (i.e., I can sell my
house very quickly and easily for $5, but that doesn’t mean it is liquid!). Typically, the
more liquid the asset, the lower the return. Take money, typically considered to be the
most liquid asset of all. Money earns a nominal return of zero and a real return equal to
the ‘negative’ of the inflation rate.9
Liquidity is especially attractive in a highly uncertain environment. When we discuss
financial crises and shocks like 9/11, we will see the impact on financial markets when
investors demand more liquid assets. US Treasuries are often considered very liquid and
thus the term: “rush to the safe haven of US Treasuries.” The safe haven refers naturally
to the perceived zero default risk quality of US Treasuries.
Asset price = f (Liq) :
+
{stated as “the asset price is a positive (+) function (f) of it’s liquidity (Liq), all else
constant}
3) Risk: The more risky the asset, the more uncertain as to the assets’ return. Risk arises
for a variety of reasons and we assume that all else equal, investors prefer assets with less
9
Suppose inflation over a year is 10% and I keep $100 in my pocket. That $100 next year would be able to
purchase 10% less in real goods and services given the 10% rise in the general price level that has occurred
over the year.
35
risk (i.e., on average, investors are risk averse). We also note that risk and expected return
are related – typically, the higher the risk, the higher the expected return (investors
require a higher expected return to take on the higher risk).
Asset price = f (Risk) :
{stated as “the asset price is a negative (-) function (f) of it’s Risk, all else constant}
Stock Price Determination
As most of us could gather, the obvious driving force underlying any the price of any
stock is the expected future stream of profits or earnings (earnings and profits are used
interchangeably). We need to be more specific, it is the present value (PV) of current and
future earnings that matter. We all should recall that the present value of say $1,000
today is larger than the present value of $1,000 ten years from now. But how much
larger? The answer depends on the expected nominal interest rate to prevail over the next
ten years. Let’s make life simple, let us suppose that the interest rate over the next ten
years will be 10% year in and year out. In this case, given these assumptions, the PV of
$1,000 ten years from now would be:
PV1000 = $1,000/(1 + 0.10)10 = $ 385.54
What does $385.54 represent? The answer is that if we take $385.54 and invest it today
at a 10% annual return and take the principal and interest and continue rolling it over for
10 years, at the end of the 10th year, we would have $1,000. An equivalent way of
thinking about this is, and the way most relevant for understanding how stock prices are
determined is the following: Given the above conditions, I would be willing to pay
$385.54 today, to receive $1,000 ten years from now. In what follows, the $1,000 in this
example would be the “expected profits” of the firm ten years from now. These expected
profits are continuously changing given the continuous NEWS that investors digest and
process on a day to day basis.
In terms of stock price determination, investors form expectations as to the future profits
of any particular firm as well as the expected path of interest rates, since together, they
determine the present value of the firm. Similar to the above, the present value of a firm
can be thought of as the most investors would be willing to pay for the firm today, to
have the ownership rights to all the current and future profits expected in the future.
When we divide the present value of the firm by the number of shares of stock
outstanding, we arrive at the price of the stock. Before getting into more specifics, please
read the following summation.
36
Three major factors to keep in mind when considering stock
price determination
1) Stock prices are driven by expectations and changes in expectations. Just about
everything influences expectations and these changes in expectations are reflected
immediately in the relevant stock price.10
2) Stock prices are positively related to expected earnings and expected earnings nearer
to the present have a stronger influence on stock prices than do the same expected
earnings further out into the future. For example, the present value of $10,000 in
expected earnings 2 years from now is larger than the present value of $10,000 in
expected earnings 10 years from now (assuming away zero interest rates)11
3) Stock Prices are typically negatively related to the expected path of interest rates. The
expected path of interest rates is so important in financial markets, not to mention,
aggregate economic activity. Many investors spend much of their time trying to figure
out what the Federal Reserve may or may not do. Interest rates also change for reasons
not directly related to Fed policy, and a big portion of this class revolves around interest
rate determination. For the present, we need to understand why lower interest rates are
‘typically’ good for stocks. First, the present value of future profits rises the lower the
expected path of interest rates. Let’s return to our example above. It was shown that the
PV of $1,000 ten years from now, assuming 10% interest rates year in and year out, was:
PV1000 = $1,000/(1 + 0.10)10 = $ 385.54
Now let’s let the expected path of interest rates be 5% year in and year out. What is the
PV of $1,000 ten years from now given this lower expected path of interest rates?
PV1000 = $1,000/(1 + 0.05)10 = $ 613.91
So if the expected path of interest rates fall, all else constant, that should be good for
stocks as the PV of the firm will rise.
Second, we can not ignore the influence of the change in the expected path of interest
rates on expected profits. This influence is very real but also very hard to analyze and
therefore, the context must be taken into account. For example, on one hand, lower
interest rates in the future should stimulate economic activity and according to this
version of the story, should result in higher expected profits. On the other hand, if people
expect lower interest rates due to a poorly performing economy, then perhaps expected
profits will fall instead of rise. So the influence of lower expected interest rates on the
10
This notion applies to bond and foreign exchange markets as well.
In addition to the PV, near term expected profits have less uncertainty than expected profits well into the
future, so when the expected profits change, it is the nearer term(s) of expected profits that have the most
influence on the stock price.
11
37
expectations of future profits is ambiguous, and thus, needs to be examined on a case by
case basis.
Numerical Example and some Terminology
The stock price of any firm is equal to the (expected) present value of the firm (market
cap) divided by the number of shares outstanding. Any factor, and there are many, that
changes the expected present value of the firm, will change that stock price.12
The assumption (in the numerical example that follows) is that this firm falls off the face
of the earth after three years, a more realistic example would include many more terms
(an infinite amount!).
Earnings 1e Earnings e2 Earnings 3e
Present Value of Compay 



1  i1 1
1  i2e 2
1  i3e 3
e  an expected value
Present Value of Company  Market Cap
Price per Share 
Market Cap
# of Shares Outstandin g
Example:
Year
Exp. Earnings
Exp. 1 yr Interest
Rate
MarketCap 
Company ABC (10,000 shares outstanding)
1
2
$15,000
$50,000
0.03
0.04
3
$100,000
0.05
$15,000 $50,000 $100,000


1  .031 1  .042 1  .053
 $147,175
$147,175
10,000
Pr ice  per  share  $14.72
MarketCap /# Shares 
Price to earnings ratio (PE ratio): The price to earnings ratio is often used by
investors as a guidepost as to whether a stock is “overvalued” or “undervalued.”
12
Psychology also plays a role here. How people feel, waves of optimism and pessimism certainly move
stocks, and a strand of finance referred to as behavioral finance will be addressed at a later time. Needless
to say, when we add psychology to the ‘equation,’ analysis becomes that much more difficult as well as
less concrete in nature.
38
Given that stock prices are determined by expectations of the future, we NEVER
know whether a stock price is overvalued, undervalued, or valued ‘just right.’13
The price to earning ratio can be calculated in two equivalent ways:
1) Take the market cap, which is equal to the number of shares outstanding times the
current price of the stock and divide it by current year earnings. From the example
above:
PE ratio = $147,175 / $15,000 = 9.81
2) Take the price per share and divide it by current year earnings per share:
PE ratio = $14.72 / $1.50 = 9.81
We can now do some exercises:
1) Suppose the Federal Reserve makes a dovish announcement and as a result, investors
expect the path of short term interest rates to be steady at 3% (as opposed to previous
expectations over the three year life of the firm of 3, 4, and 5% respectively).
Exercise: What will happen to the Stock Price?14
Exercise: What will happen to the PE ratio?
2) Suppose the CEO of Company ABC makes a statement that the company’s expected
earnings are now lower than previously expected (i.e., a pessimistic outlook) so that
investors now expect profits to be ‘flat’ at $15,000 for the next three years (assume
the initial expected path of interest rates of 3, 4, and 5% in year 1, 2, and 3
respectively).
Exercise: What will happen to the Stock Price?
In December of 1996, Alan Greenspan stated that investors were “irrationally exuberant,” implying that
investors were erroneously optimistic about future profits. Another way to state the same thing is that a
bubble had formed in the stock market! Alan Greenspan was heavily criticized for this comment and truly
regrets saying it. The moral of the story is that we don’t know when stocks are overvalued or undervalued
and thus, major figureheads should refrain from giving their personal opinion. The following statement is
believed by just about everyone in finance and economics: “We never know if there is an asset market
bubble until the bubble breaks.”
14
We are holding expected earnings constant in this example.
13
39
Exercise: What will happen to the PE ratio?
3) Give two specific reasons why the PE ratio would be high for a firm and comment on
the type of firm that may have a high PE ratio. Finally, does a high PE ratio imply
that the firm is over valued? Why or why not?
The Optimal Forecast and Rational Expectations.
Example 1: Rational Expectations and a Question Before You Hand in Your Exam!
When I was at Grad School here at PSU, a professor told a story that I believe really
clarifies exactly what we mean by rational expectations. Suppose I would say to the class
before anyone handed in their exam (assume it is a multiple choice exam):
“Put an asterisk next to the three questions that you think you missed”
So let’s think about this for a moment……. which questions would you pick? The
answer is that if you have rational expectations formation, you should not pick any!
Why?? If you pick a question that you think you missed, then change the answer! Of
course I know a lot of you are thinking that well…. some questions are harder than others
and I will simply choose the three hardest questions! That is fine and consistent with
rational expectations, but that is not admitting that you think you missed them because if
you think you missed it, again, you would change the answer. So again, if I asked you
how many questions you think you missed, your answer should be zero!
Another interesting and useful feature of this example is the concept of a probability
distribution – some questions probably fall into the ‘no brainer’ category and thus, you
are quite certain that you got them correct; some are in the easy but not that easy, etc. As
we shall see, probability distributions and the associated uncertainty plays a critical role
in financial markets and the economy.
Example 2: Using Rational Expectations on Your Drive to Work Each Day
Suppose you live in Port Matilda and work in State College. Suppose also that you do
not want to arrive at work “too” early and you don’t want to arrive at work “too” late.
Suppose through experience, you estimate the commute to be 15 minutes and thus leave
40
15 minutes before you are scheduled to work.15 Suppose you begin work at 8 am and
thus you leave at 7:45 am.
Questions:
1) Would you expect to get to work at starting time each and everyday?
2) Would you actually get to work at exactly the same time?
3) Is your forecast of the time it takes to get to work optimal? Why or why not?
Consider the following two scenarios:
a) One the way to work you get stuck in traffic due to an accident, somebody hit a
deer and you end up getting to work 15 minutes late!
Question: Would you change your forecast on how long it takes to get to work and
would this forecast be optimal?
b) The state begins construction (on the road you travel) and you are 15 minutes
late for work. You learn that the construction is going to last for 6 months. Would
you change your forecast on how long it takes to get to work and would this forecast
be optimal?
Let’s define the forecast error (FE) as the starting time (8 am) minus (-) the actual
arrival time. If the actual arrival time is 8am, then the forecast error equals zero; if
the arrival time is not 8 am, then the FE is non-zero. What are the properties of this
forecast error (there are three of them)?
a.
b.
c.
Let’s assume that your employer is okay with you being a little late or a little early and thus, as long as
you are to work on time, on average, all is well.
15
41
Predicting Tomorrow’s Stock Price and the Efficient Market
Theory
In the driving to work example above, we had the incentive to obtain an optimal forecast
for the commute and thus, we used all the relevant information available to formulate that
optimal forecast. For example, if it snowed all night and you believed the roads are likely
to be slippery, you would use that relevant and available information immediately and
incorporate (process the information) it into your forecast of the time it will take to get to
work. In terms of jargon, we would say you were irrational if you did not account for the
snowfall.
Naturally, any investor would love to be able to predict the future, because if you can
predict future movements in asset prices, you could place the appropriate bet(s) and make
lots of money! The example that follows applies to stocks, but the same line of reasoning
can be applied to the bond and foreign exchange markets.
Suppose you were to try to predict tomorrow’s stock price today. Let us define the
information set available to you today as Ωt. Naturally, Ωt contains ALL information
that is available at time t, where the subscript t stands for today, the subscript t+1 stands
for tomorrow (next period in general).
We can write the following:
St+1 = f (Ωt):
{stated as: “Tomorrow’s stock price is a function of the (entire) information set available
today.”}
Naturally, we would want to use all the relevant information that is currently available in
predicting an asset price. Another way to say this is that it would be irrational if we did
not use all the relevant and available information that was available today (recall the
drive to work and ignoring the snowfall example). In fact, rational expectations
formation simply means that agents use all the information that is available today in
making their forecasts and thus, the forecast is optimal.
Predicting stock prices is very similar in that you rationally use all the relevant
information that is available to you when formulating your optimal forecast.
Predicting Stock Prices: A forecasting model
In the equation below, we could add a plethora of information that is available today.16
Naturally, we would want to use only the relevant information but how do we know what
16
In the conduct of monetary policy, the Fed monitors over 850,000 data series.
42
information is relevant and what information is not? In the equation below, ie stands for
expected interest rates, UR for unemployment rates, CC for consumer confidence, GDP
for gross domestic product, HS for housing starts, etc. Naturally, we could just keep on
adding variables to the model and thus, the forecasting model will become very complex
(Ωt is extremely large). Thankfully, we have the efficient market theory to make ‘life’
much easier.


S t 1  f ite , UR, CC, GDP, HS , 
THE EFFICIENT MARKET THEORY
Definition: If markets are efficient, then the current asset price has already incorporated
all the relevant and available information related to that asset. Furthermore, if
markets are efficient, then NEWS, as defined as the ‘unexpected,’ is immediately
reflected in the asset price. That is, asset prices process new information very quickly
and accurately (as in the snowfall and commute to work example).
Implications of the efficient market theory – since efficient markets imply that the
current asset price has already incorporated all the relevant and currently available
information, then it would be a waste of our time (fruitless) building fancy and
complex models to predict future asset prices, since today’s price has already
processed all the current, relevant and available information. The good news is
that it makes our forecasting equation very simple. The bad news is that in order to
predict changes the stock price, we would need to predict the unexpected; e.g., we
would need a crystal ball.17 Good luck with that!
Best forecasting equation assuming efficient markets:
St+1 = f (St)
In other words, the best predictor of tomorrow’s stock price is today’s stock price.
This fact supports the Efficient Market Theory which states that today’s stock price
contains all current and relevant information associated with the fundamental value of
the firm that is available today (it efficiently processes what is in Ωt). According to
efficient markets, the only reason that tomorrow’s stock price will differ from today’s
would be due to NEWS that occurs between today and tomorrow. So, in effect, the
NEWS is exactly equal to FE, which is defined as the forecast error. If there is no
news then FE=zero, and St = St+1.18
17
We would actually need two crystal balls, one to predict the NEWS and another to predict the (asset
price) reaction to the NEWS.
18
This statement ignores what is often referred to as the ‘equilibrium return’ in the ‘market.’ We know that
the bond market and the stock market are often substitutes for investors’ funds and thus, investing in the
stock market embodies a positive expected return.
43
S t 1  S t  FE
FE is the Forecast Error
Properties of the forecast error, assuming efficient markets (recall commute to work ex.).
1. The FE must have a mean of zero (we assume that good news is as likely as
bad news).
2. The FE must be independent of Ωt, where Ωt is the entire information set
that is available at time t. If FE is not independent, that implies that St is not
processing all the relevant and available information contained in Ωt, and thus,
violates the assumption of the efficient market theory.
3. The FE must be uncorrelated with past FE’s (serially uncorrelated). Another
way to state this is that NEWs is completely absorbed immediately so that
today’s forecast error does not help us predict tomorrows forecast error.
Recall specifically the commute to work example when there was a 1)
accident that resulted in being late for work and 2) the road construction.
Even though these was a large forecast error (we were really late for work),
does that forecast error help us predict the forecast error tomorrow. The
answer is no, the expected forecast error would again be zero, since rational
expectations formation ensures that we use all relevant information available.
TESTING THE EFFICIENT MARKET THEORY (EMT)
My goal in what follows is to give you a clue as to what many economists do for a living,
and that is, crunch numbers! A good amount of economic research is theoretical, and a
good amount of economic research is empirical. I much prefer empirical analysis, and
empirical analysis is often utilized to test (prove or disprove) economic theories.19
A Primer on Regression Analysis: A Consumption Function Example
The example below should be a little familiar to you from econ 004. Consumption
accounts for about 70% of GDP and is thus, very much studied by economists and
other economic actors interested in understanding and predicting economic activity.
In econ 004 you should, at the very least, recall that disposable income and the level
of consumption are tightly related, that is, if we have data on disposable income, then
we can make pretty good guesses as to the level of consumption. You should also
recall that consumption is also influenced by other factors as well. In what follows,
we develop a fairly realistic model of consumption, and then we simplify it when
interpreting the empirical results.
19
The proper jargon is thateconomists use econometrics to conduct empirical analysis. Keep in mind that
the results from empirical analyses are often contentious since the results are often sensitive to the
econometric techniques employed and/or the sample selection.
44
Consumption Function





 

C  f  Yd , WSM , WRE , r , EX , CC 


where:
Yd is personal disposable income
WSM is wealth in the stock market
WRE is wealth in real estate
r is the real interest rate
EX is the exchange rate where an increase implies the dollar is
appreciating
CC is consumer confidence
If we used all the variables (above) to predict consumption, the regression
equation will take the following form:
C  a1Yd  a2WSM  a3WRE  a4 r  a5 EX  a6 CC
The ai’s are sensitivity parameters. They tell us which direction and by how much
consumption is affected by changes in each of the variables. For instance, a1 is the
marginal propensity to consume (MPC), and tells us how sensitive consumption is to
changes in disposable income.20
Empirical Results – The Consumption Function
The set up: I estimate a consumption function that includes all the arguments: above
except for the exchange rate. The purpose of this example is to get you familiar with the
usefulness and interpretation of these empirical results.
Important features of regression output:
R2 represents the fit of the model; the higher the R2, the better the fit. The maximum
value for R2 is 1.00 and the minimum value is zero.
t-stats; if the absolute value of the t-stat exceeds 2.00, then we say that the associated
variable ‘belongs’ in the regression. t-stats basically test whether or not a coefficient is
significantly different than zero. If the t-stat exceeds two, then the coefficient is said to
be ‘statistically different than zero.’
Coefficient interpretation: We are typically interested in the sign of the coefficient (i.e.,
is it consistent with economic theory) as well as the size (this has to do with economic
20
You should recall the marginal propensity to consume from your principles classes and also that the
value of the MPC plays a critical role in determining the “multiplier” and thus, determining, in part, the
‘power’ of monetary and fiscal policy.
45
significance). Example: the MPC (a1) in the equation above should be positive, close to
one, and significant.21
Empirical Results on the consumption function
Equation estimated
C = a0 + a1 Yd + a2 r + a3 WSM + a4 WRE + a5 CC
Priors:
a1 is the marginal propensity to consume and should be somewhere around 0.9 in value
and very significant (high t-statistic) since we know there does exist a tight relationship
between consumption and disposable income.
a2 should be negative since the lower the real rate of interest, the less in pays to save (i.e.,
consume!).
a3 should be positive and significant – i.e., the wealth effect in terms of stock market
wealth.
a4 should be positive and significant – i.e., the wealth effect in terms of real estate wealth.
Note also that the claim is that a4 should be greater than a3, that is, dollar for dollar, the
wealth effect in real estate is great than the wealth effect in stocks since changes in the
former (real estate wealth) are perceived by economic agents to be more permanent and
stable than the latter (changes in stock market wealth ,’here today, gone tomorrow.’
a5 should be positive, the more confident you are, the more you consume!
Also, the overall fit should be quite good, since we know that there is tight relationship
between C and Yd
21
Most believe that the MPC in the US is quite high relative to the rest of the world with the empirical
estimates somewhere around 0.9, which implies that for each $1.00 increase in disposable income,
consumption will rise by 90 cents with the remaining 10 cents being saved.
46
Regression Output: 1977Q3 – 2006Q2
C = -115 + .788(Yd) – 10.486(r) + .032(WSM) + .078(WRE) + .516(CC)
Dependent Variable: Consumption
Method: Least Squares
Date: 04/23/07 Time: 19:04
Sample: 1977:3 2006:2
Included observations: 116
Variable
Coefficient
Std. Error
t-Statistic
Prob.
