ECONOMICS 2013-14: SECTION 2: MACROECONOMICS...

Economics 2013-14: Section 2: Macroeconomics Standard Page 1

ECONOMICS 2013-14: SECTION 2: MACROECONOMICS STANDARD Business Cycles

• In Economic Development we will examine how growth can be increased through various policies designed to increase productivity: o The economy as a whole moves in an upward direction called the long term

trend or growth pattern which results from: Population growth Increases in productivity or output per person which come from: investment

in capital, human capital, and R & D leading to technological breakthroughs. • In Macroeconomics we deal with cycles and policies to counteract cycles. During

any ten year period there is a cycle in the economy which appears to be related to the replacement of worn out capital equipment.

• Seasonal cycles are related to the primary sector: agriculture, forestry, fishing. • With industrialization, a new manufacturing or industrial cycle appeared:

o The two most powerful cycles appear to be a 3 year cycle and a 10 year cycle. Because they are not matched, it means that the combination of the two leads to different patterns each decade.

• Typically at the end of a decade, industrialized countries tend to enter a serious

recession which ends in a trough in the first year or two of the new decade, followed by an economic recovery. o Recovery proceeds to roughly the middle of the decade at which point there is

typically a mini-recession with a small peak and a trough. o A new recovery period begins and countries enter a boom toward the end of the

decade o Once the economy peaks, a new recession follows.

• The cycles are not exact, and sometimes the mini-recession in the middle of the

decade is deeper than the recession at the end of the decade. Boom Times • During a boom the

economy is operating at or beyond full capacity. There is a shortage of skilled people and raw materials. It is a period of excess demand. o Prices rise faster than

costs, profits are rising and investors are optimistic.


• The boom can turn into a slump if people decide they do not need to replace capital equipment because this leads to a fall in spending.

Capital Utilization Rate • Rather than calling capital unemployed, we reverse the definition and look at the

capacity utilization rate. o Typically 15% of capital is being repaired or replaced and the average utilization

rate is around 85%. o During boom times the capacity utilization rate rises to as high as 92%.

The rate of replacement of capital is slower than the demand for services from capital equipment.

But there is a price for running capital so hard: maintenance schedules are not maintained and the capital wears out at a faster rate.

Recessions • During a downturn, the job creation rate is

typically slower than the number of people entering the job market looking for work: o If there are people looking for work who

cannot find it, they are defined as unemployed.

o As the economy starts to recover, the job creation rate speeds up and the unemployment rate falls particularly for skilled people. For the hard core unemployed, there may be very little change.

Trough • A trough is associated with high unemployment of labour and unused productive

capacity (unemployed capital). o Unemployment rises not because people are laid off, but because the job

creation rate is slower than the number of people entering the job market. o Capacity utilization rates for capital may drop as low as 70%, this means that

machines do not need to be replaced: when a machine wears out, you simply replace it with an existing machine which has been shut down.

o Business profits are low, and investors are pessimistic. • A trough cannot last long because capital equipment wears out and both

households and businesses start to replace it. o Spending picks up and we enter a recovery. o As sales and profits pick up, investors become more optimistic.

Depression • If the recession is particularly deep and long lasting, it is called a depression.

o Typically a depression results when there is a financial panic during a recession. o Better knowledge about the economy, stronger economic policies and the

steady growth resulting from industrialization and technological breakthroughs appear to have prevented serious depressions in most western economies since 1930.


Output Gaps • The output gap: a measure of the difference between actual and potential GDP.

o If the gap is negative: (Y – Yfe) < 0, we refer to it as a recessionary gap. o If the gap is positive: (Y – Yfe) > 0, it means that we have gone beyond full

employment and we are in an inflationary gap. • It is possible to go beyond full employment by running more shifts in factories,

using machines beyond their normal capacity utilization rate, and by paying workers more per hour to work more hours.


Euro zone economy falls deeper than expected into recession

Thu, Feb 14 2013 By Philip Blenkinsop and Annika Breidthardt BRUSSELS/BERLIN (Reuters) - The euro zone slipped deeper than expected into recession in the last three months of 2012 after its largest economies, Germany and France, shrank at the end of a wretched year for the region. It marked the currency bloc's first full year in which no quarter produced growth, extending back to 1995. For the year as a whole, gross domestic product (GDP) fell by 0.5 percent Economic output in the 17-country region fell by 0.6 percent in the fourth quarter, EU statistics office Eurostat said on Thursday, following a 0.1 percent output drop in the third. The quarter-on-quarter drop was the steepest since the first quarter of 2009 and more severe than the average forecast of a 0.4 percent drop in a Reuters poll of 61 economists. Within the zone, only Estonia and Slovakia grew in the last quarter of the year, although there are no figures available yet for Ireland, Greece, Luxembourg, Malta and Slovenia. The big economies set the tone. Germany contracted by 0.6 percent on the quarter, official data showed, marking its worst performance since the global financial crisis was raging in 2009. France's 0.3 percent fall was also slightly worse than expectations. Worryingly for Berlin, it was export performance - the motor of its economy - that did most of the damage, declining significantly more than imports, although economists expect it to bounce back quickly. The euro hit a session low against the dollar after the weaker than forecast German reading and dropped again after the release of full euro zone figures. Back revisions to the French figures showed its output fell by 0.1 percent in each of the first and second quarters of 2012, meaning the country has already experienced one bout of recession in the last twelve months. While the European Central Bank's pledge to do whatever it takes to save the euro has taken the heat out of the bloc's debt crisis, even its stronger members are gripped by an economic malaise that could push debt-cutting drives off track. French Prime Minister Jean-Marc Ayrault acknowledged for the first time on Wednesday that weak growth was putting his government's deficit goal for 2013 out of reach.


Resilient Germany is expected to rebound and the bloc as a whole is expected to have improved in the first quarter, as suggested by a pick-up of factory orders in December, but it is not yet clear if growth has returned. Nick Kounis, economist at ABN AMRO, said the decline of fears the euro could break apart and cheap credit had sown the seeds for the recovery. "However, ongoing severe budget cuts, rising unemployment, bank deleveraging all point to the recovery being excruciatingly slow," he said, adding the strong euro was also a threat. The ECB has a wide-ranging projection for euro zone GDP growth in 2013 of between -0.9 and +0.3 percent. ECB Vice President Vitor Constancio said on Tuesday he expected no major change to the forecasts in March. WEAK PERIPHERY Dutch GDP dropped 0.2 percent over the quarter, keeping it in recession, and the Austrian economy shrank at the same rate. For the more embattled members of the currency bloc, matters are worse. The greatest reported decline was in bailed-out Portugal, down 1.8 percent. Italy suffered its sixth successive quarterly fall in GDP - this time by a sharp 0.9 percent - putting it into a longer slump than it suffered in 2008/2009. Its recession has been deepened by austerity measures that outgoing Prime Minister Mario Monti introduced to stave off a debt crisis. With an election due on February 24/25, all sides in a three-way race between Monti's centrist bloc, Pier Luigi Bersani's center-left coalition and Silvio Berlusconi's center-right are pledging to cut taxes to try to kickstart economic growth. Spain, the euro zone's fourth largest economy, released figures two weeks ago which showed it remained deep in recession after a 0.7 percent contraction in the fourth quarter. Madrid is also pressing on with austerity measures to cut its debt but may be given more time to meet its deficit targets by the European Commission if its economy worsens further. There are signs that countries like Spain are starting to benefit from internal devaluations - marked by wage falls and job losses aimed at making companies leaner and more productive. The ECB predicts the euro zone will pick up later in the year although its currency, if it keeps strengthening, could quickly snuff out any of those hard-won competitive advantages for its high debt members. More recent data for January have already suggested some upturn in the first months of 2013, in the bloc's stronger members at least, and if improvement comes it is expected to be seen in Germany first. (Additional reporting by Steve Scherer, Vicky Buffery, Robert-Jan Bartunek, Ethan Bilby, writing by Mike Peacock, editing by Jeremy Gaunt)


December 5, 2013

Faster Pace of Growth May Not Last Long

By NELSON D. SCHWARTZ

Stoked by rising inventories, the American economy grew at a significantly faster pace in the third quarter than first estimated, but probably at the expense of economic activity during the current quarter as businesses work off some of the excess stock on their shelves and in warehouses.

As investors digested the better-than-expected data on Thursday from the Commerce Department for July, August and September, many economists immediately cut their estimates for fourth-quarter growth.

Barclays, for example, now expects the nation’s gross domestic product to advance at only a 1.5 percent annual rate, down from 2 percent and far below the government’s latest estimate of a 3.6 percent pace for the third quarter. A final revision is scheduled Dec. 20.

Still, the latest data comes at a time when other signs are pointing to improved economic performance next year, both in the United States and abroad, including more robust manufacturing activity and hiring.

In London on Thursday, British officials raised their projections for growth in 2013 and 2014, a sharp reversal from a year ago, when Britain was flirting with a double-dip recession.

On the Continent, however, the outlook is bleaker.

On Thursday, the European Central Bank raised its estimate for growth next year by just 0.1 percentage point to a still-anemic 1.1 percent; the central bank expects the euro zone — the 17 European nations that use the euro — to show a contraction of 0.4 percentage point once all the data for 2013 is in.

“All in all, we’re seeing positive developments,” Mario Draghi, the president of the central bank, said at a news conference, after the bank left its main interest rate unchanged at 0.25 percent.


The situation in Europe makes the United States look good by comparison, even if things are not as rosy as the latest figures from Washington might suggest.

“You can never be unhappy with a 3.6 percent number for gross domestic product,” said Ian Shepherdson, chief economist at Pantheon Macroeconomics. “But the details are more sobering than the headlines. Apart from the inventory numbers, the revisions are pretty trivial.”

“Either companies thought demand would accelerate and built inventories in anticipation of sales that didn’t happen,” Mr. Shepherdson added, “or they’re building in anticipation of stronger demand in the fourth quarter.” With demand uncertain in the final three months of the year, Mr. Shepherdson expects fourth-quarter growth will probably run at a pace of 1 to 2 percent.

