Chapter 1. a Tour of the World

CHAPTER 1. A TOUR OF THE WORLD I. MOTIVATING QUESTION

What Is Macroeconomics? The chapter does not provide an explicit or formal answer. Instead, it describes the issues of concern to macroeconomists who study the United States, Europe, and Japan. A working definition of macroeconomics at this point is the study of output, unemployment, and inflation, terms that will be defined precisely in Chapter 2. II. WHY THE ANSWER MATTERS

This chapter attempts to provide students an incentive to master the theoretical material that follows in the remainder of the text. The implicit promise is that the theoretical model developed in the text will allow students to make sense of current economic problems of obvious importance around the world. III. KEY TOOLS, CONCEPTS, AND ASSUMPTIONS

1. Tools and Concepts Chapter 1 does not provide any analytical tools. However, it does force students to confront some basic data and introduces data sources for various regions of the world. In addition, the chapter introduces and defines briefly the concepts of output, growth, the unemployment rate, and the inflation rate. A precise definition of these terms follows in Chapter 2.

2. Assumptions Implicit in the Tour of the World is the assumption that the same basic macroeconomic tools can be used to analyze economies throughout the world. It might be worth making this point explicitly. The macroeconomic framework developed in the text would be neither terribly useful, nor compelling as a theory, if it applied only to the United States, and not to the other market economies. IV. SUMMARY OF THE MATERIAL

1. The United States After a period of historically high growth, low inflation, and low unemployment over the years 1994 to 2000, the U.S. economy slowed substantially in 2001. Although output growth remained (barely) positive over 2001, growth was actually negative for much of the year, and economists refer to this period as the recession of 2001. In response to the recession, the Federal Reserve sharply reduced interest rates and the Bush administration, with the help of a Republican Congress, enacted large tax cuts. These measures led to higher spending, and recovery was under way by 2002. Since then, growth has increased and inflation has remained low. Unemployment increased in 2003, but has fallen since then. As this book goes to press, the U.S. economy is generally doing well, but there are two concerns about the future.

The first issue is whether the economy will return to the high growth rates of the late 1990s. In that period, it became fashionable to talk about a “New Economy,” a more prosperous economy that behaved much differently from the postwar U.S. economy to date. The text dismisses the general claim, but takes seriously the specific assertion that the U.S. economy has begun a period of faster technological progress. Average annual productivity growth increased to 2% over the period 1994-2004 from 1% over the period 1973-1993. Average annual productivity growth was 2.1% over the period 1960-1973. The variability of annual productivity growth rates is so high, however, that it is difficult to tell whether the recent

1 experience indicates a lasting change in the economy. Some economists believe that there has been a change in productivity growth that will persist into the future; others believe that we need more evidence.

The other issue is the federal budget deficit, which moved from a surplus of 2% of GDP in 2000 to a deficit of 4.6% in 2003, with large deficits projected for the rest of the decade, absent changes in policy. The recession of 2001 had a temporary adverse effect on the deficit, but the recession is over and the deficit remains. The two major causes of the deficit are the loss of revenue from the Bush tax cuts, which were made permanent, and the increased expenditure associated with the wars in Iraq and Afghanistan. Many economists worry that the large deficits will ultimately lead to less capital accumulation, since the borrowing required to finance the government will occupy private saving that would otherwise be used to finance investment in new capital. Less capital accumulation means less output in the future. As this book goes to press, there is no serious political discussion about reducing the deficit.

2. The European Union Over the decade 1994-2004, the countries of the European Union together experienced positive but relatively low growth, combined with low inflation and continued high unemployment (relative to Europe in the 1960s and to the United States today). At the same time, twelve of the member countries of the European Union have formed a single currency—the Euro—as part of an ongoing effort to unify Europe politically and economically. Continuing high unemployment and the economic effects of the Euro are the two principal macroeconomic issues facing European policy makers.

The debate over remedies for high unemployment in Europe is characterized by two polar views. According to the first view, high unemployment is the legacy of the wage explosion of the 1970s and high interest rates in the 1980s and 1990s. Thus, the suggested remedies are wage moderation and better monetary policy. According to the second view, high unemployoment is a result of rigid labor market institutions. Thus, the suggested remedy is to restructure labor market institutions to promote more flexibility in the labor market.

As for the Euro, there are benefits and costs. Although the Euro will eliminate exchange rate uncertainty among participating countries, and thus may have economic benefits, the adoption of a single currency eliminates the discretion of each country individually to use monetary policy to stimulate output and reduce unemployment. Countries that participate in the Euro have a common monetary policy, in the same way that states in the United States have a common monetary policy. This situation creates the possibility of policy conflicts when some countries are in recession and others are in an economic boom. In the U.S. rarely experience booms and recessions uniformly. The last recession, for example, hit California particularly hard (as did the preceding boom) If growth remains low in Europe generally, and some countries suffer disproportionately, such policy conflicts may surface in the years ahead. Policy issues associated with monetary union are discussed further in Chapter 21.

