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E550 Business Conditions Analysis

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Dr. David A. Dilts Department of Economics June 2006 first revision May 2005

Business Conditions Analysis, E550

Dr. David A. Dilts

All rights reserved. No portion of this book may be reproduced, transmitted, or stored, by any process or technique, without the express written consent of Dr. David A. Dilts

2006

Published by Indiana - Purdue University - Fort Wayne for use in classes offered by the Department of Economics, Richard T. Doermer School of Business and Management Sciences at IPFW by permission of Dr. David A. Dilts

SYLLABUS E550, Business Conditions Analysis Dr. David A. Dilts Department of Economics School of Business and Management Sciences Indiana University - Purdue University- Fort Wayne Ddilts2704@aol.com Course Policies 1. This course is an intersession course. It meets from 5:30 p.m. to 10:20 p.m. for ten straight weekdays beginning August 7, 2006. 2. Grades will be determined through take-home quizzes. A package of quizzes will be distributed to class, and you will be expected to turn one in at the beginning of class on August 8, August 10, August 14, August 16 August 17, and August 18, 2005. There are a total of six quizzes, each worth twenty points. The best five quizzes will be used to calculate your final grade. The grade scale is: 89-100 77-88 65-76 53-64 52 and below A B C D F Office: Neff Hall 340D Office Phone: 481-6486 Email Office: Dilts@ipfw.edu Home Phone: 486-8225 Email Home:

3. Attendance will not be taken; however, it is strongly encouraged. 4. The quizzes may be turned-in early, but will not be accepted more than one class day late. Remember, as much as this is like taking a drink from a fireplug, it is worse for the instructor who has to grade the work you turn in, and you people outnumber me. Im not trying to be officious, but I want to survive this too. 5. All other department, school, campus and university policies will be applicable to this course and strictly observe. Course Objectives: This course has several objectives, which are very much intertwined. These objectives include: To solve problems innovatively, using the following tools, and concepts:

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1. A quick review of the essence of macroeconomics which is most important in understanding the environment of business both domestically and globally, including: A. National Income Accounts, Price Indices, and Employment Data B. Keynesian Model of Macroeconomic Activity 1. Business Cycles 2. Fiscal Policy C. Monetary Aggregates 1. Monetary Policy 2. Exchange rates 3. Interest Rates 2. Economic data sources and their interrelations A. Economic Indicators 1. Leading indicators 2. Concurrent indicators 3. Trailing indicators B. Understanding sector performance using economic aggregates 3. Forecasting models and their uses A. Simple internal models B. Correlative methods C. Limitations and value 4. Putting together the notion of business environment within a strategic view of a business enterprise With these issues mastered it is also the objective of this course to master these tools to be able to integrate and synthesize business conditions information and analysis for the purposes of planning and decision making. Reading Assignments Economics: Monday, August 7, 2006 Dilts, Chapters 1-2 Tuesday, August 8, 2006 Dilts, Chapters 3 Wednesday, August 9, 2006 Dilts, Chapters 4-5 Thursday, August 10, 2006 Dilts, Chapters 6-7 iii

Friday, August 12, 2006 Dilts, Chapters 8-9 Monday, August 14 2006 Dilts, Chapter 10-11 Tuesday, August 15, 2006 Dilts, Chapter 12 Data: Wednesday, August 16, 2006 Dilts, Chapter 13-14 Thursday, August 17, 2006 Dilts, Chapter 15 Friday, August 18, 2006 Dilts, Chapter 16 -17 and Catch-up

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Chapter 1

Introduction to Economics
In general, the purpose of this chapter is to provide the basic definitions upon which the subsequent discussions of macroeconomics and business conditions will be built. The specific purpose of this chapter is to define economics (and its major component fields of study), describe the relation between economic theory and empirical economics, and examine the role of objectivity in economic analysis, before examining economic goals and their relations. For those of you who have had E201 or E202, Introduction to Microeconomics or Introduction to Macroeconomics much of the material contained in this chapter will be similar to the introductory material contained in those courses. However, you will find that there is considerable expansion of the discussions offered in the typical principle courses, as a matter of foundation for the more in depth discussions of business conditions that will occur in E550.

Definitions Economics has been studied since sixteenth century and is the oldest of the social studies. Most of the business disciplines arose in attempt to fill some of the institutional and analytical gaps in the areas with which economics was particularly well suited to examine. The subject matter examined in economics is the behavior of consumers, businesses, and other economic agents, including the government in the production and allocation processes. Therefore, any business discipline will have some direct relation with the methods or at least the subject matter with which economists deal. Economics is one of those words that seems to be constantly in the newspapers and on television news shows. Most people have some vague idea of what the word economics means, but precise definitions generally require some academic exposure to the subject. Economics is the study of the allocation of SCARCE resources to meet UNLIMITED human wants. In other words, economics is the study of human behavior as it pertains to the material well-being of people (as either individuals or societies). Robert Heilbroner describes economics as a "Worldly Philosophy." It is the organized examination of how, why and for what purposes people conduct their day-today activities, particularly as relates to the production of goods and services, the accumulation of wealth, earning incomes, spending their resources, and saving for 1

future consumption. This worldly philosophy has been used to explain most rational human behavior. (Irrational behavior being the domain of specialties in sociology, psychology, history, and anthropology.) Underlying all of economics is the base assumption that people act in their own best interest (at least most of the time and in the aggregate). Without the assumption of rational behavior, economics would be incapable of explaining the preponderance of observed economic activity. Consistent responses to stimuli are necessary for a model of behavior to predict future behavior. If we assume people will always act in their best economic interests, then we can model their behavior so that the model will predict (with some accuracy) future economic behavior. As limiting as this assumption may seem, it appears to be an accurate description of reality. Experimental economics, using rats in mazes, suggests that rats will act in their own best interest, therefore it appears to be a reasonable assumption that humans are no less rational. Most academic disciplines have evolved over the years to become collections of closely associated scholarly endeavors of a specialized nature. Economics is no exception. An examination of one of the scholarly journals published by the American Economics Association, The Journal of Economic Literature reveals a classification scheme for the professional literature in economics. Several dozen specialties are identified in that classification scheme, everything from national income accounting, to labor economics, to international economics. In other words, the realm of economics has expanded to such an extent over the centuries that it is nearly impossible for anyone to be an expert in all aspects of the discipline, so each economist generally specializes in some narrow portion of the discipline. The decline of the generalist is a function of the explosion of knowledge in most disciplines, and is not limited to economists. Economics can be classified into two general categories, these are (1) microeconomics and (2) macroeconomics. Microeconomics is concerned with decision-making by individual economic agents such as firms and consumers. In other words, microeconomics is concerned with the behavior of individuals or groups organized into firms, industries, unions, and other identifiable agents. Microeconomics is the subject matter of E201 and E321 Microeconomics. Macroeconomics is concerned with the aggregate performance of the entire economic system. Unemployment, inflation, growth, balance of trade, and business cycles are the topics that occupy most of the attention of students of macroeconomics. In E202 and E321 the focus is on macroeconomic topics. These matters are the topics to be examined this course E550, Business Conditions Analysis. Macroeconomics is a course that interfaces with several other academic disciplines. A significant amount of the material covered in this course involves public policy and has a significant historical foundation. The result is that much of what is 2

currently in the news will be things that are being studied in this course as they happen. In many respects, that makes this course of current interest, if not fun.

Methods in Economics Economists seek to understand the behavior of people and economic systems using scientific methods. These scientific endeavors can be classified into two categories, (1) economic theory and (2) empirical economics. Economic theory relies upon principles to analyze behavior of economic agents. These theories are typically rigorous mathematical models (abstract representations) of behavior. A good theory is one that accurately predicts future behavior and is consistent with the available evidence. Empirical economics relies upon facts to present a description of economic activity. Empirical economics is used to test and refine theoretical economics, based on tests of economic theory. The tests that are typically applied to economic theories are statistically based, and is generally called econometric methods. Much of the material involved in forecasting techniques draws heavily from these methods. The regression-based forecasting models are very similar to the econometric models used to analyze the macroeconomy. In Business Conditions analysis we will rely heavily on a sound theoretical basis to understand the macroeconomic framework in which business activity arises. Within this theoretical framework a range of empirical models, and data will be examined which will allow us to both formally and informally forecast economic conditions and what sorts of phenomenon are associated with these conditions for specific markets. Theory concerning human behavior is generally constructed using one of two forms of logic. Sociology, psychology and anthropology typically rely on inductive logic to create theory. Inductive logic creates principles from observation. In other words, the scientist will observe evidence and attempt to create a principle or a theory based on any consistencies that may be observed in the evidence. Economics relies primarily on deductive logic to create theory. Deductive logic involves formulating and testing hypotheses. Often the theory that will be tested comes form inductive logic or sometime informed guess-work. The development of rigorous models expressed as equations typically lend themselves to rigorous statistical methods to determine whether the models are consistent with evidence from the real world. The tests of hypotheses can only serve to reject or fail to reject a hypothesis. Therefore, empirical methods are focused on rejecting hypotheses and those that fail to be rejected over large numbers of tests generally attain the status of principle. However, examples of both types of logic can be found in each of the social sciences. In each of the social sciences it is common to find that the basic theory is 3

developed using inductive logic. With increasing regularity standard statistical methods are being employed across all of the social sciences and business disciplines to test the validity of theories. The usefulness of economics depends on how accurate economic theory predicts behavior. Even so, economics provides an objective mode of analysis, with rigorous models that permit the discounting of the substantial bias that is usually present with discussions of economic issues. The internal consistency brought to economic theory by mathematical models often fosters objectivity. However, no model is any better than the assumptions that underpin that model. If the assumptions are either unrealistic or formulated to introduce a specific bias, objective analysis ca still be thwarted (under the guise of scientific inquiry). The purpose of economic theory is to describe behavior, but behavior is described using models. Models are abstractions from reality - the best model is the one that best describes reality and is the simplest (the simplest requirement is called Occam's Razor). Economic models of human behavior are built upon assumptions; or simplifications that allow rigorous analysis of real world events, without irrelevant complications. Often (as will be pointed-out in this course) the assumptions underlying a model are not accurate descriptions of reality. When the model's assumptions are inaccurate then the model will provide results that are consistently wrong (known as bias). One assumption frequently used in economics is ceteris paribus which means all other things equal (notice that economists, like lawyers and doctors will use Latin to express rather simple ideas). This assumption is used to eliminate all sources of variation in the model except for those sources under examination (not very realistic!).

Economic Goals, Policy, and Reality Most people and organizations do, at least rudimentary planning, the purpose of planning is the establishment of an organized effort to accomplish some economic goals. Planning to finish your education is an economic goal. Goals are, in a sense, an idea of what should be (what we would like to accomplish). However, goals must be realistic and within our means to accomplish, if they are to be effective guides to action. This brings another classification scheme to bear on economic thought. Economics can be again classified into positive and normative economics. Positive economics is concerned with what is; and normative economics is concerned with what should be. Economic goals are examples of normative economics. Evidence concerning economic performance or achievement of goals falls within the domain of positive economics. 4

Most nations have established broad social goals that involve economic issues. The types of goals a society adopts depends very much on the stage of economic development, system of government, and societal norms. Most societies will adopt one or more of the following goals: (1) economic efficiency, (2) economic growth, (3) economic freedom, (4) economic security, (5) an equitable distribution of income, (6) full employment, (7) price level stability, and (8) a reasonable balance of trade. Each goal (listed above) has obvious merit. However, goals are little more than value statements in this broad context. For example, it is easy for the very wealthy to cite as their primary goal, economic freedom, but it is doubtful that anybody living in poverty is going to get very excited about economic freedom; but equitable distributions of income, full employment and economic security will probably find rather wide support among the poor. Notice, if you will, goals will also differ within a society, based on socio-political views of the individuals that comprise that society. Economics can hardly be separated from politics because the establishment of national goals occurs through the political arena. Government policies, regulations, law, and public opinion will all effect goals and how goals are interpreted and whether they have been achieved. A word of warning, eCONomics can be, and has often been used, to further particular political agendas. The assumptions underlying a model used to analyze a particular set of circumstances will often reflect a political agenda of the economist doing the analysis. For example, Ronald Reagan argued that government deficits were inexcusable, and that the way to reduce the deficit was to lower peoples' taxes -- thereby spurring economic growth, therefore more income that could be taxed at a lower rate and yet produce more revenue. Mr. Reagan is often accused, by his detractors, of having a specific political agenda that was well-hidden in this analysis. His alleged goal was to cut taxes for the very wealthy and the rest was just rhetoric to make his tax cuts for the rich acceptable to most of the voters. (Who really knows?) Most political commentators, both left and right, have mastered the use of assumptions and high sounding goals to advance a specific agenda. This adds to the lack of objectivity that seems to increasingly dominate discourse on economic problems. On the other hand, goals can be publicly spirited and accomplish a substantial amount of good. President Lincoln was convinced that the working classes should have access to higher education. The Morrell Act was passed 1861 and created Land Grant institutions for educating the working masses (Purdue, Michigan State, Iowa State, and Kansas State (the first land grant school) are all examples of these types of schools). By educating the working class, it was believed that several economic goals could be achieved, including growth, a more equitable distribution of income, economic security and freedom. In other words, economic goals that are complementary are consistent and can often be accomplished together. Therefore, conflict need not be the centerpiece of establishing economic goals. Because any society's resources are limited there must be decisions about which goals should be most actively pursued. The process by which such decisions are made is called prioritizing. Prioritizing is the rank ordering of goals, from the most important to 5

the least important. Prioritizing of goals also involves value judgments, concerning which goals are the most important. In the public policy arena prioritizing of economic goals is often the subject of politics. Herein lies one of the greatest difficulties in macroeconomics. An individual can easily prioritize goals. It is also a relatively easy task for a small organization or firm to prioritize goals. For the United States to establish national priorities is a far larger task. Adam Smith in the Wealth of Nations (1776) describes the basic characteristics of capitalism (this book marks the birth of capitalism). Smith suggests that there are three legitimate functions of government in a free enterprise economy. These three functions are (1) provide for the national defense, (2) provide for a system of justice, and (3) provides those goods and services that cannot be effectively provided by the private economy because of the lack of a profit motive. There is little or no controversy concerning the first two of these government functions. Where debate occurs is over the third of these legitimate roles. Often you hear that some non-profit organization or government agency should be "run like a business." A business is operated to make a profit. If the capitalist model is correct, then the only reason for an entrepreneur to establish and operate a business is to make profits (otherwise the conduct of the business is irrational and cannot be explained as self-interested conduct). A church, charity, or school is established for purposes other than the making of a profit. For example, a church may be established for the purposes of maximizing spiritual well-being of the congregation (the doing of good-works, giving testimony to one's religion, worship of God, and the other higher pursuits). The purpose of a college or a secondary/elementary school system, likewise is not to make profits, the purposes of educational institutions is to provide access knowledge. A University is to increase the body of knowledge through basic and applied research, professional services, and (of primary importance to the students) to provide for the education of students. To argue that these public or charitable organizations should be run like a business is to suggest that these matters can be left to the private sector to operate for a profit. Inherent in this argument is the assumption (a fallacy) that the profit motive would suffice to assure that society received a quality product (spiritual or educational or both) and in the quantities necessary to accomplish broad social objectives. Can you imagine what religion would become if it was reduced to worldly profitability (some argue there's too much of that sort of thing now), can you imagine what you would have to pay for your education if, instead of the State of Indiana subsidizing education, the student was asked to pay for the total cost of a course plus some percentage of cost as a profit? Perhaps worse still, who would do the basic research that has provided the scientific breakthroughs that result in thousands of new products each year? Would we have ever had computers without the basic research done in universities, what would be missing from our medical technology? Priorities at a national level are rarely set without significant debate, disagreements, and even conflict. It is through our free, democratic processes that we establish national, state and local priorities. In other words, the establishment of our 6

economic priorities are accomplished through the political arena, and therefore it is often impossible to separate the politics from the economics at the macro level.

Objective Thinking Most people bring many misconceptions and biases to economics. After all, economics deals with people's material well-being. Because of political beliefs and other value system components rational, objective thinking concerning various economic issues fail. Rational and objective thought requires approaching a subject with an open-mind and a willingness to accept what ever answer the evidence suggests is correct. In turn, such objectivity requires the shedding of the most basic preconceptions and biases -- not an easy assignment. What conclusions an individual draws from an objective analysis using economic principles, are not necessarily cast in stone. The appropriate decision based on economic principles may be inconsistent with other values. The respective evaluation of the economic and "other values" (i.e., ethics) may result in a conflict. If an inconsistency between economics and ethics is discovered in a particular application, a rational person will normally select the option that is the least costly (i.e., the majority view their integrity as priceless). An individual with a low value for ethics or morals may find that a criminal act, such as theft, as involving minimal costs. In other words, economics does not provide all of the answers, it provides only those answers capable of being analyzed within the framework of the rational behavior that forms the basis of the discipline. Perhaps of greatest importance by modeling economic systems, it provide a basis of cold, calculation free from individual emotion and self-interest. Do not be confused, anytime we deal with economic forecasts, there is always the problem of hope versus whats next. By modeling economic activity, and empirically testing that model, one may be able to produce forecasting models or even indicators that permit unbiased forecasts. To forecast is one thing, to hope is another. There are several common pitfalls to objective thinking in economics. After all, few things excite more emotion than our material well-being. It should come as no surprise that bias and less than objective reasoning is common when it comes to economic issues, particularly those involving public policy.. Among the most common logical pitfalls that affect economic thought are: (1) the fallacy of composition, and (2) post hoc, ergo prompter hoc. Each of these will be reviewed, in turn. The fallacy of composition is the mistaken belief that what is true for the individual must be true for the group. An individual or small group of individuals may exhibit behavior that is not common to an entire population. In other words, this fallacy is simply assuming a small, unscientifically selected sample will predict the behavior, 7

values, or characteristics of an entire population. For example, if one individual in this class is a I.U. fan then everyone in this class must be an I.U. fan is an obvious fallacy of composition. Statistical inference can be drawn from a sample of individual observations, but only within confidence intervals that provide information concerning the likelihood of making an incorrect conclusion (E270, Introduction to Statistics, provides a more in depth discussion of confidence intervals and inference). Post hoc, ergo prompter hoc means after this, hence because of this, and is a fallacy in reasoning. Simply because one event follows another does not necessarily imply there is a causal relation. One event can follow another and be completely unrelated. All of us have, at one time or another, experienced a simple coincidence. One event can follow another, but there may be something other than a direct causal relation that accounts for the timing of the two events. For example, during the thirteenth century people noticed that the black plague occurred in a location when the population of cats increased. Unfortunately, some people concluded that the plague was caused by cats so they killed the cats. In fact, the plague was carried by fleas on rats. When the rat population increased, cats were attracted to the area because of the food supply (the rats). The people killed the predatory cats, and therefore, rat populations increased, and so did the population of fleas that carried the disease. This increase in the rat population also happened to attract cats, but cats did not cause the plague, if left alone they may have gotten rid of the real carriers (the rats, therefore the fleas). The idea that cats were observed increasing in population gave rise to the conclusion that the cats brought the plague is a post hoc, ergo prompter hoc fallacy, but this example has an indirect relation between cats in the real cause. Often, even this indirect relation is absent. Many superstitions are classic examples of this type of fallacy. Broken mirrors causing seven years bad luck, or walking under a ladder brining bad luck are nothing but fallacies of the post hoc, ergo prompter hoc variety. There is no causal relation between breaking glass and bad luck or walking under ladder (unless something falls off the ladder on the pedestrian). Deeper examination of the causal relations are necessary for such events if the truth of the relations is to be discovered. However, more in depth analysis is often costly, and the cost has the potential of causing decision-makers to skip the informed part and cut straight to the opinion. Economic history has several examples of how uniformed opinion resulted in very significant difficulties for innocent third-parties, in addition, to those responsible for the decisions. The following box presents a case where policy was implemented based on the failure to recognize that there is a significant amount of interdependence in the U.S. economy. This story shows fairly conclusively that private interests can damage society as a whole. While our economic freedom is one of the prime ingredients in making our economy the grandest in the world, such freedom requires that it be exercised in a responsible fashion, lest the freedom we prize becomes a source of social harm. Like 8

anything else, economic freedom for one group may mean disaster for another, through no fault of the victims. Government and the exercise of our democratic responsibilities is suppose to provide the checks on the negative results of the type portrayed in the above box.

Statistical Methods in Economics The use of statistical methods in empirical economics can result in errors in inference. Most of the statistical methods used in econometrics (statistical examination of economic data) rely on correlation. Correlation is the statistical association of two or more variables. This statistical association means that the two variables move predictably with or against each other. To infer that there is a causal relation between two variables that are correlated is an error. For example, a graduate student once found that Pete Rose's batting average was highly correlated with movement in GNP during several baseball seasons. This spurious correlation cannot reasonably be considered path-breaking economic research. On the other hand we can test for causation (where one variable actually causes another). Granger causality states that the thing that causes another must occur first, that the explainer must add to the correlation, and must be sensible. As with most statistical methods Granger causality models permit testing for the purpose of rejecting that a causal relation exists, it cannot be used to prove causality exists. These types of statistical methods are rather sophisticated and are generally examined in upper division or graduate courses in statistics. As is true with economics, statistics are simply a tool for analyzing evidence. Statistical models are also based on assumptions, and too often, statistical methods are used for purposes for which they were not intended. Caution is required in accepting statistical evidence. One must be satisfied that the data is properly gathered, and appropriate methods were applied before accepting statistical evidence. Statistics do not lie, but sometimes statisticians do! A whole chapter will be dedicated to forecasting methods in this course. It is not so much that forecasting methods are the cognitive content of this course, as much as it is presented to provide the student with a menu of the types of forecasting techniques that are available to help get a handle on what to expect. BUFW H509 is Research Methods in Business which focuses on data collection, statistical methods, and inference. Together with E550 these two courses should provide the student with a deep-dish approach to both subjects.

Objectivity and Rationality Objective thinking in economics also includes rational behavior. The underlying assumptions with each of the concepts examined in this course assumes that people will act in their perceived best interest. Acting in one's best interests is how rationality is defined. The only way this can be done, logically and rigorously, is with the use of marginal analysis. This economic perspective involves weighing the costs against the benefits of each additional action. In other words, if benefits of an additional action will be greater than the costs, it is rational to do that thing, otherwise it is not.

Forecasting Objectivity and rationality are critical in developing models and understanding how business conditions arise. However, the forecaster is less interested in explaining how the economy works, and more interested in what some series of numbers is going to do over time, and in particular, in the near future. The end result is that forecasting and economic analyses are very often similar processes. If one is interested in the economic environment (business conditions), one must understand how the economy actually works. This is why much of the first half of this course is focused exclusively on the macroeconomy. Forecasting is like most other endeavors, you need to have a plan. The steps in forecasting provide an organized approach to permitting the best possible forecasts. The steps in forecasting involve the identification of the variable or variables you wish to forecast. Once these are identified, you need to determine the sophistication of the forecasting method, i.e., who is going to do the forecasting, and who is going to use the forecast will determine the sophistication. Once the sophistication level is determined, then the selection of the method, i.e., exponential smoothing, moving averages at the simple end, at the more complex end, two-stage least squares, autoregressive models, etc. This, again, involves sophistication, but also the nature of the variable to be forecasted may have something to say about the method selected. Once the methodology is selected, predictor variables must be selected, tested, and incorporated into the model. Once the model is developed it will be subject to nearly constant evaluation, and re-specification. The efficacy, accuracy and usability of the results, and the efficiency of the model in making the forecasts are the primary criteria used in determining whether the model needs to be revised. Finally, forecasting reports will need to be framed and circulated to the appropriate management officials for their use. These reports will also be subject to evaluation and re-specification. In sum, the forecasting plan includes several, interrelated steps, which are: 1. Selection of variables to be forecast 10

2. 3. 4. 5. 6.

Determining the level of forecast sophistication Specification of the model to be used to forecast Specification of the variables to be used in the model Re-evaluation of the model, using the results, their efficiency and efficacy Creating the reports, and evaluating the effectiveness of the reports

One should never lose track of the fact that a forecast will never be perfectly accurate, realistic goals for the forecasts must be set. If one can pick up the direction of moves in aggregate economic data, the models is probably pretty good. Arriving at exact magnitudes of the changes in economic aggregates is probably more a function of luck than of good modeling in most cases. In other words, be realistic in evaluating the efficiency and efficacy of the forecasting models selected.

Conclusion Business Conditions Analysis is focused on macroeconomic topics and how these topics result in various aspects of the business environment in which the modern enterprise operates. It is not simply a macroeconomics course, nor is it simply a data collection, modeling and inference course. E550 is the managerial aspects of macroeconomics, together with a quick and dirty introduction to analysis of the macroeconomy. This course is far different than what the typical MBA course of the same title would have been twenty-five years ago. Twenty-five years ago this course would have focused on a closed economy, with very little foreign sector influences, and an economy that was far more reliant on the goods producing sectors. Today, the U.S. economy is still losing manufacturing, fewer people are employed in mining and agriculture, and it is truly an economy searching for what it wants to be. This is in some ways a more exciting economy to study because it is at a cross-roads. The U.S. economy was the dominate economy when it was a manufacturing based system. At this cross-roads, there is the potential to re-double that economic dominance, a system full of opportunities and challenges. On the other hand, there is always the path the British followed in the 1960s and since, towards less satisfactory results. In U.S. economy history we have had many mis-steps, but in general the long-term trend has been toward ever-increasing prosperity. That is no guarantee, but it is certainly cause for optimism, particularly if everyone masters the ideas that comprise this course.

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KEY CONCEPTS Economics Microeconomics Macroeconomics Empirical economics v. Theoretical economics Inductive logic v. Deductive logic Model Building Assumptions Occams Razor Normative economics v. Positive economics Objective Thinking Rationality Fallacy of Composition Cause and effect Bias Correlation v. causation Cost-benefit analysis Forecasting Steps Plan Evaluation

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STUDY GUIDE Food for Thought: Most people are biased in their thinking particularly concerning economic issues. Why do you suppose this is? Sample Questions: Multiple Choice: Which of the following is not an economic goal? A. B. C. D. Full Employment Price Stability Economic Security All of the above are economic goals

Which of the following methods can be applied to test for the existence of statistical association between two variables? A. B. C. D. Correlation Granger causality Theoretical modeling None of the above

True - false: Non-economists are no less or no more biased about economics than physics or chemistry {FALSE}. Assumptions are used to simplify the real world so that it may be rigorously analyzed {TRUE}.

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Chapter 2

National Income Accounting

The aggregate performance of a large and complex economic system requires some standards by which to measure that performance. Unfortunately our systems of accounting are imperfect and provide only rough guidelines, rather than crisp, clear measurements of the economic performance of large systems. As imperfect as the national income accounting methods are, they are the best measures we have and they do provide substantial useful information. The purpose of this chapter is to present the measures we do have of aggregate economic performance.

Gross Domestic and Gross National Product The most inclusive measures we have of aggregate economic activity are Gross Domestic Product and Gross National Product. These measures are used to describe total output of the economy, by source. In the case of Gross Domestic Product we are concerned with what is produced within our domestic economy. More precisely, Gross Domestic Product (GDP) is the total value of all goods and services produced within the borders of the United States (or country under analysis). On the other hand, Gross National Product is concerned with American production (regardless of whether it was produced domestically). More precisely, Gross National Product (GNP) is the total value of all goods and services produced by Americans regardless of whether in the United States or overseas. These measures (GDP and GNP) are the two most commonly discussed in the popular press. The reason they garner such interest is that they measure all of the economy's output and are perhaps the least complicated of the national income accounts. Often these data are presented as being overall measures of our population's economic well-being. There is some truth in the assertion that GDP and GNP are social welfare measures, however, there are significant limitations in such inferences. To fully understand these limitations we must first understand how these measures are constructed. The national income accounts are constructed in such a manner as to avoid the problem of double-counting. For example, if we count a finished automobile in the national income accounts, what about the paint, steel, rubber, plastic, and other components that go into making that car? To systematically eliminate double-counting, only value-added is counted for each firm in each industry. The value of the paint, used in producing a car, is value-added by the paint manufacturing company, the 14

application of that paint by an automobile worker is value-added by the car company (but the value of the paint itself is not). By focusing only on value-added at each step of the production process in each industry national income accountants are thus able to avoid the problems of double-counting.

GROSS DOMESTIC PRODUCT by COMPONENT 1940-2000 (billions of current U.S. dollars) YEAR 1940 1950 1960 1970 1980 1990 2000 2005 Personal Consumption 71.1 192.1 332.4 646.5 1748.1 3742.6 6257.8 8745.7 Gross Domestic Investment 13.4 55.1 78.7 150.3 467.6 802.6 1772.9 2105.0 Government Expenditures 14.2 32.6 99.8 212.7 507.1 1042.9 1572.6 2362.9 Net Exports 1.4 0.7 -1.7 1.2 -14.7 -74.4 -399.1 -726.5 GDP 100.1 286.7 513.4 1010.7 2708.0 5513.8 9224.0 12487.1

The above box presents the GDP accounts in the major expenditures components. GDP is the summation of personal consumption expenditures , gross domestic private investment (Ig), government expenditures (G) and net exports (Xn), where net exports are total export minus total imports. Put in equation form:

GDP (Y) = C + Ig + G + Xn
GDP can also be calculated using the incomes approach. GDP can be found by summing each of the income categories and deducting Net American Income Earned Abroad. The following illustration shows how GNP and GDP are calculated using the incomes approach as follows:

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______________________________________________________________________ ______________________________________________________________________ Depreciation + Indirect Business Taxes + Employee Compensation + Rents + Interest + Proprietors' Income + Corporate Income Taxes + Dividends + Undistributed Corporate Profits = Gross National Product - Net American Income Earned Abroad = Gross Domestic Product ______________________________________________________________________ ______________________________________________________________________ In a practical sense, it makes little difference which approach to calculating GDP is used, the same result will be obtained either way. What is of interest is the information that each approach provides. The sub-accounts under each approach provide useful information for purposes of understanding the aggregate performance of the economy and potentially formulating economic policy. Under the expenditures approach we have information concerning the amount of foreign trade, government expenditures, personal consumption and investment. The following accounts illustrate how GDP is broken down into another useful set of sub-accounts. Each of these additional sub-accounts provides information that helps us gain a more complete understanding of the aggregate economic system. The following illustration demonstrates how the sub-accounts are calculated:

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______________________________________________________________________ ______________________________________________________________________ Gross Domestic Product - Depreciation = Net Domestic Product + Net American Income Earned Abroad - Indirect Business Taxes = National Income - Social Security Contributions - Corporate Income Taxes - Undistributed Corporate Profits + Transfer Payments = Personal Income - Personal Taxes = Disposable Income ______________________________________________________________________ ______________________________________________________________________ The expenditures approach provides information concerning from what sector proportions of GDP come. Personal consumption, government expenditures, foreign sector, and investment all are useful in determining what is responsible for our economic well-being. Likewise, the incomes approach provides greater detail to our understanding of the aggregate economic output. Net National Product is the output that we still have after accounting for what is used-up in producing, in other words, the capital we used-up getting GDP is netted-out to provide a measure of the output we have left. National Income takes out of Net National Product all ad valorem taxes that must be paid during production and net American income originating from overseas. Appropriate adjustments are made to National Income to deduct those things that do not reach households (i.e., undistributed corporate profits) and adds in transfer payments to arrive at Personal Income. The amount of Personal Income that households are free to spend after paying their taxes is called Disposable Income. So far, the national income accounts appear to provide a great deal of information. However, we do know that this information fails to accurately measure our aggregate economic well-being. There are many aspects of economic activity that do not lend themselves well to standard accounting techniques and these problems must be examined to gain a full appreciation for what this information really means.

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National Income Accounts as a Measure of Social Welfare Accounting, whether it is financial, cost, corporate, nonprofit, public sector, or even national income, provides images of transactions. The images that the accounting process provides have value judgments implicit within the practices and procedures of the accountants. National income accounting, as do other accounting practices, also has significant limitations in the availability of data and the cost of gathering data. In turn, the costs of data gathering may also substantially influence the images that the accounts portray. GDP and GNP are nothing more than measures of total output (or income). However, the total output measured is limited to legitimate market activities. Further, national income accountants make no pretense to measure only positive contributions to total output that occur through markets. Both economic goods and economic bads are included in the accounts, which significantly limit any inference that GDP or any of its sub-accounts are accurate images of social welfare. More information is necessary before conclusions can be drawn concerning social welfare. Nonmarket transactions such as household-provided services or barter are not included in GDP. In other words, the services of a cook if employed are counted, but the services of a man or woman doing the cooking for their own household is not. This makes comparisons across time within the United States suspect. In the earliest decades of national income accounting, many of the more routine needs of the household were served by the household members own labor. As society became faster paced, and two wage earners began to become the rule for American households, more laundry, housecleaning, child rearing, and maintenance work necessary to maintain the household were accomplished by persons hired in the marketplace. In other words, the same level of service may have been provided, but more of it is now a market activity, hence included in GNP. This is also the case in comparing U.S. households with households in less developed countries. Certainly, less market activity is in evidence in less developed countries that could be characterized as household maintenance. Few people are hired outside of the family unit to perform domestic labor in less developed countries, and if they are, they are typically paid pennies per hour. Less developed countries' populations rely predominately on subsistence farming or fishing, and therefore even food and clothing may be rarely obtained in the marketplace. Leisure is an economic good but time away from work is not included in GNP. The only way leisure time could be included in GNP is to impute (estimate) a value for the time and add it to GNP (the same method would be required for household services of family members). Because of the lack of consistency in the use of time for leisure activities these imputation would be a very arbitrary, at best. However, commodities used in leisure activities are included in GNP. Such things as movie tickets, skis, and 18

other commodities are purchased in the market and may serve as a rough guide to the benefits received by people having time away from work. Product quality is not reflected in GNP. There is no pretense made by national income accountants that GDP can account for product or service quality. There is also little information available upon which to base a sound conclusions concerning whether the qualitative aspects of our total output has increased. It is clear that domestic automobiles have increased in quality since 1980, and this same experience is likely true of most of U.S. industry. No attempt is made in GDP data to account for the composition output. We must look at the contributions of each sector of the economy to determine composition. The U.S. Department of Commerce publishes information concerning output and classifies that output by industry groups. These industry groupings are called Standard Industrial Codes (S.I.C.) and permits relatively easy tracking of total output by industry group, and by components of industry groups. Over time, there are new products introduced and older products disappear as technology advances. Whale oil lamps and horseshoes gave way to electric lights and automobiles between the Nineteenth and Twentieth Centuries. As we moved into the latter part of this century vinyl records gave way to cassettes, which, in turn, have been replaced by compact disks. In almost every aspect of life, the commodities that we use have changed within our lifetimes. Therefore, comparisons of GNP in 1996 with GNP in 1966 are really comparing apples and oranges because we did not have the same products available in those two years. As we move further back in time, the commodities change even more. However, it is interesting to note the relative stability of the composition of output before the industrial revolution. For centuries, after the fall of the Roman Empire, the composition of total output was very similar. Attila the Hun would have recognized most of what was available to Mohammed and he would have recognized most of what Da Vinci could have found in the market place. Therefore, the rapid change in available commodities is a function of the advancement of knowledge, hence the advancement in technology. Another shortcoming of national income accounting is that the accounts say nothing about how income is distributed. In the early centuries of this millennium, only a privileged few had lifestyles that most of us would recognize as middle income or above. With recent archaeological work at Imperial Roman sites, many scholars have concluded that over 95% of the population lived in poverty (the majority in lifethreatening poverty), while a very few lived in extreme wealth. With the tremendous increases in knowledge over the past two-hundred years, technology has increased our productivity so substantially that in the 28 industrialized nations of the world, the majority of people in those countries do not know poverty. However, the majority of the world's population lives in less developed countries and the overwhelming majority of the people in those countries do know poverty, and a significant minority of these 19

people knows life threatening poverty. In short, with the increase in output has come an increase in the well-being of most people. Per capita income is GDP divided by the population, and this is a very rough guide to individual income, which still fails to account for distribution. In the United States, the largest economy in the world, there are still over 40 million people (about 14 percent) that live in poverty, and only a very few these in life threatening poverty. Something just under four percent of the population (about 1 person in 26) is classified as wealthy. The other 81 percent experience a middle-income lifestyle in the United States. The distribution of poverty is not equal across the population of this country. Poverty disproportionately falls to youngest and oldest segments of our population. Minority group persons also experience a higher proportion of poverty than do the majority. Environmental problems are not addressed in the national income accounts. The damage done to the environment in the production or consumption of commodities is not counted in GDP data. The image created by the accounts is that pollution, deforestation, chemical poisoning, and poor quality air and water that give rise to cancer, birth defects and other health problems are economic goods, not economic bads. The cost of the gasoline burned in a car that creates pollution is included in GNP, however, the poisoning of the air, especially in places like Los Angeles, Denver, and Louisville is not deducted as an economic bad. The only time these economic bads are accounted for in GNP is when market transactions occur to clean-up the damage, and these transactions are added to GNP. The end result is that GNP is overstated by the amount of environmental damage done as a result of pollution and environmental damage. The largest understatement of GNP comes from something called the underground economy. The underground economy is very substantial in most less developed countries and in the United States. It includes all illegitimate (mostly illegal) economic activities, whether market activities or not. In less developed countries, much of the underground economy is the "black market," but there is also a significant amount of crime in many of these countries. Estimates abound concerning the actual size of the underground economy in the United States. The middle range of these estimates suggests the amount of underground economic activities may be as much as one-third of total U.S. output. The F.B.I. has, for years, tracked crime statistics in the United States and publishes an annual report concerning crime. It is clear that drugs, organized theft, robberies, and other crimes against property are very substantial in the United States. However, when these crimes result in income for the offenders, there is also the substantial problem of income tax evasion from not reporting the income from the criminal activity. After all, Al Capone never went to jail for all of the overt criminal acts involved in his various criminal enterprises, he went to jail for another crime, that is, because he did not pay income taxes on his ill-gotten gains. 20

Drug trafficking in the United States is a very large business. The maximum estimates place this industry someplace in the order of a $500 billion per year business in the U.S. Few legitimate industries are its equal. Worse yet, the news media reports that nearly half of those incarcerated in this nation's prisons are there on drug charges. The image that the national income accounts portrays is that the $100 billion, plus that is spent on law enforcement and corrections because of drug trafficking is somehow an economic good, not a failure of our system. Drugs, however, are not the only problem. As almost any insurance company official can tell you, car theft is also another major industry. A couple of years ago CNN reported that a car theft ring operating in the Southeast (and particularly Florida) was responsible for a large proportion of vehicles sold in certain Latin American countries. Further, that if this car theft ring were a legitimate business it would be the fourteenth largest in the United States (right above Coca-Cola in the Fortune 100). In an economy with total output of $6 trillion, when nearly 10% of that is matched by only one illegitimate industry - drugs - there is a serious undercounting problem. If estimates are anyplace close to correct, and $500 billion per year are the gross sales of drug dealers, and if the profits on this trade are only eighty percent (likely a low estimate), and if the corporate income tax rate of forty-nine percent could be applied to this sum, then instead of a $270 billion budget deficit, the Federal government would be experiencing a surplus of something in the order of $130 billion, without any reduction in expenditures for law enforcement and corrections (which could be re-allocated to education, health care or other good purposes). Maybe the best argument for the legalization of drugs is its effect on the nation's finances (assuming, of course, drugs were only a national income accounting problem).

Price Indices Changes in the price level pose some significant problems for national income accountants. If we experience 10% inflation and a reduction of total output of 5% it would appear that we had an increase in GNP. In fact, we had an increase in GNP, but only in the current dollar value of that number. In real terms, we had a reduction in GNP. Comparisons between these two time periods means very little because the price levels were not the same. If we are to meaningfully compare output, we must have a method by which we can compare output with from one period to another by controlling for changes in the price levels. Nominal GDP is the value of total output, at the prices that exist at that time. By adjusting aggregate economic data for variations in price levels then we have data that can be compared across time periods with different price levels. Real GDP is the value of total output using constant prices (variations in price levels being removed). 21

Price indices are the way we attempt to measure inflation and adjust aggregate economic data to account for price level variations. There is a wide array of price indices. We measure the prices wholesalers must pay, that consumers must pay (either urban consumers (CPI(U) or that wage earners must pay (CPI(W)), we measure prices for all goods and services (GNP Deflator) and we also have indices that focus on particular regions of the country, generally large urban areas, called Standard Metropolitan Statistical Areas -- S.M.S.A.). Price indices are far from perfect measures of variations in prices. These indices are based on surveys of prices of a specific market basket of goods, at a particular point in time. The accuracy of any inference that may be drawn from these indices depends on how well the market basket of commodities used to construct the index match our own expenditures (or the expenditures of the people upon whom the analysis focuses). Further complicating matters, is the fact that the market basket of goods changes periodically as researchers believe consumption patterns change. Every five to ten years (generally seven years) the Commerce Department (Current Population Surveys) changes the market basket of goods in an attempt to account for the current expenditure patterns of the group for which the index is constructed (total GNP, consumers, wholesalers, etc.). For the consumer price indices, there is a standard set of assumptions used to guide the survey takers concerning what should be included in the market basket. The market basket for consumers assumes a family of four, with a male wage earner, an adult female not employed outside of the home, and two children (one male, one female). There are also assumptions concerning home ownership, gift giving, diet, and most aspects of the hypothetical family's standard of living. The cost of living and the standard of living are mirror images of one another. If someone has a fixed income and there is a two percent inflation rate per year, then their standard of living will decrease two percent per year (assuming the index used is an accurate description of their consumption patterns). In other words, a standard of living is eroded if there is inflation and no equal increase in wages (or other income, i.e., pensions). Under the two percent annual inflation scenario, a household would need a two percent increase in income each year simply to avoid a loss in purchasing power of their income (standard of living). During most, if not all, of your lifetime this economy has experienced inflation. Prior to World War II, however, the majority of American economic history is marked by deflation. That is, a general decrease in all prices. With a deflationary economy all one must do to have a constant increase in their standard of living is to keep their income constant while prices fall. However, deflation is a problem. Suppose you want to buy a house. Most of us have mortgages; we borrow to buy a house. If you purchase a house worth $50,000 and borrow eighty percent of the purchase price, $40,000 you may have a problem. If we have five percent deflation per year, it only takes five years for the market value of that house to reach $38689. In the sixth year, you owe more on 22

your thirty-year mortgage than the market value of the house. Credit for consumer purchases becomes an interesting problem in a deflationary economy. On the other hand, if you owe a great deal of money, you have the opportunity to pay back your loans with less valuable money the higher the rate of inflation. Therefore, debtors benefit from inflation if they have fixed rate loans that do not adjust the rates for the effects of inflation. The inflationary experience of the post-World War II period has resulted in our expecting prices to increase each year. Because we have come to anticipate inflation, our behaviors change. One of the most notable changes in our economic behavior has been the wide adoption of escalator provisions in collective bargaining agreements, executory contracts, and in entitlement laws (social security, veterans' benefits, etc.). Escalator arrangements (sometimes called Cost of Living Adjustments, C.O.L.A.) typically tie earnings or other payments to the rate of inflation, but only proportionally. For example, the escalator contained in the General Motors and United Auto Workers contract provides for employees receiving 1 per hour for each .2 the CPI increases. This protects approximately $5.00 of the employees earnings from the erosive effects of inflation (.01/.2)100, assuming a base CPI of 100. (There is no escalator that provides a greater benefit to income receivers than the GM-UAW national agreement). There are other price indices that focus on geographic differences. (Price data that measures changes over time are called time series, and those that measure differences within a time period but across people or regions are called cross sections). The American Chamber of Commerce Research Association (ACCRA) in Indianapolis does a cross sectional survey, for mid-sized to large communities across the United States. On this ACCRA index Fort Wayne generally ranges between about 96.0 and 102.0, where 100 is the national average and the error of estimate is between 2 and 4 percent. There are also producer and wholesale price indices and several component parts of the consumer price indices that are designed for specific purposes that focus on regions of the country or industries. For example, the components of the CPI are also broken down so that we have detailed price information for health care costs, housing costs, and energy costs among others. Paashe v. Laspeyres Indices There are two different methods of calculating price indices; these are the Laspeyres Index and the Paashe Index. The Laspeyres Index uses a constant market basket of goods and services to represent the quantity portion of the ration Q0 so that only price changes are in the index. L = PnQ0 / P0Q0 X 100 23

This is the most widely used index in constructing price indices. It has the disadvantage of not reflecting changes in the quantities of the commodities purchased over time. The Paasche index overcomes this problem by permitting the quantities to vary over time, which requires more extensive data grubbing. The Passche index is: P = PnQn / P0Qn X 100

Measuring the Price Level The discussion here will focus on the Consumer Price Index (CPI) but is generally applicable. The CPI is based on a market basket of goods and is expressed as a percentage of the value of the market baskets' value in a base year (the year with which all prices in the index are compared). Each year's index is constructed by dividing the current year market basket's value by the base year market basket's value and then multiplying the result by 100. Note that the index number for the base year will be 100.00 (or 1 X 100). By using this index we can convert nominal values into real values (real value are expressed in base year dollars). We can either inflate or deflate current values to obtain real values. Inflating is the adjustment of prices to a higher level, for years when the index is less than 100. Deflating is the adjustment of prices to a lower level, for years when the index is more than 100. The process whereby we inflate and deflate is relatively simple and straightforward. To change nominal into real values the following equation is used: Nominal value/ (price index/100) For example, in 1989 the current base year the CPI is 100. By 1996 the CPI increased to 110.0. If we want to know how much $1.00 of 1996 money is worth in 1989 we must deflate the 1996 dollar. We accomplish this by dividing 110 by 100 and obtaining 1.1; we then divided 1 by 1.1 and find .909, which is the value of a 1996 dollar in 1989. If we want to know how much a 1989 dollar would buy in 1996 we must inflate. We accomplish this by dividing 100 by 110 and obtaining .909; we then divide 1 by .909 and find 1.10, which is the value of a 1989 dollar in 1996. Because the government changes base years it may be necessary to convert one or more indices with different base years to obtain a consistent time series if we want to compare price levels between years decades apart. Changing base years is a relatively simple operation. If you wish to convert a 1982 base year index to be consistent with a 1987 base year, then you use the index number for 1982 in the 1987 series and divide all other observations for the 1982 series using the 1982 value in 1987 index series. This results in a new index with 1987 as a base year. If inflation was 24

experienced during the entire period then the index number for 1987 will be 100, for the years prior to 1987 the indices will be less than 100 and for the years after 1987 the numbers will be larger than 100. The price index method has problems. The assumptions concerning the market basket of goods to be surveyed causes specific results that are not descriptive of a general population. In the case of the consumer price index, families without children or with more than two may find their cost of living differs from what the index suggests. If both parents work, the indices may understand the cost of living. For families with ten year old, fixed rate mortgages and high current mortgages rates, the CPI may understate their current cost of living. Therefore, the CPI is only a rough measure, and its applicability differs from household to household. Cost of Living Adjustments David A. Dilts and Clarence R. Deitsch, Labor Relations, New York: Macmillan Publishing Company, 1983, p. 167. To the casual observer, COLA clauses may appear to be an excellent method of protecting the real earnings of employees. This is not totally accurate. COLA is not designed to protect the real wage of the employee but is simply to keep the employee's nominal wage, within certain limits, close to its original purchasing power. With a 1 cent adjustment per .4 increase in the CPI (if no ceiling is present) the base wage which is being protected from the erosive effect of inflation is $2.50 per hour, 1 cent per .3 increase in the CPI protects $3.33 per hour, and 1 cent per .2 increase in the CPI protects $5.00 per hour. This is quite easy to see; since the CPI is an index number computed against some base year (CPI = 100 in 1967) and the adjustment factor normally required in escalator clauses is 1 cent per some increase x, in the CPI, the real wage which is protected by the escalator is the inverse of the CPI requirement or 1/x. The items, which go into the market basket of goods to construct the price indices, and the proper inference, which can be drawn from these data, are published in several sources. Perhaps the easiest accessible location of this information is at the Bureau of Labor Statistics site www.bls.gov, which also publishes a wealth of information concerning employment, output, and prices.