C
Yd(-1)
r (-1)
WSM(-1)
WRE(-1)
CC(-1)
-115.9823
0.787909
-10.48553
0.032054
0.078031
0.515951
31.78627
0.015640
2.276948
0.005459
0.005771
0.279377
-3.648819
50.37847
-4.605081
5.871944
13.52198
1.846792
0.0004
0.0000
0.0000
0.0000
0.0000
0.0675
R-squared
Adjusted R-squared
S.E. of regression
Sum squared resid
Log likelihood
Durbin-Watson stat
0.999554
0.999534
48.44171
258125.9
-611.6384
0.802282
Mean dependent var
S.D. dependent var
Akaike info criterion
Schwarz criterion
F-statistic
Prob(F-statistic)
4512.648
2243.232
10.64894
10.79136
49299.63
0.000000
We will interpret all of this in class!
47
Testing of the efficient market hypothesis
S = closing price of Google Stock. Daily Data from Yahoo!!
The data: Daily Data from August 20, 2004 – August 30, 2007 (790 observations)
700
600
500
400
300
200
100
0
8/19/04
5/26/05
3/02/06
12/07/06
9/13/07
Spot price of "goog"
Equation estimated
(1) St+1 = α + β St + FEt+1
which is, if you back date (go back one day ), the same as
(2) St = α + β St-1 + FEt
Equation (2) is the equation that is estimated: What are our priors?
α should be positive, yet small, and should represent the “equilibrium” market return
β should be one, implying that the difference between today’s and tomorrows spot price is (ignoring α
for a second) equal to FEt+1.
We are going to test here shortly the properties of FEt+1. Recall what they are?
1)
2)
3)
48
But first, let’s look at some results predicting tomorrow’s stock price with todays!
Check out the fit!
800
600
400
40
200
20
0
0
-20
-40
8/20/04
5/27/05
FE t+1
3/03/06
12/08/06
Actual Spot
Fitted Spot
Equation Estimated: St = α + β St-1 + FEt
Dependent Variable: GOOG
Method: Least Squares
Date: 10/09/07 Time: 23:01
Sample(adjusted): 8/20/2004 8/30/2007
Included observations: 790 after adjusting endpoints
Variable
Coefficient
Std. Error
t-Statistic
Prob.
C
GOOG(-1)
1.222339
0.998410
0.748589
0.001970
1.632858
506.8233
0.1029
0.0000
R-squared
Adjusted R-squared
S.E. of regression
Sum squared resid
Log likelihood
Durbin-Watson stat
0.996942
0.996938
6.919524
37729.29
-2648.094
1.911456
Mean dependent var
S.D. dependent var
Akaike info criterion
Schwarz criterion
F-statistic
Prob(F-statistic)
359.5207
125.0430
6.709099
6.720927
256869.8
0.000000
Note that β is very close to one and the fit is very good!
49
Lets try to improve the fit by adding more “Cats and Dogs” to the right hand side of the
equation.
Dependent Variable: GOOG
Method: Least Squares
Date: 10/09/07 Time: 22:55
Sample(adjusted): 8/27/2004 8/29/2007
Included observations: 784 after adjusting endpoints
Variable
Coefficient
Std. Error
t-Statistic
Prob.
C
GOOG(-1)
GOOG(-2)
GOOG(-3)
GOOG(-4)
GOOG(-5)
GOOG(-6)
YIELD10YR(-1)
YIELD10YR(-2)
YIELD10YR(-3)
YIELD10YR(-4)
YIELD10YR(-5)
YIELD10YR(-6)
2.977423
1.039484
-0.017874
-0.045028
0.079843
-0.071880
0.014510
1.818302
2.780892
-1.921781
-3.839147
1.075725
-0.365652
4.155744
0.036204
0.052057
0.052110
0.052103
0.052165
0.036306
5.814346
8.115906
8.096711
8.113601
8.157192
5.839052
0.716460
28.71193
-0.343355
-0.864088
1.532399
-1.377945
0.399663
0.312727
0.342647
-0.237353
-0.473174
0.131874
-0.062622
0.4739
0.0000
0.7314
0.3878
0.1258
0.1686
0.6895
0.7546
0.7320
0.8124
0.6362
0.8951
0.9501
R-squared
Adjusted R-squared
S.E. of regression
Sum squared resid
Log likelihood
Durbin-Watson stat
0.996877
0.996828
6.958013
37327.15
-2626.770
1.994819
Mean dependent var
S.D. dependent var
Akaike info criterion
Schwarz criterion
F-statistic
Prob(F-statistic)
360.8032
123.5483
6.734107
6.811451
20508.10
0.000000
Note – nothing helps! The only significant predictor is today’s stock price! Is this
consistent with the efficient market theory????
50
We now exam the properties of FE!
Let try to predict it with Ωt
Dependent Variable: FE
Method: Least Squares
Date: 10/10/07 Time: 07:15
Sample(adjusted): 8/27/2004 8/29/2007
Included observations: 784 after adjusting endpoints
Variable
Coefficient
Std. Error
t-Statistic
Prob.
C
GOOG(-1)
GOOG(-2)
GOOG(-3)
GOOG(-4)
GOOG(-5)
GOOG(-6)
YIELD10YR(-1)
YIELD10YR(-2)
YIELD10YR(-3)
YIELD10YR(-4)
YIELD10YR(-5)
YIELD10YR(-6)
2.977423
0.039484
-0.017874
-0.045028
0.079843
-0.071880
0.014510
1.818302
2.780892
-1.921781
-3.839147
1.075725
-0.365652
4.155744
0.036204
0.052057
0.052110
0.052103
0.052165
0.036306
5.814346
8.115906
8.096711
8.113601
8.157192
5.839052
0.716460
1.090603
-0.343355
-0.864088
1.532399
-1.377945
0.399663
0.312727
0.342647
-0.237353
-0.473174
0.131874
-0.062622
0.4739
0.2758
0.7314
0.3878
0.1258
0.1686
0.6895
0.7546
0.7320
0.8124
0.6362
0.8951
0.9501
R-squared
Adjusted R-squared
S.E. of regression
Sum squared resid
Log likelihood
Durbin-Watson stat
0.008677
-0.006752
6.958013
37327.15
-2626.770
1.994819
Mean dependent var
S.D. dependent var
Akaike info criterion
Schwarz criterion
F-statistic
Prob(F-statistic)
0.639936
6.934641
6.734107
6.811451
0.562386
0.872886
THE FIT IS TERRIBLE – R2 = 0.008677, We can’t predict the change in price of
Google between today and tomorrow with today’s information set.
51
NOW LETS TRY TO PREDICT FE WITH ITS PAST
Dependent Variable: FE
Method: Least Squares
Date: 10/10/07 Time: 07:14
Sample(adjusted): 8/30/2004 8/30/2007
Included observations: 784 after adjusting endpoints
Variable
Coefficient
Std. Error
t-Statistic
Prob.
C
FE(-1)
FE(-2)
FE(-3)
FE(-4)
FE(-5)
FE(-6)
0.606648
0.043617
0.028162
-0.022462
0.057552
-0.013378
-0.025935
0.253054
0.035867
0.035995
0.036045
0.036051
0.036096
0.036047
2.397310
1.216089
0.782389
-0.623170
1.596412
-0.370624
-0.719473
0.0168
0.2243
0.4342
0.5334
0.1108
0.7110
0.4721
R-squared
Adjusted R-squared
S.E. of regression
Sum squared resid
Log likelihood
Durbin-Watson stat
0.006995
-0.000673
6.938667
37408.74
-2627.626
2.004756
Mean dependent var
S.D. dependent var
Akaike info criterion
Schwarz criterion
F-statistic
Prob(F-statistic)
0.649273
6.936333
6.720985
6.762631
0.912226
0.485310
SAME KIND OF STORY, PAST FORECAST ERRORS DO NOT HELP PREDICT
FUTURE FORECAST ERRORS
ALL TOLD – IT IS IMPOSSIBLE TO PREDICT CHANGES IN THE SPOT PRICE OF
GOOGLE
52
Does FE have mean of zero???
2 00
Series: FE
Sample 8/20/2004 8/30/2007
Observations 790
1 50
1 00
50
Mean
Median
Maximum
Minimum
Std. Dev.
Skewness
Kurtosis
3.12E-14
-0.325965
35.95978
-37.51833
6.915138
0.055580
7.276715
Jarque-Bera
Probability
602.4621
0.000000
0
- 40
- 30
- 20
- 10
0
10
20
30
Summary: Our empirical results are consistent with the efficient market theory implying
that it is impossible to predict changes in stock prices, suggesting that the closing price
of coke follows a random walk.22
Another way to state this is that it is impossible to “beat the market.”
A very well known book regarding this topic is titled “A Random Walk Down Wall Street,” and is
authored by Burton G. Malkiel.
22
53
The Wall Street Journal tested this random walk proposition by comparing the return of
professional investors against a portfolio that was chosen by throwing darts. For more
information, see:
Journal's Dartboard Retires
After 14 Years of Stock Picks
By GEORGETTE JASEN
Staff Reporter of THE WALL STREET JOURNAL
Below is a graphic summarizing the results:
54
Most economists believe that all three of the asset markets; stocks, bonds, and foreign
exchange are quite efficient.
This article contains a discussion among two very prominent economists from the
University of Chicago about how efficient the ‘market’ may or may not be..
October 18, 2004
PAGE ONE
Stock Characters
As Two Economists
Debate Markets,
The Tide Shifts
Belief in Efficient Valuation
Yields Ground to Role
Of Irrational Investors
Mr. Thaler Takes On Mr. Fama
By JON E. HILSENRATH
Staff Reporter of THE WALL STREET JOURNAL
October 18, 2004; Page A1
For forty years, economist Eugene Fama argued that financial
markets were highly efficient in reflecting the underlying
value of stocks. His long-time intellectual nemesis, Richard
Thaler, a member of the "behaviorist" school of economic
thought, contended that markets can veer off course when
individuals make stupid decisions.
In May, 116 eminent economists and business executives gathered
at the University of Chicago Graduate School of Business for a
conference in Mr. Fama's honor. There, Mr. Fama surprised
some in the audience. A paper he presented, co-authored with
a colleague, made the case that poorly informed investors
could theoretically lead the market astray. Stock prices, the
55
paper said, could become "somewhat irrational."
Coming from the 65-year-old Mr. Fama, the intellectual father of the theory known
as the "efficient-market hypothesis," it struck some as an unexpected concession.
For years, efficient market theories were dominant, but here was a suggestion that
the behaviorists' ideas had become mainstream.
"I guess we're all behaviorists now," Mr. Thaler, 59, recalls saying after he heard Mr.
Fama's presentation.
Roger Ibbotson, a Yale University professor and founder of Ibbotson Associates Inc., an
investment advisory firm, says his reaction was that Mr. Fama had "changed his thinking
on the subject" and adds: "There is a shift that is taking place. People are recognizing that
markets are less efficient than we thought." Mr. Fama says he has been consistent.
The shift in this long-running argument has big implications for real-life problems,
ranging from the privatization of Social Security to the regulation of financial markets to
the way corporate boards are run. Mr. Fama's ideas helped foster
the free-market theories of the 1980s and spawned the $1 trillion
index-fund industry. Mr. Thaler's theory suggests policy makers
have an important role to play in guiding markets and individuals
where they're prone to fail.
Take, for example, the debate about Social Security. Amid a tight
election battle, President Bush has set a goal of partially privatizing
Social Security by allowing younger workers to put some of their
payroll taxes into private savings accounts for their retirements.
In a study of Sweden's efforts to privatize its retirement system, Mr.
Thaler found that Swedish investors tended to pile into risky
technology stocks and invested too heavily in domestic stocks. Investors had too many
options, which limited their ability to make good decisions, Mr. Thaler concluded. He
thinks U.S. reform, if it happens, should be less flexible. "If you give people 456 mutual
funds to choose from, they're not going to make great choices," he says.
If markets are sometimes inefficient, and stock prices a flawed measure of value,
corporate boards and management teams would have to rethink the way they compensate
executives and judge their performance. Michael Jensen, a retired Harvard economist
who worked on efficient-market theory earlier in his career, notes a big lesson from the
1990s was that overpriced stocks could lead executives into bad decisions, such as
massive overinvestment in telecommunications during the technology boom.
Even in an efficient market, bad investments occur. But in an inefficient market where
prices can be driven way out of whack, the problem is acute. The solution, Mr. Jensen
says, is "a major shift in the belief systems" of corporate boards and changes in
compensation that would make executives less focused on stock price movements.
56
Few think the swing toward the behaviorist camp will reverse the global emphasis on
open economies and free markets, despite the increasing academic focus on market
breakdowns. Moreover, while Mr. Fama seems to have softened his thinking over time,
he says his essential views haven't changed.
A product of Milton Friedman's Chicago School of thought, which stresses the virtues of
unfettered markets, Mr. Fama rose to prominence at the University of Chicago's Graduate
School of Business. He's an avid tennis player, known for his disciplined style of play.
Mr. Thaler, a Chicago professor whose office is on the same floor as Mr. Fama's, also
plays tennis but takes riskier shots that sometimes land him in trouble. The two men have
stakes in investment funds that run according to their rival economic theories.
Highbrow Insults
Neither shies from tossing about highbrow insults. Mr. Fama says behavioral economists
like Mr. Thaler "haven't really established anything" in more than 20 years of research.
Mr. Thaler says Mr. Fama "is the only guy on earth who doesn't think there was a bubble
in Nasdaq in 2000."
In its purest form, efficient-market theory holds that markets distill new information with
lightning speed and provide the best possible estimate of the underlying value of listed
companies (IT’S THE FUNDAMENTALS – RECALL THE EQUATION). As a result,
trying to beat the market, even in the long term, is an exercise in futility because it adjusts
so quickly to new information.
Behavioral economists argue that markets are imperfect because people often stray from
rational decisions. They believe this behavior creates market breakdowns and also buying
opportunities for savvy investors(THIS IN A SENSE IS ARGUING THAT YOU CAN
BEAT THE MARKET AT CERTAIN TIMES!) Mr. Thaler, for example, says stocks
can under-react to good news because investors are wedded to old views about struggling
companies.
For Messrs. Thaler and Fama, this is more than just an academic debate (WHAT DOES
MORE THAN ACADEMIC MEAN??). Mr. Fama's research helped to spawn the idea of
passive money management and index funds. He's a director at Dimensional Fund
Advisers, a private investment management company with $56 billion in assets under
management. Assuming the market can't be beaten, it invests in broad areas rather than
picking individual stocks. Average annual returns over the past decade for its biggest
fund -- one that invests in small, undervalued stocks -- have been about 16%, four
percentage points better than the S&P 500, according to Morningstar Inc., a mutual-fund
research company.
Mr. Thaler, meanwhile, is a principal at Fuller & Thaler, a fund management company
with $2.4 billion under management. Its asset managers spend their time trying to pick
stocks and outfox the market (TRYING TO PICK WINNERS!) The company's main
growth fund, which invests in stocks that are expected to produce strong earnings growth,
57
has delivered average annual returns of 6% since its inception in 1997, three percentage
points better than the S&P 500.
Mr. Fama came to his views as an undergraduate student in the late 1950s at Tufts
University when a professor hired him to work on a market-forecasting newsletter. There,
he discovered that strategies designed to beat the market didn't work well in practice. By
the time he enrolled at Chicago in 1960, economists were viewing individuals as rational,
calculating machines whose behavior could be predicted with mathematical models.
Markets distilled these differing views with unique precision, they argued.
"In an efficient market at any point in time the actual price of a security will be a good
estimate of its intrinsic value," Mr. Fama wrote in a 1965 paper titled "Random Walks in
Stock Market Prices." Stock movements were like "random walks" because investors
could never predict what new information might arise to change a stock's price. In 1973,
Princeton economist Burton Malkiel published a popularized discussion of the
hypothesis, "A Random Walk Down Wall Street," which sold more than one million
copies.
Mr. Fama's writings underpinned the Chicago School's faith in the functioning of
markets. Its approach, which opposed government intervention in markets, helped
reshape the 1980s and 1990s by encouraging policy makers to open their economies to
market forces. Ronald Reagan and Margaret Thatcher ushered in an era of deregulation
and later Bill Clinton declared an end to big government. After the collapse of
Communist central planning in Russia and Eastern Europe, many countries embraced
these ideas.
As a young assistant professor in Rochester in the mid-1970s, Mr. Thaler had his doubts
about market efficiency. People, he suspected, were not nearly as rational as economists
assumed.
Mr. Thaler started collecting evidence to demonstrate his point, which he published in a
series of papers. One associate kept playing tennis even though he had a bad elbow
because he didn't want to waste $300 on tennis club fees. Another wouldn't part with an
expensive bottle of wine even though he wasn't an avid drinker. Mr. Thaler says he
caught economists bingeing on cashews in his office and asking for the nuts to be taken
away because they couldn't control their own appetites (THESE ARE SUPPOSEDLY
EXAMPLES OF IRRATIONAL BEHAVIOR)
Mr. Thaler decided that people had systematic biases that weren't rational, such as a lack
of self-control (LACK OF SELF CONTROL – THALER WANTS TO EXPLOIT
THIS!!). Most economists dismissed his writings as a collection of quirky anecdotes,
so Mr. Thaler decided the best approach was to debunk the most efficient market of
them all -- the stock market.
Small Anomalies
58
Even before the late 1990s, Mr. Thaler and a growing legion of behavioral finance
experts were finding small anomalies that seemed to fly in the face of efficientmarket theory. For example, researchers found that value stocks, companies that
appear undervalued relative to their profits or assets, tended to outperform growth
stocks, ones that are perceived as likely to increase profits rapidly. If the market was
efficient and impossible to beat, why would one asset class outperform another?
(Mr. Fama says there's a rational explanation: Value stocks come with hidden risks
and investors are rewarded for those risks with higher returns.)
Moreover, in a rational world, share prices should move only when new information hit
the market. But with more than one billion shares a day changing hands on the New York
Stock Exchange, the market appears overrun with traders making bets all the time.
Robert Shiller, a Yale University economist, has long argued that efficient-market
theorists made one huge mistake: Just because markets are unpredictable doesn't mean
they are efficient. The leap in logic, he wrote in the 1980s, was one of "the most
remarkable errors in the history of economic thought." Mr. Fama says behavioral
economists made the same mistake in reverse: The fact that some individuals might be
irrational doesn't mean the market is inefficient (IN OTHER WORDS, AS LONG AS
THE MAJORITY OF INVESTORS ARE RATIONAL THEN MARKETS WILL BE
EFFICIENT – ADD IN THE FOOTBALL BETTING THESIS)
Shortly after the stock market swooned, Mr. Thaler presented a new paper at the
University of Chicago's business school. Shares of handheld-device maker Palm Inc. -which later split into two separate companies -- soared after some of its shares were sold
in an initial public offering by its parent, 3Com Corp., in 2000, he noted. The market
gave Palm a value nearly twice that of its parent even though 3Com still owned 94% of
Palm. That in effect assigned a negative value to 3Com's other assets. Mr. Thaler titled
the paper, "Can the Market Add and Subtract?" It was an unsubtle shot across Mr. Fama's
bow. Mr. Fama dismissed Mr. Thaler's paper, suggesting it was just an isolated anomaly.
"Is this the tip of an iceberg, or the whole iceberg?" he asked Mr. Thaler in an open
discussion after the presentation, both men recall (HIGH BROW INSULT FOR SURE!!)
Mr. Thaler's views have seeped into the mainstream through the support of a number of
prominent economists who have devised similar theories about how markets operate. In
2001, the American Economics Association awarded its highest honor for young
economists -- the John Bates Clark Medal -- to an economist named Matthew Rabin who
devised mathematical models for behavioral theories (I WONDER IF THESE
MATHEMATICAL MODELS FAILED RECENTLY??) . In 2002, Daniel Kahneman
won a Nobel Prize for pioneering research in the field of behavioral economics. Even
Federal Reserve Chairman Alan Greenspan, a firm believer in the benefits of free
markets, famously adopted the term "irrational exuberance" in 1996 (PARSE THIS
TERM! RECALL THALER ARGUES THAT AT TIMES, PEOPLE EXPERIENCE
LACK OF CONTROL!)
59
Andrew Lo, an economist at the Massachusetts Institute of Technology's Sloan School of
Management, says efficient-market theory was the norm when he was a doctoral student
at Harvard and MIT in the 1980s (OF COURSE IT WAS THE NORM!!! )"It was drilled
into us that markets are efficient. It took me five to 10 years to change my views." In
1999, he wrote a book titled, "A Non-Random Walk Down Wall Street."