The economy’s performance in the final months of 2013 will also determine the denouement of one of the longest-running dramas on Wall Street — the timing of when the Federal Reserve begins easing its stimulus efforts. Investors and traders had expected policy makers to begin tapering its monthly $85 billion bond purchases in September, but the central bank held off because of mixed economic data.

Although the latest data on growth in gross domestic product comes after a series of better-than-expected figures in the United States, American central bankers don’t appear to be in a rush to pull back on the stimulus. While they could act as soon as the next Fed meeting later this month, many analysts do not expect a move until early 2014.

On Thursday, the president of one regional Fed bank indicated that he remained cautious. “The strong third quarter doesn’t make a trend,” said Dennis P. Lockhart, president of the Atlanta Fed. “I am not prepared to interpret the revised third-quarter number as an indication that the economy is on a much stronger track — I think we’re still on that relatively moderate growth track.”

The spotlight on the Fed will grow more intense after Friday, when the Labor Department reports the latest figures for job creation and the unemployment rate in November. Although many economists say that the job market will remain cloudy because of the aftereffect of October’s government shutdown, the report will be closely watched because it will provide the last major clue to the economy before Fed policy makers gather on Dec. 17 and 18.

“It’s a big number,” said Diane Swonk, chief economist at Mesirow Financial. “I think they won’t taper in December, but it is close.”

With a gain of 204,000 positions, the jobs data for October was surprisingly robust, catching most economists off-guard. On Friday, the consensus calls for payrolls to have increased by 185,000 last month with the unemployment rate falling to 7.2 percent, according to Bloomberg News.

On Thursday, the Labor Department said initial weekly jobless claims unexpectedly dropped to 298,000, the lowest in more than two months.

Experts warn the numbers could be volatile, especially the unemployment rate, which is based on a survey separate from the one that tracks hiring and was affected heavily by furloughed government workers in October. The subsequent return of those workers could push the unemployment rate back down more sharply for November, economists said. If it drops to 7.1 percent, it would reach the lowest level in five years.

“The unemployment rate is a complete guess,” said Ellen Zentner, senior United States economist at Morgan Stanley. Even if the more reliable payroll number is stronger than predicted, she said there was little chance of a Fed move this month because fourth-quarter growth looks so weak. Morgan Stanley expects the United States economy to expand by just 1 percent in the final three months of the year.

Stephen Castle, Julia Werdigier and Jack Ewing contributed reporting.


Growth Rose 7.4% in First Quarter, China Reports By KEITH BRADSHERAPRIL 15, 2014 HONG KONG — Confirming the concerns of investors and economists, the Chinese government announced on Wednesday morning that the country’s inflation-adjusted economic output in the first quarter was up 7.4 percent from a year ago — and had risen much less than that, compared with the previous quarter. Beijing officials have set a growth target for the whole year of about 7.5 percent; unlike growth targets in previous years, this year’s target has not been set as a floor, giving the government some political leeway if the final figure falls slightly short. But for the first quarter by itself, the annualized growth rate compared with that in the fourth quarter appears to have been less than 6 percent, economists said. Sheng Laiyun, a spokesman for the National Bureau of Statistics, said the latest figures nonetheless represented an economy showing considerable strength. “Despite the economic slowdown, China’s economy is still growing at a medium to high speed,” he said during a news conference in Beijing. Weak exports and a plunge in housing starts, down 27.2 percent from the first quarter of last year, were powerful brakes on growth in the first quarter. A credit squeeze has hurt many developers, as well as smaller exporters that struggle to borrow enough money to finance purchases of raw materials and sales of finished goods. Troubles in the housing market have also created broad nervousness about the sustainability of high home prices, with small, outlying apartments costing more than an entire decade’s salary for a recent college graduate. But the service sector, which includes industries like hotels and restaurants and which has emerged as a big job creator in recent years, fared better than expected in the first quarter. Louis Kuijs, a China economist in the Hong Kong office of the Royal Bank of Scotland, said the service sector’s resilience and recently announced government initiatives like an acceleration of railroad construction and redevelopment of shantytowns meant it was still possible for economic growth in all of 2014 to meet his forecast of 7.7 percent. Industrial production, which is not adjusted for inflation, was up 8.8 percent in March from a year ago, the government also announced on Wednesday morning. Retail sales climbed 12.2 percent in March. Both were weak figures by Chinese standards but suggested some improvement from January and February. Fixed-asset investment for the first three months of the year was 17.6 percent higher than for the first quarter of last year, the weakest year-to-date figure since November 2001, as the home building sector’s troubles offset extensive construction of infrastructure. Much of the year-on-year growth in the Chinese economy reflected by the 7.4 percent growth figure released on Wednesday morning was the result of economic expansion that actually took place during the second, third and fourth quarters of last year. Although the United States and many other industrialized countries release annualized economic growth figures for each quarter compared with the previous quarter, China does not provide this statistic, preferring year-on-year figures that show less volatility. Private economists estimated that the annualized, quarter-on-quarter growth was between 5.2 and 5.7 percent, depending on what seasonal adjustment was used. Some private economists had expected year-on-year growth to be slightly weaker, at 7.3 percent. The Shanghai stock market was up 0.33 percent in the first hour and a half after the figures were released, while the Hong Kong market was up 0.74 percent. The year-on-year growth of 7.4 percent was the slowest since the third quarter of 2012, also 7.4 percent; the last time year-on-year growth was slower was in the third quarter of 2009, during the global financial crisis, when it was 6.6 percent.


Even three or four years ago, growth of less than 8 percent would have alarmed Chinese officials. But the Chinese economy needs somewhat less growth to maintain nearly full employment these days, because the labor force has begun to shrink, Mr. Sheng said. The falling number of Chinese ages 16 to 55 reflects the increasingly strict enforcement of the “one child” policy through the 1990s and has produced surging blue-collar incomes that are helping to sustain growth in the services sector. A version of this article appears in print on April 16, 2014, on page B4 of the New York edition with the headline: Growth Rate Rose 7.4% in 1st Quarter, China Reports.


2.3 Macroeconomic Goals 2.3.1 Full employment

Policy Goal: Full Employment • We assume that output and employment are closely related because output can

only increase if employment increases. • In a recessionary gap (negative output gap), there is a loss of production as a

result of the unemployment: we can never retrieve that production. • The labour force is often defined as those people between the ages of 15 and 65

who are either working or actively seeking work if they are not employed. o Only unemployed people who are registered as unemployed will appear in

national statistics. • In MDCs there is a strong incentive to register because of unemployment benefits.

This is not true in LDCs which means their unemployment statistics are less accurate.

• The unemployment rate is defined as:

• Full employment: there is no output gap, we are at potential income. There are no people unemployed for cyclical reasons, but unemployment occurs: o Search (or frictional): those who are in transition, they have finished studying

and are entering the work force for the first time, or moving between jobs. o Structural: those who have the wrong skills or are in the wrong location.

There may be job openings but there is a mismatch between the skills required and the skills of the people looking for work

People are not prepared to move communities to take the jobs for which they have the skills but which are located in other communities.

o Discouraged workers are usually young people who have had to wait too long between graduating and finding a career related job.

Types of Unemployment • Except in depressions or serious recessions, unemployment increases when the

creation of new jobs falls below the net increase in the size of the labour force. • Short term unemployed: Except during deep recessions or depressions, most

workers who are laid off only experience a short period of unemployment. • Long term unemployed: people who lack skills or are in the wrong locations. • Involuntary unemployment: in depressed regions unemployment is higher than the

official figures because people have given up looking for work. • Underemployment or disguised unemployment occurs if people accept a part time

job because full time work is not available, or if firms are overstaffed. • Marginal unemployment: workers moving in and out of jobs several times a year. • Youth unemployment: young workers have a higher unemployment rate:

o They have been denied a working experience early in their careers. o They may remain as marginal workers who take temporary jobs at low pay and

with little future job security. o With minimum wage laws employers are discouraged from hiring young people

while providing on the job training.


• Female participation: the rapid increase in female participation has made it very

difficult for markets to respond adequately. • The inflow of women in the labour force exceeded the speed of new job creation

for women, creating a higher unemployment rate for women. o As this rate has slowed down, the female unemployment rate has fallen. o The discrepancy between men and women has narrowed considerably as

women have received training in areas formerly dominated by men. Cyclical Unemployment • At full employment income, there is only search (or frictional) and structural

unemployment. • During recessions there is cyclical unemployment which can be corrected with

fiscal, monetary or trade policy. • In most industrialized countries, unemployment rises when the rate of new job

creation slows down during a recession: o Even in a recession there are thousands of new jobs being created, but the rate

of new job creation is not as fast as the rate of people looking for work. o Skilled people may have lost a job but will soon find one as soon as the rate of

job creation picks up. o The structurally unemployed will never get another job even if the rate of job

creation picks up, they do not have the skills or are in the wrong place. Structural Unemployment • There is a mismatch between the structure of the labour force in terms of skills,

industries and location, and the types or places where jobs are available. Sectoral structural unemployment: • The only sector in which employment has not increased and in many countries has

decreased is in the primary, natural resource sectors. • In many industrialized countries there has also been a decline in manufacturing and

construction accompanied by tremendous growth in the service sector. • Market services: provide inputs to the goods producing industries, the value of

services is included in the goods they help to produce, and include: o Transport, communication, utilities, wholesale and retail trade o Finance, insurance, real estate, business and personal services

• Non-Market services: are paid for out of taxes, they contribute to human capital and economic infrastructure, and include: o Health, education and public administration.

Industrial structural unemployment • Unemployment develops in sunset industries where international competition forces

change: • The goods industries operate in an environment of international competitiveness.

Productivity and the ability to compete are fundamental to their success and to the demand for services: goods and services are starting to merge into each other.


Regional structural unemployment • In regions where natural resources have run out or where industries cannot

compete internationally or domestically, severe unemployment can develop. Minimum wage structural unemployment • Minimum wage laws cause structural unemployment by pricing the unskilled out of

the market. • While this increases the wages for the workers who are lucky enough to get jobs, it

makes it difficult for elderly people looking to supplement their pension or for young people who have no working experience.

