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Economics 104B - Lecture Notes - Professor Fazzari

Topic IV: Major Components of the Economy (Final March 17, 2013) A. Consumption: Source of Demand – Determinant of Saving 1. Consumption and income a) Psychological “law:” consumption spending rises with income  In his classic book, The General Theory, Keynes described what he called a “fundamental psychological law:” the more income people have, the more they will consume.  This “law” may seem fairly obvious, but it is not necessary for people to consume more just because they make more money. People could live in a way where they just meet their needs and save all remaining income. However, this is not the usually the case; when people make more money, they tend to spend more.  Equivalently, when peoples’ incomes fall, they will consume less.  We can see evidence of this law at work in recessions and booms. Usually, consumption declines (or at least its growth slows substantially) in recessions, while consumption usually grows fast in economic booms with rising income. b) Marginal propensity to consume (MPC)  Definition of the “MPC:” the change in consumption that occurs from a small change of income; the amount that will be spent from an additional $1 of income (or the amount spending is reduced when income declines by $1).  The MPC for an economy is usually assumed to be between 0 and 1. The MPC is positive because of the “psychological law.” A positive MPC means that consumption rises when income rises and falls when income falls. An MPC of 1 means that consumers spend all of any additional income they get and save none of it. An MPC of 0 means that households save all of any additional income they get and consume none of it. (All income either goes either into consumption or saving.)  The opposite of MPC is MPS, Marginal Propensity to Save: MPS = 1 - MPC The current savings rate in the U.S. economy is below five percent. If we think of the savings rate as a crude approximation for MPS, then aggregate MPC is about 0.95.  An individual could theoretically have an MPC greater than 1. Suppose that someone spent all of their additional income and also used their higher income to get a loan and spend even more. But this is unlikely for the economy as a whole.  It is important to understand the meaning of the work marginal in the definition of the MPC. The MPC is the effect of a small change of income on consumption, that is, the effect “on the margin.” The MPC is not simply the ratio of consumption to income (a concept often called the “average” propensity to consume). o Example: Suppose a household has income of $100,000 and consumes $90,000 in a year. This information is enough to determine that the average propensity to consume is 0.9. But we don’t know the MPC from these figures alone. o If the household were to receive an additional $1,000 in income, then we could observe the change in consumption to see what the MPC would be. For example, if consumption of the household rose by $800, we could estimate the MPC as 0.8. c) Evidence of fluctuations in consumption and income over the business cycle  The graph below shows real consumption expenditures from 1970 through 2012. The main feature is strong growth in consumption over time as the economy has expanded.  If you look carefully at the graph, however, you will see that most of the time when the economy goes into recession (as indicated by the gray bars), consumption growth noticeably slows. This shows a linkage between consumption and income.

 Careful inspection shows two events that stand out in the graph: o First, consumption did not really show any tendency to slow in the 2001 recession or the slow growth period after this downturn. The 2001 recession was driven primarily by a decline of business investment. The fact that consumption continued to grow strongly right through the recession helped make that event quite mild by historical standards. o Second, the most obvious deviation in consumption from the long-term trend happens with the Great Recession beginning late 2007. The drop is by far the largest on the graph and although consumption resumed growing in 2009 it has not recovered fast enough to attain the previous trend. . From a demand-side perspective, the drop in consumption in the Great Recession is an important cause of that significant event.

2. The Consumption Function a) A mathematical model  C = a + (MPC) (Y) where C = consumption a = constant Y = Income MPC = Marginal Propensity to Consume, a number between zero and one assumed to be constant.  The constant “a” is literally the amount of consumption that would take place if income were zero. But we really don’t know what consumption would be if income were zero. In practice, “a” represents other factors affecting consumption besides income. An exogenous consumption “shock” will change “a.” For example an intense marketing campaign by automakers may cause consumption of cars to increase even though incomes have not changed. (1) Movements along the consumption function with changes in disposable income  Holding all else constant, if Disposable Y changes, then you only move along the graph. (2) Relation between slope of the consumption function and MPC  The algebraic consumption function describes a standard linear equation in “slope-intercept” form. The constant a is the intercept and the MPC is the slope.

C

slope = MPC

a

Y b) Shifts of the Consumption Function  Extra Material: Some General Principles in Working with Graphs. There are three types graphical movements you need to know:

- A movement along the graph: holding all else constant, if Disposable Y changes, then you only move along the graph.

Example: This is a movement along the graph when income increases C1 from Y0 to Y1. Consumption changes from C0 to C1. Neither a nor MPC is changed. C0

Y0 Y1 - A change in the slope of the graph: this is caused ONLY by a change in the MPC.

Example: A greater MPC will make the slope of the graph increase. At a given value of Y, a C1 greater MPC will cause C to shift from C to C . Note that C0 0 1 a does not change.

Y - A change in the vertical-axis intercept: caused by a change in a. a will change due to a change in an exogenous variable (a consumption shock). Examples of typical shocks appear later in the notes.

Example: A consumption shock will change a. In this case, we have a positive consumption shock that shifts a from a0 to a1. Therefore, at any C1 value of Y, consumption C0 increases by (a1 – a0).

Note that MPC does not change. Y (1) Wealth changes: distinction between wealth and income  Wealth is different from income. Wealth is a “stock” variable. Wealth is the value of all a person’s possessions at a point in time. Income is a “flow” variable. It is the amount earned over a period of time. Because a “flow” variable is measured over a period of time, we need to specify what that period is, whether an hour, month, quarter, or year.  Generally, a person who has a high income will have high wealth, but this is not always the case. A person right out of college can get a great job with an income of $100,000 a year, but he/she will have not accumulated a lot of wealth yet. Similarly, a person with a relatively low income could have invested some money in “the right” stocks, and made a lot of money. That person’s wealth would be high, but their income would remain low.  High consumer wealth will cause a larger value of “a,” that is, an upward shift in the consumption function. If consumers have high wealth, they will spend more for every income level.  Application: a fall in stock market prices will cause a decrease in consumer wealth. Therefore, the consumption function will shift down.

C High Wealth A drop in stock market prices causes a decrease in wealth. When consumer Low Wealth wealth goes down, a0 consumption decreases at every value of Y. This is a an exogenous consumption 1 shock, causing a to shift. Y  The decline in the stock market after the “tech bubble” burst in early 2000 could have been a factor contributing to the slowing of the economy and the recession of 2001.  There is a lot of interest in “wealth effects” due to the dramatic changes in the value of houses in recent years. o Many economists argue that the significant rise in the value of homes from the middle 1990s through 2007 pushed consumption upward, even holding income constant. This is a wealth effect, it would be modeled with the consumption function by pushing up the value of the intercept term “a.” Consumption would rise for any level of income. o Conversely, the remarkable fall in house prices after 2007 could cause a negative wealth effect on consumption. o From a demand-side perspective, these wealth effects could have an important impact on output and employment. The positive wealth effect from rising home prices stimulates consumption spending. Higher spending encourages firms to produce more and hire more workers. Economic growth is strong and unemployment falls. But the negative wealth effect after 2007 could be an important cause of the Great Recession. Reduced home prices lower wealth, reduce consumption and firms sales. Firms cut production and lay off workers (or at least do not replace workers that quit for other reasons). GDP and employment fall. (2) Interest Rates  The interest rate is effectively the reward for saving. Therefore, when the Fed lowers interest rates, they are lowering the reward for saving. This encourages consumption. Furthermore, lower interest rates will reduce the amount of money households need to service their existing debt, which will make more money available for them to consume.

Low interest rates An increase in the C interest rates increases High interest rates the reward for saving. Therefore, at every value a1 of Y, consumers save more. This is an a0 exogenous consumption shock, causing a to shift. Disp Y