In 1991, Mr. Fama's theories seemed to soften. In a paper called "Efficient Capital
Markets: II," he said that market efficiency in its most extreme form -- the idea that
markets reflect all available information so that not even corporate insiders can beat
it -- was "surely false." Mr. Fama's more recent paper also tips its hand to what
behavioral economists have been arguing for years -- that poorly informed investors
could distort stock prices.
But Mr. Fama says his views haven't changed. He says he's never believed in the
pure form of the efficient-market theory. As for the recent paper, co-authored with
longtime collaborator Kenneth French, it "just provides a framework" for thinking
about some of the issues raised by behaviorists, he says in an e-mail. "It takes no
stance on the empirical importance of these issues."
The 1990s Internet investment craze, Mr. Fama argues, wouldn't have looked so crazy if
it had produced just one or two blockbuster companies, which he says was a reasonable
expectation at the time. Moreover, he says, market crashes confirm a central tenet of
efficient market theory -- that stock-price movements are unpredictable. Findings of other
less significant anomalies, he says, have grown out of "shoddy" research.
Defending efficient markets has gotten harder, but it's probably too soon for Mr. Thaler
to declare victory. He concedes that most of his retirement assets are held in index funds,
the very industry that Mr. Fama's research helped to launch. And despite his research on
market inefficiencies, he also concedes that "it is not easy to beat the market, and most
people don't." (PUT YOUR MONEY WHERE YOUR MOUTH IS AND NO KIDDING,
IT IS TOUGH TO BEAT THE MARKET!)
Write to Jon E. Hilsenrath at [email protected]
URL for this article:
http://online.wsj.com/article/0,,SB109804865418747444,00.html
Hyperlinks in this Article:
(1) mailto:[email protected]
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60
Using technical analysis
Although there are many, these Bollinger Bands examples will give us a good feel
for the notion of technical analysis. Note that technical analysis is completely
removed from the fundamentals, which are based on expected profits and interest
rates. As such, “technical analysts” are often referred to as “chart watchers,” as the
following, as the following analysis demonstrates.
Bollinger bands are a very useful and popular technique in predicting stock
movements. They provide many useful signals, such as whether a price is relatively high
or low, whether a current trend is likely to continue or reverse, and market volatility.
What separates Bollinger bands from most other price channeling techniques is in the
way the bands are derived. Rather than setting the channels at a fixed percentage above
and below the moving average, Bollinger bands are plotted two standard deviations
above and below the moving average. This is done to ensure that 95% of price data will
fall between the bands. It also ensures that the bands are sensitive to volatility.
When speaking of market trends, Bollinger bands can provide a signal based on
both penetrations of the bands, as well as width of the bands. A penetration of either
band, high or low, implies a continuation of the current trend. When the bands move far
apart relative to the norm, the current trend may be ending. If the bands are unusually
tight, it may be a sign of a new trend beginning.
Price targets can also be achieved through the use of Bollinger bands. For
example, if a price is moving along the lower band and proceeds to cross above the
moving average, the upper band will become a price target. Of course, the opposite also
applies.
Finally, momentum can also be checked through the use of Bollinger bands. If a
price is seen to move above or below a band, and on a subsequent move, fails to reach the
band for a second time, there is a good chance that momentum is being lost and a reversal
may be in the works. It is important to note that even if the subsequent move reaches a
higher or lower price, it must still penetrate the respective band in order to indicate
lasting momentum.
61
Bollinger Bands – Test One
Above we see a current six-month chart of Dell Inc. (DELL) The standard set up
for use of Bollinger bands includes a six-month chart, along with a 20-day moving
average. Starting from the left portion of the graph, you can see the sell signals, indicated
by red arrows. As you can see, as the price bars pass through the bottom band during
mid-March, a trend may be starting. In addition, the bands are fairly tight during this time
period. As we progress into the early and middle of April, the lower band continues to be
penetrated by the price, confirming the downtrend. As the bands widen into May, the
price begins to stabilize and then rise. Dell’s price then crosses through the moving
average and continues up through the upper band. However, it does not continue to hug
the band, so no uptrend can be confirmed. As the bands become very wide through late
May and early June, the price evens out. Two more potential buy signals are seen in June
and July, but once again, only for a couple of days at a time. During this time, attention
should also be focused on the bands, which are once again becoming tighter.
Looking back on what was just covered; it is safe to say that the rules regarding
Bollinger bands seem to work just as described. For each change in price, the bands
properly adjusted and did not provide any erratic signals. That being said, the buy and
sell signals shown on the graph should not be immediately followed as soon as a band is
penetrated. While each instance would provide a profit if followed, most would be
minimal.
Using the rules provided by Bollinger bands, it would seem quite easy to predict
the short-term future for Dell’s stock price. However, there are no definitive movements
currently in progress. We can still take a look at what the chart is showing us and try to
make an educated guess. The bands are beginning to widen once again, implying less
volatility. The price has recently dropped below the moving average and seems to be
staying somewhat near the lower band. The price drop does not appear to look
dramatically sharp, and looking at similar trends and price levels throughout the past six
months, it seems as though there will be no drastic price changes in the near future. But,
62
if the price continues to descend throughout the following week and eventually hugs the
bottom band, there is a good chance we may be seeing the start of a downtrend worth
moving in on with a short-position.
Bollinger Bands – Test Two
To get a better view of the accuracy and potential gains associated with Bollinger
bands, let’s take a look at some more examples and see how they fare. The chart below
depicts the current state of Ford Motor Company’s (F) stock. It provides a good look at a
consistent downtrend beginning in late February through mid-April. Taking a short
position at first sign of a downtrend on February 25 at a price of 13.00 and riding it out
through April 22 at 9.89 would provide a change of 23.92%. Comparing this change to
the S&P 500 rate of 4.89%, we can undoubtedly say that we would have beaten the
market. Also interesting to point out is the single buy signal, which if followed would
provide a false signal, and thus a loss.
Bollinger Bands – Test Three
The next chart shows the previous six months of International Business Machines
(IBM) stock and a good opportunity to profit from both the drop and rise in price during
this time. If a short position was taken at the first sell signal on March 22 at a price of
89.50 and held onto until it was clear that the trend was over on, say, April 26 at 74.65,
then it would clearly show a market beating opportunity (-16.59% change). During the
same time period, the S&P 500 was growing at a rate of -1.70%, so it is clear that
following the bands would have paid off.
In the second part, taking a long position at the sign of an uptrend starting July 11
at a price of 78.96 and selling off on July 22 (84.44) once it appears the trend is over,
another profitable opportunity is seen. A change of 6.94% is seen, as compared to the
S&P 500 of 1.17%.
63
Bollinger bands can provide information about the market that many other
technical strategies cannot. When seeking information regarding volatility, the bands are
second to none. Furthermore, once locked into a trend, Bollinger bands can give us a very
good idea of what to expect in the near future. One needs to use caution when studying
Bollinger bands however, as prices movements which penetrate the outer bands do not
always send the correct signal. Instead, it is the movement that occurs near the outer
bands that is most important, especially when the movements are consistent. That is
where the real strength of Bollinger bands shines through.
Key Terms
1. Stock price determination formula.
2. The efficient market theory.
3. Autoregressive properties.
4. Technical analysis.
5. Jawboning.
6. Price to earnings ratio.
7. Earnings per share.
8. Inside information.
9. Random walk.
10. Two Crystal Balls
11. Bollinger bands
64
Appendix: Another test of the efficient market theory
Data: Closing price of Coke – daily data, 1970 – 1999.
The graph below depicts that data that will be used to test the efficient market
hypothesis.
160
140
120
100
80
60
40
20
1/02/70
9/02/77
5/03/85
1/01/93
CLOSE - Coke
As we know, according to the efficient market theory, the best predictor of tomorrow’s
(coke) stock price is today’s (coke) price.
Our regression model takes the following form:
St+1 = α0 + α1St
Priors: If the efficient market theory holds, we should 1) see a good fit (a high R2), 2)
an α1 near 1 and significant. We also need to obtain the forecast errors and examine
them to see if they embody the characteristics previously discussed: the FE must have
a mean of zero, be independent of Ωt where Ωt the entire information set that is
available at time t, and the FE must be uncorrelated with past FE’s (serially
uncorrelated).
65
Results:
Dependent Variable: Coke
Method: Least Squares
Date: 10/24/04 Time: 11:20
Sample(adjusted): 1/05/1970 1/25/1999
Included observations: 7581 after adjusting endpoints
Variable
Coefficient
Std. Error
t-Statistic
Prob.
C
Coke(-1)
0.113314
0.998174
0.047963
0.000689
2.362514
1449.142
0.0182
0.0000
R-squared
Adjusted R-squared
S.E. of regression
Sum squared resid
Log likelihood
Durbin-Watson stat
0.996404
0.996403
1.673779
21232.84
-14660.82
2.008938
Mean dependent var
S.D. dependent var
Akaike info criterion
Schwarz criterion
F-statistic
Prob(F-statistic)
63.79229
27.90979
3.868308
3.870138
2100012.
0.000000
St+1 = 0.11 + 0.9981St
R2 = 0.996
So the results are consistent with our priors. The fit is terrific with the R2 approaching
one and the coefficient on today’s coke price (α1) also approaching one.
66
Tests on the forecast errors:
Test 1: Mean of zero?
The chart below depicts some statistics on the forecast error. According efficient
markets, the forecast error should have a mean of zero. As you can see from the results,
the forecast error has a mean very close to zero.
5000
Series: Close (t) - Close (t-1)
Sample 1/05/1970 1/25/1999
Observations 7581
4000
3000
2000
Mean
Median
Maximum
Minimum
Std. Dev.
Skewness
Kurtosis
-0.003166
0.000000
6.000000
-82.75000
1.674444
-23.14830
962.4173
Jarque-Bera
Probability
2.91E+08
0.000000
1000
0
-75.0 -62.5 -50.0 -37.5 -25.0 -12.5 0.0
67
Test 2: Independent of Ωt ?
To conduct this test correctly, we would need to include virtually and infinite amount of
variables on the right hand side of the equation (all the information, relevant or not) that
were available at time t. Since this is unreasonable, I have decided to include the current
and past values of coke to see if they can possibly predict tomorrow’s forecast error.
Priors: the ‘Fit’ as measured by R2 should be very poor and all the coefficients should be
insignificantly different from zero.
Results:
Dependent Variable: Forecast Errors
Method: Least Squares
Date: 03/14/05 Time: 14:08
Sample (adjusted): 1/09/1970 1/25/1999
Included observations: 7577 after adjustments
Variable
Coefficient
Std. Error
t-Statistic
Prob.
C
CLOSE(t)
CLOSE(t-1)
CLOSE(t-2)
CLOSE(t-3)
CLOSE(t-4)
-0.002946
-0.004620
-0.002241
-0.006108
0.011725
0.001287
0.048054
0.011493
0.016200
0.016200
0.016200
0.011492
-0.061314
-0.401970
-0.138322
-0.377004
0.723806
0.112013
0.9511
0.6877
0.8900
0.7062
0.4692
0.9108
R-squared
Adjusted R-squared
S.E. of regression
Sum squared resid
Log likelihood
Durbin-Watson stat
0.000237
-0.000423
1.674370
21225.40
-14653.76
2.000054
Mean dependent var
S.D. dependent var
Akaike info criterion
Schwarz criterion
F-statistic
Prob(F-statistic)
-3.49E-05
1.674016
3.869542
3.875032
0.359482
0.876388
As we can see from the regression results, trying to predict tomorrow’s forecast error
with information available today is fruitless, consistent with the efficient market theory.
The R2 is extremely low (.000237) suggesting a very poor fit of this model. None of the
lagged closing prices of Coke are significant, implying that they contain no useful
information in predicting the forecast error.
68
Test 3: The forecast errors are serially uncorrelated (past forecast errors do not
help predict future forecast errors).
Priors: Fit should be poor (as measured by the R2) and all the coefficients should be
insignificantly different than zero.
Results:
Dependent Variable: FE(t+1)
Method: Least Squares
Date: 10/25/04 Time: 11:11
Sample(adjusted): 1/19/1970 1/25/1999
Included observations: 7571 after adjusting endpoints
Variable
Coefficient
Std. Error
t-Statistic
Prob.
C
FE(t)
FE(t-1))
FE(t-2)
FE(t-3)
FE(t-4)
FE(t-5)
FE(t-6)
FE(t-7)
FE(t-8)
FE(t-9)
-0.003859
-0.005667
-0.008836
-0.014633
-0.002607
-0.026925
0.004066
-0.019810
-0.004913
-0.003631
-0.021146
0.019250
0.011499
0.011499
0.011499
0.011498
0.011497
0.011498
0.011498
0.011499
0.011498
0.011498
-0.200447
-0.492847
-0.768422
-1.272572
-0.226782
-2.341823
0.353615
-1.723006
-0.427293
-0.315763
-1.839080
0.8411
0.6221
0.4423
0.2032
0.8206
0.0192
0.7236
0.0849
0.6692
0.7522
0.0659
R-squared
Adjusted R-squared
S.E. of regression
Sum squared resid
Log likelihood
Durbin-Watson stat
0.001850
0.000529
1.674927
21208.67
-14642.17
2.000118
Mean dependent var
S.D. dependent var
Akaike info criterion
Schwarz criterion
F-statistic
Prob(F-statistic)
-0.003533
1.675370
3.870868
3.880940
1.401002
0.172788
The results above are also consistent with the properties of the FE according to the
efficient market theory as the model fits the data very poorly (R2 = 0.001850).
Summary: Our empirical results are consistent with the efficient market theory implying
that it is impossible to predict changes in stock prices, suggesting that the closing price
of coke follows a random walk.23
A very well known book regarding this topic is titled “A Random Walk Down Wall Street,” and is
authored by Burton G. Malkiel.
23
69
Chapter 4: A Review of the Principles of Macroeconomics with
some Rigor!
In Econ 004 or equivalent, you should have ‘gotten a clue’ as to what makes the US
economy tick! This Chapter is designed to make sure you have that clue and then
some. We start with the aggregate demand side of the economy and then move on to
the aggregate supply side of the economy. Note that policy makers, both Fiscal
Policy makers and Monetary Policy makers are considered to be aggregate demand
side managers, that is, changes in these policies are designed to shift the aggregate
demand (AD) curve. Thus, to really understand how these policies work, we need to
really understand what makes the AD side of the economy tick.
I. The Aggregate Demand (AD) Side of the Economy
Think of AD as being summarized by the following:
AD = C + I + G + (X-M)
Where:
C = Personal Consumption Expenditures (henceforth: Consumption)
I = Gross private domestic investment (henceforth: Investment)
G = Government Purchases
(X-M) = Net Exports (exports minus imports)
Consumption (Personal Consumption Expenditures)
Consumption is by far the biggest component of aggregate demand, accounting for
slightly over 70% of real GDP (as of the second quarter of 2006). So we will spend a
dis-proportionate amount of time understanding what make consumption tick. Before
discussing in detail the determinants of consumption, we begin with its elements.
Elements of Consumption
1) Non-durable Goods These are the goods that are tangible but are not meant to last
over three years. Items such as food, clothing, and textbooks fall into the non-durable
good element of consumption. According to 2006 data, non-durable good consumption
accounted for 29% of total consumption.
2) Durable Goods – These goods are meant to last three years or more. Items such as
home appliances, automobiles, furniture, and other “big ticket” items fall into the durable
good category of consumption. Durable goods statistics are closely monitored by
economists as a gauge of current and future economic activity. For example, economists
believe that a fall in durable goods purchases may signal a weaker economy ahead in the
following way: If consumers are uncertain and insecure about future income, one of the
70
first signals would be a drop off in durable goods consumption (big ticket items). That is,
consumers will hold off buying a new car, a new washer and dryer, etc. Also important,
the demand for durable goods are thought to be interest sensitive and this provides us
with a link between durable goods consumption and monetary policy (more on this
below). According to 2006 data, durable goods consumption accounted for 15% of total
consumption.
3) Services – Services account for the biggest proportion of consumption. According to
2006 data, the service element of consumption accounted for 59% of total consumption.
Services are non-tangible. You are consuming a service by taking this class since the
human capital enhancement is non-tangible. Going to a concert, a football game, getting
a haircut, etc. are all services. According to 2006 data, services accounted for 56 % of
consumption. You have probably heard that the US is a “service based economy,” a
phrase that is certainly consistent with the data. This has not always been the case. For
example, in 1950, services accounted for only a third (33%) of consumption. Since 1950,
we have gradually moved from a goods producing economy to a service based economy.
Figure 1 (below) shows this movement from a goods producing nation to being service
based.
60
Services as Percent of Consumption
50
40
30
Durable Goods as percent of Consumption
20
50
55
60
65
70
75
80
85
90
95
00
FIGURE 1
71
Figure 2 (below) depicts consumption as a percentage of GDP since 1980.24 Again, we
can see how important consumption has become in terms of its share of GDP.
Consumption as a Percentag e of GDP
72
70
68
66
64
62
60
80
82
84
86
88
90
92
94
96
98
00
02
FIGURE 2
Observations:


Most recently, consumption accounts for approximately 70% of GDP! It is no
surprise that consumption and the determination of consumption receives so much
attention in economic research.
We will discuss the determinants of consumption shortly.
Investment (Gross Private Domestic Investment)
Investment is a very important component of aggregate demand since 1) investment
today plays a large role in determining future productivity growth rates25 and 2)
investment expenditures are thought to be the most interest rate sensitive of all the GDP
components (i.e., C + I + G + X-M) and thus, is thought to be the major channel in which
monetary policy is supposed to work. Naturally, investment in technology is a big
factor underlying the surge in worker productivity since 1995.26
24
Source: The Federal Reserve Economic Database (FRED): Federal Reserve Bank of St. Louis. The data
are quarterly (1980:1 – 2002:3).
25
We will learn that increases in productivity growth rates are the key to increasing living standards.
26
This surge in productivity growth rates is the cause of what is referred to as the ‘new economy.’
72
Elements of Investment
1) Residential Structures – Naturally, new home construction is quite sensitive to the
level of interest rates. When I arrived at Penn State in the summer of 2003, I was very
lucky because I was buying a house and fixed rate mortgages hit a low. The following
graph depicts the movement of adjustable and fixed rate mortgages from 2002 – 2006.
Not surprisingly, rates have been rising given that the Fed has had raised interest rates 17
times in a row beginning June, 2004. The idea that the Fed can or cannot influence long
term interest rates is a vital part of this class. Note also our previous discussion about
durable goods consumption and how durable goods are also thought to be interest rate
sensitive. Naturally, when one buys a new home, they typically fill it up with durable
goods.
2) Non Residential Structures – These
include all structures that are nonresidential, often referred to as
commercial real estate. Naturally, the
non-residential structures element of
investment is thought to be interest rate
sensitive as well (as was the case with
residential structures).
3) Tools, Equipment, and Software –
This element of investment is very
important since it plays such a critical role in
determining future growth rates in worker productivity. The graph below shows that this
portion of investment was very weak during the 2001 recession. Note that the official
recession dates of the 2001 recession were from March – November 2001.27 Beginning
in 2003 the growth rates for equipment and software, both ‘high’ and ‘non-high’ tech
have picked up which bodes well for future worker productivity growth rates.28
4) Inventories – This element of investment is also closely watched by economists. For
example, an increase in inventories can be intentional or unintentional. If the increase in
inventories is intentional, then firms expect stronger demand in the future and in order to
satisfy the increased demand, they will build up inventories (increasing employment).
This being the case, a build up of inventories suggests a strong economy moving forward.
The National Bureau of Economic Research (NBER) is responsible for identifying ‘official’ recession
dates.
28
There are two strong arguments as to why investment in equipment and software fell during 2000 and
2001. First, the economy showed signs of slowing in the latter part of 2000 and as we have already
mentioned, the US economy ‘fell’ into a recession during 2001 and to the extent that real business fixed
investment is pro-cyclical (most would agree that it is), the state of the economy helps explain this
weakness. The second argument is Y2K in that firms significantly built up their equipment and software
and thus, a slow down after this build up is very natural.
27
73
Conversely, if the increase in inventories is unintentional, then firms realize
(unintentional) excess inventories and will cut back on production and thus lay off
workers. This being the case, this build up of inventories suggests a weaker economy
moving forward. How do policymakers (primarily the Fed) find out whether or not a
building of inventories is intentional or not, simple, they ask!29
The figure below depicts investment as a percentage of GDP since 1980.30
29
During a visit at the Federal Reserve Board (FRB) in Washington DC in March, 2005, I chatted with the
chief of staff for hours and he made very clear to me that the Fed stays in very close contact with the
private sector in order to stay on the frontier of current and expected economic activity and thus, it becomes
very natural for the Fed to ask questions like “Is the build up of your inventories intentional or not?”