• Lower wages are needed to pay for on the job training for young people or for the lower productivity of older workers.

• Retraining and relocation: workers can retrain and develop new skill sets and move to where there are jobs available. This is unlikely to occur except in the case of young workers. o The UK pursued policies of trying to move jobs to the people, but industries

would not move and structural unemployment increased. o In Sweden, a policy to promote mobility and to assist with retraining kept

unemployment rates low for many decades. • Unskilled service jobs: the growth in this sector has more than compensated for the

loss of unskilled jobs in the manufacturing and construction industries. • Jobs do not pay well, are often part time, and do not provide job security. • They provide work for those who cannot find jobs elsewhere, they offer part time

employment for those looking for such work, and they often provide the first job experience for young people who are completing their education and looking to enter the work force.

Search (Frictional) Unemployment • The normal turnover as young people enter the labour force, and other people

leave and search for a better job. • Involuntary unemployment occurs when a person is willing to accept a job at the

market wage, but no job is available. • Voluntary unemployment occurs when a job is available but the person is not willing

to accept it. o The person is looking for a better job. o They do not have knowledge of all available jobs and the wage rates.

• The costs of searching are lowered if the household has another source of income

or if there is unemployment insurance available: this makes it easier for the unemployed to spend longer searching for a better job.

Real Wage Unemployment • If labour unions or minimum wages hold the real wage above equilibrium, or if

there is an economy wide rise in real product wages, some firms will not be able to cover their labour costs and will shut down, leading to unemployment.

• This is most likely to occur when breaking entrenched inflation. Despite the drop in the inflation rate, unions will push for higher wages and real wages will rise.


• If high real wages persist because there is resistance to wages falling, the firms that survive will adapt new technology that replaces expensive labour with capital: o This leads to unemployment o Unemployment may eventually force real wages down or new technologies may

be invented which will hire the unemployed despite the high real wages. The Natural Rate of Unemployment • The natural rate of unemployment means the amount of frictional and structural

unemployment associated with the full employment income level. o For Sweden and Japan it was 2% for many years, in the US it has been at the

4% level since 1985, and in Canada and Australia it has been around 7.5%. • NAIRU: the non-accelerating inflation rate of unemployment, also referred to as the

natural rate of unemployment, is that level of unemployment which does not lead to an increase in inflation.

• NAIRU rose steadily until 1979, the year when most developed nations agreed to stop accommodating inflation in an attempt to control inflation.

• During recessions the natural rate of unemployment falls (search). During the

recovery from recessions, the natural rate of unemployment starts to rise again: o During recessions, people will take a job more quickly, and less time is spent in

searching for the perfect job (search or frictional unemployment falls). o During boom times, workers are willing to take longer to find a job.

• The natural rate of unemployment is assumed to consist of structural and search

(frictional) unemployment but not cyclical unemployment. Measures to deal with unemployment • Cyclical unemployment can be reduced with appropriate fiscal and monetary policy. • Real wage unemployment can be reduced by not allowing inflation to break out

leading to the need to break entrenched inflation which can create the problem in the first place.

• Search (frictional) unemployment can be reduced by: o Reducing unemployment benefits. o Creating employment agencies to reduce the search time. o Study-work programs such as the German one which allows half the students in

high school to learn by working in a job several afternoons per week. • Structural unemployment can be reduced through retraining and relocation:

o Older workers resist changes and are reluctant to admit that innovations have destroyed the value of the knowledge and experience that they already have. Employers tend to hire younger workers who will learn the new skill faster.

• In many industrialized countries, sunset industries and regions are supported with

subsidies. But agreements with industry to hire un-needed (usually older) workers increases costs and makes the industry even less viable and puts an even greater burden on taxpayers.


• In Sweden the state approaches firms in the sunrise area and arranges for unemployed people from sunset industries to enter into a training program which eventually leads to a full time position. The govt. pays all the labour costs during the training period.

• In Japan, the govt. approaches companies with sunset divisions and assists them in investing in new sunrise divisions by paying for retraining of workers.

• Large, sick, declining industries appear like a national disgrace. o However, at any point in time there are a number of new firms in sunrise

industries. o The attempt by govt. to pick winners and losers has proven to be a waste of

money, and often inhibits the real winners. o A policy is needed that encourages private initiatives and risk taking. o Retraining and relocation grants make movement easier and reduce structural

unemployment without inhibiting economic change and growth. Reducing Unemployment in the Future: • The Japanese govt. has found that a certain percentage of the workforce does not

adapt well to industrial manufacturing and it has encouraged the continuation of quasi-traditional industries like agriculture, fishing, forestry, ceramics etc. o By buying the output at subsidized prices and reselling it at market prices people

are able to earn a living without it costing the government a great deal of money.

o This is not welfare, people are only paid if they produce. o And the industries must remain labour intensive rather than substituting capital

for labour. • Knowledge driven methods of production force countries to adjust to structural

changes more rapidly in the future. • How can countries succeed in global markets while maintaining a humane social

welfare system which encourages workers to cooperate with change? • Countries which have experienced the most success have streamlined their capital

markets to make investment more attractive and less tied up with red tape. o These countries have tended to foster technology extension systems to help

small firms adapt to the new technology. o They do not shield large, inefficient firms from market discipline but they do

provide training support for change. • Promotion of small business in Japan:

o A loan guarantee system for small firms is run with no cost to the govt. o A small debt policing system prevents large firms from preying on small supplier

firms by refusing to pay for goods or services delivered unless the small firm lowers the price.


Cyclical UE

Last updated: January 8, 2013 4:17 pm

EU jobless total hits fresh record high By Michael Steen in Frankfurt

Eurozone unemployment hit a fresh record of 11.8 per cent in November, official statistics showed on Tuesday, highlighting the dire state of the bloc’s economy in spite of hopes for a gradual recovery this year.

Across all 27 members of the EU, more than 26m people were out of work in November, or 10.7 per cent of the workforce, according to Eurostat, the EU’s statistical office. The seasonally adjusted unemployment rates for both the eurozone and the wider EU jumped significantly from a year earlier, when they were 10.6 per cent and 10 per cent, respectively.

The crisis-hit countries of Greece, Spain, Cyprus and Portugal saw the biggest increases in unemployment compared with a year earlier. Youth unemployment also rose further, hitting roughly 24 per cent both in the euro area and the EU.

Spanish joblessness hit 26.6 per cent in November, up from 26.2 per cent in October and 23 per cent a year ago. Among those aged 15-24, the rate rose to 56.5 per cent. Separate figures for the number of registered unemployed from Spain’s labour ministry released last week suggested there was a slight drop in December, although this was likely to reflect a seasonal uptick in service sector jobs around Christmas.

An improvement in financial markets and forward-looking economic indicators has fuelled hopes that the acute phase of Europe’s sovereign debt crisis may be drawing to a close, but the region’s economy remains precariously balanced.

Thursday’s meeting of the European Central Bank’s rate-setting governing council is expected to leave interest rates unchanged at 0.75 per cent, according to polls of economists by Bloomberg and Reuters, but there is likely to be discussion over whether more action is required.


The European Commission also released its monthly business and consumer confidence survey, which improved for the second consecutive month in December but remained well below its long term average.

“While the lull in the debt crisis has continued, the eurozone’s economic outlook remains very weak,” Jonathan Loynes, chief economist at Capital Economics, said in a note.

In Germany, Europe’s biggest economy, November trade figures showed a sharp fall in exports and imports, bolstering expectations that it slid into contraction in the fourth quarter. However, it is expected to return to growth in the present period. A first official estimate of German growth for the fourth quarter of 2012 is due to be published on January 15.

Copyright The Financial Times Limited 2014.


Structural UE

September 19, 2013

U.S. Textile Plants Return, With Floors Largely Empty of People By STEPHANIE CLIFFORD GAFFNEY, S.C. — The old textile mills here are mostly gone now. Gaffney Manufacturing, National Textiles, Cherokee — clangorous, dusty, productive engines of the Carolinas fabric trade — fell one by one to the forces of globalization. Just as the Carolinas benefited when manufacturing migrated first from the Cottonopolises of England to the mill towns of New England and then to here, where labor was even cheaper, they suffered in the 1990s when the textile industry mostly left the United States. It headed to China, India, Mexico — wherever people would spool, spin and sew for a few dollars or less a day. Which is why what is happening at the old Wellstone spinning plant is so remarkable. Drive out to the interstate, with the big peach-shaped water tower just down the highway, and you’ll find the mill up and running again. Parkdale Mills, the country’s largest buyer of raw cotton, reopened it in 2010. Bayard Winthrop, the founder of the sweatshirt and clothing company American Giant, was at the mill one morning earlier this year to meet with his Parkdale sales representative. Just last year, Mr. Winthrop was buying fabric from a factory in India. Now, he says, it is cheaper to shop in the United States. Mr. Winthrop uses Parkdale yarn from one of its 25 American factories, and has that yarn spun into fabric about four miles from Parkdale’s Gaffney plant, at Carolina Cotton Works. Mr. Winthrop says American manufacturing has several advantages over outsourcing. Transportation costs are a fraction of what they are overseas. Turnaround time is quicker. Most striking, labor costs — the reason all these companies fled in the first place — aren’t that much higher than overseas because the factories that survived the outsourcing wave have largely turned to automation and are employing far fewer workers. And while Mr. Winthrop did not run into such problems, monitoring worker safety in places like Bangladesh, where hundreds of textile workers have died in recent years in fires and other disasters, has become a huge challenge. “When I framed the business, I wasn’t saying, ‘From the cotton in the ground to the finished product, this is going to be all American-made,’ ” he said. “It wasn’t some patriotic quest.” Instead, he said, the road to Gaffney was all about protecting his bottom line. That simple, if counterintuitive, example is changing both Gaffney and the American textile and apparel industries. In 2012, textile and apparel exports were $22.7 billion, up 37 percent from just three years earlier. While the size of operations remain behind those of overseas powers like China, the fact that these industries are thriving again after almost being left for dead is indicative of a broader reassessment by American companies about manufacturing in the United States. In 2012, the M.I.T. Forum for Supply Chain Innovation and the publication Supply Chain Digest conducted a joint survey of 340 of their members. The survey found that one-third of American companies with manufacturing overseas said they were considering moving some production to the United States, and about 15 percent of the respondents said they had already decided to do so. “This is a completely different manufacturing paradigm than what we saw 10 years ago,” said David Simchi-Levi, a professor at M.I.T. who conducted the survey. Beyond the cost and time benefits, companies often get a boost with consumers by promoting American-made products, according to a survey conducted in January by The New York Times. The survey found that 68 percent of respondents preferred products made in the United States, even if they cost more, and 63 percent believed they were of higher quality. Retailers from Walmart to Abercrombie & Fitch are starting to respond to those sentiments, creating sections for American-made items and sourcing goods domestically. But as manufacturers find that American-made products are not only appealing but affordable, they are also finding the business landscape has changed. Two decades of overseas production has decimated factories here. Between 2000 and 2011, on average, 17 manufacturers closed up shop every day across the country, according to research from the Information Technology and Innovation Foundation. Now, companies that want to make things here often have trouble finding qualified workers for specialized jobs and American-made components for their products. And politicians’ promises that American manufacturing means an abundance of new jobs is complicated — yes, it means jobs, but on nowhere near the scale there was before, because machines have replaced humans at almost every point in the production process.