 The link between interest rates and consumption constitutes one way in which Fed policy affects overall macroeconomic activity. (3) Expectations of future income: consumer confidence  Consumers make their spending decisions based not only on current income, wealth, etc., but also with an eye toward future conditions. Thus, expectations matter for consumption. Indeed, the importance of expectations is a major theme in modern research on consumption. o If households expect income to rise in the future, they will consume more today for a given level of current income. Therefore, the consumption function shifts upward. o In an important sense, higher expected future income is similar to an increase in wealth. Higher future income raises the resources available to households over time, just like the effect of higher wealth.  One aspect of this point relates to the importance of "consumer confidence" about future conditions. A private economic analysis group (the Conference Board) surveys American consumers monthly and publishes an index of consumer confidence. When this index falls, the implication is that people are more concerned about the future and therefore may cut back their spending plans. Thus, weaker consumer confidence shifts the consumption function downward. According to demand-side theory, this "shock" will reduce output and employment.  This consumer confidence effect explains how geopolitical events, outside of the narrow economic sphere, may affect the macro economy. For example, many analysts believed that the September 11, 2001 terrorist attacks would cause consumer confidence to fall and therefore hurt spending and weaken the economy through the demand side. (While this theory was logically coherent, in fact consumer spending held up pretty well after the attacks.) (4) Application: temporary vs. permanent tax changes and consumption  Tax changes are another factor that shift the consumption function. It is sensible to assume that consumption depends on disposable income, which is income households have after their taxes are deducted (or paid directly to the government for self-employed people). Sometimes disposable income is called “take-home pay.”  When taxes are cut, people have more money in their pockets for a given level of pre-tax income. Consumption rises. Assuming that the horizontal axis of the consumption function measures pre-tax income, the consumption function would shift upward. o Note that later in the course we will consider more realistic models that include endogenous taxes such that the amount of taxes paid varies with the level of income. In this case, the effect on the consumption function is more complicated. But for now, it’s OK to think of taxes as “lump sum,” so that a tax change just shifts the consumption function up or down.  Because consumers base their spending decisions on expectations of the future, at least in part, we expect that permanent shocks will have a bigger effect on consumption than temporary shocks. The reason is that permanent changes affect not only current conditions, but future conditions as well.  An excellent example of this point is the impact of various tax cuts in recent years. o During the 1974-1975 recession, the government, led by President Gerald Ford, tried to stimulate consumption by sending a $100 check to every person who filed a 1974 tax return. Everybody knew that this was a temporary increase in their income. Nobody felt wealthier. Nobody expected a higher future income. Therefore, their consumption functions did not change very much. o In the early 1980s, President Ronald Reagan proposed tax cuts to permanently reduce the tax rates. Congress passed these tax cuts in 1981 and they went into effect over the next few years. Because this tax cut was permanent, it raised expected future disposable income, as well as current disposable income. Therefore, the effect on consumption was likely larger than the Ford plan discussed above. There was, in fact, a consumption boom in the 1980s, and while we cannot necessarily attribute this boom entirely to the tax cut, it is likely that it did play a role. . Because the Reagan tax cut raised peoples' expected future income, it shifted the consumption function. o An example of an obviously temporary tax cut with entirely short-term effects is from the George H.W. Bush administration (the “original” President Bush). The administration reduced employer tax withholding while keeping tax rates the same. Tax deductions on paychecks fell, but this change was offset by a smaller refund (or larger tax bill) when people filed their tax returns the following spring. The effect on consumption was negligible and temporary. o Similar arguments could be made in favor of allowing the tax cuts passed under President George W. Bush (the son) to be made permanent. Many people believe that even though the tax cuts now are scheduled to "sunset" (be repealed) in a few years, this threat is more of political game and the tax cuts will be made permanent.  Here is a graphical way to interpret temporary versus permanent tax cuts with the consumption function:

Consumption

C

B

A

Y0 Y1 Disposable Income

 In this graph, the economy begins with disposable income of Y0 and consumption at point A. Now, a tax cut raises disposable income to Y1 and consumption rises to point B, assuming the tax cut is temporary. But if the tax cut is permanent and future disposable income is expected to be higher, the consumption function will shift upward (due to the change in expectations). The result will be higher consumption today, as shown by point C. 3. Consumption and Saving  When consumption rises, by definition, saving declines. Therefore, the factors that affect consumption also affect saving. Why should we care about saving? a. Saving and individual wealth accumulation  Most obviously, saving determines the rate at which individuals build up personal wealth. Thus, society often conveys a message that saving is good and virtuous. People will benefit in the future by “sacrificing” consumption today.  One primary reason for saving is to provide resources for a household to maintain its consumption spending after retirement. o In particular, the large “baby boom” generation is encouraged to save because there are so many of them. When the baby boom retires, there will not be as many workers to support each retiree as was the case in earlier years, particularly the years when the baby boom generation was in the work force. o Because of these demographic realities, the baby boom generation will put more strain on programs that transfer income from workers to retirees, particularly the Social Security system. The normative conclusion from this observation is usually that the baby boom generation should save more than earlier generations. o In this context, many economists and policy makers worry about the strong trend in the U.S. toward higher consumption. Higher consumption implies less saving, and this trend has occurred just when the baby boom generation should have been putting away resources for their retirement. b. Saving as source of funds for investment  Saving affects individual wealth. In particular, it determines how the ownership of an economy’s assets is distributed across individuals. But the larger question for performance of the aggregate macroeconomic system is how saving affects output and growth.  Some people save and others borrow. These transactions cancel out. But the household sector as a whole usually chooses to save more than it spends. You can think of the whole household sector as if it makes a deposit into the banking system. The more the households save, the more the banking system can lend to other parts of the economy.  In particular, the saving of the household sector is channeled by the financial system into financing for businesses. Firm use these funds to build new factories, purchase new and better equipment, and develop new technologies.  Higher saving (that is, lower consumption) by households releases resource that can be used for investment and capital accumulation by businesses. c. Relevance of saving for the supply side and potential output  As we discussed in section III of the course, business capital and technology are key factors that determine potential output on the supply side. They also are perhaps the most important factor that determines growth in the long-run standard of living in society.  From this supply-side perspective, low consumption and high saving improve macroeconomic performance. d. Conflict between demand-side and supply-side roles of consumption and saving  Note that the demand-side and supply-side perspectives on consumption and saving are contradictory. o According to the demand-side view, higher consumption stimulates business sales and encourages firms to produce more and hire more workers. o In supply-side theory, higher consumption reduces saving which lowers the resources available to business for investment and technological development. The result is lower potential output.  Which perspective is correct? The answer is complex and subject to debate. One simple resolution is that the demand-side perspective is correct in the short run (when demand-side theory is most relevant) while the supply-side theory applies to the long run. This resolution suggests that a rise in saving may hurt the economy for a while, but eventually it improves economic performance. o This is an attractive and intuitive conclusion. It is similar to the idea that a household sacrifices consumption today to have a higher of standard of living in the future. o But there are a number of reasons why this simple analogy between individual households and the economy as a whole may not be correct. We will return to this important and intellectually challenging question near the end of the course when we have studied macroeconomic theory more completely.  This distinction between the demand-side and supply-side effects of consumption and saving is also of relevance for determining whether the Great Recession was primarily a demand-side or a supply-side phenomenon. o Recall from the chart above that consumption dropped dramatically at the beginning of the Great Recession. This is consistent with a demand-side explanation for the Recession. Consumer spending declines, firms sell less, and they cut back on production and employment. o A basic interpretation of consumption in the Great Recession largely contradicts the supply-side explanation for this economic event. In a pure supply-side model, less consumption should raise saving and encourage higher output by making more resources available for business investment and capital accumulation. It is pretty clear that this did not happen. (We will look at investment data in the Great Recession in the next section of these notes.) o Largely for this reason, a majority of economists likely see the Great Recession as a demand-side phenomenon. . But supply-side effects, like labor-market mismatch, may still play some role in the Recession. . Some “new classical” economists, who explain macroeconomic fluctuations as almost exclusively supply side in origin, maintain that supply-side factors can still be responsible for the Great Recession even though the economy weakened when consumption declined. This approach would typically argue that there is some other factor (related to potential output) that caused both output and consumption to decline. In this case, the drop in consumption did not cause the Great Recession (as it would according to demand-side theory). 4. Consumption Statistics a) Consumer spending constitutes largest portion of sales  Consumption is the largest part of aggregate demand, by far. In consists of everything bought by households except new houses (these are counted as residential investment).  Consumption can be divided up into "durable" and "non-durable" categories. Durables include longer-lasting goods like cars and appliances. Non-durables include food and clothing and many services. But usually we refer to consumption as a whole. b) Trends in shares of consumption in total output  The share of consumption in demand has risen from about 62 percent in the 1960s to about 71 percent in recent years (see the graph below).  See your class notes for further information about the role of consumption in the lead-up to the Great Recession and the actual crash.