30
Source: The Federal Reserve Economic Database (FRED): Federal Reserve Bank of St. Louis. The data
are quarterly (1980:1 – 2002:3).
74
Investment as a Percentag e of GDP
19
18
17
16
15
14
13
80
82
84
86
88
90
92
94
96
98
00
02
Observations:


Investment is pro-cyclical. That is, investment as a percentage of GDP is related
to the stage of the business cycle. For example, investment falls as a percentage
of GDP when the economy is in recession. Recall the dates of recent US
recessions (1980 – 1982, 1990-1991, and the most recent recession beginning in
March of 2001).
Investment as a percentage of GDP rises when the economy is growing strong. In
particular, note the increase in investment as a percentage of GDP during the ‘new
economy’ years (1996-2000).
Government Purchases – By Government Purchases we mean just that, purchases and
not spending. For example, transfer payments such as social security expenditures,
welfare payments, and unemployment insurance are not included in government
purchases.
Officially, the Bureau of Economic Analysis (BEA) categorizes Government Purchases
into two components: consumption and investment. The figure below depicts this
information since 2000.
A few comments are in order. First, Fiscal policy is one way policymakers can fight
recession (the other of course is monetary policy) and thus, we would expect the growth
rate of real government expenditures to rise during 2001 and beyond, assuming that the
Fiscal authorities were trying to ‘fight’ the 2001 recession. Additionally, we would
expect these expenditures to rise given the war in Iraq.
75
The figure below depicts government purchases as a percentage of GDP since 1980.31
Government Purchases as a Percentag e of GDP
22
21
20
19
18
17
80
82
84
86
88
90
92
94
96
98
00
02
31
Source: The Federal Reserve Economic Database (FRED): Federal Reserve Bank of St. Louis. The data
are quarterly (1980:1 – 2002:3).
76
Observations:


Government purchases as a percentage of GDP has fallen since the early 1990s.
This fact, along with very strong rates of economic growth during the latter half
of the 1990s helps us understand the movement from federal budget deficits to
federal budget surpluses during this time.
Most recently, government purchases are rising as a percentage of GDP, perhaps
reflecting the expansionary fiscal policy conducted by fiscal authorities in
reaction to the US recession that began in March of 2001.
Net Exports – Net exports are simply defined as the value of exports (from US) minus
the value of imports (to the US). Net exports have been negative for some time now
implying that the value of imports exceeds the value of exports – i.e., we have a trade
deficit. We will discuss why this is so below.
Net Exports as a Percent of GDP
1
0
-1
-2
-3
-4
-5
80
82
84
86
88
90
92
94
96
98
00
02
Observation:
 Throughout the 1990s, net exports have become ‘more of a negative’ in terms of
its percentage of GDP. Two determinants of this phenomenon are worthy of
noting: 1) The US economy was growing faster than the economies of our trading
partners during this time (especially Japan). In simple terms, this difference in
economic growth rates implies that our (the US) appetite for purchasing foreign
goods exceeds the foreign economies’ appetite for purchasing US goods. Result:
imports exceed exports leading to a larger trade deficit. 2) Since the US economy
was performing so well, investors invested in US stocks and bonds. This influx of
capital flows strengthened the value of the US dollar, relative to the currencies of
our trading partners. The stronger US dollar results in cheaper US imports and
raises the price of US exports, again, implying a larger trade deficit.
77
Modeling the Components of Aggregate Demand
Modeling Consumption
As noted above, consumption is by far the biggest component of aggregate demand.
What determines consumption? The first thing that comes to my mind is income,
namely, disposable income.32 The graph below depicts the tight relationship between
disposable income and consumption.33
8000
6000
Personal Disposable Income
Consumption
4000
2000
0
80
82
84
86
88
90
92
94
96
98
00
02
Question: What does the vertical distance between personal disposable income and
consumption represent?
But there must be other determinants, besides disposable income, that influence the level
of consumption. Can you think of any? Suppose you inherit a $100,000. Would your
level of consumption change?
Disposable income is the income left over after all taxes and benefits are subtracted from your ‘gross
income.’
33
Source: The Federal Reserve Economic Database (FRED): Federal Reserve Bank of St. Louis. The data
are quarterly (1980:1 – 2002:3).
32
78
The Consumption Function
In the space below, draw a graph with the level of consumption expenditures on the
vertical axis and disposable income on the horizontal axis.
If we were to attempt to predict the level of consumption in the economy we would
certainly focus on disposable income. In terminology, consumption is said to be a
function of disposable income. In terms of notation:
C = f (Yd) ; where C stands for consumption, f implies “is a function of”; and Yd denotes
disposable income.
But we know there are other determinants of consumption, so our model of consumption
is too simple. Can you think of other factors that influence consumption? We have
already mentioned at least two. Recall the durable goods component of consumption, the
so-called “big ticket” items. We argued that demand for durable goods depends, in part,
on the cost of borrowing, that is, the level of interest rates. Naturally, this relationship
between durable goods consumption and the level of interest rates should be negative,
that is, if the cost of borrowing falls, you will be more likely to borrow $ to finance the
purchase of a durable good. Think of your willingness to purchase a new car. Is your
decision whether to purchase a new car influenced by the cost of financing that car? You
bet! In conclusion, the lower the interest rate, the higher the level of consumption
expenditures.
Exercise - Show how lower interest rates influence the consumption function that
you have drawn above. Be sure to interpret carefully: At any given level of
disposable income, people are willing to consume more. Be sure to be able to
explain the converse: the influence that higher interest rates have on the
consumption function.
79
Updating the Consumption Function
C = f (Yd, r ): where r represents the real rate of interest.34
The other influence on consumption, besides changes in disposable income and interest
rates that we mentioned before, is changes in your wealth. If you inherit $100,000, then
you will probably consume more even if your disposable income and the level of interest
rates remain the same. Put differently, an increase in your wealth, all else constant, will
result in you increasing your consumption expenditures. The connection between changes
in wealth and its influence on consumption is a very current and active area in economic
research. We consider two forms of wealth: 1) Wealth changes due to changes in the
value of the stock market (denoted WSM), and 2) Wealth changes due to changes in the
value of real estate (denoted WRE). One ‘thing’ that economists investigate is to
estimate the sensitivity of consumption to changes in these two forms of wealth (most
often referred to as the “Wealth Effect in consumption.”)
Please read the article below “Swings in Stock, Homes Values Present
Challenges to the Fed, Greenspan Says”
August 31, 2001
Economy
Swings in Stock, Homes Values Present
Challenges to the Fed, Greenspan Says
A WALL STREET JOURNAL ONLINE News Roundup
WASHINGTON -- Federal Reserve Chairman Alan Greenspan said Friday
that the recent tendency of home prices to rise even as stock prices are
plummeting is blunting the central bank's ability to fine-tune U.S. economic
performance.
The country must develop better ways of measuring its economy, Mr. Greenspan said in a
speech delivered at the Fed's annual retreat in Wyoming's Grand Tetons. Mr. Greenspan
didn't discuss the near-term outlook for the economy.
Consumer spending accounts for two-thirds of all economic activity and has
been a main force propping up the struggling economy. The yearlong economic
slowdown has led to a slide in the stock market. But the value of homes, for the
most part, have gone up. That divergence "could have significant implications"
There is a very important difference between nominal interest rates (the rate that you typically ‘hear’
referred to in the press, newspapers, etc.,) and real interest rates. We will address this important distinction
at a later point in the course.
34
80
for U.S. economic growth, Mr. Greenspan said. The task before policy makers
is to try to better understand how gains or losses on stock investments and in
home values affect consumers' willingness to spend.
"There can be little doubt that sizable swings in the market values of business
and household assets have created important challenges for policy makers,"
Mr. Greenspan said.
Mr. Greenspan said the Fed is discovering that wealth gains from different
types of asset sales tend to affect the economy in different ways. To assess how
gains or losses from these different types of assets affect consumer spending
and thus the overall economy will require more analysis by policy makers, he
said.
"To answer these questions we need far more information than we currently
possess about the nature and the sources of capital gains and the interaction of
these gains with credit markets and consumer behavior," he said.
He said the Fed is in the process of studying the matter to try and develop more
detailed information.
In general, for every $1 increase in consumer wealth, consumer spending is
raised by three to five cents, he said. But when a home is sold, with the resulting
cash from the capital gains, consumers tend to spend more -- 10 cents to 15
cents of that dollar.
"Household capital gains on directly held equities and mutual funds in recent
years have been two to four times the size of overall gains on homes," Mr.
Greenspan said. "The sheer size of such gains suggests that capital gains on
equities have been a more potent factor in determining spending than gains on
homes."
Mr. Greenspan also said that the government's calculation of the nation's
personal savings rate -- savings as a percentage of after-tax income -- gives an
incomplete picture of household finances.
That is because the savings rate measures only the amount of money being put
aside for savings. It doesn't represent a calculation of personal wealth, which
would involve calculating the gains or losses households have realized on their
savings from such things as investment and higher real estate values for their
homes.
The Fed has cut short-term interest rates seven times this year, reducing the key
federal-funds rate to a seven-year low of 3.5%. But the economy has slowed
to a virtual halt: it grew just 0.2% in the second quarter, the slowest rate in eight
years. Stock prices, moreover, have continued to fall. So far this year, the Dow
81
Jones Industrial Average has declined about 8%.
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Summary of Article
Alan Greenspan suggests that
the wealth effect is stronger
for real estate gains (10-15
cents on the dollar) as
compared to stock market
gains (3 to 5 cents on the
dollar). Can you think of
why this may be the case?
He also mentions that
movements in stock market
valuations are so large
compared to changes in real
estate valuations that the
former influence on consumption is larger than the latter. If you put yourself in
Greenspan’s shoes (currently Ben Bernanke’s), you could easily imagine how important
it is to accurately measure the influence of changes in wealth on consumption, that is, the
size of the wealth effect(s). The graph below depicts exactly what Greenspan is
discussing. From the mid-1990s until 2000, household stock and mutual funds wealth
has tripled (from around $4 trillion to around $12 trillion). During the same time period,
household real-estate wealth had increased less than 50%. Thus Greenspan’s statement:
"Household capital gains on directly held equities and mutual funds in recent years have
been two to four times the size of overall gains on homes," Mr.Greenspan said. "The
sheer size of such gains suggests that capital gains on equities have been a more potent
factor in determining spending than gains on homes."
82
Updating the Consumption Function
C = f (Yd, r, WSM, WRE): where WSM stands for Wealth in the Stock Market and WRE
stands for Wealth in Real Estate. Both relationships are assumed to be positive; increases
in either source of wealth result in higher consumption.
Another determinant of consumption is psychological – a sort of how do you feel about
your economic security question. For example, if the unemployment rate is rising and
many of my co-workers are losing their jobs, I may get very concerned about my job
security. If so, then I would probably delay some big ticket (durable good) purchases
(the old car is not that bad!) as well as other consumption expenditures. The
psychological element connected to consumption is captured by an economic statistic
known as the consumer confidence index (or index of consumer sentiment). To construct
this index, researchers conduct a survey asking individuals a variety of questions
attempting to capture consumers’ moods. For example, questions similar to: How do
you feel about your job security in the next six months? Do you plan on buying a new
home in the next six months….a new car….etc. Naturally, if consumer confidence falls,
we would expect consumption to fall as well. The figure below depicts the behavior of
the consumer confidence index in recent years.
Observations. Consumer sentiment decreased quite dramatically (especially the
measure constructed by the Conference Board) beginning in the second half of 2000 and
remained quite low until the beginning of 2003. Perhaps one of the reasons that consumer
confidence remained so low after the US recovery began in late 2001 was due to the
nature of the US recovery during this time. In particular, the US “suffered” from what is
referred to as the “Job-Loss Recovery,” a situation where output (GDP) grows even
83
though less people are working. The graph below depicts exactly what we mean by “Job
Loss Recovery.”
Updating the Consumption Function – we now add our consumer confidence (CC) to
our consumption function.
C = f (Yd, r, WSM, WRE, CC): where CC stands for consumer confidence.
Our Final Determinant of Consumption
Our final determinant of consumption is the exchange value of the US dollar. The
exchange rate value of the US dollar, all else constant, influences the prices of imports
and exports. For example, a stronger US dollar, all else constant, results in imports
becoming cheaper while US exports become more expensive to foreign nations. Let’s
use a simple example to verify:
Suppose the value of the US $ is one US dollar equals 0.80 euros. So an import from
Europe that is priced at 80 euros would cost $100 US dollars.
Now suppose the US dollar strengthens so that one US dollar equals one euro. What
would happen to the price, in US dollars, of the item that cost 80 euros?
84
Answer: The price would fall to 80 US dollars. Since the same item costs less, a typical
US consumer would tend to buy more European (produced) goods and less US
(produced) goods. Thus, we arrive at the conclusion that a stronger US dollar, all else
constant, results in less US consumption and thus, a stronger US dollar negatively effects
consumption. Make sure you can intuit the opposite: that a weaker US dollar will result
in the opposite, all else constant.35
Updating the Consumption Function – we now add the exchange rate value of the US
dollar (EX) to our consumption function. Importantly, we define a rise in EX as the US
dollar strengthening (appreciating) relative to our trading partners.
C = f (Yd, r, WSM, WRE, CC, EX): where EX stands for the exchange rate value of the
US dollar.
The final version of our consumption function can be summarized as follows: There are
6 distinct determinants of consumption. We would expect consumption, which again
represents 70% of the economy, to rise if 1) disposable income (Yd) rises, 2) interest rates
(r) fall, wealth in the stock market (WSM) rises, wealth in the real estate market (WRE)
rises, consumer confidence (CC) rises, and/or the US dollar gets weaker (EX falls)..
A formal model of consumption
Think of yourself as an advisor to Chairman Bernanke. Suppose that Ben asks you to
develop a model that can be used to predict consumption. Knowing what you do now,
your task is not all that difficult. Consider the following more formal model of
consumption.
C = a0 + a1 (Yd) + a2 (i) + a3 (WSM) + a4 (WRE) + a5 (CC) + a6 (EX)
Question – what are the values of a3 and a4 (big hint, see “Swings in Stock, Homes
Values Present Challenges to the Fed, Greenspan Says.”)
Summary of our formal model of consumption
Consumption expenditures can be influenced by a variety of factors. The influence of
each factor is relatively uncertain, but very important from a policy-making perspective.
In terms of the equation above, a1 through a5 are known as sensitivity parameters; that
is, they measure how sensitive consumption is to changes in the respective
determinants. For example, the parameter a3 measures the strength of the connection
between changes in stock market wealth and consumption. Greenspan suggested this
number is 0.03 to 0.05.
35
I recall that policymakers were actually pleased with the strong dollar and large trade deficit during the
new economy years of 1996 – 2000 since this “put a drag on aggregate demand” and thus helped keep the
economy from overheating.
85
Exercises:
1. What is the parameter a1 called and why is it so important?
2. Interpret what a2 = 0 implies.
3. Name all the factors that can shift the consumption function.
4. What could cause a movement along the consumption function?
5. If the current level of consumption is unacceptably low, what can policy makers do
and what factors would determine their success? Be very specific as there is much to
consider!
In the space below, draw a consumption function (CF) being sure to label your diagram
completely. Be sure to put all the shift variables in brackets next to the CF along with
their associated signs. Comment on the slope of the CF and what could cause a
movement along the CF?
86
The Investment Demand Function and the Role of ‘Animal Spirits.’
As noted previously, investment expenditures are thought to be quite sensitive to
interest rates. In the space below, draw an investment demand function with the price of
investment, the interest rate (r), on the vertical axis and the quantity of investment (I) on
the horizontal axis.
r
I
Note that all else constant, there exists a negative relationship between the level of
interest rates and the quantity of investment. Can you explain why (use the space below)?
The sensitivity of investment to changes in interest rates is very important to monetary
policymakers as this sensitivity determines, in part, the power of monetary policy. 36 For
example, if investment is very sensitive to changes in the interest rate, then we say that
monetary policy is quite powerful. Alternatively, if investment is (relatively) insensitive
to changes in interest rates, then we say monetary policy is weak or not very powerful.37
Recall that consumption expenditures (esp. durable goods) are also ‘sensitive’ to changes in the interest
rate (r).
37
The link between investment and interest rates is just one part of the transmission mechanism of
monetary policy (i.e., how monetary policy is supposed to influence economic activity).
36
87
Consider the following two investment demand schedules.
(1) I = 500 – 50 (r)
(2) I = 500 – 25 (r)
In equation 1, the quantity of investment demand is more sensitive to changes in interest
rates than it is in equation 2. For example, suppose that interest rates fall from 5 percent
to 4 percent. Let’s compare the change in investment in equations 1 and 2.
For equation 1
(1) I = 500 – 50 (5) = 250; now let interest rates fall from 5 to 4; I = 500 – 50 (4) = 300
So, according to equation (1), investment rises by 50 (from 250 to 300) when interest
rates are lowered by one percentage point. Let’s examine equation 2.
(2) I = 500 – 25 (5) = 375; now let interest rates fall from 5 to 4; I = 500 – 25 (4) =400
So, according to equation 2, investment rises by 25 (from 375 to 400) when interest rates
are lowered by one percentage point.
Most economists agree that investment is negatively related to interest rates. They may
differ, however, in their thoughts as to how tight and reliable this relationship is.
Other determinants of investment
John Maynard Keynes spoke of animal spirits when he addressed the determinants of
investment. He argued that interest rates play a minor role in determining investment
expenditures. Investment instead was primarily determined by a virtually un-measurable
element referred to as animal spirits, a psychological notion that for the present, can be
thought of as investor confidence (recall, similarly, that consumer confidence, a
psychological notion as well, was a determinant of consumption).
In terms of capturing the “animal spirits” influence on investment demand, we can
specify the following investment demand equation:
(3) Id = IC + b1 (r)
IC stands for investor confidence (animal sprits). The parameter b1 measures the
sensitivity of investment demand to changes in r with b1 < 0. The larger b1 in absolute
value, the more powerful monetary policy is, all else constant.
88
The following problems are from my principles class. Being able to do these will
make sure we are all on the ‘same page’ before we move forward. Note that 1) we
really don’t bother modeling the G (government purchases) component of aggregate
expenditures (AE) nor do we model the X-M component and thus, we take both of
these as given (exogenous).38
Problem 1
Suppose the demand side of the economy is characterized by the following equations:
1) AE = C + I + G + X-M
2) C = 500 + .8(Y – 100)
3) I = 10000 – 200 r
4) G = 500
5) X-M = -80
a) Find an expression for the AE function and then graph 2 separate AE functions, one
for r = 5 and one for r = 4 on the same diagram.
38
It is more typical to take G as given and model X-M. We will say a few words about the determination
of X-M but we will not formally model it at this point.
89
b) Now calculate equilibrium income when r = 5 and r =4 and label your diagram
accordingly (show all work).
c) Draw a new AE diagram assuming r = 5 being sure to label everything. Now, the
Federal Government decides increase government purchases to 700 (from 500). Do the
math and calculate the new equilibrium output (assume r=5 still). Show new AE curve
on diagram and label everything.
d) Compare your answers to b) with those of c). Which do you prefer, stimulating
demand with monetary policy or stimulating demand with fiscal policy? Explain.
90
e) Now depict your results using an aggregate demand diagram. Be sure to label
everything including all the shift variables in brackets next to the AD curves.
f) What assumption have we implicitly imposed in this problem (hint: totally
Keynesian!)?
g) Comment on the following: Policymakers are aggregate demand side managers.
91
Problem 2
Suppose the initial conditions of the economy are characterized by the following
equations.
1) C = a0 + a1 (Y-T) + a2 (r) + a3 (WSM) + a4 (WRE) + a5 (CC)
1’) C = a0 + a1 (Y-200) + a2 (3) + a3 (3000) + a4 (4000) + a5 (120)
2) I = IC + b1 (r)
2’) I = 440 + b1 (3)
3) G = G
3’) G = 300
4) X-M = X-M
4’) X-M = -100
5) AE = C + I + G + X-M
Where: a0 = 50, a1 = .9, a2 = -30. a3 = .04, a4 = .12, a5 = .2, b1 = -100
Part 1
a) Interpret the ai’s in equation 1 and b1 in equation 2. Explain why their values are so
important from a policy making perspective.
92
b) Why is a4 bigger than a3 ?
c) Now graph the consumption function and discuss the slope of the consumption
function, why the slope is so important, as well as all the factors that could cause the
consumption function to shift.