Take Parkdale: The mill here produces 2.5 million pounds of yarn a week with about 140 workers. In 1980, that production level would have required more than 2,000 people. Curse of Long Distance When Bayard Winthrop founded American Giant, he knew precisely what he wanted to make: thick sweatshirts like the one from the Navy that his father used to wear. They required a dry “hand feel,” so the fabric would not seem greasy to the touch, and a soft, heavily plucked underside. Mr. Winthrop had already produced sportswear overseas, so he looked there for the advanced techniques and affordable pricing he needed. He wanted to sell his hooded sweatshirt for around $80, between the $10 Walmart version, made in China, and the $125 Polo Ralph Lauren version, made in Peru. He was insistent on cutting and sewing the sweatshirts in the United States — a company called American Giant couldn’t do that part overseas, he felt — but wasn’t picky about where the fabric came from. With the help of a consultant, he settled on a mill in Haryana, India, that could make the desired fabric. After several months of back-and-forth, Mr. Winthrop was ready to ship his first sweatshirts in February 2012. But he was frustrated with the quality, and the lengthy process. By October of last year, Mr. Winthrop had moved production to South Carolina. Now it takes just a month or so, start to finish, to get a sweatshirt to a customer. “We just avoid so many big and small stumbles that invariably happen when you try to do things from far away,” he said. “We would never be where we are today if we were overseas. Nowhere close.” The problems in India were cultural, bureaucratic and practical. Time was foremost among them. The Indian mill needed too much time — three to five months — to perfect its designs, send samples, schedule production, ship the fabric to the United States and get it through customs. Mr. Winthrop was hesitant to predict demand that far in advance. There were also communication issues. Mr. Winthrop would send the Indian factory so-called tech packs that detailed exactly what kind of fabric he wanted and what variations he would allow. But even with photos and drawings, the roll-to-roll variance was big. And he couldn’t afford to fly to India regularly, or hire someone to monitor production there. He also found that suppliers deferred to his wishes, rather than being frank about some of his choices, which weren’t, he conceded, always good ones. “I’m a supporter of outsourcing when it makes sense,” he said. But it had stopped making sense. Now that production has shifted to the United States, Mr. Winthrop says those problems have disappeared. Mr. Winthrop and his team visit Carolina Cotton Works and Parkdale whenever they want, check on quality and toss ideas around with the managers. And, he says, the cost is less than in India.

Where Mr. Winthrop relies on labor — the cutting and sewing of the sweatshirts, which he does in five factories in California and North Carolina — is where the costs jump up. That costs his company around $17 for a given sweatshirt; overseas, he says, it would cost $5.50. But truth be told, labor is not a big ingredient in the manufacturing uptick in the United States, textiles or otherwise. Indeed, the absence of high-paid American workers in the new factories has made the revival possible. “Most of our costs are power-related,” said Dan Nation, a senior Parkdale executive.


March of the Machines Step inside Parkdale Mills, and prepare to be overwhelmed by machines. The ceilings are high and the machines stretch city block after city block — this one tossing around bits of cotton to clean them, that one taking four-millimeter layers from different bales to blend them. Only infrequently does a person interrupt the automation, mainly because certain tasks are still cheaper if performed by hand — like moving half-finished yarn between machines on forklifts. Beyond that, there is little that resembles the mills of just a few decades ago. Tell people about a textile plant and “their image is ‘Norma Rae,’ and everyone’s sick and dirty and coughing and it’s terrible,” said Mike Hubbard, vice president of the National Council of Textile Organizations. Not here. The air-cleaning room, where air is washed 6.5 times an hour to get contaminants out, could be a modern-art installation, with liquid raining into pools of water. Along the ceiling, moving racks like those at a dry cleaner snake throughout the factory, carrying the finished yarn to a machine for packaging and shipping. That machine has enough lights and outlets on it that it resembles a music studio soundboard. For Parkdale, the new technology has been its salvation. Founded in 1916, Parkdale is the largest buyer of raw cotton in the United States. In the 1960s, when its current chairman, Duke Kimbrell, took over, it was a single plant with a couple of hundred workers.

Outside air is filtered through cold water and cycled through the Parkdale textile plant in Gaffney, S.C., 30 times an

hour, regulating temperature and humidity and removing contaminants. Mike Belleme for The New York Times Seeing that other plants in the area were streamlining their businesses and ceasing to make their own yarn, Parkdale supplied yarn to nearby manufacturers like Hanesbrands. Business flourished, and Parkdale acquired competitors and soared until the 1990s. That’s when its clients started fleeing the United States. The North American Free Trade Agreement in 1994 was the first blow, erasing import duties on much of the apparel produced in Mexico. The Asian financial crisis in the late 1990s, when currencies collapsed, added a 30 to 40 percent discount to already cheaper overseas products, textile executives said. China joined the World Trade Organization in 2001 and quickly became an apparel powerhouse, and as of 2005, the W.T.O. eliminated textile quotas. In 1991, American-made apparel accounted for 56.2 percent of all the clothing bought domestically, according to the American Apparel and Footwear Association. By 2012, it accounted for 2.5 percent. Over all, the American manufacturing sector lost 32 percent of its jobs, 5.8 million of them, between 1990 and 2012, according to Bureau of


Labor Statistics data. The textile and apparel subsectors were hit even harder, losing 76.5 percent of their jobs, or 1.2 million. “With all the challenges that we’ve had with cheap imports, we knew in order to survive we’d have to take technology as far as we could,” said Anderson Warlick, Parkdale’s chief executive. The company began meeting with machine manufacturers, doing trial runs of equipment and offering feedback and debugging, so it got dibs on the newest technology. It looked for business opportunities in the countries where its customers were heading, those in Central America in particular, and now 75 percent of its business is in exports. Over all, the company employs 4,000 people, its biggest work force ever, but it is technology that has made it competitive. “We’ve been able to be effective here because we invested in our manufacturing to the point that labor is not as big of an issue as far as total cost as it once was,” Mr. Warlick said. “It’s allowed us to be able to compete more effectively with foreign countries that pay, you know, a fraction of what we pay in wages. We compete with them on technology and productivity.” Back From the Dead All that automation has made working in the mill — which once meant mostly dead-end jobs for people with no other options — desirable for many people. Howard Taggert, 86, got his first mill job in 1948 after high school. “By being a color, yeah, you’ve got the worst jobs there was in textile,” said Mr. Taggert, who is African-American. “It was rough, but it was a living. We made a living.” He started by opening cotton bales, which involved striking an ax onto a metal tie around the bales — a dangerous job, given that a spark from metal striking metal could ignite a room full of cotton. The dust was so thick that he couldn’t see to the next aisle, he said. He was paid 87 cents an hour. “I had to. I didn’t have no other choice,” he said of working in the mills. The work was so bad that Mr. Taggert refused to let his children go into mill work. He might be surprised to hear about Donna McKoy, who went back to work in a mill even after earning an associate degree in criminal justice. Ms. McKoy, 47, lost her job at Continental Fabrics in North Carolina in the early 2000s, “when everything was downsizing and going over to China.” In 2001 alone, textile plants in the Carolinas eliminated 15,000 jobs. The sense of desperation was palpable, Ms. McKoy said. “Now what?” she remembers asking herself before she decided to go to college. After a headhunter contacted her in 2007, she became a supervisor at Parkdale, overseeing a night shift of 11 workers. The work — and the workplace — are barely recognizable compared with her job a decade ago. A couple of things struck her right away. First, the mill was clean. “Most open-end spinning plants that have the older model spinning frames in them are really dirty and dusty and not fun to be around,” she said. Thanks to the new technology, “my plant is always clean.” Second, Ms. McKoy got training. For her first eight months, Parkdale paid for hotels, food, dry-cleaning and gas for trips home as she rotated around different factories and learned all of the jobs. And there were fewer people. Ms. McKoy now works at a plant in Walnut Cove, N.C., which she described as a smaller version of the Gaffney plant. On a typical 12-hour shift, Ms. McKoy said, two of the 11 people on her team fix the spinning machines about 4,000 times, with robots’ help. She earns $47,000 a year and says the perks are good, like health care, an in-house nurse and monthly management classes for supervisors. She recently bought a three-bedroom house and owns a car. “I have a comfortable life,” she said. “With this recession that we just had, I didn’t feel it.” Still, some Parkdale employees worry about the future. They’ve seen too much hardship in the textile industry to be overly hopeful about a real turnaround. Scott Symmonds, 40, of Galax, Va., works as a technician for two plants in the area. He never planned on manufacturing work, but after time in the National Guard in Iraq, his home went into foreclosure and he had trouble getting work because of his low credit score and lack of a college degree. As a teenager in rural Iowa, he knew people who worked in manufacturing and watched two plants go out of business. “I saw how they would come home dirty, smelly and often injured,” he said. “I didn’t want that.” But he needed a job, and Parkdale was hiring. Mr. Symmonds started as a spinner, then got a job on the packing line, and then snagged a technician’s job after a technical-aptitude test. He earns $15 an hour, which he says is better than what competitors pay. He fears, though, that his higher pay could become a liability. “We are making far more money than our counterparts in China or other nations,” he said. “We can’t afford to take a big enough cut in pay to be on an even level with those places.”