B. Investment: A Volatile Component of Aggregate Demand 1. Volatility of Investment over the business cycle.  Investment is the second major component of the economy that we will study in some detail. Investment consists of three major pieces. o The largest part is “non-residential fixed investment” or, more simply, business investment. This figure includes the value of structures, equipment, and software purchased by firms. This variable plays an important role in supply-side theory because it affects the accumulation of capital resources, a major determinant of potential output. In recent decades, business investment has usually been between 10% and 12% of GDP. o The second component of investment is the change in inventories. This component is usually quite small. But it can be volatile over the business cycle. A decline in inventories was an important part of the adjustment to the Great Recession crisis in 2009. o Third, as we discussed earlier in the course, investment includes new residential construction (both single-family and multi-family buildings). Residential investment also includes expenditure on major home remodeling. In the mid 1990s, residential investment accounted for about 4% to 5% of GDP. In the housing boom of the middle 2000s, it rose to just over 6% of GDP. But it started to decline in 2006 and then absolutely collapsed to less than 2.5%. As of late 2010, residential investment has stabilized, but at a level dramatically lower than historical averages.  Note that investment is substantially smaller than consumption. Adding up all three components, investment has typically been 15% to 17% of GDP (although it is a smaller share, closer to 13% in the Great Recession period). Consumption accounts for more than 70% of economic activity.  But investment is much more volatile than consumption. Its growth rate jumps around a lot more.  Between 2000 and 2010, the annualized growth rate of quarterly real investment has ranged from -42% to +31%. The corresponding range for consumption was -3.5% percent to +6.4 percent. Obviously, investment jumps around more than consumption.  Investment is also highly procyclical, that is, it rises strongly when the business cycle is good and falls steeply when the business cycle is weak. Consumption is procyclical as well, but the effect is much stronger for investment. 2. Business confidence, sales and capacity utilization  Why does business investment slow significantly in a recession? The vast majority of investment consists of durable goods. These goods are expensive. Firm purchase them based on expectations about future business conditions over the life of the capital good, which can be very long. Business confidence, that is, the outlook of managers about the future, determines these long-term expectations. In a weak economy, we expect expectations to be pessimistic which feeds into weak investment.  Companies can often employ the capital they already have when their sales are slow, so there is no motivation for them to invest in more capital during a recession.  Economists often focus on a statistic called "capacity utilization." This figure estimates the proportion of productive capacity that business is actually using. When firms are producing a lot, and capacity utilization is high, there is much more incentive to invest in new capacity. But when sales are weak and capacity utilization is low, there is not much reason for firms to build new capacity.  For technical reasons, capacity utilization is typically between 80 and 85 percent when the economy is doing well. (Part of the reason for this fact is that firms want to maintain extra capacity so they can meet increased sales if necessary.) But it's clear that capacity utilization declines substantially in recessions and can get quite low (below 70 percent at the depth of the Great Recession, see chart below). Therefore, firms have plenty of capacity to increase production if sales should rise without investing more.  The capacity utilization figures are for goods-producing industries, but the service sector can also have under-utilized capital. (Think of empty tables at a restaurant.)  Bottom Line: When the economy is strong, firms' motivation to expand capacity and introduce new products is strong and investment therefore grows quickly. The opposite is the case in a slow growing or recession economy. These points help to explain the highly "procyclical" volatility of investment.  Another channel that results in the “procyclical” volatility of investment is through expectations. Expectations affect investment, perhaps even more so than consumption. When business decides to increase its productive capacity, this often involves a long-term commitment. (Think of the decision to build a new factory). The financial outlay will be substantial and it will take years of profits to make it worthwhile. Thus, firms have to look into the future to forecast the business conditions they will face as they make capital investment decisions.  Obviously, many of the future considerations firms will take into account depend on the details of the firms' microeconomic market. But firms will also care about macroeconomic conditions. Will the economy be strong or weak in the future? Remember, the behavior of micro markets tends to be correlated over time. Perspectives on the overall economic outlook can change rather quickly.  Example: the economy was booming in 1999 and early 2000. The stock market was soaring. Economic growth was high, unemployment was near a half-century low and inflation was virtually zero. Everything seemed great for the U.S. economy. Firms' forecasts were probably quite optimistic, which helps explain their strong investment performance. But by 2001, the economy was in a recession, things looked pretty weak. Correspondingly, investment fell significantly.  Geopolitical events, such as conflict in the Middle East, may also affect investment through expectations.  Stock market effect: Many economists and business analysts consider the stock market an index of business expectations. People buy stock to earn shares in future corporate profits. If they expect future profits to be high, they will be willing to pay a high price for shares, and vice-versa. o In this sense, the crash in the stock market in 2000 and 2001 could have been partially responsible for weak investment performance. Businesses could take falling stock prices as a signal that people throughout the economy were much less optimistic about the future strength of markets than they had been a year or two earlier.  It is also the case that if stock prices fall it will be more expensive for firms to issue new shares of stock to finance investment. Overall, not much investment is financed by new stock issues, but this could be an important factor in some sectors of the economy, particularly high-tech startup firms.  The effect of sales, capacity utilization, confidence, expectations, etc. often focus on the demand side of investment. When investment declines for these reasons, demand for the output of capital goods industries declines and these industries reduce production and employment. Recognize, however, that investment also has a supply-side effect. Capital accumulation takes place because of business investment. Thus, strong (or weak) investment leads to faster (or slower) growth in potential output. o Perhaps the reason that cyclical aspects of investment are usually associated with the demand side is that the cycles in investment usually occur rather quickly. o The total capital stock is large. The effect of any single year’s investment on the total amount of capital available to produce potential output is relatively small. o Therefore, even large, short-run fluctuations of investment have rather small effects on the overall capital stock and cyclical investment swings are likely of little importance to long-run supply-side changes. 3. Productivity of capital and technical change  Investment declines in recessions, but it does not fall to zero, even when capacity utilization is low. Firms might invest for a different reason than just to expand their capacity. At the very least, firms are likely to replace equipment and machinery because of depreciation. Also, as technology changes, firms might purchase new equipment and software, even build new buildings, to benefit from new ways of doing things. This kind of activity will raise their productivity and cut their costs.  Thus, we might expect that investment will be particularly strong when new technologies become available. An example of this point is the middle to late 1990s when internet technology became widely available. The desire to implement this new technology no doubt contributed to the 1990s investment boom.  Investment in response to technical change has a larger supply-side effect than the cyclical factors covered under the previous topic. Over the long term, technical change, including the development of new products, is critical to supply-side growth of potential output. New technologies will be introduced to production through the investment process. (Think about automation, for example.) Therefore, investment motivated by technology opportunities is an important part of long-run analysis of the supply side. 4. Cost of Capital a) Interest Rates  Most economists believe that interest rates are a major determinant of investment. When interest rates go up, investment falls. This is because higher interest rates increase the cost of capital, which is just a firm’s cost to put capital in its place.  The most obvious reason for the link between interest rates and investment is that firms may borrow funds to undertake investment. Many investment projects are quite large, so that firms may not have the money to finance them without getting loans from external sources. The interest rate is the "price" of borrowed money. Thus, higher interest rates raise the cost of capital and reduce investment.  As we discussed for consumption, this process creates a channel through which monetary policy influences the economy. For example, the decline of investment was a major contributor to poor U.S. economic performance in 2001 and 2002. The Fed also cut interest rates dramatically, especially in 2001. Part of the Fed's motivation was to lower the cost of capital and help investment to rebound. From a demand-side perspective, more investment implies more spending and more sales for capital producing firms that motivate them to produce more and hire more people.  The link between interest rates and the cost of capital is fairly obvious for firms that borrow money to finance their investment. However, firms that use internal funds (their own money, without borrowing) for investment are also sensitive to the interest rate also. This is an important point because research shows that about 70 percent of investment is financed with firms' own profits from their operations.  The reason for this is linked to the microeconomic concept of "opportunity costs." Opportunity cost is loosely defined as what one gives up to do something. o When the interest rate is high, the opportunity cost of investment is high for the firm's own money because the firm can earn more by putting its money in the bank to earn interest. A firm will not undertake an investment project if interest from the bank will give a higher rate of return. o When interest rates fall, interest-bearing accounts look less attractive, and firms are more likely to invest in their own businesses.  Thus, the effect of interest rates on investment (and therefore the impact of monetary policy on investment) does not require that firms borrow money. b) Saving, interest rates, and investment  The link between interest rates and investment helps explain the supply-side effects of saving.  When households save more, the increased flow of funds into the financial system reduces the interest rate. According to the discussion above, lower interest rates reduce the cost of capital and raise investment.  Higher investment raises the capital stock and increases supply-side potential output.  In a modern economy, the interest rate is therefore the key variable that links saving behavior with capital accumulation and faster supply-side growth. c) Tax rates  Businesses pay taxes on their earnings. Because earnings are the motivation for capital investment, economists argue that taxes on earnings affect the incentive to invest, that is, business tax rates affect the "cost of capital."  At various times since the 1960s, the U.S. has implemented a subsidy for investment called the investment tax credit. This credit reduces corporate taxes by a percentage of investment spending on qualifying assets. (It usually has applied to investment in equipment, but not structures.) The investment tax credit reduces the cost of investment by giving firms a direct tax write off for a proportion of their capital expenditure.  The government does not allow firms to write off the entire cost of investment goods all at once. Instead, firms deduct depreciation every year. The tax laws give rules for how much depreciation a firm can write off on a yearly basis. For example, computers have a “lifespan” of three years. Therefore, the cost of a computer is deducted over three years. A building may have a “lifespan” of thirty years, so the cost of the building would be written off slowly over a period of thirty years.  The tax laws determine the length of time it takes for firms to write off the entire investment. Thus, the tax law is independent of how long assets actually last (for example, a computer may actually last for five years, but depreciation is only written off for three years)  Businesses lobby for quick depreciation schedules. The more quickly they can write off their assets, the sooner they can use that money for other business activities. The faster depreciation is allowed, the lower the cost of capital and the higher is investment.  Tax depreciation schedules have changed a number of times in recent years, with some noticeable effects. Perhaps the most dramatic change was a reform in the early 1980s that allowed businesses to write off buildings over 17 years, a very short time. There was a lot of commercial construction after this change, designed in part to get the tax benefits of quick depreciation. But when the tax law was change in 1986 to require building depreciation over 31 years, commercial construction fell off. This change may have contributed to the 1990- 91 recession.  Capital gains taxes are not directly levied on business, they are paid by owners of assets, such as corporate stock. But some business analysts argue that cutting capital gains tax rates is a powerful stimulus to investment.  Definition of capital gains: the money one makes by buying and selling assets. The most common example is stocks. When you buy stock for a low price and sell for a high price, the money you make is considered a capital gain. Another example is real estate. If you buy property and it goes up in value, the profit you make when you sell it is called capital gains. If you lose money buying and selling assets you have a "capital loss."  The capital gains tax is the tax one pays on this income. Capital gains income is taxed differently from regular income tax. The tax rate is substantially lower. Why? Some economists and policymakers have argued that a low capital gains tax rate encourages people to invest in profit-making activities that raise the value of their firms. Thus, low capital gains taxes may stimulate entrepreneurial activity.  One critique of the this argument is that tax cuts on income earned by buying and selling assets, such as paintings, antiques, or even pre-existing company shares, do not necessarily spur economic growth because such activities do not reflect new investment. In addition, capital gains taxes are not paid by businesses but shareholders. Although economic theory would assume that a tax cut on shareholder capital gains and an investment tax credit would yield equivalent outcomes, in practice a tax credit that goes directly to businesses could well be more effective at spurring investment.  There has been a downward trend on U.S. capital gains taxes which are reached an all-time low during the administration of George W. Bush. This administration also enacted a new policy to cut the tax rate on dividends. Such a cut would tend to benefit old companies relatively more than newer companies as these are likelier to pay out dividends. Tax cuts on capital gains conversely tend to disproportionately affect the new economy.  Critics of low capital gains taxes point out that the vast majority of capital gains income is earned by the wealthy. In fact, it is likely that at least 50% of all capital gains income is earned by the wealthiest 1% of society. Thus, these tax cuts disproportionately benefit the wealthiest individuals in society to a greater extent than perhaps any other tax cut. 5. The availability of finance: cash flow and credit crunches  The cost of capital in the previous topic is analogous to the “price” of investment. This includes the interest rate for loans, the opportunity cost of investing internal funds, and various tax rates. We will now look at availability of investment funds.  If a firm uses its own internal funds to finance investment, then the availability of funds is related to cash flow. Cash flow is the difference between a firm's revenue and its cash expenses. This is money the firm can use without convincing a bank or other "outsider" to make it a loan.  Cash flow is very closely related to profits, and variations in profits cause variations in cash flow. The two concepts are not identical, however. When a firm computes profits it deducts certain "non-cash" expenses (the most important of these is depreciation). Thus, the firm really has somewhat more money to use for investment than what its profits alone would suggest.  The majority of investment is financed by internal funds. There are two main reasons why firms choose to use internal funds:  The firm simply has more control of the investment funds if it is using its own money.  It is less expensive to use internal funds than it is to borrow because you do not have to pay an interest rate that includes the lender's various costs. (Remember, while using internal funds is less expensive than borrowing, there is still the opportunity cost of investing rather than earning interest on money put in the bank. The cost of investing with internal funds is not zero.)  Cash flow is highly procyclical. This is because a high proportion of a firm’s expenses are usually fixed in the short run. However, revenues obviously vary closely with the business cycle, making cash flow quite volatile in percentage terms.  The fact that (1) cash flow is volatile and (2) cash flow affects investment, helps to explain why investment is volatile.  Credit crunches affect those firms who invest using borrowed money. The basic theory is that as the availability of loans increases, so does investment. The availability of loans is not the interest rate! Rather, it has to do with banks’ lending policies. When there is high risk for a bank (due to high consumer or business debt for example), banks are less willing to lend money, probably at any interest rate. A low availability of funds does not mean that firms cannot afford the interest on a loan, but it means that firms with lower credit ratings cannot get a bank to give them a loan. Some firms may get bank financing, but not as much as they want. The inability to take out a loan may prevent a firm from undertaking a good investment project.  In the late 1980s/early 1990s, there was a tightening of banking regulations. This change was the result, at least in part, of the failure of lending institutions called Savings and Loans in 1980s. The S&L failures led to a big bailout of depositors by the government. The government then required banks and other lenders to hold more "capital" as reserves against bad loans. The result was a restriction in lending. This made it more difficult for firms to get a loan, and investment fell in the early 1990s. There was also a perceived increasing in lending risk as the economy slowed. Many economists believed that this "credit crunch" caused, or at least contributed to, the early 1990s recession. o The lending policies of banks can be a leading indicator of a recession. This means that bank tightening takes place prior to the onset of the actual recession.  In the financial crisis associated with the Great Recession, especially in late 2008 and early 2009, it became difficult for business to access many different kinds of credit. This problem partially explains the large drop of business investment during this period.  A dramatic tightening in credit availability also was clearly important in the collapse of residential investment (new housing construction) prior to and during the Great Recession. Through 2012, credit remained much tighter than it had been prior to the Great Recession. 6. Residential investment (construction of new housing)  Because new houses are “durable” (they last a long time), residential investment is included in the investment component of GDP. But, obviously, the construction of new houses is different from investment to expand productive capacity in many ways. a) Interest sensitivity  Residential investment may well be the most interest sensitive component of GDP. Almost all new homes are purchases with mortgages and the monthly payment homeowners make on their mortgage depends in large part on the interest rate that they pay.  This sensitivity implies that housing can be an important channel through which monetary policy affects the economy. The Fed controls the short-term interest rate. While mortgage rates are determined by a variety of factors, changes in the short-term interest rate have historically correlated with changes in mortgage rates. So when the Fed cuts interest rates in a recession, mortgage rates usually decline, which can have a big effect on housing. b) Important role of housing in historical recoveries  The data show that residential investment has rebounded significantly in every strong recovery from recession since (at least) 1974-75. (See the data chart posted on the course web site.) One reason for this fact is that the Fed typically cuts interest rates significantly in a recession. Residential construction may be the component of GDP that responds most strongly to this policy. o Note that this is a “demand-side” point. If the Fed cuts interest rates and stimulates home purchases and construction, it is the demand for houses that causes an increase in the production of houses. (There is no obvious role for housing on the supply side.)  One can conclude from the data that residential construction is highly procyclical. Also, it seems that a robust recovery requires a strong rebound in home construction. o The pattern of residential construction in the recovery from the Great Recession of 2007 to 2009 is less clear as of this writing (early 2011). Obviously, residential construction was hit very hard by the Great Recession. It has yet to rebound, despite the fact that interest rates are extremely low and the economy has been growing for more than 18 months. An open question: can the U.S. economy enjoy a strong recovery with significant improvement in the labor market without an improvement in residential construction? This has not happened in (at least) the past 40 years, but things may be different this time. c) Access to finance and housing  It is not just the cost of housing that is relevant to residential construction, but also the ability of potential homeowners to get mortgages, regardless of the interest rate. Changes in credit availability have been important factors in recent housing cycles.  Housing finance was widely available on very easy terms prior to the Great Recession. Confidence in the housing market was high in the middle 2000s. Various innovations in housing finance greatly expanded the kind of households who could get mortgages. o The most obvious manifestation of this greater access to credit was the so- called “subprime” mortgage market. Mortgages issued in this category went to households with poorer credit records or less documentation of their income, assets, and credit that was typically required in the more traditional, or “prime,” mortgage market.  It is clear that this greater access to finance stimulated the housing market. Home prices rose dramatically (see the data charts on the course web site). Higher home prices encouraged greater residential construction, which stimulated the economy from the demand side, as discussed above.  The most obvious cause of the Great Recession was the end of the housing boom, likely initiated by a shift in the availability of credit for mortgage lending. Home prices peaked in 2006. Lenders could no longer count on rising home prices to “bail out” risky borrowers. o If you can’t pay your mortgage, but the value of your house has been rising, you can sell the house, pay the mortgage, and still pocket some profit (more accurately, the money you make on your house would be a capital gain). o But when home prices stop rising, this way out of a risky loan is no longer available. Indeed, if a lot of people are all of sudden trying to sell their houses to pay their mortgages. (Or if lenders foreclose on lots of homes because people can’t pay the mortgages, and then the lenders try to sell the foreclosed properties.) The result will be a further decline in home prices, just as we experienced from 2007 through 2009 (and to some extent into early 2011).  In summary, the evidence supports an explanation of the Great Recession that is closely tied to the financing of houses and residential construction. o Note that the shift in access to mortgage credit also likely affected consumer spending outside of housing. People were refinancing their home mortgages and borrowing large amounts of cash on their new mortgages to spend on other things besides housing. When the access to new mortgages tightened during the early part of the Great Recession financial crisis, this kind of activity was severely curtailed. o The result was a major reduction in the growth of consumer spending. Because consumption is such a large part of aggregate demand, this effect also contributed to a demand-side explanation of the Great Recession. d) Recent Minsky cycle  The history of housing over the past 25 years corresponds to the general economic theory of financial instability put forward by Hyman Minsky. o Minsky was a W.U. professor of economics from the middle 1960s until his retirement around 1990. He passed away in 1997. o His ideas did not get all that much attention during most of his career, but the Great Recession and the collapse of housing finance has led to a resurgence of interest in Minsky’s perspective.  The basic Minsky idea is that financial markets have a systematic tendency toward instability. Let’s apply his thinking to the recent history of residential construction. o Think of housing as of the middle 1980s. We had just been through a deep recession. Interest rates had been very high, but they came down rather quickly. A lot of the financially weakest households had defaulted on their mortgages. The availability of finance was probably restricted as both lenders and borrowers were chastised by the recent difficulties. o In this environment with a recovering economy, it made sense for some mortgage lenders to test the water with modestly more aggressive home financing. Perhaps they relaxed credit standards a bit or required a slightly lower down payment. o In a rather subdued housing market, these experimenters were likely to attract business. As conditions improved, the new financing practices made money and encouraged even more risk taking. o In addition, the increase in housing construction provided demand-side stimulus for the economy that improved the job market and helped justify (or, in Minsky’s words, “validate”) the more aggressive financial practices. o And as credit flowed more freely, home prices rose. (This was quite evident by the late 1990s.) Rising home prices increased the collateral value for lenders, providing further validation. o All these events encouraged even more risky lending. Down payments were reduced. Credit standards were relaxed further (consider the emergence of “subprime” lending.) The institutions making these riskier loans were very profitable. Their managers attained high status. The full housing boom was on. o But these riskier loans were increasing the financial fragility of the household sector. The system was more vulnerable. A small negative shock that might not have caused much problem a decade earlier could lead to more loan default. Increases in interest rates, perhaps designed to prevent inflation in a booming economy, might trigger trouble in the housing markets. o This process follows Minsky’s famous dictum: “stability is destabilizing.” When the housing market looked pretty stable and robust, it encouraged more aggressive, riskier borrowing and lending, raising financial fragility and making financial instability more likely. o Eventually, the boom leads to so much financial fragility, the process breaks down. Homeowners can no longer service all their debt. People need to sell houses to pay off risky mortgages. But this pushes home prices down. With falling home prices, the ability to finance and refinance housing collapses. Residential construction grinds to a halt. This collapse leads to falling demand and, according to basic Keynesian macroeconomic theory, the economy slows. In this case, the result was the Great Recession.  Minsky talked about how a wide variety of business cycles followed this general pattern. Initial good times encourage and validate more risky financing, eventually leading to a more fragile system that ends in some kind of financial crisis, dragging the economy down with it. He mostly focused on these patterns in the link between finance and business investment, but the basic story applies very well the housing markets in the U.S. and elsewhere from the middle 1980s through the Great Recession. C. International Trade  International trade consists of the export and import components of aggregate demand. Exports are those goods and services produced domestically and sent to foreign countries. Imports are all goods and services produced by foreign countries and consumed domestically. Exports and Imports can be consumption goods/services or investment capital. Remember that we subtract imports from the GDP equation because they are included in the consumption or investment categories. For example, if you buy a bottle of French wine, it is included in consumption, but then it must be subtracted from GDP in imports. 1. Magnitude of International Trade  Over the last few decades, the U.S. economy has become more open, meaning there is much more international trade. Exports as a share of GDP have grown from 4.3 percent in 1970 to 12.8 percent in 2010. Imports have increased from 5.7 percent to 16.1 percent over the same period. These figures indicate a multifold expansion of trade.  Yet, almost any other economy in the world is more “open” than the United States. The unusual status of the U.S. stems from the sheer size of its economy and population. Other countries depend even more heavily on international trade.  As pointed out above, the United States now imports substantially more than it exports. When a country buys more abroad than it sells abroad, it is called a trade deficit.  The trade deficit has bounced up and down over the past 50 years. It was particularly large in the middle 1980s. However, the trade deficit by 2006 was just under 6 percent of GDP, is the biggest it has been in the last half century.  A trade deficit is not necessarily bad for an economy. Indeed, a trade deficit could be a side effect of a good economy. In the two decades leading up to the Great Recession, the United States has experienced a higher growth rate than the rest of the world. This means that the United States is consuming more, and part of consumption will be in imports. However, the other countries have not experienced the same growth and therefore demand for U.S. exports has not grown as much as imports. o What is the policy implication of this paradoxical side effect? The way to reduce the trade deficit is to encourage trade partners to stimulate their economies, not to enact domestic policies that would slow down the growth of the U.S. economy. o During the Great Recession, the trade deficit shrank significantly. Weaker economies in the U.S. and abroad led to reduced imports and reduced exports. But the import drop was larger, reducing the trade deficit.