Part 2
a) Now graph the Investment demand function (be sure to label your diagram
completely). Discuss what determines the slope of the investment demand function and
why the slope of this function is so important to policy makers. Finish this part by
discussing possible sources of shifts in the investment function (using at least 2 real
world events). Be specific!
93
Part 3
a) Now calculate equilibrium income given the initial conditions. Show ALL your work.
b) Now graph the AE function being sure to label everything (Label the equilibrium point
A)
94
Part 4
We now let conditions change. In particular, let WSM go down to 2000, WRE go up to
4500, CC falls to 80 and IC falls to 340.
a) What could cause conditions to change like this?
b) Now resolve for equilibrium income – show ALL work and then add the new AE
curve on to your diagram (that you drew in part 3). Label this new equilibrium point as
Point B.
Part 5
a) Now policymakers are not happy about this and react accordingly! Ben Bernanke and
the Federal Reserve lower (real) interest rates to 1 and the Federal Government
(Congress) votes to lower taxes to 100 as well as voting to increase G to 400.
Recalculate equilibrium income again showing ALL work.
95
b) Now add this final AE curve to your diagram and label the new equilibrium point as
Point C. Have policy makers offset the negative shocks offered in part 4? Explain.
Part 6
Re do parts 4 and 5 using an aggregate demand curve diagram.
96
II. The Aggregate Supply (AS) side of the economy
When you think of AS, you should be thinking of production and all the costs associated
with producing goods and services! There is a lot to discuss when thinking about any
particular production process. First, we need to consider the production function (PF).
Think of the production function as a ‘black box,’ one that takes inputs (land, labor,
capital, technology) and turns it into output, output that is typically used to increase the
welfare of society. In fact, it is often stated that increases in the growth rate of
productivity are the key to increasing living standards since increases in the growth
rate of productivity allows the economy to produce more with the same inputs
(alternatively: produce the same output with less inputs).
Exercise: In the space below, draw a production function and discuss the
assumptions underlying any production function, what the shape implies, and the
factors that cause the production function to shift.
97
Deriving Supply from the Production Function: A Plastering Example from my
econ 004 class.
Define MPL and MRP.
Fill in the table below and figure out how many workers I should hire to maximize
profits.
TABLE 1
L
0
Q
0
1
10
2
25
3
36
4
45
5
52
6
55
MPL
-
MRP
-
Marginal Profit
-
Total Profit
0
The current wage is $80 and the price of output (Q) = $10.
98
In the space that follows, draw:
1) The production function
2) A labor market diagram including labor demand and labor supply
3) Derive the supply curve (hint: allow prices to rise to $12)
AND LABEL THIS INITIAL EQUILIBRIUM AS POINT A
99
Exercise #1: Higher Wages and its influence on supply
Let’s return to our original conditions (TABLE 1) except that wages have risen to $100
(rather than the original $80).
Fill in the table below and figure out how many workers I should hire to maximize
profits.
TABLE 2
L
Q
0
0
1
10
2
25
3
36
4
45
5
52
6
55
MPL
-
MRP
-
Marginal Profit
-
Total Profit
0
The current wage is $100 and the price of output (Q) = $10.
Exercise: Show the influence of the higher wages on:
1) Your production function diagram
2) Your labor market diagram
3) Your supply curve Diagram
AND LABEL THIS NEW EQUILIBRIUM AS POINT B
Conclusion: All else constant, an increase in wages will result in lower employment
and lower profits. In terms of economy wide statistics, the unemployment rate will
likely rise, the stock markets will likely fall (lower profits): There will also be
upward pressure on prices as firms may try to maintain profits by raising prices (in
effect, passing this increased cost of labor onto the consumer).
Note also that this exact analysis holds regarding changes in any of the input costs.
It is conventional to focus on changes in labor costs (wages) since labor costs account
for roughly 70% of the costs of the ‘typical’ good or service, but there are many
other costs of production that are relevant. See how many other inputs costs we can
name that applies to this ‘plastering’ example.
100
Exercise #2: A Change in productivity
Let’s return to our original conditions and allow a technological innovation to increase
the productivity of each worker by two (assume no change in wages or output prices).
Fill in the table below. What is my profit maximizing level of labor input now?
TABLE 3
L
0
Q
MPL
-
MRP
-
Marginal Profit
-
Total Profit
0
1
2
3
4
5
6
The current wage is $80 and the price of output (Q) = $10.
101
Exercise: In the space below, redraw the original 3 diagrams (with equilibrium
point A) and then show the influence of the higher productivity on:
1) Your production function diagram
2) Your labor market diagram
3) Your supply curve Diagram
PLEASE LABEL THE NEW EQUILIBRIUM AS POINT B
Conclusion: All else constant, an increase in productivity growth will result in
higher profits and likely result in more employment, as firms have an incentive to
hire more workers since the gain in productivity makes each and every worker
more productive.39
39
Whether or not firms hire more labor depends critically on (aggregate) demand conditions. For example,
during the ‘new economy’ years (1996-2000), demand was very strong and thus, labor growth was
significant as the unemployment rate got below 4% on two occasions. Conversely, as the economy slowed
during the beginning years of the new millennium, growth in the labor force slowed as well even though
the growth rate of productivity ‘held its own.’ In fact, the recovery following the 2001 recession is referred
to as the job-loss recovery, consistent with high productivity growth rates combined with slack aggregate
demand. During this period, the Fed continued to lower their target for the federal funds rates to 40 + year
lows (1%).
102
Finally, suppose workers want a “piece of the action” and demand an increase in wages
to $90. Assume that you give it to them. Compare profits now with the original profits.
The very common statement that you hear often when discussing the new economy and
the surge in productivity growth is as follows: increases in the growth rate of
productivity allow firms to raise profits, and pay workers higher wages, without
raising prices. This is what the new economy is all about – the ability of the
economy to grow faster without inflation (i.e., a change in the speed limit).
Comments: The supply curve can shift for many reasons, we have discussed two of the
‘biggies’ (changes in wages and/or productivity) when in comes to shifting supply. For
the increase in productivity example, we see that the supply curve shifts to the right, all
else constant. Another way to think about the increase in productivity is that it lowers the
costs of production. That is, if we hire the same amount of labor and incur the exact
same costs of production, we can produce more output. This being the case, we can also
state, and this must be the case, that we can produce the same output at a lower cost! So
we can make this general statement: Anything that lowers the costs of production will
shift the AS curve to the right, all else constant.
Conversely, anything that raises the costs of production will shift the AS curve to the left.
Our example with wages rising should convince us that higher labor costs will result in
less people working and thus, a decrease in the level of output produced.
Changes in productivity and the wage costs are probably the most important variables
when analyzing aggregate supply. We have already discussed the new economy and the
fact that increases in the growth rate of productivity is the key to increasing living
standards. With regard to wages, it is typically stated that wage costs account for
approximately 70% of the cost of producing any good or service.40
Exercise: Determine which direction the AS curve shifts for each of the following
changes:
1. Wages rise.
2. Environmental regulation eases.
3. A rise in the corporate income tax.
4. Law that accelerates the amount that firms can write off in the form of depreciation
allowances.
5. A government subsidy for new investment.
6. Lower interest costs.
7. A rise in inflationary expectations.
8. The US dollar weakening that results in more expensive imported raw materials.
9. A decrease in raw material costs.
10. A rise in productivity growth.
40
This is a general statement. Naturally, the proportion of labor costs to total costs depends on the nature
of the production processes (i.e., labor intensive vs. capital intensive).
103
11. A fall in the price of energy.
Exercise: Using Aggregate Demand (AD) and Aggregate Supply (AS) to depict the
stagflation of the 1970s (use the space below). Please label the initial point, before
the stagflation as point A. Now let stagflation occur and label this new equilibrium
point as point B. Please answer the following questions:
What caused the stagflation in 1970s and is the US economy equally susceptible to
stagflation now as it was back then?
Given ‘Stagflation,’ what is the influence on inflation, GDP growth and
unemployment rates?
104
Misery Index: A misery index is simply the summation of the inflation rate and
unemployment rate. As we know, in a stagflation environment, both inflation and
unemployment rates are high.
The Misery Index – Source – FRED – Federal Reserve Bank of St. Louis
25.0
20.0
15.0
Series1
10.0
5.0
Jan-06
Jan-04
Jan-02
Jan-00
Jan-98
Jan-96
Jan-94
Jan-92
Jan-90
Jan-88
Jan-86
Jan-84
Jan-82
Jan-80
Jan-78
Jan-76
Jan-74
Jan-72
Jan-70
0.0
Note how “miserable” we were in the 1970s. These are the two episodes of stagflation.
105
Exercise: The New Economy
The surge in productivity that began during the beginning of 1996 has effectively
changed the speed limit of the economy.
The Goldilocks Economy
We are about to discuss the fact that increases in productivity growth rates resulted in a
very happy situation in virtually every aspect of the US economy!
We recall the phrase that increases in productivity growth allows firms to pay higher
wages and increase profits without raising prices. We witnessed this phenomenon in our
plastering example and we are about to show this phenomenon at work with real world
data.
Before looking at the facts, let’s refresh ourselves with the AS, AD and their respective
determinants.
Aggregate Supply
AS = f [ Wages (W), Prod Growth (PG), Costs of inputs (COI) , other costs (OC)]
In words, AS is increasing in PG and decreasing in W, COI ,OC.
Most economists believe that 1) policy makers have little if any influence on AS and 2)
AS conditions determine output, especially in the long run (think of a vertical AS
curve)41
Aggregate Demand
AD = C + I + G + X-M
Model each:
Consumption
C = a0 + a1 (Yd) + a2 (r) + a3 (WSM) + a4 (WRE) + a5 (CC) + a6(EX)
Where the ai ‘s are sensitivity parameters (a0, a1, a3, a4 > 0 ; a2, a6 < 0)
Most all believe that the ‘world’ is classical in the long run they simply differ on how long it takes to get
to the long run. John Maynard Keyens was famous for, among other things, the following quote: “In the
Long Run We Are All dead.”
41
106
Investment
I = b0 (IC) + b1(r)
Where b0 > 0 ; b1 < 0
Government Purchases (take as given: exogenous)
Net Exports (take as given: exogenous)
Now set up our AS – AD model of the economy: In the space below, draw the
picture beginning in 1995 (use 95 as subscripts and label this initial equilibrium as
point A)
Please read the excerpt posted on web titled The Navigator
Fed Chief's Style: Devour the Data, Beware of Dogma
As Retirement Looms in 2006, Greenspan's Strong Record Will Be Hard to Replicate.
Did He Help Create a Bubble? November 18, 2004
1996: New Economy
Mr. Greenspan doesn't mingle much with his fellow governors.
Though a fixture on Washington's social circuit, he's an introvert
who would rather read staff memos. He rises at 6 a.m. and starts the
day reading newspapers and economic reports and working on
speeches, often in his bathtub. He eats breakfast at his office most
mornings, usually hot cereal and decaf Starbucks coffee. Classical
music sometimes plays on the stereo.
In September 1996, Ms. Yellen and Laurence Meyer, a new Fed
governor and a former top-ranked independent economic forecaster,
made a rare visit to Mr. Greenspan's office. It was the week before
an FOMC meeting and Ms. Yellen and Mr. Meyer hoped to influence his
recommendation on interest rates.
The pair worried that unemployment had been so low for so long that a resurgence in
inflation was inevitable. Conventional economic models held that companies would have
to pay higher wages to attract enough staff and would pass on those costs to consumers as
higher prices. They warned Mr. Greenspan that if he didn't recommend higher rates soon,
they might vote against him, recalls Mr. Meyer, who has since joined an economic
forecasting firm.
107
Mr. Greenspan listened without tipping his hand. He had noted the same developments
but reached a different conclusion based on his analysis of worker-productivity numbers.
Like many economists, Mr. Greenspan had long wondered why the spread of computers
in the 1970s and 1980s hadn't boosted productivity, or output per hour of work. He was
taken with the argument of economic historian Paul David, who noted that electricity
didn't boost productivity for decades until working patterns adjusted. Mr. David
suggested the same lag applied to computers.
Mr. Greenspan now saw surging orders for high-tech equipment since 1993 -- coupled
with higher profits at the companies that bought the equipment -- as evidence the
productivity payoff had arrived. If this effect was real, it meant economists were
underestimating how fast the economy could grow before inflation reared its head.
Companies could produce more without incurring the cost of hiring fresh labor.
When the meeting rolled around the next week, it was a tense affair. A Reuters report had
made public the fact that eight of the 12 regional banks had asked for higher rates.
Mr. Greenspan disagreed and told the committee he wanted to hold rates firm. An
important reason, he argued, was that the government's productivity data were wrong.
According to an analysis he commissioned from two Fed economists, productivity since
1990 in many services industries such as health care must have declined if the
government's numbers were accurate.
This "makes no sense," Mr. Greenspan told the meeting. "The tremendous contraction in
productivity, which all of our data show, is partially phony." Instead, he pointed to other
government reports showing that companies were recording ever-wider profit margins
without raising prices, a sure sign of productivity gains. "Productivity is indeed rising a
lot faster than our statistics indicate."
Many committee members remained skeptical; half still wanted to raise rates. New York
Fed President William McDonough called for solidarity with Mr. Greenspan, saying talk
about dissension had hurt staff morale, transcripts show. Some bridled at the suggestion.
In the end, all but one member voted with Mr. Greenspan. The Fed kept rates steady
through the fall and winter, against the expectations of most mainstream economists. The
decision had an added benefit of keeping the Fed out of the limelight during the
presidential election between Mr. Clinton and Republican Bob Dole.
Productivity growth, subsequent data show, did accelerate in 1996 from a disappointing
two-decade trend. The U.S. economy, once thought by the Fed to be capable of growing
safely at only about 2.5% a year, could now grow about 3.5% or more without igniting
inflation.
108
Mr. Greenspan "got it right before the rest of us
THE RECORD
did," Mr. Meyer wrote in a memoir published this
year.
The decision to not increase interest rates allowed
the unemployment rate to fall to a generation-low
of 4%, extended the 1990s boom and helped
America's most-disadvantaged workers share the
benefits.
Key moments in Greenspan's
career as chairman of the
Federal Reserve.
1987 Appointed chairman of
the Fed
1987 Cuts rates in response to
Despite his early recognition of the
stock-market crash
transformative power of technology, Mr.
1990 Cuts rates in response to
Greenspan doesn't use e-mail. He does have an
recession, budget agreement
Apple Computer Inc. iPod digital-music player
1993 Backs Clinton's tax
given to him by his friend, World Bank President increase
James Wolfensohn. Regardless, his arguments
1994 Rapidly raises rates,
made him the leading apostle of what was then
roiling bonds, derivatives
dubbed the "New Economy," the idea that
1995 Helps bail out Mexico
technology had permanently raised the economy's 1996 Warns of "irrational
growth rate.
exuberance"
1996 Holds rates steady, says
SO GREENSPAN SAW THE ‘NEW
higher productivity growth
ECONOMY’ BEFORE ANYONE ELSE AND
damps inflation
THUS, DID NOT TAKE AWAY THE PUNCH
1998 Backs rescue of Long
BOWL
Term Capital hedge fund
1998 Decides to not prick
NOTE PART OF THE TITLE OF ARTICLE:
stock-market bubble
Did He Help Create a Bubble?
2001 Backs George W. Bush's
tax cut
NOW, ON TO THE FACTS
2001 Slashes rates as tech,
stock bubbles burst
And remember the phrase, higher productivity 2002 Urges restoration of
allows firms to pay higher wages and increase balanced-budget rules
profits without raising prices.
2003 Cuts rates to 1% to
prevent deflation
The graph below depicts the surge in productivity 2004 Calls post-bubble
that Alan Greenspan arguably ‘saw’ first.
strategy "successful"
109
110
Let’s examine the behavior of the three big economic statistics:
Recall the implications (from plastering example) of a surge in productivity growth:
What are some priors???
Nominal Wages?
Inflation?
Real Wages?
What about profits and thus the value of the stock market?
What about labor market conditions?
Consumption?
Investment?
Economic growth?
111
First pic – the percent change in nominal wages.
Note how the growth rate in nonfarm compensation per hour surged beginning in 1996,
perfectly consistent with the idea that given a surge in productivity growth, firms were
willing and able to pay higher wages. Do you remember the ‘rest of the story?’
112
A look at inflation: Two Pics – note how well behaved inflation was during this
period. This fact is certainly consistent with our priors.
113
Given that the growth rate of nominal wages exceeded the growth rate of prices
(inflation), we can conclude that real wages were growing during this time, consistent
with our prior and the plastering example.
Profits: The following two graphs depict the performance of the Dow Jones
Industrial Average and Nasdaq stock market indexes. Note the surge in the value of
these markets during the new economy years.
THE DOW
114
NASDAQ
Given our previous analysis on the consumption function, what are the inferences
regarding the consumption function given the surge in stock valuations? Be
specific!
115
Labor Market Conditions – recall a surge in productivity growth should
increase the profit maximizing level of labor input assuming sufficient demand.
Note how solid employment growth was during the New Economy.
In the space below, draw a production function labeling point A as the point prior to
the New Economy and label point B as the point in the midst of the New Economy.
Explain precisely why you drew the diagram as you did and the difference between
point A and B.
116
Let us now examine the behavior of consumption and investment during this period.
Recall the consumption function and its determinants! We would expect that the
consumption function would be shifting up. In the space below, provide all the
arguments you can think of as to why the consumption function was shifting up.
Consumption and Income During the New Economy
Two observations: 1) The growth rate of consumption during this period was very strong
and 2) During the latter stages of the new economy, personal consumption expenditures
exceeded disposable income, almost without exception.
117
Use the space below to show this latter phenomenon utilizing the consumption function
and it associated shift variables. In particular, begin with point A, before the New
Economy began and end with point B, in the midst of the new economy. Be sure to
explain in detail the movement from point A to point B as well as being sure to label your
diagram completely with all the shift variables in brackets next to the consumption
function.
Investment During the New Economy
118
Use the space below to depict the behavior of the investment demand schedule during
this period. Begin with point A, before the New Economy began and end with point B, in
the midst of the new economy. Be sure to explain in detail the movement from point A to
point B (hint: John Maynard Keynes).
Economic Growth During the New Economy – naturally, given the surge in
productivity growth and the increased size of the labor force, the implications are
that GDP growth should be strong. The graph bellows depicts this outstanding
performance of the US economy in terms of real GDP growth.
119
Finally, on your initial Aggregate Supply and Aggregate Demand Diagram, model
the New Economy and label point B as representing the point in the midst of the
New Economy.
120
Chapter 5: The Cruise Ship Analogy: Aggregate Demand and
Aggregate Supply: Part II, and the New Economy
Use the space below to draw a cruise ship that represents the US economy.
Key Terms from cruise ship example:
1. Fiscal policy
2. Monetary policy
3. Recognition lag
4. Implementation lag
5. Effectiveness lag
6. NAIRU
7. Full employment
8. Open market operations
9. Potential growth rate of economy
10. Stagflation
11. The FOMC
12. Exogenous shocks
13. Overheating
14. The new economy
15. Speed limit of the economy
16. Traditional model
121
The Cruise Ship
Goals (the port)
1. Stable Prices
2. Full Employment (NAIRU)
3. Economic Growth (PGE)
NAIRU (Non Accelerating Inflation Rate of Unemployment) – the lowest the
unemployment rate can go without inflation accelerating. We really don’t know exactly
what this number is and it probably changes through time. Most economists would agree
that NAIRU is lower today than it was back in 1995 and before.42
PGE (The Potential Growth rate of the Economy) – The fastest real GDP can grow
without inflation accelerating. This growth rate is often referred to as the speed limit of
the economy or the sweet spot of economic growth. Similar to NAIRU, PGE is a concept
and we are not really sure what number to use and thus, we often talk about NAIRU and
PGE in ranges. For example, I believe PGE is 4% which means that if GDP grows faster
than that, then inflation will accelerate and the Fed will have to respond by cranking up
interest rates to fight the incipient inflation. When Governor Olson was at here at Penn
State in April of 2006, he stated that the board believes that the PGE is around 3.25 –
3.5%. Any growth above that would be inflationary with the implication of
overheating.43
Speed Limits of New vs. Old Economy
Old (traditional) Economy – pre 1995, before the surge in productivity in the late 90’s
NAIRU – 5.5% - 6%
PGE – 2.5%
New Economy – post 1995, after the surge in productivity in the late 90’s
NAIRU – 4 – 4.5
PGE – 3.25 – 4%
As stated previously, we are not sure what NAIRU and PGE are since they are
unobservable, but almost all economists would agree that these “speed limits” have
changed since 1995.44
The surge in productivity occurred somewhere around 1995 – 1996 and Alan Greenspan was arguably
the first to see this change. As we shall see, increases in the rate of productivity growth are dis-inflationary
and thus, helps the Fed in terms of achieving their price stability objective.