2.3.2 Price stability Policy Goal: Price Stability • The price level refers to the average level of prices in the economy while the rate of

inflation is the rate at which the price level is rising. • A price index measures the average of a group of prices from some initial time

called the base period. • The most common is the Consumer Price Index (CPI) which measures the cost of

living for a typical household. o A survey is done to determine which items are the most important in most

household budgets, and a weighting scheme is devised. o The prices for those goods are weighted (in percent terms) by their importance

in the budget. o The summation of all the weighted prices is then set equal to 100 in the base

year. If the following year the sum adds up to 104, then we know there has been 4% inflation since the base year.

• One problem that arises is that consumption patterns change over time, and the

weights on various items change steadily as people's tastes switch to different products. In many countries the central statistics bureau does a new survey every 5 to 10 years to recalculate the weights.

• The inflation rate between any two periods of time is measured by the percent

change in the price index from the first period to the second where we use the GDP Implicit Price Deflator for the whole GDP rather than just the CPI:

o If prices fall we have deflation, if prices rise we have inflation. o If the rate of inflation falls, we have disinflation: prices are still rising but at a

slower rate. The History of Inflation • From 1200 to 1525 prices were very stable, periods of inflation were followed by

periods of deflation. • The first period of sustained inflation ran from 1525 to 1650 and is associated with

the gold from the New World being brought back to Spain. It is estimated that the amount of gold increased 5 times, and prices did likewise.

• From 1650 to 1935 prices moved up and down but there were no periods of

sustained inflation or deflation. The inflation in the 1920's was matched by a deflation in the 1930's.

• By 1935 most developed countries made the decision to go off the gold standard:

there was no check on the money supply and many govts. started printing money. Prices in most countries have risen at least 20 times those in 1935.


• Between 1976 and 1979, most industrialized countries decided not to print money in excess, and prices have been increasing only slowly ever since.

Purchasing Power • The purchasing power of money measures the real value of money in terms of the

goods and services that can be purchased with a given amount of money. • Inflation reduces the real value of anything with a price fixed in money terms. If

people do not anticipate inflation, there will be winners and losers: o The winners include people who owe money to others: the real value of the

amount owed will decline. o Employers will gain as the real value of the wages they have contracted to pay

declines. o The losers include people on fixed incomes, wage earners who fall behind in real

wage terms, and people who lend money. o Inflation makes export prices more expensive and imports look cheaper so net

exports fall and importers will gain while exporters lose. • To protect against inflation potential losers can anticipate inflation:

o Wages can have an expectational element built in to contracts to protect workers.

o Banks and other people lending money can charge an interest rate high enough to include the anticipated inflation.

o However, people on fixed incomes, particularly the retired are unable to alter their pensions, and this group has been very badly hurt by inflation.

• It is unlikely that inflation will be anticipated properly and different adjustment rates

mean that some will gain and some will lose from inflation. One problem area is taxation. o If there is a capital gain (the value of something purchased has gone up before

being sold) some of that gain will be due to inflation and should not be taxed. • However, most govts. do not make an allowance for inflation in the tax system. The Interest Rate • The interest rate is the price paid to borrow money. • The prime rate of interest is what the banks charge their best business customers

and may be thought of as the market interest rate or opportunity cost rate of return.

• The real interest rate gives us the return on the investment in terms of purchasing power and is equal to the nominal interest rate minus inflation:

Real interest rate = nominal interest rate – inflation rate

Supply Shocks • Inflationary shock: any event that tends to drive the price level upward. Supply

shocks arise from: o Raw materials: increases in price such as the oil shock. Increases in the price of

imported raw materials such as oil are usually isolated and not persistent.


o Labour: continued wage cost push is an example of repeated supply shocks. • The SRAS shifts inward, to the left:

o The price level rises and income falls below the full employment point. This is referred to as stagflation.

o A recessionary gap opens, and pressure mounts for wages and other factor prices to fall.

o SRAS shifts out to the right and there is a return to full employment accompanied by a fall in prices.

• Temporary shocks lead to inflation followed by deflation. • If the CB responds by increasing the money supply, we say the price shock has

been accommodated: o The increase in the money supply leads to an outward shift of the AD curve. o This eliminates the recessionary gap, but leads to further inflation.

• Keynesians believe that waiting for cost deflation to restore full employment forces

the economy to suffer through an extended slump because wages are sticky down and productivity grows very slowly in a recession.

Wage-cost push inflation: • Powerful unions may administer repeated shocks by pushing for higher wages:

o Firms pass the wage increases on in the form of higher prices. o If the CB does not accommodate, the SRAS shifts inward creating a recession. o Unions would eventually cease pushing wages up in order to maintain jobs. o Persistent unemployment will erode the power of unions.

Demand Pull Inflation • A rightward shift in AD can only come about either because of an increase in an

autonomous element or an increase in the money supply: o An inflationary gap opens up and wages and other costs rise leading to a

leftward shift of the SRAS. o The rise in the price level induces changes leading to a movement back along

the AD curve to the full employment point. This leads to even more inflation. • If the CB reacts to the demand shock by increasing the supply of money, it is

validating the shock. • Govt. may not want output to fall, particularly if they face an election.

o Wage increases cause SRAS to shift left, but money supply increases again and AD shifts to the right.

o The price level rises, but output does not fall. Sticky Wages • There is a tendency for employers to smooth out the income of employees by

paying steady wages and letting profits and layoffs do the adjusting to the shocks in the economy.

• Productivity rises as a worker gains experience but falls off as the worker gets older.


• With wages rising with seniority and layoffs done by seniority, workers and employers are bound to each other.

• Employers know that self policing is the best policy. If workers feel they are unfairly treated they will cut productivity, which is one reason why employers are so reluctant to lower wages.

• It is also a reason why employers tend to pay more than the market wage. They know that working is better than being laid off, and workers will work hard without the need for monitoring if they are paid slightly more than the market wage.

Random Shock Inflation • These are the supply and demand shocks which often trigger bursts of inflation

which must come to an end unless monetary expansion occurs. • The cost of labour must be related to growth in productivity. If wage increases

lead to a rise in unit costs, it must be because wages are rising faster than productivity.

Inflationary gap inflation • The excess demand for labour associated with an inflationary gap puts upward

pressure on wages and the SRAS curve shifts in to the left. • The excess supply of labour associated with a recessionary gap puts downward

pressure on wages. Entrenched inflation • Non-accommodated wage push inflation tends to be self limiting. • If the CB accommodates, both money wages and prices will have risen.

o Workers are no better off so unions try again. • If the CB accommodates the new supply shock, costs and prices will rise leading to

a wage price spiral: o This can only be halted if the CB stops accommodating the supply shocks. o The longer the CB waits to do so, the more entrenched will be the expectations.

Employers expect prices to rise and grant wage increases. Workers push for higher wages as they see prices rising.

o Once accommodation stops, stagflation sets in: rising prices combined with rising unemployment.

• If inflation is to continue it must be accompanied by continuing increases in the

money supply. • The general expectation of an x percent inflation creates pressures for wages to

rise by x percent and hence for SRAS to shift by x percent. • In the long run, shifts in SRAS and AD do not effect employment and output, they

affect only the price level. o Thus inflation is a purely monetary phenomenon from the point of view of long

run equilibrium. • If income is held above potential income, the price level will be rising. This can

only happen if the CB is accommodating the increase in wages.


• When the SRAS and the AD curves are shifting up at the same speed, the inflationary gap remains unchanged. Eventually people will believe that monetary validation (accommodation) and hence inflation will continue: o The SRAS will begin to shift up even faster:

If the CB is told to accommodate in order to hold the level of output constant, it must increase the rate at which the money supply is increased.

The rate of inflation will start to increase which fuels expectations of increased inflation leading to accelerating or entrenched inflation.

Breaking Entrenched Inflation • If employers expect 5% inflation, they will agree to wage increases of 5% and raise

prices 5%. • If the CB accommodates, then AD will be rising by 5% per year as well. • Even if the CB does not accommodate completely, the negative demand effect of a

recessionary gap may be rather weak. The demand effect may be swamped by the expectational and random shock effects.

• To break entrenched inflation, the expectation of inflation must be broken: o Step 1: stop accommodating:

Tthe rate of monetary expansion has to be slowed to lower the rate at which AD is shifting up.

The SRAS will keep shifting left at the old rate and will soon eliminate the inflationary gap (from Eo to E1).

Disinflation results: prices are still rising but at a slower and slower rate.

o Step 2: because of inflationary expectations,

the SRAS will continue to shift left leading to stagflation: Rising unemployment will dampen

expectations of inflation and the inflation will halt leaving a large recessionary gap.


o Step 3: return to full employment either: By waiting for the SRAS curve to shift to the right (moving to E3a) because

productivity is rising faster than wages which lowers prices and increases output

By using fiscal or monetary policy to shift the AD curve (moving to E3b). The great fear is that this may rekindle inflationary expectations.

• Economists who worry about waiting for wages

and prices to fall, fear that the process will take a long time and create a great deal of misery for the unemployed.


April 21, 2009

Spain’s Falling Prices Fuel Deflation Fears in Europe By NELSON D. SCHWARTZ

VALENCIA, Spain — Faced with plunging orders, merchants across this recession-wracked

country are starting to do something that many of them have never done: cut retail prices.

