Lecture 2 on the US Economy – 1 st Hour Lots of Dilemmas to Consider

How is the US Doing on Growth, Unemployment, and Inflation? These are the Big Three indicators of how well the economy is doing.

This Graph Assumes that US Potential Output Growth Fell Substantially After 2009

Average or Natural Growth was about % for the US from The US is in recovery now but growth is not very high – only about 2.2% annualized rate 2010Q1-2014Q2.

Why has this happened? Many Possible Reasons – Here are Two. (1)Discouraged Worker Problem Ex. 2 Workers where 1 has Job and the Other is Unemployed U-Rate = ½ = 50% Now Suppose that the Unemployed Worker Leaves the Labor Force. This means only 1 Worker in Labor Force U-Rate = 0/1 = 0% This example shows a big drop in U-Rate, but NO change in output.

(2) Part-Time Worker Problem Ex. 2 Workers – 1 has Job the Other is Unemployed U-Rate = ½ = 50% Now Suppose that the Unemployed Worker Gets a Part-Time Job (say 2 hours per week). This means only 2 Workers in Labor Force and Both Have Jobs U-Rate = 0/2 = 0% This example shows a big drop in U-Rate but SMALL change in output.

Okun’s Law is Weakening. Changes in Unemployment Generate Much Weaker Changes in Economic Growth Forecasting Growth with Constant Okun Coefficient Forecasting Growth with Declining Okun Coefficient and Natural Growth Unemployment Rate is Not a Good Measure of Progress

It is very difficult for government to create stable new jobs. By definition, the government is trying to use temporary methods to restart the economy. Only private business can create millions of jobs. Business needs to see a permanently positive business environment.

By the way, China is not really taking all that many jobs from the US. The US is losing manufacturing jobs, but not so much because of cheap imports. Low priced imports are helping to keep the real value of wages in manufacturing high. That’s a good thing. The real issues are productivity growth, exports, and the change in demand towards services

Natural Unemployment (5%-6%) (0.5%) Total US Unemployment Rate = 5.5 % + 0.6% = 6.1%

Lecture 2 on the US Economy – 2 nd Hour More Dilemmas to Consider

How about inflation in the US?

The costs of low and steady inflation are not really that high Unanticipated inflation can redistribute income between lenders and borrows. Inflation hurts people on fixed nominal incomes, especially the elderly. Inflation makes it harder for firms to replace depreciated capital. Inflation can increase real tax burdens, if rates are not indexed. Inflation causes firms to waste real resources in re-labeling prices and in forecasting future rates of inflation. Unanticipated inflation can alter exchange rates and increase risk. Inflation is often confused with all important changes in relative prices. Inflation is a surreptitious tax on real money balances. Here is a short list of costs typically mentioned by economists

Many People are Arguing that We Should Increase Inflation as a Means of Stimulating the Economy Who are these people – Bernanke, Krugman, Yellen,

The argument is that the demand for money is too high....people want to hold money and not goods and services....this is slowing aggregate demand and hampering a full expansion of the economy....so, if people want more money, just give it to them....give them so much that they will not want to hold it anymore and will begin to spend it....and if they wish to buy bonds -- they will not hold T-Bills (which are like cash at the zero lower bound) but will try to buy long term bonds, driving down long term interest rates and stimulating investment...the increase in spending will inflate the economy and things will begin to expand...

But, what if there is a liquidity trap? Won’t people just continue to hold the money after all. How can that be inflationary or expansionary? They don’t spend it. Krugman, Summers, and others say that this is the role of fiscal policy. Greater government spending can drive the economy forward and can be financed by the money creation. Governments can borrow at extremely low interest rates and don’t need to raise taxes. If that sounds inflationary...well a little inflation can be good for the economy. The cost is low compared to the social cost of continued recession.

Thus, if people want money and do not want goods you merely issue bonds, let the central bank buy these bonds and create money for the government to spend and this will generate more money satisfying the public’s demand to hold, while also creating greater spending by government for business to supply. Doing this enough will make inflation rise and raise the cost of holding money. Keynes was a big believer in this excessive demand for liquidity theory of recession...as can be seen from Chapter 17 Section 3 of the General Theory. “Unemployment develops, that is to say, because people want the moon; — men cannot be employed when the object of desire (i.e. money) is something which cannot be produced and the demand for which cannot be readily choked off. There is no remedy but to persuade the public that green cheese is practically the same thing and to have a green cheese factory (i.e. a central bank) under public control.”

Some Criticisms of This Policy (1)It is not “people” but commercial banks that want to sit on trillions of dollars of money (reserves held at the Fed). They do this because of simple Keynesian liquidity preference – they expect higher rates will prevail in the future and do not want to lend now at low rates. (2)Pushing short term rates to zero (and making them negative in real terms) has decreased the return to private lenders at this segment of the yield curve. The effect on private financing of wage bills and inventory and cash management is difficult to sort out. The market has been distorted and this is a supply effect. (see next 2 pages) (3)Purposively inflating without collective bargaining or indexing is tantamount to an income transfer from workers and the retired on relatively fixed incomes to the owners of capital. (4)QE policies are generating asset inflation rather than general price inflation, but it is inflation all the same, and at some time the bubble must burst.