43
Overheating is a common ‘economic’ term and is associated with demand outstripping supply.
44
Note importantly that it is the growth rate of productivity that has surged and has changed the speed
limit. If the rate of productivity growth returns to its pre-1995 levels, then the speed limits (NAIRU: PGE)
would return to their pre-1995 levels as well. Due to these and other reasons, productivity growth statistics
are closely watched by policy makers and the public alike.
42
122
Policy Lags
1. Recognition lag: The recognition lag is the time it takes policy makers to know
the current level of economic activity as well as where the economy is headed. We
would think it would be easy to know current economic conditions given the constant
stream of economic data available, but this is not necessarily the case since much of
this data is reflecting previous economic activity. For a case in point of the
recognition lag consider the following: At an FOMC meeting in October of 1990,
Chairman Alan Greenspan did not recognize the economy was in the midst of an
“official recession,” a recession that is commonly referred to as the gulf war
recession.45
Lags are so important for policy makers and we assume that the recognition lag is the
same for Fiscal policy makers (FP) as it is for Monetary policy makers (MP). That is,
we assume that the economists that work on the council of economic advisors to the
President and the economists that work for the Federal Reserve are equal in their
abilities to recognize where the economy is and where it is headed.
2. Implementation lag: The implementation lag represents the time lag between
recognizing a need for discretionary policy and the time it takes to implement the
policy. For Fiscal policy, this lag can be quite long since our elected officials have to
write up the policy and then talk about the details. As we all know, the political
process, say, for a recommended tax cut can become very tedious and take many
months of discussion in either the House of Representatives and/or Congress.
For Monetary policy the implementation lag is very short, as the FOMC directs the
federal funds desk to change the target for the federal funds rate by conducting open
market operations. According to a high ranking Federal Reserve official, open
market operations take about 15 seconds to perform!
3. Effectiveness Lag: The effectiveness lag refers to the time it takes for the
implemented policy to influence real economic activity. In term of the cruise ship
example, it represents the time it takes for the cruise ship to turn once the wheel is
turned (i.e., once the policy is implemented). For Fiscal policy, the effectiveness lag
is thought to be relatively short. For example, once a tax cut becomes effective,
households immediately have more disposable income and chance are good, they will
spend it and thus, economic activity will rise quite quickly.
45
The National Bureau of Economic Research (NBER) is the official recession dating body and they
typically identify recessions well after they are over. For example, the trough (end of) the 2001 recession
occurred in November 2001 but wasn’t announced by the NBER until July 17, 2003! Chairman Bernanke
used to be a member of this committee. For all the official recession dates, as well as more information
about the process, go to http://www.nber.org/cycles/cyclesmain.html.
123
For Monetary policy, the effectiveness lag is long and variable, with the typical range
of time being anywhere from 6 months to 2 years.46 Some economists believe that the
effectiveness lag for monetary policy can be even longer than two years.47 This lag in
monetary policy means that the Federal Reserve must be forward looking and thus,
the “Fed” spends a lot of its resources in building and analyzing economic forecasting
models.
Exercise: In the Space below, draw a road and a car and discuss lags in policy and
the varying power of policy.
Monetary Policy
1. The Fed conducts open market operations (OMO) to keep the FF rate close to the
target
2. Open Market Sales – used to raise rates to the federal funds target
3. Open Market Purchases – used to lower rates to the federal funds target
Fiscal Policy
1. Changes in Government Purchases (G)
2. Changes in Taxes
Exogenous Shocks – an exogenous shock is an influence on the economy that is either
determined by ‘something’ outside of the economic model and/or is totally unexpected.
Examples of exogenous shocks:
1. 9/11
2. Y2K (even though we saw it coming)
3. Oil shocks
4. Stock market crashes
5. Wars
6. Financial crises (Asian, Russian, Argentina, Brazil, etc.)
46
This range is associated with the following reference: Milton Friedman and Anna Jacobson Schwartz, A
Monetary History of the United States, 1867-1960. Princeton: Princeton University Press (for the National
Bureau of Economic Research), 1963. xxiv + 860 pp.
47
When I spoke with Frederic Mishkin during his visit to Penn State, he suggested that the lag between
changes in Federal Reserve policy and its impact on inflation is “at least two years.” This fact must be kept
in mind since there is a group of economists adamant about inflation targeting, and thus, to successfully
target inflation, you must be able to forecast inflation 2 plus years into the future, a difficult task indeed!
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Whether or not policy makers react to exogenous shocks depends on the nature of the
shock and to what degree it may jeopardize the Fed’s ultimate objectives. Policy makers
will consider a variety of factors when determining: a) whether or not react and b) the
degree of reaction. 9/11 serves as an example of a very serious negative exogenous
shock, one in which the Federal Reserve and Federal Government alike reacted strongly
to by conducting major expansionary monetary policy and expansionary fiscal policy
respectively.48
Boiler Example: An Informational Variable Approach to Monetary Policy
The Fed uses an “informational variable approach” to monetary policy. Instead of
watching only a few variables, policymakers watch all of them and depending on the
current economic environment, assign certain weights (importance) to each. The
composition and value of these weights evolve through time and Greenspan’s legacy
is exactly in this area – how does one choose these weights and the value associated
with each? It’s all in Greenspan’s head (not in a textbook!).49
Use the space below to construct the boiler example (an informational approach to
monetary policy):
The New Economy and the movement of the Port – show on diagram.
48
The federal reserve immediately (the first business day) lowered their target for the federal funds rate by
50 basis points and eventually lowered the federal funds target to 1%, a forty year low. The Federal
Government responded by passing a significant tax cut.
Alan Greenspan had a reputation of conducting policy by “the seat of his pants.” From the WSJ
11/18/2004: "When Greenspan's replacement, whoever he or she is, walks into that office and opens the
drawer for the secrets, he's going to find it's empty," says Alan Blinder, a former Fed governor. "The
secrets are in Greenspan's head."
49
125
Chapter 6: Keynesian vs. Classical Economics, Rules vs.
Discretion, the Fed’s Loss Function and the Taylor Rule.
AGGREGATE DEMAND AND AGGREGATE SUPPLY ANALYSIS - revisited
AD – policy variables ( r, T, G) and non-policy variables ( CC, IC, WSM, WRE, Ex)
AS – productivity, wages, other input costs
GDP = C + I + G + (X-M)
Key: AD = Aggregate Demand; AS = Aggregate Supply; r = real interest rate; T = taxes;
G = Government Purchases; CC = Consumer Confidence; IC = Investor Confidence and
can be used interchangeably with animal spirits; WSM = Wealth in the Stock Market;
WRE = Wealth in Real Estate, Ex = Exchange rate value of the US dollar; Ex rising
implies dollar appreciation; W = wages.
CLASSICAL vs. KEYNESIAN ECONOMICS
Pre-Great Depression
Classical: Government takes a back seat to natural (and unavoidable) fluctuations in
supply demand relationship. According to Classical Economists, policymakers
should be totally passive and allow markets to work.
Invisible Hand: If everyone pursues their own self interest, social welfare will be
maximized (works best with minimal government intervention) The invisible hand
theorem is associated with Adam Smith who is often referred to as the father of
economics
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Show the Classical model in an AS/AD framework below being sure to emphasize
the self correcting mechanism
Depict the Great Depression in the space below
Keynesian: Keynes argued that wages and prices could be “sticky,” especially in the
downward direction. He promoted government intervention in the form of
discretionary Fiscal Policy. Why not monetary policy?
127
Show the Keynesian model in an AS/AD framework (with “sticky” prices)
128
Please read the following article 2 articles:
Friday, Dec. 31, 1965
"We Are All Keynesians Now"
THE ECONOMY
(See Cover)
The ideas of economists and political philosophers, both when they are right and when
they are wrong, are more powerful than is commonly understood. Indeed the world is
ruled by little else. Practical men, who believe themselves to be quite exempt from any
intellectual influences, are usually the slaves of some defunct economist.
—The General Theory of
Employment, Interest and Money
Concluding his most important book with those words in 1935, John Maynard Keynes
was confident that he had laid down a philosophy that would move and change men's
affairs. Today, some 20 years after his death, his theories are a prime influence on the
world's free economies, especially on America's, the richest and most expansionist. In
Washington the men who formulate the nation's economic policies have used Keynesian
principles not only to avoid the violent cycles of prewar days but to produce a
phenomenal economic growth and to achieve remarkably stable prices. In 1965 they
skillfully applied Keynes's ideas—together with a number of their own invention—to lift
the nation through the fifth, and best, consecutive year of the most sizable, prolonged and
widely distributed prosperity in history.
By growing 5% in real terms, the U.S. experienced a sharper expansion than any other
major nation. Even the most optimistic forecasts for 1965 turned out to be too low. The
gross national product leaped from $628 billion to $672 billion—$14 billion more than
the President's economists had expected. Among the other new records: auto production
rose 22% , steel production 6% , capital spending 16% , personal income 7% and
corporate profits 21%. Figuring that the U.S. had somehow discovered the secret of
steady, stable, noninflationary growth, the leaders of many countries on both sides of the
Iron Curtain openly tried to emulate its success.
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Basically, Washington's economic managers scaled these heights by their adherence to
Keynes's central theme: the modern capitalist economy does not automatically work at
top efficiency, but can be raised to that level by the intervention and influence of the
government. Keynes was the first to demonstrate convincingly that government has not
only the ability but the responsibility to use its powers to increase production, incomes
and jobs. Moreover, he argued that government can do this without violating freedom or
restraining competition. It can, he said, achieve calculated prosperity by manipulating
three main tools: tax policy, credit policy and budget policy. Their use would have the
effect of strengthening private spending, investment and production.
From Mischief to Orthodoxy. When Keynes first propagated his theories, many people
considered them to be bizarre or slightly subversive, and Keynes himself to be little but a
left-wing mischief maker. Now Keynes and his ideas, though they still make some people
nervous, have been so widely accepted that they constitute both the new orthodoxy in the
universities and the touchstone of economic management in Washington. They have led
to a greater degree of government involvement in the nation's economy than ever before
in time of general peace. Says Budget Director Charles L. Schultze: "We can't prevent
every little wiggle in the economic cycle, but we now can prevent a major slide."
A slide, of course, is not what the U.S. Government's economic managers have been
worrying about in 1965; they have been pursuing a strongly expansionist policy. They
carried out the second stage of a two-stage income-tax cut, thus giving consumers $11.5
billion more to spend and corporations $3 billion more to invest. In addition, they put
through a long-overdue reduction in excise taxes, slicing $1.5 billion this year and
another $1.5 billion in the year beginning Jan. 1. In an application of the Keynesian
argument that an economy is likely to grow best when the government pumps in more
money than it takes out, they boosted total federal spending to a record high of $121
billion and ran a deficit of more than $5 billion. Meanwhile, the Federal Reserve Board
kept money easier and cheaper than it is in any other major nation, though proudly
independent Chairman William McChesney Martin at year's end piloted through an
increase in interest rates—thus following the classic anti-inflationary prescription.
Why They Work. By and large, Keynesian public policies are working well because the
private sector of the economy is making them work. Government gave business the
incentive to expand, but it was private businessmen who made the decisions as to
whether, when and where to do it. Washington gave consumers a stimulus to spend, but
millions of ordinary Americans made the decisions—so vital to the economy —as to how
and how much to spend. For all that it has profited from the ideas of Lord Keynes, the
U.S. economy is still the world's most private and most free-enterprising. Were he alive,
Keynes would certainly like it to stay that way.
The recent successes of Keynes's theories have given a new stature and luster to the men
who practice what Carlyle called '.'the dismal science." Economists have descended in
force from their ivory towers and now sit confidently at the elbow of almost every
important leader in Government and business, where they are increasingly called upon to
forecast, plan and decide. In Washington the ideas of Keynes have been carried into the
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White House by such activist economists as Gardner Ackley, Arthur Okun, Otto Eckstein
(all members of the President's Council of Economic Advisers), Walter Heller (its former
chairman), M.I.T.'s Paul Samuelson, Yale's James Tobin and Seymour Harris of the
University of California at San Diego.
First the U.S. economists embraced Keynesianism, then the public accepted its tenets.
Now even businessmen, traditionally hostile to Government's role in the economy, have
been won over—not only because Keynesianism works but because Lyndon Johnson
knows how to make it palatable. They have begun to take for granted that the
Government will intervene to head off recession or choke off inflation, no longer think
that deficit spending is immoral. Nor, in perhaps the greatest change of all, do they
believe that Government will ever fully pay off its debt, any more than General Motors or
IBM find it advisable to pay off their long-term obligations; instead of demanding
payment, creditors would rather continue collecting interest.
To a New Stage. Though Keynes is the figure who looms largest in these recent changes,
modern-day economists have naturally expanded and added to his theories, giving birth
to a form of neo-Keynesianism. Because he was a creature of his times, Keynes was
primarily interested in pulling a Depression-ridden world up to some form of prosperity
and stability; today's economists are more concerned about making an already prospering
economy grow still further. As Keynes might have put it: Keynesianism + the theory of
growth = The New Economics. Says Gardner Ackley, chairman of the Council of
Economic Advisers: "The new economics is based on Keynes. The fiscal revolution
stems from him." Adds the University of Chicago's Milton Friedman, the nation's leading
conservative economist, who was Presidential Candidate Barry Goldwater's adviser on
economics: "We are all Keynesians now."
Within the next two weeks, Ackley and his fellow council members will have to give
President Johnson a firm economic forecast for the year ahead and advise him about what
policies to follow. Their decisions will be particularly crucial because the U.S. economy
is now moving into a new stage. Production is scraping up against the top levels of the
nation's capacity, and federal spending and demand are soaring because of the war in Viet
Nam. The economists' problem is to draw a fine line between promoting growth and
preventing a debilitating inflation. As they search for new ways to accomplish this
balance, they will be guided in large part by the Keynes legacy.
That legacy was the product of a man whose personality and ideas still surprise both his
critics and his friends. Far from being a socialist left-winger, Keynes (pronounced canes)
was a high-caste Establishment leader who disdained what he called "the boorish
proletariat" and said: "For better or worse, I am a bourgeois economist." Keynes was
suspicious of the power of unions, inveighed against the perils of inflation, praised the
virtue of profits. "The engine which drives Enterprise," he wrote, "is not Thrift but
Profit." He condemned the Marxists as being "illogical and so dull" and saw himself as a
doctor of capitalism, which he was convinced could lead mankind to universal plenty
within a century. Communists, Marxists and the British Labor Party's radical fringe
damned Keynes because he sought to strengthen a system that they wanted to overthrow.
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Truth & Consequences. Keynes was born the year Marx died (1883) and died in the first
full year of capitalism's lengthy postwar boom (1946). The son of a noted Cambridge
political economist, he whizzed through Eton and Cambridge, then entered the civil
service. He got his lowest mark in economics. "The examiners," he later remarked,
"presumably knew less than I did." He entered the India Office, soon after became a
Cambridge don. Later, he was the British Treasury's representative to the Versailles
Conference, and saw that it settled nothing but the inevitability of another disaster. He
resigned in protest and wrote a book, The Economic Consequences of the 'Peace, that
stirred an international sensation by clearly foretelling the crisis to come.
He went back to teaching at Cambridge, but at the same time operated with skill and dash
in business. The National Mutual Life Assurance Society named him its chairman, and
whenever he gave his annual reports to stockholders, the London Money Market
suspended trading to hear his forecasts for interest rates in the year ahead. He was also
editor of the erudite British Economic Journal, chairman of the New Statesman and
Nation and a director of the Bank of England.
Keynes began each day propped up in bed, poring for half an hour over reports of the
world's gyrating currency and commodity markets; by speculating in them, he earned a
fortune of more than $2,000,000. Money, he said, should be valued not as a possession
but "as a means to the enjoyments and realities of life." He took pleasure in assembling
the world's finest collection of Newton's manuscripts and in organizing London's
Camargo Ballet and Cambridge's Arts Theater. Later, the government tapped him to head
Britain's Arts Council, and in 1942 King George VI made him a lord.
Part dilettante and part Renaissance man, Keynes moved easily in Britain's eclectic world
of arts and letters. Though he remarked that economists should be humble, like dentists,
he enjoyed trouncing countesses at bridge and Prime Ministers at lunch-table debates. He
became a leader of the Bloomsbury set of avant-garde writers and painters, including
Virginia and Leonard Woolf, Lytton Strachey and E. M. Forster. At a party at the
Sitwells, he met Lydia Lopokova, a ballerina of the Diaghilev Russian ballet. She was
blonde and buxom; he was frail and stoop-shouldered, with watery blue eyes. She
chucked her career to marry him. His only regret in life, said Keynes shortly before his
death of a heart attack, was that he had not drunk more champagne.
The Whole Economy. The thrust of Keynes's personality, however strong, was vastly less
important than the force of his ideas. Those ideas were so original and persuasive that
Keynes now ranks with Adam Smith and Karl Marx as one of history's most significant
economists. Today his theses are the basis of economic policies in Britain, Canada,
Australia and part of Continental Europe, as well as in the U.S.
Economics is a young science, a mere 200 years old. Addressing its problems in the
second half of its second century, Keynes was more successful than his predecessors in
seeing it whole. Great theorists before him had tried to take a wide view of economic
forces, but they lacked the 20th century statistical tools to do the job, and they tended to
concentrate on certain specialties. Adam Smith focused on the marketplace, Malthus on
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population, Ricardo on rent and land, Marx on labor and wages. Modern economists call
those specializations "microeconomics"; Keynes was the precursor of what is now known
as "macroeconomics"—from the Greek makros, for large or extended. He decided that
the way to look at the economy was to measure all the myriad forces tugging and pulling
at it—production, prices, profits, incomes, interest rates, government policies.
For most of his life, Keynes wrote, wrote, wrote. He was so prolific that a compendium
of his books, tracts and essays fills 22 pages. In succession he wrote books about
mathematical probability (1921), the gold standard and monetary reform (1923), and the
causes of business cycles (1930); each of his works further developed his economic
thinking. Then he bundled his major theories into his magnum opus, The General Theory,
published in 1936. It is an uneven and ill-organized book, as difficult as Deuteronomy
and open to almost as many interpretations. Yet for all its faults, it had more influence in
a shorter time than any other book ever written on economics, including Smith's The
Wealth of Nations and Marx's Das Kapital.
Permanent Quasi-Boom. Keynes perceived that the prime goal of any economy was to
achieve "full employment." By that, he meant full employment of materials and machines
as well as of men. Before Keynes, classical economists had presumed that the economy
was naturally regulated by what Adam Smith had called the "invisible hand," which
brought all forces into balance and used them fully. Smith argued, for example, that if
wages rose too fast, employers would lay off so many workers that wages would fall until
they reached the point at which employers would start rehiring. French Economist Jean
Baptiste Say embroidered that idea by theorizing that production always creates just
enough income to consume whatever it produces, thus permitting any excesses of
demand to correct themselves quickly.
Keynes showed that the hard facts of history contradicted these unrealistic assumptions.
For centuries, he pointed out, the economic cycle had gyrated from giddy boom to violent
bust; periods of inflated prosperity induced a speculative rise, which then disrupted
commerce and led inexorably to impoverished deflation. The climax came during the
depression of the 1930s. Wages plummeted and unemployment rocketed, but neither the
laissez-faire classicists nor the sullen and angry Communists adequately diagnosed the
disease or offered any reasonable remedies.
By applying both logic and historical example to economic cycles, Keynes showed that
the automatic stabilizers that economists had long banked on could actually aggravate
rather than prevent a depression. If employers responded to a fall-off in demand by
slicing wages and dumping workers, said Keynes, that would only reduce incomes and
demand, and plunge production still deeper. If bankers responded to a fall-off in sayings
by raising interest rates, that would not tempt penniless people to save more—but it
would move hard-pressed industrialists to borrow less for capital investment. Yet Keynes
did not despair of capitalism as so many other economists did. Said he: "The right
remedy for the trade cycle is not to be found in abolishing booms and keeping us
permanently in a semi-slump; but in abolishing slumps and thus keeping us permanently
in a quasi-boom."