Prices dipped everywhere, from restaurants and fashion retailers to pharmacies and

supermarkets in March. Hoping to increase sales, Fernando Maestre reduced prices by a third

on the video intercoms his company makes for homes and apartment buildings. But that has not

helped, so, along with many other Spanish employers, he is continuing to fire workers.

The nation’s jobless rate, already a painful 15.5 percent, could soon reach 20 percent, a troubling

number for a major industrialized country.

With the combination of rising unemployment and falling prices, economists fear Spain may be

in the early grip of deflation, a hallmark of both the Great Depression and Japan’s lost decade of

the 1990s, and a major concern since the financial crisis went global last year.

Deflation can result in a downward spiral that can be difficult to reverse. As unemployment rises

sharply and consumers cut spending, companies cut prices. But if sales do not pick up, then

revenue can decline further, forcing more cuts in workers or wages. Mr. Maestre is already

contemplating additional job and wage cuts for his 250 employees.

Nowhere is this cycle more evident than in Spain. Last month, it became the first of the 16

nations that use the euro to record a negative inflation rate. The drop, though just 0.1 percent,

had not happened since the government began tracking inflation in 1961, and Spanish officials

have said prices could keep dropping through the summer.

Some of the decline came as volatile food prices sank; the cost of fish fell 6.2 percent, and sugar

was down 5.7 percent. But even prices in normally stable sectors like drugs and medical

treatments fell 0.7 percent in March, and there were slight declines in footwear, clothing and

prices for household electronics.

“Alarm bells are going off,” said Lorenzo Amor, president of the Association of Autonomous

Workers, which represents small businesses and self-employed people. “Economies can recover

from deceleration, but it’s harder to recover from a deflationary situation. This could be a

catastrophe for the Spanish economy.”

Deflation is not just a Spanish concern. Luxembourg, Portugal and Ireland have reported price

drops, too. While the declines have been slight — and prices rose modestly after factoring out

food and energy prices, which can fluctuate widely — other figures released this month suggest

the risk of deflation is growing.


In Germany, wholesale prices dropped 8 percent in March from a year ago, the steepest fall

since 1987. In Japan, wholesale prices fell 2.2 percent on an annual basis. In the United States,

the Consumer Price Index fell 0.1 percent in March, year over year, the first decline of its kind

since 1955, though prices rose 0.2 percent excluding food and energy.

“It doesn’t mean it will spread here to the U.S., but we need to look closely at Spain and other

places to understand the dynamic,” says Simon Johnson, a professor at the Sloan School of

Management at the Massachusetts Institute of Technology and a former chief economist for the

International Monetary Fund. “It’s like the front line of a new virus outbreak.”

The trends have unnerved even well-established businesses. “There is such a huge lack of

confidence in the politicians, in the European Union and in the banks,” said Arturo Virosque,

79, president of Valencia’s chamber of commerce and the owner of a local logistics company.

Ticking off crises going back to the Spanish Civil War in his youth, he said, “this is different. It’s

like an illness.”

After price cuts by competitors, Mr. Virosque’s company reduced charges for storage and

transportation, and slashed its work force to about 170, from 250. “The worst thing is that we

have to cut the young people,” he said, because higher severance makes it too expensive to fire

older workers.

While unemployment traditionally is higher in Spain than in much of Europe, the sharp increase

has many here nervous. The jobless rate for those under 25 is at a Depression-like level of 31.8

percent, the highest among the 27 nations of the European Union.

Before cutting prices in early 2009, Mr. Maestre ordered several rounds of job cuts at his

company, Fermax, as sales of the intercoms collapsed with Spain’s housing bubble.

“It’s a question of survival for everybody,” he said. Still, the lower prices have not translated into

higher sales. Fermax’s orders fell 25 percent in the first quarter. Prices for some intercom parts

that he buys, like video screens, have also come down, but it is not enough to make up for the

sales drought. “Prices have to come down more and we will have to spend less,” he said.

The effects of this downward spiral are evident at Valencia’s principal soup kitchen, in an

imposing stone building constructed a century ago as an alms house. Each day, a line forms

around the block by noon. The Casa de la Caridad, or House of Charity, is helping three times as

many people as it did a year ago. More than 11,000 meals were served in March, and it expects

to top 12,000 this month.

As the economic decline has broadened, so has the range of people seeking help. In the past,

most were out-of-work immigrants or the homeless, said the center’s director, Guadalupe

Ferrer. Today, “it’s more and more people like us who had a house, a respectable job, but are

now unemployed.”

The employed worry that falling prices will endanger their jobs as well.

Yolanda Garcia has worked as a butcher under the arches of Valencia’s soaring Art Nouveau

central market for a decade, but she’s troubled that a drop in the price of chicken, to 5.99 euros a

kilo, from 6.99, has not attracted more customers to her stall.


“Of course, we’re worried the boss will have to reduce staff,” said Ms. Garcia, 38, whose

husband, a construction worker, was laid off two months ago.

All this has made deflation, once a subject largely reserved for economists who studied the Great

Depression, into front-page news here.

The American economy is less vulnerable to deflation, in part because of the Federal Reserve’s

decision to cut interest rates to near zero and increase lending by $2 trillion. The European

Central Bank has also cut rates, though more slowly, and it has resisted the lending measures

adopted by the Fed and the Bank of England to prop up spending.

When Spain had its own currency, the peseta, the central bank could have simply devalued it, or

cut interest rates to zero. But that is not an option in the era of the euro, when monetary policy

is controlled from the European Central Bank’s headquarters in Frankfurt, said Santiago Carbó,

a professor of economics at the University of Granada.

“If we enter into a deflationary period, we won’t have the monetary tools to sort it out,” Mr.

Carbó said. Spanish deflation – 1. Define deflation.

2. Explain how the multiplier might accelerate the deflationary spiral? Who is the heavily impacted by deflation? 3. With the help of a diagram, suggest policies that the Spanish government can use to stop the decrease in the price level.



Food Costs Threaten Rebound in China By REUTERS Published: March 11, 2013

BEIJING — Diners looking for beef hot pot on a chilly evening in Beijing pay more than their counterparts in Boston, a discrepancy that shows the challenges China faces in reviving growth as inflationary pressures return. A 6 percent increase in food costs drove a rise in the Chinese consumer price index to 3.2 percent in February, compared with the same period a year earlier, a 10-month high, official data released Saturday showed. The index was 2 percent in January. On Monday, China’s top economic planning agency, the National Development and Reform Commission, forecast consumer price inflation at about 3 percent for 2013. Food prices typically rise in advance of the Lunar New Year holiday, which occurred in February this year. But since the holiday ended, meat prices, especially those for beef and lamb, have stayed elevated. Retail beef prices in Beijing city markets are higher compared with supermarkets in the Boston area. Pork, China’s staple meat, is only about 50 cents per kilogram, or 23 cents a pound, below the U.S. price, a Reuters comparison of standard retail prices show. Those prices represent a direct hit on the spending power of Chinese, whose average income is about a 10th the size of Americans’ salaries. Contributing to food production costs are the loss of farmland and farm labor to urbanization — Chinese cities are swelling as they absorb hundreds of millions of people. Grazing restrictions because of land degradation are also causing costs to rise across the country. “The more the economy develops, the harder it is to raise calves,” said Wang Jimin, who tracks cattle trends for the Chinese Academy of Agricultural Science’s Rural Economic Development Institute. “In the short term, I don’t see meat prices falling unless there are a lot of imports.” After an international outbreak of mad-cow disease a decade ago, China allows beef imports only from Australia, New Zealand and Uruguay, so options to tame prices with imports appear limited. For the near future, high feed costs will also help elevate the price of pork, an increase that is expected to drive broader inflation gains by the third quarter. “It’s a question of fundamentals, not monthly C.P.I. fluctuations,” said Shi Tao, a livestock analyst at eFeedlink in Shanghai, referring to the consumer price index. He said he expected a reduction in the pork supply this year because some pig breeders had decided to drop out of the business after losing money last summer. Beef production in China has decreased every year since 2008, although it could rise by less than 1 percent this year, the U.S. Department of Agriculture estimates.


“Cattle take at least a year to raise, not like chickens, which need a few months at most,” said Yang Shaohui, a poultry vendor in Beijing. “Poultry producers can respond to the market much faster.” His chicken was selling for about a third of the price of the beef at a nearby stall. The pressure on meat prices in China highlights not only the challenge of bringing inflation under control but also the drive to shift the economy toward consumer-led growth, Beijing’s stated goal after decades of export-led expansion. “Accelerating food prices mean less growth in spending on other goods and services in the economy,” Carl Weinberg, the China-watching chief economist at the New York consulting firm High Frequency Economics, wrote in a client note. A large increase in prices could jeopardize Chinese economic growth, which weakened in 2012 to its slowest pace in more than a decade. Growth only started to pick up in the fourth quarter after a seven-quarter slide. It is a dilemma that China’s incoming leaders, Xi Jinping and Li Keqiang, might have hoped they would not have to face so early in the economic recovery. “This year, I think, there are three priorities: to stabilize economic growth, which is not too big of a problem,” to stabilize the prices of goods, “where already it looks like there could be some pressure,” and to reduce the risk from hidden debt, like off-book wealth management products, said Zhao Xijun, deputy director of the Finance and Securities Institute at Renmin University in Beijing. There are already indications that the Chinese central bank is shifting its policy focus to inflation from growth. China needs to control inflation as a priority, the central bank said in its fourth-quarter policy report in February, shifting from a pledge in its previous report to support the economy above other needs. Rising food prices represent a sensitive area for the Chinese Communist Party leadership given that social tension has often accompanied price increases. Food price increases can fuel inflation expectations that lead to a broader rise in inflation and the risk that the central bank will tweak monetary policy to keep a lid on the price pressures. But policy makers should resist the temptation for pre-emptive action, said Ting Lu, chief China economist at Bank of America Merrill Lynch in Hong Kong. “Though policy makers should be wary of inflation later this year with an economic growth recovery, it’s too early to call for significant monetary tightening,” he wrote in a note to clients. A version of this article appeared in print on March 12, 2013, in The International Herald Tribune.