2. Determinants of imports and exports a) Preferences of domestic and foreign consumers  Preferences often drive international trade. For example, French wine is considered better than domestic wine. Many people used to (perhaps still do) believe that Japanese cars are superior to cars produced within the U.S. People buy what they like the best, and what they like the best may be produced abroad. o Consider your choices of music purchases. If you were restricted to choose music produced in Missouri only, you probably would not be very happy! b) Technology  A country tends to export what it is good at producing. This pattern of trade is related to the technology of a given country. For example, the United States through Boeing is the technological leader of aircraft. The Unites States is also a leader in agricultural production. Japan consumes large quantities of rice but the technology of rice production happens to work much better in the U.S. than in the mountainous land of Japan. Likewise, the Great Plains are very well suited to wheat production. International trade can result simply because one country has better technology for producing certain goods. This is why economists generally favor free trade: citizens of a country can enjoy the benefits of what other countries can produce better. a. International trade theory argues that countries will specialize in goods for which they have “comparative advantage.” This means countries will produce the things that they are relatively good at. c) Domestic and foreign Incomes  If domestic incomes are high, this will lead to a demand for more “stuff” domestically, some of which will be imports.  If foreign income is high, this will lead to a greater demand for more “stuff” abroad, some of which will be exported from the United States. Therefore, other countries’ economic situations can affect U.S. exports. d) Relative prices  Different costs of production across countries help explain how trade flows. For example, wages are lower in Mexico, India, or China relative to the United States. This would help explain why the United States imports goods and services from these countries. Also, even though the United States is a leader in the electronics business, electronics are made more cheaply in Southeast Asia. o U.S. companies can take advantage of international labor cost differences to reduce costs and raise profits. Companies may “outsource” some of their production to other countries with lower costs. o Examples: Mexican workers produce some components of U.S. branded cars. U.S. companies’ customer service is often outsourced to call centers in India.  A macroeconomic determinant of relative prices is the exchange rate between trading partners’ currencies. 3. What are exchange rates? Depreciation and appreciation of Currencies  Some definitions: o The exchange rate between the Mexican Peso and the U.S. Dollar reflects simply how many pesos it takes to buy one dollar. o Depreciation: the value of a country’s currency falls relative to another currency. o Appreciation: the value of a country’s currency rises relative to another currency.  If the dollar appreciates relative to the Yen (Japanese currency), then Japanese goods become cheaper for the U.S. Similarly, U.S. goods will become more expensive for Japan.  Example: Prof. Fazzari’s pizza eating adventures in Italy. o He visited Italy in June 2001 and got pizza. The pizza cost 9 Euros (€ 9); the exchange rate at the time was 0.893 $/€. This means that it takes 0.893 dollars to buy one Euro. o The cost of pizza in dollars was: (€ 9) x (0.893 $/€) = $8.04 o In 2004, he went back to Italy. The pizza still cost € 9. The exchange rate was 1.215 $/€ then, however. This means it takes 1.215 dollars to buy one Euro. o The cost of pizza in dollars was: (€ 9) x (1.215 $/€) = $10.94. o Therefore, although the price in Euros stayed the same between the two trips, the relative price for Prof. Fazzari increased because the exchange rate changed. Because the dollar depreciated, it took more dollars to equal € 9. o Note: An equivalent exchange rate for 1.215 $/€.is 0.823 €/$. This means that “0.823 Euros equal one dollar” is equivalent to “1.215 dollars equal one Euro.”  This example shows that Italian goods got more expensive for the U.S. because the dollar depreciated relative to the Euro. Now, let’s see what happens from Italy’s perspective. o An Italian buys a U.S. PC system that costs $1200 in 2001, when the exchange rate was 1.120 €/$. How much in Euros does the PC cost? Answer: $1200 * 1.120 €/$ = € 1344 o In 2004, when the exchange rate is 0.823 €/$, the PC would cost: $1200 * 0.823 €/$ = € 987.6 o Just as Italian goods became more expensive for the U.S. when the dollar appreciates, so do U.S. goods become cheaper for Italy when the Euro appreciates.  Here is a short and useful supplement compiled by an earlier note taker: o The exchange rate between the dollar and the Japanese Yen fluctuated quite a bit in the late 1990s. Exchange rates were between 100 ¥/$ and 140 ¥/$ o First, a quick test of understanding: Which exchange rate indicates a stronger Yen? The answer is 100 ¥/$ because it takes fewer yen to equal one dollar. Similarly, 140 ¥/$ indicates a stronger dollar because one dollar buys more yen. o So, which exchange rate is “better” for the U.S.? o That is a difficult question. If you are from the U.S. and buying Japanese goods (either U.S. imports or traveling), then a strong dollar is good for you because it makes Japanese goods cheap. However, a strong dollar makes it more expensive for Japan to buy U.S. goods. If you are a U.S. exporter, you want a weak dollar so Japan can afford to buy your goods. A strong dollar can be disastrous for manufacturers trying to export. 4. Purchasing Power Parity a) Definition: The “law” of one price  Tradable goods should cost the same in all places. This statement means that the exchange rates should adjust so the price is the same wherever you buy a good. (This does not mean that a good sells for the same number of yen as dollars, but that the prices and exchange rates make it so a good would cost the same amount in dollars, or the same amount in yen, wherever you buy it.) b) Movements of exchange rates to restore purchasing power parity:  Definition of arbitrage: when two identical goods sell for different prices, people can make money without risk by purchasing the good where it is cheap and selling it where it is expensive.  Arbitrage applies to a variety of markets, particularly financial markets. If stocks, bonds, or currencies sell for different prices in different markets, traders can make money by buying the security where it is cheap and selling it where it is more expensive. The same thing holds true for some tangible goods, although the cost of undertaking arbitrage (transportation costs, for example) are likely higher than in financial markets. Some goods cannot be arbitraged, for example, hotel rooms in St. Louis and New York.  If PPP does not hold, there are arbitrage opportunities available by buying goods where they are cheap and selling them where they are expensive. These activities will cause exchange rates to move in a way that moves them closer to levels that will give the PPP condition.  Notice that in this discussion we are assuming a flexible exchange rate regime. Government intervention in currency markets, such as by pegging a national currency to the dollar, can prevent PPP from being restored.  An example where the Law of One Price does not hold: o Assume U.S. cars and Japanese cars are identical. A U.S. car costs $20,000. A Japanese car costs ¥2,000,000. The exchange rate is 150 ¥/$.