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Management of Demand. The key to achieving that, Keynes perceived, is to maintain
constantly a high level of what he called "aggregate demand." To him, that meant the
total of all demand in the economy—demand for consumption and for investment, for
both private and public purposes. His inescapable conclusion was that, if private demand
should flag and falter, then it had to be revived and stimulated by the only force strong
enough to lift consumption: the government.
The pre-Keynesian "classical" economists had thought of the government too. But almost
all of them had contended that, in times of depression, the government should raise taxes
and reduce spending in order to balance the budget. In the early 1930s, Keynes cried out
that the only way to revive aggregate demand was for the government to cut taxes, reduce
interest rates, spend heavily—and deficits be damned. Said Keynes: "The State will have
to exercise a guiding influence on the propensity to consume partly through its scheme of
taxation, partly by fixing the rates of interest, and partly, perhaps, in other ways."
A few other economists of Keynes's time had called for more or less the same thing. Yet
Keynes was the only one with enough influence and stature to get governments to sit up
and pay attention. He was the right man at the right time, and his career and fame derived
largely from the fact that when his theories appeared the world was racked by history's
worst depression and governments were desperately searching for a way out.
Contrary to the Marxists and the socialists, Keynes opposed government ownership of
industry and fought those centralists who would plan everything ("They wish to serve not
God but the devil"). While he called for conscious and calculated state intervention, he
argued just as passionately that the government had no right to tamper with individual
freedoms to choose or change jobs, to buy or sell goods, or to earn respectable profits. He
had tremendous faith that private men could change, improve and expand capitalism.
Perhaps Immoral. Like any genius, Keynes had plenty of faults and shortcomings. Even
his admirers admit that he could be maddeningly abstruse and confusing. MJ.T.'s Paul
Samuelson, for example, thinks that Keynes downplayed the importance of monetary
policy. His few outright critics feel that, while he knew how to buoy a depressionstricken industrial economy, he offered little in the way of practical information about
how to keep a prosperous modern economy fat and secure. Keynesian theories are
certainly unworkable in the underdeveloped nations, where the problem is not too little
demand but insufficient supply, and where the object is not to stimulate consumption but
to spur savings, form capital and raise production.
Such critics as former U.S. Budget Director Maurice Stans still worry that Keynes makes
spenders seem virtuous and savers wicked, and thus subtly threatens the nation's moral
fiber. Other doubters contend that earlier obscure economists originated some of the ideas
that Keynes popularized, and that all he did was wrap them up in a general theory. But
even his severest de tractors bow to his brilliance, use the macroeconomic terms and
framework that he devised, and concede that his main theories have largely worked out in
practice.
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What Did He Say? Though Keynes's gospel has only recently come to full flower, a
school of fervid apostles has been preaching it in the U.S. for more than a generation.
Harvard's Alvin Hansen, the first great Keynesian teacher, taught it to hundreds of
economists, many of them now in high positions. Hansen's brightest student was Paul
Samuelson, who later wrote a Keynesian-angled college textbook on economics that has
gone to 2,000,000 copies and influenced the thinking of count less teachers and students.
Franklin Roosevelt was at first no fan of Keynes — "I didn't understand one word that
man was saying," he sniffed after being lectured by Keynes at the White House in 1934
— but some of his economists gradually began to lean on Keynesian language and logic
to rationalize huge deficits. In World War II, Washington planners used Keynesian ideas
to formulate their policies of deficit spending.
Congress adopted the Keynesian course in 1946, when it passed the Employment Act,
establishing Government responsibility to achieve "maximum employment, production
and purchasing power." The act also created the Council of Economic Advisers, which
for the first time brought professional economic thinking into close and constant touch
with the President. Surprisingly it was Dwight Eisenhower's not-notably-Keynesian
economists who most effectively demonstrated the effi cacy of Keynes's antirecession
prescriptions; to fight the slumps of 1953-54 and 1957-58, they turned to prodigious
spending and huge deficits.
J.M.K. & L.B.J. Still, Keynesianism made its biggest breakthrough under John Kennedy,
who, as Arthur Schlesinger reports in A Thousand Days, "was unquestionably the first
Keynesian President." Kennedy's economists, led by Chief Economic Adviser Walter
Heller, presided over the birth of the New Economics as a practical policy and set out to
add a new dimension to Keynesianism. They began fo use Keynes's theories as a basis
not only for correcting the 1960 recession, which prematurely arrived only two years
after the 1957-58 recession, but also to spur an expanding economy to still faster growth.
Kennedy was intrigued by the "growth gap" theory, first put across to him by Yale
Economist Arthur Okun (now a member of the Council of Economic Advisers), who
argued that even though the U.S. was prosperous, it was producing $51 billion a year less
than it really could. Under the prodding and guidance of Heller, Kennedy thereupon
opened the door to activist, imaginative economics.
He particularly called for tax reductions—a step that Keynes had advocated as early as
1933. The Kennedy Administration stimulated capital investment by giving businessmen
a 7% tax kickback on their purchases of new equipment and by liberalizing depreciation
allowances. Kennedy also campaigned for an overall reduction in the oppressive incometax rates in order to increase further both investment and personal consumption. That
idea, he remarked, was "straight Keynes and Heller."
Lyndon Johnson came into the presidency worrying about the wisdom of large deficits
and questioning the need for a tax cut, but he was convinced by the Keynesian
economists around him, and hurried the measure through Congress. The quick success of
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the income-tax cuts prompted Congress to try a variant: the reduction this year of excise
taxes on such goods as furs, jewelry and cars.
Nowadays, Johnson is not only prac ticing Keynesia? economics but is pursuing policies
of Pressure and persuasion that go far beyond anything Keynes ever dreamed of. In 1965
Johnson vigorously wielded the wage-price guide-lines" to hold wages and prices down,
forced producers of aluminum, copper and wheat to retreat from price hikes by
threatening to dump the Government's commodity stockpiles and battled the nation s
persistent balance-of-payments deficit ,with the so-called "voluntary" controls on
spending and lending abroad. Some Keynesians believe that these policies violate
Keynes's theories because they are basically microeconomic instead of macroeconomic
—because they restrict prices, wages and capital movements in some parts of the
economy but not others. Businessmen also complain about what they call "government
by guideline or "the managed economy, but not with total conviction-Business after all, is
booming, and besides the Government is a big customer with unbounded retaliatory
powers. _
Imitation Behind the Curtain. While the U.S. has been accepting the idea of more and
more Government intervention within the bounds of private enterprise, many other
nations are drifting away from strong central controls over their economies and opting for
the freer American system. Britain's ruling Labor Party has become practically bourgeois,
and this year scrapped almost all notions of nationalizing industry; West Germany's
Socialists have long since done the same in an effort—so far unsuccessful—to wrest
power from the free-enterprising Christian Democrats; and traditionally Socialist Norway
in 1965 voted a conservative government into power for the first time in 30 years.
Piqued by the ideas popularized by Soviet Economist Evsei Liberman, the command
economies of Communist Europe are openly and eagerly adopting such capitalist tenets
as cost accounting and the profit motive. East Germany, Czechoslovakia and other
formerly Stalinist satrapies are cautiously granting more powers to local managers to.
boost or slash production, prices, investments and labor forces. State enterprises in
Poland, Hungary and Rumania this year closed deals to start joint companies in
partnership with capitalist Western firms.
Near the Goal. The U.S. right now is closer to Keynes's cherished goal of full
employment of its resources than it has ever been in peacetime. Unemployment melted
during 1965 from 4.8% to an eight-year low of 4.2%. Labor shortages, particularly
among skilled workers, are beginning to pinch such industries as aerospace, construction
and shipbuilding. Manufacturers are operating at a ten-year high of 91% of capacity, and
autos, aluminum and some other basic industries are scraping up against 100%. Contrary
to popular belief, industrialists do not like to run so high because it forces them to start up
some of their older and less efficient machines, as many companies lately have been
obliged to do.
The economy is beginning to show the strain of this rapid expansion. For the first time in
five years, labor costs rose faster than productivity in 1965: 4.2% v. 2.5%. Consumer
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prices last year jumped 1.8% , and wholesale prices rose 1.3%, the first rise of any kind
since 1959. This is already threatening the nation's remarkable record of price stability.
The economy cannot continue its present growth rate at today's productivity level without
serious upward pressure on prices.
Growth v. Stability. The economic policies of 1966 will be determined most of all by one
factor: the war in Viet Nam. Barring an unexpected truce, defense spending will soar so
high —by at least an additional $7 billion—that it will impose a severe demand upon the
nation's productive capacity and give body to the specter of inflation. Keynes feared
inflation, and warned that "there is no subtler, no surer means of overturning the existing
basis of a society than to debauch the currency." Once chided for undertipping a
bootblack in Algiers, he replied: "I will not be party to debasing the currency."
The immediate problem that Viet Nam and the threat of inflation pose to Washington's
economic planners is whether they should aim for more growth or more stability. Labor
Secretary Willard Wirtz argues that the Government should continue pushing and
stimulating the economy, even at the risk of some inflation, in order to bring
unemployment down to 3%. Treasury Secretary Henry Fowler's aides argue just as firmly
that the Government should tighten up a bit on spending and credit policy in order to
check prices and get the nation's international payments into balance.
The man whose counsel will carry the most weight with Lyndon Johnson and who must
make the delicate decisions in the next few weeks is the President's quiet, effective and
Keynesian-minded chief economic strategist, Gardner Ackley. "We're learning to live
with prosperity," says Ackley, "and frankly, we don't know as much about managing
prosperity as getting there."
The Sword's Other Side. Prosperity will bring the Government an extra $8.5 billion in tax
revenues in the next fiscal year, and that means the U.S. can afford to boost its total
federal spending by $8.5 billion without causing significant inflationary pressure. If
spending bulges much higher, the economists can fight inflation by brandishing the other
sides of their Keynesian swords. Though Keynes spoke more about stimulus than
restraint, he also stressed that his ideas could be turned around to bring an overworked
economy back into balance. Says Walter Heller: "It should be made entirely clear that
Keynes is a two-way street. In many ways we're entering a more fascinating era than the
one I faced. Essentially the job is to maintain stability without resorting to obnoxious
controls as we did in World War II and Korea."
In the event demand heats up too much, Lyndon Johnson's economists will recommend
one or more restrictive moves, probably in this order: cutbacks in domestic spending,
still-tighter money, higher withholding rates for income taxes (up from 14% to 20%), and
lastly, temporary tax increases. The step that businessmen fear most—general , and
deflationary controls on prices, wages, profits, materials, mortgage and installment
credit—would be taken only as a desperate final resort. Johnson almost surely will not
turn to controls for the key reason that defense spending is unlikely to amount to more
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than 8.5% of the G.N.P. as against 13% during the Korean War. Ackley says that controls
are "very remote."
Better than '65. Next year's challenge will be more easily manageable because business
and Government pursued intelligent policies this year. The Labor Department reckons
that businessmen's exuberant capital spending—they have invested $190 billion in new
plants and machines in the past five years—will pay off with a 3% productivity gain in
1966. That will serve to temper inflation, and so will the fact that the medicare bill will
lift social security taxes $5.5 billion yearly beginning Jan. 1. As of now, Government
economists expect that consumer prices will rise about 2.5% and wholesale prices will
increase 3%—which is not bad enough to require stern corrective measures.
Economists in and out of Government are much more bullish than they were a year ago.
The economy is not only running close to optimum speed, but has no serious excesses
and few soft spots. Says Economic Adviser Okun: "It's hard to find a time when the
economy has been closer to equilibrium than it is today." Orders are rising faster than
production; wages are rising faster than prices; corporate profits are now rising faster
than the stock market, even though the Dow-Jones average has jumped more than 400
points since mid-1962 and last week closed at an alltime high of 966. Businessmen plan
in 1966 to increase capital spending 15% ; automakers and steelmakers expect to top this
year's production records. Ackley and his colleagues anticipate that the gross national
product will grow another 5% in real terms during 1966, to $715 billion—or perhaps
more.
The Feeling Is Mutual. More meaningful than breaking records is the fact that the U.S.
economy is changing for the better. In Lyndon Johnson's profit-minded Administration,
Government planners have come to appreciate the importance of helping private business
to invest in order to create jobs, income and demand. Johnson knows that he must have a
vigorous economy to support his Great Society programs as well as the war in Viet Nam
and the U.S.'s reach for the moon. To further that aim, he has more day-to-day contact
with businessmen than any President since Hoover; he telephones hundreds of them
regularly and invites scores to the Oval Room to hear their opinions. Under the
atmospherics of the Johnson Administration, the U.S. has a Government whose economic
policies are simultaneously devoted to Keynesianism, committed to growth, and
decidedly probusiness.
Businessmen, for their part, have come to accept that the Government should actively use
its Keynesian tools to promote growth and stability. They believe that whatever happens,
the Government will somehow keep the economy strong and rising. With this new
confidence, they no longer worry so much about the short-term wiggles and squiggles of
the economic curve but instead budget their capital spending for the long-term and thus
help to prolong the expansion.
If the nation has economic problems, they are the problems of high employment, high
growth and high hopes. As the U.S. enters what shapes up as the sixth straight year of
expansion, its economic strategists confess rather cheerily that they have just about
138
reached the outer limits of economic knowledge. They have proved that they can prod,
goad and inspire a rich and free nation to climb to nearly full employment and
unprecedented prosperity. The job of maintaining expansion without inflation will require
not only their present skills but new ones as well. Perhaps the U.S. needs another, more
modern Keynes to grapple with the growing pains, a specialist in keeping economies at a
healthy high. But even if he comes along, he will have to build on what he learned from
John Maynard Keynes.
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139
The Fed’s Loss Function
Inflation Hawk: Policymaker who is very concerned about inflation, more so than any of
the other
Inflation Dove: Policymaker who is less concerned about inflation and more concerned
about other goals of the fed such as full employment and GDP growth.
The Fed’s Loss Function
L = - [α (π-π*)2 + β ( y-y*)2 ]
OR
L = -[α (π-π*)2 + β ( UR - NAIRU)2 ]
Where:
π = actual inflation rate
π* = target or “optimal” inflation rate
y = actual gdp growth
y*= potential (or optimal) gdp growth
α = parameter measuring the degree of “hawkishnish”
β = parameter measuring the degree of “dovishness”
UR = actual unemployment rate
NAIRU = non-accelerating inflation rate of unemployment
Be familiar with the following terms when interpreting the Fed’s loss function:
Inflation Targeting
Core PCE
Alpha
Beta
Stagflation
Hawks
Doves
Discuss Paul Volcker and his behavior during the second oil shock.
Discuss the reputation that Chairman Bernanke has acquired and why.
Be very clear about the 180 degree difference in policy between hawks and doves
in a stagflation environment. That is, in a stagflation environment, hawks and
doves would most definitely disagree.
140
October 12, 2004
American, Norwegian Win Nobel
Prescott, Kydland Honored
In Economics for Research
Crucial to Central Banking
By JON E. HILSENRATH
Staff Reporter of THE WALL STREET JOURNAL
October 12, 2004; Page A2
An American and a Norwegian were awarded the Nobel prize in economics for research
that laid the intellectual foundation for modern central banking and for their somewhat
controversial work that redefined how some economists think about the causes of
economic booms and busts.
The award went to Edward C. Prescott, 63 years old, an economics professor at Arizona
State University and longtime researcher with the Federal Reserve Bank of Minneapolis,
and his frequent collaborator Finn E. Kydland, 60, a Norwegian-born economist now on
faculty at Carnegie Mellon University in Pittsburgh and at the University of California at
Santa Barbara. Mr. Prescott has long been seen as a favorite to win the award; Mr.
Kydland has received less attention.
The Royal Swedish Academy of Sciences said the men's work has "profoundly
influenced the practice of economic policy in general and monetary policy in particular."
The reforms that central banks around the world undertook in part as a result of their
work "are an important factor underlying the recent period of low and stable inflation."
The main insight came in a paper called "Rules Rather than Discretion: The
Inconsistency of Optimal Plans," written in 1977. In that paper, the authors
examined how government policy makers invited long-term trouble when they
strayed from their goals to address short-run problems. They applied the theory to
everything from patent enforcement to federal disaster assistance, but it was in the area of
central banking that the ideas in the paper struck a chord. At the time, inflation was
running rampant and economic growth was stagnant -- a phenomenon called
"stagflation."
141
Most central bankers around the world typically espoused a
commitment to contain inflation, but in practice central bankers
would shift policy to tolerate a little more inflation in the short
run as a trade-off for stronger economic growth and rising
employment. The professors showed how these short-term shifts
in policy had long-term consequences and could push up
inflation expectations of households and businesses, leading to
long-running bouts of rising prices.
"Kydland and Prescott's analysis provided an explanation for
the failure to combat inflation in the 1970s," the academy said.
The key to any policy, they argued, was to make a commitment
and stick to it. Central bankers responded by demanding more
independence, so that they would be less prone to interference by elected officials
who were concerned about short-term fluctuations in the economy. It also led many
central banks -- such as those of New Zealand, Sweden and the U.K. -- to adopt
formal inflation targets to underline the commitment to low inflation. "You should
not
think in terms of controlling the economy," Mr. Prescott says. "That
leads to bad outcomes. You should think in terms of committing to
good policy rules."
Their research into business cycles has been more contentious. Before
the authors took up the subject in a 1982 paper, many economists
believed that economic booms and busts were caused by changes in
demand by consumers and businesses, a point espoused by John
Maynard Keynes, whose views dominated economic thought after the
Great Depression. Mr. Keynes prescribed government stimulus when
consumer spending or business investment softened.
But Messrs. Prescott and Kydland, who were the forefront of a broad shift
away from the teachings of Keynes, argued that other factors, most notably a nation's
productivity, were critical driving forces in short-term shifts in the business cycle. They
theorized that supply-side shocks, such as a new technological innovation or a surge in
the price of oil, could alter productivity patterns and cause a recession or an economic
boom. Before their work, economists thought productivity of a nation's work force
mainly affected long-term economic performance.
Those views about the business cycle may seem straightforward, but they remain
contentious even today, in part because they undercut arguments for the government to
act to stimulate demand when the economy weakens. Lawrence Summers, the president
of Harvard and the former U.S. Treasury secretary, once wrote that the work of Messrs.
Prescott and Kydland on business cycles had "nothing to do with the business-cycle
phenomena observed in the United States or other capitalist economies." In an e-mail
yesterday, Mr. Summers said the two professors "richly deserve" the prize because of the
economic methods they introduced, even though "I like many others find their particular
theories [about business cycles] implausible."
142
Messrs. Prescott and Kydland will share an award of 10 million Swedish kronor, or $1.4
million. The award is officially called the Bank of Sweden Prize in Economic Sciences in
Memory of Alfred Nobel. It is the last of six prizes announced by the Royal Swedish
Academy of Sciences; the others were all announced last week.
Write to Jon E. Hilsenrath at [email protected]
Two majors points to emphasize: 1) Prescott and Kydland won noble prize for hands off
policy prescription; and 2) their work on real Business cycle analysis is contentious.
Applications to the Aggregate Supply / Aggregate Demand Model
143
1. In the space below – Draw an aggregate supply / aggregate demand diagram and label the initial
equilibrium point as point A (assume this point is also consistent with full employment GDP).
Consider the contributions by Kydland and Prescott – that is, show how the policy makers have an
incentive to cheat by stimulating aggregate demand to stimulate GDP beyond its potential. Label this
point B. Point B is a short-run equilibrium and is not consistent with a long run equilibrium since we
assume that potential output is driven by supply side factors.50 Now let wages rise and show what
happens to equilibrium GDP and the equilibrium price level. Label this point as point C. Which do
you prefer – point A or point C. Use the loss function that we developed in class to buttress your
argument.
50
Most if not all economists agree with the notion that potential output is driven by the production function
which is typically a function of total factor productivity, labor, capital, and land resources.
144
In the space below, draw two diagrams depicting the contribution of Kydland and
Prescott. On the first diagram, use indifference curves and show how society is worse off
if policy makers ‘cheat’ by trying to stimulate output beyond its potential. In the second
diagram, show that the Phillips curve is vertical as opposed to being negatively sloped as
was previously thought.
145
The Fed: Are they currently Hawkish or Dovish? Most people believe that if you are
considering only the federal funds target, a target at 3% or below would be considered as
“easy” policy, anywhere between 3 and 5% would be considered neutral, and above 5%
would be considered “tight” policy. Examination of the Taylor Rule will help us
understand where these numbers came from.
The Taylor Rule
Ask Dr. Econ
What is Taylor's rule and what does it say about Federal Reserve monetary policy?