DEMAND-SIDE AND SUPPLY-SIDE POLICIES Demand-side policies

2.4 Fiscal Policy • Fiscal Policy is a tool of stabilization or demand management policy conducted by

elected governments, and is used to remove recessionary and inflationary gaps by altering G and T.

• The budget balance, G – T, is the difference between expenditures and revenue:

o If they are equal, the govt. has a balanced budget. o If revenue or receipts are greater than expenditures we have a budget surplus

and if expenditures exceed receipts we have a budget deficit.

• If expenditures (G) are increased without a matching increase in T, it must be

deficit financed meaning the govt. must borrow money. • A recessionary gap can be removed by cutting T or increasing G which causes the

AD to shift right. • Alternatively the govt. could do nothing:

o Wages will fall, although very slowly, leading to a rightward shift in SRAS. o Cyclical recovery: there may be cyclical forces in the economy that increase AD. o There is a tendency for productivity, Q/L, to increase steadily over time leading

to a rightward shift of the SRAS.

Closing an Inflationary Gap: Fiscal Policy • An inflationary gap can be removed by increasing T or cutting G which causes AD to

shift left. • Alternatively if the govt. chose to do nothing:

o Cyclical downturn: there may be cyclical forces in the economy that reduce AD. o Or wages start to rise, shifting the SRAS in to the left leading to inflation. o The value of money transactions rises, people sell bonds to obtain more money. o Bond prices fall, interest rates rise, there is a price induced fall in investment. o The fall in real expenditure leads to a movement back along the AD curve.


• Thus inflationary gaps are self correcting as long as the money supply is not increased, but the process is frustrated if the money supply is increased. o With inflation of 15%, if the money supply increases 15%, people do not sell

bonds to obtain cash, interest rates do not rise to choke off real expenditure. Automatic Stabilizers (a type of autonomous fiscal policy) • AD is constantly changing as a result of shifts in I, C, X and M. As recessionary and

inflationary gaps appear they lead to changes in wage rates and shifts in the SRAS. • This makes it difficult to identify when there is a recessionary or inflationary gap. • In most western economies, there are built in stabilizers which tend to offset the

fluctuations in AD: o G tends to be very stable, the tax rate tends to be very stable, and govt.

transfer payments for such things as pensions tend to be stable. o However, transfer payments for welfare or to the unemployed tend to increase

in recessions, thus automatically increasing G. o Tax revenues equal the tax rate times income: (T = t*Y)

If income rises as it does during inflationary gaps, tax revenues rise because both Y is rising and t is rising as people are pushed into higher tax brackets.

As income falls during recessionary gaps, tax revenues fall. • Taxes reduce the marginal propensity to consume:

o Even if the MPC is 80%, if taxes take away 50% of income, then effectively the MPC is only 40% out of national income.

• Short term fluctuations are dampened by the automatic stabilizers even when it is

difficult to recognize when gaps appear and to apply policy. • Automatic stabilizers impose fiscal drag during recoveries:

o As the economy recovers G falls and T rises which slows recovery.


January 29, 2008 6:56 pm The case for a targeted fiscal boost

By Dominique Strauss-Kahn

A global economic slowdown is under way: problems in US housing continue, the US and European financial systems remain under stress and growth in the rest of the world is beginning to be dragged down. Of course, from the International Monetary Fund’s perspective, medium-term considerations are of critical importance. Nonetheless, this does not preclude potentially effective counter-cyclical policies.

Our latest forecasts, released on Tuesday, are for a marked US slowdown and a more moderate but still significant slowdown in other industrial countries. The precise timing of a slowdown in emerging markets is not completely clear, but we think it may come sooner rather than later given their strong linkages with industrialised countries.

What should policymakers around the world do if growth slows as sharply as we expect? Many countries have worked hard in recent years to build the credibility of monetary policy, so that inflation expectations are low and stable. Many have put their fiscal policy on to a more sustainable footing to deal with challenging demographics, including rising dependency ratios as populations age. And key industrialised countries and emerging markets have come together, through the multilateral consultation co-ordinated by the IMF, to reduce medium-term global imbalances between savings and investment.

It is this hard work that has created the space today for policies to be able to counter the slowdown. The first line of defence remains monetary policy. If growth slows and inflation remains under control, there is scope for cutting interest rates. Of course, countries face risks to inflation, from global forces such as oil prices or from internal ones such as a strong push for higher wages.

However, as long as expectations of inflation remain well anchored, the credibility that monetary policy currently enjoys creates the space for interest rate cuts to help economies facing a slowdown.

Leading central banks, in particular, have strong credibility – witness their ability to support liquidity in money markets over the past six months, while being clear about their continued commitment to low inflation.

But monetary policy may not be enough. Why? There are two main reasons.

First, the transmission mechanism for monetary policy is damaged. While cutting interest rates is still effective, it may not work to stimulate investment and consumption as fast as usual. Banks have suffered substantial capital losses and thus want to consolidate their balance sheets and avoid taking on additional risk. Moreover, normally low-risk assets (such as jumbo mortgages in the US) are at present regarded as higher-risk. These impediments may slow down the positive effects of monetary policy.

Second, there is a risk that if a slowdown really takes hold, it will be hard to shake off. The US and some emerging markets have a history of bouncing back quickly. Other countries, including some in Europe and some in the developing world, have traditionally found a rapid recovery to be more difficult.

In fact, the US also might find it harder to shake off a slowdown this time, given that households need to rebuild savings rates after many years in which their wealth was boosted by housing and equity market returns.

Timely and targeted fiscal stimulus can add to aggregate demand in a way that supports private consumption during a critical phase. Of course, it has to be temporary – there is still much work to be done to get ready for the approaching retirement boom. And it has to focus on adding to aggregate demand quickly. In a sense, medium-term fiscal policy is all about saving for a rainy day. It is now raining.

The appropriateness of this approach will vary country by country. Some countries have fiscal space given low debt levels and reasonable budget deficits or even surpluses; others have monetary space as inflation is low and likely to decline as output slows. Countries that have fiscal and monetary space should consider now what it would take to line up a temporary fiscal stimulus that can be deployed quickly if needed as events unfold in 2008.


Of course, there are risks to this use of fiscal policy. But doing nothing raises the risk of very bad outcomes. Identifying, trying to prevent and helping to reduce such risks is a core business of the IMF.

Industrial countries and emerging markets alike have built monetary policy credibility and strong fiscal frameworks, in ways that are consistent with the IMF’s advice and its view of the world. The space created by these past efforts should now be used.

The global downturn can be short-lived and ultimately moderate if leading countries of the world understand the need for a sensible and well-timed policy response. And what is good for one country – a responsible combination of monetary and fiscal policy – will also be good for the world economy.

The writer is managing director of the International Monetary Fund


February 12, 2013

In Shovels, a Remedy for Jobs and Growth By EDUARDO PORTER The budget deficit in 2013 is expected to fall below $1 trillion for the first time in five years. Perhaps policy makers in Washington can now focus on the other $1 trillion deficit, one that gets next to no attention yet is much more threatening to the well-being of American families: our sluggish economic growth. At the end of last year, according to the nonpartisan Congressional Budget Office, the economy was still about 5.5 percent smaller than it would have been had it avoided the recession and kept growing along its long-term potential path, making full use of the workers and equipment currently sitting idle. A rebound is hardly around the corner. Growth this year will average only 1.4 percent, according to the budget office’s latest forecast. By the time we recover to our potential — which the C.B.O. expects will take until 2017 — the Great Recession set off by the implosion of the housing bubble more than five years ago will have cost us nearly half of one year’s entire economic production: about $7.5 trillion. We will be paying the price for years. The slump is hindering capital investment, stunting the careers of college graduates and encouraging workers to drop out of the labor force, potentially blighting the economy over the long term. The C.B.O. expects unemployment to remain above 7.5 percent through next year. And low growth is crimping government finances — reducing tax revenue while, at the same time, increasing the cost of programs like unemployment insurance. Last year, the budget office calculated that sluggish growth alone was responsible for more than a quarter of the budget deficit over the last four years. And yet the government is doing little to turn things around. The collapse of public spending, mainly by state and local governments, explains most of the subpar growth since 2009, according to the C.B.O., more than sluggish consumer spending or business investment. In the final three months of last year, the economy may have even shrunk a bit, dragged down by declining military spending. Now, the government is expected to deliver another wallop to the struggling economy. This year, the budget office expects that budget tightening — including the so-called sequestration, the battery of spending cuts set to take effect on March 1 unless the White House and the Republicans agree on an alternative plan to cut the budget — will cut economic growth in half. Our protracted stagnation calls into question the priorities of our elected officials, who are consumed in a debate over how to cut spending even as the economy drifts. “We should be thinking about all the tools of economic policy to get the economy to escape velocity,” said Lawrence Summers, President Obama’s former top economic adviser. This is bringing us back to the questions that were hotly debated over the Obama administration’s fiscal stimulus package of 2009. What power does the government have to pull the economy out of its rut? How much do tax cuts or spending programs stimulate growth? Even if Mr. Summers’s priorities were shared across the political spectrum, there is little consensus on what kind of tools should be used. Jared Bernstein, the former chief economic adviser to Vice President Joseph Biden who is now at the Center on Budget and Policy Priorities, argues that while fiscal consolidation would have been necessary at some point, the government slammed the brakes on spending before families were ready to spend again, while they were still working to reduce large debt burdens. “The stimulus didn’t last long enough,” Mr. Bernstein said. “We pivoted to deficit reduction too soon.” Not everybody agrees. Conservative economists, and most Republicans in the House, make the exact opposite argument: that spending cuts stimulate growth by giving businesses confidence that the government will be able to pay its debts. While few economists share this view, many are indeed skeptical of deploying more government spending now to pull the economy out of the hole. When the Obama administration unveiled its first fiscal stimulus package, in the early weeks of 2009, the federal government’s debt to the public amounted to only 35 percent of our gross domestic product. Today, it amounts to about 75 percent. That kind of debt scares people. “If debt were at 20 percent of G.D.P. I would be a big stimulus guy,” said Olivier Blanchard, the International Monetary Fund’s chief economist. “Now, more fiscal stimulus would be playing with fire.”