The following boxes provide some recent information of the type to be found at the Bureau of Labor Statistics site. The first box provides annual data for consumer prices for both All Urban Consumers (CPI-U), and Urban Wage Earners and Clerical Employees (CPI-W).

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Consumer Prices 1996-2005, Annual Averages Year 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 CPI-U 156.9 160.5 163.0 166.6 172.2 177.1 179.9 184.0 188.9 195.3 CPI-W 154.1 157.6 159.7 1632. 168.9 173.5 175.9 179.8 184.5 191.0 Difference (U-W) 2.8 2.9 3.3 3.4 3.3 3.6 4.0 4.2 4.4 4.3

Not seasonally adjusted 1982-84 = 100.0 Source: U.S. Department of Labor, Bureau of Labor Statistics

Notice that the trend of prices is upwards, and that the CPI (W) is always slightly larger than the CPI (U). The difference between the two series is growing in 1996, the difference was about 1.78% of CPI (U), whereby in 2005 the difference was 2.2 % of CPI (U). The market basket of goods and services that go into calculating the consumer price index has been the subject of substantial controversy. For inference to be properly drawn concerning the underlying prices in the CPI one must have some idea of what goes into to the market basket and whether that mix of goods and service is of any particular significance for a consumer. The general categories of expenditures by consumers which are represented by the CPI (U) are presented in the following table. The table presents the categories of expenditure, rather than each specific item that is included in the market basket. This category of expenditure is for the base period 198284 and is supposed to be representative of what the average urban consumer purchased during this time frame. Consider the consumer expenditure categories used in calculating the CPI (U) which are presented in the following table:

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CPI (U) Expenditure Categories 1982-84 Category Food Alcoholic Beverage Relative Importance Dec. 2005 13.942 1.109

Shelter 32.260 Fuels & Utilities 5.371 Furnishings & Operations 4.749 Apparel Transportation Medical Care Recreation Education Communication 3.786 17.415 6.220 5.637 2.967 3.080

Other goods & services 3.463 ___________________________ All Categories 99.999

Source: Bureau of Labor Statistics

This is an exercise in positive economics. These are NOT the percentages of incomes that consumers spend. These are the percentages of incomes assumed to be spent by consumers in constructing the CPI (U). It is clear that there are value judgments and biases included in these data, but is not so clear is whether the data is upwardly or downwardly biased. With the increases in health care costs and recent increases in oil prices it is very likely that, in general, the CPI (U) is downwardly biased. However, there are those who argued that the CPI (U) is upwardly biased, and should be adjusted downward. These economists, however, are those who also argue that indexing government transfer payments and social security is a bad idea. Where the truth actually lies is an empirical question. 27

Other Price Level Aggregates The key price level measures are published data from the Commerce Department. Some simple relationship has been demonstrated in the economic literature which is worth examining here. The consumer price index is divided into core components and also includes things which are more volatile, these items are food and energy. Housing, clothing, entertainment, etc. are less volatile are often referred to as the core elements of the consumer price index. Theoretically it is presumed that the Wholesale Price Index, an index of items that wholesalers provide to retailers, and the Producer Price Index, an index of intermediate goods are leading indicators of prices at the consumer level. In fact, these two price indices, over the broad sweep of American economic history, have been pretty reasonable indicators of what to expect from consumer prices. The Producer Price Index is a complex, but useful collection of numbers. The PPI is divided into general categories, industry and commodity. The major groupings under each of these broad categories have a series of price data which has been collected monthly for several years. The following two tables present simple examples of the types of PPI data that are available. The first table presents industry data, the second box presents commodity data. There are also series on such specialized pricing information as import and export prices, and these are all available on the www.bls.gov site. Industry PPI data, 1996-2005 Year Petroleum Refineries Book Publishers 224.7 232.1 238.8 247.6 255.0 263.3 273.0 283.0 293.7 305.4 35.9 Auto & Light Vehicle Mfg 140.4 137.8 136.8 137.6 138.7 137.6 134.9 135.1 136.5 135.1 -3.9 General Hospitals 112.5 113.6 114.6 116.6 119.8 123.4 127.9 135.3 141.9 147.3 30.9

1996 85.3 1997 83.1 1998 62.3 1999 73.6 2000 111.6 2001 103.1 2002 96.3 2003 121.2 2004 151.5 2005 205.3 % 1996-05 140.7

Source: Bureau of Labor Statistics 28

As can be easily seen from the above table, there is wide variation in PPI by industry. Oil refineries costs of operation have gone up more than 140% over the period, while the costs for automobile and light vehicle manufacturers have actually declined over the period by nearly 4 percent. In keeping with the high costs of health care, hospitals costs of operation have increased nearly as much as the costs to book publishers over the period. Remember, these are industry cost numbers. The following table present commodity cost statistics in the PPI series. Commodity PPI data, 1996-2005 Year 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 % 1996-05 All Commodities 127.7 127.6 124.4 125.5 132.7 134.2 131.1 138.1 146.7 157.4 23.3 Petroleum Crude 62.6 57.5 35.7 50.3 85.2 69.2 67.9 83.0 108.2 150.1 139.8 Paper 149.4 143.9 145.4 141.8 149.8 150.6 144.7 146.1 149.4 159.6 6.8 Iron and Steel 125.8 126.5 122.5 114.0 116.6 109.7 114.1 121.5 162.4 171.1 36.0

Source: Bureau of Labor Statistics

As can readily be seen in comparing the two series, there is a reason why oil refineries costs of operations increased. The price of crude oil increase by just about what the costs to the refiners increased. However, book publishers need not look to the price of paper to explain their cost increases. In sum, the costs of commodities went up over the nine year period by a rather small 23.3 percent or just over two and one-half percent. Monetary aggregates have also been used as a rough gauge of what to expect in the behavior price variables over time. Later in the course there will be substantial discussion of the Federal Reserve and monetary economics, but it is interesting to note here that monetary aggregates have both a practical and theoretical relationship to aggregate price information in the economy. Monetary aggregates generally have significant influence over interest rates, which, in turn, will have both aggregate supply 29

and aggregate demand implications. A presentation and discussion of these economic statistics is reserved for the monetary economics chapters in this course. Employment and Output Unemployment and employment data have implications for the business cycle, as will be discussed in detail later. However, it is important to note here that employment statistics are generally a lagging indicator, that is, they trail (or confirm) what is going on in the aggregate economy. Forecasting can be as much a game of indications, more than precision. If we see industrial output is on the rise, we can expect that unemployment rates will decline once a trough in the business cycle has been reached. On the other hand, if industrial output is declining, we can expect future unemployment rates to be on the rise. This presumes that there has not been prolonged recession or structural changes in the economy. When there are structural changes or prolonged recession, then such phenomenon as the discouraged worker hypothesis may operate to make the unemployment rates move in directions that would be otherwise inconsistent with what had been recently observed in the aggregate economy. In other words, even though the unemployment and employment statistics have a generally predictable relationship with output, you can get fooled sometimes because of underlying phenomenon in the economy. These theoretical relationships are only indicative and can sometimes be overwhelmed by other economic pressures in the economy. A discussion of the various economic statistics relevant to employment and output will be reserved for the following chapter where more discussion of the concepts which underpin these data is discussed.

KEY CONCEPTS National Income Accounting Social Welfare Under-estimations Over-estimations Gross Domestic Product v. Gross National Product Value added 30

Expenditures Approach Income Approach Criticisms Net Domestic Product v. Net National Product Depreciation National Income Personal Income Disposable Income Inflation v. Deflation Cost-Push Inflation v. Demand-Pull Inflation Pure Inflation Monetarist School Quantity Theory of Money Price Indices CPI PPI Other Indices Inflating v. Deflating Paasche v. Laspeyres Price aggregates CPI and WPI and PPI relations Monetary aggregates Employment and Unemployment 31

Relations with output Indicators, not hard and fast rules

STUDY GUIDE Food for Thought: Critically evaluate the use of national income accounts as measures of social welfare.

Using the following data construct the price indices indicated: Year Market basket $ 1989 1990 1991 1992 1993 350 400 440 465 500

Calculate a price index using 1989 as the base year

Calculate a price index using 1991 as the base year

If the nominal price of new house in 1993 is $100,000, how much is the house in 1989 dollars? In 1991 dollars?

If the price of a new house in 1989 is $90,000 what is the price in 1991 dollars? 32

Critically evaluate the use of price indices for comparison purpose across time.

Using the following data calculate GDP, NDP, NI, PI, and DI Undistributed Corporate profits $40 Personal consumption expenditures $1345 Compensation of employees $841 Interest $142 Gross exports $55 Indirect business taxes $90 Government expenditures $560 Rents $115 Personal taxes $500 Gross imports $75 Proprietors income $460 Depreciation $80 Corporate income taxes $100 Net Investment $120 Dividends $222 Net American income earned abroad $5 Social security contributions $70

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Sample Questions: Multiple Choice: If U.S. corporations paid out all of their undistributed corporate profits as dividends to their stockholders then which of the following national income accountants would show an increase? A. B. C. D. Gross Domestic Product Net Domestic Product Personal Income National Income

The following are costs of market baskets of goods and services for the years indicated: 1900 1910 1920 1930 1940 1950 1960 $100 $102 $105 $90 $100 $110 $160

Using 1920 as a base year what is the price index for 1900 and for 1960? A. B. C. D. 1900 is 105, 1960 is 160 1900 is 95.2, 1960 is 152.4 1900 is 111.1, 1960 is 177.8 Cannot tell from the information given

True - False: The GDP is overstated because of the relatively large amount of economic activity that occurs in the underground economy {TRUE}. The difference between Personal Income and Disposable Income is personal taxes {TRUE}.

34

Chapter 3

Unemployment and Inflation

When one thinks of business conditions, the first thing to come to mind, typically, is the recurrent cycles that the economy repeats with near regularity. Business cycles are a fact of economic life with a market based economy. Recessions are generally followed by recoveries which give a sort of up and down vibration to the long-term secular growth trend in the U.S. economy. The way we track this vibration is through the two major economic phenomenons that are used to track business cycles, these are employment and price level stability. The purpose of this chapter is to examine two of the most important and recurrent economic problems that have characterized modern economic history throughout the industrialized world, including the United States. These two problems are unemployment (associated with recessions) and inflation (associated with the loss of purchasing power of our incomes). Most economic policy focuses on mitigating these, most serious, of problems in the macroeconomy.

Mixed Economic System and Standard of Living American capitalism is a mixed economic system. There are small elements of command and tradition, and some socialism. However, our economic system is predominately capitalist. The economic freedom and ability to pursue our individual self-interest provides for the American people a standard of living, in the main, that is unprecedented in world history. Perhaps more important, our high standards of living are widely shared throughout American society (with fewer than 17.5% of Americans living in poverty). The accomplishments of American society ought not to be taken lightly, no other epoch and no other nation, has seen a "golden" age as impressive as modern America. However, there are aspects of our freedom of enterprise that are not so positive. Free market systems have a troubling propensity to experience recessions (at the extreme depressions) periodically. As our freedom of inquiry develops new knowledge, new products and new technologies, our freedom of enterprise also results in the abandonment of old industries (generally in favor of new industries). At times we also seem to lose faith in accelerating rates of growth or economic progress. At other times, we have experienced little growth in incomes (at the extreme declines in consumer incomes). All of these problems have resulted in down-turns in economic activity. At other times, consumer's income have increased at accelerating rates, people have become enthusiastic about our economic future, and the growth of new industries have 35

far outpaced the loss of old industries that have resulted in substantial expansions of economic activity. Together these down-turns and expansions are referred to as the business cycle.

Business Cycles

The business cycle is the recurrent ups and downs in economic activity observed in market economies. Troughs, in the business cycle, are where employment and output bottom-out during a recession (downturn) or depression (serious recession). Peaks, in the business cycle, are where employment and output top-out during a recovery or expansionary period (upturn). These ups and downs (peaks and troughs) are generally short-run variations in economic activity. It is relatively rare for a recession to last more than several months, two or three years maximum. The Great Depression of the 1920s and 1930s was a rare exception. In fact, the 1981-85 recession was unusually long. One of the most confusing aspects of the business cycle is the difference between a recession and depression. For the most part, recessionary trends are marked by a downturn in output. This downturn in output is associated with increased levels of unemployment. Therefore, unemployment is what is typically keyed upon in following the course of a recession. In 1934, the U.S. economy experienced 24.9% unemployment, this is clearly a depression. The recession of 1958-61 reached only 6.7% unemployment. This level of reduced economic activity is clearly only a recession. However, in the 1981 through 1986 downturn the unemployment rate reached a high of 12%, and in both 1982 and 1983 the annual average unemployment rate was 10.7%. Probably the Reagan recession was close to, if not actually, a short depression, arguably a deep recession. This 1981-85 period was clearly the worst performing economy since World War II, but it also was clearly nothing compared to the problems in the decade before World War II. The old story about the difference between a recession and depression probably is as close to describing the difference between a recession and a depression as anything an economist can offer. That is, a recession is when your neighbor is out of work, a depression is when you are out of work! In general, the peaks and troughs associated with the business cycle, are shortrun variations around a long-term secular trend. Secular trends are general movements in a particular direction that are observed for decades (at least 25 years in macroeconomic analyses). Prior to World War II the secular trend started as relatively flat and limited growth period and then it took a sharp downward direction until the beginnings of the War in 36

Europe (a period of about twenty years). Since the end of World War II we have experienced a long period of rather impressive economic growth (a period of over fifty years). The following diagram shows a long-term secular trend that is substantially positive (the straight, upward sloping line). About that secular trend is another curved line, whose slope varies between positive and negative, this is much the same as the business cycle variations about that long-term growth trend. If we map out economic activity since World War II we would observe a positive long-term trend, with marked ups and downs showing the effects of the business cycle.

Output Peak

Secular trend

Trough

Years

There are other variations observed in macroeconomic data. These variations, called seasonal variations, last only weeks and are associated with the seasons of the year. During the summer, unemployment generally increases due to students and teachers not having school in the summer and both groups seeking employment during the summer months. Throughout most of the Midwest agriculture and construction tend to be seasonal. Crops are harvested in the fall, then in the winter months farmers either focus on livestock production or wait for the next grain season. In the upper Midwest, north of Fort Wayne, outside work is very limited due to extreme weather conditions, making construction exhibit a seasonal trend. In the retail industry, from Thanksgiving through New Year's Day is when disproportionately large amounts of business are observed, with smaller amounts during the summer. Most series of data published by the Commerce Department or the Bureau of Labor Statistics concerning prices and employment have two different series. There will typically be data which does not account for predictable seasonal variations (not seasonally adjusted) and those data which have had the seasonal variations removed (seasonally adjusted). From a practical standpoint, the raw numbers capture what actually happens and may be useful for forecasts and analyses where you wish to have the actual results. On the other hand, knowing what the seasonal variations are 37

permitting the analyst to capture affects with their models that are from more fundamentally economic or political processes. Therefore, both series of data are of significance to the economics profession.

Unemployment

Unemployment is defined to be an individual worker who is not gainfully employed, is willing and able to work, and is actively seeking employment. A person who is not gainfully employed, but is not seeking employment or who is unwilling or unable to work is not counted as unemployed, or as a member of the work force. During the Vietnam War unemployment dropped to 3.6% in 1968 and 3.5% in 1969. This period illustrates two ways in which unemployment can be reduced. Because of the economic expansion of the Vietnam era more jobs were available, but during the same period many people dropped out of the work force that may otherwise have been unemployment or, alternatively, vacated jobs that became available to others to avoid military service. One way to keep from being drafted was to become a full time student, which induced many draft-age persons to go to college rather than risk military service in Vietnam. Additionally, there was a substantial expansion in the manpower needs of the military with nearly 500,000 troops in Vietnam in 1969. Therefore, the unemployment rate was compressed between more job, and fewer labor force participants. Unemployment can decrease because more jobs become available. It can also decrease because the work force participation of individuals declines, in favor of additional schooling, military service, or leisure. Unemployment is more than idle resources, unemployment also means that some households are also experiencing reduced income. In other words, unemployment is associated with a current loss of output, and reductions in income into the foreseeable future. Economists classify unemployment into three category by cause. These three categories of unemployment are (1) frictional, (2) structural, and (3) cyclical. Frictional unemployment consists of search and waits unemployment which is caused by people searching for employment or waiting to take a job in the near future. Structural unemployment is caused by a change in composition of output, changes in technology, or a change in the structure of demand (new industries replacing the old). Cyclical unemployment is due to recessions, (the downturns in the business cycle). Structural unemployment is associated with the permanent loss of jobs, however, cyclical unemployment is generally associated with only temporary losses of employment opportunities. Full employment is not zero unemployment, the full employment rate of unemployment is the same as the natural rate. The natural rate of unemployment is thought to be about 4% and is a portion of structural unemployment and frictional 38

unemployment. However, there is not complete professional agreement concerning the natural rate, some economists argue that the natural rate, today is, about 5%. The disagreement centers more on observation of the secular trend, than any particular technical aspect of the economy (and there are those in the profession who would disagree with this latter statement). The reason that frictional and structural unemployment will always be observed is that our macroeconomy is dynamic. There are always people entering and leaving the labor force, each year there are new high school and college graduates and secondary wage earners who enter and leave the market. There is also a certain proportion of structural unemployment that should be observed in a healthy economy. Innovations result in new products and better production processes that will result in displacement of old products and production processes that results employees becoming unnecessary to staff the displaced and less efficient technology. Therefore, the structural component of the natural rate is only a fraction of the total structural rate in periods where there is displacement of older industries that may result from other than normal economic progress. Perhaps the best example of this is the displacement of portions of the domestic steel and automobile industries that resulted from predatory trade practices (i.e., some of the dumping practices of Japan and others). The level of output associated with full utilization of our productive resources, in an efficient manner is called potential output. Potential output is the output of the economy associated with full employment. It is the level of employment and output associated with being someplace on the production possibilities curve (from E201). This level of production will become important to us in judging the performance of the economy. Full employment is not zero unemployment and potential GNP is not total capacity utilization (full production), such levels of production are destructive to the labor force and capital base because people fulfill other roles (i.e., consumer, parent, etc.) and capital must be maintained. The Nazi's slave labor camps (during World War II) were examples of the evils of full production, where people were actually worked to death.

Unemployment rates

The unemployment rate is the percentage of the work force that is unemployed. The work force is about half of the total population. Retired persons, children, those who are either incapable of working or those who choose not to participate in the labor market are not counted in the labor force. Another way to look at it, is that the labor force consists of those persons who are employed or unemployed who are willing, able and searching for work. 39

People who are employed may be either full time or part time employees. In aggregate the average number of hours worked by employees in the U.S. economy generally is something just under forty-hours per week (generally between 38 and 39 hours per week). This statistic reflects the fact that people have vacation time, are absent from work, and may have short periods of less than forty hours available to them due to strikes, inventories, or plant shut-downs. Part time employees are included in the work force. You are not counted as unemployed unless you do not work and are actively pursuing work. Those who do not have 40 hours of work (or the equivalent) available to them are classified as part time employees. At present there are about 6.5 million U.S. workers were involuntarily parttime workers, and about 12 million were voluntarily part-time employees, this is up about 3 million from total part time employment in 1982. The unemployment rate is calculated as:

UR = Unemployed persons labor force

There are problems with the interpretation of the unemployment rate. Discouraged workers are those persons who dropped out of labor force because they could not find an acceptable job (generally after a prolonged search). To the extent there are discouraged workers that have dropped out of the work force, the unemployment rate is understated. There are also those individuals who have recently lost jobs who are not interested in working, but do not wish to lose their unemployment benefits. These individuals will typically go through the motions of seeking employment to remain eligible for unemployment benefits but will not accept employment or make any effort beyond the appearance of searching. This is called false search and serves to overstate the unemployment rate. There has yet to be any conclusive research that demonstrates whether the discouraged worker or false search problem has the greatest impact on the unemployment rate. However, what evidence exists suggests that in recent years the discouraged worker problem is the larger of the two problem, suggesting that the unemployment rate may be slightly understated. The following box provides a snapshot of available economic data concerning employment aggregates:

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Labor Market Data, 1996-2006 (seasonally adjusted January) Year 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Civilian Labor Force (1000s) 132616 135456 137095 139003 142267 143800 143883 145937 146817 147956 150114 Employment Level (1000s) 125125 128298 130726 133027 136559 137778 136442 137424 138472 140234 143074 Unemployment Level (1000s) 7491 7158 6368 5976 5708 6023 8184 8513 8345 7723 7040 Unemployment Rate (%) 5.6 5.3 4.6 4.3 4.0 4.2 5.7 5.8 5.7 5.2 4.7

Source: Bureau of Labor Statistics

Okun's Law As mentioned earlier, unemployment is not just a single dimensional problem. Based on empirical observation an economist determined that there was a fairly stable relation between unemployment and lost output in the macroeconomy. This relation has a theoretical basis. As we move away from an economy in full employment, noninflationary equilibrium, we find that we lose jobs in a fairly constant ratio to the loss of output. Okun's Law states that for each one percent (1%) the unemployment rate exceeds the natural rate of unemployment (4%) there will be a gap of two and one-half percent (2.5%) between actual GDP and potential GDP. In other words, employment is a highly correlated with GDP. This is why it is not technically incorrect to look to the unemployment rate to determine whether a recession has begun or stopped. It is also true that unemployment tends to trail behind total output of the economy. In other words, unemployment is a trailing indicator. As the economy recovers we could still see worsening unemployment, but after a lag of a quarter or so, the improving economic conditions will result in less unemployment. This relationship permits some rough guesses about what is happening to total output in the economy, however, it is only a rough guide, because unemployment is a trailing indicator. In other words, as the economy goes into recession that last variable to reflect the loss of output is the unemployment rate. Okuns Law, as it turns out, is also very useful in formulating policy within the Keynesian framework which will be developed later in the course. 41

Burden of Unemployment The individual burden of unemployment is not uniformly spread across the various groups that comprise our society. There are several factors that have been historically associated with who bears what proportion of the aggregate levels of unemployment. Among the factors that determine the burden of unemployment are occupation, age, race and gender. The individual occupational choice will affect the likelihood of becoming unemployed. Those with low skill and educational levels will generally experience unemployment more frequently than those with more skills or education. There are also specific occupations (even highly skilled or highly educated) that may experience unemployment due to structural changes in the economy. For example, with the decline in certain heavy manufacturing many skilled-trades persons experienced bouts of unemployment during the 1980s. As educational resources declined in the 1970s and again recently, many persons with a Ph.D. level education and certified teachers experienced unemployment. However, unemployment for skilled or highly educated occupations tends to be infrequent and of relatively short duration. Age also plays a role. Younger people tend to experience more frictional unemployment than their older, more experienced counterparts. As people enter the work force for the first time their initial entry puts them into the unemployed category. Younger persons also tend to experience a longer duration of unemployment. However, there is some evidence that age discrimination may present a problem for older workers (the Age Discrimination Act covers those persons over 40, and it appears those over 50 experience the greatest burden of this discrimination). Race and gender, unfortunately, are still important determinants of both incidence and duration of unemployment. Most frequently the race and gender effects are the result of unlawful discrimination in the labor market. There is also a body of evidence that suggests there may be significant discrimination in the educational opportunities available to minorities. Edmund Phelps developed a theory called statistical theory of racism and sexism that sought to explain how discrimination could be eliminated as a determinate of the burden of unemployment. His theory was that if there was not a ideological commitment to racism or sexism, that if employers were forced to sample from minorities they would find that there was no difference in these employees' productivity and the productivity of the majority. This formed the basis of affirmative action programs. The lack of effectiveness of most of these programs suggests that the racism and sexism that exists is ideological and requires stronger action, than simple reliance on economic rationality and sampling. 42

Inflation The news media reports inflation, generally, as increases in the CPI. This is not technically accurate. Inflation is defined as a general increase in all prices (the price level). The CPI does not purport to measure all prices, wholesale prices and producer prices are not included in the consumer data. The closest we have to a measure of inflation is the GNP deflator that measures prices for the broadest range of goods and services, but even this broader index is not a perfect measure, but its all we have and some information (particularly when we know the short-comings) is better than perfect ignorance. One of the more interesting bits of trivia concerning inflation is something called the Rule of 70. The rule of 70 gives a short-hand method of determining how long it takes for the price level to double at current inflation rates. It states that the number of years for the price level to double is equal to seventy divided by the annual rate of increase (i.e., 70/%annual rate of increase(expressed as a whole number)). For example, with ten percent inflation, the price level will double every seven years (70/10 = 7). There are three theories of inflation that arise from the real conduct of the marcoeconomy. These three theories are demand-pull, cost-push, and pure inflation. There is a fourth theory that suggests that inflation has little or nothing to do with the real output of the economy, this is called the quantity theory of money. Each of these theories will be reviewed in the remaining sections of this chapter.

Demand - Pull Inflation Using a naive aggregate supply/aggregate demand model, we can illustrate the theory of demand-pull inflation. The following chapter will develop a more sophisticated aggregate supply/aggregate demand model, but for present purposes the naive model will suffice. The naive model has a linear supply curve and a linear demand curve, much the same as the competitive industry model developed in the principles of microeconomics course (or in A524). However, the price variable here is not the price of a commodity, it is the price level (the CPI for want of a better measure) and the quantity here is the total output of the economy, not some number of widgets.

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Price

Aggregate Supply

Aggregate Demand

Output

Using a naive aggregate demand\ aggregate supply model, as the aggregate demand shifts to the right or increases, all prices increase. This increase in all prices is called inflation. However, this increase in aggregate-demand is also associated with an increase in total output. Total output is associated with employment (remember Okun's Law?). In other words, even though this increase in aggregate demand causes inflation, it does not result in lost output, hence unemployment. Policy measures designed to control demand-pull inflation, will shift the aggregate demand curve to the left, (i.e., reduce aggregate demand) and this reduction in aggregate demand is associated with loss of output, hence increased unemployment. Demand-pull inflation is therefore only a problem with respect to price level instability. On the other hand, there is another model of inflation which creates problems in both price level instability and unemployment, and that model is called Cost-Push Inflation.

Cost - Push Inflation Again using a naive aggregate supply/aggregate demand approach, cost-push inflation results from particular changes in the real activity in the macroeconomy. In this case, a decrease in the aggregate supply curve. A decrease in aggregate supply can occur for several reasons. Government regulations which divert resources from productive uses, increases in costs of intermediate goods and factors of production, ad valorem taxes, and sources of inefficiency (excess executive salaries etc.) can all result in a leftward shift in the aggregate supply curve.

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The following diagram shows a shift to the left or decrease in aggregate supply curve.

Price

Aggregate Supply

Aggregate Demand

Output
The OPEC Oil embargo may present the best case for cost-push inflation. As oil prices doubled and then tripled, the costs of production that were comprised at least in part from oil also dramatically increased. Therefore, the dramatic increase in the price of oil shifted the aggregate supply curve to the left (a decrease) , resulting in cost-push inflation. The general case is, as the price of any productive input increases, the aggregate supply curve will shift to the left. This decrease in aggregate supply also results in reduced output, hence unemployment. This is consistent with the economic experience of the early 1980s during the Reagan Administration when the economy experienced high rates of both inflation and unemployment. It is also interesting to note that the experiences of the Nixon-Ford administration and later the Carter administrations were not unlike that of Reagans era. In the NixonFord administration the 1973 Mid-East war resulted in very high oil prices, and monetary policies that resulted in rapidly increasing interest rates which together created what economists labeled Stagflation high rates of inflation together with high rates of unemployment. Again, tracing the causes of this back to the origin results in a conclusion that the Cost-Push model provided an interesting, albeit, over-simplified explanation of the Nixon-Ford experience. Jimmy Carter fared no better. The double digit inflation and unemployment of the early 1970s was repeated at the end of the decade. Even though Carters move to deregulate the airlines industry and the trucking industry may have had long-term positive results for the economy, foreign policy was about to intervene and create essentially the same havoc as plagued the previous regime. In 1979 the Iranian 45

revolution and the Russian invasion of Afghanistan created a foreign policy disaster in the U.S. At the time of the Iranian crises, Iran was one this countrys largest trading partner. With the loss of this source of foreign demand for U.S. goods, and the second largest source of foreign oil, the shock resulted in returning to the same double digit unemployment and inflation that swept the Republicans out of office just three years earlier and again, the experience was not unlike the results predicted by Cost-Push Inflation models.

Pure Inflation Pure inflation results from an increase in aggregate demand and a simultaneous decrease in aggregate supply. For output to remain unaffected by these shift in aggregate demand and aggregate supply, then the increase in aggregate demand must be exactly offset by an equal decrease in aggregate supply. The following aggregate supply/aggregate demand diagram illustrates the theory of pure inflation:

Price

Aggregate Supply

Aggregate Demand

Output
Notice in this diagram, that aggregate supply shifted to the left, or decreased by exactly the same amount that the aggregate demand curve shifted to the right or increased. The result is that output remains exactly the same, but the price level increased. Intuitively, this makes sense, with the loss of aggregate supply we would expect an increase in prices, and with an increase in aggregate demand we would also expect an increase in prices. As aggregate supply and aggregate demand move in opposite directions, it is not perfectly clear what happens to output. In this case, with equal changes in aggregate demand and supply output should remain exactly the same. 46

Put the two models together, and it is a roll of the dice whether the economy grows or declines as the price level runs amuck. If aggregate supply declines more severely than aggregate demand increases, you will get stagflation. On the other, hand economic growth, oddly enough, is still possible if aggregate demand outpaces the declines in aggregate supply an interesting quandary to say the least.

Quantity Theory of Money The models of cost-push, demand-pull and pure inflation presented above, are rather naive simplifications. These models suggest that there are causes of inflation that are generated by the real rather than the monetary economy. In other words, it is possible to create inflation through real shocks to the economy (Real Business Cycle Theory from Tom Sargent and the Minnesota School). In fact, there may be pressures that can influence both policy makers, and have implications for inflation if monetary authorities make mis-steps. The Monetarist School of economic thought points to another possible explanation for inflation. These economists do not reject the idea that inflationary pressures can occur because of an oil embargo or increases in consumer demand. However, these economists argue that inflation cannot occur simply as a result of these events. They are quick to point out that a change in a single price in the price index market basket can give the appearances of inflation, when all that happened was a change in the relative price of one commodity with respect to all others. More of this theory will be discussed in the final weeks of the semester, however, one point is necessary here. Inflation, in the monetarist view, can only occur if the money supply is increased which permits all prices to increase. If the money supply is not increased there can be changes in relative prices, for example, oil prices can go up, but there has to be offsetting decreases in the prices of other commodities. An increase in all prices or in the price of a particular good, therefore, is a failure of the Fed to appropriately manage the money supply. As oil prices rose from $15 a barrel to over $70 a barrel we would have expected to experience very significant inflation if the histories of the Nixon-Ford, and Carter administrations were instructive. However, so far at least, these histories have not been repeated. What is interesting to note is that the price level has remained remarkably stable in the face of the quadrupling of crude oil prices. There are two explanations for this observation together they illustrate the point of inflation and monetary economics. The explanation is rather straightforward and simple. After 9/11/01 the Federal Reserve drove the discount rate down to 1%. The result was that this extremely easy monetary policy prevented what should have been a serious recession. The 47

unemployment rate in August of 2001 was a mere 4.9% and immediately started a significant increase in September. By December of 2002 the rate was over 6 percent seasonally adjusted. However, the Fed had brought interest rates to such a low point that two dramatic changes occurred. We began a bull market in housing (interest rate sensitive) and the declines in automobile production reversed (again, interest rate sensitive commodities). These two portions of the economy kept the whole thing from disaster. As the United States became mired in military actions in Southwest Asia, the dollar began to lose value. The loss of the dollars value served to prevent even greater penetration of domestic markets by Japanese and European competitors, hence again keeping unemployment from become a more serious problem. However, this monetary stimulus resulted in the Fed having record low interest rates, at a time that the Federal budget deficits began run out of control. High Federal debt levels being held, in large measure, by foreigners resulted in further downward pressure on the value of the dollar. This downward pressure on the value of the dollar meant that the price of foreign goods had an upward pressure. At the same time, China was pegging the value of their currency on the value of the dollar and those exports to the U.S. were increasing and driving rather dramatic economic growth in China. In turn, the increasing economic prosperity in China resulted in increased demand for everything in China, and particularly in commodities, like gold, copper, and oil. In turn, the prices of these commodities in the U.S. sky-rocketed because of world demand increasing faster than supply, and the loss of purchasing power of the dollar. The tight monetary policy which began some two years ago has generated a 4 1/4% increase in the discount rate, and has essentially stopped inflation in its tracks. The quadrupling of the price of oil has had little effect in the overall price level simply because of the quadrupling of interest rates. However, the second reason is not to be entirely ignored. Over the period that oil prices went up dramatically, the demand for oil in the U.S. has not kept pace. Increased gas mileage, together with the loss of manufacturing has meant that oil demand has increased at lower rates than in recent decades in the U.S. As oil intensive industries become less important, the inflationary effects of oil price increases that were so devastating in the 1970s are less so in the first decade of this century.

Effects of Inflation The effects of inflation impact different people in different ways. Creditors and those living on a fixed income will generally suffer. However, debtors and those whose incomes can be adjusted to reflect the higher prices will not, and perhaps this group may even benefit from higher rates of inflation. If inflation is fully anticipated and people can adjust their nominal income or their purchasing behavior to account for inflation then there will likely be no adverse effects, 48

however, if people cannot adjust their nominal income or consumption patterns people will likely experience adverse effects. This is the same as if people experience unanticipated inflation. Normally, if you cannot adjust income, are a creditor with a fixed rate of interest or are living on a fixed income you will pay higher prices. The result is that those individuals will see their standard of living eroded by inflation. Debtors, whose loans specify a fixed rate of interest, typically benefit from inflation because they can pay loans-off in the future with money that is worth less. It is this paying of loans with money that purchases less that harms creditors. It should come as no surprise that the double digit inflation of fifteen years ago caused subsequent loan contracts to often specify variable interest rates to protect creditors from the erosive effects of unanticipated inflation. Savers may also find themselves in the same position as creditors. If savings are placed in long-term savings certificates that have a fixed rate of interest, inflation can erode the earnings on those savings substantially. Savers that anticipate inflation will seek assets that vary with the price level, rather than risk the loss associated with inflation. Inflation will effect savings behavior in another way. If a person fully anticipates inflation, rather than to save money now, consumers may acquire significant debt at fixed interest rates to take advantage of the potential inflationary leverage caused by fixed rates. Rather than to save now, consumers spend now. Therefore, inflation typically creates expectations among people of increasing prices, and if people increase their purchases aggregate demand will increase. An increase in aggregate demand will cause demand-pull inflation. Therefore, inflationary expectations can create a spiraling of increased aggregate-demand and inflationary expectations that can feed off one another. At the other extreme, recessionary expectations may cause people to save, that results in reduced aggregate demand, and another spiral effect can result (but downwards). This is what economists call rational expectations. Rational expectations are the simple idea that people anticipate what is going to occur in the economy. In other words, markets will have everything priced into them because both buyers and sellers know everything there is to know about the prices and availability of the goods and services in the economy. While this view expectations makes it easier to manipulate economic models, it is not very realistic. To account for expectations in a less harsh way in economic behavior, the theory of adaptive expectations has been formulated. It is more likely that people will not take extreme views of economic problems, including perfect knowledge. People will anticipate and react to relatively "sure things" and generally in the near term and wait to see what happens. As economic conditions change, consumers and producers change their expectations to account for these changes; in another words, they adapt their expectations to current and near term information about future economic events. 49

The adaptive expectations model is supported by a substantial amount of economic evidence. It appears that the overwhelming majority of the players in the macroeconomy are adaptive in their expectations. Unemployment Differentials David A. Dilts, Mike Rubison, Bob Paul, Unemployment: which person's burden man or woman, black or white?" Ethnic and Racial Studies. Vol. 12, No. 1 (January 1989) pp. 100-114. . . . The race and sex of the work force are significant determinants of the relative burdens of unemployment. Blacks are experiencing a decreasing burden of unemployment over the period examined while white females exhibit a positive time trend (increasing unemployment over the period). The dispersion of unemployment for blacks varies directly with the business cycle which suggests greater labor force participation sensitivity by this group. . . . The dispersions of white female unemployment vary countercyclically with the business cycle which is consistent with the inherited wisdom concerning unemployment and macroeconomics. . . . These results, together with the unemployment equation results, indicate that the unemployment rate for white males is not sensitive to the fluctuations in the business cycle nor do these data exhibit any significant time trend. These are rather startling results. This evidence suggests that while males bear substantially the same relative unemployment rates over all ranges of the business cycle. . . .

KEY CONCEPTS Business Cycle Peaks Troughs Seasonal trends Secular trends Unemployment frictional structural 50

cyclical Full employment Natural rate of unemployment Potential output Labor Force part-time employment discouraged workers false search Okuns Law Burden of Unemployment Inflation v. Deflation CPI Rule of 70 Demand-pull Cost-push Pure inflation Monetarists Stagflation Historical experiences in the U.S. with Stagflation Impact of Inflation Expectations

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STUDY GUIDE Food for Thought: Using the basic supply & demand model demonstrate cost-push, demand-pull, and pure inflation.

Critically evaluate the three categories of unemployment, be sure to discuss the problems with conceptualizing and measuring each.

Critically evaluate the qualitative and quantitative costs of both inflation and unemployment. Which is worse? Why?

Sample Questions: Multiple Choice: Which of the following is most likely to benefit from a period of unanticipated inflation? (assuming fixed assets and liabilities) A. Those whose liabilities are less than their assets B. Those whose liabilities exceed their assets, and whose loans are variable rate C. Those whose liabilities exceed their assets, and whose loans are fixed rate loans D. None of the above will benefit

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People who are unemployed due to a change in technology that results in a decline in their industry fit which category of unemployment? A. B. C. D. frictional structural cyclical natural

True - False: Seasonal variations in data are impossible to observe in annual data {TRUE}. Cost-push inflation is often associated with increased unemployment {TRUE}

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Chapter 4

Aggregate Supply & Aggregate Demand

The aggregate supply/ aggregate demand model of the macroeconomy will be developed in this chapter. This model is one of two models (the other is the Keynesian Cross) of the U.S. macroeconomic system that we will develop in this course. The aggregate demand and aggregate supply model is the main mode of analysis that characterized the classical school of economic thought and provides some useful insights. However, because the Keynesian Cross permits more direct analysis of the multiplier effects and other economic phenomenon it will be the model that is relied upon for the majority of the course.

Aggregate Supply and Aggregate Demand The aggregate supply/aggregate demand model is comparative static (slice of time) model of the macroeconomy. Rather than to be able to observe changes during each second of a period of time (dynamic), we will compare the economy in one time period with the model in a subsequent and distinct period. Its elegance arises from the fact that the model has foundations in microeconomics. In this view of the macroeconomy we simply aggregate everything on the supply side to obtain an aggregate supply curve and aggregate everything on the demand side to obtain an aggregate demand curve. Where aggregate supply intersects aggregate demand we observe a macroeconomic equilibrium. However, because the two functions are aggregations, the horizontal axis does not measure the quantity of a particular good, it measures GNP. The vertical axis is not a price in the sense of a microeconomic market, but is the price level in the entire economy.

Aggregate Demand The aggregate demand curve is a downward sloping function that shows the inverse relationship between the price level and gross domestic output (GDP). The reasons that the aggregate demand curve slopes down and to the right differ from the reasons that individual market demand curves slope downward and to the right (i.e., the substitution & income effects - these do not work directly with macroeconomic aggregates, for among other reasons, we are dealing with all prices of all commodities, not a single price of a single commodity, as in a microeconomic sense).