(03/1998)
Taylor's rule is a formula developed by Stanford economist John Taylor. It was
designed to provide "recommendations" for how a central bank like the Federal
Reserve should set short-term interest rates as economic conditions change to
achieve both its short-run goal for stabilizing the economy and its long-run goal
for inflation.
Specifically, the rule states that the "real" short-term interest rate (that is, the
interest rate adjusted for inflation) should be determined according to three
factors: (1) where actual inflation is relative to the targeted level that the Fed
wishes to achieve, (2) how far economic activity is above or below its "full
employment" level, and (3) what the level of the short-term interest rate is that
would be consistent with full employment. The rule "recommends" a relatively
high interest rate (that is, a "tight" monetary policy) when inflation is above its
target or when the economy is above its full employment level, and a relatively
low interest rate ("easy" monetary policy) in the opposite situations. Sometimes
these goals are in conflict: for example, inflation may be above its target when
the economy is below full employment. In such situations, the rule provides
guidance to policy makers on how to balance these competing considerations in
setting an appropriate level for the interest rate.
Although the Fed does not explicitly follow the rule, analyses show that the rule
does a fairly accurate job of describing how monetary policy actually has been
conducted during the past decade under Chairman Greenspan. This fact has
been cited by many economists inside and outside of the Fed as a reason that
inflation has remained under control and that the economy has been relatively
stable in the US over the past ten years.
References
Judd, John P. and Bharat Trehan. 1995. "Has the Fed Gotten Tougher on
Inflation?" FRBSF Weekly Letter, Number 95-13, March 31.
146
Please read the two articles at on the Taylor Rule (at the end of this customization
packet)
(use the space below to write out and explain the Taylor Rule)
147
Greenspan’s Legacy Article
November 18, 2004
PAGE ONE
The Navigator
Fed Chief's Style:
Devour the Data,
Beware of Dogma
As Retirement Looms in 2006,
Greenspan's Strong Record
Will Be Hard to Replicate
Did He Help Create a Bubble?
By GREG IP
Staff Reporter of THE WALL STREET JOURNAL
November 18, 2004; Page A1
WASHINGTON -- In September 1996, Alan Greenspan was fixated on a statistic
neglected by most economic forecasters. It was service-sector worker productivity, a
measure of how much an employee could produce in an hour.
Government data suggested it was falling. The chairman of the Federal Reserve was
convinced they were wrong. Casting his eye across the American economic landscape,
he focused on other signals: rising orders for high-tech equipment and higher profits at
the companies that bought the gear.
He knew it had taken decades for the innovation of electricity to boost productivity.
Now, he thought, the advent of computers was finally having a similar delayed effect.
Mr. Greenspan was so sure of his insight, he was ready to bet the fortunes of the U.S.
148
economy.
That fall, his fellow Fed officials worried that economic growth was so robust it would
push up inflation. Eight of the Federal Reserve's 12 regional banks wanted to cool
things down by raising interest rates. Two Fed governors took the rare step of warning
Mr. Greenspan they might publicly dissent if he didn't recommend such a move.
At a meeting to vote on interest rates, Mr. Greenspan refused and argued that
rates should be held flat, according to a transcript. Following his analysis of the
productivity data, he believed companies could now make and sell more
without having to hire more employees, reducing the threat of inflation. His
conviction was backed by his earlier investigation of some truly arcane
statistics, such as the gap between the government's two main measures of gross
domestic product. His colleagues, with misgivings, went along.
Today, it's clear Mr. Greenspan was correct. By not raising rates, the Fed allowed the
economy to continue growing and unemployment to drop to its lowest level in a
generation, even as inflation edged downward. Other central banks "would have
clamped down," says Nobel Prize-winning economist Robert Solow of the
Massachusetts Institute of Technology. "[Mr. Greenspan] refused to be slave to a
doctrine. He kept saying, 'Let's look around us and see what's happening, and act
accordingly.' "
For 17 years, Mr. Greenspan, who is now 78 years old, has deftly steered the American
economy by relying on two strengths: an unparalleled grasp of the most intricate data
and a willingness to break with convention when traditional economic rules stop
working. In an era when economics is increasingly driven by mathematical models and
politics by dogma, Mr. Greenspan rejects both.
As a result, few people -- including those who have watched him from inside the Fed - understand how he works or how his successor might reproduce his record. In setting
interest rates, he has studied mortgage repayments, the expected price of oil six years
in the future and communications equipment order backlogs. Mr. Greenspan's current
term ends in January 2006 and because of term limits imposed on Fed governors, he
cannot serve another.
"When Greenspan's replacement, whoever he or she is, walks into that office and
opens the drawer for the secrets, he's going to find it's empty," says Alan Blinder, a
former Fed governor. "The secrets are in Greenspan's head."
Some of Mr. Greenspan's success was built on the work of others, including
predecessor Paul Volcker's defeat of inflation in the early 1980s, technological
advances and changes in financial and labor markets.
Moreover, Mr. Greenspan's judgments on occasion turned out to be erroneous. He
overestimated the value of late-1990s investments in technology, leading critics to
149
charge that he egged on the stock-market bubble. He also misread the durability of the
late 1990s federal budget surplus and supported sweeping tax cuts that ultimately
made the deficit more intractable.
In addition, Mr. Greenspan's decision in 1998
to not prick the stock-market bubble is still
controversial. Some fear his alternate move to
cushion its aftermath with low rates fueled
worrisome growth in consumer debt, housing
prices and foreign debt.
Nevertheless, taken as a whole, Mr.
Greenspan's accomplishments add up to a
striking record, one that helps explain how the
U.S. has been able to keep up its growth while
many other major economies still struggle.
Three pivotal decisions illustrate the theme:
raising rates in 1994, leaving them alone in
1996 and letting the stock bubble inflate. In
each case, Mr. Greenspan rewrote the rules of
central banking, even in the face of opposition from those around him.
1994: Soft Landing
In the first eight months of 1994, in a bid to slow the economy, the Fed raised its shortterm interest rate five times, or a total of 1.75 percentage points, to 4.75%. The
Greenspan Fed had a long tradition of moving in small increments, hoping to give
officials time to assess the impact on corporate borrowing or consumer spending
before moving again. Changing rates too rapidly, the theory went, risked an
unnecessarily sharp slowdown and higher unemployment.
But the economy showed no signs of slowing. Investors still worried about inflation -then running at an annual rate of about 3%. That concern led the bond market to drive
up long-term interest rates. When bond buyers worry their investment will be eroded
by inflation, they typically demand a higher rate of return as compensation.
The Fed's challenge was to raise rates enough to slow growth and yet also contain
inflation -- an elusive combination called a "soft landing." But the Fed might raise
rates too much, or the inflation-obsessed bond market could drive up long-term interest
rates too high, causing the economy to fall into recession with a "hard landing."
In November 1994, Mr. Greenspan made a dramatic proposal to the Federal Open
Market Committee, the body that votes on interest rates: Jack up the Fed's key shortterm interest rate by three-quarters of a percentage point in one shot, something he had
never recommended before. Mr. Greenspan believed such a move would demonstrate
the Fed's resolve and finally stamp out inflation worries.
150
"I think that we are behind the curve," he told the Fed's policy committee, transcripts
show. Doing less, he said, could undermine confidence in the Fed's ability to control
inflation. With none of the ambiguity that marked his public statements, Mr.
Greenspan said such an eventuality could provoke a "run on the dollar, a run on the
bond market, and a significant decline in stock prices."
Some of the six other governors and 12 regional bank presidents who made up the
FOMC worried Mr. Greenspan was overdoing it. Especially concerned were two new
Clinton-appointed governors, Janet Yellen and Mr. Blinder, academic economists
inclined at the time to worry more about unemployment than inflation. "There is a real
risk of a hard landing, instead of a soft landing, if we are too impatient and overreact,"
Ms. Yellen, who is now president of the San Francisco regional bank, told the
committee.
Mr. Blinder thought the bond market would consider the increase a sign of more
drastic action to come and would continue boosting long-term rates. Mr. Greenspan's
proposal, he told the meeting, would "be like feeding red meat to the bond-market
lions. They will chew it up and they will ask for more."
Mr. Greenspan held firm. In theory, the 12 voting members of the FOMC decide
interest rates, but in practice, they rarely dissent from the chairman's recommendation,
in part to present a united public front. Without enthusiasm, Ms. Yellen and Mr.
Blinder went along with the three-quarter point rate increase. They did the same again
11 weeks later when Mr. Greenspan pushed rates up a final half-percentage point, to
6%. Both votes were unanimous.
Mr. Greenspan's gamble paid off. Investors concluded that the Fed's actions would
contain inflation. Long-term interest rates stabilized shortly after the November
increase and fell steadily after February's. The stock market rallied. The economy
slowed sharply in the first half of 1995 but didn't lapse into recession. By the second
half of the year it was growing briskly again. Inflation remained at 3%. Mr. Greenspan
had achieved the "soft landing," central banking's holy grail. It set the stage for six
more years of growth and the longest U.S. economic expansion on record.
At the time, neither Mr. Blinder nor Ms. Yellen disputed the economy's strength or the
need to raise rates, but differed with Mr. Greenspan on how to proceed. "I learned that
when it comes to tactics, you should just defer to Greenspan," Mr. Blinder says in an
interview. In a 2002 book, Mr. Blinder and Ms. Yellen wrote: "This stunningly
successful episode ... elevated Greenspan's already lofty reputation to that of
macroeconomic magician."
The gamble also helped solidify the Fed's political independence. "It educated a lot of
politicians, including Bill Clinton and many members of Congress, that it isn't terrible
every time the Fed raises interest rates," Mr. Blinder says.
The move had a downside, however, in that it emboldened investors. Many started
151
believing the Fed would always prevent recessions, a notion that in their minds made
stocks less risky and helped justify ever-increasing prices. "The
idea that the business cycle had become less violent, became: 'the
business cycle is dead,' " says Ethan Harris, a former New York
Fed staffer and now chief U.S. economist at Lehman Brothers. It
was one reason, he says, why investors drove up stocks to prices
that later became unsustainable.
1996: New Economy
Mr. Greenspan doesn't mingle much with his fellow governors.
Though a fixture on Washington's social circuit, he's an introvert
who would rather read staff memos. He rises at 6 a.m. and starts
the day reading newspapers and economic reports and working
on speeches, often in his bathtub. He eats breakfast at his office
most mornings, usually hot cereal and decaf Starbucks coffee. Classical music
sometimes plays on the stereo.
In September 1996, Ms. Yellen and Laurence Meyer, a new Fed governor and a former
top-ranked independent economic forecaster, made a rare visit to Mr. Greenspan's
office. It was the week before an FOMC meeting and Ms. Yellen and Mr. Meyer
hoped to influence his recommendation on interest rates.
The pair worried that unemployment had been so low for so long that a resurgence in
inflation was inevitable. Conventional economic models held that companies would
have to pay higher wages to attract enough staff and would pass on those costs to
consumers as higher prices. They warned Mr. Greenspan that if he didn't recommend
higher rates soon, they might vote against him, recalls Mr. Meyer, who has since
joined an economic forecasting firm.
Mr. Greenspan listened without tipping his hand. He had noted the same developments
but reached a different conclusion based on his analysis of worker-productivity
numbers. Like many economists, Mr. Greenspan had long wondered why the spread of
computers in the 1970s and 1980s hadn't boosted productivity, or output per hour of
work. He was taken with the argument of economic historian Paul David, who noted
that electricity didn't boost productivity for decades until working patterns adjusted.
Mr. David suggested the same lag applied to computers.
Mr. Greenspan now saw surging orders for high-tech equipment since 1993 -- coupled
with higher profits at the companies that bought the equipment -- as evidence the
productivity payoff had arrived. If this effect was real, it meant economists were
underestimating how fast the economy could grow before inflation reared its head.
Companies could produce more without incurring the cost of hiring fresh labor.
When the meeting rolled around the next week, it was a tense affair. A Reuters report
had made public the fact that eight of the 12 regional banks had asked for higher rates.
152
Mr. Greenspan disagreed and told the committee he wanted to hold rates firm. An
important reason, he argued, was that the government's productivity data were wrong.
According to an analysis he commissioned from two Fed economists, productivity
since 1990 in many services industries such as health care must have declined if the
government's numbers were accurate.
This "makes no sense," Mr. Greenspan told the meeting. "The tremendous contraction
in productivity, which all of our data show, is partially phony." Instead, he pointed to
other government reports showing that companies were recording ever-wider profit
margins without raising prices, a sure sign of productivity gains. "Productivity is
indeed rising a lot faster than our statistics indicate."
Many committee members remained skeptical; half still wanted to raise rates. New
York Fed President William McDonough called for solidarity with Mr. Greenspan,
saying talk about dissension had hurt staff morale, transcripts show. Some bridled at
the suggestion. In the end, all but one member voted with Mr. Greenspan. The Fed
kept rates steady through the fall and winter, against the expectations of most
mainstream economists. The decision had an added benefit of keeping the Fed out of
the limelight during the presidential election between Mr. Clinton and Republican Bob
Dole.
Productivity growth, subsequent data show, did accelerate in 1996 from a
disappointing two-decade trend. The U.S. economy, once thought by the Fed to be
capable of growing safely at only about 2.5% a year, could now grow about 3.5% or
more without igniting inflation.
153
Mr. Greenspan "got it right before the rest of
us did," Mr. Meyer wrote in a memoir
published this year.
THE RECORD
The decision to not increase interest rates
allowed the unemployment rate to fall to a
generation-low of 4%, extended the 1990s
boom and helped America's mostdisadvantaged workers share the benefits.
Key moments in Greenspan's
career as chairman of the
Federal Reserve.
1987 Appointed chairman of
the Fed
1987 Cuts rates in response to
stock-market crash
1990 Cuts rates in response to
recession, budget agreement
1993 Backs Clinton's tax
increase
1994 Rapidly raises rates,
roiling bonds, derivatives
1995 Helps bail out Mexico
1996 Warns of "irrational
exuberance"
1996 Holds rates steady, says
higher productivity growth
damps inflation
1998 Backs rescue of Long
Term Capital hedge fund
1998 Decides to not prick
stock-market bubble
2001 Backs George W. Bush's
tax cut
2001 Slashes rates as tech,
stock bubbles burst
2002 Urges restoration of
balanced-budget rules
2003 Cuts rates to 1% to
prevent deflation
2004 Calls post-bubble
strategy "successful"
Despite his early recognition of the
transformative power of technology, Mr.
Greenspan doesn't use e-mail. He does have an
Apple Computer Inc. iPod digital-music player
given to him by his friend, World Bank
President James Wolfensohn. Regardless, his
arguments made him the leading apostle of
what was then dubbed the "New Economy,"
the idea that technology had permanently
raised the economy's growth rate.
Given that the tech boom eventually went bust,
helping push the economy into recession, did
Mr. Greenspan's enthusiasm go too far? One
predecessor as Fed chairman, William
McChesney Martin Jr., said central bankers are
supposed to take away the punch bowl when
the party gets going. In words at least, Mr.
Greenspan did the opposite. "He went a little
overboard on the 'New Economy,' " says Mr.
Solow the MIT economist.
In public and private, Mr. Greenspan was clear
he thought stock prices were irrational. "The
danger is that in these circumstances, an
unwarranted, perhaps euphoric, extension of
recent developments can drive equity prices to
levels that are unsupportable," he told
Congress in 1999.
But he fully bought into the idea that booming sales of tech gear, which helped fuel the
stock mania, were both rational and sustainable. "The veritable explosion of spending
on high-tech equipment and software...could hardly have occurred without a large
increase in the pool of profitable projects available to business planners," he told a
White House conference in April 2000.
154
Shipments of high-tech equipment peaked five months after that conference, then
plunged 25% over the next year. Many of the investment projects Mr. Greenspan
praised proved to be losers. Start-up telecoms and dot-com businesses, flush with
capital, spent billions building online businesses that were barely used. Between 1997
and 2001, companies invested $90 billion laying fiber-optic cable but less than 3% of
it was in use when the recession struck.
Moreover, some of the profits of the late 1990s, at companies such as Enron and
WorldCom, turned out to be fictitious. "He was right about the productivity change,"
says Allan Meltzer, a Fed historian at Carnegie Mellon University. "He was wrong
about much of the profitability of the productivity change."
Still, even if Mr. Greenspan had realized that a lot of investment spending was wasted,
it's not clear he would have raised rates sooner. Productivity has actually accelerated
since the recession. Investors meanwhile ignored his warnings about the stock market,
creating the biggest challenge of Mr. Greenspan's career.
1998: Stock Bubble
Back in spring 1994, when the Dow Jones Industrial Average was below 4000, Mr.
Greenspan worried that a stock-market bubble had formed, according to transcripts of
Fed meetings, and he raised rates partly to deflate it. The effect was temporary. Once it
became clear the Fed had achieved its soft landing, stocks headed higher again.
By fall 1996, as the Dow approached 6000, Lawrence Lindsey, then a Fed governor,
told Mr. Greenspan and his fellow governors that the Fed should halt the bull market.
"All bubbles end badly," Mr. Lindsey recalls telling a meeting of Fed governors.
A few months later, in a December speech
given to the American Enterprise Institute, Mr.
Greenspan famously asked if stock investors
were gripped by "irrational exuberance."
Again, the effect was temporary. By spring
1998, the Dow topped 9000 and pressure on
Mr. Greenspan was intense to damp the
market with actions, not just words.
In April of that year, the Economist magazine
ran an editorial titled, "America's bubble
economy: The Fed needs to pop it, and the
sooner the better." That issue's cover featured
a bubble floating over the Statue of Liberty.
The article asserted that the 1929 crash and
subsequent Depression were caused by a
similar Fed failure to rein in stock speculation.
Mr. Lindsey, who had since joined a think
155
tank, visited Mr. Greenspan and the two discussed the piece. Mr. Greenspan
maintained that the Great Depression could have been avoided if the Fed had acted
more aggressively after the crash, Mr. Lindsey recalls. "1929 didn't cause 1932. It
depends on what you do in 1930 and 1931," Mr. Lindsey recalls Mr. Greenspan
saying.
At an FOMC meeting the following month, the central bank's staff warned in a
presentation that rising stock prices were creating a bubble that threatened to create
economic instability. Donald Kohn, then a top Fed staffer and now a Fed governor,
offered several options. The most severe: Raise rates promptly if the committee
thought the eventual collapse of a stock bubble posed a "sufficient threat ... to the
health of the economy and the financial system."
Mr. Greenspan told the meeting he didn't want to prick the bubble. First, he told the
committee members, it was hard to second-guess millions of investors on the right
value for stock prices. Secondly, he said permanently ending a bubble required rates so
high they'd also wreck the economy.
The bubble began to deflate by itself in April 2000. When the economy weakened, the
Fed cut rates sharply, following Mr. Greenspan's analysis of what the Fed did wrong in
1929. It cut rates twice in January 2001 and five times more through August. After the
Sept. 11 attacks, it cut four more times, and did so again in 2002 after corporate
scandals undermined investor confidence. In 2003, when the Iraq war and threat of
deflation hung over the economy, the Fed cut rates again. By June 2003, the Fed's key
rate was at 1%, the lowest in 45 years.
The same thinking also led Mr. Greenspan to slash rates after the 1987 stock-market
crash and in 1998 after Russia defaulted on its debt, roiling world stock and bond
markets. On both occasions, the economy rapidly bounced back.
This time, however, debate still rages over Mr. Greenspan's strategy. For now, it
appears to have worked. The U.S. escaped with a mild recession instead of a 1930sstyle Depression or Japanese-style stagnation, says Nobel Prize winner Milton
Friedman. For that, Mr. Friedman credits the Greenspan Fed's aggressive rate-cutting.
"The bubble left real costs on the economy, in a significant waste of capital," Mr.
Friedman says. "But I don't believe the Federal Reserve could or should have done
anything significant about it. It's not the business of the Federal Reserve to control the
stock market; it's the business of the Federal Reserve to produce stable prices."
Mr. Greenspan has been confident enough in the outlook to start raising rates, but the
expansion seems tentative. Scarred by the aftermath of 1990s, businesses are hesitant
to hire and invest. Some economists worry by having kept rates so low, the Fed fueled
excessive borrowing and a housing-market bubble. A plunge in housing prices would
be particularly painful because property comprises such a sizable part of most families'
wealth. It's also the collateral for many loans.
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"It's a lingering issue Alan Greenspan has to defuse in writing his own history," says
veteran Wall Street economist Henry Kaufman.
Write to Greg Ip at [email protected]
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