The cost of the Japanese car in dollars: (¥2,000,000) / (150 ¥/$) = $13,333 o Since the dollar cost in Japan is $13,333 and the cost in the U.S. is $20,000, the Law of One Price and PPP do not hold. (Want a quick exercise? Show that the Japanese car is also cheaper in Yen.) o This situation presents an opportunity for arbitrage. An international car dealer could buy Japanese cars and sell them in the U.S. for a higher price. o But to buy Japanese cars, an American importer would need to obtain yen. She would sell her dollars for yen. This activity would cause the yen to appreciate and the dollar to depreciate. Say the value of the yen rose to 120 ¥/ $. (Note that even though the exchange rate number falls from 150 to 120, this is still appreciation of the yen because it takes fewer yen to buy a dollar after the exchange rate changes.) Now, the gap between the dollar price of a car in Japan and the U.S. is not as large, although there will still be an arbitrage possibility. o If this process continues until the exchange rate is 100 ¥/$, PPP equilibrium will be established. Thus, market forces move exchange rates to establish purchasing power parity, thus eliminating the opportunity for arbitrage, at least eventually. o An important point to notice is that the actual prices have not changed. A U.S. car is still sold for $20,000. A Japanese car is still sold for ¥2,000,000. Only the exchange rates will adjust so that ¥2,000,000 equals $20,000.  What does the phrase “the dollar is overvalued” mean? This means that the exchange rates are not in PPP equilibrium, in this case, the dollar is stronger than it should be for PPP to hold. An overvalued dollar means goods in other countries are cheaper than they are in the U.S. after adjusting for the current exchange rate. The argument is symmetric for an “undervalued currency.” These concepts are defined relative to the PPP benchmark.  In recent years, the U.S. has complained that the Chinese currency (sometimes called both the yuan or the renminbi) is under-valued. That means that it is cheaper for American importers to buy Chinese currency than the PPP standard would imply. The implication is that Chinese goods cost less in the U.S. than they would if PPP were to hold. o American presidents and diplomats have encouraged the Chinese to allow the value of their currency to rise toward the PPP level. This would make Chinese goods more expensive in the U.S., and supposedly reduce the U.S. trade deficit with China. o The Chinese have resisted this pressure, presumably because they don’t want to lose their market share in the U.S. But note that if the Chinese currency were to appreciate, Chinese citizens would find that goods on world markets were cheaper and they could raise their living standards. c) Effect of different inflation rates across countries on exchange rates  Recap of PPP: exchange rates will adjust so that the law of one price holds.  Countries with high inflation rates will experience currency depreciate relative to those countries with low inflation. If the prices in a country increase, goods are more expensive in that country (in terms of its own currency). To maintain PPP, currency has to depreciate, which reduces the cost of the country’s goods in foreign currencies.  Currency markets are sensitive to news that may lead to higher expected inflation. And if, for example, higher inflation is expected in Mexico, the peso will depreciate.  High inflation can explain why the Japanese currency (the yen) had such a low unit value. Japan in the past has experienced high inflation. This caused their currency to depreciate to the point where a single yen was worth just about a penny.