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The reasons for the downward sloping aggregate demand curve are: (1) the wealth or real balance effect, (2) the interest rate effect, and (3) the foreign purchases effect. As the price level increases, with fixed incomes, the given amount of savings and assets consumers have will purchase less. On the other hand, as the price level decreases the savings and wealth consumers have will purchase more. The negative relation between the price level and the purchasing power of savings (wealth or real balances) is called the real balances or wealth effect. Assuming a fixed supply of money, an increase in the price level will increase interest rates. Increases in interest rates will reduce expenditures on goods and services for which the demand is interest sensitive (e.g., consumer durables such as cars and investment). This negative relation between the interest rate and purchases is called the interest rate effect. If the prices of domestic goods rise relative to foreign goods (an increase in the price level), domestic consumers will purchase more foreign goods as substitutes, assuming stable exchange rates for currencies. Remember from Chapter 2 that if exports remain constant and imports increase GNP declines (net exports). Therefore, as the price level increases, imports will also increase, ceteris paribus. The foreign purchases effect is the propensity to increase purchases of imports, when the domestic price level increases. Each of these effects describes a negative relation between the price level and the aggregate demand for the total output of the economy. Therefore, the aggregate demand curve will slope downward and to the right, as shown in the diagram below:

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The determinants of aggregate demand are the factors that shift the aggregate demand curve. These determinants are: (1) consumer and producer expectations concerning the price level, and real incomes, (2) consumer indebtedness, (3) personal taxes, (4) interest rates, (5) changes in technology, (6) excess capacity in industry, (7) government spending, (8) net exports, (9) national income earned abroad, and (10) exchange rates. The expectations of producers and consumers concerning real income or inflation (including profits from investments in business sector) will effect aggregate demand. Inflationary expectations and anticipated increases in real income are consistent with increased current expenditures. Should real income or inflation be expected to fall, purchases may be postponed in favor of future consumption or investment. As personal taxes, interest rates and indebtedness increase aggregate demand should decrease due to a general reduction in effective demand. Should any of these three decrease there should be an increase in aggregate demand due to the increased ability to purchase output. Changes in technology operate on aggregate demand in two distinct ways, the creation of new products or new production processes, and the reduction of the costs of producing resulting in less expensive output. The amount of excess capacity in industry will also impact the demand for capital goods. If there is substantial excess capacity, output can be increased without obtaining more capital, on the other hand, if there is very little excess capacity an expansion of output will require purchasing more capital. 56

Government expenditures account for a significant proportion of GNP. If government expenditures decrease, so will aggregate demand; if they increase, so will aggregate demand. The same is true of national income earned abroad, as American economic activity moves abroad, the demand for domestic output will generally decline. Exchange rates refer to how much of a foreign currency the U.S. dollar will purchase. If the Japanese Yen loses value with respect to the U.S. dollar, then Japanese goods will become cheaper. As the dollar buys more imports aggregate demand will decrease simply because the U.S. dollar gains value relative to that foreign currency. As the dollar loses value relative to a foreign currency, such as the Yen, then the Japanese goods become more expensive and American consumers will substitute American goods for Japanese goods and aggregate demand increases. These determinants of aggregate demand act together to shift the aggregate demand curve. Several of these determinants may change at the same time, and possibly in different directions. The actual observed change in an aggregate demand curve will result from the net effects of these changes. For example, if the dollar gains one or two percent in value relative to the Yen this alone may cause a slight decrease in aggregate demand. However, if government purchases increase by two or three percent this should offset any exchange rate tendency toward a reduction in aggregate demand and shift the aggregate demand curve to the right.

Aggregate Supply The aggregate supply curve shows the amount of domestic output available at each price level. The aggregate supply curve has three ranges, the Keynesian range (horizontal portion), the intermediate range (curved portion), and the classical range (vertical portion). These ranges of the aggregate supply curve are identified in the following diagram.

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The Keynesian range of the aggregate supply curve shows that any output is consistent with the particular price level (the intersection of the aggregate supply curve with the price level axis) up to where the intermediate range begins. In other words, wages and prices are assumed to be sticky (fixed) in this range of the aggregate supply curve. The classical range of the aggregate supply curve is vertical. Classical economists believed that aggregate supply curve goes vertical at the full employment level of output. In other words, any price level above the end of the intermediate range is consistent with the full employment level (potential) of GNP. The intermediate range is the transition between the horizontal and vertical ranges of the aggregate supply curve. As the macroeconomy approaches full employment levels of output the price level begins to increase, as output increases in this range. The determinants of aggregate supply cause the aggregate supply curve to shift. There are three general categories of the determinants of aggregate supply, these are: (1) changes in input prices, (2) changes in input productivity, and (3) changes in the legal or institutional environment. As input prices increase, aggregate supply decreases. For example, when the price of oil increased dramatically in 1979-80, aggregate supply decreased because the costs of production increased in general in the United States. In other words, for the same level of production cost, we got less GNP. Should input prices decline, we should expect to observe an increase in aggregate supply. In other words, for the same level of production cost we got more GNP. Changes in input productivity will also shift the aggregate supply curve. If labor or capital becomes more productive then producers will receive more output for the same cost of production. This can occur because of better quality resources or because of the ability to use more efficient technology. Changes in the legal or institutional environment will also increase aggregate supply. One of the reasons that de-regulation is so popular in certain business circles is that such changes in the legal environment will often result in lower costs of production. To the extent that there are no diseconomies, this increases aggregate supply. More efficient capital markets (i.e., the recent proposed S.E.C. changes concerned, among 58

others, the New York Stock Exchange), better schools, better health care, and less crime all have the potential for increasing aggregate supply through the institutional environment of business.

Macroeconomic Equilibrium As mentioned earlier in this chapter, macroeconomic equilibrium in this model is the intersection of aggregate supply and aggregate demand. The idea of equilibrium in the macroeconomy is similar to that in microeconomic market. Where aggregate supply and aggregate demand intersect, if there is no force applied to disturb the intersection (change in a determinant), then there is no propensity for the output and price levels to change from those determined by the intersection. The following diagram portrays a macroeconomy in equilibrium. In this case the intersection of aggregate supply and aggregate demand is in the Keynesian range. Should aggregate demand increase up to where the intermediate range starts, only output will change. Through the intermediate range both output and the price level will increase as aggregate demand increase. In the classical range if aggregate demand increases, output will remain the same, but the price level will increase. The following diagram shows a macroeconomy in equilibrium. The solid aggregate demand curve is the initial equilibrium. The two dotted lines show an increase in aggregate demand (AD1) and a decrease in aggregate demand (AD2).

The changes in aggregate supply are analytically only marginally more complicated than aggregate demand. An increase in aggregate supply is simply a shift 59

of the entire curve to the right (downward). As aggregate supply shifts downward along the aggregate demand curve in the Keynesian and intermediate ranges, the price level falls, and output will increase. However, in the classical range a decrease in aggregate supply changes neither the price level or total output. The following diagram portrays an increase in aggregate supply, the line labeled (AS1) and a decrease in aggregate supply, the line labeled (AS2), and the original aggregate supply curve is the solid line.

There is a more complicated view of changes in equilibrium in the aggregate supply and aggregate demand model called the Ratchet Effect. The Rachet Effect is where there is a decrease in aggregate demand, but producers are unwilling to accept lower prices (rigid prices and wages). Rather than to accept the lower price levels resulting from a decrease in aggregate demand, producers will decrease aggregate supply. Therefore, there is a ratcheting of the aggregate supply curve (decrease in the intermediate and Keynesian ranges) which will keep the price level the same, but with reduced output. In other words, there can be increases in prices (forward) but no decreases in the price level (but not backward) because producer will not accept decreases (price rigidity). The same is argued to exist for wages in the labor market, in other words, unions will resist decreases in wages associated with a decrease in aggregate demand, hence they too, will place downward pressure on aggregate supply. The following diagram illustrates the rachet effect:

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An increase in aggregate demand from AD1 to AD2 moves the equilibrium from point a to point b with real output and the price level increasing. However, if prices are inflexible downward, then a decline in aggregate demand from AD2 to AD1 will not restore the economy to its original equilibrium at point a. Instead, the new equilibrium will be at point c with the price level remaining at the higher level and output falling to the lowest point. The ratchet effect means that the aggregate supply curve has shifted upward (a decrease) in both the Keynesian and intermediate ranges.

KEY CONCEPTS Aggregate Demand Real balance effect Interest rate effect Foreign purchases effect Determinants of Aggregate Demand Aggregate Supply Keynesian Range Classical Range Intermediate Range 61

Determinants of Aggregate Supply Equilibrium in Aggregate Supply and Aggregate Demand Rachet Effect

STUDY GUIDE Food for Thought: Explain and demonstrate the operation of the determinants of aggregate supply and aggregate demand.

Critically evaluate both the Keynesian and Classical ranges of the aggregate supply curve.

Is the ratchet effect plausible? Explain.

Why does the aggregate demand curve slope downward? Why do we find ranges in the aggregate supply curve? Explain.

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Sample Questions: Multiple Choice: The aggregate demand curve is most likely to shift to the right (increase) when there is a decrease in: A. B. C. D. the overall price level the personal income tax rates the average wage received by workers consumer and business confidence in the economy

A short-run increase in interest rates on consumer loans may cause a decrease in aggregate demand. What would we expect to observe, if there is no ratchet effect? A. B. C. D. In the classical range only a reduction in prices In the Keynesian range only a reduction in output Both A and B are correct Neither A or B are correct

True - False: All economists are convinced that ratchet effect exists in today's economy. {FALSE} One of the major reasons that the aggregate demand curve slopes downward is the real balances effect. {TRUE}

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Chapter 5

Classical and Keynesian Models

The purpose of this chapter is to extend the analysis presented in Chapter 4. Based on the foundations of the relatively simple aggregate supply and aggregate demand model both the Classical and Keynesian theories of macroeconomics will be developed and compared in this chapter. Introduction The Classical theory of employment (macroeconomics) traces its origins to the nineteenth century and to such economists as John Stuart Mill and David Ricardo. The Classical theory dominated modern economic thought until the middle of the Great Depression when its predictions simply were at odds with reality. However, the work of the classical school laid the foundations for current economic theory and a great intellectual debt is owed to these economists. During the beginnings of the 1930s economists in both Europe and the United States recognized that current theory was inadequate to explain how a depression of such magnitude and duration could occur. After all, the miracle of free market capitalism was suppose to always result in a return to prosperity after short periods of correction (recession). For a long term disequilibrium to be observed was both disconcerting and fascinating. It became very obvious by 1935 that the market mechanisms were not going to self-adjust and bring the economy out of a very deep depression. John Maynard Keynes, an English mathematician and economist, is the father of modern macroeconomics. His book, The General Theory, (1936) was to change how economists would examine macroeconomic activity for the next six decades (until present). Keynes' work laid aside the notion that a free enterprise market system can self-correct. He also provided the paradigm that explained how recessions can spiral downwards into depression without active government intervention to correct the observed deficiencies in aggregate demand. Some of Keynes' ideas were original, however, he borrowed heavily from the Swedish School, in particular, Gunar Myrdal, in his explanations of the fact that there is no viable mechanism in our system of markets that provide for correction of recessionary spirals. Many economists, on both sides of the Atlantic, were working on the problem of why the classical theory had failed so miserably in explaining the prolonged, deep downturn and in offering policy prescriptions to cure the Great Depression. In some ways it resembled an intellectual scavenger hunt. As soon as Keynes had worked out 64

the theory, he literally rushed to print before someone beat him to the punch, so to speak. The result is that The General Theory is not particularly well written and has been subject to criticism for the rushed writing, however, its contributions to understanding the operation of the macroeconomy are unmistakable.

The Classical Theory The classical theory of employment (macroeconomics) rests upon two fundamental principles, these are: (1) underspending is unlikely to occur, and (2) if underspending should occur, the wage-price flexibility of free markets will prevent recession by adjusting output upwards as wages and prices declined. What is meant by underspending is that private expenditures will be insufficient to support the current level of output. The classicists believed that spending in amounts less than sufficient to purchase the full employment level of output is not likely. They also believed that even if underspending should occur, then price/wage flexibility will prevent output declines because prices and wages would adjust to keep the economy at the full employment level of output. The classicists based their faith in the market system on a simple proposition called Say's Law. Say's Law in its crudest form states that "Supply creates its own demand." In other words, every level of output creates enough income to purchase exactly what was produced. However, as sensible as this proposition may seem there is a serious problem. There are leakages from the system. The most glaring omission in Say's Law, is that it does not account for savings. Savings give rise to gross private domestic investment and the interest rates are what links savings and investment. However, there is no assurance that savings and investment must always be in equilibrium. In fact, people save for far different reasons that investors' purchase capital. Further, the classicists believed that both wages and prices were flexible. In other words, as the economy entered a recession both wages and prices would decline to bring output back up to pre-recession levels. However, there is empirical evidence that demonstrates that producers will cut-back on production rather than to lower prices, and that factor prices rarely decline in the face of recession. The classicists believed that a laissez faire economy would result in macroeconomic equilibria through the unfettered operation of the market system and that only the government could cause disequilibria in the macroeconomy. One need only look to the automobile industry of the last ten years to understand that wage - price flexibility does not exist. Automobile producers have not lowered prices in decades. When excess inventories accumulate, the car dealers will offer rebates or inexpensive financing, but they have yet to offer price reductions. There has 65

been some concession bargaining by the unions in this industry, but even where wages were held down, it is rare that a union accepts a nominal wage cut. Modern neo-classical macroeconomics takes far less rigid views. Even though the neo-classicists have come to realize that the market system has its imperfections, they believe that government should be the economic stabilizer of last resort. Further, even though there is now recognition that the lauded wage-price flexibility is unlikely, by itself, to be able to correct major downturns in economic activity, the neo-classicists stubbornly hold to the view that government must stay out of the economic stabilization business. The one exception they seem to allow, is the possibility of a major external shock to the system, otherwise they claim there is sufficient flexibility to prevent major depressions, with only very limited government responses (primarily through monetary, rather than fiscal policy). In other words, the differences between the Keynesians and the neo-classicists are very subtle (magnitude of government involvement) and focus primarily on the starting point of the analysis (Keynes with recession, neo-classicist with equilibrium).

Keynesian Model Keynes recognized that full employment is not guaranteed, because interest motivates both households and businesses differently - just because households save does not guarantee businesses will invest. In other words, there is no guarantee that leakages will result in investment injections back into the system. Further, Keynes was unwilling to assume that self-interest in a market system guaranteed that there would be wage-price flexibility. In fact, the empirical evidence suggested that wages and prices exhibited a substantial amount of downward rigidity. Under the Keynesian assumptions there is no magic in the market system. The mechanisms that the classicist thought would guarantee adjustments back toward full employment-equilibrium simply did not exist. Therefore, Keynes believed that government had to be pro-active in assuring that underspending did not spiral the economy into depression once a recession began. Keynes' views were revolutionary for their time. However, it must be remembered that the Great Depression was an economic downturn unlike anything experienced during our lifetimes. Parents and grandparents, no doubt, have related some of the traumatic experiences they may have endured during the Depression to their children and grandchildren (perhaps you have heard some of these stories). However, such economic devastation is something that is nearly impossible to imagine unless one has lived through it. One-quarter of the labor force was unemployed at points during the Depression. The U.S. economy had almost no social safety net, no unemployment compensation, little in the way of welfare programs, no social security, no collective bargaining, and very small government. Our generations have gotten 66

used to the idea that there is something between us and absolute poverty, there are programs to provide income during times of unemployment, generally for a sufficient period to find alternative employment. Even though these programs may have a personal significance, they were intended to prevent future demand-deficiency depressions. The array of entitlement programs, particularly unemployment, welfare, and social security provides an automatic method to keep spending from spiraling into depression. Once recessionary pressures begin to build in the economy, the loss of employment does not eliminate a household's consumption as soon as savings are depleted. Unemployment compensation and then welfare will keep the lights on (and I & M employees working), food on the table (to the relief of those working at Krogers and Scotts), and clothes on the back of the those in need (keeping people working at Walmart through Hudsons). Further, the government has been proactive in stabilization of economic downturns since the beginning of World War II. Thereby providing us with the expectation that something will be done to get things back in order as soon as possible once a recession starts. The government's ability to tax and to engage in deficit spending provides the flexibility in the market system to deal with underspending that was only presumed to exist by deflating the economy. Without the automatic stabilizers and the government flexibility to deal with serious underspending the economy could theoretically produce the same results that it did in the 1930s. Aggregate supply and aggregate demand can now be expanded to include the savings and investment in the analysis to make for a more complete model. In so doing, we can also create a more powerful analytical tool.

The Consumption Schedule In beginning the development of the Keynesian Cross model, we return to aggregate supply and aggregate demand. Along the vertical axis we are going to measure expenditures (consumption, government, or investment). Along the horizontal axis we are going to measure income (disposable income). At the intersection of these two axes (the origin) we have a forty-five degree line that extends upward and to the right. What this forty-five degree line illustrates is every point where expenditures and income are equal.

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The consumption schedule intersects the 45 degree line at 400 in disposable income, this is also where the savings function intersects zero (in the graph below the consumption function). At this point, (400) all disposable income is consumed and nothing is saved. To the left of the intersection of the consumption function with the 45 degree line, the consumption function lies above the 45 degree line. The distance between the 45 degree line and the consumption schedule is dissavings, shown in the savings schedule graph by the savings function falling below zero. Dissavings means people are spending out their savings or are borrowing (negative savings). To the right of the intersection of the consumption function with the 45 degree line, the consumption schedule is below the 45 degree line. The distance that the consumption function is below the 45 degree line is called savings, shown in the bottom graph by the savings function rising above zero. This analysis shows how savings is a leakage from the system. Perhaps more importantly the analysis also shows that there is a predictable relation between consumption and savings. What is not consumed is saved, and vice versa. However, there is more to this than savings plus consumption must equal income. The Marginal Propensity to Consume (MPC) is the proportion of any increase in disposable income that is spent on consumption (if an entire increase in income is spent MPC is 1, if none is spent then MPC is zero). The Marginal Propensity to Save (MPS) is the proportion of any increase in disposable income that is saved. The relation between MPC and MPS is that MPS + MPC =1, in other words, any change in income will be either consumed or saved. This relation is demonstrated graphically in the following diagram:

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The slope (rise divided by the run) of the consumption function is the MPC and the slope of the savings function is the MPS. The slope of the consumption function is .8 or (8/10) and the slope of the savings function .2 or (2/10). Total change in income will be either spent or saved. If ten dollars of additional income is obtained then $2 ($10 times .2) will be saved and $8 ($10 times .8) will be spent on consumption. The marginal propensities to save and to consume deal with changes in one's income. However, average propensities to consume or save deal with what happens to total income. The Average Propensity to Consume (APC) is total consumption divided by total income, Average Propensity to Save (APS) is total savings divided by total income. Again, (just like the marginal propensities) if income can be either saved or consumed (and nothing else) then the following relation holds, the average propensity to consume plus the average propensity to save must equal one (APC + APS = 1). For example, if total income is $1000 and the average propensity to consume is .95 and the average propensity to save is .05, then the economy will experience $950 is consumption (.95 times $1000) and $50 in savings ($1000 times .05). The non-income determinants of consumption and saving cause the consumption and savings functions to shift. The non-income determinants of consumption and saving are: (1) wealth, (2) prices, (3) expectations concerning future prices, incomes and availability of commodities, (4) consumer debts, and (5) taxes. In general, it has been empirically observed that the greater the amount of wealth possessed by a household the more of their current income will be spent on consumption, ceteris paribus. All other things equal, the more wealth possessed by a household the less their incentive to accumulate more. Conversely, the less wealth possessed by a household the greater the incentive to save. An Italian economist, 69

Franco Modigliani, observed that this general rule varied somewhat by the stage in life a person was in. The young (twenties) tend to save for homes and children, in the late twenties through the forties, savings were less evident as children were raised, and with the empty nest, came savings for retirement. This is called the Life Cycle Hypothesis. An increase in the price level has the effect of causing the consumption function to shift downward. As prices increase, the real balances effect (from the previous chapter) becomes a binding constraint. As the value of wealth decreases, so too does the command over goods and services, so consumption must fall (and savings increase). If the price level decreases, then we would expect consumption to increase (and savings to fall). The expectations of households concerning future prices, incomes and availability of commodities will also impact consumption and savings. As households expect price to increase, real incomes to decline or commodities to be less available, current consumption will increase (and current savings decline). If, on the other hand, households expect incomes to increase, prices to fall, or commodities to become more generally available, current consumption will decline (and savings will increase). Consumer indebtedness will also effect consumption and savings. If consumers are heavily indebted, save a third of their income goes on debt maintenance then current consumption will decline to pay off debts (dis-savings). However, if indebtedness is relatively low, consumers will consume more of their current income, perhaps even engage in dis-savings (borrowing) to consume more currently. Taxation operates on both the savings and consumption schedules in the same way. Because taxes are generally paid partly from savings and partly from current income, an increase in taxes will cause both consumption and savings to decline. On the other hand, if taxes are decreased, then both the savings and consumption functions will increase (shift upwards).

Investment Investment demand is a function of the interest rate. The following diagram shows an investment demand curve. The investment demand curve is downward sloping, which suggests that as the interest rate increases investment decreases. The reason for this is relatively simple. If the expected net return on an investment is six percent, it is not profitable to invest when the interest is equal to or more than six percent. A firm must be able to borrow the money to purchase capital at an interest rate that is less than the expected net rate of return for the investment project to be undertaken Therefore, there is an inverse relation between expected return and the interest rate; and the interaction of the interest rate with the expected rate of return determine the amount of investment. 70

The determinants of investment demand are those things that will cause the investment demand curve to shift. The determinants of investment demand are: (1) acquisition, maintenance & operating costs of capital, (2) business taxes, (3) technology, (4) stock of capital on hand, and (5) expectations concerning profits in future. The investment demand depends on whether the expected net rate of return is higher than the interest rate. Therefore, anything that increases the expected net return will shift the investment demand curve to the right, anything that cause the expected return to fall will shift the investment demand curve to the left (decrease). As the acquisition, maintenance and operating costs of capital increase, the net expected return will decrease, ceteris paribus, thereby shifting the demand curve to the left. If the acquisition, maintenance and operating costs decline, we would expected a higher rate of return on this investment and therefore the demand curve shifts to the right (increase). Business taxes are a cost of operation. If business taxes increase, the expected net (after tax) return will decline, this shifts the investment demand curve to the left. If business taxes decrease, the expected net return on the investment will increase, thereby increasing the investment demand curve. Changes in technology will also shift the investment demand curve. More efficient technology will generally increase expected net returns and shift the investment demand to the right (increase). By decreasing production costs or improving product quality through technological improvements competitive advantages may be reaped and this is one of the most important determinants of investment since World War II. The stock of capital goods on hand will also impact investment demand. To the extent that producers have a large stock of capital goods on hand, investment demand 71

will be dampened. On the other hand, if producers have little or no inventory of capital goods, then investment demand may increase to restore depleted stocks of capital. Business investment decisions are heavily influenced by expectations. Expectations concerning the productive life of capital, its projected obsolescence, expectations concerning sales and profits in the future will also impact investment decisions. For example, expectations that technological breakthroughs may make current computer equipment less competitive may dampen current investment demand. Further, if competitors are tooling-up to enter your industry, you may be hesitant to invest in more capital if the profits margins will be cut by the entrance of competitors.

Autonomous v. Induced Investment Autonomous investment is that investment that occurs which is not related to the level Gross Domestic Product. Investment that is based on population growth, expected technological progress, changes in the tax structure or legal environment, or on fads is generally not a function of the level of total output of the economy and is called autonomous investment. In examining the following diagram, the autonomous investment function is a horizontal line that intercepts the investment axis at the level of autonomous investment. Induced investment is functionally related to the level of Gross Domestic Product. The following diagram has an investment function that slopes upward (increases as GDP increases). Induced investment is that investment that is "induced" because of increased business activity. In short, induced investment means that investment that is caused by increased levels of GDP.

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Throughout American economic history the level investment has been very volatile. In fact, much of the variation in the business cycle can be attributed to the instability of investment in the United States. There are several reasons for this instability, including: (1) variations in the durability of capital, (2) irregularity of innovation, (3) variability of profits, and (4) the expectations of investors. The durability of most capital goods means that they have an expected productive life of at least several years, if not decades. Because of the durability and expense of capital goods, their purchase can be easily postponed. For example, a bank may re-decorate and patch-up an old building, rather than build a new building, depending on their business expectations and current financial position. Perhaps the most important contributors to the instability of investment in the post- World War II period is the irregularity of innovations. With the increase in basic knowledge, comes the ability to develop new products and production processes. During World War II there was heavy public investment in basic research in medicine and the pure sciences. What was intended from these public expenditures was for military use, but many of these discoveries had important civilian implications for new products and better production methods. Again, in the late 1950s and early 1960s an explosion of basic research occur that led to commercial advantages. The Russians launched Sputnik and gave the Western World a wake-up call that they were behind in some important technical areas, the government again spent money on education and basic research. For the private sector to invest there must be some expectation of profits flowing from that investment. Much of the decline in private investment during the Great Depression was because private investors did not expect to be able to make a profit in the economic environment of the time. In the late 1940s, automobile producers knew that profits would be nearly guaranteed because no new private passenger cars were built in the war years. There was very significant investment in plant and equipment in the auto industry in those years (mostly to convert from war to peace-time production). The expectations of business concerning profits, prices, technology, legal environment and most everything effecting their business are simply forecasts. Because the best informed forecasts are still guess-work, there is substantial variability in business conditions expectations. Because these expectations vary substantially across businesses and over time, there should be significant variability in investment decisions.

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KEY CONCEPTS Classical Theory Says Law Keynesian Model price-wage rigidity No guarantee of full employment Income v. Expenditures Consumption Function Marginal Propensity to Consume v. Marginal Propensity to Save Determinants of consumption and savings Investment Demand Determinants of investment demand Investment instability in U.S. Induced investment v. autonomous investment

STUDY GUIDE Food for Thought: Compare and contrast the classical model of the economy with the Keynesian model. Are these models really that different? Explain.

Develop the consumption and savings schedules. Fully explain the assumptions underlying the models, its mechanics, and its implications.

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What is the relation between savings and investment? Explain.

Critically evaluate Say's Law.

Sample Questions: Multiple Choice: If you receive $40 in additional income and you save $4, what is your marginal propensity to consume? A. B. C. D. .4 .9 1.0 None of the above

Which of the following contribute to investment instability? A. B. C. D. Irregularity in innovation Variable investor expectations Purchases of capital durable goods are postponable All of the above

True - False: MPC + MPS = 1 {TRUE} The forty-five degree line in the consumption function model shows each point at which disposable income and consumption are equal. {TRUE}

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Chapter 6

Equilibrium in the Keynesian Model

The purpose of this chapter is to extend the analysis of Chapter 4. The basic Keynesian Cross model will be developed and examine how equilibrium can be achieved in the macroeconomy. In Chapter 6, that follows we will complete the analysis of the Keynesian view of the macroeconomy.

Equilibrium and Disequilibrium Equilibrium GDP is that output that will create total spending just sufficient to buy that output (where aggregate expenditure schedule intersects 45 degree line). Further, once achieved, an equilibrium in a macroeconomy has no propensity to change, unless there is a shock to the system, or some variable changes to cause a disequilibrium. Disequilibrium where spending is insufficient (recessionary gap) or too high for level of output (inflationary gap). The neo-classicists view the primary macroeconomic as one of maintaining equilibriums. Their analysis of the system begins with equilibrium, because unless there is some external intervening problem, they believe this is the state of nature for the macroeconomy. Keynesians, on the other hand, begin their analysis with disequilibrium because this is the natural state for a macroeconomy. The constant changes associated with policies, technological change, and autonomous influences will impact the economy periodically and cause it to move out of equilibrium. In fact, this is the major analytical difference between the neo-classical and Keynesian economists.

Keynes' Expenditures - Output Approach From Chapter 2, remember that one of the ways that GDP can be calculated is using the identity Y = C + I + G + X ; where Y = GDP, C = Consumption, I = Investment, G= Government expenditures, and X = Net exports (exports minus imports). This provides for us the formula by which we can complete the model we began in the previous chapter. Consider the following diagram:

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Remember that the 45 degree line is each point where spending is exactly equal to GDP. The above figure shows a simple economy with no public or foreign sectors. We begin the analysis by adding investment to consumption, and obtaining Y = C + I. The equilibrium level of GDP is indicated above where C + I is equal to the 45 degree line. Investment in this model is autonomous and the amount of investment is the vertical distance between the C and the C + I lines.

Keynes' Leakages - Injections Approach The same result obtained in the expenditures - output approach above can be obtained using another method. Remember that APC + APS = 1, and MPC + MPS = 1, this suggests that leakages from the system are also predictable. The leakages injections approach relies on the equality of investment and savings at equilibrium in a macroeconomic system (I = S). The reason that the leakages - injection approach works is that planned investment must be equal savings. The amount of savings is what is available for gross private domestic investment. When investors use the available savings, the leakages (savings) from the system are injected back into the system through investment. However, this must be planned investment. Unplanned investment is the cause of disequilibrium. Inventories can increase beyond that planned, and inventories are investment (stock of unsold output). When inventories accumulate there is output that is not purchased, hence reductions in spending which is recessionary; or, on the other hand, if intended inventories are depleted which this inflationary because of the excess spending in the system. Consider the following diagram, where savings is equal to I1, investment. If there is unplanned investment, the savings line is below the investment line, at the lowest level 77

of GDP, the vertical line label UPI (Unplanned Investment), if inventories are depleted beyond the planned level, then the savings line is above I1, as illustrated with the highest level of GDP, and that vertical line is labeled Dep. Inv. for Depleted Inventory.

The original equilibrium is where I1 is equal to S. The if the unplanned inventory or unplanned depletion of inventory become planned investment the analysis changes. If we experience a decrease in planned investment we move down to I2, with a reduction in GDP (Recession), just like an increase in unplanned investment, and if an increase in investment is observed it will be observed at I3, which is expansionary, and this is similar to unplanned depletion of inventories (which could also be inflationary).

Re-spending The interdependence of most developed economies, results in an observed respending effect if there is an injection of spending in the economy. This re-spending effect is called the multiplier, and we will provide a more detailed analysis of the multiplier effects in the following chapter, however, the re-spending effect represented by the multiplier will be introduced here to provide a full understanding of the model. If there is an increase in expenditures, there will be a re-spending effect. In other words, if $10 is injected into the system, then it is income to someone. That first person will spend a portion of the income and save a portion. If MPC is .90 then the first individual will save $1 and spend $9.00. The second person receives $9.00 in income and will spend $8.10 and save $0.90. This process continues until there is no money left to be spent. Instead of summing all of the income, expenditures, and/or savings there is a short-hand method of determining the total effect -- this is called the 78

Multiplier, which is 1/1-MPC or 1/MPS. The significance any increase in expenditures is that it will increase GDP by a multiple of the original increase in spending. The re-spending effect and the leakage - injection approach to GDP provides for curious paradox. This paradox is called the paradox of thrift. To accumulate capital, it is often the policy of less developed countries to encourage savings, to reduce the country's dependence on international capital markets. What often happens is that as a society tries to save more it may actually save the same amount, this is called the paradox of thrift. The reason that savings may remain the same is that unless investment moves up as a result of the increased savings, all that happens is that GDP declines. The higher rate of savings with a smaller GDP results in the same amount of savings if GDP declines proportionally with the increase in savings rates. If investment is autonomous then there is no reason to believe that investment will increase simply because the savings rate increased. In fact, because of the re-spending effects of the leakages, generally savings will remain the same as before the rate went up. Full Employment Simply because C + I + G intersects the 45 degree line does not assure utopia. The level of GDP associated with the intersection of the C + I + G line with the 45 degree line may be a disequilibrium level of GDP, and not the full employment level of GDP. The full employment level of GDP may be to the right or to the left of the aggregate expenditures line. Where this occurs you have respectively, (1) a recessionary gap or (2) an inflationary gap. In either case, there is macroeconomic disequilibrium that will generally require appropriate corrective action (as will be described in detail in the following chapter on fiscal policy). Both forms of disequilibrium can be illustrated using the expenditures - output approach. Consider the following two diagrams: Recessionary Gap

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In the above diagram the dashed line labeled Full Employment GDP. Is the level of GDP that is associated with potential GDP or full employment. The distance between the C + I line and the 45 degree line along the dashed indicator line is the recessionary gap. The dotted line shows the current macroeconomic equilibrium. Okun's Law (Chapter 3) provides some insight into what this means, remember that every 2.5% of lost potential GDP is associated with 1% unemployment above the full employment level. Therefore, this recession represents lost output and unemployment is fixed proportions of 1% to 2.5%. In other words, if we know what the unemployment rate is, then theoretically we should also know where we are with respect to potential GDP. For example, if we have an 8% unemployment rate and the current GDP is $1000 billion dollars, we can calculate what the full employment, non-inflationary level of GDP is quite simply. Using Okuns law we know that for every 1% the unemployment rate exceeds the 4% natural rate, we lose 2.5% of potential GDP. With 8% unemployment we know that we are currently 10% below potential GDP (2.5% times 4 = 10%). To calculate what potential GDP is one need only a little 8th grade algebra, to wit: .9GDPpotential = $1000 billion dividing both sides of the equation by .9 yields: GDPpotential = $1000 billion / .9 or GDPpotential = $1,111.11 billion Therefore, Okuns law turns out to be a handy road map to where the economy should be with respect to where it currently is. Most of what will be done in this course with respect to disequilibrium will be concerned with recessionary gaps. Inflation is best left to monetary policy, the record shows that stagflation has been obtained and therefore a better system than just simple recessionary and inflationary gaps is needed. In this case, recessionary gaps have been appropriately dealt with using Keynesian economics, but inflation is a monetary phenomenon. However, in order to present a balanced view, a brief examination of the inflationary gap view of the rudimentary Keynesian model will be presented.

Inflationary Gap An inflationary gap can arise in the Keynesian view of the world by actions which take the economy past the potential GDP levels of output. Consider the following diagram below:

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Again the full employment (non-inflationary) level of GDP is indicated by the dashed line labeled full employment GDP. The distance between the C + I line and the 45 degree line along the dashed indicator line is the inflationary gap. The dotted indicator line shows the current macroeconomic equilibrium. In this case, there is too much spending in the economy or some other (similar) problem that has resulted in an inflated price level. A reduction in GDP is necessary to restore price level stability, and to eliminate excess output. The various C + I and 45 degree line intersections, if multiplied by the appropriate price level will yield one point on the aggregate demand curve. Shifts in aggregate demand can be shown with holding the price level constant and showing increases or decreases in C + I in the Keynesian Cross model. Both models can be used to analyze essentially the same macroeconomic events. However, from this point on will concentrate on our efforts on mastering the Keynesian Cross. With these basic tools in hand, we can now turn our attention to economic stabilization and the use of fiscal policy for such activities. In the following chapter, the Keynesian model will be applied to problems of economic stabilization using taxes, government expenditures, and the combination of the two to eliminate recessionary and inflationary gaps.

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KEY CONCEPTS Macroeconomic Equilibrium v. Macroeconomic Disequilibrium Expenditures - Output Approach Leakages - Injections Approach Planned v. Unplanned Investment Re-spending Multiplier Effect Paradox of Thrift Economic Development constraints Full Employment Potential GDP Natural Rate of Unemployment Recessionary Gap Inflationary Gap

STUDY GUIDE Food for Thought: Critically evaluate the paradox of thrift.

What specifically is meant by a recessionary gap? Explain, and how does this differ from an inflationary gap? Explain.

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What insight does the multiplier provide for the Bush tax cuts of 2003? Explain.

Sample Questions: Multiple Choice: With a marginal propensity to consume of .8 the simple multiplier is: A. B. C. D. 0.25 2.00 4.00 None of the above

An inflationary gap is: A. The amount by which C+I+G exceeds the 45 degree line at or above the full employment level of output B. The amount by which C+I+G is below the 45 degree line at the full employment level of output C. The amount by which the full employment level of output exceed the current level of output D. None of the above True - False A recessionary gap is how much the aggregate expenditure line must increase to attain full employment without inflation. {TRUE} The equilibrium level of output is that output whose production will create total spending just sufficient to purchase that output. {TRUE}

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Chapter 7

John Maynard Keynes and Fiscal Policy

The Great Depression demonstrated that the economy is not self-correcting as alleged by many of the classical economists of the time. The revolutionary Keynesian view that government must take a proactive role in stabilization of the business cycle focused in large measure on the powers of the federal government to tax and to make expenditures. That power and its uses is what comprises the majority of the discussion in this chapter. Together the government's activities involving taxing and spending are called fiscal policy. The purpose of this chapter is to examine the fiscal policy tools and their effectiveness.

The Keynesian Revolution What is not well-understood even today is what a revolution John Maynard Keynes brought to economic reasoning. The classical model was, unfortunately, not capable of explaining much of what was being observed in the first third of the twentieth century in the Western world. Keynes and other, primarily European economists, were observing and writing concerning the inability of the classical model to explain the financial shocks which rocked both the U.S. economy and the many of the European economies both pre and post-World War I. What is perhaps somewhat disturbing is that some seventy years after the appearance of the General Theory there are those who still cling to some of the more peculiar aspect of the old classical reasoning. Markets are imperfect and they have tendencies which result in less than satisfactory results left unrestrained. Yet in this system populated by imperfect people, we have not yet devised ways of allocating scare resources which provide entirely satisfactory results for everyone concerned. In our second-best world we struggle to get-by, and it is the recognition of the fact that we do live in a second-best world that is important to our practical progress. In fact, it is that very recognition that is probably the greatest achievement of Keynes work within the economic profession. Chapter 1 of the General Theory of Employment, Interest and Money by John Maynard Keynes sums up the economy quandary of the day, and is replicated here, since it is less than a full page. It is this chapter that basically sums up what had been transpiring, and its results for the economic system and for the profession. It also nicely portrays what the real meaning of the idea classical versus neo-classical or as they are now called, Keynesian economists are. The following box provides interesting insight into the controversy:

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Chapter 1, The General Theory I have called this book the General Theory of Employment, Interest and Money, placing the emphasis on the prefix general. The object of such a title is to contrast the character of my arguments and conclusions with those of the classical* theory of the subject, upon which I was brought up and which dominates the economic thought, both practical and theoretical, of the governing and academic classes of this generation, as it has for a hundred years past. I shall argue that the postulates of the classical theory are applicable to a special case only and not to the general case, the situation which it assumes being a limiting point of the possible positions of equilibrium. Moreover, the characteristics of the special case assumed by the classical theory happen not to be those of the economic society in which we actually live, with the result that its teaching is misleading and disastrous if we attempt to apply it to the facts of experience. * The classical economists was a name invented by Marx to cover Ricardo and James Mill and their predecessors, that is to say for the founders of the theory which culminated in the Ricardian economics. I have become accustomed, perhaps perpetrating a solecism, to include in the classical school the followers of Ricardo, those, that is to say, who adopted and perfected the theory of Ricardian economics including (for example) J. S. Mill, Marshall, Edgeworth and Prof. Pigou. From this beginning it can be seen that the immodest title General Theory had a specific meaning within the context of the inherited economic theory of the day, and not something more conceited.

Discretionary Fiscal Policy The Employment Act of 1946 formalized the federal government's responsibility for promoting economic stability. The economic history of the first half of the twentieth century was a relatively stormy series of financial panics prior to World War I, a relatively stagnant decade after World War I, and the Depression of the 1930s. After World War II, a new problem arose called inflation. It should therefore come as no surprise that the Congress wished to assure that there was a pro-active role for the government to smooth-out these swings in the business cycle. The government has several roles to fulfill in society. Its fiscal powers are necessary to providing essential public goods. Without the federal government national defense, the judiciary, and several other critical functions could not be provided for society. There is also the ebb and flow of politics. The Great Society of Lyndon B. Johnson represents the public opinion of the 1960s, today's political agenda seems to be substantially different. The result is that as political opinion changes so will the government's pattern of taxation and expenditures. 85

The government's taxing and spending authority to stabilize the economy is called discretionary fiscal policy. Taxation and spending by the federal government has been used, with some frequency, to smooth out the business cycle. In times of underspending, the short-fall is made up by government spending or reductions in taxes. In times of inflation, cuts in spending or increases in taxes have been used to cool-off the economy. However, in recent year the discretionary fiscal policies of the federal government have become extremely controversial. The first step in understanding this controversy, is to understand the role of fiscal policy in economic stabilization. Milton Friedman and others, have argued that there is no role for discretionary fiscal policy. Friedmans position is that much of the business cycle is the result of governmental interference and that the long lags in fiscal policy becoming operationalized makes it only a potential force for mischief, and not hope for stability. In other words, Friedman believes that the classical economists, while over simplifying the argument, were basically correct about keeping government out of the economy.

Simplifying Assumptions As was discussed in E201, Introduction to Microeconomics, assumptions are abstractions from reality. The utility of these abstractions is to eliminate many of the complications that have the potential to confuse the analyses and to simplify the presentation of the concepts in which we are interested. It must be remembered that the assumptions underlying any model determine how good an approximation of reality that model is. In other words, a good model is one that is a close approximation of the real world. To analyze the macroeconomy using the Keynesian Cross some simplifying assumptions are necessary. We will assume that all investment and net exports are determined by factors outside of GDP (exogenously determined), it is also assumed that government expenditures do initially impact private decisions and all taxes are lump-sum personal taxes (with some exogenous taxes collected, i.e., customs duties, etc.). It is also assumed that there are no monetary affects associated with fiscal policy, that the initial price level is fixed, and that any fiscal policy actions impact only the demand side of economy, in other words, fiscal policy is not offset by, nor does impact the monetary side of the economy. It is also assumed that there are not foreign affects of domestic fiscal policy.

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The Goals of Government Expenditures The primary and general goal of discretionary fiscal policy is to stabilize the economy. Often other goals, involving public goods and services as well as political are included in the discretionary aspects of fiscal policy. However, for present purposes we are concerned only with government expenditures used to stabilize the economy (taxes will be examined elsewhere in this chapter). To remedy a recession the government must spend an amount that will exactly make-up the short-fall in spending associated with that recession. The government can also mitigate inflation by reducing government expenditures. However, the amount of increased expenditures necessary to bring the economy back to full employment is subject to a multiplier effect (the same is true of decreases in government expenditures). Therefore, the government must have substantial information about the economy to make fiscal policy work effectively. To determine the proper value of the multiplier the fiscal policy makers must know either the Marginal Propensity to Save or to Consume. Further, the policy makers will need to know the current level of output and what potential GDP is, (potential GDP is that output associated with full employment). In a practical sense, in the near term the government may have reasonably accurate information upon which to base forecasts to conduct fiscal policy. For present purposes, we will assume the government has all the necessary information at hand to conduct fiscal policy.

The Simple Multiplier When the government increases expenditures, the effect on the economy is more than the initial increase in government expenditures. In fact, this is also true of investment and consumption expenditures, not just government expenditures. When there is an increase in expenditures, through an increase in government expenditures, those expenditures become income for someone. They will save a portion of the expenditures and spend the rest which then become income to someone else. The result of this chair-reaction re-spending is that there is a direct relation between the total amount of re-spending and the marginal propensity to save. This is the re-spending effect discussed in Chapter 6. The multiplier is the reciprocal of the marginal propensity to save:

The multiplier = 1/MPS

Because MPS + MPC = 1, there is an equivalent expression: 1/MPS = 1/1-MPC. The multiplier is the short-cut method of determining the total impact of an increase or decrease in total spending in the economy. For example, if the government spends $10 87

more and the marginal propensity to consume is .5, then the multiplier is 2 and the total increase in spending resulting from the increase of $10 in government expenditures is $20. This is called the simple multiplier because the only leakage in the respending system is savings. In reality there are more leakages. People will use a portion of their income to buy foreign goods (imports), and will have to pay income taxes. These are also leakages and would be added to the denominator in the multiplier equation. The Council of Economic Advisors tracks the multiplier that contains each of these other leakages, called the complex multiplier. The complex multiplier has remained relatively stable over the past couple of decades is estimated to be about 2.0. The following diagram presents a case of recession that will be eliminated by increasing government expenditures by just enough to eliminate the recession, but not to create inflation. Assuming that our current level of GDP is $350 billion and we know that full employment GDP is $430 we which to eliminate this recession using increases in government expenditures. We also know that MPC is .75 and therefore MPS is .25.

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With an MPC of .75 we know the multiplier is 4 (1/.25). We also know that we must obtain another $80 billion in GDP to bring the economy to full employment. The distance between the forty-five degree line and the C+I=G1 line at $430 is $20 billion which is our recessionary gap in expenditures. Therefore to close this gap we must spend $20 billion and the multiplier effect turns this $20 billion increase in government expenditures into $80 billion more in GDP. Another way to calculate this is, that we are $80 billion short of full employment GDP, we know the multiplier is 4, so we divide $80 by the multiplier 4 and find the government must spend an additional $20 billion. The leakages approach yields the same results.