3. Japan After a long period of exceptional growth in the postwar period, the Japanese economy slumped markedly in the 1990s. The average growth rate fell to 1.4 percent between 1994 and 2000. Growth was near zero in 2001 and negative in 2002. Lower growth has been accompanied by historically high unemployment rates, which seem to be declining as this book goes to press. High unemployment has led not merely to low inflation, but to negative inflation – or deflation – for much of the last decade.

Most economists attribute the onset of Japan’s slump to the collapse of an overvalued stock market and an overvalued real estate market in the early 1990s. The collapse of asset prices led to a decline in demand. As the economy slowed, the Japanese central bank reduced interest rates as much as possible (short term interest rates are now equal to zero) and the government increased spending on public works projects and

2 reduced taxes and now faces persistently high budget deficits. These macroeconomic policy measures, designed to stimulate demand, had little effect. Tax cuts, in particular, were not effective because the nervous Japanese consumers saved all of the increased disposable income.

The ineffectiveness of macroeconomic policy led many economists to argue that the Japanese economy had deeper structural problems, in particular an inefficient banking system. The slump made it difficult for firms that had borrowed from banks to repay. Rather than recognize these losses explicitly (and so perhaps become bankrupt), many bank managers in Japan chose to extend more credit to failing firms. As a result, it has been difficult for more successful firms to get access to needed credit.

The Japanese government has taken steps to improve the banking system. For example, the Japanese are increasingly willing to allow foreign ownership of banks. The process is politically painful, since it involves forcing firms and banks into bankruptcy. Whether these improvements account for the recent increase in growth is unclear. There have been other important factors, including an increase in Chinese demand for Japanese exports.

The Japanese slump has some parallels to the Great Depression. Both events featured a collapse in asset prices, low or negative growth, a liquidity trap, falling goods prices. Chapter 22 discusses these parallels more explicitly. V. PEDAGOGY

1. Points of Clarification A subtle point that arises from the discussion of the macroeconomic data is the division of postwar time into pre- and post-1973. Since few of today’s undergraduates would have been alive in 1973, a brief mention of the oil crisis (as well as the final collapse of the fixed exchange rate system) would be helpful to introduce students to the seminal historical episodes of macroeconomics.

2. Alternative Sequencing Output, the unemployment rate, and the inflation rate are not defined precisely until Chapter 2. Some instructors may prefer to cover the definitions from Chapter 2 and the discussion of why macroeconomists care about these variables, before discussing the material in this chapter.

3. Enlivening the Lecture An alternative to posing the motivating question of this chapter is to ask students what they hope to learn from the course. The answers can be used to construct a description of what the course—and macroeconomics—is about. Another alternative is to begin a lecture on this chapter (and the course) by asking whether the Fed should raise interest rates at the next meeting of the Open Market Committee and to develop alternative opinions based on illustrative newspaper quotes or student answers. In addition to portraying macroeconomics as a lively and sometimes contentious field, this approach also immediately introduces students to the central issue of U.S. macroeconomic policy and connects the course with current topics in the news.

Likewise, rather than sticking to the facts presented in the chapter, one could ask students to raise questions about countries of interest to them. Other topics that might make the lecture more provocative are discussed in the Extensions below. VI. EXTENSIONS

1. The Rest of the World

3 The Tour of the World presented in this chapter focuses attention on the United States, Europe, and Japan. Economic events in the rest of Asia, Latin America, Africa, and Central and Eastern Europe are discussed only briefly. Current economic events in some of these regions are discussed at various places throughout the text. However, instructors may wish to devote more time to these regions at the outset, especially if the course will consider the open economy. China, in particular, offers rich possibilities, given its size, rate of growth, substantial trade surplus, and fixed exchange rate regime (an issue of contention between China and the United States as the Instructor’s Manual goes to press.)

2. Positive and Normative Economics, Policy Disagreements among Economists, and Economic Methodology Instructors may wish to distinguish between positive and normative economics and to discuss how normative perspectives can lead economists to different policy prescriptions even when they agree on the facts. Instructors may also wish to remind students of the difficulties that economists and other social scientists face because of the inability to conduct controlled experiments. A discussion of this sort was presented in Chapter 1 of the first edition of the text.

3. Distribution of Economic Benefits The second edition of the text included a discussion about wage inequality in the section on the U.S. economy. Instructors may wish to raise this issue in their introduction to macroeconomics. In particular, it may be interesting to examine which groups suffered most with respect to unemployment or wage growth during and after the recession of 2001.

4. The Liqudity Trap in Japan The text alludes to the liquidity trap in Japan, but does not discuss the issue in detail. Chapter 22 examines the issue more explicitly. Instructors may wish to raise the issue of a zero nominal bound on interest rates. There is also a question about the effectiveness of the Japanese policy response to the slump. Did the Bank of Japan wait too long to reduce interest rates?