5. Relative strength of economies and exchange rates  A country doing well economically will have fast income growth, fast consumption growth, and therefore fast import growth. If imports in the U.S. are increasing, the U.S. needs more foreign currency. If the U.S. trading partners are growing more slowly, U.S. exports will grow relatively slowly and the demand for dollars will be relatively weak. Therefore, the U.S. demand for foreign currency goes up fast while the demand for dollars does not grow quickly, which causes the dollar to depreciate.  In general, a country with a trade deficit will see its currency depreciate. A country with a trade surplus will see its currency appreciate.  Implications for the strength of the dollar in late 2003? Since the United States has been growing faster than its trading partners, we would expect the dollar to depreciate based on this theory alone. There was some evidence of a weaker dollar at that time. We need to look, however, at other factors that affect exchange rates. 6. Interest rates and exchange rates a) Relative interest rates and across countries and the foreign demand for domestic assets  We have been talking about exchange rates and how they are affected by the international trade of goods (and some services). However, many international financial flows are for financial transactions.  The theory predicts that as U.S. interest rates rise, so will the strength of the dollar. Higher interest rates make interest-bearing assets in the U.S. more attractive to investors around the world. To put their money in the U.S., however, foreigners need to buy dollars. (For example, to purchase a high-interest certificate of deposit from a U.S. bank, a foreigner would need dollars.) The increased demand for the dollar causes it to appreciate.  Of course, this process is symmetric, lower interest rates reduce the value of the dollar. c) Examples: Strong dollar in the mid-1980s o In the mid-1980’s, the U.S. had high real interest rates. This was because inflation was falling more quickly than the nominal interest rate. . Notation to know: "r" means interest rate

 Nominal Interest Rates on a 10 Year U.S. Treasury Bond

Nominal r Inflation Real r 1982 – 1984 12% 5% 7% 1994 - 1996 6.5% 2.5% 4%

Exchange Rates: Deutsche Mark to Dollar and Yen to Dollar

DM/$ ¥/$ 1982 – 1984 2.8 240 1994 - 1996 1.5 100 (The Deutsche Mark was the German currency before the introduction of the common “Euro” currency.)