An increase in $20 of government expenditures moves the investment plus government expenditures line for I+G1 to I+G2 by a total of $20 billion dollars on the expenditures axis, but because of the re-spending effects, this increase results in $80 billion more in GDP, from $350 billion to $430 billion.

Taxation in Fiscal Policy The government can close a recessionary gap by cutting taxes, just as effectively as it can by increasing government expenditures (bearing in mind, that there will be differences in the lag between the actual enactment of law and the impact of the policy on the economy, in general taxes show up later in affect, than do expenditures). Assuming that it is a lump-sum tax the government will use (lump-sum meaning it is the same amount of tax regardless of the level of GDP). The lump sum tax must be multiplied by the MPC to obtain the change in consumption, however, such taxes are also paid proportionately from savings. So the effect is not the same as is observed with government expenditures. The tax is multiplied by the MPC and the remainder paid from savings. However, there is also no immediate increase in expenditures. In 89

other words, the impact of a change in taxes is always less than the impact of expenditures. In other words, the taxation multiplier is always the simple multiplier minus one or:

taxation multiplier = (1/MPS) - 1

Consider the following diagrammatic presentation of the impact of decrease in taxes on an economy.

If full employment GDP is $600 billion and we are presently at $500 billion with an MPC of .8, then if we are going to increase GDP by $100 billion we must cut taxes by $25 billion. The simple multiplier with an MPC of .8 is 1/.2 = 5; but the taxation multiplier is the simple multiplier minus one, hence 4. The decrease in taxation necessary to increase GDP by $100 billion is the $100 billion divided by 4 or $25 billion. The major difference between increasing expenditures or decreasing taxes is that the multiplier effect for taxation is less. In other words, to get the same effect on GDP you must decrease taxes by more than you would have had to increase expenditures.

Balanced Budget Multiplier An alternative policy is to increase taxes by exactly the amount you increase expenditures. This balanced budget approach can be used to expand the economy. Remember that the simple multiplier results in 1/MPS times the increase in expenditures, but the taxation multiplier is one less than the simple multiplier. In other 90

words, if you increases taxes by the same amount as expenditures, GNP will increase by the amount of the initial increase in government expenditures. That is because only the initial expenditure increases GDP and the remaining multiplier effect is offset by taxation. Therefore, the balanced budget multiplier is always one. For example, if full employment GDP is $700 billion, and we are presently at $650 billion, with an MPC of .75, then the simple multiplier is 4, (1/.25) and the taxation multiplier is 3, [(1/.25)-1], therefore the government must spend $50 billion and increase taxes by $50 to increase GDP by $50.

Tax Structure Taxation is always a controversial issue. Perhaps the most controversial of all tax issues concerns the structure of taxation. Tax structure refers to the burden of the tax. Progressive taxation is where the effective tax rate increases with ability to pay. Regressive taxation is where the effective tax rate increases as ability to pay decreases. A proportional tax structure is where a fixed proportion of ability to pay is taken in taxes. In general consumption is more greatly effected by taxation when the tax is progressive, and savings are impacted more when the tax is regressive. Therefore, if the distribution of the tax across income groups will have a variable impact on the consumption and savings. At present, the federal income tax structure is nearly proportional, most ad valorem taxes, tobacco etc., are regressive. State income tax structures also vary substantially. States like Kansas, California and New Jersey have mildly progressive income taxes. States like Indiana and South Carolina use gross income tax schemes that tend to be very regressive. Therefore, the current tax structures are not neutral with respect to their re-distributional effects across income groups. In total, the taxes collected across the federal, state and local level are at best proportional and are probably slightly regressive. Probably the most regressive of these taxes is the gasoline tax.

Automatic Stabilizers During the New Deal period several social welfare programs were enacted. The purpose of these programs was to provide the economy with a system of automatic stabilizers to help smooth business cycles without further legislative action. Among these programs were: (1) progressive income taxes, 91

(2) unemployment compensation, and (3) government entitlement programs. Since the end of the Carter administration these automatic stabilizers have become controversial. President Clinton moved in his first term in office to eliminate some of these programs, but it was really the Republican congress and Governors like Tommy Thompson in Wisconsin who eliminated much of then welfare programs. Since 2002 much of this welfare reform has also come under fire for not having produced the results that were advertised. In 2002 the movie Bowling for Columbine by Michael Moore, brought many of these issues to an international audience. The idea behind a progressive income tax was basic fairness. Those with the greatest wealth and income have the greatest ability to pay and generally receive more from government. As recessions occur, it is that segment of the population with the greatest wealth that will have resources upon which to draw to pay taxes, the poor will generally be impacted the most by high level of unemployment and recessions generally leave them with very little ability to pay. Unemployment compensation is paid for in every state of the union by a payroll tax. The payroll tax is generally less than one percent of the first $10,800 of payrolls. Most states also impose an experience rating premium, that is those companies that have laid people off in the last year will pay a higher rate based on their experience. The preponderance of this tax is paid during periods of expansion and is placed in a trust fund. Unemployment benefits are then paid from this trust fund as the economy enters a recession. The effect is that money is taken out of the system during expansion and injected during recession which dampens the top of the cycle (peaks) and eases the bottom of the cycle (trough). Most social welfare programs have essentially the same effect, except that the expansions tend not to be dampened as much because the funding comes from general budget authority rather than a payroll tax. The significant increases in the proportion of poor people during recessions, however, do not add as much to the downward spiral of underspending that would have otherwise been observed in the absence of these entitlement programs.

Problems with Fiscal Policy There are several serious problems with fiscal policy as a method of stabilizing the macroeconomy. Among these problems are (1) fiscal lags, (2) politics, (3) the 92

crowding-out effect, and (4) the foreign sector. Each of these will be addressed, in turn, in the following paragraphs.

Fiscal Lag There are numerous lags involved with the implementation of fiscal policy. It is not uncommon for fiscal policy to take 2 or 3 years to have a noticeable effect, after Congress begins to enact corrective fiscal measures. These fiscal lags fall into three basic categories. There is a recognition lag. The recognition lag is the amount of time for policy makers to realize there is an economic problem and begin to react. Administrative lags are how long it takes to have legislation enacted and implemented. Operational lags are how long it takes for the fiscal actions to effect economic activities. Because of the typical two to three years for fiscal policy to have its intended effects, they may cause as many problems as they cure. For example, it is not uncommon for the Congress to cut taxes because of a perceived recession that subsequently ends within months of the enactment of the legislation. When the effects of the fiscal policies actually effect the economy, it may be in a rapid expansion and the tax cut or increase in government expenditures add to inflationary problems.

Politics, Crowding-out, the Foreign Sector and Fiscal Policy Often politics overwhelms sound economic reasoning in formulating fiscal policies. Public choice economists claim that politicians maximize their own utility by legislative action, and are little concerned with the utility of their constituents. Perhaps worse, is the fact that most bills involve log-rolling and negotiations. Special interest often receive benefits simply to because they pay many of the election costs, and the interests of these lobbyists may be inconsistent with the best interests of the nation as a whole. The end result is that politics confounds the formulation of policy designed to deal with technical ills in the economy. The neo-classicist have long argued that government deficits (often associated with fiscal policy) results in increased interest rates that crowds-out private investment. there is little empirical evidence that demonstrates the exact magnitude of this crowding-out effect, but there is almost certainly some small element of this. The neo-classicist also argue that there is another problem with government borrowing to fund deficit financing of fiscal policies. This problem is called Ricardian Equivalence. David Ricardo hypothesized that the deficit financing of government debt 93

had the same effect on GDP as increased taxes. To the extent that capital markets are not open (foreign investors) the argument is plausible, however, in open economies there is little empirical evidence to support this view. There are also problems that result from having an open economy. The most technical of these problems is the net export effect. An increase in the interest rate domestically (associated with a recession, or with an attempt to control inflation) will attract foreign capital, but this increases the demand for dollars which increases their value with respect to foreign currencies. As the value of the dollar increases it makes U.S. goods more expensive overseas and foreign goods less expensive domestically. This results in a reduction of net exports, hence a reduction in GDP. There have also been shocks to the U.S. economy that have their origins outside of the United States and are difficult if not impossible to address with fiscal policy. The Arab Oil Embargo is a case in point. The United States and Holland supported the Israeli in their war with the Arabs in the early 1970s. The problem was we also had treaty obligations to some of the Arab states. Because of our support, the Arabs embargo oil shipments to the United States and Holland which had the result of increasing domestic oil prices and decreased aggregate supply, hence driving up the price level. This all occurred because of American Foreign Policy, but little could be done with fiscal policy to offset the problems for aggregate supply caused by the embargo.

KEY CONCEPTS Social Welfare Programs 1946 Employment Act Politics and change Expenditures Expansionary v. Contractionary Fiscal Policy Political Goals Public Goods and Services Taxation Expansionary v. Contractionary Fiscal Policy Multipliers 94

Simple Taxation Balanced Budget Tax Structure Proportional Regressive Progressive Automatic Stabilizers Progressive Income Taxes Unemployment Compensation Entitlement Programs Fiscal Lags Recognition Administrative Operational Politics and Fiscal Policy Log-rolling Public Choice Economics Government Deficits Crowding-out Ricardian Equivalence Open Economy 95

STUDY GUIDE Food for Thought: Develop the expenditures - output model and show an increase (decrease) in taxes to close an inflationary (recessionary) gap. Now, do the same thing using increases and decreases in government expenditures. Do the exercise one more time using the balanced budget approach. [do this exercise using various MPCs].

Critically evaluate fiscal policy as an economic stabilization policy.

Critically evaluate the Ricardian Equivalence Theorem, and be careful to explain its implications for the national debt.

Which is most reliable as a fiscal policy tool, taxes or expenditures? Defend your answer.

Sample Questions: Multiple Choice: With an inflationary gap of $100 million and a large budget deficit which has become a serious political issue and an economy with an MPC of .95, what would you do to close the gap? A. Increase taxes $5 million 96

B. Decrease expenditures $5 million C. Increase taxes $100 and decrease expenditures $100 D. None of the above With a recessionary gap of $70 million and an MPS of .1 which of the following policy would close the gap? A. B. C. D. Increase taxes and expenditures by $70 million Increase expenditures by $7 million Decrease taxes by $7.8 million All of the above will work

True - False: The crowding - out effect is the theory that a government deficit raises interest rates and absorbs resources that could have been used for private investment. {TRUE} Automatic stabilizers, such as unemployment compensation, provide counter cyclical relief from economic instability without additional government action. {TRUE}

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Chapter 8

Money and Banking

The real economy has been the subject of most of the analysis to this point. There is, however, another part of this story. That other part of this story is money. Notice to this point we have assumed away any difficulties that may arise because of the impact of policy on monetary aggregates. This chapter is the first of three which will develop monetary economics. In primitive, tribal societies the development and use of money occurs only after that society reaches a size and complexity where barter is no longer a viable method of transacting business. Barter, the trading of one good or service for another, requires a coincidence of wants. When one individual has something another wants, and vice verse, trade can be arranged be there is a coincidence of wants. Larger, more complex social orders generally require the division of labor and specialization, which in turn, increases the number of per capita market transactions. When individuals live in a higher interdependent society, most necessities of life are obtained through market transactions. In a modern industrialized country it is not uncommon for an individual to make more than a dozen transactions per day. This volume of business makes barter nearly impossible. The result is that societies will develop money to facilitate the division of labor and specialization that provide for higher standards of living. The purpose of this chapter is to introduce the reader to money and to the banking system. This chapter will provide the basic definitions essential to understanding our complex monetary and banking systems. The following chapters will extend the analyses to demonstrate how money is created and how the monetary system is used to stabilize the fluctuations in the business cycle.

Functions of Money 98

There are three functions of money, these are: (1) a medium of exchange, (2) a measure of value, and (3) a store of value. Each of these functions will be examined, in turn, in the following paragraphs. Money serves as a medium of exchange. It is generally accepted as "legal tender" or something of general and specified value, such that, people have faith that they can accept it for payment, because they can use it in exchange without loss of value. Because barter requires a coincidence of wants, trade occurs only when two people have different commodities that the other is willing to accept in trade for their own wares. A barter economy makes exchange difficult, it may take several trades in the market before you could obtain the bread you want for the apples you have. Money solves the barter problem. If you have apples and want bread, you simply sell the apples for money and exchange the money for bread. If barter persists it may take a dozen or more transactions to turn apples into bread. In other words, money is the grease that lubricates modern, sophisticated economic systems. Money is also a measure of value. Without money as a standard by which to gauge worth, value would be set by actual trades. The value of a horse in eighteenth century Afghanistan could be stated in monetary units in the more modern areas of the country. However, the nomads that wandered the northern plains of that country could tell you in terms of goats, carpets, skins, and weapons what the range of values were for horses. However, there were as many prices of horses as there were combinations of goods and services that could be accepted in exchange for the animal. Money permits the value of each commodity to be stated in simple terms of a single and universally understood unit of value. Money is also a store of value. Money can be saved with little risk, with virtually no chance of spoilage, and little or no cost. Money is far easier to store than are perishable foodstuffs, or bulky commodities such as coal, wool or flour. To store money (save) and later exchange it for commodities is far more convenient than having to store commodities for future use, or to have to continually go through barter exchanges. Together, these functions vest in money a critical role in any complex modern economy. Our prices are stated in terms of money, our transactions are facilitated by money, and we can store the things we which to consume in the future by simply saving 99

money. In fact, money may not make the world go 'round, but it certainly permits the economic world to go 'round much more smoothly.

The Supply of Money The supply of money has a very interesting history in both U.S. economic history and world economic history. Several historians note that one of the contributing factors to the fall of the Roman Empire was that there was significant deflation in the third and fourth centuries. The reason for this was that money, in those days, was primarily coinage minted of gold, silver, and copper. As gold and silver was traded for commodities from the orient there was a flow of coinage out of the west. In addition, "barbarians" were constantly raiding Roman territory and it was the gold and silver that they carried back with them (for trade). Further, as the population grew at a faster rate than the availability of precious metals, the money supply fell relative to the need for it to make the economy function efficiently. This rapid deflation, added to a extremely maldistributed income, and loss of productive resources resulting in a rapidly declining economy after the second century A.D. The Roman economy collapsed, with the collapse of the economy the military and government were also doomed. Given the times, once the Roman government and military were ruined, it was short-work to eliminate the empire and social structure. In 1792, the U.S. Congress enacted the first coinage act. The Congress authorized the striking of gold and silver coins. The Congress set the ratio of the value of gold to silver in the coinage at 15 units of silver equaled one unit of gold. The problem with this was that gold was worth more than silver as bullion than as coinage. This arbitrary setting of the coinage value of these metals resulted in the gold coins disappearing from circulation (being melted down as bullion) and only silver coins circulating. At the same time, most coinage that circulated in the eighteenth century western hemisphere (including the United States) was of Spanish origin. In fact, the standard unit adopted for U.S. coinage was the dollar, however, the Spanish minted coins that were also called dollars (from a Dutch word, tolar). The Spanish one dollar coins contained more silver, than did the U.S. dollar and the Spanish coins were being melted down and sold, at a profit, at the U.S. mint. Herein is the problem with using gold or silver as minted coins or as backing for currency. Money has value in exchange that is unrelated to the value of precious metals. Their relative values fluctuate and result in money disappearing if the value of the metal is more than the unit of currency in which the metal is contained. One of the classical economists noted this volatility in the monetary history of most countries. As the value of the gold or silver made the currency worth more as bullion, that currency disappeared and was quickly replaced by monetary devices of lessor value. Gresham's Law is that money of lesser value will chase money of greater value out of the market. 100

A modern example of this is available from U.S. coinage. In 1964, the value of silver became nearly 4 times (and later that decade nearly 22 times) its worth in coinage. Therefore, the last general circulation coins that were minted in the United States that contained any silver was 1964. Today, the mint issues one dollar coins that contain one ounce of silver (rather than .67 ounces), but that silver is worth $5.30 per ounce as bullion. Therefore, you do not see actual silver dollars in circulation, and will not until the value of silver drops below $1.00 per ounce. This observation is Gresham's law in operation. Since the American Civil War there have been various forms of money used in this country other than coinage. The government issued paper money, particularly after the Greenback Act of 1861 (there were numerous examples of U.S. paper money before that year, including bank notes, state notes, and colonial notes). The Greenback Act provided for the denominations of bills with which you are familiar, but it also provided for 5 10, 25, and 50 bills (fractional currency). Today, there are numerous definitions of money. The most commonly used monetary items are included in the M1 through M3 definitions of money; these definitions are: (1) M1 is currency + checkable deposits, (2) M2 is M1 + noncheckable savings account, time deposits of less $100,000, Money Market Deposit Accounts, and Money Market Mutual Funds, and (3) M3 is M2 + large time deposit (larger than $100,000). The largest component of the M1 money supply is checkable deposits (checking accounts, credit union share drafts, etc.), currency is only the second largest component of M1. Monetary Aggregates, Monthly 2005 (Seasonally adjusted) Month January February March April May June July August September October November December M-1 1357.2 1363.0 1368.0 1360.4 1366.8 1359.8 1355.2 1359.1 1355.1 1363.8 1363.1 1363.2 M-2 6439.3 6446.9 6464.9 6471.9 6482.8 6502.6 6515.4 6548.3 6580.2 6612.9 6641.0 6663.9 M-3 9487.2 9531.6 9565.3 9620.9 9665.0 9725.3 9762.4 9864.6 9950.8 10032.0 10078.5 10154.0

Source: Federal Reserve System

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The presented above are from the historical tables at the Federal Reserves site www.Federalreserve.gov. The Fed routinely publishes money supply data on a weekly, monthly, and annual average basis, both seasonally adjusted, and not seasonally adjusted. As the above box demonstrates, there is a fairly stable relationship between each of the three major definitions of the money supply. The growth in each of the categories over the calendar year 2005 (on a seasonally adjusted basis) is also relatively slow.

Near Money Near money are the items that fulfill portions of the requirements of the functions of money. Near money can be simply a store of value, such a stocks and bonds that can be easily converted to cash. Credit cards are often accepted in transactions, and the line of credit they represent can serve as a medium of exchange. Gold, silver, and precious stones have historically served as close substitutes for money because these commodities have inherent value and can generally be converted to cash in almost any area of the world. Much of the wealth smuggled out of Europe at the end of World War II by escaping Nazis was smuggled out in the form of gem stones, gold, and silver bullion. The widespread use of near money is relatively rare in the world's economic history. However, in modern times, there is a potential for problems. Indiana's history presents an interesting example. The State of Indiana issued currency in the 1850s, in part to help finance the canals that were being built across the State. In 1855 and 1856, the railroads put the canals out of business, even before they were completed, virtually bankrupting the State, hence the 1857 Constitution, rather the year Indiana entered the Union. State currency or even private bank currency is not controlled by a central bank and is worth only what faith people have in it or the intrinsic value of the monetary unit. If the full faith and credit of a bankrupt State or bank is all that backs the currency, it is worthless.

What Gives Money Value? The value of the U.S. dollar (or any other currency) can be expressed as the simple reciprocal of the price level: D = 1/P 102

Where D is the value of the dollar and P is the price level. In other words, the value of the dollar is no more or less than what it will buy in the various markets. This is true of any currency (money in general). However, there are reasons why money has value. The value of money is determined by three factors, these factors are: (1) its general acceptability for payment, (2) because the government claims it is legal tender (hence must be accepted for payment), and (3) its relative scarcity (as a commodity). Money can be used to buy goods and services because people have faith in its general acceptability. It is not that the coin or paper has intrinsic value that makes money of value in exchange, it is simply because people know that they can accept it in payment and immediately exchange it for like value in other commodities, because virtually everyone trusts its value in exchange. Money also has value in international currency markets, not just domestic ones. The international currency markets provide a very good example of why trust provides money with value. The world's currencies are generally divided into two categories, hard currency and soft currency. A hard currency is one that can be exchanged for commodities in any nation in the world. A soft currency is one whose value is generally limited to nation that issued it, and often to some limited extent in the world currency markets (often with significant limitations or even discounts). The U.S. dollar, French Franc, German Deutsche Mark, Canadian Dollar, Japanese Yen, British Pound Sterling, and Italian Lire were recognized as hard currencies (generally the Swiss Franc is also included in the hard currencies), at least prior to the Euro. These seven nations are the G-7 nations and are the world's creditor nations (even though each has a national debt of their own, the private sector extends credit to less developed countries). The reason that these countries are the creditor nations is that they are the largest free market economies, have democratic and stable governments, and long histories of rather stable financial markets. These nations' currencies are termed "hard" currencies because they are relatively stable in value and can be readily exchanged for the goods and services of these largest most advanced economies. In other words, the economic systems and governments that generate these currencies are the markets from which everyone else imports a wide array of necessary commodities. On the other hand, the Mexican Peso, Kenyan Dollar, and Greek Drachma (among 165 others) are currencies of less developed nations that have very little of value, relative to any of the G-7 nations in the world's markets, do not have histories of stable financial markets, governments, and they are typically in debt to the G-7 nations. Because of their limited value in exchange, and rather volatile value these currencies are called "soft" currencies. The difference between a hard and a soft currency is trust in its present and future value in exchange for commodities. Hard currencies are generally trusted, hence accepted, soft currencies are not. There is also an element of legality in the value of money. For example, the United States is a large, economically powerful country. Its government is also a large, powerful government that has always paid its bills. People have faith and trust in the 103

U.S. government making good on its financial obligations, therefore people have taken notice when the United States government says that Federal Reserve Notes are legal tender. Also contributing to the value of money is its scarcity. Because money is a scarce and useful commodity it also has value the same as any other commodity. It is interesting to note that the U.S. $100 bill is the most widely circulated currency outside of the United States, and more of these bills circulate outside of the U.S. than within the U.S. This suggests something of the commodity value of U.S. dollars, as well as the general international trust in the U.S. dollar.

By spring 1971, the exchange rate problems had become acute. This was true for Japan and especially for West Germany, who had large trade surpluses with the United States and held more dollars than they wanted. Under these conditions, the U.S. dollar was rapidly losing value against the German Deutsche mark. From January to April of 1971, in keeping with the Bretton Woods agreements, the German Bundesbank had to acquire more than $5 billion of international reserves in order to defend the value of the dollar. To protect the value of the dollar and its exchange rate with the German mark, however, the German central bank was losing control over its domestic monetary policy. By May 5, 1971, the Bundesbank abandoned its efforts to protect the dollar and permitted the Deutsche mark to seek its own value in the world's currency markets. The scenario was the same for all countries that had trade surpluses with the United States. The excess supply of dollars was causing those countries to lose control over their money supplies. Given that the United States was rapidly losing its gold reserves, on August 155, 1971, by Richard Nixon's order, it was announced that the United States officially abandoned the Bretton Woods system and refused to exchange gold for U.S. dollars held by foreigners. For the first time in modern monetary history, the U.S. dollar was permitted to seek its value in open markets. The move to a flexible exchange rate system where the exchange rates are determined by the basic market forces was the official demise of the Bretton Woods system. Mashaalah Rahnama-Moghadam, Hedayeh Samavati, and David A. Dilts, Doing Business in Less Developed Countries: Financial Opportunities and Risks. Westport, Conn: Quorum Books, 1995, p. 74.

The Demand for Money The demand for money consists of two components of total money demand, these are: (1) transactions demand, and (2) asset demand. Transactions demand for money is the demand that consumers and business have for cash (or checks) to 104

conduct business. Transaction demand is related to a preference to have wealth or resource in a form that can be used for purchases (liquidity). There is also an asset demand for money. In times of volatility in the stock and bond markets, investors may prefer to have their assets in cash so as not risk losses in other assets. Together, the asset and transaction demand for money comprise the total demand for money. Money is much the same as any other commodity, it has a demand curve and a price. The price of money is interest, primarily because money is also a claim on capital in the financial markets. The demand curve for money is a downward sloping function that is a schedule of interest rates to the quantity of money.

The Money Market The money market is a particularly interest market. In reality there are several markets in which money is exchanged as a commodity. In examining only M1, the currencies of various countries are exchanged for one another for the purpose of doing business across national boundaries. The price of one nation's currency is generally expressed in terms of another countries currency. For example, 105 Yen is the value of a dollar, in the case of a Deutsche Mark, 1.26 DM is worth one dollar. There is also the credit market. The credit market is where consumers and businesses go to borrow money. A consumer purchasing a house will typically need a mortgage and will borrow to buy a house. Businesses will need to borrow to purchase capital equipment (investing) to produce commodities to sell in product markets. Both types of borrowing influence the credit markets, because money is a relatively scarce commodity. One of the largest borrowers in the U.S. economy is the U.S. Treasury. Typically the government borrows by selling Treasury Bonds. The following diagram is for a general money market (credit market):

105

The money supply curve is vertical because the supply of money is exogenously determined by the Federal Reserve. The Federal Reserve System regulates the money supply through monetary policy and can increase or decrease the money supply by the various actions it has available to it in regulating the banking system and in selling or buying Treasury Bonds. The money demand curve slopes downward and to the right. The intersection of the money demand and money supply curves represents equilibrium in the money market and determines the interest rate (price of money). Bonds are financial obligations. Both private companies and governments issue bonds and receive cash. The bonds typically state that the owner of the bond will receive a specific payment in dollars periodically for holding the bond, and at the end of the bond's life it will be redeemed for its face value. This is the primary market, where bonds are sold directly by the government or company. In the case of the Treasury the bonds are generally sold at auction. This method of paying interest creates a "secondary" market for bonds. Bonds may be resold for either a discount or a premium. As the market value of the bond increases, it drives down the rate of return on the bond, conversely, if the market value of the bond decreases the rate of return increases. For example, consider a $1000 bond that the government agrees to pay $60 per year in interest over its life. If the bond remains at the $1000 face value the interest rate is 6%. However, if bonds are viewed as a safer investment than other possible investments, or there is excess demand for bonds, the market price may increase. If the market price of this $1000 bond increases to $1200 then the rate of return falls to only 5% (60/1200 = .05). On the other hand, if the bond is viewed as more risky, or there is an excess supply of bonds the market price may fall, say to $800, then the rate of return increases to 7.5% (60/800 = .075). Notice how bonds become a good investment. Bonds are good investments when the interest rate is falling. As the interest rate falls, the market value of the bond increases, (remember that the payment made by the original borrower is a fixed payment each period). In other words, falling interest rates mean larger market values for the bonds, and greater profits for investors in bonds.

An Overview of the U.S. Financial System The U.S. financial system is a complex collection of banks, thrifts, savings & loans, credit unions, bond and stock markets, and numerous markets for other financial instruments such as mutual funds, options, and commodities. The complete analysis of these markets is not a single course, its an entire curriculum called Finance. What is 106

important for understanding the basics of the effects of money on the macroeconomy is the banking system and the closely associated regulatory agencies, such as the Federal Reserve System and Federal Deposit Insurance Corporation (F.D.I.C.). Federal Reserve System (FED) is comprised of member banks. These member banks are generally large, nationally chartered banks that do significant amounts of commercial banking. The FED is owned by these member banks. However, under the Federal Reserve Act, the Board of Governors and Chairman are nominated by the President of United States and confirmed by the Senate. The structure of the system is: (1) Board of Governors - that governs the FED and is responsible for the operations of the Fed, (2) Open Market Committee - buys and sells bonds (called open market operations, (3) Federal Advisory Council - provides advise concerning appropriate banks regulations and monetary policies, and (4) The FED has 12 regional banks that serve as check clearing houses, conduct research, and supervises banks within the region. Fort Wayne is in the Chicago region, however, Evansville is in the St. Louis region. The Federal Reserve Banks are for each of the 12 regions are located in the following cities: 1. Atlanta, Georgia 2. Boston, Massachusetts 3. Chicago, Illinois 4. Cleveland, Ohio 5. Dallas, Texas 6. Kansas City, Missouri 7. Minneapolis, Minnesota 8. New York, New York 9. Philadelphia, Pennsylvania 10. Richmond, Virginia 11. San Francisco, California 12. St. Louis, Missouri The functions of FED are basically associated with bank regulation and the conduct on monetary policy. The functions of the FED include: 1. Set reserves requirements, 2. Check clearing services, 3. Fiscal agents for U.S. government, 4. Supervision of banks, and 5. Control money supply through Open Market Operations (buying and selling of bonds). 107

The supervision of banks and check clearing services are routine FED functions that are focused on making the banking system safer and more efficient. Because the FED is the agency through which Treasury obligations are bought and sold the FED is the fiscal agent for the federal government. The setting of reserve requirements for the banking system and open market operations are the tools of monetary policy and are the subjects of the following chapter. The Federal Deposit Insurance Corporation is a quasi-governmental corporation whose purpose is to insure the deposits of member banks. Credit unions, thrifts, and savings & loans had separate independent agencies designed to provide the same insurance. However, after the savings & loans crisis, these other agencies were consolidated under the control of F.D.I.C. The reason for these programs was the experience of the banking industry during the Great Depression when many depositors lost their life savings when the banks failed. Many banks failed, simply because of "runs." Runs are where depositors demand their funds, simply because they have lost faith in the financial ability of the banks to meet their obligations (sometimes the loss of faith was warranted, often it was nothing more than panic). Therefore, to foster depositor faith in the banking system, F.D.I.C. was created that provided a guarantee that depositors would not loss their savings even if the bank did fail. There is a problem with such insurance arrangements. This problem is called moral hazard. Moral hazard is the effect that having insurance reduces the insured's incentive to avoid the hazard against which they are insured. The savings and loan crisis was at least in part the result of moral hazard. The managers of the failed saving and loans often would extend loans or make investments that were high risk, but were less concerned because if it resulted in failure, the government would pay-back the depositors. This is a classic example of moral hazards, but there were also other problems involving fraud, bad loans in Mexico, and shaky business practices, against which it was not intended that F.D.I.C. would risk substantial exposure.

KEY CONCEPTS Functions of Money Medium of Exchange Avoidance of Barter Measure of Value Store of Value Supply of Money 108

M1, M2, and M3 Near Money Value of Money Demand for Money Transactions Demand Asset Demand Total Demand Money Market Interest rates Federal Reserve System Board of Governors F.M.O.C. Federal Advisory Council 12 regions Functions of the Fed Sets Reserve Requirements Check clearing Fiscal agent for the U.S. government Supervision of Banks Control of Money Supply Moral Hazard STUDY GUIDE Food for Thought: 109

Develop and explain each: Functions of money, Demand for money, Money supply, and Value of money.

Critically evaluate the Federal Reserve System as a regulatory agency.

What is near money? Explain and critically evaluate the use of near money.

Sample Questions: Multiple Choice: The U.S. money supply is backed by: A. B. C. D. Gold Gold and Silver Gold, silver & government bonds People's willingness to accept it

If a U.S. government 30-year bond sold originally for $1000 with a specified interest rate of five percent, each year the bond holder receives $50 from the government. If the sales price of the bond falls to $900 what is the interest rate? 110

A. B. C. D.

5.56% 5.00% 4.50% None of the above

True - False: If the Fed wishes to decrease the money supply they can buy bonds {FALSE}. The FDIC provides insurance for deposits in member banks {TRUE}.

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Chapter 9

Multiple Expansion of Money

The purpose of this chapter is to analyze how banks create money and how the Federal Reserve System plays an essential role in regulating the banking system. After a brief history of banking reserves is examined, we will proceed to analyze the multiple expansion of money. Paper money is produced at the United States Bureau of Printing and Engraving in Washington, D.C. Each day, the Bureau of Printing and Engraving produces about $22 million in new currency. Once the Bureau of Printing and Engraving produces the money it is then shipped to the twelve regional Federal Reserve banks for distribution to the member banks. The stock of currency is created and maintained by a simple printing and distribution process. However, the stock of paper money is only a small part of the M1 money supply. The majority of the M1 money supply is checkable deposits. Counterfeiting is of U.S. currency is a significant problem. The U.S. Bureau of Printing and Engraving has developed a new fifty dollar bill that will make counterfeiting more difficult. Periodically for the next several years the new design will be extended to all denominations of U.S. currency. A few years ago, a strip was added to U.S. currency that when held to the light shows the denomination of the bill, so that counterfeiters cannot use paper from one dollar bills to create higher denomination bills. The government agency responsible for enforcing the counterfeiting laws in the United States is the U.S. Secret Service, the same agency that provides security for the President.

Assets and Liabilities of the Banking System 112

Assets are items of worth held by the banking system, liabilities are claims of non-owners of the bank against the banks' assets. Net worth is the claims of the owners of the bank against the banks' assets. Over the centuries a system of double entry accounting has evolved that presents images of businesses. The double entry system accounts for assets, liabilities, and net worth. Accounts have developed a balance sheet approach to present the double entry results of the accounting process. On the left hand side are entered all of the bank's assets. On the right hand side of the ledger are entered all of the claims against those assets (claims by owners are net worth and claims by non-owners are liabilities). The assets side of the ledger, must equal the net worth and liabilities side. This rather simple method, is an elegant way to assure that claims and assets balance. The balance sheet method will permit us a method to track how banks create money through the multiple expansion process.

Rational for Fractional Reserve Requirements The fractional reserve approach to monetary stability dates from the middle-ages in Europe. Goldsmiths received gold to make jewelry, religious objects, and to hold for future use. In return the goldsmiths would issue receipts for the gold they received. In essence, these goldsmith receipts were the first European paper money issued and they were backed by stocks of gold. The stocks of gold acted as a reserve to assure payment if the paper claims were presented for payment. In other words, there was a 100% reserve of gold that assured the bearer of the receipt that the paper receipt would be honored. The reserves of gold held by the goldsmiths created faith in the receipts as mediums of exchange, even though there was no governmental involvement in the issuing of this money. However, the goldsmiths in Europe were not the first to issue paper money. Genghis Khan first issued paper money in the thirteenth century. Genghis did not hold reserves to back his money, it was backed by nothing except the Khan's authority (which was absolute). Therefore in the case of the Great Khan, it was the ability to punish the untrusting individuals that gave money its value. In Europe, two-hundred years later, it was trust in reserves that gave money its value. The U.S. did not have a central banking system, as we know it, from the 1840s through 1914. There were two early "national" banks whose purpose was to serve as the fiscal agent of the U.S. government and to provide limited regulation for the U.S. monetary system. Both failed and were eliminated. In the early part of this century several financial panics pointed to the need for a central banking system and for strong financial regulations. 113

During the first half of this country's history both states and private companies issued paper money. Mostly this paper money was similar to the gold receipts issued by the European goldsmiths, except the money was not backed by gold, typically the money was a claim against the assets of the state or company, in other words, the money issued represented debt. It is little wonder that most of this currency became worthless, except as collectors' items. Prior to 1792, Spanish silver coins were widely circulated in the U.S. because they were all that was available for use as money (for more details see the previous chapter). The first widespread issuance of U.S. paper money was during the Civil War (The Greenback Act), which included fractional currency (paper dimes & nickels!). Earlier attempts to issue U.S. notes were less than successful, simply because people trusted coinage because of the silver and gold therein contained, and paper money was a novelty (but not a very valuable one). Today, the Federal Reserve requires banks to keep a portion of its deposits as reserves, to help assure the solvency of the bank in case of a financial panic, like those experienced in the first decade of this century and again in the 1930s. The fact that these reserves are kept also helps to assure the public of the continuing viability of their banking system, hence the safety of their deposits. In turn, this public faith should prevent future runs on the banking system that have historically caused so much economic grief due to bank failures.

The Required Reserve Ratio The Required Reserve Ratio (RRR) is set by the FED's Board of Governors within limits set by statute. The minimum legally allowable RRR is three percent, where the current RRR has been set by the Board of Governors. The RRR determines by how much the banking system can expand the money supply. The RRR is the amount of reserves that a bank must keep, as a percentage of their total liabilities (deposits). Banks are permitted some freedom to determine how their reserves are kept. A bank can keep reserves as vault cash or deposits with the regional Federal Reserve bank. Should a bank be short of the amount required to meet the reserves necessary, then a bank can borrow their reserves for short periods from either the FED or other member banks. The FED regulates the borrowing of reserves, and sets an interest rate for these short term loans if they are borrowed from the FED. The rate charged on borrowed reserves from the FED is called the discount rate. The rate of interest charged on reserves borrowed from other member banks is called the Federal Funds Rate (currently about 5.5%).

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The banking system has three forms of reserves, these are actual, required, and excess reserves. Actual reserves are the amounts the banks have received in deposits that are currently held by the bank. The required reserves are the amounts the Board of Governors requires the banks to keep (as vault cash, deposits with the FED, or borrowed). The excess reserve is amount of actual reserves that exceeds the required reserves. It is the excess reserves of the banking system that may be used by the member banks to expand the checkable deposits component of the U.S. money supply.

Multiple Expansion of Checkable Deposits The largest component of the M1 money supply is checkable deposits. Rather than printing Federal Reserve Notes, the majority of the money supply is created through a system of deposits, loans, and redeposits. Money is created by a bank receiving a deposit, and then loaning that non-required reserve portion of the deposit (excess reserve), which, in turn, is deposited in another checking account, and loans are subsequently made against those deposits, after the required reserve is deducted and placed in the banks vault or deposited with the FED. For example, if the RRR is .10, then a bank must retain 10% of each deposit as its required reserve and it can loan the 90% (excess reserves) of the deposit. The multiple expansion of money, assuming a required reserve ratio of .10, can, therefore, be illustrated with the use of a simple balance sheet (T-account): Deposit Loans ________________________ | $10.00 | 9.00 9.00 | 8.10 8.10 | 7.29 . | . . | . _______ | _______ $ 100.00 | $90.00 | 10.00 (required reserves) | $100.00

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The total new money is the initial deposit of $10 and an additional $90 of multiple expansion for a total of $100.00 in new money. The T-account used to illustrate this multiple expansion of money is really a crude balance sheet for the banking system with the liabilities on the left side and the assets on the right side of the ledger. Notice, however, that the T-account balances, and that there is $100.00 on each side of the ledger. There is a far easier way to determine how much the money supply can be expanded through the multiple deposit - loan, re-deposit - loan mechanism. This shortcut method is called the money multiplier (Mm). The money multiplier is the reciprocal of the required reserve ratio:

Mm= 1/RRR
The money multiplier is the short-hand method of calculating the total entries in the banking systems' T-accounts and shows how much an initial injection of money into the system can generate in total money supply through checkable deposits. One of the tools of the FED to expand or contract the money supply is to make or withdraw deposits from its member banks. This element of monetary policy will be discussed in greater detail in the following chapter. The following chapter examines monetary policy and how the FED operates to maintain control over the money supply. The potential creation of money is therefore inversely related to the required reserve ratio. For example, with a required reserve ratio of .05 the money multiplier is 20. This means that a $1.00 increase in deposits can potentially create $20 in new checkable deposits as it is loan and re-deposited through the system. On the other hand, with a required reserve ratio of .20 the money multiplier is 5 and only $5 of new money can be created from an initial deposit of $1.00. With the current required reserve ratio of .03, the money multiplier is 33.33. Currently, an initial deposit of $1.00 can potentially create $33.33 in new money through increased checking deposits. The reason that the word potential is used to describe this process, is that there is no guarantee that the banking system will be able to loan all of its available excess reserves. The amount that will be loaned still depends on the demand for money and investment in plant and equipment. The monetary history of several nations illustrates how well the multiple expansion of money has been understood. The United States has had recurrent bouts of inflation during the post-World War II period. As the Fed struggled with understanding how the system worked in this country, the Swiss understood since the turn of the century. Switzerland is a relatively small economy, and the money supply in this small nation was very competently managed. The result is that the Swiss have experienced usually stable price levels ever since 1945. 116

The recurrent bouts of inflation in the post-World War II economic history of the United States, are not consistent with the economic history of this country prior to World War II. Most of American history experienced significant deflation. Deflation is rarely discussed today, but is, in many ways, a far more destructive problem than inflation. The reason this problem persisted for so many decades in this country was that there was no stable central banking system to manage the money supply and that the value of the U.S. dollar was tied to an increasingly rare commodity - gold. This is what was called the gold standard. The deflation that was a symptom of the Great Depression moved then President Herbert Hoover to order that gold coinage be no longer minted. A couple of years later President Roosevelt ordered that the gold coinage be taken out of circulation, and later in his administration gold was not permitted to be held in coinage by private citizens. Finally, the destabilizing affects of the lack of allowing the U.S. dollar to find its own value on a free market motivated President Nixon to eliminate the gold standard altogether in 1971. Gold prices have been allowed to float in the market place. In 2001 the annual average price of gold was just under $272, today the price of gold is nearing the levels reached right after the demise of the gold standard in 1971. $650 an ounce for gold in May of 2006 is merely a couple of hundred dollars below the lofty levels set in 1972. Need for Regulation and Inflation One of the serious implications of the money multiplier is that the banking system has the potential for significant harm to economic stability. In Chapter 3 we examined the various theories of inflation. One of those theories is called the quantity theory of money, where MV = PQ. Because V and Q grow very slowly, they are generally regarded as nearly constant. The implication is that what happens to the money supply should be nearly directly reflected in the price level. During expansions in the business cycle, investment demand is generally high and banks can often loan all of their excess reserves. If we reduced the required reserve ratio to .01 then banks could expand the money supply $100 for each $1.00 in additional deposits made in the system. If the required reserve ratio was only .001, then $1000 of new money can be created for every dollar of new deposits. Without any required reserve ratio, the money supply could be theoretically be expanded infinitely for each dollar of new deposits. These high multiple potential expansions could create serious inflationary problems for the economy, and therefore the required reserve ratio of the central bank is an essential portion of any nation's economic stabilization policies. During this period of a political swing to the right of public opinion, the idea of deregulation has gained some new support. However, there is no serious, and informed move toward de-regulating the money supply. Without monetary controls imposed by a 117

central bank, there will most certainly be serious economic problems associated with the loss of some modicum of sensible control of the money supply. This need for regulation has been long recognized by economists. Since at least the 1890s classical economists described the role of money in the economy, and the need to control the money supply if price stability was to achieved. Most prominent among the classical economists writing at the beginning of the twentieth century concerning monetary economics was Irving Fisher, who developed the modern quantity theory of money presented in Chapter 3.

We come back to the conclusion that the velocity of circulation either of money or deposits is independent of the quantity of money or of deposits. No reason has been, or, so far as is apparent, can be assigned, to show why the velocity of circulation of money, or deposits, should be different, when the quantity of money or deposits, is great, from what it is when the quantity is small. There still remains one seeming way of escape from the conclusion that the sole effect of an increase in the quantity of money in circulation will be to increase prices. In may be claimed -- in fact it has been claimed -- that such an increase results in an increased volume of trade. We now proceed to show that (except during transition periods) the volume of trade, like the velocity of the circulation of money, is independent of the quantity of money. An inflation of the currency cannot increase the product of farms and factories, nor the speed of freight trains or ships. The stream of business depends on natural resources and technical conditions, not on the quantity of money. The whole machinery of production, transportation, and sale is a matter of physical capacities and technique, none of which depend on the quantity of money . . . . We conclude, therefore, that a change in the quantity of money will not appreciably affect the quantities of goods sold for money. Since, then, a doubling in the quantity of money: (1) will normally double deposits subject to check in the same ratio, and (2) will not appreciably affect either the velocity of circulation of money or of deposits or the volume of trade, it follows necessarily and mathematically that the level of prices must double . . . . Irving Fisher, The Purchasing Power of Money. New York, Macmillan, 1911, pp. 15457. KEY CONCEPTS 118

Fractional Reserve Requirements Balance Sheet Required Reserve Ratio Money Multiplier Monetary History Genghis Kahn Gold Receipts U.S. had no central bank prior to 1914 Greenback Act Reserves Required Excess Actual Money Creation

STUDY GUIDE Food for Thought: Trace the deposit of $100 through a banking system with a .25 RRR. Does an injection of $100 really result in an increase in the money supply of $400? Explain.

Explain the sources of reserves for member banks. How does the Fed control the money supply when reserves can be borrowed? Explain and critically evaluate this practice. 119

Critically evaluate the Fed as maker and implementer of monetary policy in the United States.

Sample Questions: Multiple Choice: With a required reserve ratio of .05 by how much will the money supply be increased in the Federal Reserve deposits a check of $1000 with National City Bank? A. B. C. D. $1000 $5000 $20,000 None of the above

Which of the following is the interest rate that member banks charge one another for borrowing excess reserves? A. B. C. D. Federal funds rate Money Market rate Discount rate Prime rate

True - False: Excess reserves are the funds in the Federal Reserve Banks that the Fed does not need to assure the solvency of the banking system. {FALSE} Money multiplier with a RRR of .25 is 4. {TRUE} 120

Chapter 10

Federal Reserve and Monetary Policy

The neo-classicists continue to reject the idea that the government has a proactive role to play in economic stabilization. However, where the neo-classicists see any role for government in stabilizing the macroeconomy it is in monetary policy arena. There is some merit to this point of view. Fiscal policy has significant lags that often results in counter-productive governmental actions, by the time the fiscal policy actually impacts the economy. Monetary policy, on the other hand, has very short lags between the recognition of a problem and the impact on the macroeconomy. At a minimum, monetary policy is quicker to change the economy's direction, is involved in far less political game-playing, and is more efficient than is fiscal policy. The purpose of this chapter is the examine the role of the Fed in the formulation and implementation of monetary policy for the purpose economic stabilization. Each of the major tools of monetary policy will be examined, and their potential effects presented.

Monetary Policy The monetary policies of a government focus on the control of the money supply. These policies directly control inflation or deflation, but also can influence real economic activity. The focal point of control over real economic activity through the management of monetary aggregates is the interest rate. The demand for investment is dependent upon the relation between expected rates of return from that investment, and the interest rate that must be paid to borrow the money to buy capital. 121

Monetary policy in the United States is conducted by the Federal Reserve, either through the Board of Governors or the Federal Open Market Committee. The monetary policies of the United States have focused primarily on the control of various monetary aggregates, i.e., the money supply, which, in turn, influences interest rates and hence aggregate economic activity. The fundamental objective of monetary policy is to assist the economy in attaining a full employment, non-inflationary macroeconomic equilibrium.

Tools of Monetary Policy The Federal Reserve has an arsenal of weapons to use to control the money supply. The Fed can buy and sell U.S. Treasury bonds, called open market operations, it can control the required reserve ratio, within statutory limits, and it can manipulate the discount rate (the interest rate charged by the Fed for member banks to borrow reserves). This array of tools provides the Fed with several options in taking corrective actions to help stabilize the economy. Each of these tools will be examined in the following paragraphs.

Open Market Operations Open Market Operations (OMO) involves the selling and buying of U.S. Treasury obligations in the open market. OMO directly influences the money supply through exchanging money for bonds held by the public (generally commercial banks and mutual funds). Expansionary monetary policy involves the buying of bonds. When the Fed buys bonds, it replaces bonds held by the public with money. When someone sells a bond, they receive money in exchange, which increases the money supply. Contractionary monetary policy involves the Fed selling bonds to the general public. When the Fed sells bonds it removes money from the hands of the public and replaces that money with U.S. Treasury bonds. The Fed sells and buys both long-term (thirty year) Treasury bonds, and shortterm (primarily two, five and ten year) Treasury bonds. In theory the Fed can focus its influence on either long-term interest rates or short term-interest rates. However, what most security analysts argue is that the Fed's bond buying and selling behavior is not a leadership position. In recent years, the Fed buys and sell bonds after the money market establishes a direction for interest rates. In times, of high inflation or steep recession, however, the evidence suggests that the Fed's OMO leads the market, rather 122

than follows. In reality, this is what we should expect to observe in the responsible exercise of monetary policies. The Fed also buys and sells lower denomination and shorter term obligations called Treasury Bills. While bonds are sold only periodically in Treasury auctions, Treasury Bills are available at any time through the Federal Reserve Banks. The Treasury Bill is also the buying and selling of U.S. government debt, but is not the primary tool of open market operations, even though it has the same impact of increasing or decreasing the money supply. The market for Treasury Bills is small relative to the Bond market.

The Required Reserve Ratio As discussed in the previous chapter, it is the required reserve ratio that determines the size of the money multiplier. The money multiplier determines how much money can be created by the member banks through the deposit - loan process. Therefore, the Fed can directly control how much the banking system can expand the money supply through the manipulation of the required reserve ratio. The Fed can raise or lower the required reserve ratio, within statutory limits. Increasing the required reserve ratio, reduces the money multiplier, hence reduces the amount by which multiple expansions of the money supply can occur. By decreasing the required reserve ratio, the Fed increases the money multiplier, and permits more multiple expansion of the money supply through the deposit - loan process described in the previous chapter. Most of the new deposits that result in the multiple expansion of money occur because the Fed bought bonds from the public. When the Fed buys bonds, this is injecting new money into the system that is, in turn, deposited -- which set the money multiplier (multiple expansion) into motion.

The Discount Rate The Discount Rate is the rate at which the Fed will loan reserves to member banks for short periods of time. To tighten monetary policy, the Fed will raise the discount rate. The raising of the discount rate will discourage the borrowing of required reserves by member banks, hence encourages using their reserves as required reserves, rather than excess reserves (which they loan and start the multiple expansion of money). By lowering the discount rate, the Fed encourages the borrowing of required reserves, which may result in more excess reserves hence potentially more loans, and 123

a greater expansion of the money supply through the loan - deposit process described in the previous chapter (Chapter 9). It is the Discount Rate over which the Fed may exert direct control. However, member banks may borrow reserves from one another, as well as the Fed. The rate at which member banks borrow from one another is called the Fed Funds Rate. The Fed Funds Rate is heavily influenced by what the Fed does with respect to the Discount Rate, and the Feds supervisory impact on member banks. Therefore, the Fed Funds Rate is often targeted by the Fed, and is not entirely immune to Fed influence, even though not under the direct control of the Fed. It is also worth mentioning that the Fed sets the margin rate minimums that brokerages may charge customers to buy stocks with borrowed money. This function of the Fed is not an important current monetary policy tool. In fact, it is pretty much a symptom of the Federal Reserve Act being passed as a result of a series of financial panics immediately prior to the out-break of World War I and of the devastation brought later by the Great Depression.

Fed Targets The Fed must have benchmarks to determine the need for and effectiveness of monetary policies. The quantity theory of money suggests that the money supply itself is the appropriate policy target for the Fed. As noted by Irving Fisher, the velocity of money is how often the money supply turns-over, and is unrelated to economic activity. Further, Fisher argued that money does not directly influence the real output of the economy. Therefore, in any policies aimed at controlling inflation or deflation the Fed's monetary targets should simply be the money supply. However, the economy is not as simple as the quantity theory of money would suggest. Many consumer purchases and most investment is interest rate sensitive. Therefore, to the extend that the Fed's policies do impact interest rates, the Fed can also correct downturns in the business cycle. If investment is too low to maintain fullemployment level of GDP, the Fed can reduce the required reserve ratio or buy bonds thereby increasing the supply of money and lowering the interest rate. The lower interest rate may encourage consumption expenditures and investment, thereby mitigating recession. There are dilemmas for the Fed in selecting targets for their monetary policies. Interest rates and the current business cycle may present a dilemma. Expansionary monetary policy may result in higher interest rates, by increasing the rate of inflation, which will be reflected in the interest rates. As the interest rate increases and people's inflationary expectations develop, these may serve to dampen the expansionary effects of the Fed's monetary policies. At the same time, there is no necessary coordination of 124

fiscal and monetary policies. At the time an expansion monetary may be necessary to reverse a recession, contractionary fiscal policies may begin to affect the economy. Therefore, the Fed must keep an eye on the Congress and account for any fiscal policies that may be contradictory to the appropriate monetary polices. The presents a delicate balancing act for the Fed. Not only must the Fed correct problems in the economy, it may well have to correct Congressional fiscal mistakes, or at least, account for this errors when implementing monetary policies.

Tight and Easy Money Discretionary monetary policy, therefore, fits into one of two categories, (1) easy money, and (2) tight money policies. Easy money policies involves the lowering of interest rates, and the expansion of the money supply. The purpose of easy money policies are typically to mitigate recession and stimulate economic growth. Tight monetary policies involve the increasing interest rates, and contracting the money supply. The purpose of tight money policies is generally to mitigate inflation and slow the rates of economic growth (typically associated with inflation). These monetary policies may also have a significant impact on the value of the U.S. Dollar in foreign exchange markets. In general, tight monetary policies are associated with increasing the value of the U.S. Dollar, whereas easy monetary policies will generally have the opposite affect. Consider the following diagram showing both tight and easy money policies impact on the money market.

125

Assuming that the money supply remains constant, we can analyze the changes in the money supply imposed by the Fed. As the Fed engages in tight money policies the supply curve is shifted to the left (dashed line labeled tight), this increases the interest rate and lowers the amount of money available in the economy. On the other hand, easy money policy is a shift to the right of the money supply curve (dashed line labeled easy). With easy money policies, the quantity of money increases and the interest rate falls. The effectiveness of such policies in influencing GDP result from changes in autonomous investment. In the case of an easy money policy, as the interest falls, investment will increase which results in an increase in the C+I+G line as illustrated below:

The decrease in the interest rate is associated with an increase in investment (the vertical distance between C+I+G1 and C+I+G2) which results in an increased GDP and levels of spending. The acceptance of discretionary monetary policies are often associated with Keynesian views of a pro-active role for government in economic stabilization. Even though most neo-classicists argue that monetary policy is necessary to the proper functioning of a market economy. However, there is another view. The most extreme of the neo-classicists argue that there is simply no role for either discretionary fiscal or monetary policies, except in dealing with extreme variations in economic activity, i.e., like the Great Depression of the 1930s.

Friedman's Monetary Rules Argument 126

The leading economist of the neo-classical school (Chicago School of Thought or Monetarist) is the Nobel Prize winning economist, Milton Friedman. Professor Friedman won his Nobel Prize for, among other contributions, his work on the monetary history of the United States. Friedman argues, with some persuasion, that Irving Fisher's work establishes the appropriate standard for monetary policy. Based on the presumption that discretionary fiscal policy can be abolished, Friedman would have all monetary policies based on a simple rule that follows directly from Fishers formulation of the quantity theory of money. Assuming that discretionary fiscal policy has been eliminated, and that the economy is operating at a full-employment, non-inflationary equilibrium, monetary policy should be nothing more or less than estimating the growth rate of economy (change in Q) and matching the growth rate of the money supply to the growth rate of the economy. Such monetary policy leaves nothing to the discretion of policy makers. The Fed's sole role is to make sure that the money supply simply facilitates economic growth by expanding at the same pace as the real economic activity. If the Fed underestimates growth, there could be small deflations that could be eliminated but subsequent adjustments to the money supply and overestimations of the growth rate causing inflation could be dealt with in the same type of subsequent adjustments. If nothing else, Friedman's suggestion would eliminate any government induced variations in economic activity. Real Business Cycle Theory is another paradigm that has arisen out of the ashes of the classical school, and these economists would not find much to argue with Friedman about, as far as the analysis goes. These economists, primarily Thomas Sargent from the University of Minnesota, argue that recessions and inflations result from either major structural changes in the economy or external shocks, such as the Arab Oil Embargo. When these types of events occur, the Real Business Cycle Theorists would have the government play a pro-active role, but focused specifically on the shock or structural problem. In this sense, there is a role for discretionary fiscal and monetary policies, but very narrowly focused on very specific events. KEY CONCEPTS Monetary Policy Expansionary Contractionary Tools of Monetary Policy Bonds 127

Required Reserves Ratio Discount Rate Velocity of Money Quantity Theory of Money Target Dilemma in Monetary Policy Discretionary Monetary Policy vs. Monetary Rules

STUDY GUIDE Food for Thought: Critically evaluate the tools and the independence of the Fed to use them in monetary policy.

If the MV = PQ equation is correct then inflation can be dealt with as a monetary problem. If we are experiencing 10 percent inflation with $4 billion real economy (in other words nominal GDP is $4.4 billion) and the velocity of money 2.8 how do we control inflation? Would we want to? Explain.

What must the Fed do with each of its tools to create (1) a tight money policy, and (2) an easy money policy? Critically evaluate each.

Sample Questions: 128

Multiple Choice: If the Fed wanted to create a tight money policy which of the following is inconsistent with this goal? A. B. C. D. Increasing the Required Reserve Ratio Increasing the Discount Rate Buying bonds All of the above are consistent with a tight money policy

If the Fed wishes to stimulate the economy during a recession what might we expect to observe? A. B. C. D. Lowering the Required Reserve Ratio Lowering the Discount Rate Fed Buying Bonds None of the above

True/False: The main goal of the Federal Reserve System is to assist the economy in achieving and maintaining a full-employment, non-inflationary, stability. {TRUE} A tight money policy assists in bringing the economy out of recession, but at the risk of possibly causing inflation. {FALSE}

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Chapter 11

Interest Rates and Output: Hicks IS/LM Model

The final issue with which to build a complete picture of the macroeconomy is the development of a model to explain the relationship of interest rates to the overall output of the economy. Sir John Hicks developed a model which directly equates the interest rate with the output of the economy. This model is called the IS/LM model and provides valuable insights into the operation of the U.S. economy this chapter offers a quick and simple view of these relations. IS Curve The IS curve shows the level of real GDP for each level of real interest rate. The derivation of the IS curve is a rather straightforward matter, observe the following diagram. INCOME/EXPENDITURE Expenditure or Aggregate Demand

GDP AUTONOMOUS SPENDING Interest Rate Interest Rate

IS Autonomous Spending GDP

130

The Income-Expenditure diagram determines for each level of aggregate demand the associated level of GDP. There is a portion of this GDP which is determined within the system (autonomous spending) and for each level of autonomous spending there is a specific interest rate. The indicator line from the IncomeExpenditure diagram provides levels of GDP, which are associated with specific interest rates, which in turn are associated with specific level of autonomous spending. The resulting IS curve is a schedule of levels of GDP associated with each interest rate. The intercept of the IS Curve is the level of GDP that would obtain at a zero real interest rate. The slope of IS Curve is the multiplier (1/1 - MPC) times marginal propensity to Invest (resulting from a change in real interest rates) and the marginal propensity to export (resulting from a change in real interest rates). The IS curve can be shifted by fiscal policy. An increase in government purchases pushes the IS curve to the right, and a decrease will shift it left. Conversely, an increase in taxes pushes the IS curve left, while a decrease in taxes will push the curve to the right. However, almost anything that changes the non-interest-dependent components of autonomous spending will move the IS curve. For example, foreigners speculating on the value of the dollar may result in a shift in the IS curve to the extent it impacts purchases of imports. Changes in Co or Io will also move the IS curve. Anytime the economy moves away from the IS curve there are forces within the system which push the economy back onto the IS curve. Observe the following diagram: Real Interest Rate

IS Curve

Real GDP

131

If the economy is at point A there is a relatively high level of real interest rates which results in planned expenditure being less than production, hence inventories are accumulating, and production will fall, hence pushing the economy toward the IS curve. On the other hand, at point B the relatively low real interest rate results in planned expenditure being greater than production, hence inventories are being sold into the market place and product will rise to bring us back to the IS curve. LM Curve The LM Curve is derived in a fashion similar to that of the IS curve. Consider the following diagram:

Interest Rate

Money S

Interest Rate LM Curve D1

D2 D3 GDP (Y) Real Qty of Money Low Y As can be readily observed from this diagram the LM curve is the schedule of interest rates associated with levels of income (GDP). The interest rate, in this case, being determined in the money market. With a fixed money supply each level of demand for money creates a different interest rate. If the money market is to remain in equilibrium, then as incomes rise so too, then must the interest rate, if the supply of money is fixed. The shifting of the LM curve is obtained through inflation or monetary policy. If the price level is fixed, then a decrease in the money supply will shift the LM curve to the left, and an increase in the money supply will push the LM curve to the right. Conversely, if the money supply 132 High Y Moderate Y

remains fixed and there is inflation, then the real money supply declines, and the LM curve shifts left, and vice versa. Equilibrium in IS-LM Just as in the Keynesian model, the intersection of the IS and LM curve results in there being an equilibrium in the macroeconomy. The following diagram illustrates an economy in equilibrium at where LM is equal to ISe: Interest Rate LM

r IS1 ISe IS2 GDP Y Where the IS and LM curves intersect is where there is an equilibrium in this economy. With this tool in hand the affects of the interest rate on GDP can be directly observed. As the IS curve shifts to the right along the LM curve notice that there is an increase in GDP, but with a higher interest rate (IS1) and just the opposite occurs as the IS curve shifts back towards the origin (IS2). From above it is clear the sorts of things that shift the IS curve, fiscal policy or changes in Co or Io. Fiscal policy is associated with changes in the position of the IS curve. If the government decreases taxes, and there is no change in monetary policy associated with this fiscal change we would expect to observe a shift to the right of the IS curve, hence an increase in GDP, but with an increase in interest rates. For interest rates to remain the same with this increase in GDP, the Fed would have to engage in easy monetary policies and shift the LM curve to the right which would also have the effect of increasing GDP. The same analysis would result in the case of an increase in government expenditures. In the case of an increase in taxes, the GDP would fall, but so too would interest rates. If the Fed were to increase the interest rates back to previous levels it would need to engage in tight monetary policies to shift the LM curve back to the left. In other words, the interest rate is the driving mechanism behind the equilibrium in the macroeconomy as suggested by the monetarists and Keynesians alike. It is simply that 133

neither the Keynesian cross nor the quantity theory of money made it easy to examine these relations in any significant detail. It is therefore clear that the results of fiscal policy are dependent on what happens with the money supply. Expansionary and Contractionary Monetary Policies The LM curve, too, can be moved about by changes in policy. If the money supply is increased or decreased that will have obvious implications for the LM curve and hence the interest rate and equilibrium level of GDP. Consider the following diagram: Interest Rate LM2 LMe LM1

IS GDP Y As the Fed engages in easy monetary policies the LM Curve shifts to the right, and the interest rate falls, as GDP increases. This is the prediction of quantity theory of money and is consistent with what is presumed to be the case if there is not monetary neutrality in the Keynesian model. If the Fed engages in tight monetary policy then we would expect to observe a shift to LM2. In the case of LM2 the decrease in the money supply results in a higher interest rate, and a lower GDP. Again, these are results consistent with the predictions of the quantity theory of money and consistent with what we would expect without monetary neutrality in the case of the Keynesian model. Foreign Shocks The U.S. economy is not a closed economy, and the IS-LM Model permits us to examine foreign shocks to the U.S. economy. There are three of these foreign shocks worthy of examination here; these are (1) increase in demand for our exports, (2) increases in foreign interest rates, and (3) currency speculators expectations of an increase in the exchange rate of our currency with respect to some foreign currency. Each of these foreign shocks results in an outward expansion of the IS Curve as portrayed in the following diagram: 134

Interest Rate LM r2 r1 IS1 ISo GDP Y1 Y2 As the demand for domestic exports increases overseas the IS curve shifts from IS o to IS1. The interest rate increases domestically which will have the tendency to reduce the exchange rate, which will have two countervailing affects, which are to put downward pressure on further exports, and to increase imports. The result is initially we export more, and that increase is dampened somewhat by the countervailing effects in the second round. An increase in the foreign real interest rates has the effect of increasing our domestic imports because foreign exchange rate has become more favorable to foreigners, and allows their currency to go further in our economy. The end result is that the same shift in the IS curve will be observed with same results. Speculators in currency markets may also generate the same result as an increase in foreign interest rates, if they believe that a weak dollar will result in their currency gaining value. Hence, much of the foreign exchange and balance of payments phenomena can also be readily analyzed using the IS-LM Model.

KEY CONCEPTS IS Curve Slope and Intercept LM Curve Money Market Equilibrium in the IS-LM Model Fiscal Policy 135

Monetary Policy Real Interest Rates Foreign Sector Demand for exports Foreign interest rates Currency speculation

STUDY GUIDE Food for thought: Describe the role that interest rates play in determining equilibrium in the macroeconomy. Is this role clear in the quantity theory of money or the Keynesian models? Explain.

What if currency speculators believed that the dollar was going to become stronger, or that the demand for exports decreased abroad? What would happen to the analysis offered above?

Critically evaluate monetary and fiscal policy within the context of the IS-LM model. IS this different than you believed coming into this course? Explain.

136

Sample Questions: Multiple Choice: If we are off of the IS curve, and above it, what will happen to bring us back to the IS curve? A. B. C. D. Monetary and / or fiscal policy will be required Inventories will accumulate and bring us back This cannot occur in theory or reality None of the above

To shift the LM curve to the right which of the following must occur? A. B. C. D. Increase taxes Increase government expenditures Increase the money supply Any of the above

True / False: The main determinants of the LM Curve are in the money market. {True} Anything that affects the non-interest-dependent components of autonomous spending shifts the position of the IS curve. {True}

137

Chapter 12

Economic Stability and Policy

The focus of this course is managerial, however, public policy has a significant impact on business conditions. It is therefore of importance that some discussion occur with respect to these issues. Perhaps the most important macroeconomic problems of the last forty years are unemployment and price level instability. During the post-World War II period price level instability has primarily been inflation. There are several other matters that have also been the focus of economic policy, including poverty (income distribution), and the federal debt and budget deficit. The purpose of this chapter is to examine these policy issues.

The Misery Index During the Reagan administration both unemployment and inflation topped ten percent. This record gave rise to an economic statistic called the misery index. The misery index is the summation of the civilian unemployment rate and the consumer price index. For example, with 10 percent unemployment and twelve percent inflation, the misery index would be 22. The consumer price index is based on a market basket of goods that household typically purchase. Therefore, the CPI measures the impact of increasing prices on the standard of living of consumers. The unemployment rate also focuses on the welfare of families, when the household wage earning is out of work it has serious implications for that household's income. The misery index can be interpreted as a measure of the loss of well-being of households. Since 1973 American households have not fared well. The U.S. Department of Commerce, Current Population Survey, tracks economic and demographic data concerning households. Between 1973 and 1993 the median real income of American households has not changed. The slight increases enjoyed in the 1970s were all given back during the 1980s. However, between 1973 and 1993 there has been a dramatic increase in the number of two wage earner households, and households where a fulltime worker also has a part-time job. Increasingly, economists are warning that the distribution of misery in the U.S. economy is becoming more extreme and that the social ills associated with this misery are increasing. Crime, drug abuse, social and economic alienation, and stress related illnesses have become epidemic. The fraudulent arguments that what was needed was a return to traditional family values, is used as a substitute for what is really 138

transpiring, something must be done to reduce economic disparity, particularly as it negatively effects the family. As Lester Thurow has noted:

If the real GNP is up and real wages are down for two thirds of the work force, as an algebraic necessity wages must be up substantially for the remaining one third. That one third is composed of Americans who still have an edge in skills on workers in the rest of the world -- basically those with college educations. In the 1980s educational attainment and increases or decreases in earnings were highly correlated. American society is now divided into a skilled group with rising real wages and an unskilled group with falling real wages. The less education, the bigger the income reduction; the more education, the bigger the income gains. These wage trends have produced a sharp rise in inequality. In the decade of the 1980s, the real income of the most affluent five percent rose from $120,253 to $148,438, while the income of the bottom 20 percent dropped from $9,990 to $9,431. While the top 20 percent was gaining, each of the bottom four quintiles lost income share; the lower quintile, the bigger the decline. At the end of the decade, the top 20 percent of the American population had the largest share of total income, and the bottom 60 percent, the lowest share of total income ever recorded. Lester Thurow, Head to Head: The Coming Economic Battle Among Japan, Europe, and America. New York: William Morrow and Company, 1992, p. 164.

It is beyond dispute that since 1981 there has been a fundamental change in American society. As Lester Thurow notes, America is becoming two separate and unequal societies, one group with an increasing misery index, and another one with increasing affluence. The Bush Administrations 2003 Tax Cut has also been heavily criticized as having provided significant tax relief for the wealthy in the form of reduced rates on dividends. At the same time, the deficits necessary to fund those dividend tax cuts will increase interest rates over the next few quarters, which impact mortgage rates and consumer loan interest rates. This is an empirical question and will be answered by cold, objective evidence within the year.

The Phillips Curve Since the Kennedy administration much of American economic policy has been based on the idea that there is a trade-off between unemployment and inflation. It was not until the recession of 1981-85 that we experienced very large amounts of 139

unemployment together with high rates of inflation. It was thought that there was always a cruel choice in any macroeconomic policy decision, you can have unemployment and low inflation, or you can have low rates of unemployment, but at the cost of high rates of inflation. This policy dilemma, results from acceptance of a statistical relation observed between unemployment and inflation named for A. W. Phillips who examined the relation in the United Kingdom and published his results in 1958. (Actually Irving Fisher had done earlier work on the subject in 1926 focused on the United States).

The Short-Run, Trade-off Phillips Curve The following diagram presents the short-run trade-off view of the Phillips curve. Actually, A. W. Phillips' original research envisioned a linear, downward sloping curve that related nominal wages to unemployment. Over two years after A. W. Phillips' paper was published in Economica, Richard Lipsey replicated Phillips' study specifying a non-linear form of the equation and using the price level, rather than nominal wages in his model. It is Lipsey's form that is commonly accepted, in the literature, as the shortrun, trade-off view of the Phillips curve.

The short-run, trade-off view of the Phillips curve is often used to support an activist role for government. However, the short-run, trade-off view of the Phillips Curve shows that as unemployment declines, inflation increases, and vice versa. It is this negative relation between unemployment and inflation, portrayed in the above diagram that gives rise to the idea of cruel policy choices between unemployment and inflation. However, there are alternative views of the Phillips Curve relation.

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Natural Rate Hypothesis Classicists argue that there can only be a short-run, trade-off type Phillips Curve if inflation is not anticipated in the economy. Further, these economists argue that the only stable relation between unemployment and inflation that can exist is in the longrun. In the long run the Phillips Curve is alleged to be vertical at the natural rate of unemployment, as shown in the following diagram:

In this view of the Phillips Curve any rate of inflation is consistent with the natural rate of unemployment, hence the Natural Rate Hypothesis. It is based on the idea that people constantly adapt to current economic conditions and that their expectations are subject to "adaptive" revisions almost constantly. If this is the case, then businesses and consumers cannot be fooled into thinking that there is a reason for unemployment to cure inflation or vice versa, as is necessary for the short-run, trade-off of the Phillips Curve to exist. If taken to the extreme, the adaptive expectations view can actually result in a positively sloped Phillips Curve relation. The possibility of a positive sloping Phillips Curve was first hypothesized by Milton Friedman. Friedman was of the opinion that there may be a transitional Phillips Curve, caused by people adapting both their expectations and institutions to new economic realities. In fact, the experience of 1981-85 may well be a transitional period, just like that envisioned by Friedman. The beginning of the period was marked by OPEC driving up the price of exported oil, and several profound changes in both the American economy and social institutions. The Reagan appointments to the N.L.R.B., Justice Department (particularly the Anti-Trust Division), the Supreme Court (and Circuit Courts of Appeals, and District Courts) and significant changes in the tax code changed much of the legal environment significantly. Further, the very significant erosion of the traditional base 141

industries in the United States (automobiles, transportation, steel, and other heavy manufacturing) together with massive increases in government spending on defense arguably created a transitory economy, consistent with the increases in both inflation and unemployment. The positively sloped Phillips Curve is show in the following picture:

The positively sloped transitional Phillips Curve is consistent with the observations of the early 1980s when both high rates of unemployment existed together with high rates of inflation (the positive slope) -- a condition called stagflation (economic stagnation accompanied by inflation). Cruel choices may only exist in the case of the short-run, trade-off view of the Phillips Curve. However, there maybe a "Lady and Tiger Dilemma" for policy makers relying on the Phillips Curve to make policy decisions. If fiscal policy is relied upon, only the timing of the impact of those fiscal policies will result in any positive influence on the economy. Therefore, to act, through taxes or expenditures, may result in having a counter-productive effect by the time the policy impacts the economy (the tiger). On the other hand, if accurate two and three year into the future forecasts can be acted upon in time, recession or inflation could be mitigated by current action -- a real long-shot! (the lady). However, if the rational expectations theories are correct, then the long-shot is exactly what would be predicted. Rational expectations is a theory that businesses and consumers will be able to accurately forecast prices (and other relevant economic variables). If the accuracy of consumers and businesses' expectations permit them to behave as though they know what will happen, then it is argued that only a vertical Phillips Curve is possible, as long as political and economic institutions remain stable.

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Market Policies Market policies are focused on measures that will correct specific observed economic woes. These market policies have been focused on mitigating poverty, mitigating unemployment, and cooling-off inflation. For the most part, these market policies have met with only limited success when implemented. One class of market policies have been focused on reducing poverty in the United States. These equity policies are designed to assure "a social safety net" at the minimum, and at the liberal extreme, to redistribute income. In part, the distribution of income is measured by the Lorenz Curve, and more completely by the Gini coefficient. The following diagram presents the Lorenz Curve:

The Lorenz curve maps the distribution of income across the population. The 45 degree line shows what the distribution of income would be if income was uniformly distributed across the population. However, the Lorenz curve drops down below the 45 degree line showing that poorer people receive less than rich people. The further the Lorenz Curve is bowed toward the percentage of income axis the lower the income in the poorer percentiles of the population. The Gini coefficient is the percentage of the triangle (mapped out by the 45 degree line, the indicator line from the top of the 45 degree line to the percentage of income axis, and the percentage of income axis) that is accounted for by the area between the Lorenz curve and the 45 degree line. If the Gini coefficient is near zero, income is close to uniformly distributed (and the 45 degree line); if is near 1 then income is distributed in favor of the richest percentiles of the population (and the Lorenz curve is close to the horizontal axis). If that distribution is consistent with the productivity or meritorious performance of the population, there may be an efficiency argument that can be used to justify the distribution. However, if the high income skewness of the 143

distribution is not related to productivity, then the skewed distribution is inefficient and unfair, hence mal-distributed. In the United States the Gini coefficient exceeds .5, and while incomes in the lower three-quarters of the upper quintile are highly correlated with education (and presumably productivity) the overwhelming amount of the highest part of the distribution does not have any prima facie evidence to prove the justice or efficiency of such high incomes. Recently, (December 8, 1995) CNN reported that Chief Executive Officer salaries in the entertainment industries appeared to be out of line with similar officials in more productive industries, and that stock holders in several of these companies were beginning to revolt over these high levels of compensation. In particular, Viacom and Disney were experiencing stock holder queries concerning executive salaries. In general, most economists familiar with the income distribution in the United States, would probably agree that income in this country is mal-distributed, because it does not reflect the market contributions of those at either the highest end, or in the lower end of the distributions. Productivity has also the subject of specific policies. The Investment Tax Credit, WIN program, and various state and federal training programs have been focused on increasing productivity. For the most part, there has been very little evidence concerning most of these programs that give reason for optimism. The one exception was the work of Mike Seeborg and others that found substantial evidence that Job Corps provided skills that helped low income, minority teenagers find and keep reasonably well-paying jobs. Many of the recent treaties concerning international trade have aspects that can be classified as market policies. To the extent that trade barriers to American exports have been reduced through NAFTA and GATT it was hoped that there may have been positive effects from these treaties. In fact, little if any, positive effects have been observed from these initiatives. There have been recurrent attempts have to directly control inflation through price controls. These controls worked well during World War II, mainly because of appeals to patriotism during a war in which the United States was attacked by a foreign power. Further, during World War II the idea of sacrifice was reinforced by many families having relatives serving in the military, which made the idea of sacrifice more acceptable to most people. However, absent the popular support for these policies created by World War II for rationing and wage and price controls, these policies have been uniformly failures. President Carter tried voluntary guidelines that failed, and Richard Nixon had earlier tried short-lived wage and price controls that simply were a policy disaster.

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Debt and Deficit The national debt is often argued to have an adverse effect on interest rates, which, in turn, crowds out private investment. The empirical evidence concerning this crowding out hypothesis suggests that increased public debt often results in higher interests rates, assuming that the debt was not acquired to mitigate recession. The supply side economics of the Reagan Administration were based on the theory that stimulating the economy would prevent deficits as government spending for the military was substantially increased. This failed theory was based on something called the Laffer Curve. The Laffer Curve (named for Arthur Laffer) is a relation between tax rates and tax receipts. Laffer's idea was rather simple and straightforward, he posited that there was optimal tax rate, above which and below which tax receipts fell. If the government was below the optimal tax rate, an increase in the rate would increase receipts and in the rate was above the optimal rate, receipts could be increased by lowering tax rates. The Laffer Curve is shown below:

The Laffer Curve shows that the same tax receipts will be collected at the rates labeled both "too high" and "too low." What the supply-siders thought was that tax rates were too high and that a reduction in tax rates would permit them to slide down and to the right on the Laffer Curve and collect more tax revenue. In other words, they thought the tax rate was above the optimal. Therefore Reagan proposed and obtained from Congress a big tax rate reduction and found, unfortunately, that we were below the optimal and tax revenues fell. While tax revenue fell significantly, the Reagan Administration increased the defense budget by tens of billions of dollars per year. The reduction in revenues, combined with substantial increases in government spending made for record-breaking federal budget deficits and substantial additions to our national debt. 145

There were other tenets of the supply-side view of the world. These economists thought there was too much government regulation. They would have de-regulated most aspects of economic life in the United States. However, after Jimmy Carter deregulated the trucking and airlines industries, there was considerable rhetoric and little action concerning the de-regulation other aspects of American economic life.

Politics and Economic Policy Unfortunately, the realities of American economic policy is that politics is often main motivation for policy. Whatever anyone may think of Reagan's Presidency there is simply no doubt that he was probably the most astute observer of the political arena of any of his competitors. Reagan argued that taxes were too high and needed to be cut. This is probably the single most popular political theme any candidate can adopt. Remember McGovern? He said if he were elected President he would raise taxes, he did not have to worry about how, because he won only two states. The surest way to lose a bid for public office is to promise to raise taxes. As it turned-out McGovern was right, there should have been a tax increase, at the time Reagan cut them. Being right, does not have anything to do with being popular. What we now face is a direct result of the unprecedented deficits run during the Reagan years. In fact, during those eight years this country acquired nearly $1.7 trillion of its national debt. No other President in U.S. history has generated this amount of debt in nominal dollars. However, before Reagan is judged too harshly, it must remembered that we were in the midst of a major recession during his first term in office, and the cold war was still at its zenith. Again, in Mr. Reagan's defense the first three years of his administration also witnessed exceedingly high rates of inflation, that are reflected in the nominal value of the deficits. The following table shows the national debt for the period 1980 through 1988, notice, if you will, how the national debt accelerated during the Reagan administration, remember that the first three years were deepening recession.

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______________________________________________________________________ ____________________________________________________________________ Table I: National Debt 1980 - 2005 _____________________________________________________________________ YEAR 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 NATIONAL DEBT (billions of U.S. dollars) 908.3 994.3 1136.8 1371.2 1564.1 1817.0 2120.1 2345.6 2600.6 2868.0 3206.6 3598.5 4002.1 4351.4 4643.7 4921.0 5181.9 5369.7 5478.7 5606.1 5629.0 5803.1 6228.2 6783.2 7379.1 7932.7

_____________________________________________________________________ Nearly $1692.3 of additional debt was accumulated during the years that President Reagan was in office. The first nine months of this period was under Carter's budget, but the first nine months of 1989 was under Reagan's and this data makes Reagan's record look better than it really was. At a six percent interest rate, the current yield on the 30 year Treasury Bond (as of December 8, 1995) the debt accumulated during these eight years adds $101.5 billion to the federal budget in interest payments. 147

There is a lesson here, that has nothing to do with political propensities, tax cuts that do not generate continuing economic growth, will add to the national debt, and the interest payments on that debt will add to even further budget deficits. It cannot be denied that Reagan was one of the most popular Presidents of this century. The very things that made him popular, tax cuts, and military build ups are responsible for much of our current controversy concerning the balanced budget.

Is the Debt Really a Problem? The most valid criticism of the debt is its potential for disrupting credit markets, by artificially raising interest rates and crowding out private investment. Naturally, a debt as large as ours will have an upward influence on interest rates, but the evidence does not suggest that it is substantial. Today, we find ourselves in roughly the same position this country was in 1805. President Jefferson borrowed about the same amount as our GDP from England and Holland to buy Louisiana from the French (we owe an amount almost the same as GDP). History has taught us that even when we added the debt acquired in the War of 1812, it did not bankrupt the government or its citizens. By the end of World War II, we again had a national debt of $271 billion and a GDP of $211.6 billion. The predictions that my generation would be paying 60 and 70 percent effective tax rates to pay off the debt never materialized. Frankly, I wish my debt was only equal to my annual income, and I suspect most people in their thirties and forties have the same wish. Surely the size of debt and current deficits are not a source of any grief. If it is then little is learned from history and little is known about economics. The serious question is why did we acquire the debt and what must we give up if we are to pay it off. When Reagan took office, we were in the midst of a cold war. The increases in government expenditures for the military, caused our chief rivals to spend larger proportions of their GNP on the military and eventually caused the economic and political collapse of the Soviet bloc. Was the end of the Cold War worth the debt we acquired? Are the benefits of education worth a few million dollars in current debt? Is providing for the poor, the elderly, and children worth a few billion in debt? Are veterans' pensions for those who stood between us and our enemies worth a few billion in debt? What about the Interstate Highway System, subsidies for the company where you work, research for medical reasons, the pure sciences, the social sciences, and the tens of thousands of things on which the government spends our tax dollars? These are the priorities that any society must set. Probably the only realistic answer to whether the debt is a problem is what we do about it and what priorities we set. History will judge this society, whether we are judged as compassionate, or barbarians, or economically astute or fools is for future generations of historians. Let us all hope that we choose correctly. 148

Hedayeh Samavati, David A. Dilts, and Clarence R. Deitsch, "The Phillips Curve: Evidence of a 'Lady or Tiger Dilemma,'" The Quarterly Review of Economics and Finance. Vol. 34, No. 4 (Winter 1994) pp. 333-345. During the period examined, January 1974 to April 1990, the evidence reported (here) suggests that there is a unidirectional causal relation from the inflation rate to the rate of unemployment. If, the Phillips Curve were vertical over this sixteen year period, one should have observed no causality between the unemployment rate and the rate of inflation (the natural rate hypothesis, i.e., any rate of inflation can be associated with the natural rate of unemployment). The empirical findings reported here, however, suggest a non-vertical Phillips Curve. Finally, the results reported here suggest the proper specification of the empirical models used to test the Phillips Curve relation. Friedman argued that the proper specification of the regression equations used to estimate the Phillips Curve relation is of significance (both theoretically and empirically). "The truth of 1926 and the error of 1958" (as Friedman argued) is supported by the evidence presented in this paper. The statistical evidence presented here supports Friedman's claim that inflation is properly specified as the independent variable in "Phillips Curve" analyses. That is, rather that the specification proposed by A. W. Phillips (1958), the proper specification is that proposed by Irving Fisher (1926) as asserted by Friedman. This finding is of significance to those researchers using ordinary least squares to examine relations between inflation and unemployment. Irving Fisher's specification is consistent with Friedman's well known theoretical arguments concerning posited relations between inflation and unemployment, hence, his taste for inflation as the independent variable.

Maybe this box does not represent the final word in the Phillips curve controversy, but this research suggests that there is a short-run view of the Phillips curve and that the idea of rational expectations may not be as good as it looks at first blush. This study employed the Granger causality methods to inflation and unemployment data in the United States for the period identified to see if there was causality -- the evidence suggests that inflation causes unemployment.

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KEY CONCEPTS Misery Index Inflation Unemployment Phillips Curve Short-run Trade-off Long-term, natural rate hypothesis Positively sloped Rational Expectations Market Policies Lorenz Curve Gini Coefficient Investment Tax Credits NAFTA & GATT Wage-Price Policies Laffer Curve Supply Side Economics Budget Deficit National Debt

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STUDY GUIDE Food for Thought: Compare and contrast the various views of the Phillips Curve. Map out each and demonstrate how there may be a cruel choice in economic policy.

Develop the Laffer Curve. What does it tell us? How then can we have witnessed the large increases in the deficit during the years this model held center stage? Critically evaluate.

What are market policies? Explain the major market policies observed in the U.S. economy today. Compare and contrast these.

Sample Questions: Multiple Choice: In the short-run view of the Phillips curve policy-makers are left with a cruel choice. What is this cruel choice? A. B. C. D. Inflation will exist regardless of the level of unemployment Unemployment will exist regardless of the level of inflation Policies that improve unemployment will create inflation and vice versa Inflation appears not to have a causal relation with unemployment, hence a downward sloping Phillips curve is not plausible.

Stagflation is: A. B. C. D. general decreases in the price level excess employment which causes inflation both high rates of unemployment and inflation both very low rates of unemployment and inflation

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True - False: The Laffer curve suggests that the higher the tax rate the lower will be tax revenues. {FALSE} Supply side economics was the view of the Reagan administration which believed Say's Law. {FALSE}

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Chapter 13

Data: Categories, Sources, Problems and Costs

Business conditions analysis requires that the analyst have a solid understanding of the theoretical underpinnings of macroeconomics. However, theory is simply not enough. One must have data to monitor or analyze what is occurring in the economy. Data imply empirical economics, and a mastery of a tool-kit of empirical methods to analyze the economy and perhaps make forecasts from those empirical methods. The purpose of this chapter is present the types of data, their sources, and the practical problems in the gathering, storing, and use of data. A following chapter, Chapter 15 will introduce you to some preliminary types of data analysis to be used to become familiar with and understand the data set with which you are working.