o You will notice that the real interest rate was 3 percentage points higher between the years 1982-1984 than it was 1994-1996. This corresponds to a markedly stronger dollar during 1982-1984. 7. Exchange rates, confidence, and speculation  Another factor that can influence exchange rates is the confidence other countries have in the U.S. economy. During the mid to late 1990’s, the U.S. stock market was doing very well. International investors had confidence in the U.S. economy; they wanted to invest their money in the U.S. stocks. Therefore, the demand for dollars increases, leading to a stronger dollar.  Speculation can also influence exchange rates. International investors will look for opportunities to make money, or prevent losses, from exchange rate movements. As an example, suppose there is a fear of economic crisis in Mexico. If this crisis occurred, it would lead to a depreciation of the peso. This fear will likely cause people to sell their pesos now and buy dollars. The peso will depreciate relative to the dollar. This outcome can occur not because of any actual economic crisis in Mexico, but just because of the speculation. The fear of a depreciation causes people to dump the currency and cause an actual depreciation. Speculation leads to a self- fulfilling prophecy.  The Asian Crisis: Between 1997 and 1998, many East Asian countries were having great economic difficulties. The central banks of these countries used monetary policy to try to maintain a fixed exchange rate with the dollar. However, the dollar was strengthening as the result of strong conditions in the U.S., so the Asian currencies were becoming overvalued relative to the rest of the world. (Do you remember what it means to say that a currency is "overvalued?") o Eventually, a belief spread in international markets that the East Asian currencies were overvalued caused international investors to sell these currencies, creating a "speculative attack" on several currencies, including the baht (Thailand), the ringget (Malaysia), the rupiah (Indonesia), and the won (South Korea) o Frenzied selling of the East Asian currencies caused them to depreciate dramatically, by as much as 80% in just a week or two. o The collapse of their currencies made it very expensive for East Asian countries to import because foreign goods became so expensive. Remember that most countries import a far greater percentage of their goods than the U.S. does. The result was great economic hardship in these countries. o If a country’s currency depreciates significantly, it also makes it very difficult to pay back a debt to the U.S. If Thailand, for example, owes the U.S. $1,000,000, and Thailand’s currency depreciates, Thailand still owes the U.S. a million dollars. The depreciation of their currency means it takes much more of Thailand’s currency to pay back the debt. 8. Link between exchange rates, imports, exports, and aggregate demand Effect on Net Exports and Aggregate Demand  How is AD affected when the dollar appreciates? There are two related paths that will lead to a decrease in AD when the dollar appreciates: o Foreign goods are cheaper in the U.S., which causes U.S. imports to rise. o U.S. goods become more expensive abroad, which causes U.S. exports to fall. o Both of these channels reduce U.S. aggregate demand. That is, "net exports" (Exports – Imports) decline.  In general, a strong currency can be bad for an economy because it lowers AD, which can weaken the economy through the demand side, as we have discussed extensively. a) Channel for Monetary Policy  The Fed can affect foreign trade by changing interest rates. Suppose the Fed wants to slow down AD growth because of fears of inflation. The Fed would then raise interest rates. In addition to decreasing consumption and investment (as we discussed previously), raising interest rates can also affect exports and imports.  Higher interest rates cause the dollar to appreciate (see discussion from an earlier lecture). The stronger dollar reduces net exports and AD.  Short review: We now have three ways that the interest rate can affect aggregate demand. (Learn all of these; they are important.) A lower interest rate will: o Increase consumption because it lowers the reward for saving o Increase investment because it decreases the cost of capital. o Increases exports and decreases imports because of depreciating currency. o Symmetrically, higher interest rates reduce AD through all three channels above. 9. Trade Deficits a) Trade deficits and international debt  TRADE DEFICIT = IMPORTS - EXPORTS o A positive trade deficit implies that Imports > Exports  A trade deficit creates a possible problem because the country will accumulate foreign debt. The idea of a country accumulating debt is like a household accumulating debt. If a household spends more than it earns, it accumulates debt. Similarly, if a country spends (buy imports) more than it earns (sell exports), it will accumulate foreign debt. The need to “service” debt forces payments of interest, and possibly principal, through time. Debt service places a burden on future generations.  When dollars flow from the U.S. to other countries, foreigners can do one of two things with the dollars: o Buy U.S. goods, which will increase U.S. exports o Buy U.S. assets, this is equivalent to increasing U.S. debt to foreign countries. For example, if a foreigner buys a new U.S. bond, this is a loan to the U.S. If a foreigner buys an existing U.S. bond from an American, the foreigner now will receive the debt service payment on that bond. (1) Production vs. "absorption" of goods and services o Let's look at international debt from a somewhat different angle. In equilibrium, production or GDP (Y) equals AD, so Y = C+I+G+Ex-Im o Define C+I+G domestic "absorption" of goods and services. These are the products used in the domestic economy. o If the country runs a trade deficit, Ex-Im is negative. Therefore, production is less than absorption. The country uses more goods than it produces. (2) Economic “burden” of foreign debt o If a country uses more goods than it produces, it will build up an international debt. Foreigners are not going to give the extra stuff as a gift, they will expect to be re-paid at some future date. o To re-pay foreign debt, production must be greater than absorption, this means that the country must run a trade surplus and will not get to enjoy all that it produces in the future. o In this sense, a trade deficit today creates a burden on future generations. b) Problem with debt denominated in foreign currency rather than domestic currency  Most countries borrow in foreign currency. This means that if Mexico borrows from the United States, it will have to pay back the debt in dollars, not pesos.  Debt denominated in foreign currency can get a country into trouble if the exchange rates change. For example, prior to the East Asian crisis of the late 1990s, those countries were rapidly developing. They therefore borrowed money from the U.S. to fund their growth. (For example, they might borrow dollars to purchase U.S. machinery to improve their manufacturing capital, enhancing their supply-side potential output.) When the Asian Crisis hit, the affected countries’ currencies depreciated dramatically. Therefore, their debt is the same in dollars, but increases significantly when measured in their own currency. As their currencies depreciated, it became much more difficult for these countries to service their foreign debt. a. To pay back the debt, countries may be forced to pursue “austerity” policies that cut spending, and therefore lower aggregate demand (demand-side theory at work again). b. Austerity may take place through reduced government spending, but also by restrictions on new credit to the private sector that forces reductions in private consumption and investment.  There is another channel at work as a debtor's currency depreciates. Its exports become cheaper and thus increase and imports become more expensive and thus decrease. As a result, a large currency depreciation will likely create a net inflow of "hard" currency into the country. The depreciated currency also lowers imports and boosts exports, restoring the aggregate demand that was lost in the crisis described in the previous note. o This process operates more slowly than the crisis situation described above (which can unfold in a matter of days, even hours). So shifts in international trade do not prevent the crisis. o But it is often the case that currency depreciation helps rapidly indebted countries recover from currency crises, usually in a matter of a year or two.  The European Union countries that run into debt problems face difficulties that, in one sense, are more difficult to solve. o These countries have foreign debts denominated in various currencies, but largely in euros. o If the perception in international markets is that these debts have become too high, they must pay back the euros by reducing domestic absorption of goods and services. This leads to reduced living standards. o But because these countries are part of the European Monetary Union (often called the EMU), their currencies cannot depreciate relative to other European countries. o Therefore, smaller EMU members do not have the benefit of a falling currency to stimulate demand for their goods and help with recovery. (Unlike, for example, east Asian countries like Thailand and South Korea that recovered rather quickly from the sharp recessions associated with their currency crises.) o These problems hit several European countries very hard. Greece is the most obvious example, and its economy has been devastated through 2012. Spain and Ireland also have related problems, with excessive unemployment and slow growth. Italy has also been affected, although not to the same extent. o The EMU helps facilitate beneficial trade across member countries by avoiding the transactions costs of currency exchange. (It is very convenient to travel across EMU borders and not have to worry about exchanging currencies!) But the lack of a flexible exchange rate hurts countries in relatively weak situations compared to their larger neighbors. They do not get the demand-generating benefits from currency depreciation.  Borrowing in foreign currency is not a problem for the United States. The U.S. borrows from other countries in its own currency, so it does not have debt in foreign currency. This gives the U.S. an advantage. While the dollar may depreciate, the U.S. will still pay back its debt in dollars, so the change in exchange rates will not affect its ability to service its international debt. a. This point implies that the U.S. is unlikely to be face severe consequences from a speculative currency attack. b. If the concern is government debt, it’s clear that default is very unlikely. The federal government can always create dollars to pay foreign debt so there the U.S. government would never be forced to default. It would be a political mistake of huge magnitude for Congress or the President to cause such a default. c. Private U.S. debtors could default on debt obligations to foreigners, but in a crisis the government always has the ability to “bail out” private debtors and prevent crisis-level defaults. i. Example: In the fall of 2008 during the “Great Recession” financial crisis, the large U.S. insurance company AIG was in danger of not paying its debt obligations. AIG owed the larger German institution Deutsche Bank a huge amount of money. The U.S. Treasury and Federal Reserve arranged loans to AIG to pay back its creditors, including Deutsche Bank. This was only possible because AIG had dollar debts. If it owed euros, the U.S. government could not have helped as easily. c) Trade deficits and foreign saving  As we have discussed, a trade deficit is “financed” by foreigners’ purchase of assets in the country that runs the deficit. Thus, the deficit can be thought of as foreign saving flowing into a deficit country.  Let’s look at this relationship in more detail: a. From the GDP equation: Output = Y = C + I + G + Ex – Im. b. From our earlier discussion, we know that, aside from technical details, output is conceptually equivalent to income: Y = Income. c. Income can be used for three things: consumption, saving (S), or taxes (T), so: Income = C + S + T = Y = C + I + G + Ex – Im. d. Even though it is unrealistic, for now assume that the government runs a balanced budget (we will consider government deficits later in the course). Then, G = T, so those terms cancel from the equation above. We can also cancel the C terms from both sides of the equation. This leaves S = I + Ex – Im or S + (Im – Ex) = I. e. The S term is saving by domestic citizens (the part of their income not consumed or paid as taxes). The term Im – Ex is the trade deficit, or equivalently saving by foreigners flowing into the country with the trade deficit.  This algebra shows that a trade deficit can be a source for financing investment, just like domestic saving. From a supply-side perspective, more saving lowers interest rates, raises investment and capital accumulation, and boosts potential output.  Therefore, a trade deficit can enhance a country’s growth. Some economists argue that the large U.S. trade deficit is good because it allows more investment to take place. It represents the desire of foreigners to invest in a safe and productive economy. Thus, a trade deficit can be interpreted as a signal of economic strength. a. This interpretation was especially common when the U.S. trade deficit widened in the late 1990s. (See graphics elsewhere on the course web site, or just look at the nifty graph easily generated by the St. Louis Fed’s macroeconomics data website below. This graph shows net exports divided by GDP).  In the context of less developed countries, a widely accepted recommendation is to import capital goods (or the funds to purchase capital goods) from developed, mature economies. The import of capital will, other things equal, create a trade deficit. But the rise in the capital stock will increase potential output and long-run growth prospects and living standards for the country. This policy will work if the rate of return on the new capital is higher than the “cost” of foreign saving (which might be the interest rate on foreign loans).  Be careful, however. The basic equation above, S + Trade Deficit = I, always holds (under the assumption that government spending equals taxes). But if the trade deficit rises it does not necessarily mean that I will rise. Alternatively, S could fall to balance the equation. What does that mean? That the trade deficit (or foreign saving) was used to finance more consumption (the same as less domestic saving) rather than more investment. a. Critics of the U.S. trade deficit can convincingly point out that the higher level of foreign saving represented by the recent huge trade deficit has caused Americans to consume more, rather than invest more. b. If this is the case, U.S. citizens will need to service the foreign debt in the future without having a larger capital stock and higher potential output that would grow the economy to provide higher output. c. Look at the graph above again. While it was arguably the case that the rise in the trade deficit (decline in net exports) during the late 1990s helped facilitate higher investment during the tech boom of that period, this interpretation is less likely correct when the trade deficit continued to rise dramatically in the early 2000s. Remember, that investment collapsed during this period, while consumption continued to grow. i. So, the trade deficit was not likely helping the supply side by the early 2000s. Rather it likely created more foreign debt for Americans without adding to the capital stock. Thus, the trade deficit reduced the national wealth of the U.S., if this interpretation is correct. ii. To the extent that debt has risen without adding productive assets, future “generations” have to service the debt without the benefit of a stronger economy. In this sense, the trade deficit creates a drain on future resources. iii. Macro can be difficult. Pay careful attention to the subtle issues raised in the previous paragraphs d) Trade deficits and exchange rates: self correction?  U.S. imports have been much higher than U.S. exports for some time. The gap declined during the Great Recession period, but it remains large.  This inflow of imports puts downward pressure on the dollar. The dollar's value will fall at a modest rate over a long period of time. This would encourage U.S. exports and would eventually lead to the closing of the gap between exports and imports.  If this adjustment process is effective, exchange rate movements offset trade deficits over time. Thus, the trade deficit has a tendency to “self correct.” As a practical matter, however, the U.S. trade deficit has been quite persistent even as exchange rates have moved.  Some economists, however, strongly believe that the trade deficit will eventually be closed by movements in the exchange rate. This is another sense in which the currency may not be correctly valued: a large trade deficit suggest a currency is over valued and will depreciate over time.