Data Types Data may be categorized in several different ways, but all classification tend to be by the nature of the underlying processes that generate that data. Economic data are generally of two basic categories. There is time series data, and cross sectional data. Time series data are metrics for a specific variable observed over time. Crosssectional data, on the other hand, are data for a specific time period, for a specific variable, but across subjects. For example, unemployment rates are measured over time. The U.S. annual average unemployment rate is calculated for months, quarters, and years such data is time series data. On the other hand, for each month, quarter and year, the Bureau of Labor Statistics publishes unemployment rates for each State in the U.S. Unemployment rate data for a specific month, quarter or year is called crosssectional data. Economists sometimes find that cross-sectional data over time provides for insights not available by looking at only time-series or just cross-sectional data. The combination of cross-sectional data over time is called panel-data. The empirical examination of each type of data has its own peculiarities and statistical pitfalls. These will be examined in greater detail, in a latter chapter. There is discrete data, and continuous data. Discrete data are metrics that have specific and finite number of potential values. Continuous data, on the other hand, are metrics, which can take on any value either from plus infinity to negative infinity, or within specific limits. Discrete data generally require more sophisticated statistical models than just simple ordinary least squares. Continuous variables are things such 153

as Federal budgets, GDP, and work force. Discrete variable include things like Likert scales in survey research. Data can also be classified as to stocks and flows. A stock variable is generally a variable in which there is a specific value at some point. A flow variable is generally something that has some beginning, ending or changing value over time. Inventory data is a useful example to illustrate the difference between stocks and flows. At any point in time a retail establishment will have a certain dollar value of goods on hand and for sale. Such a metric is a stock variable. On the other hand, the amount of turn-over of that inventory each week or month is a flow variable. Data is sometimes generated by surveys, rather than the measurement of some state of nature. Survey data is generally reported by an individual who may or may not have some motivation to accurately report the data requested in the survey. Therefore, when surveys are used to gather data, two specific issues arise with respect to the data. These two issues are validity and reliability. Validity has two broad dimensions. The response rate from the sample of a population will define how representative that sample is of the population. The sample must be large enough to have confidence that inference can be drawn from the sample about the population. The second issue involves whether the items on the survey actually capture what the researcher intends. Validity in this respect means that care must be exercised to assure that the items on the survey are constructed so as to eliminate ambiguities. Field testing and editing of the instruments make survey research often time consuming and difficult.1 This second issue with validity also has three distinct dimensions these are: (1) content validity, (2) criterion-related validity and (3) construct validity. Content validity concerns whether the measures used actually are capturing the concepts that are the target of the research. Face validity is often what is relied on concerning content that is on the face of it, it appears that the measures are adequate. Otherwise, one must have a theoretical basis for the measures. Criterion-related validity involves whether the measures differentiate in a manner that predicts values in the dependent or criterion variable. Finally, construct validity involves whether or not the empirical measures are consistent with the hypothesis or theory being tested. Each of these validity issues are described in greater detail in Sekarans book.2 Reliability has to do with assuring the accuracy of responses. Opinion surveys and self-reporting is often very risky with respect to inference. A well-constructed survey will ask the same thing is more than one way so that correlations can be
1

Uma Sekaran, Research Methods for Business: A Skill Building Approach, second edition. New York: John Wiley and Sons, 1992 presents a detailed discussion of the nuts and bolts of survey and interview methods for business analyses.
2

Ibid. 154

calculated to at least assure consistency in a respondents answers. Reliability of survey results is often very problematic, but does not render these methods necessarily unreliable. It just means thought must be given in ways to check the accuracy and consistency of the data gathered. States of nature data, involve things like market prices, number of persons, tons of coal and other such metrics that can be physically observed or measured. Often these data are estimated from surveys, i.e., Consumer Price Index, so that there are situations where there are combinations of methods in gathering data. Interviews and observational methods are also often utilized to gather what is sometimes referred to as primary data. These data also have particular difficulties concerning the metrics used and the validity and reliability of the data gathered using these methods. There are seasonally adjusted and not seasonally adjusted data. Seasonal adjustment methods vary by the type of data examined. The Consumer Price Index comes both seasonally adjusted, and without seasonal adjustment. There are almost always published technical reports that discuss the methods used to adjust for seasonal variations in the data. Conceptually, there are a number of economic time series data, which have specific, predictable biases created by the time of year. Unemployment predictably increases every summer because students and teachers enter the work force during the summer months, and then exit again at the end of summer or beginning of fall when school resumes. The Christmas season always results in a jump up in retail sales that will decline when the return rush is over in January. In these cases seasonal adjustments permit long term trends to be identified that may be hidden in the shortterm variations. Data Sources Data sources are also diverse. There are public data sources and private data sources. Public data sources are governments, and international organizations. Private data sources include both proprietary and non-proprietary sources. Each of these will be briefly examined in the following paragraphs. Public data sources for the United States includes both Federal and State agencies. Economic data is gathered, compiled and published by virtually every Federal Agency. State and local agencies also gather data, much of which is reported to a Federal agency, which compiles and publishes the data. For example, crime statistics are available annually from the Federal Bureau of Investigation for both Federal and State crimes. The Justice Department directly gathers statistics on Federal crimes, but has to rely on State reporting to compile statistics concerning crimes in 155

states, such as car-theft, murder, and battery. The same relationship holds for several other types of data. Unemployment is compiled in two distinct ways. There is an establishment survey conducted by the Commerce Departments, Current Population Surveys, which is then compiled and given over to the Bureau of Labor Statistics. There is also another series, called covered unemployment, which is reported by the States through their Employment Security Divisions, and those numbers are also compiled and reported by the Commerce and Labor Departments. The Commerce Department gathers industry data, foreign trade data, and a wealth of statistics concerning the National Income Accounts. Most developed countries follow the lead of the United States in closely monitoring data concerning various demographic, economic, infrastructure and health statistics. However, there are also several international organizations, which are involved in these sorts of activities. Perhaps one of the easiest to use sources of international statistics comes from the U.S. Central Intelligence Agency. The CIA routinely publishes something called the World Fact Book, which is available online at www.cia.gov and contains a wealth of economic, political, demographic, and health care statistics for the majority of the worlds countries. The Board of Governors of the Federal Reserve System and several of the Federal Reserve Banks publish statistical series on various monetary aggregates. Most of these data are available in historical time series. The World Bank and International Monetary Fund monitor various nations trade, inflation, and indebtedness data. The World Bank routinely publishes the World Debt Tables, which reports various aspects of the debt markets for LDCs debts, both private and sovereign. The United Nations, through the auspices of their dozens of international agencies also gathers and publishes data concerning various aspects of the demographics and economics of the worlds nations. These public sources of information publish current statistics, and most have available historical time series data. Most of the data gathered by the U.S. Government is available online at sources such as www.bls.gov and www.federalreserve.gov. These data also generally have accompanying handbooks or articles, which describe how the data are gathered, de-seasonalized, or otherwise technically handled. There are also private sources of information, both proprietary and nonproprietary. Stock, bond, and commodity prices are generally proprietary information available for a fee from a brokerage or investment bank. However, there are sources of much of this information, which have little or no cost. The S&P 500 stock price data is available on www.Standard&Poors.com however, if you need historical data that comes for a price. There are non-profit organizations that publish data. The National Bureau of Economic Research and other such organizations keep tabs on various aspects of the 156

business cycle and National Income Accounts and have data available. There are also several professional organizations and industry organizations that have data sources. Perhaps one of the more interesting of these is the ACCRA Price Index which is a cross-sectional price index published quarterly, to wish a person may subscribe for a small fee. The market basket assumes a mid-management household and surveys many smaller cities, Fort Wayne is included in the survey and has been pretty stable at about 88% of the national average cost of living www.aacra.org.

Problems and Costs How we know something is a matter of individual perception. That perception is shaped by the data we have and the observations we have made. These perceptions will also be colored by a persons values and their training. As a result people untrained in the scientific method will often attach significance to evidence they believe supports their position, it is a form of bias, and is often associated with anecdotal evidence. As it turns out, anecdotal evidence is sometimes very misleading. The natural tendency is to rely on a single isolated observation and use inductive logic to form conclusions. What, however, is required scientifically is the systematic gathering of a large number of observations, and the use of deductive logic to test theories concerning why that data is the way that it is. This however, is expensive in time and resources. Information is almost never free. It is the cost of information that often becomes a limiting factor in making business decisions, based on such things as business conditions analysis. Over the past several years there have been numerous studies concerning the problems with the use of information for making managerial decisions, even including strategic management. Kathleen M. Sutcliff and Klaus Weber, published an article in the Harvard Business Review in May of 2003, which takes a very practical and managerial approach to the problems associated with High Cost of Accurate Knowledge. Sutcliff and Weber argue that the accuracy of data is an expensive proposition and that too often managers have neither the expertise nor the time to fully analyze what imperfect information they can gather. What Sutcliff and Weber contend is that intuition is perhaps a better modus operandi, what they call a humble optimism but based on what knowledge can be gleaned without becoming a victim of the old clich paralysis by analysis. The effects of accuracy are summarized in the following charts:

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Magnitude of Change

Perceptual Accur
Performance

Perceptual accuracy

Sutcliff and Weber studies suggest that organizational change has an inverted U shaped relation to perceptual accuracy. In other words, over the initial ranges there are increases in the return to perceptual accuracy for positive organizational change up to some optimal point. Beyond that optimal, additional accuracy actually results in negative returns. On the other hand, organization performance is negatively correlated with perceptual accuracy. The more resources (time, etc.) are devoted to perceptual accuracy of analysis or the underlying data the more likely performance will decline. 158

These authors account for this relation perceptual accuracy to both organizational change and performance with several different factors. Chief among these factors are the individual characteristics of the executives, growth trends in the industry, complexity, controllability of the business fortunes, positiveness in the culture, and the companies contingent strategies. The more capable a manager, the more familiar with the business, and more experienced with the specific issues, which arise the more likely that manager, is to make the right call. The more optimistic the organizational culture, the more likely it is that there will be a get it done ethic, which guides the organization. The ability to control the business success regardless of environment makes data and its analysis less critical to the business, whereas the more complex the business relation to its environment the more critical data and its analysis becomes to the success of the company. There is also an old clich, which is operable here. A higher tide, floats all boats, is true in this case. If the business is in a market in which there is rapid growth, then data becomes less important to the extent that everyone is prospering. The dot com firms in the 1990s, mini-steel mills in the last two decades, and numerous other examples exist that suggest some validity to this view. There will be more concerning these issues in the final chapter of this book. Suffice it to say that there are significant internal costs of the management of data and its uses. There are other writers who point to other problems with data and its analysis. In many enterprises there are external requirements that force a firm to invest heavily in the gathering and analysis of data. Among the causes of this behavior is the fact that there are substantial government regulations involving health and safety that require data gathering and analysis. The automobile industry is required to engage in quality control measures, and document those measures with data for safety critical parts. Pharmaceutical companies have very stringent regulations from FDA concerning not other the safety of their products, but there must also be evidence of their efficacy before those products can go to market. While these data issues are not necessarily business conditions in a macroeconomic sense, they are part of the regulatory environment, which face businesses and are of critical importance to the success of the enterprise. Further, just like market analysis, the development of this information and its analysis must be part of the firms strategic planning functions. Again, issues to be addressed later in this course. Professor James Brian Quinn has observed that the move into high-tech business (science based) has forced many firms to examine their strategies and how they deal with information. In fact, Dr. Quinn believes that these science based industries have been forced into a situation where knowledge sharing is of critical importance to the success of industries and firms within those industries. The following quotation states his point: 159

James Brian Quinn Strategy, Science and Management Sloane Management Review, Summer 2002 No enterprise can out-innovate all potential competitors, suppliers and external knowledge sources. Knowledge frontiers are moving too fast. In almost every major discipline, up to 90% of relevant knowledge has appeared in the last 15 years. . . . To exploit such interactions, leading companies develop flexible core-knowledge platforms and, equally important, the entrepreneurial skills to seize opportunity waves. They systematically disseminate and trade knowledge and, if necessary, share proprietary information, recognizing that larger, unexpected innovations may arise to increase their own innovations value by orders of magnitude. They know its impossible to foresee all combinations and profit opportunities. As was drive surfers, external forces often drive companies success. Managers must read the waves expertly. But that means adopting a humility unfamiliar to traditional titans of industry. Accomplishments depend on ensembles of others work and unfold in way managers cant anticipate. Because leaders cant predict which combinations will succeed, they cant drive their organizations toward predetermined positions.

Conclusions Clearly the gathering and analysis of data has implications for both the success, and the cost structure of the firm. However, it is also clear that much of the problem associated with data, its acquisition and its use is also a function of the culture and behavior within the organization. It is sort of amazing how humility seems to be a recurrent theme in this literature. In many organizations the control of information is a source of power within that business, and that is almost universally destructive to the enterprise. Finally, economists have long recognized that there is cost associated with information. In the analysis of the macroeconomy it is worthy to note, that information, through both rational and adaptive expectations played very important roles in the results obtained from the economic models presented. The matter of expectations also played significant roles in policy decisions fiscal lags, inflationary expectations, and aggregate demand are shaped heavily by what information people have and what they do with it.

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KEY CONCEPTS Data Categories Time Series Cross-section Panel Data Stocks and Flows Discrete and Continuous Surveys and states of nature Validity and reliability Seasonally adjusted versus not seasonally adjusted Sources of Data Public Government Relations between levels of government International Organizations Private Non-Proprietary and proprietary Costs of data acquisition and analysis Determinants of performance Organizational cultural Performance-Organizational Change Humility versus Power and the role of information

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STUDY GUIDE Food for Thought: Why has information traditionally been power? Why has this concept being replaced with the idea that humility should reign with respect to information and its uses? Explain.

Critically evaluate the idea that there is some optimal level of information for an organization or a manager to utilize.

Compare and contrast the various types of data, their uses, and their short-comings for management of an enterprise.

Have advances in science resulted in the need for information in business enterprises? Explain.

What would you use a seasonally adjusted series of data for, over data that has not been seasonally adjusted? Explain.

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Sample Questions Multiple Choice: Data that is concerned with the levels of a particular variable at a specific time is: A. B. C. D. Flow Stock Discrete Continuous

Perceptual accuracy is related to performance of a firm, according Sutcliff and Weber: A. B. C. D. Negatively Positively Positively to a point then negatively Not at all

True / False: Panel data is a mixture of discrete and continuous date. {False} Survey data has problems not associated with data, which are measurements of states of nature, and require greater attention be paid to reliability and validity. {True}

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Chapter 14

Economic Indicators
Perhaps the easiest method of analysis of macroeconomic trends and cycles is with the use of rather simple devices called economic indicators. Leading Economic Indicators are often focused on by the press, particularly the financial press (i.e., CNBC and the Wall Street Journal). By examining specific data, without the use of complicated statistical methods one can often obtain a sense of where the macroeconomy is headed, is currently, and has been. The purpose of this chapter is to present the economic indicators, and describe their usefulness and limitations. Why these indicators are being given such attention is not just their popularity in the press, they are also theoretically connected to the business cycle and are useful, quick and dirty methods of forecasting where we are in the business cycle.

Cyclical Indicators: Background The Arthur F. Burns and Wesley C. Mitchell at the Bureau of Economic Research began to examine economic time series data in the 1930s to determine if there were data which were useful in predicting business cycles.3 What this research produced was the classification of approximately 300 statistical series by their response to the business cycle. These data are classified as leading indicators, concurrent indicators, and trailing indicators. The selection of variables to be included in the indices are done on the basis of criteria, discussed below. The index for leading indicators is designed to provide a forecasting tool, which permits calls to be made in advance of turning points in the business cycle. The index of concurrent indicators is a confirmatory tool, and the trailing indicator index suggests which each phase of the business cycle has been completed. There is nothing complicated about the application of these indices, as opposed to big multiple regression models. However, the simplicity is at the expense of model the underlying processes, which produce the time series data, used to construct these indicator indices. These indicators are described in Bureau of Economic Analysis Handbook of Cyclical Indicators.4 These indicators were selected using six criteria. These criteria are described in John J. McAuleys Economic Forecasting for Business: Concepts and Applications, to wit: W. C. Mitchell and A. F. Burns, Statistical Indicators of Cyclical Revivals, New York: NBER Bulletin 69, 1938.
4 3

Handbook of Cyclcial Indicators. Washington, D.C.: Government Printing Office, 1977. 164

John McAuley, Economic Forecasting for Business: Concepts and Applications Cyclical indicators are classified on the basis of six criteria: (1) the economic significance of the indicator; (2) the statistical adequacy of the data; (3) the timing of the series whether it leads, coincides with, or lags turning points in overall economic activity; (4) conformity of the series to overall business cycles; a series conforms positively if it rises in expansions and declines in downturns; it conforms inversely if it declines in expansions and rises in downturns: a high conformity score indicates the series consistently followed the same pattern; (5) the smoothness of the series movement over time; and (6) timeliness of the frequency of release monthly or quarterly and the lag in release following the activity measured.

In other words, not only is there a basis in economic theory for these indicator variables, these indicator variables appear to be statistically well-behaved over time. As a result the indicators are considered, in general, to be useful, simple guides to the variations in the business cycle in the U.S. Leading Indicators There are twelve variables that are included in the index of leading economic indicators. Leading indicators are those variables, which precede changes in the business cycle. In a statistical sense, these variables are those, which rather consistently and accurately lead turning points in the business cycle, as measured by other series i.e., lagging indicators, and coincident indicators, which will be presented below, as well as the national income accounting data, and employment data, which are used to define the business cycle. Table 1 presents these variables and the weights of the series within the index of leading indicators.

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___________________________________________________________ Table 1: Leading Economic Indicator Index Variable Weight in Index 1. Average workweek of production workers, manufacturing 2. Average weekly initial claims, State Unemployment Insurance (Inverted) 3. Vendor performance (% change, first difference) 4. Change in credit outstanding 5. Percent change in sensitive prices, smoothed 6. Contracts and orders, plant and equipment (in dollars) 7. Index of net business formation 8. Index of stock price (S&P 500) 9. M-2 Money Supply 10. New Orders, consumer goods and materials (in dollars) 11. Building permits, private housing 12. Change in inventories on hand and on order (in dollars, smoothed) 1.014 1.041 1.081 .959 .892 .946 .973 1.149 .932 .973 1.054 .985

Source: Business Conditions Digest, 1983 ______________________________________________________________________ From the discussions of macroeconomic activity in the first eleven chapters of this text, there should be hints as to why this selection of twelve variables form the leading indicator index. Rather straightforward reasoning concerning the first two variables leads directly to household income in base industries, which drive the remainder of the economy. As the workweek increases so too does consumer income, and the inverse of initial unemployment claims also suggests something about the prospects for consumer income. The base industries, manufacturing and other goods producing activities are the pro-cyclical industries, which support the service sector. As these industries become more capable of sustaining household incomes, this bodes will for industries downstream. The same reasoning extends to credit outstanding. As consumers anticipate their incomes declining, they typically extend themselves less with respect to taking on new debt obligations, and attempt to repay the debts they currently have. Prices of sensitive items include those things, which are cyclical sensitive. Consumer durables and other large purchases which are interest rate sensitive are typically postponed when recession is anticipated, exerting downward pressure on the prices of those commodities. To the extent that producers expectations account for these perceived changes in household income, then we would expect producers to react prior to upturns and downturns in economic activity. These producer reactions will be reflected in the 166

Vendor Performance, plant and equipment, business formation, building permits, and inventory series. If producers react, we would also expect retailers and wholesalers to react, hence orders for consumer goods and materials. This leaves two components of the leading index, which have not yet been discussed, these are stock prices, and the M-2 money supply. The M-2 money supply is a function of the monetary policies of the Fed. As the Fed wishes to induce economic recovery with monetary policy, it is typically observed that the Fed moves to an easy monetary policy from a neutrality or if the Fed erred, a tight monetary policy. Hence the M-2 money supply increases prior to an upturn in economic activity. The opposite is typically observed in times of recession. As the Fed wishes to eliminate the risk of inflation from an overheated economy, the Fed will retreat from an easy money policy towards neutrality or even a tight monetary policy, which typically precedes a recession. In other words, the money supply changes observed conform with the coming business cycle and precedes the inflection point. Stock prices are perhaps the most interesting of the leading indicators. Going back to the finance literature, there is an interesting hypothesis. Eugene Fama and others working on rational expectations in securities markets proposed that the financial market price-in all available information, and therefore everything one needs to know about prices are already in price of stocks and bonds. This is called the efficient market hypothesis. In other words, a bear market signals that there is a recession about to occur, and a bull market signals that economic expansion is on the way. In fact, the empirical evidence suggest that the financial markets are very good predictors of coming business cycles and that the S&P 500 index is the best of those predictors. Why, one may ask, is the stock market such a good predictor of future fortunes in the U.S. economy. It is a simple matter of the fundamentals underpinning investments. Investors put their money where they believe the best returns are. When earnings begin to increase, inventories start to decline, and revenues start to grow, this is the time to buy the stock. If you wait until the analysts start recommending the stock, and the prices go through the roof, you are late to the party and have pretty much nothing but downside risk, and little upside potential. Hence, it is clear the stock market should be an excellent predictor of future economic fortunes.

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Coincident Indicators These indicators are the ones, which happen as we are in a particular phase of the business cycle, in other words, they happen concurrently with the business cycle. Statistically their variations follow the leading indicators and occur prior to the lagging indicators. There are four variables, which comprise the Index of Coincident Indicators, and they are presented in Table 2 below: ______________________________________________________________________ Table 2: Index of Coincident Indicators Variable 1. 2. 3. 4. Employees on nonagricultural payrolls Index of industrial production, total Personal Income, less transfer payments Manufacturing and trade sales Weight 1.064 1.028 1.003 .905

Source: Business Conditions Digest, 1983. ____________________________________________________________________ The coincident indicator variables are those, which happen at the particular points in the business cycle. That is, this variables tend to confirm what is going on presently. At the top of recovery cycle we should observe that each of these variables have reached their highpoint during the cycle, and their low point is generally observed during the trough of a recession. As these variables are increasing, then we should be in recovery, and as they are declining we should be moving toward recession. Employees on nonagricultural payrolls and the Index of Industrial Production are stock variables. Whereas Personal income and Manufacturing and trade sales are flow variables. The stocks of output should be growing during recovery, as should personal income (all industries) and sales. The exact opposite is true during recessions. Therefore, these variables are simply confirming what phase of the business cycle the economy is experiencing currently. Lagging Indicators Lagging indicators are those, which trail the phase in the business cycle that the economy just experienced. Again, confirming what the leading indicators predicted, and what the coincident indicators also confirmed as it occurred. There are six variables that comprise the Index of Lagging Indicators. The movements of these variables trail what actually transpired in the phases of the business cycle. 168

These six variables are presented in Table 3: ______________________________________________________________________ Table 3: Lagging Indicators Variables 1. 2. 3. 4. 5. 6. Average duration of unemployment Labor cost per unit of output, manufacturing Ratio constant dollar inventories to sales, and manufacturing and sales Commercial and industrial loans outstanding Average prime rate charged by banks Ratio, consumer installment debt to personal income Weights 1.098 .868 .894 1.009 1.123 1.009

Source: Business Conditions Digest, 1983. ____________________________________________________________________ The Index of Lagging Indicators follows what has already transpired in the business cycle. The average duration of unemployment trails the recession in an economy. For the stock variable, duration of unemployment, to increase means that there are a lot of people out of work, who have been out of work for a considerable period of time. Hence, this variables tends to continue to increase once the recovery is in its early stages. Labor costs in manufacturing also tend to increase after the recession has ended, because producers are hesitant to hire additional labor, and are willing to work overtime at premium pay, to avoid hiring which may yet turn out to be temporary. The average prime rate reflects the banks risk premium not yet being mitigated as a result of experience with a recovery. Hence the prime rate is sticky downward, much the same as employment is sticky upward in the beginnings of a recovery. Commercial and industrial loans tend to increase during periods in which liquidity is a problem for enterprise. These loans tend to reach their peak shortly after a recession has ended and recovery has begun. The consumer installment debt to income ratio, also tends to reflect a recent history of a lack of income, which has, in part, been supplemented by credit at the worst of a recession for some households. The time necessary to work down an inventory excess generally extends past the end of a recession for goods producing entities. Manufacturing companies will often accumulate inventories, which cannot be brought down during a recession, and must be carried forward until the recovery becomes strong enough that customers are willing and able to buy down those inventory levels. Hence, inventories for the base industries tend to persist into the recovery phase of the business cycle. Other Indicators 169

There are other indicators, which are constructed and published concerning various aspects of the business cycle. The University of Michigan publishes a Consumer Confidence index. The University of Michigan has developed a survey instrument and surveys consumers concerning what they expect in their economic future. The Conference Board also does something similar for producers. Real Estate firms have a lobby and research group that does surveys of new home construction, and sales of existing housing which plays on essentially the same sort of economic activities captured by Building permits, private housing variable found in the Index of Leading Indicators. The Federal Reserve is not to be outdone in this forecasting business. The Philadelphia Federal Reserve Bank does an extensive survey of business conditions and plans in the Philadelphia Federal Reserve District and publishes their results monthly. This report is commonly referred to as The Beige Book and it eagerly anticipated as providing insights into what to expect in the near future in the eastern part of the United States. There are also numerous proprietary forecasts and indices constructed for every purpose imaginable. Stock price data have been subjected to nearly every torture imaginable in an attempt to gain some sort of trading advantage. Bollinger Bands, Dow Theory, and even Sun Spots have been used in an attempt to forecast what will happen in the immediate short run with financial markets. As one might guess virtually all of these schemes are proprietary. The normal warning applies, if it sounds too good to be true, it generally is little more than fun and games with little substance. Care should be exercised in taking advantage of these sorts of things. Frankly with financial markets there is no substitute for ones own due diligence, however, there are a couple of good sources of information. If one is interested in the cumulative wisdom of stock analysts, then Zacks (www.Zacks.com) is a good reporting service, which provides not only average analyst ratings, but their own recommendations based on sound fundamentals. Standard and Poors provides a rating system based on up to five stars for the best performing stocks, again based on sound fundamentals. For mutual funds, Morningstar provides both proprietary (a premium service) and non-proprietary ratings of mutual funds and considerable information concerning the management charges and loads on respective funds www.morningstar.com. Conclusions It is interesting to note that these indices have been constructed and are rough guides to what is occurring in the business cycle. However, it is also not encouraging to know that as the economy changes, becomes more global, and more service oriented, that the efficacy of these indices becomes less clear. These have never been perfectly 170

accurate, they are at best only rough guides to the landscape of business cycles in the U.S. economy, However, it also must be remembered that a subscription to these indices is far cheaper than having a battalion of econometricians on staff gathering and analyzing economic data. Further, these numbers are also reasonable indicators of what is occurring and can give considerable empirical pop for the buck. To the extent that all economic forecasting is, at best, little more than sophisticated number grubbing these sorts of approaches are worth careful consideration. It is also interesting to note that OECD (Organization for Economic Cooperation and Development) gathers and publishes indices of economic indicators for several European nations at their website www.OECD.org. These numbers provide essentially the same sorts of leading, coincident, and lagging indicators as are described here. The U.S. publication of the Economic Indicators is not longer shouldered entirely by the Bureau of Economic Analysis. The Conference Board now publishes these series for the U.S. These indicators are available through the Conference Board at their website and requires a subscription www.ConferenceBoard.org. However, the construction of the indices are still accomplished using data provided by the U.S. Department of Commerce, and many organizations have constructed their own indices mirroring what was done by the Bureau of Economic Analysis. There are specialized data systems mostly for stocks, and mutual funds. These are almost all proprietary for the premium services, but most brokerages provide one or more these services, and some are available without a fee and without the premium portions of the service. Many of these are quite good. KEY CONCEPTS Economic Indicators Based in economic theory Six criteria are used for variable selections Different weighting used for each variable Index of Leading Indicators Prediction variables Efficient Market Hypothesis 12 variables make up the index 171

Index of Coincident Indicators Occurs with the cycle 4 variables make up the index Index of Lagging Indicators Confirms where weve been 6 variables make up the index Variables are selected for their efficacy in the index Other Indicators and Sources of Information Proprietary services Philadelphia Feds Beige Book Investment information Zacks S&P Morningstar

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STUDY GUIDE Food for Thought: Critically evaluate the idea that an index can be created to predict future economic activity, measure current economic activity, and confirm where weve been in the business cycle.

Why do you suppose there are different weights for different variables in each of these indices? Explain.

Keep it Simple!!! There is no doubt these indices are simple, but what do we give up for the simplicity? Explain.

What other sorts of information is available based loosely on this index of indicators idea? Explain.

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Sample Questions: Multiple Choice: Which of the following variables are included in the Index of Leading Indicators? A. B. C. D. Vendor Performance Building Permits, Private Housing Index of Stock Prices All of the above

The duration of unemployment is included in the lagging indicators index. This variable indicates the average length someone has been off work. What is this variable? A. B. C. D. A flow variable A stock variable A discrete variable None of the above

True / False There are indicator indices constructed for and available for countries other than the United States. {True} High conformity scores for variables in the respective economic indicator indices suggest the series consistently followed the same pattern. {True}

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Chapter 15

Guide to Analytical and Forecasting Techniques

Since time immemorial knowledge of the future has been a quest of all mankind. Frankly, we are all probably better-off not knowing whats in store for us. However, what is undisputable is that some insight into what business conditions are going to be, allows us more an opportunity to prepare to take advantage of the opportunities, which await us, and avoid the threats that may also be present. It is this risk that motivates one to have as much information as is optimally available so as to effectively deal with the contingencies we face. It is this motivation that brings most business organizations to the need for forecasting. The purpose of this chapter is to present a menu of forecasting techniques and provide some guidance as to their utility and to what ends they are best suited. It is presumed that students will have had a basic grounding in statistical methods so that most of the discussion presented here will be readily understood. However, it is not the purpose of this chapter to go into the nuts and bolts of the methods presented. A second course, M509, Research Methods, will provide the computational expertise necessary to deploy these methods.

Methods to be Presented This chapter is divided into three basic sub-sections. The first sub-section will present a class of models referred to collectively as Time Series Methods. The next section deals with correlative methods, including ordinary least squares and variants of that model. The final section will present a sampling of other statistical methods, which may be useful in dealing with special cases. Time Series Methods This class of methods is the most simple in dealing with time series data. Time series methods includes. There are several different approaches varying from the most simple, to somewhat more complex. The methods to be briefly presented here include: (1) trend line, (2) moving averages, (3) exponential smoothing, (4) decomposition, and (5) Autoregressive Integrative Moving Average (ARIMA). Each of these methods is readily accessible, and easily mastered (with the possible exception of certain variants of ARIMA). The first four of these methods involves little more than junior high school arithmetic and can be employed for a variety of useful things. 175

1. Trend Line This method is also commonly called a naive method, it that is simply fitting a representative line to the data observed. One method, presented later, to determine what the representative line is, is called ordinary least squares, or regression analysis. In fitting a naive trend line, however, we rely on something more basic that is extrapolation. In other words, if we have a pool of data and the plot of that data reveals a predictable pattern we simple fit the line over what that observed pattern is. X

Y The Nobel Prize winning economist Paul Samuelson (a Gary, Indiana native) described this method as the black string method. That is, if you have a collection of data point, simply pull a string out of your black socks and position in such a manner as it best fits your data. In other words, best judgment suggests that the dotted line is most representative of this collective of data points. The line either passes through or touches five of eleven data points, with three points being above and three points being below the dotted line. However, there is nothing any more rigorous that visual observation and letting the eye tell you what looks like it best represents the data.

2. Moving Averages Moving averages are the next most rigorous method of best guess. If we have three observations over time of a particular variable, and we wish to obtain an estimate of the next observation we might choose to use something that gives use a particular number, rather than a slope and intercept from which to extrapolate as in the trend line method above. If we have three data points 6, 7, and 8. The moving average is calculated as: 176

X = 6+7+8 3 = 7 The moving average of this series is 7. However, it is clear that if the series continues that the next number will be 9. Therefore, a weighted moving average may result in a more satisfactory result. If the we use a method that weights the last observation in the series more than the first observation we will get closer to the next number in the series, which we presume is 9. Therefore, the following weighted average is used: X = (.5) 6+7+ (1.5)8 3 = 7.333 This weighting scheme still undershoots the forecast. Therefore we try using something in which the last number is weighted more heavily. X = (.5) 6+7+(2)8 +1 3 = 9 This weighting scheme with the addition of a constant term one provides a more satisfactory result. Unfortunately, using a weighted average scheme results in guessing for the best weighting scheme. Hence a better method is need. This sort of method is often useful for forecasting very simple, shop floor sorts of things. If you are dealing with a single data series, and need a very rough estimate of what is going to happen next with this data, the moving average, or exponential smoothing technique is often the most efficient.

3. Exponential Smoothing One of the problems with moving averages is determining how much to weight observations to obtain reasonably accurate forecasts. The weighting process is simply guessing, albeit hopefully informed guessing, about what sort of weights will produce the least error in future forecasts. Exponential smoothing is an effort to take some of the guess work out, or at least formalize the guess work. The equation for the forecast model is: F = () X2 + (1 - ) S1 Where alpha is the smoothing statistic, X is the last observation in the data set, and S is the first predicted value from the data set. For example, if we use the following series: 25, 23, 22, 21, 24 177

To obtain the initial value of S or S1 we add 25 and 23 and divided the sum by 2 to obtain 24. The X2 in this case is our last observation or 25. All that is left is the selection of . Normally, an analyst will select .3 with a series, which does not a linear trend upwards or downwards. This gives a systematic method of determining the appropriate value of . Make predictions using beginning at .1 and work your way to .9 and determine which gives the forecast with the least error term over a range of the latest available data, and use that until such time as error begin to increase. To complete the example, lets plug and chug to a get a forecast. F = (.3) 25 + (1 - .3) 24 = 7.5 + 16.8 = 24.3 The mechanics are simple, far simpler than name implies, and the method to adjust for the best alpha is easy to implement.

3. Decomposition There are several ways in which to decompose a time series data set. Outliers, trend, and seasonality are among the most common methods to strip away variations in the data so as to be able to look at fundamentals in the data. Each of these methods relies upon an indexing routine in order to provide a basis to normalize the data. Perhaps the most complicated of these is seasonality, and therefore we will examine that example. The process begins with calculating a moving average for the data series. For quarterly data the moving average is: MA = (Xt-2 + Xt-1 + Xt + Xt+1) / 4

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We will apply this method to the following data: Year 1 First Quarter Second Quarter Third Quarter Fourth Quarter Year 2 First Quarter Second Quarter Third Quarter Fourth Quarter Year 3 First Quarter Second Quarter Third Quarter Fourth Quarter Applying our moving average method: MA3 = (10+12+13+11)/4 = 11.50 MA4 = (12+13+11+11)/4 = 11.75 MA5 = (13+11+11+13)/4 = 12.00 MA6 = (11+13+14+11)/4 = 12.25 The data are now presented for year as a moving average of the quarters centered on the quarter represented by the number following the MA. For the year, the data for this series centered on the third quarter is 11.50, centered on the fourth quarter it is 11.75 and for the first quarter of the previous year it is 12.00. Now we can calculate an index for seasonal adjustment, in a rather simple and straightforward fashion. The index is calculated using the following equation: SI t = Y t / MA t where SI t is the seasonal index, Y t is the actual observation for that quarter, and MA t is the moving average centered on that quarter, from the method shown above. A 179 X 10 12 13 11 X 11 13 14 11 X 10 13 13 11

seasonally adjusted index can then be created which allows the seasonality of the data to be removed. Using the three years worth of data above we can construct a seasonality index, which allows us to remove the seasonal effects from the data. The average for each quarter is calculated: Y1 = (10+11+10)/3 = 10.33 Y2 = (12+13+13)/3 = 12.67 Y3 = (13+13+13)/3 = 13.00 Y4 = (11+11+11)/3 = 11.00 Therefore plugging in the values for Y t and MA t the equation above allows us to construct an index for seasonality from this data: SI 1 = 10.33/11.50 = .8983 SI 2 = 12.67/11.75 = 1.0783 SI 3 = 13.00/12.00 = 1.0833 SI 4 = 11.00/12.25 = .8988 To seasonally adjust the raw data is then a simple matter of divided the raw data by its appropriate seasonal index. Year 1 First Quarter Second Quarter Third Quarter Fourth Quarter Year 2 First Quarter Second Quarter Third Quarter Fourth Quarter Year 3 First Quarter Second Quarter Third Quarter Fourth Quarter X Seasonally Adjusted 10/0.8983 = 11.1321 12/1.0783 = 11.1286 13/1.0833 = 12.0004 11/0.8988 = 12.2385 11/0.8983 = 12.2453 13/1.0783 = 12.0560 14/1.0833 = 12.9235 11/0.8988 = 12.2385 10/0.8983 = 11.1321 13/1.0783 = 12.0560 13/1.0833 = 12.0004 11/0.8988 = 12.2385

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Decomposition of a data series can be accomplished for monthly, weekly, even daily data. It can also be used to eliminate variations that occur for reasons other than just seasonality. Any cyclical or trend influences in data can be controlled using these classical decomposition methods.

ARIMA ARIMA is an acronym that stands for Autoregressive Integrated Moving Average. This method uses past values of a time series to estimate future values of the same time series. According to John McAuley, The Nobel Prize winning economist Clive Granger is alleged to have noted: it has been said to be difficult that it should never be tried for the first time. However, it is useful tool in many applications, and therefore at least something more than a passing mention is required here. There are basically three parts of an ARIMA model, as are described in McAuleys text these three components are:5 (1) The series can be described by an autoregressive (AR) component, such that the most recent value (X1) can be estimated by a weighted average of past values in the series going back p periods: X1 = (X t-1) + . . . + p (X t-p) + + where p = the weights of the lagged values = a constant term related to the series mean, and = the stochastic term (2) The series can have a moving average (MA) component based on a q period moving average of the stochastic errors: X1 = + (t - 1) t-1 - . . . - q + t-u where = the mean of the series q = the weights of the lagged error terms and = the stochastic errors. John J. McAuly, Economic Forecasting for Business: Concepts and Applications, Englewood Cliffs, N.J.: Prentice-Hall, Inc., 1985. 181
5

(3) Most economic series are not stationary (can be transformed through differencing using a stationary process), but instead display a trend or cyclical movements over time. Most series, however, can be made stationary by differencing. For instance, first differencing is the period-to-period change in the series: X t = X t - X t-1

As can readily been seen the application of an ARIMA model requires a certain modicum of statistical sophistication that is beyond the scope this course. For those interested, consider taking M509. However, a few concluding remarks are necessary here. To apply an ARIMA model to data there are three procedures necessary. First, the analyst must determine what autoregressive process is most appropriate to the series. Second, the model must be then fitted to the data, and thirdly, diagnostic tests for check for the models adequacy and that the data are stationary are minimally necessary before attempting to draw inference from the results. Clive Granger mentioned above won his Nobel Prize for extending ARIMA models to where they were useful in testing any casual relations that may exist between two time series variables. The method is called, Granger Causality. In many sophisticated forecasting activities it is necessary to use models such as ARIMA, and unfortunately such models generally require a professional statistician and are generally beyond the reach of most managerial personnel. However, that does not mean that you cant learn enough to be able to draw inference from the results, and understanding the limitations and benefits of such modeling.

Correlative Methods Correlative methods rely on the concept of Ordinary Least Squares, or O.L.S., which is also sometimes referred to as regression analysis. O.L.S. refers to the fact that the representative function of the data is determined by minimizing the sum of the squared errors of each of the data points from that line. Consider the follow diagram:

182

The lines from each data point to the representative line are the error terms. Squaring the error terms eliminates the signs, and the regression analysis minimizes these squared errors in order to determine what the most representative line is for there data points. The general form of the representative equation for a bi-variate regression is: Y = + X + where Y is the dependent variable, and X is the independent variable; is the intercept term, is the slope coefficient and random error term.

Correlation To be able to determine what a representative line is, requires some further analysis. The model is said to be a good fit if the R squared is relatively high. There R squared can vary between 0 (no correlation) to 1 (perfect correlation). Typically an F statistic is generated by the regression program for the R squared which can be checked against a table of critical values to determine if the R squared is significant different than zero. If the F statistic is significant, then the R squared is significantly more than zero. 183

The simple r is calculated as: _ _ _ _ r = (X - X) (Y - Y) / ([ (X - X)2 ][ (Y - Y)2 ])-1 and the simple r is squared to obtain the R squared.

Significance of Coefficients There are also statistical tests to determine the significance of the intercept coefficient and the slope coefficient, these are simple t-statistics. The test of significance is whether the coefficient is zero. If the t-statistic is significant for the number of degrees of freedom, then the coefficient is other than zero. In general, the analyst is looking for coefficients, which are significant, and of a sign that makes theoretical sense. If the slope coefficient for a particular variable is zero, it suggests that there is no statistical association between that independent variable and the dependent variable. There is also a problem in which additional data being added to the series or another variable will sometimes cause the sign of a coefficient already in the model to swap signs. This is a symptom of problem with the data called heteroskedasticity. This problem is a result data not conforming to the underlying assumptions of ordinary least squares that is that the errors or residuals do not have a common variance. You basically have two ways in which to deal with this problem, select a different analytical technique or try transforming the data. If you transform the data, log transformations or deflating the data into some normalized series will sometime eliminate the problem and give unbiased, efficient estimates. With time series data there also arises a problem called serial correlation. That is when the error terms are not randomized as assumed. In other words, the error terms are correlated with one another. There is test for this problem, called the DurbinWatson (d) statistic. When dealing with time series data one should, as a matter of routine, have the program calculate a DW (d) and check with a table of critical values so as to eliminate any problems in inference associated with correlated error terms. If this problem arises, often using the first difference of observations in the data will eliminate the problem. However, often a low DW (d) statistic is an indication that the regression equation may be mis-specified which results in further difficulties, both statistically and conceptually.

Other Issues 184

Correlative methods are often used because of there accessibility. You can do regressions on Excel Spreadsheets. However, there are a couple of other issues worthy of some mention here before moving on. If there is something that has happened that is suspected of fundamentally changing the data series at some particular point in time. Statisticians use a method called a dummy variable. If you believe that when we went off the gold standard in 1971 that fundamentally changed the prices of oil, then you would add a dummy variable to test that hypothesis. For each year that the country was off the gold standard the value of that variable would be 1 and for all other years (i.e., when we were on the gold standard) the value would be zero. You may use multiple dummy variables, but there must be variation in the observations, otherwise you create for yourself something called a dummy variable trap - which results in a zero coefficient and other unpleasantries. Instrumental variables are also sometimes used. These variables are constructed for the purpose of substituting for something we could not directly measure or quantify. For example, in years in which we had heavy military commitments, we could also have been at war. Clearly during the cold war there we heavily military commitments, but only intermittent combat. Rather than use a dummy for years at war, an instrumental variable such troops abroad, or Department of Defense budgets may capture more of what the research was looking for.

OTHER METHODS This chapter has simply scratched the surface of methods useful in statistical analysis of data and in forecasting. There are an array of other statistical methods, which are useful for both purposes. Included in these methods are nonparametric methods. Nonparametric methods are useful with data in which quantification of the data is problematic. For example, the use of survey methods generate results that are, in large measure, arbitrary. A Likert scale asking someone to strongly agree, agree, disagree or strongly disagree is imprecise. The ordering is all we know for sure, and that the magnitude is set in two options, rather than the continuous data used in parametric methods. Just because data is discrete does not mean there are not good ways to analyze that data. There are also other methods of analyzing continuous data. There are unique circumstances in continuous data that do not necessarily lend themselves to the O.L.S. methods described above. We will also briefly describe some of these methods in this section.

Continuous Data 185

One of the more simple and practical methods of examining data is the analysis of variance and analysis of covariance. Analysis of variance is typically used to isolate and evaluate the sources of variation within independent treatment variable to determine how these variables interact. An analysis of variance is generally part of the output of any regression package and provides additional information concerning the behavior of the data subjected to the regression. There are variations on the analysis of variance theme. There is a multivariate analysis of variance, which provides information on the behavior of the variables in the data set controlling for the effects of the other variables in the analysis., and the analysis of covariance, which goes a set further, as the name suggests, and provides an analysis of how the multiple variable interact statistically. Factor analysis and cluster analysis are related processes, which rely on correlative techniques to determine what variables are statistically related to one another. A factor may have several different dimensions. For example, men and women. In general, men tend to be heavier, taller, and live shorter lives. These variables would form a factor of characteristics of human beings. Cluster analysis is analogous in that rather than a particular theoretical requirement that results in factors, there may be simple tendencies, such as behavioral variables. Canonical correlation analysis is a method where factors are identified and the importance of each variable in a factor is also identified. These elements are calculated for a collection of variables, which are analogous to a dependent variable in a regression analysis, and a collection of variables, which are analogous to independent variables in a regression. This gives the research the ability to deal with issues which may be multi-dimensional and do not lend themselves well to a single dependent variable. For example, strike activity in the United States has several different dimensions, and data measuring those dimensions. The competing theories explaining what strikes happen and why they continue can then be simultaneously tested against the array of strike measurements, lending to more profound insights than if just one variable was used. There are methods of analysis which involving the mixing of discrete and continuous data. Profit analysis uses categorical dependent variables (discrete) and explains the variation in that variable with a mixture of continuous and discrete variables. The output of these computer programs yields output, which permits inference much the same as is done with regression analysis. If there is a stochastic dependent logit analysis is an alternative to profit.

Discrete Data 186

There are several nonparametric methods devised to deal specifically with discrete data. These methods are typically useful with survey data, such as marketing research or in some types of social science research in psychology or sociology. We will briefly examine a couple of the generally applicable tests for comparing data populations, and two of the most commonly used tests dealing with ordinal data obtained from surveys, or other such methods. The Mann-Whitney U test provides a method whereby two populations distributions can be compared. The Kruskal-Wallis test is an extension of the MannWhitney U test, in that this method provides an opportunity to compare several populations. These tests can be used with the distributions of the data do not fit the underlying assumptions necessary to apply an F test (random samples drawn from normally distributed populations with equal variances). There are also methods of dealing with ordinally ranked data. For example, the Wilcoxon Signed-Rank test can be utilized to analyze paired-differences in experimental data. This is particularly useful in educational studies or in some types of behavioral studies where the F statistic assumptions are not fulfilled or the two tests above do not apply (not looking at population differences). Finally, there is a test that is somewhat analogous to regression analysis to deal with ranked data. Spearman Rank Correlations are useful in determining how closely associated individual observations may be to specific samples or populations. For example, item analysis in multiple-choice exams can be analyzed using this procedure. Students who perform well on the entire exam can have their overall score assessed with respect to specific questions. In this example, if the top students all performed well on question 1, their rank correlation would be near 1, however, if they all performed well, but on question 2 they did relatively poorly, that correlation would be closer to zero, say .35. If, on the other hand, none of the students who performed well got question 2 correct, then we would observe a zero correlation for that question. This method is useful in marketing research and in behavioral, as well as college professors with too much time on their hands. There are several other nonparametric methods available. This section simply presented the highlights so that you are aware that discrete data can be analyzed with developed and generally accepted statistical techniques, which are well supported with canned computer programs, which are generally available commercially. Just because you have discrete data does not mean that you have no reasonable methods to analyze that data.

Conclusions 187

This chapter presented a brief overview of some of the commonly used forecasting and statistical methods commonly used in business for analysis of specific issues concerning the business environment. This was done more as a menu of whats available rather than a seven-course meal in statistical fun and games. There is a well-developed literature concerning these methods and numerous excellent sources on the detailed nuts and bolts in applying these and other related statistical methods. For the multivariate techniques6 there is an excellent text by Hair, Anerson et al, which is often the basic textbook for the M509 course. Also for a basic treatment of the nonparametric methods discussed here see Mendenhall, Reinmuth and Beavers text.7 This text also presents an excellent discussion of regression analysis and some of the related topics. In this discussion very little was offered concerning survey research and the particular problems associated with this specialized topic. For those desiring more concerning survey methods Sekarans text is an excellent primary source.8 For those whose tastes run along the lines of the basic models used for forecasting described in the first section of this chapter, you may wish to consult a text by Wilson and Keating for further details.9 Of course, no course would be complete concerning forecasting without some mention of the most advanced text books in the field. For more in-depth and advanced discussions of forecasting see Makridakis, Wheelright and McGee.10 There are also several classic textbooks concerning econometric methods. Still the most complete and comprehensive of these books is the one by Henri Theil.11 Finally, there is an article that is pretty much the authoritative piece on managers guide to statistical and forecasting methods. This article appears in

J. F. Hair, R. E. Anderson, R. L. Tatham, and W. C. Black, Multivariate Data Analysis with Readings, third edition. New York: Macmillian Publishing Company, 1992. W. Mendenhal, J. E. Reimth, and R. Beaver, Statistics for Management and Economics, sixth edition. Boston: PWS-Kent Publishing Company, 1989. U. Sekaran, Research Methods for Business, second edition. New York: John Wiley & Sons, 1992. J. H. Wilson and B. Keating, Business Forecasting. Homewood, IL: Richard D. Irwin, Co., 1990.
10 9 8 7

S. Makridakis, S. C. Wheelright, and V. E. McGree, Forecasting: Methods and Applications, second edition. New York: John Wiley & Sons, 1983. H. Theil, Principles of Econometrics. New York: John Wiley & Sons, 1976. 188

11

the Harvard Business Review in 1986.12 The reason for all of these citations, when we seemed to live quite nicely without them to this point in the course, is that knowledge comes in two varieties, either you know something yourself, or you know where to go find the information you need. These citations fall into the later category.

KEY CONCEPTS Time Series Methods Trend Line Moving Averages Exponential Smoothing Decomposition Autoregressive Integrative Moving Average Correlative Methods Regression Correlation Statistical Significance Heterosckdasticity Serial Correlation Dummy Variables Other Continuous Data Methods Analysis of Variance Multivariate Analysis of Variance Analysis of Covariance Factor Analysis D. M. Georgoff and R. G. Murdick, Managers guide to forecasting, Harvard Business Review, January-February 1986. 189
12

Cluster Analysis Canonical Correlation Profit Analysis Nonparametric Methods Mann-Whitney U Kruskal-Wallis Wilcoxon Signed-Rank Spearman Rank Correlations

STUDY GUIDE Food for Thought: What are the problems encountered in the data that may face you in applying regression analysis to time series data? Explain.

Keeping things simple has obvious advantages with respect to cost and expertise, but what are the drawbacks? Be specific.

Compare and contrast the occasions in which the various methods presented here may be appropriate or inappropriate to the analysis of business conditions.

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What is meant by statistical significance? Why is this of importance? Explain.

Critically evaluate de-seasonalizing time series data.

Sample Questions: Multiple Choice: Which of the following models are methods, which rely in some respect on correlation? A. B. C. D. Exponential Smoothing Wilcoxon Signed-Rank Trend Line None of the above

Serial correlation is: A. The value of the simple r B. Correlation between the slope coefficients in a bi-variate regression C. The residuals being correlated with one another in a multi-variate regression D. None of the above True / False A significant t-statistic for a regression coefficient means we do not know that coefficient differs from zero. {False} Correlation is the strength of statistical association between two variables, and R squared is the amount of variation explained in the dependent variable by the independent variables. {True}

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Chapter 16

Data: In the Beginning

This chapter is the follow-on of Chapter 13, but based, in part, on the discussions found in Chapter 15. We again, return to the subject of data, and what to do with it so as to accomplish the analyses or forecasts we wish to complete. The purpose of this chapter to present brief discussion of the preliminary examination of data for the purposes of various forecasting and analytical techniques. This chapter presents some basics idea on how to become familiar with and handle problems, which commonly arise in empirical economics. It is through these methods that an analyst can best decide what methods are appropriate to her needs, and how to best torture the data to obtain the desired results.

Data Inspection Just like in the goods producing segments of the economy there are certain quality control procedures that must be implemented with data before you begin using it for testing theories or forecasting. Familiarity with the data, its characteristics and its limitations will help determine, not only the methods that will be applied to it, but the problems and benefits would may expect to encounter with its use. The following sections provide a basic set of tools and considerations for the quality control of data. The use of these methods can save a great deal of grief and aggravation and are highly recommended.

Becoming Familiar with the Data The simple single variable forecasting techniques are not very sensitive to data problems, which may create considerable difficulties with correlative methods. However, the time series data gathered may very well determine what single variable forecasting techniques are best suited for forecasting purposes. Trend line, quite naturally is a best guess method and is not subject to many of these problems, it is simply "eye-balling" the data. However, exponential smoothing is not particularly robust with data with large variations, and little trend to it. Whereas, decomposition may be better suited to data, which can have some of, the variation removed through elimination of seasonality, outliers, or other identifiable issues with the data. 192

Calculating means, medians, and modes will give you some idea what the distribution of the data looks like. Mean is the arithmetic average, median is the midpoint in the data series, and mode is the most commonly appearing observation in the data. In a normal distribution, the mean, median, and mode are all equal to one another. The first thing one should do when examining a data set, is to calculate each of these descriptive statistics to determine how its distribution looks. Further, some measure of variation should also be calculated, variance 2 or standard deviation which will provide some insight into how the data may be distributed. Plots of the data will also help the analyst to come to some better understandings of how the data are distributed as well. Consider the following equations for the mean and for the variance for data that is roughly normally distributed:

Mean: X =

fm
i i =n

/n

Variance: 2 =

fm
i i =n

i2

- [(

fm
i i =n

i 2

) / n] / n - 1

Standard Deviation: =[ where: mi = midpoint of data series I fi = frequency of observation in series

fm
i i =n

i2

- [(

fm
i i =n

i 2

) / n] / n - 1]

-1

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The mean is used in the calculation of variance, however, it is a descriptive statistic, which give the analyst some indication of the magnitude of the observations. When compared with the median and the mode, the mean also provides some indication of how that data may be distributed. Variance is also a useful idea. If data are distributed very tightly around the mean, the variance will tend to be small. If, on the other hand, there are large numbers of outliers, or the data is tightly distributed the variance will tend to be large. Therefore, variance or the square root of variance which is standard deviation is useful in determining how tightly distributed the data set is. Variance is commonly used, but as one can easily see from the equation is the square of the standard deviation. Standard deviation is more easily interpreted because it is in the same numeraire as the data itself. The data series may be systematically distributed in some fashion that will have some impact on modeling or technique decisions. Perhaps the most common of these problems is the data being skewed. The following graph shows skewed data:

X Mode Median Mean

Y Z
This graph is presented with three variables, X, Y, and Z. The colored-in area, is the plain created in this three-dimensional space, rather than the two-dimensional line you are used to seeing. This data set is skewed to the left. If the tail observed is to the other side of the distribution this is referred to as the data being skewed to the right. Notice that the mean, median and mode are all different numbers in this graph.

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Mode Median Mean

In examining a data set with the tail to the other side, and this time in two dimensions (just variables X and Y) we can observe a data set that is skewed to the right. There is a statistical principle called the law of large numbers. For purposes of most statistical analyses, if the data are random sample from a population with the same variance and continuous, then if you have more than 30 observations it is assumed that those number of observations or more will approximate a normal distribution. If the mode appears precisely in the middle of the plot, and mean, mode and median are all the same number, with a sombrero-shaped distribution, this is would be what is called a normal distribution. The following diagram presents a normal distribution.

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Mean, Mode and Median

Correlated Independent Variables

In the discussion of the regression analysis in the previous chapter, there was mention of correlated residuals sometimes referred to as serial correlation, or multicolinearity. This most often occurs because there are two or more of the independent variables explanatory variables, which are correlated with one another. That is that they have a statistically significant correlation. That is a correlation, which is .3 or higher (ignoring the sign). The best way to handle this issue with respect to forecasting models is to make sure beforehand that you are not using correlated independent variables. Unfortunately, you may not have a choice in the selection of variables with a structural model, or if you do, the instrumental variable you choose instead of the correlated variable may still exhibit a significant correlation with the remaining independent variables. The simplest and quickest method for dealing with multicolinear variables is to run a correlation matrix of the variables being considered for use in the forecasting model. A correlation matrix is simply the correlation between each of the variables presented. Consider the following correlation matrix where we have correlated unemployment rate, with Manufacturing inventories (in millions of dollars), Coincident index of copper prices, and the Standard and Poors 500 index of common stock prices in the U.S.

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_____________________________________________________________________ Unemployment Inventories Coincident S&P Rate Mfg. Copper Prices 500 _____________________________________________________________________ Unemployment rate Inventories Mfg. Copper Prices (coincident) S&P 500 1.000 -0.881 -0.793 -0.679 1.000 0.535 0.790 1.000 0.243 1.000

_____________________________________________________________________ From inspection of this matrix it is clear that all of these variables are highly correlated with one another, except for Coincident Copper Prices and the S&P 500 stock index. The unemployment rate is negatively associated with each of the other variables, and manufacturing inventories are positively associated with both the price of copper and the S&P 500 index although the statistical association between inventories and copper prices is not as high as the remaining variables. Copper prices and the S&P 500 may be useable in the same regression equation without causing significant statistical problems. In examining these variables it should come as no surprise that these variables are highly correlated. Unemployment rate is highly correlated with persons unemployed (.98) which is also statistically associated with the lagging economic indicator average duration of unemployment. The S&P 500 is very highly correlated with most of the major categories within the National Income Accounts and is leading economic indicator. With some understanding of the economic theory, which underpins these indicators an analysis, could very easily pick out the types of variables, which would be expected to highly correlated with one another. Factor analysis will provide essentially the same sorts of information, and many scholars will utilize factor analysis because it also give some basis for making other decisions. If there are highly correlated variables, which are important to the analysis, and you have these sorts of difficulties on both sides of the equation, independent and potential dependent variables that are highly correlated, then this is precisely what canonical correlation techniques are for. Therefore, these sorts of preliminary analyses may be very useful in determining what methods are most appropriate to the task at hand.

197

Forecasting versus Structural Models It is wise to remember that business conditions analysis may involve two different sorts of activities. There is the need to confirm theory or academic econometrics and the need to get some fix on future developments forecasting. There are differences in both the rigor and the activities required when conducting research for the purposes of understanding and explaining economic phenomenon or testing theories, and just forecasting. With empirical examination of a theory, there is the need to fully specify your model. Missing variables will bias results, and such under-specified models will rarely get past a referee. However, the formalities of academic research are less rigorous when it comes to forecasting. The large econometric forecasting models, such as the Wharton Model and other such simultaneous equations models are formal models of the U.S. economy and attempt to model each aspect of what is measured in the National Income Accounts. This sort of forecasting borders on academic research and is not the nuts and bolts sort of thing we expect from simple forecasts of a single variable or focused on something far less complex. Forecasting is more pragmatic. Forecasters will look to find those variables that give consistent guidance to what might be expected in the selected dependent variable, and if a variable can be found which predicts turn-around points, the forecaster is typically elated, if some connection can be theoretically found as conformation for the result. One should always remember why you came to the swamp. Draining the swamp doesnt necessarily mean you have to wrestle every alligator that wanders into camp. Forecasting is a down and dirty application of statistical and economic knowledge, which is clearly more focused on pragmatics than what is expected of empirical tests of economic theory.

Conclusions The more information you have concerning the nature and statistical properties of the data you have with which to work, the better choices you will be able to make concerning the selection of variables and statistical techniques. You are generally well advised to make choices for variable to explain variations in your dependent variable which have both sound theoretical reasons for their inclusion, but which cause the least amount of statistical headaches. Prior planning does prevent poor performance. In this case, get to know the data you are going to torture, it will help in the long - run.

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KEY CONCEPTS Know the Data Independent variables Dependent variables Descriptive statistics Mean Mode Median Variance Skewed Data Correlation matrix Choice of techniques related to data Forecasting versus Structural equations

STUDY GUIDE Food for Thought: Why sorts of things would be useful to know about the variables you are going to use for independent variables? Explain.

199

What are the differences between simple forecasting, and academic research concerning testing theories? Explain.

In what ways will getting to know your data help in analyzing it? Explain.

Critically evaluate the use of descriptive statistics, correlations matrices, and data plots to select variables for inclusion in a forecasting model.

Multiple Choice: When the mode is greater than the mean and median what is this called? A. B. C. D. Normal distribution Skewed to the left data Skewed to the right data None of the above

Which of the following problems is associated with independent variables, which are highly correlated? A. B. C. D. Residuals are correlated The estimated coefficients may be biased The estimated coefficient may be unstable All of the above 200

True / False Standard deviation is one measure of the variability of a data set. {True} A normal distribution has a mean, mode and median which are all equal, among other characteristics. {True}

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Chapter 17

Epilog:
Management and Business Conditions Analysis
The purpose of this chapter is to examine the managerial aspects of business conditions analysis. Data gathering and data sources are the starting point of any attempt to analyze business conditions. However, this must be done on a firm foundation of sound economic analysis. The uses of the analyses and by who will, in large measure, determine the rigor of analyses, and how it is communicated. Finally, in this chapter, the discussion of the managerial aspects will end with an examination of the role of this subject in strategic planning.

Information and Managerial Empowerment To this point in the course, the discussion has focused almost entirely on the development of macroeconomic models used to examine and explain the business environment in which an enterprise must function. In the broadest sense, it is the macroeconomic environment in which an enterprise must function. However, this course, in a more practical sense, is a management course. All of the economics and data analysis in the world doesnt mean very much unless it can be translated into some productive activities. Information should, first and foremost, be one means by which people in an organization are empowered to contribute to success of the organization. If the information technology gurus and the economists are the only ones with access to information, and the results of analyses then a barrier is being erected between the people who are responsible for the organizations performance and the information necessary to discharge those responsibilities. Empowerment in a managerial sense requires that those closest to the events should be making the calls, within broad policy constraints. To do this effectively, it is also clear that these people must have access to the analyses and the data necessary to effective decision making. How this is done is of critical importance. First and foremost, it must be remembered that information (its acquisition and dissemination) is a support function. Accounting, information technology and economic analysis are staff function, which are useful to line functions in determining the best strategies for the organization to follow. These support functions are subsidiary functions. There is a serious danger here, too many times these support functions take 202

on decision-making authority simply because they control the information necessary to effective decision-making. THIS SHOULD NEVER HAPPEN. Economists and accountants are not physicians, engineers or Indian chiefs and not the people with the line authority or expertise to properly execute that line authority. Policy parameters must be set for the gathering, analysis and use of data. Open access to these data and the resultant analyses, regardless of where it is performed, is essential if it is to be useful within the context of overall management of the organization. It is an extremely delicate balancing act, but discretion within the policy parameters is the essence of managerial empowerment. If you delegate authority, you must permit discretion to exercise that authority, and information is one tool to make sure that discretion is exercised wisely.

Policy and Strategy The purpose of a strategic plan is to provide not only guidance for managerial actions, hence policy, but also to provide a set of goals by which the directed actions of the enterprise can be assessed. An effective strategic plan is not just simply a roadmap. An effective strategic plan accounts for contingencies, and provides for guidance so as to reduce ambiguities with respect to what and how a firm should be performing. Naturally, business conditions analysis plays a very important role in formulating business strategies. Both opportunities and risks arise from the economic environment in which an enterprise operates. There for anticipation of those conditions, and contingencies for situation in which the anticipation was inaccurate are important results of business conditions analysis. Decision-making is a fact of life in any organization. The culture that is developed in an organization concerning how decision-making occurs is often one of the most important determinants of the organizations success or failure. Consistently, studies of why enterprises fail suggest that poor planning is often at the heart of failure, and that effective planning is predictive of success. How this planning gets implemented is part and parcel of decision-making. Effective organizations empower those with line authority throughout the organization. However, to effectively empower line managers, requires that their efforts be focused and coordinated. Unfortunately, to some that means micro-managing, and the organization falls victim to all the ills associated with this bankrupt managerial model. Effective organizations delegate authority, and have a mission statement that provides general directions, and a series of well understood and reasonable policies to guide those individuals to whom that authority has been delegated. The role of information and its analysis in formulating and evaluating the goals these policies are developed to achieve is critical. Not only are external business 203

conditions opportunities and threats, but how the organization responds to these issues, given the information, is also of critical importance and should be a crucial part of the planning process.

Qualitative Issues What has been done in this course is primarily quantitative analysis, however, this is not to minimize the qualitative aspects of a business environment. It is difficult to measure ethics, or business regulations, however both of these have significant implications for the environment in which businesses operate. There are other issues, which tend to be more internal that are also shaped by the business environment. The culture and design of organizations are often heavily influence by what the business environment is anticipated to be. Enrons culture was in large measure the result of rise of derivatives and fast moving financial markets. Enrons management was successful in playing a sort of shell game moving losses and assets to give the appearance of a thriving company. It is doubtful this culture would have developed at all, except for the financial market environment in which they operated. As intrusive as Sarbanes - Oxley is for businesses, the legislative result was predictable from the behavior of Ken Lay, Jeff Skilling, and Bernie Ebbers. When these sorts of scandals arise which cost pension funds, and mutual funds billions of dollars there will be a public outcry for action to prevent such conduct in the future. Such qualitative aspects of the business environment does not lend itself to quantification and statistical analysis. Yet these matters are important aspects of the conditions in which business operates.

Forecasting and Planning Interrelations Forecasting and planning cannot be separated, as a practical matter. Strategies require a vision of the future. However, as pointed out earlier in the course, there are costs to the gathering and analysis of information. Therefore, there is some optimal amount of analysis and forecasting that is consistent with an effective business plan. There are some general rules, which help in finding the optimal amount of analysis for the purposes of planning. Perhaps the foundation of these rules is a requisite flexibility to react to forecast "vision" errors. The religious adherence to plans is a formula for disaster. Plans are subject to forces, which alter the results expected. It is absolutely essential that the feed-forward, feed-back processes that generate the original plans remain open during implementation so contingencies can be made 204

operable and goals revised as conditions require. This culture of flexibility requires a certain humility and willingness to permit participation across the organization. For those with work experience, it is clear that this requirement is far easier said, then done. Over time and across organizations we have become far better at understanding the planning process than we were even twenty years ago. There are clear relationships between goals specified in the plan and what the authors of those plans anticipated. A good strategic plan is going to specify specific objectives as guides to whether goals are being met. Those specific objectives will be measurable either qualitative or quantitatively. There will be provision for revisions of goals that the objectives suggest are not being obtained or are being exceeded. Perhaps most importantly the process will be one of continuous improvement and ongoing. Forecasting and business conditions analysis is just one critical cog in this overall wheel of strategic management. Goal are in an important sense nothing more than forecasts, and the enabling objectives are simply road-signs along the way to allow us to gauge how well we are doing.

Risk and Uncertainty Risk is simply the down-side of opportunity. We could call this chapter clichs centered on quantitative methods, but sometimes those clichs are accurate descriptions of the real world. Just because they are clich doesnt mean you shouldnt pay attention. Risk is the reason entrepreneurs are rewarded. Risk is also the reason enterprises fail. The trick is to take those risks you understand and can appropriately manage. That sounds very simple, but its not or we would all be rich. To understand the risk one faces requires insight and hard work hard work to do the data gathering and crunching necessary to have a handle on what you are up against. Most people simply dont gain the insights because they are either unwilling or unable to do the homework necessary to make some enterprise work. Stochastics are what breeds uncertainty, which, in turn, breeds ambiguity. When we dont know what to expect, that is sometimes the most anxiety producing situation. Remember when you were a kid, and you transgressed on some rules your parents made. The anxiety waiting for the verdict as to the appropriate corrective action was almost always worse than the punishment. Thats what uncertainty does for you. To the extent that the knowledge acquired in this course is useful to you as an individual it can make your economic well-being less stressful. However, the lessons here properly applied can help you to understand your world a little better, but if extended to your organization can make the culture of the place you work less stressful and more informed. Understanding the macroeconomy and having at your disposal a few forecasting techniques can help minimizes uncertainty and if extended through your 205

organization can help co-workers and the enterprise deal with ambiguities at least those that arise from the business environment.

Conclusions The issues examined in this course have not only a practical implication for the gathering and analysis of information. It also is concerned with where that analysis and information gathering fits in with the successful management of an organization. Information and its uses is a major part of what a manager does in the day to day operations of her part of an organization. However, it is unlikely that anyone in an M.B.A. program will be put in charge of a major forecasting model for a big brokerage or Federal Reserve Bank. Just as unlikely is that the typical M.B.A. will progress through their careers without dealing with the issues presented here on a routine basis. Therefore it is of critical importance that you at least know what the macroeconomic environment is, and how analysts deal with the business cycle. Go forth and prosper!!!

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E550 Lecture Notes

1. Introduction to Economics Lecture Notes

1. Economics Defined - Economics is the study of the allocation of SCARCE resources to meet unlimited human wants. a. Microeconomics - is concerned with decision-making by individual economic agents such as firms and consumers. b. Macroeconomics - is concerned with the aggregate performance of the entire economic system. c. Empirical economics - relies upon facts to present a description of economic activity. d. Economic theory - relies upon principles to analyze behavior of economic agents. e. Inductive logic - creates principles from observation. f. Deductive logic - hypothesis is formulated and tested. 2. Usefulness of economics - economics provides an objective mode of analysis, with rigorous models that are predictive of human behavior. 3. Assumptions in Economics - economic models of human behavior are built upon assumptions; or simplifications that permit rigorous analysis of real world events, without irrelevant complications. a. Model building - models are abstractions from reality - the best model is the one that best describes reality and is the simplest. b. simplifications: 1. Ceteris paribus - means all other things equal. 2. Problems with abstractions, based on assumptions. Too often, the models built are inconsistent with observed reality - therefore they are faulty and require modification. When a model is so complex that it 1

cannot be easily communicated or its implications understood - it is less useful. 4. Goals and their Relations - Positive economics is concerned with what is; normative economics is concerned with what should be. Economic goals are value statements. a. Most societies have one or more of the following goals: 1. Economic efficiency, 2. Economic growth, 3. Economic freedom, 4. Economic security, 5. Equitable distribution of income, 6. Full employment, 7. Price level stability, and 8. Reasonable balance of trade. 5. Goals are subject to: a. Interpretation - precise meanings and measurements will often become the subject of different points of view, often caused by politics. b. Complementary - goals that are complementary are consistent and can often be accomplished together. c. Conflicting - where one goal precludes or is inconsistent with another. d. Priorities - rank ordering from most important to least important; again involving value judgments. 6. The Formulation of Public and Private Policy - Policy is the creation of guidelines, regulations or law designed to affect the accomplishment of specific economic goals. 2

a. Steps in formulating policy: 1. Stating goals - must be measurable with specific stated objective to be accomplished. 2. options - identify the various actions that will accomplish the stated goals & select one, and 3. Evaluation - gather and analyze evidence to determine whether policy was effective in accomplishing goal, if not re-examine options and select option most likely to be effective. 7. Objective Thinking: a. Bias - most people bring many misconceptions and biases to economics. Because of political beliefs and other value system components rational, objective thinking concerning various issues requires the shedding of these preconceptions and biases. b. Fallacy of composition - is simply the mistaken belief that what is true for the individual, must be true for the group. c. Cause and effect - post hoc, ergo propter hoc - after this, because of this fallacy. 1. Correlation - statistical association of two or more variables. 2. Causation - where one variable actually causes another. Granger causality states that the thing that causes another must occur first, that the explainer must add to the correlation, and must be sensible. d. Forecasting - Steps 1. Selection of variables 2. Sophistication 3. Model 4. Specification 5. Re-evaluation of model 6. Reports etc.

2. National Income Accounting Lecture Notes

1. Gross Domestic Product - (GDP) the total value of all goods and services produced within the borders of the United States (or country under analysis). 2. Gross National Product - (GNP) the total value of all goods and services produced by Americans regardless of whether in the United States or overseas. 3. National Income Accounts are the aggregate data used to measure the wellbeing of an economy. a. The mechanics of these various accounts are: Gross Domestic Product - Depreciation = Net Domestic Product + Net American Income Earned Abroad - Indirect Business Taxes = National Income - Social Security Contributions - Corporate Income Taxes - Undistributed Corporate Profits + Transfer Payments = Personal Income - Personal Taxes = Disposable Income

4. Expenditures Approach vs. Incomes Approach a. Factor payments + Nonincome charges - GNP/GDP adjustments = GDP is the incomes approach b. Y = C + Ig + G + Xn is the expenditures approach (where Y = GDP) 5. Social Welfare & GDP - GDP and GNP are nothing more than measures of total output (or income). More information is necessary before conclusions can be drawn concerning social welfare. There are problems with both measures, among these are: a. Nonmarket transactions such as household-provided services or barter are not included in GDP. b. Leisure is an economic good but time away from work is not counted, however, movie tickets, skis, and other commodities used in leisure time are. c. Product quality - no pretense is made in GDP to account for product or service quality. d. Composition & Distribution of Output - no attempt is made in GDP data to account for the composition or distribution of income or output. We must look at sectors to determine composition and other information for distribution. e. Per capita income - is GDP divided by population, very rough guide to individual income, but still mostly fails to account for distribution. f. Environmental problems - damage done to the environment in production or consumption is not counted in GDP data unless market transactions occur to clean-up the damage. g. Underground economy - estimates place the amount of underground economic activities may be as much a one-third of total U.S. output. Criminal activities, tax evasion, and other such activities are the underground economy.

6. Price Indices - are the way we attempt to measure inflation. Price indices are far from perfect measures and are based on surveys of prices of a specific market basket of goods. a. Market basket surveys - The market basket of goods and services are selected periodically in an attempt to approximate what the average family of four purchases at that time. b. CPI (U) is for urban consumers & CPI (W) is for urban wage earners. GDP Deflator is based on a broader market basket and may be more useful in measuring inflation. 1. Standard of living - is eroded if there is inflation and no equal increase in wages. 2. COLA - are escalator clauses that tie earnings or other payments to the rate of inflation, but only proportionally. 3. Other indices - American Chamber of Commerce Research Association in Indianapolis does a cross sectional survey, there are wholesale price indices and several others designed for specific purposes. c. Inflation/Deflation - throughout most of U.S. economic history we have experienced deflation - which is a general decline in all prices. Inflation is primarily a post-World War II event and is defined to be a general increase in all prices. d. Nominal versus Real measures - economists use the term nominal to describe money value or prices (not adjusted for inflation); real is used to describe data, which are adjusted for inflation. 7. Paashe and Laspeyres Indices L = PnQ0 / P0Q0 X 100 Laspeyres index is the most widely used index in constructing price indices. It has the disadvantage of not reflecting changes in the quantities of the commodities purchased over time. The Paasche index overcomes this problem by permitting the quantities to vary over time, which requires more extensive data grubbing. The Passche index is: P = PnQn / P0Qn X 100 6

Measuring the price level a. CPI = (current year market basket/ base year market basket) X 100 the index number for the base year will be 100.00 (or 1 X 100) b. Inflating is the adjustment of prices to a higher level, for years when the index is less than 100. c. Deflating is the adjustment of prices to a lower level, for years when the index is more than 100. 1. To change nominal into real the following equation is used: Nominal value/ (price index/100) d. Changing base years - a price index base year can be changed to create a consistent series (remembering market baskets also change, hence the process has a fault). The process is a simple one. If you wish to convert a 1982 base year index to be consistent with a 1987 base year, then you use the index number for 1982 in the 1987 series and divide all other observations for the 1982 series using the 1982 value in 1987 index series.

3. Unemployment and Inflation Lecture Notes

1. Business Cycle - is the recurrent ups and downs in economic activity observed in market economies. a. troughs are where employment and output bottom-out during a recession (downturn) b. peaks are where employment and output top-out during a recovery (upturn) c. seasonal trends are variations in data that are associated with a particular season in the year. d. secular trends are long-run trend (generally 25 or more years in macroeconomic data.

Output Peak

Secular trend

Trough

Years

2. Unemployment - there are various causes of unemployment, including: a. frictional - consists of search and wait unemployment which is caused by people searching for employment or waiting to take a job in the near future.

b. structural - is caused by a change in composition of output, change in technology, or a change in the structure of demand. c. cyclical - due to recessions, (business cycle). 3. Full employment - is not zero unemployment, full employment unemployment rate is the same as the natural rate. a. natural rate - is thought to be about 4% and is structural + frictional unemployment. 1. potential output - is the output of the economy at full employment. 4. Unemployment rate - is the percentage of the workforce that is unemployed. a. labor force - those employed or unemployed who are willing, able and searching for work; the labor force is about 50% of the total population. b. part-time employment - those who do not have 40 hours of work (or equivalent) available to them, at 6 million U.S. workers were involuntarily part-time, and about 10 million were voluntarily part-time employees in 1992. c. discouraged workers - those persons who dropped out of labor force because they could not find an acceptable job. d. false search - those individuals who claim to be searching for employment, but really were not, some because of unemployment compensation benefits. 5. Okun's law a. Okun's Law states that for each 1% unemployment exceeds the natural rate there will be a gap of 2.5% between actual GDP and potential GDP. 6. Burden of unemployment differs by several factors, these are: a. Occupation - mostly due to structural changes. 9

b. Age young people tend to experience more frictional unemployment. c. Race and gender reflect discrimination in the labor market and sometimes in educational opportunities. 7. Inflation - general increase in all prices. a. CPI - is the measure used to monitor inflation. b. Rule of 70 -- the number of years for the price level to double = 70/%annual rate of increase. 8. Demand - pull inflation
Price Aggregate Supply

Aggregate Demand

Output

Using a naive aggregate demand - aggregate supply model (similar to the supply and demand diagrams for a market, except the supply is total output in all markets and demand is total demand in all markets, as the aggregate demand shifts outwards prices increase, but so does output.

9. Cost - push inflation - again using a naive aggregate supply - aggregate demand approach cost-push inflation results from a decrease in aggregate supply:

10

Price

Aggregate Supply

Aggregate Demand Output

a. pure inflation results from an increase in aggregate demand that is equal to a decrease in aggregate supply:

Price

Aggregate Supply

Aggregate Demand

Output

10. Effects of inflation impact different people in different ways. If inflation is fully anticipated and people can adjust their nominal income to account for inflation then there will be no adverse effects, however, if people cannot adjust their nominal income or the inflation is unanticipated those individual will see their standard of living eroded.

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a. Debitors typically benefit from inflation because they can pay loans-off in the future with money that is worth less, thereby creditors are harmed by inflation. b. Inflation typically creates expectations among people of increasing prices, which may contribute to future inflation. c. Savers generally lose money because of inflation if the rate of return on their savings is not sufficient to cover the inflation rate.

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4. Aggregate Supply & Aggregate Demand Lecture Notes

1. Aggregate demand is a downward sloping function that shows the inverse relation between the price level and domestic output. The reasons that the aggregate demand curve slopes down and to the right differs from the reasoning offered for individual market demand curves (substitution & income effects these do not work with aggregates). The reasons for the downward sloping aggregate demand curve are: a. wealth or real balance effect - higher price level reduces the real purchasing power of consumers' accumulated financial assets. b. interest-rate effect - assuming a fixed supply of money, an increase in the price level increases interest rates, which in turn, reduces interest sensitive expenditures on goods and services (e.g., consumer durables cars etc. c. foreign purchases effect - if prices of domestic goods rise relative to foreign goods, domestic consumers will purchase more foreign goods as substitutes.

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2. Determinants of aggregate demand - factors that shift the aggregate demand curve. a. expectations concerning real income or inflation (including profits from investments in business sector), b. Consumer indebtedness, c. Personal taxes, d. Interest rates, e. Changes in technology, f. Amount of current excess capacity in industry, g. Government spending, h. Net exports, i. National income abroad, and j. Exchange rates. 3. Aggregate Supply shows amount of domestic output available at each price level. The aggregate supply curve has three ranges, the Keynesian range (horizontal), the intermediate range (curved), and the classical range (vertical).

a. Keynesian range - is the result of downward rigidity in prices and wages. 14

b. Classical range - classical economists believed that the aggregate supply curve goes vertical at the full employment level of output. c. Intermediate range - is the range in aggregate supply where rising output is accompanied by rising price levels. 4. Determinants of Aggregate Supply cause the aggregate supply curve to shift. a. Changes in input prices, b. Changes in input productivity, and c. Changes in the legal/institutional environment. 5. Macroeconomic Equilibrium - intersection of aggregate supply and aggregate demand:

6. Ratchet Effect - is where there is a decrease in aggregate demand, that producers are unwilling to accept lower prices (rigid prices and wages) therefore there is a ratcheting of the aggregate supply curve (decrease in the intermediate and Keynesian ranges) which will keep the price level the same, but with reduced output. In other words, there can be increases in prices (forward) but no decreases (but not backward).

15

An increase in aggregate demand from AD1 to AD2 moves the equilibrium from point a to point b with real output and the price level increasing. However, if prices are inflexible downward, then a decline in aggregate demand from AD2 to AD1 will not restore the economy to its original equilibrium at point a. Instead, the new equilibrium will be at point c with the price level remaining at the higher level and output falling to the lowest point. The ratchet effect means that the aggregate supply curve has shifted upward (a decrease) in both the Keynesian and intermediate ranges.

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5. Classical and Keynesian Models Lecture Notes

1. Classical theory of employment (macroeconomics) rests upon two founding principles, these are: a. underspending unlikely - spending in amounts less than sufficient to purchase the full employment level of output is not likely. b. even if underspending should occur, then price/wage flexibility will prevent output declines because prices and wages would adjust to keep the economy at the full employment level of output. 2. Say's Law "Supply creates its own demand" (well not exactly) a. in other words, every level of output creates enough income to purchase exactly what was produced. b. among others, there is one glaring omission in Say's Law -- what about savings? 3. Savings a. output produces incomes, but savings is a leakage b. savings give rise to investment and the interest rates are what links savings and investment. 4. Wage-Price flexibility a. the classicists believed that a laissez faire economy would result in macroeconomic equilibria and that only the government could cause disequilibria. 5. Keynesian Model - beginning in the 1930s the classical models failed to explain what was going on, hence a new model was developed -- the Keynesian Model. a. full employment is not guaranteed, because interest motivates both consumers & businesses differently - just because households save does not guarantee businesses will invest. b. price-wage rigidity, rather than flexibility was assumed by Keynes 17

6. The Consumption schedule - income & consumption a. consumption schedule - the 45-degree line is every point where disposable income is totally consumed. b. saving schedule - shows the amount of savings associated with the consumption function.

The consumption schedule intersects the 45-degree line at 400 in disposable income; this is also where the savings function intersects zero (in the graph below the consumption function). To the left of the intersection of the consumption function and the 45-degree line, the consumption function lies above the 45-degree line. The distance between the 45-degree line and the consumption schedule are dissavings, shown in the savings schedule graph by the savings function falling below zero. To the right of the intersection of the consumption function with the 45 degree line the consumption schedule is below the 45-degree line. The distance that the consumption function is below the 45-degree line is called savings, shown in the bottom graph by the savings function rising above zero. c. Marginal Propensity to Consume (MPC) is the proportion of any increase in disposable income spent on consumption (if all is spent MPC is 1, if none is spent MPC is zero). The Marginal Propensity to Save (MPS) is the proportion of any increase in disposable income saved. The relation between MPC and MPS is: 1. MPC + MPS = 1

18

d. The slope (rise divided by the run) of the consumption function is the MPC and the slope of the savings function is the MPS. Add the slope of the consumption function (8/10) to the slope of the savings function (2/10) and they equal one (10/10). e. The Average Propensity to Consume (APC) is total consumption divided by total income, Average Propensity to Save (APS) is total savings divided by total income. Again, if income can be either saved or consumed (and nothing else) then the following relation holds: 1. APC + APS = 1 7. The nonincome determinants of consumption and saving are (these cause shifts in the consumption and saving schedules): a. Wealth, b. Prices, c. Expectations concerning future prices, incomes and availability of commodities, d. Consumer debts, and e. Taxes. 8. Investment a. investment demand curve is downward sloping: 19

b. determinants of investment demand are: 1. acquisition, maintenance & operating costs, 2. business taxes, 3. technology, 4. stock of capital on hand, and 5. expectations concerning profits in future. c. Autonomous (determined outside of system) v. induced investment (function of GDP):

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1. Instability in investment has marked U.S. economic history. 2. Causes of this instability are: a. Variations in the durability of capital, b. Irregularity of innovation, c. Variability of profits, and d. Expectations of investors.

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6. Equilibrium in the Keynesian Model Lecture Notes

1. Equilibrium GDP - is that output that will create total spending just sufficient to buy that output (where aggregate expenditure schedule intersects 45-degree line). a. Disequilibrium - where spending is insufficient (recessionary gap) or too high for level of output (inflationary gap). 2. Expenditures - Output Approach a. Y = C + I + G + X is the identity for income where Y = GDP, C = Consumption, I = Investment, G= Government expenditures, and X = Net exports (exports minus imports)

The equilibrium level of GDP is indicated above where C + I is equal to the 45-degree line. Investment in this model is autonomous and the amount of investment is the vertical distance between the C and the C + I lines. This model assumes no government and that net exports are zero. 3. Leakages - Injections Approach relies on the equality of investment and savings at equilibrium. a. I = S is equilibrium in the leakages - injections approach.

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b. planned v. actual investment, the reason that the leakages - injection approach works is that planned investment must equal savings. Inventories can increase beyond that planned, hence output that is not purchased which is recessionary; or intended inventories can be depleted which is inflationary.

The original equilibrium is where I1 is equal to S and that level of GDP is shown with the solid indicator line. If we experience a decrease in investment we move down to I2 and if an increase in investment is observed it will be observed at I3. 4. If there is an increase in expenditures, there will be a respending effect. In other words, if $10 is injected into the system, then it is income to someone. That first person will spend a portion of the income and save a portion. If MPC is .90 then the first individual will save $1 and spend $9.00. The second person receives $9.00 in income and will spend $8.10 and save $0.90. This process continues until there is no money left to be spent. Instead of summing all of the income, expenditures, and/or savings there is a short-hand method of determining the total effect -- this is called the Multiplier, which is: a. Multiplier M = 1/1-MPC or 1/MPS b. significance - any increase in expenditures will have a multiple effect on the GDP. 5. Paradox of thrift - the curious observation that if society tries to save more it may actually save the same amount - unless investment moves up as a result of the 23

savings, all that happens is that GDP declines and if investment is autonomous then savings remain the same. 6. Full Employment level of GDP may not be where the aggregate expenditures line intersects the 45-degree line. There are two possibilities, (1) a recessionary gap or (2) an inflationary gap, both are illustrated below. a. Recessionary gap

The distance between the C + I line and the 45-degree line along the dashed indicator line is the recessionary gap. The dotted line shows the current macroeconomic equilibrium. .9 GDP potential = $1000 billion divide each side by .9 get $1,111.11 b. Inflationary gap

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The distance between the C + I line and the 45-degree line along the dashed indicator line is the inflationary gap. The dotted indicator line shows the current macroeconomic equilibrium. 7. Reconciling AD/AS with Keynesian Cross the various C + I and 45-degree line intersections, if multiplied by the appropriate price level will yield one point on the aggregate demand curve. Shifts in aggregate demand can be shown with holding the price level constant and showing increases or decreases in C + I in the Keynesian Cross model. Both models can be used to analyze essentially the same macroeconomic events.

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7. John Maynard Keynes and Fiscal Policy Lecture Notes

1. Discretionary Fiscal Policy - involves government expenditures and/or taxes to stabilize the economy. a. Employment Act of 1946 - formalized the government's responsibility in promoting economic stability. b. simplifying assumptions for the analyses presented here: 1. exogenous I & X, 2. G does initially impact private decisions, 3. all taxes are personal taxes, 4. some exogenous taxes collected, 5. no monetary effects, fixed initial price level, and 6. fiscal policy impacts only demand side. 2. Changes in Government Expenditures - can be made for several reasons: a. Stabilization of the economy, 1. To close a recessionary gap the government must spend an amount that time the multiplier will equal the total gap. 2. To close an inflationary gap the government must cut expenditures by an amount that times the multiplier will equal the inflationary gap. b. Political goals, and c. Provision of necessary goods & services.

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An increased government expenditure of $20 billion results in an increase in GDP of $80 billion with an MPC of .75, hence a multiplier of 4. 3. Taxation effects both consumption and savings. a. If the government uses a lump sum tax increase to reduce an inflationary gap the reduction in GDP occurs thusly: 1. The lump sum tax must be multiplied by the MPC to obtain the reduction in consumption; 2. The reduction in consumption is then multiplied by the multiplier. b. A decrease in taxes works the same way, the total impact is the lump sum reduction times the MPC to obtain the increase in consumption, which is, in turn, multiplied by the multiplier to obtain the full impact on GDP. c. A short-cut method with taxes is to calculate the multiplier, as you would with an increase in government expenditures and deduct one from it. 4. The balanced budget multiplier is always one. a. Occurs when the amount of government expenditures goes up by the same amount that a lump sum tax is increased. b. That is because only the initial expenditure increases GDP and the remaining multiplier effect are offset by taxation. 27

5. Tax structure refers to the burden of the tax: a. progressive is where the effective tax rate increases with ability to pay, b. regressive is where the effective tax rate increases as ability to pay decreases, c. proportional is where a fixed proportion of ability to pay is taken in taxes. 6. Automatic stabilizers help to smooth business cycles without further legislative action: a. Progressive income taxes, b. Unemployment compensation, c. Government entitlement programs 7. Fiscal Lag - there are numerous lags involved with the implementation of fiscal policy. It is not uncommon for fiscal policy to take 2 or 3 years to have a noticeable effect, after Congress begins to enact fiscal measures. a. Recognition lag - how long to start to react. b. Administrative lag - how long to have legislation enacted & implemented. c. Operational lag - how long it takes to have effects in economy. 8. Politics and Fiscal Policy. a. Public choice economists claim that politicians maximize their own utility by legislative action. b. Log-rolling and negotiations results in many bills that impose costs.

9. Government deficits and crowding - out. It is alleged that private spending is displaced when the government borrows to finance spending: a. Ricardian Equivalence - deficit financing same effect on GDP as increased tax. 28

10. Open economy problems. Because there is a foreign sector that impacts GDP there are potential problems for fiscal policy arising from foreign sources. a. increased interest - net export effect 1. An increase in the interest rate domestically will attract foreign capital, but this increases the demand for dollars which increases their value and thereby reduces exports, hence GDP. b. foreign shocks - in addition to currency exchange rates. 1. Oil crises increased costs of production in the U.S.

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8. Money and Banking Lecture Notes

1. Functions of Money - there are three functions of money: a. Medium of exchange - accepted as "legal tender" or something of general and specified value. 1. Use avoids reliance on barter. 2. Barter requires a coincidence of wants and severely complicates a market economy. b. Measure of value - permits value to be stated in terms of a standard and universally understood standard. c. Store of value - can be saved with little risk, chance of spoilage and virtually no cost and later exchanged for commodities without these positive storage characteristics. 2. Supply of Money a. There are numerous definitions of money M1 through M3 most commonly used. 1. M1 is currency + checkable deposits 2. M2 is M1 + noncheckable savings account, time deposits of less $100,000, Money Market Deposit Accounts, and Money Market Mutual Funds. 3. M3 is M2 + large time deposit (larger than $100,000).