10. Is a Strong Dollar Good or Bad for the U.S.?  Note that the following arguments hold for any currency.  A strong dollar increases the purchasing power of U.S. citizens buying foreign goods. In this sense, a strong dollar makes Americans more “wealthy.” It increases their international purchasing power.  A strong dollar tends to raise the trade deficit. Why? A strong currency raises imports (which become cheaper for Americans) and lowers exports (which become more expensive for foreigners). A bigger trade deficit raises foreign debt and, as discussed above, shifts the burden of servicing higher debt to future generations.  A strong dollar makes a country wealthier, but it can reduce AD (and therefore hurt growth and employment through the demand side). A weak dollar is more likely to stimulate aggregate demand and is often preferred by manufacturers who want to sell their output abroad. For this reason, a strong dollar is usually viewed as bad for employment.  A strong dollar is a signal of low inflation.  A strong dollar is a signal of confidence in the U.S. economy.  A strong currency makes it easier to service foreign debt (this argument does not apply to the United States because its foreign debt is denominated in dollars).

A little economics humor from the original version of the lecture notes prepared by TA Jamie Kucher several years ago:

Experienced economist and not so experienced economist are walking down the road. They get across road kill lying on the asphalt: Experienced economist: "If you eat it I'll give you $20,000!" Not so experienced economist runs his optimization problem and figures out he's better off eating it so he does and collects money. Continuing along the same road they see more road kill. Not so experienced economist: "Now, if YOU eat this road kill I'll give YOU $20,000." After evaluating the proposal experienced economist eats the road kill, getting the money. They go on. Not so experienced economist starts thinking: "Listen, we both have the same amount of money we had before, but we both ate road kill. I don't see us being better off." Experienced economist: "Well, that's true, but you overlooked the fact that we've been just involved in $40,000 of trade."

Comment from SF: Clever joke, but here's a thought from a really experienced economist. If the economists were really optimizing and they voluntarily offered $20,000 to see someone eat road kill, that experience must have been worth more than $20,000 to each of them. So they each got the benefit of observing the other do something disgusting. Had their been no trade, this benefit would have been lost. So, the voluntary trade here, in a subtle way, actually does make both of them better off. If you like this silliness, take 1011 or 4011 and learn some microeconomics. If you don't like this silliness, take 1011 or 4011 anyway!

D. The Government Sector 1. Size and trends of government spending a) Spending on goods and services: the contribution to GDP and b) Transfer payments  In 2010, total federal government spending was about a quarter of US GDP. Federal government spending on goods and services constituted about 8% of GDP. The difference between these two figures is the result of transfer payments, most obviously payments for Social Security, Medicare, and Medicaid.  G, government spending on goods and services, is the final component of economy we will discuss. It includes such things as military spending, hiring firms to build roads, and payments to government employees. o While we mostly hear about government spending in terms of federal government spending, G includes state and local government spending on goods and services. o The spending in G includes both government consumption and government investment. o The amount the government spends on goods and services is directly added to GDP and it is a component of aggregate demand.  The course website has a link to charts that show the trends of recent government spending and tax variables. The chart shows that total government spending rose as a share of GDP from the 1960s to the mid 1980s and then leveled off. There is a notable increase in total federal spending (including transfers) at the beginning of the Great Recession o Government spending on goods and services had actually been on a declining trend, as a share of GDP, since the late 1960s. It turned upward modestly in the Great Recession, although it is coming back down again as the economy recovers.  The growing gap between total government spending and direct spending on goods and services implies that transfer payments, primarily Social Security and Medicare, have risen substantially. This trend is likely to continue as the baby boomers reach retirement.  Total government spending is now above one third of GDP, but the direct effect of government on resource allocation and demand (that is, government spending on goods and services) is about one fifth of GDP. c) Federal government versus state and local spending  Total federal spending is larger than state and local spending, but state and local expenditures are far from trivial.  If one looks just at the direct spending on goods and services that contributes to demand and GDP, state and local spending exceeds federal spending on goods and services. 2. Composition of spending . The table below shows the share of federal spending in several major categories for 2011. 2011 Federal Expenditure Share of 2011 Total Defense+Veteran Benefits 832,814 23.1% Health 858,153 23.8% Income Sec 597,352 16.6% Social Sec 730,811 20.3% Interest 229,968 6.4% Other 353,963 9.8%

Total 3,603,061 100.0% ($ Billions)

. These figures are useful for putting certain political arguments in perspective. Some politicians argue that the federal government has become very wasteful. They also argue that the government should close its deficit by cutting spending, not by tax increases. However, when you look more closely at how the government spends its money, it is hard to imagine how the deficit could be closed by cutting spending alone. o Although some politicians seem open to cuts in national defense, this category has a lot of protection politically. It is the one category of government spending that is broadly supported by conservatives (who usually argue for lower overall government spending). o The big transfer payments, Social Security and Medicare, are going to rise, not fall, as baby boomers retire. This area could be cut by reducing benefits or raising the age of eligibility. But few politicians have been willing to propose such cuts. And even if benefits were made somewhat less generous it will be very difficult to prevent these categories from expanding, due to longer life spans and rising medical costs, without fundamentally changing the character of these programs. o We are also unlikely to see cuts in veteran and military retirement benefits. o Net interest reflect payments on the national debt. If the U.S. government defaults on these payments there would be a collapse in financial markets. Furthermore, it's unlikely that interest rates will get much lower than they have been over the past couple of years. o This leaves us with other, relatively small categories. If there is substantial federal government waste, this is where it has to reside. This category includes all the typical things we think of as part of the federal government: embassies, parks, government agencies, the courts, Congress and the President, etc. Maybe some cuts could be made here. But it should be clear that this part of the budget is just not large enough to make a lot of difference for macro purposes. Even huge cuts in these categories would not be enough to close the budget deficit, which was greater than 30% of total federal spending in 2012. 3. Trends and composition of taxes  Taxes are not directly a component of the economy, but they do have an indirect effect on the demand side through consumption. If taxes decrease, disposable income will increase, consumption will increase, and AD will increase. Tax rates also matter through the supply side because of their effect on incentives to work, save, and invest.  Total tax revenues relative to GDP had a slow upward trend through 2000 during strong economic times. It is clear that federal tax collections drop substantially when the economy weakens. o This phenomenon is often called an “automatic stabilizer.” When incomes decline, taxes collected go down, cushioning the fall of income. o This drop in taxes during recessions likely prevents consumption from falling as much as it would if tax collections stayed constant, which stabilizes demand. o But the fall in tax revenue during recessions raises the government deficit (see below).  Composition of federal taxes

Composition of Federal Taxes - 2010 ($ Billions) Individual Income 898.5 41.6% Corporate Income 191.4 8.9% Social Insurance 864.8 40.0% Estate 18.9 0.9% Other 188.1 8.7%

Total 2161.7

o Note that social security taxes are almost as large as income taxes. o Income taxes get all the attention, but for many low- and middle-income U.S. families social security taxes are much larger than income taxes. o Corporate income taxes, which also get a lot of attention, are not trivial, but much smaller than individual taxes. o Estate taxes (sometimes called the “death tax” by opponents) also get a lot of attention, but constitute a very small share of federal revenue. (It may not be best to look at 2010 to measure estate taxes, however, since this tax rate was cut substantially and it may increase again.) 4) Federal government deficits  The federal government ran huge budget deficits during World War II (well over 20% of GDP). The government ran a surplus most of the time in the immediate period after World War II. These surpluses began to pay down the huge debts incurred during that war.  Look at the chart on the course website. Starting in the 1970s, the federal government began to run persistent deficits, with the exception of the brief surplus period in the late 1990s through 2001.  The deficit is obviously affected by the business cycle. Whenever the economy slows or goes into recession the deficit expands. As discussed above, recessions lower tax revenues and raise spending. Therefore, it's not surprising that deficits accompany recessions.  President Bush has been heavily criticized for the return of the deficit after the surpluses at the end of the Clinton administration. It is true that the switch from a surplus equal to roughly 2 percent of the economy to a deficit of more than 3 percent of the economy is a big shift by historical standards. But these deficits, relative to GDP, were not particularly large compared with experience over much of the past few decades (particularly around a recession), and recent deficits have begun to shrink as a percent of GDP.  The federal deficit has reached levels unprecedented since World War 2 during the deep “Great Recession.”  High federal deficits have become a major political issue. The “fiscal cliff” at the beginning of 2013 and the “sequester” which took place on March 1, 2013 represent politically generated changes in federal tax and spending policies that arose from political fights over how to cut the government deficit. o Much of the political discussion about cutting the deficit is motivated by the basic idea that government debt is a bad thing without much discussion about why it is bad. o Perhaps the most obvious reason that politicians assume government debt is socially bad is because they perceive the debt as a burden on future generations who will have to pay it back. This way of thinking is motivated by the idea that federal debt is just like the debt of an individual household. o But the effect of federal debt across the entire economy is not as simple as the effect of debt from the point of view of an individual household. i. Note that the demand-side perspective of macro theory implies an important social cost of cutting deficits. ii. To cut the deficit, either taxes must go up or government spending must decline iii. If government spending goes down, this reduces aggregate demand, lowers sales to firms, and reduces output, income, and employment (think about the loss of a contract to produce military jets by an aircraft company as an example of this effect). iv. If taxes rise, people will likely spend less, also reducing demand.  We will discuss deficits and there effect on the economy in more detail at the end of the semester.

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