3. Near Money - are items that fulfill portions of the requirements of the functions of money.

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a. Credit cards - fulfill exchange function, but are not a measure of value and if there is a credit line, can be used to store value. b. Other forms of near money: 1. Precious metals - store of value, but not easily exchanged 2. Stocks and Bonds - earnings instruments, but can be used as store of value. c. Implications for near money - stability, spending habits & policy 4. What gives money value a. No more gold standard 1. Nixon eliminated gold standard b. The Value of money depends upon: 1. acceptability for payment, 2. because the government claims it is legal tender, and 3. its relative scarcity. c. Exchange rates 5. Value of dollar = D = 1/P 6. Demand for Money - three components of money demand: a. Transactions demand b. Asset demand c. Total demand

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The money supply curve is vertical because the supply of money is exogenously determined by the Federal Reserve. The money demand curve slopes downward and to the right. The intersection of the money demand and money supply curves represents equilibrium in the money market and determines the interest rate (price of money). 7. Money market a. With bonds that pay a specified interest payment per quarter then: 1. interest rate and value of bond inversely related 8. U.S. Financial System a. FDIC - Federal Deposit Insurance Corporation - guarantees bank deposits. b. Federal Reserve System - is comprised of member banks. The Board of Governors and Chairman are nominated by the President of United States. The structure of the system is: 1. Board of Governors 2. Open Market Committee 3. Federal Advisory Council 32

4. 12 regions, Atlanta, Boston, Chicago, Cleveland, Dallas, Kansas City, Minneapolis, New York, Philadelphia, Richmond, San Francisco, St. Louis c. Functions 1. Set reserves requirements, 2. Check clearing services, 3. Fiscal agents for U.S. government, 4. Supervision of banks, 5. Control money supply through FOMC, 9. Moral hazard - insuring reduces insured's incentive to assure risk does not happen

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9. Multiple Expansion of Money Lecture Notes

1. Balance sheet (T accounts -- assets = liabilities + net worth) a. is nothing more than a convenient reporting tool. 2. Fractional Reserve Requirements a. Goldsmiths used to issue paper money receipts, backed by stocks of gold. The stocks of gold acted as a reserve to assure payment if the paper claims were presented for payment. 1. Genghis Khan first issued paper money in the thirteenth century it was backed by nothing except the Khan's authority. b. The U.S. did not have a central banking system from the 1820 through 1914. In the early part of this century, several financial panics pointed to the need for a central banking and financial regulation. 1. States and private companies used to issue paper money. 2. In the early days of U.S. history Spanish silver coins were widely circulated in the U.S. 3. The first U.S. paper money was issued during the Civil War (The Greenback Act), which included fractional currency (paper dimes & nickels!). c. Today, the Federal Reserve requires banks to keep a portion of its deposits as reserves. 1. purposes to keep banks solvent & prevent financial panics 3. RRR (Required Reserve Ratio) and multiple expansion of money supply through T accounts a. How reserves are kept 1. Loans from Fed - discount rate at which Fed loans reserves to members 34

2. Vault cash 3. Deposits with Fed 4. Fed funds rate - the rate at which members loan each other reserves b. RRR = Required reserve/demand deposit liabilities c. actual, required, and excess reserves 4. Money created through deposit/loan redepositing a. Money is created by a bank receiving a deposit, and then loaning that nonreserve portion of the deposit, which is deposited and loans made against those deposits. 1. If the required reserve ratio is .10, then a bank must retain 10% of each deposit as a reserve and can loan 90% of the deposit; the multiple expansion of money, assuming a required reserve ratio of .10, is therefore: Deposit $10.00 9.00 8.10 . . _______ $ 100.00 Loan 9.00 8.10 7.29 . . _______ $90.00

Total new money is the initial deposit of $10 + $90 of multiple expansions for a total of $100.00 in new money. 5. Money multiplier Mm = 1/RRR a. Is the short-hand method of calculating the entries in banks' T accounts and shows how much an initial injection of money into the system generates in total money supply.

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b. With a required reserve ratio of .05 the money multiplier is 20 & with a required reserve ratio of .20 the money multiplier is 5. c. the Federal Reserve needs to inject only that fraction of money that time the multiplier will increase the money supply to the desired levels.

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10. Federal Reserve and Monetary Policy Lecture Notes

1. Monetary policy, defined and objectives a. Monetary policy is carried out by the Federal Reserve System and is focused on controlling the money supply. b. The fundamental objective of monetary policy is to assist the economy in attaining a full employment, non-inflationary equilibrium. 2. Tools of Monetary Policy a. Open Market Operations is the selling and buying of U.S. treasury obligations in the open market. b. Expansionary monetary policy involves the buying of bonds. 1. The Fed buying bonds, it puts money into the hands of those who had held bonds. c. Contractionary monetary policy involves the selling of bonds. 1. The Fed sells bonds it removes money from the system and replaces it with bonds. 3. Required Reserve Ratio - the Fed can raise or lower the required reserve ratio. a. Increasing the required reserve ratio, reduces the money multiplier, hence reduces the amount by which multiple expansions of the money supply can occur. 1. decreasing the required reserve ratio increases the money multiplier, and permits more multiple expansion of the money supply. 4. The Discount Rate is the rate at which the Fed will loan reserves to member banks for short periods of time.

5. Velocity of Money - is how often the money supply turns-over. 37

a. The quantity theory of money is: MV = PQ 1. This equation has velocity (V) which is nearly constant and output (Q) which grows slowly, so what happens to the money supply (M) should be directly reflected in the price level (P). 6. Target Dilemma in Monetary Policy a. Interest rates and the business cycle may present a dilemma. Expansionary monetary policy may result in higher interest rates, which dampen expansionary policies. b. Fiscal and monetary policies may also be contradictory. 7. Easy Money - lowering interest rates, expanding money supply. a. mitigate recession and stimulate growth. 8. Tight Money - increasing interest rates, contracting money supply. a. mitigate inflation and slow growth. 9. Monetary rules - Milton Friedman a. Discretionary monetary policy often misses targets in U.S. monetary history b. Suspicion of Fed and FOMC perhaps overblown

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11. Interest Rates and Output: Hicks IS/LM Model Lecture Notes
1. IS Curve The IS curve shows the level of real GDP for each level of real interest rate. The derivation of the IS curve is a rather straightforward matter, observe the following diagram.

INCOME/EXPENDITURE Expenditure or Aggregate Demand

GDP AUTONOMOUS SPENDING Interest Rate Interest Rate

IS Autonomous Spending 39 GDP

The Income-Expenditure diagram determines for each level of aggregate demand the associated level of GDP. The intercept of the IS Curve is the level of GDP that would obtain at a zero real interest rate. The slope of IS Curve is the multiplier (1/1 - MPC) times marginal propensity to Invest (resulting from a change in real interest rates) and the marginal propensity to export (resulting from a change in real interest rates). The IS curve can be shifted by fiscal policy Changes in Co or Io will also move the IS curve. Anytime the economy moves away from the IS curve there are forces within the system which push the economy back onto the IS curve. Observe the following diagram: Real Interest Rate

IS Curve

Real GDP If the economy is at point A there is a relatively high level of real interest rates which results in planned expenditure being less than production, hence inventories are accumulating, and production will fall, hence pushing the economy toward the IS curve. On the other hand, at point B the relatively low real interest rate results in planned expenditure being greater than production, hence inventories are being sold into the market place and product will rise to bring us back to the IS curve.

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2. LM Curve The LM Curve is derived in a fashion similar to that of the IS curve. Consider the following diagram:

Interest Rate

Money S

Interest Rate

LM Curve D1 D2 D3 Real Qty of Money Low Y As can be readily observed from this diagram the LM curve is the schedule of interest rates associated with levels of income (GDP). The interest rate, in this case, being determined in the money market. With a fixed money supply each level of demand for money creates a different interest rate. If the money market is to remain in equilibrium, then as incomes rise so too, then must the interest rate, if the supply of money is fixed. The shifting of the LM curve is obtained through inflation or monetary policy. GDP (Y) High Y Moderate Y

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3. Equilibrium in IS-LM The Intersection of the IS and LM curve results in there being an equilibrium in the macroeconomy.

Interest Rate LM

r IS1 ISe IS2 GDP Y

Where the IS and LM curves intersect is where there is an equilibrium in this economy. With this tool in hand the affects of the interest rate on GDP can be directly observed. As the IS curve shifts to the right along the LM curve notice that there is an increase in GDP, but with a higher interest rate (IS1) and just the opposite occurs as the IS curve shifts back towards the origin (IS2). From above it is clear the sorts of things that shift the IS curve, fiscal policy or changes in Co or Io.

4. Expansionary and Contractionary Monetary Policies The LM curve, too, can be moved about by changes in policy. If the money supply is increased or decreased that will have obvious implications for the LM curve and hence the interest rate and equilibrium level of GDP. Consider the following diagram:

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Interest Rate

LM2 LMe LM1

IS

GDP Y

As the Fed engages in easy monetary policies the LM Curve shifts to the right, and the interest rate falls, as GDP increases. 5. Foreign Shocks The U.S. economy is not a closed economy, and the IS-LM Model permits us to examine foreign shocks to the U.S. economy. There are three of these foreign shocks worthy of examination here; these are (1) increase in demand for our exports, (2) increases in foreign interest rates, and (3) currency speculators expectations of an increase in the exchange rate of our currency with respect to some foreign currency. Each of these foreign shocks results in an outward expansion of the IS Curve as portrayed in the following diagram:

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Interest Rate LM r2 r1 IS1 ISo GDP Y1 Y2

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12. Economic Stability and Policy Lecture Notes

1. Inflation, Unemployment and Economic Policy a. The misery index is the inflation rate plus the unemployment rate. 2. The Phillips Curve is a statistical relation between unemployment and inflation named for A. W. Phillips who examined the relation in the United Kingdom and published his results in 1958. (Actually Irving Fisher had done earlier work on the subject in 1926). a. Short run trade-off

Often used to support activitist role for government, however, the short-run tradeoff view of the Phillips curve demonstrates that there is a cruel choice between increased inflation or increased unemployment, but low inflation and unemployment together are not possible. b. Long run Phillips Curve is alleged to be vertical at the natural rate of unemployment.

45

This long-run view of the Phillips Curve is also called the Natural Rate Hypothesis. It is based on the idea that people constantly adapt to current economic conditions and that their expectations are subject to "adaptive" revisions almost constantly. If this is the case, then business and consumers cannot be fooled into thinking that there is a reason for unemployment to cure inflation or vice versa. c. Possible positive sloping has hypothesized by Milton Friedman. Friedman was of the opinion that the may be a transitional Phillips curve while people adapt both their expectations and institutions to new economic realities. The positively sloped Phillips curve is show in the following picture:

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The positively sloped transitional Phillips Curve is consistent with the observations of the early 1980s when both high rates of unemployment existed together with high rates of inflation -- a condition called stagflation. d. Cruel choices only exist in the case of the short-run trade-off view of the Phillips Curve. However, there maybe a "Lady and Tiger Dilemma" for policy makers relying on the Phillips Curve to make policy decisions. 3. Rational expectations is a theory that businesses and consumers will be able to accurately forecast prices (and other relevant economic variables). If the accuracy of consumers' and business expectations permit them to behave as though they know what will happen, then it is argued that only a vertical Phillips Curve is possible, as long as political and economic institutions remain stable. 4. Market policies are concerned with correcting specific observed economic woes. a. Equity policies are designed to assure "a social safety net" at the minimum and at the liberal extreme to redistribute income. 2. The Lorenz Curve and Gini Coefficients are used to measure income distribution in economies.

The Lorenz curve maps the distribution of income among across the population. The 45 degree line shows what the distribution of income would be if income was uniformly distributed across the population. However, the Lorenz curve drops down below the 45 degree line showing that poorer people receive less than rich people. 47

The Gini coefficient is the percentage of the triangle mapped out by the 45 degree line, the indicator line from the top of the 45 degree line to the percentage of income axis, and the percentage of income axis that is accounted for by the area between the Lorenz curve and the 45 degree line. If the Gini coefficient is near zero, income is close to uniformly distributed; if is near 1 then income is mal-distributed. b. Productivity is also the subject of specific policies. The Investment Tax Credit, WIN program, and various state and federal training programs are focused increasing productivity. c. Trade barriers have been reduced through NAFTA and GATT in hopes of fostering more U.S. exports. 5. Wage-Price Policies a. Attempts have been made to directly control inflation through price controls, this seemed to work reasonably well during World War II. Carter tried voluntary guidelines that failed, and Nixon tried controls that simply were a disaster. 6. Supply Side Economics of the Reagan Administration were based on the theory that stimulating the economy would prevent deficits as government spending for the military was increased. This failed theory was based on something called the Laffer Curve. a. Laffer Curve (named for Arthur Laffer) is a relation between tax rates and tax receipts. Laffer's idea was rather simple, he posited that there was optimal tax rate, above which receipt went down and below which receipts went down. The Laffer curve is shown below:

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The Laffer Curve shows that the same tax receipts will be collected at the rates labeled both "too high" and "too low." What the supply-siders thought was that tax rates were too high and that a reduction in tax rates would permit them to slide down and to the right on the Laffer Curve and collect more revenue. In other words, they thought the tax rate was above the optimal. We got a big tax rate reduction and found, unfortunately, that we were below the optimal and tax revenues fell, while we dramatically increased the budget. In other words, record-breaking deficits and debt. b. There were other tenets of the supply-side view of the world. These economists thought there was too much government regulation. After Jimmy Carter de-regulated trucking and airlines, there was much rhetoric and little action to de-regulate other aspects of American economic life. 7. Unfortunately, the realities of American economic policy is that politics is often main motivation for policy. a. Tax cuts are popular, tax increases are not. b. Deficits are a natural propensity for politicians unwilling to cut pork from their own districts and unwilling to increase taxes. 8. Politics - economics provides a scientific approach to understanding, politics is the art of the possible what is good economically maybe horrible politically and vice versa a. Public choice literature 2. Politicians act in self-interest just like the rest of us 49

13. Data: Categories, Sources, Problems and Costs Lecture Notes

1. Data Types A. Time series data are metrics for a specific variable observed over time. B. Cross-sectional data, on the other hand, are data for a specific time period, for a specific variable, but across subjects. C. The combination of cross-sectional data over time is called panel-data. D. Discrete data are metrics that have specific and finite number of potential values. E. Continuous data, on the other hand, are metrics, which can take on any value either from plus infinity to negative infinity, or within specific limits. . F. A stock variable is generally a variable in which there is a specific value at some point. G. A flow variable is generally something that has some beginning, ending or changing value over time. 2. Survey data is generally reported by an individual who may or may not have some motivation to accurately report the data requested in the survey. A. Validity has two broad dimensions. 1. The response rate from the sample of a population will define how representative that sample is of the population. 2. The second issue involves whether the items on the survey actually capture what the researcher intends. a. This second issue with validity also has three distinct dimensions these are: (1) content validity, (2) criterionrelated validity and (3) construct validity. B. Reliability has to do with assuring the accuracy of responses. 50

1. Internal checks 2. States of nature data, involve things like market prices, number of persons, tons of coal and other such metrics that can be physically observed or measured. 3. Interviews and observational methods are also often utilized to gather what is sometimes referred to as primary data. 3. Seasonal Adjustments Conceptually, there are a number of economic time series data, which have specific, predictable biases created by the time of year. 4. Data Sources A. Public, Federal, State, International Organizations, and Foreign Countries 1. 2. 3. 4. 5. 6. Commerce Department Bureau of Labor Statistics CIA Fed OECD World Bank, IMF, and UN

B. Private data sources include both proprietary and non-proprietary sources. 1. Market data - S&P Dow Jones etc. 2. ACCRA 5. Information is not free, there are costs associated with gathering and analyzing data. A. Sutcliff and Webber 1. Perceptual Accuracy 2. Dangers in Anecdotal evidence 3. Training, perception, experience, and humility Sutcliff and Weber argue that the accuracy of data is an expensive proposition and that too often managers have neither the expertise nor the time to fully analyze what imperfect information they can gather. What Sutcliff and Weber 51

contend is that intuition is perhaps a better modus operandi, what they call a humble optimism but based on what knowledge can be gleaned without becoming a victim of the old clich paralysis by analysis.

Magnitude of Change

Perceptual Accur

Performance

Perceptual accuracy

52

Sutcliff and Weber studies suggest that organizational change has an inverted U shaped relation to perceptual accuracy. In other words, over the initial ranges there are increases in the return to perceptual accuracy for positive organizational change up to some optimal point. Beyond that optimal, additional accuracy actually results in negative returns. On the other hand, organization performance is negatively correlated with perceptual accuracy. The more resources (time, etc.) are devoted to perceptual accuracy of analysis or the underlying data the more likely performance will decline. 6. Professor James Brian Quinn has observed that the move into high-tech business (science based) has forced many firms to examine their strategies and how they deal with information. In fact, Dr. Quinn believes that these science based industries have been forced into a situation where knowledge sharing is of critical importance to the success of industries and firms within those industries. The following quotation states his point:

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14.

Economic Indicators Lecture Notes

1. Cyclical Indicators: Background A. The Arthur F. Burns and Wesley C. Mitchell at the Bureau of Economic Research began to examine economic time series data in the 1930s to determine if there were data, which were useful in predicting business cycles. B. These indicators are described in Bureau of Economic Analysis Handbook of Cyclical Indicators. These indicators were selected using six criteria. These criteria are described in John J. McAuleys Economic Forecasting for Business: Concepts and Applications, to wit:

John McAuley,Economic Forecasting for Business: Concepts and Applications Cyclical indicators are classified on the basis of six criteria: (1) the economic significance of the indicator; (2) the statistical adequacy of the data; (3) the timing of the series whether it leads, coincides with, or lags turning points in overall economic activity; (4) conformity of the series to overall business cycles; a series conforms positively if it rises in expansions and declines in downturns; it conforms inversely if it declines in expansions and rises in downturns: a high conformity score indicates the series consistently followed the same pattern; (5) the smoothness of the series movement over time; and (6) timeliness of the frequency of release monthly or quarterly and the lag in release following the activity measured. C. Indicators are considered, in general, to be useful, simple guides to the variations in the business cycle in the U.S. 2. Leading Indicators. A. Leading indicators are those variables, which precede changes in the business cycle.

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______________________________________________________________________ Table 1: Leading Economic Indicator Index Variable Weight in Index 1.014 1.041 1.081 .959 .892 .946 .973 1.149 .932 .973 1.054 .985

1. Average workweek of production workers, manufacturing 2. Average weekly initial claims, State Unemployment Insurance (Inverted) 3. Vendor performance (% change, first difference) 4. Change in credit outstanding 5. Percent change in sensitive prices, smoothed 6. Contracts and orders, plant and equipment (in dollars) 7. Index of net business formation 8. Index of stock price (S&P 500) 9. M-2 Money Supply 10. New Orders, consumer goods and materials (in dollars) 11. Building permits, private housing 12. Change in inventories on hand and on order (in dollars, smoothed)

Source: Business Conditions Digest, 1983 ______________________________________________________________________ B. Efficient Market Hypothesis Eugene Fama 3. Coincident Indicators A. These indicators are the ones, which happen as we are in a particular phase of the business cycle, in other words, they happen concurrently with the business cycle. Statistically their variations follow the leading indicators and occur prior to the lagging indicators. ______________________________________________________________________ Table 2: Index of Coincident Indicators Variable 1. 2. 3. 4. Employees on nonagricultural payrolls Index of industrial production, total Personal Income, less transfer payments Manufacturing and trade sales Weight 1.064 1.028 1.003 .905

Source: Business Conditions Digest, 1983. ______________________________________________________________________ 55

4. Lagging Indicators A. Lagging indicators are those, which trail the phase in the business cycle that the economy just experienced. ______________________________________________________________________ Table 3: Lagging Indicators Variables 1. 2. 3. 4. 5. 6. Average duration of unemployment Labor cost per unit of output, manufacturing Ratio constant dollar inventories to sales, and manufacturing and sales Commercial and industrial loans outstanding Average prime rate charged by banks Ratio, consumer installment debt to personal income Weights 1.098 .868 .894 1.009 1.123 1.009

Source: Business Conditions Digest, 1983. ______________________________________________________________________

5. Other Indicators A. The University of Michigan publishes a Consumer Confidence index and the Conference Board also does something similar for producers. B. Real Estate firms have a lobby and research group that does surveys of new home construction, and sales of existing housing which plays on essentially the same sort of economic activities captured by Building permits, private housing variable found in the Index of Leading Indicators. C. The Federal Reserve is not to be outdone in this forecasting business. The Philadelphia Federal Reserve Bank does an extensive survey of business conditions and plans in the Philadelphia Federal Reserve District and publishes their results monthly. This report is commonly referred to as The Beige Book and it eagerly anticipated as providing insights into what to expect in the near future in the eastern part of the United States.

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D. There are also numerous proprietary forecasts and indices constructed for every purpose imaginable. Stock price data have been subjected to nearly every torture imaginable in an attempt to gain some sort of trading advantage. Bollinger Bands, Dow Theory, and even Sun Spots have been used in an attempt to forecast what will happen in the immediate short run with financial markets. E. Investment Services 1. 2. 3. 4. Zacks Standard and Poors Morningstar Others

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15. Guide to Analytical and Forecasting Techniques Lecture Notes

1. Time Series Methods These are: (1) trend line, (2) moving averages, (3) exponential smoothing, (4) decomposition, and (5) Autoregressive Integrative Moving Average (ARIMA). Each of these methods is readily accessible, and easily mastered (with the possible exception of certain variants of ARIMA). The first four of these methods involves little more than junior high school arithmetic and can be employed for a variety of useful things. A. Trend Line 1. This method is also commonly called a naive method, it that is simply fitting a representative line to the data observed. Black thread method.

58

B. Moving Averages 1. If we have three data points 6, 7, and 8. The moving average is calculated as:

0 = 6+7+8 3 = 7
2. The moving average of this series is 7. However, it is clear that if the series continues that the next number will be 9. Therefore, a weighted moving average may result in a more satisfactory result. If the we use a method that weights the last observation in the series more than the first observation we will get closer to the next number in the series, which we presume is 9. Therefore, the following weighted average is used:

0 = (.5) 6+7+ (1.5)8 3 = 7.333

3. This weighting scheme still undershoots the forecast. Therefore we try using something in which the last number is weighted more heavily.

0 = (.5) 6+7+(2)8 +1 3 = 9
C. Exponential Smoothing 1. Exponential smoothing is an effort to take some of the guess work out, or at least formalize the guess work. The equation for the forecast model is: F = () X2 + (1 - ) S1 2. Where alpha is the smoothing statistic, X is the last observation in the data set, and S is the first predicted value from the data set. For example, if we use the following series: 25, 23, 22, 21, 24 3. To obtain the initial value of S or S1 we add 25 and 23 and divided the sum by 2 to obtain 24. The X2 in this case is our last observation or 25. All that is left is the selection of . Normally, an analyst will select .3 with a series, which does not a linear trend upwards or downwards. This gives a systematic method of determining the appropriate value of . Make predictions using beginning at .1 and work your way to .9 and determine which gives the forecast with the least error term over 59

a range of the latest available data, and use that until such time as error begin to increase. To complete the example, lets plug and chug to a get a forecast. F = (.3) 25 + (1 - .3) 24 = 7.5 + D. Decomposition 1. The process begins with calculating a moving average for the data series. For quarterly data the moving average is: MA = (Xt-2 + Xt-1 + Xt + Xt+1) / 4 We will apply this method to the following data: Year 1 X First Quarter Second Quarter Third Quarter Fourth Quarter Year 2 First Quarter Second Quarter Third Quarter Fourth Quarter Year 3 First Quarter Second Quarter Third Quarter Fourth Quarter Applying our moving average method: MA3 = (10+12+13+11)/4 = 11.50 MA4 = (12+13+11+11)/4 = 11.75 MA5 = (13+11+11+13)/4 = 12.00 MA6 = (11+13+14+11)/4 = 12.25 60 10 12 13 11 X 11 13 14 11 X 10 13 13 11 16.8 = 24.3

The data are now presented for year as a moving average of the quarters centered on the quarter represented by the number following the MA. For the year, the data for this series centered on the third quarter is 11.50, centered on the fourth quarter it is 11.75 and for the first quarter of the previous year it is 12.00. Now we can calculate an index for seasonal adjustment, in a rather simple and straightforward fashion. The index is calculated using the following equation: SI t = Y t / MA t Where SI t is the seasonal index, Y t is the actual observation for that quarter, and MA t is the moving average centered on that quarter, from the method shown above. A seasonally adjusted index can then be created which allows the seasonality of the data to be removed. Using the three years worth of data above we can construct a seasonality index, which allows us to remove the seasonal effects from the data. The average for each quarter is calculated: Y1 = (10+11+10)/3 = 10.33 Y2 = (12+13+13)/3 = 12.67 Y3 = (13+13+13)/3 = 13.00 Y4 = (11+11+11)/3 = 11.00 Therefore plugging in the values for Y t and MA t the equation above allows us to construct an index for seasonality from this data: SI 1 = 10.33/11.50 = .8983 SI 2 = 12.67/11.75 = 1.0783 SI 3 = 13.00/12.00 = 1.0833 SI 4 = 11.00/12.25 = .8988 To seasonally adjust the raw data is then a simple matter of divided the raw data by its appropriate seasonal index.

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Year 1 First Quarter Second Quarter Third Quarter Fourth Quarter Year 2 First Quarter Second Quarter Third Quarter Fourth Quarter Year 3 First Quarter Second Quarter Third Quarter Fourth Quarter

X Seasonally Adjusted 10/0.8983 = 11.1321 12/1.0783 = 11.1286 13/1.0833 = 12.0004 11/0.8988 = 12.2385 11/0.8983 = 12.2453 13/1.0783 = 12.0560 14/1.0833 = 12.9235 11/0.8988 = 12.2385 10/0.8983 = 11.1321 13/1.0783 = 12.0560 13/1.0833 = 12.0004 11/0.8988 = 12.2385

E. ARIMA Autoregressive Integrated Moving Average. 1. This method uses past values of a time series to estimate future values of the same time series. According to John McAuley, The Nobel Prize winning economist Clive Granger is alleged to have noted: it has been said to be difficult that it should never be tried for the first time. However, it is useful tool in many applications, and therefore at least something more than a passing mention is required here. There are basically three parts of an ARIMA model, as are described in McAuleys text these three components are:1

John J. McAuly, Economic Forecasting for Business: Concepts and Applications, Englewood Cliffs, N.J.: Prentice-Hall, Inc., 1985. 62

(1) The series can be described by an autoregressive (AR) component, such that the most recent value (X1) can be estimated by a weighted average of past values in the series going back p periods: X1 = (X t-1) + . . . + p (X t-p) + + where p = the weights of the lagged values = a constant term related to the series mean, and = the stochastic term (2) The series can have a moving average (MA) component based on a q period moving average of the stochastic errors:

X1 = 0 + (t - 1) t-1 - . . . - q + t-u where 0 = the mean of the series q = the weights of the lagged error terms and = the stochastic errors. (3) Most economic series are not stationary (can be transformed through differencing using a stationary process), but instead display a trend or cyclical movements over time. Most series, however, can be made stationary by differencing. For instance, first differencing is the period-toperiod change in the series: X t = X t - X t-1

2. Correlative Methods A. Correlative methods rely on the concept of Ordinary Least Squares, or O.L.S., which is also sometimes referred to as regression analysis. O.L.S. refers to the fact that the representative function of the data is determined by minimizing the sum of the squared errors of each of the data points from that line. B. Graphical depiction of Ordinary Least Squares: 63

Y 1. The lines from each data point to the representative line are the error terms. Squaring the error terms eliminates the signs, and the regression analysis minimizes these squared errors in order to determine what the most representative line is for there data points. C. The general form of the representative equation for a bi-variate regression is: Y = + X + where Y is the dependent variable, and X is the independent variable; is the intercept term, is the slope coefficient and random error term.

D. Correlation 1. To be able to determine what a representative line is, requires some further analysis. The model is said to be a good fit if the R squared is relatively high. There R squared can vary between 0 (no correlation) to 1 (perfect correlation). Typically an F statistic is generated by the regression program for the R squared which can be checked against a table of critical values to determine if the R 64

squared is significant different than zero. If the F statistic is significant, then the R squared is significantly more than zero. The simple r is calculated as: r = (X - X) (Y - Y) / ([ (X - X)2 ][ (Y - Y)2 ])-1 in addition, the simple r is squared to obtain the R squared. E. Significance of Coefficients 1. There are also statistical tests to determine the significance of the intercept coefficient and the slope coefficient, these are simple tstatistics. The test of significance is whether the coefficient is zero. If the t-statistic is significant for the number of degrees of freedom, then the coefficient is other than zero. In general, the analyst is looking for coefficients, which are significant, and of a sign that makes theoretical sense. If the slope coefficient for a particular variable is zero, it suggests that there is no statistical association between that independent variable and the dependent variable. 2. There is also a problem in which additional data being added to the series or another variable will sometimes cause the sign of a coefficient already in the model to swap signs. This is a symptom of problem with the data called heteroskedasticity. This problem is a result data not conforming to the underlying assumptions of ordinary least squares that is that the errors or residuals do not have a common variance. You basically have two ways in which to deal with this problem, select a different analytical technique or try transforming the data. If you transform the data, log transformations or deflating the data into some normalized series will sometime eliminate the problem and give unbiased, efficient estimates. 3. With time series data there also arises a problem called serial correlation. That is when the error terms are not randomized as assumed. In other words, the error terms are correlated with one another. There is test for this problem, called the Durbin-Watson (d) statistic. When dealing with time series data one should, as a 65

matter of routine, have the program calculate a DW (d) and check with a table of critical values so as to eliminate any problems in inference associated with correlated error terms. If this problem arises, often using the first difference of observations in the data will eliminate the problem. However, often a low DW (d) statistic is an indication that the regression equation may be mis-specified which results in further difficulties, both statistically and conceptually. F. Other Issues 1. accessibility; you can do regressions on Excel Spreadsheets. 2. dummy variable. a. dummy variable trap - which results in a zero coefficient and other unpleasantries. 3. Instrumental variables are also sometimes used. These variables are constructed for the purpose of substituting for something we could not directly measure or quantify. 3. Other Methods A. Continuous Data 1. Analysis of variance is typically used to isolate and evaluate the sources of variation within independent treatment variable to determine how these variables interact. An analysis of variance is generally part of the output of any regression package and provides additional information concerning the behavior of the data subjected to the regression. 2. Multivariate analysis of variance, which provides information on the behavior of the variables in the data, set controlling for the effects of the other variables in the analysis. 3. Analysis of covariance, which goes a set further, as the name, suggests, and provides an analysis of how the multiple variables interact statistically. 4. Factor analysis relies on correlative techniques to determine what variables are statistically related to one another. A factor may have several different dimensions. For example, men and 66

women. In general, men tend to be heavier, taller, and live shorter lives. These variables would form a factor of characteristics of human beings. 5. Cluster analysis is analogous in that rather than a particular theoretical requirement that results in factors, there may be simple tendencies, such as behavioral variables. 6. Canonical correlation analysis is a method where factors are identified and the importance of each variable in a factor is also identified. These elements are calculated for a collection of variables, which are analogous to a dependent variable in a regression analysis, and a collection of variables, which are analogous to independent variables in a regression. This gives the research the ability to deal with issues which may be multidimensional and do not lend themselves well to a single dependent variable. For example, strike activity in the United States has several different dimensions, and data measuring those dimensions. The competing theories explaining what strikes happen and why they continue can then be simultaneously tested against the array of strike measurements, lending to more profound insights than if just one variable was used. 7. Profit analysis uses categorical dependent variables (discrete) and explains the variation in that variable with a mixture of continuous and discrete variables. The output of these computer programs yields output, which permits inference much the same as is done with regression analysis. a. If there is a stochastic dependent logit analysis is an alternative to profit.

B. Discrete Data There are several nonparametric methods devised to deal specifically with discrete data. 1. The Mann-Whitney U test provides a method whereby two populations distributions can be compared. 2. The Kruskal-Wallis test is an extension of the Mann-Whitney U test, in that this method provides an opportunity to compare several populations.

67

3. These tests can be used with the distributions of the data do not fit the underlying assumptions necessary to apply an F test (random samples drawn from normally distributed populations with equal variances). 4. There are also methods of dealing with ordinally ranked data. For example, the Wilcoxon Signed-Rank test can be utilized to analyze paired-differences in experimental data. This is particularly useful in educational studies or in some types of behavioral studies where the F statistic assumptions are not fulfilled or the two tests above do not apply (not looking at population differences). 5. Spearman Rank Correlations are useful in determining how closely associated individual observations may be to specific samples or populations. For example, item analysis in multiple choice exams can be analyzed using this procedure. a. Students who perform well on the entire exam can have their overall score assessed with respect to specific questions. In this example, if the top students all performed well on question 1, their rank correlation would be near 1, however, if they all performed well, but on question 2 they did relatively poorly, that correlation would be closer to zero, say .35. If, on the other hand, none of the students who performed well got question 2 correct, then we would observe a zero correlation for that question. This method is useful in marketing research and in behavioral, as well as college professors with too much time on their hands.

16. Data: In the Beginning Lecture Notes

1. Becoming Familiar with the Data A. Calculating descriptive statistics to determine what the data look like. 1. Mode most frequent observation 68

2. Median - midpoint in the 3. Mean:

0=

fm
i i =n

/n

4. Variance: 2 =

fm
i i =n

i2

- [(

fm
i i =n

i 2

) / n] / n - 1

5. Standard Deviation: =[

fm
i i =n

i2

- [(

fm
i i =n

i 2

) / n] / n - 1]

-1

where: mi = midpoint of data series I fi = frequency of observation in series

A. Skewed data

1. 3 dimensional, skewed left

69

X Mode Median Mean

Y Z
dimensional 2. Skewe d right, 2

Mode Median Mean

3. Normal Distribu tion

Y
70

4. T here is a statistical principle called the law of large numbers. For purposes of most statistical analyses, if the data are random sample from a population with the same variance and continuous, then if you have more than 30 observations it is assumed that that number of observations or more will approximate a normal distribution. . 2. Correlated Independent Variables A. Multicolinearity, serial correlation, correlated error or residuals B. Calculation of correlation matrix

Mean, Mode and Median

____________________________________________________________________ 71

Unemployment Inventories Coincident S&P Rate Mfg. Copper Prices 500 _____________________________________________________________________ Unemployment rate Inventories Mfg. Copper Prices (coincident) S&P 500 1.000 -0.881 -0.793 -0.679 1.000 0.535 0.790 1.000 0.243 1.000

_____________________________________________________________________ C. Forecasting versus Structural Models 1. Structural equations versus forecasting models 2. Rigor and theory

17. Epilog: Management and Business Conditions Analysis

72

Lecture Notes
1. Information and Managerial Empowerment A. Information should, first and foremost, be one means by which people in an organization are empowered to contribute to success of the organization. 1. Empowerment in a managerial sense requires that those closest to the events should be making the calls, within broad policy constraints. 2. Information (its acquisition and dissemination) is a support function. 3. Policy parameters must be set for the gathering, analysis and use of data. a. Open access b. Discretion to exercise delegated authority, and information is one tool to make sure that discretion is exercised wisely. 2. Policy and Strategy A. The purpose of a strategic plan is to provide not only guidance for managerial actions, hence policy, but also to provide a set of goals by which the directed actions of the enterprise can be assessed. B. The culture that is developed in an organization concerning how decision-making occurs is often one of the most important determinants of the organizations success or failure. C. Effective organizations empower those with line authority throughout the organization. 3. Qualitative Issues
73

A. Organizational Culture B. Regulatory Environment C. Other issues

4. Forecasting and Planning Interrelations Forecasting and planning cannot

be separated, as a practical matter. Strategies require a vision of the future.

A. Flexibility to react to vision errors B. Contingency planning C. Measurable outcomes D. Scientific approach to creation of plan and goals. 5. Risk and Uncertainty A. Risk is simply the down-side of opportunity. Risk is the reason entrepreneurs are rewarded. Risk is also the reason enterprises fail. The trick is to take those risks you understand and can appropriately manage. B. Stochastics are what breeds uncertainty, which, in turn, breeds ambiguity. When we dont know what to expect, that is sometimes the most anxiety producing situation. 6. Go forth and prosper!!!

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E550

Quizzes for Intersession 2006 August 7 - August 20, 2006

E550, Business Conditions Analysis First Quiz, August 8 Chapters 1,2,3 Dr. David A. Dilts Name_____________________________________

True/False (1 point each) ___1. Macroeconomics is concerned with the aggregate performance of the entire economic system. ___2. Inductive logic involve formulating and testing hypotheses. ___3. Positive economics is concerned with what is, and normative economics is concerned with what should be. ___4. Correlation is the causal relation between two variables. ___5. Gross Domestic Product is the total value of all goods and services produced within the borders of the United States. ___6. The difference between Gross Domestic Product and Net Domestic Product is Indirect Business Taxes. ___7. The GDP is overstated because of the relatively large amount of economic activity that occurs in the underground economy. ___8. Non-economists are no less or no more biased about economics than they are about physics or chemistry. ___9. Assumptions are used to simplify the real world so that it may be rigorously analyzed. ___10. Ceteris Paribus means consumer beware.

(Multiple Choice, each worth 2 points)

__1. People who are unemployed due to a change in technology that results in a decline in their industry fit into which category of unemployment? A. B. C. D. Frictional Structural Cyclical Natural

Quiz 1, p. 2 ___2. An increase in the price of natural gas will result in: A. B. C. D. Demand-pull inflation Cost-Push inflation Pure inflation None of the above

___3. The aggregate demand curve is most likely to shift to the right (increase) when there is a decrease in: A. B. C. D. The overall price level The personal income tax rates The average wage received by workers Consumer and business confidence in the economy

___4. An increase in the real wage will: A. B. C. D. Increase aggregate demand Decrease aggregate supply Cause cost-push inflation All of the above

___5. Which of the following are not determinants of aggregate supply? A. B. C. D. Changes in input prices Changes in input productivity Changes in the institutional environment All of the above are determinants of aggregate supply

E550, Business Conditions Analysis Second Quiz, August 10, Chapters 4,5,6,7 Dr. David A. Dilts True/False (1 point each) NAME______________________________

___1. The reasons the aggregate demand curve slopes downward is (1)real balance effect, (2) interest rate effect, and (3) foreign purchase effect. ___2. The rachet effect results from the aggregate supply curve shifting upwards which is what is often called price rigidity. ___3. Says Law is an accounting identity that is associated with aggregate demand being equal to aggregate supply in macroeconomic equilibrium. ___4. Marginal propensity to consume is the amount of consumption expenditures a person makes on average. ___5. MPC+MPS = 0 ___6. The Simple multiplier is 1/MPS. Multiple Choice (2 points each) ___1. Which of the following is not a determinate of aggregate demand? A. B. C. D. Personal taxes Government spending Exchange rates All of the above are

___2. The non-income determinates of consumption and savings are: A. B. C. D. Wealth Consumer debts Prices All of the above are

Quiz 2, p. 2 ___3. A recessionary gap is: A. The amount by which C+I+G exceeds the 45 degree line at or above the full employment level of output B. The amount by which C+I+G is below the 45 degree line at or above the full employment level of output C. The amount by which the full employment level of output exceeds the current level of output D. None of the above Short Answer (points as indicated)

With a marginal propensity to consume of .4 the simple multiplier effect is ____ (2 points) Okuns Law states that if unemployment is 8% we have lost what percent of potential GDP____ (3 points) Briefly explain the paradox of thrift (3 points) ______________________________________________________________________ ______________________________________________________________

E550, Business Conditions Analysis Third Quiz, August 15, Chapters 8,9,10, 11,12 Dr. David A. Dilts NAME______________________________ Short Answer (points as indicated) 1. The relationship between unemployment and inflation is shown by what model_________________________________________________________________ ________________ (2 points) 2. An optimal tax rate and the revenues available at each rate are shown by:___________________________________________________________________ (2 points) 3. (2 points) The way economist measure income distribution is with a:___________ curve and a ______coefficient . 4. To close a recessionary gap of $100, with a full employment level of GDP of $1000 and a marginal propensity to consume of .8 requires how much in: addition government expenditures?__________ (2points); tax cuts?______________ (2 points) 5. (2 points) What is Greshams Law? ______________________________________________ True / False (1 point each) ___1. For barter to work requires a coincidence of wants. ___2. The U.S. dollar is backed by gold on deposit at Fort Knox, Kentucky. ___3. If the Fed wishes to decrease the money supply it can buy bonds. ___4. With a fractional required reserve ratio of .05, the money multiplier is 20. ___5. The Federal Funds Rate is the overnight rate of interest charged by the Fed to loan member banks reserves. ___6. Tight monetary policy is associated with the Fed wishing to control inflation. ___7. Easy monetary policy is associated with the Fed wishing to bring the economy out of recession. ___8. The largest proportion of the money supply is currency.

E550, Business Conditions Analysis Fourth Quiz, August 16, Chapters 13, 14 Dr. David A. Dilts NAME______________________________ Short Answers (points as indicated) 1. Identify the criteria on which cyclical indicators are classified______________________________________________________________ _____________________________________________________________ (3 points) 2. (2 points) What is the largest proportion of GDP? _________________________ 3. (2 points) What are NET exports ______________________ and are they positive or negative in the national income accounts? _________ 4. (3 points) List the components of the index of coincident indicators ___________________________________________________________________ True/ False (1 point each) ___1. The Laspeyres index uses a constant market basket whereas the Paasche index uses changing weights to always have a current market basket. ___2. Seasonally adjusted unemployment differs from not seasonally adjusted in that the entrants into the market in the summer and at Christmas time are washed out of the data. ___3. Establishment data for unemployment counts workers twice who are employed in two place, whereas Household data does not. ___4. Consumption expenditures are divided up among, consumer durables, consumer nondurables, and services. ___5. Index of stock prices is a leading economic indicator. ___6. Index of industrial production is a coincident economic indicator. ___7. Average duration of unemployment is a lagging economic indicator. ___8. Two-thirds of consumer spending is accounted for by other durable goods and housing services. ___9. Producers durable equipment are reported in three categories: Motor vehicle, aircraft, and other producer durables. ___10. The simplest forecasting method is the use of leading indicators.

E550, Business Conditions Analysis Fifth Quiz, August 17, Chapter 15 Dr. David A. Dilts NAME______________________________ 1. (3 points) What three ways do economic forecasts vary: a. _________________, b.________________, c.________________ 2. What comprises the M3 money supply? (4 points) a.____________ b.____________ c. _____________ d. _________________ 3. What are the two needs of an economic forecaster?__________________________(2 points) 4. What are the five phases of the business cycle? (2 points) ______________________________________________________________________ ______________________________________________________________________ 5. Briefly outline what a regression model is (3 points) ______________________________________________________________________ ______________________________________________________________________ ______________________________________________________________________ True/False (1 point each) ___1. The domestic sector is C + I + G. ___2. Consumption is dependent on disposable income, and wealth is built in as a stream of potential earnings. ___3. Investment is sensitive to interest rates. ___4. Public savings is the amount the government spends minus the aggregate budget surpluses. ___5. A rise in interest rates abroad will reduce the value of the domestic currency at each domestic interest rate. ___6. A decrease in the domestic interest rate will cause an increase in the flow of savings in the loanable funds market domestically.

E550, Business Conditions Analysis Sixth Quiz, August 18, Chapters 16, 17 Dr. David Dilts NAME______________________________ True / False (1 point each) ___1. Quinn claims that successful strategic management with be to recognize patterns of impending change, anomalies, or promising interactions, then monitor, reinforce, and exploit them. ___2. Perceptual accuracy seems to be negatively correlated with performance as measured by profits according to Sutcliffe and Weber. ___3. Top managers should focus on managing ambiguity for subordinates, rather than worrying about the accuracy of data or forecasts according to Sutcliffe and Weber. ___4. Forecasting is just one tool in managing ambiguity and uncertainty. Short Answers (as indicated) 1. Describe briefly nine forecasting or analytical methods presented in this course. Tell what type of data it uses, what the output will be, and whether it is accessible. (9 points) a. b. c. d. e. 2. Briefly explain each of the following forecasting methods: (4 points) Judgments methods Counting methods Time Series methods Association or causal methods 3. Managers can improve their projections in the following three ways: (3 points) a. b. c. f. g. h. i.