The Congressional Budget Office’s calculations suggest caution. It estimates that the administration’s fiscal stimulus produced about $1 of economic output for every $1 in stimulus, on average. Spending on infrastructure — say, repairing bridges and roads — produced a bigger bang for the buck, because it also encouraged private investment. Tax cuts, on the other hand, yielded less, because taxpayers saved some of their windfall rather than spend it. Since federal taxes across the entire population add up to a top rate of about 25 percent, this implies that $1 worth of stimulus would generate 25 cents in taxes, increasing the deficit by 75 cents. Earlier this month, the budget office produced an analysis of the impact that further deficits would have on the economy. A $2 trillion fiscal stimulus would increase growth for the next three or four years. But as the economy recovered, the deficit would crowd out private investment, reducing growth over the decade. By 2023, government debt would amount to 87 percent of G.D.P. Perhaps low growth is something we have to live with, for now. Even assuming that sequestration takes place, the C.B.O. forecasts that the economy will grow 3.4 percent next year — bringing us a little closer to our maximum potential output. In a related analysis, it concluded that while budget tightening weakens the economy in the short term, growth rebounds more strongly a few years down the road. “We’re almost there in terms of fiscal adjustment,” said Simon Johnson, a former chief economist of the I.M.F. who is now at the Massachusetts Institute of Technology and the Peterson Institute for International Economics. “If we don’t do it now,” he asked, “when will we?” Even the liberal research group the Center for Budget and Policy Priorities recommends that the budget deficit be cut by a further $1.5 trillion over the next decade to stabilize the federal debt. But there is another way to look at our policy options. It just requires analyzing more closely the potential return on public investment over the long term. Mr. Summers points out that there are many profitable investment opportunities for the government to improve the nation’s physical infrastructure, opportunities that would yield much more than a dollar in economic output for each dollar spent. There is also plenty of idle capacity in the construction industry — unemployed workers, unused machinery. And the government can borrow for 15 years at negative real interest rates. While he argues that we also need commitments now to reduce future budget deficits, not borrowing the money now to make the investments would be unconscionable. Some of them may even pay for themselves. Putting fallow resources to work — which also means employing men and women who are becoming obsolete — will, he suggests, bolster growth more than people expect. “It’s not like we’re never going to fix our infrastructure,” Mr. Summers said. “Not doing it now burdens future generations just as surely as more debt does.” E-mail: [email protected]; Twitter: @portereduardo


2.5 Monetary Policy • A policy conducted by the Central Bank (CB) (which is govt. owned and operated)

to control the rate of growth of the money supply and influence interest rates. • Govts use the central bank to carry out monetary policy.

o The central bank is the lender of last resort: it stands ready to back any of the chartered banks if there are emergencies such as a run on the bank.

o It looks after govt. accounts and often buys govt. bonds, particularly if the bond market needs to be supported.

• Central banks are also usually responsible for the money supply.

o If the Central Bank (CB) buys a bond from the public, the public receives the cash in the form of a cheque from the CB and the CB receives the bond.

• Money is created through deposit creation rather than printing currency. • Central banks are often responsible for bond and money markets.

o Bond markets refer to markets where debt instruments which mature in one year or more are traded.

• Money markets: where debt instruments maturing within one year are traded. o In most countries the most common form of money market instrument is the

treasury bill issued by a govt. Demand for Money • Households hold wealth in many forms: cash, bonds, stocks, real estate or in

businesses. We assume that people hold only money or bonds. • Wealth held in the form of money is called the demand for money.

o Once we know the demand for money, we also know the demand for bonds. • The opportunity cost of holding money is the interest foregone on the bond that

could have been purchased instead. • As GDP rises in the economy, people will spend more because consumption rises,

therefore the transactions balances will also rise. Commercial Banks • Commercial or chartered banks hold deposits for their customers and permit certain

deposits to be transferred by cheque from one account to another. o They make loans to households and firms and buy govt. securities.


• With credit granting systems like Visa, banks form a group to spread the risk. • Bank deposits are a medium of exchange only because they can be transferred

through the use of a cheque. • Banks offer a safe place to store money and to earn a guaranteed return,

commercial bank liabilities are the deposits owed to the depositors. • Banks attract deposits by offering a rate of interest and by providing services for a

small fee such as clearing cheques and providing regular monthly statements. • Commercial bank assets are:

o The securities it buys which pay interest and dividends o The loans it makes to its customers.

Banks expect that the loan will be repaid, and that they will make enough money on the interest to pay for the paperwork and the risk of non-payment.

• Commercial banks tend to borrow short term from their depositors and lend long

term to people and businesses that need loans. Banks can suffer if interest rates increase sharply in the short term. o Part of the job of the CB is to ensure that interest rates move smoothly and

slowly and the range over which rates fluctuate is fairly narrow. Open Market Operations • The most important tool for controlling the money supply and interest rates is the

purchase and sale of bonds by the central bank (CB), referred to as open market operations.

• When the CB buys a bond from the public, the person selling the bond receives a cheque from the CB which is then deposited in a commercial bank. o The bank sends the cheque to the CB which then increases the deposits of the

commercial bank. Thus new money is injected into the system leading to a multiple expansion of deposits through the relending chain.

• When the CB sells a bond to the public, it receives a cheque from the person and

sends it to the commercial bank for payment. o The commercial bank sends the money to the CB and there is a contraction of

the money supply through the relending chain operating backwards. o Rather than calling in loans which can lead to bankruptcy, the commercial bank

typically does not make any new loans until its reserves have recovered. • When the CB sells bonds in the market, there are two effects:

o The reserve effect is that money now leaves the system and is put in the CB leading to a contraction of the money supply.

o At the same time, when the CB sells bonds, the price of bonds falls and interest rates rise leading to a contraction of investment and the AD curve.

• In reverse, when the CB buys bonds:

o The money enters the system leading to expansion through the relending system

o At the same time the price of bonds rise, interest rates fall and investment increases leading to an expansion of the AD curve.


Closing an Inflationary Gap: Monetary Policy • Monetary policy could close the gap more quickly by decreasing the money supply,

leading to a rise in interest rates, a fall in investment: AD shifts left. • If the central bank wants to raise interest rates:

o They will sell bonds, the money supply will contract o There will be an excess demand for money o Households will sell bonds, and the price of bonds will fall o This leads to an increase in interest rates in the market

Closing a Recessionary Gap: Monetary Policy • If wages fall, SRAS would shift out, prices would fall and income rise.

o The value of money transactions falls, people buy bonds with the excess money. o Bond prices rise, interest rates fall: there is a price induced rise in investment. o The rise in real expenditure leads to a movement along the AD curve.

• As wages are sticky down, however, the SRAS shifts slowly to the right, and the fall

in prices and the monetary adjustment mechanism operates very slowly. • Monetary policy could close the gap more quickly by increasing the money supply,

interest rates fall, investment rises and AD shifts out. • If the central bank wants to reduce interest rates:

o They will buy bonds, the money supply increases o People will buy bonds with the excess and the price of bonds will rise o Interest rates will fall, and there is less incentive to hold bonds and eventually

there will no longer be an excess demand for bonds.






2.6 Supply Side Policies • Because of dissatisfaction with demand management policies, policy makers have

turned to permanently reducing structural unemployment so when cycles occur, the impacts are less severe: o If unemployment at the peak of the cycles is 7%, and if it rises to 12% to 13%

at the bottom of the cycle, many people will suffer during downturns. o If the natural rate of unemployment could be reduced to 2% at the peak of the

cycle, then unemployment may not rise to more than 4% at the bottom. • Supply side policies attempt to shift the LRAS to the right far enough to reduce

inflationary pressures: o By focussing on incentives:

Taxes and subsidies are reduced to encourage work, risk taking and investment

Unemployment benefits are reduced, raising the opportunity cost of not working.

o By increasing productivity of labour (Q/L rises):

Education and training will increase productivity. Investment in capital will increase the K/L ratio.

o By increasing the productivity of capital (Q/K rises): through tax deductions for

R&D: firms are motivated to find ways to increase capital productivity.

o By reducing the costs of inputs: Eliminating or reducing the minimum wage and the strength of unions. Lowering interest rates and thus lowering the rental price of capital. Providing incentives to find cheaper sources of raw materials.

o By reducing the power of big companies through anti-monopoly regulation.

European - Japanese approach= Interventionist: • By assisting labour to move from sunset to sunrise industries, structural

unemployment can be eliminated. • In Sweden, when workers lose jobs in sunset industries:

o They have a choice of training for jobs in sunrise industries, o The govt. pays for the full wages of the worker during the retraining, which

usually lasts from 6 months to 2 years, o The firm guarantees to hire the worker for a minimum of five years.

• In Japan, when firms close down a sunset division: o The firm approaches the govt. and asks for training assistance for redundant

workers in a new or existing sunrise division. o The govt. pays the full wages during the training period, and the firm

guarantees lifetime employment.


• In Germany students in high school try out careers in sunrise industries to reduce the numbers of students graduating in a redundant career, o About 60% of high school students in Germany participate in a work coop

program where they work from 1 to 5 afternoons a week in a firm or occupation they are interested in entering.

o Students are allowed to change once a year, and employers are permitted to ask students to leave if they have problems.

o Because students are exposed only to jobs and careers where there are openings, training for sunset industries is avoided.

o Because both students and firms have a chance to assess each other, by the end of high school firms are happy to hire students and students are happy to go to work in familiar firms.

US Approach = Market based • The US govt. is reluctant to become involved in directing people into training and

careers and has depended on tax cuts to bring about supply side changes. • Reducing taxes will increase supplies of labour and capital:

o Lower taxes would increase the return on investment (ROI) and provide an incentive to invest in capital, thus increasing K/L.

o Lower taxes would also increase the return on research and development (R&D), leading to investment in even more productive capital.

o People who were already employed would work harder if they could keep more income after taxes, and those who were unemployed would be brought into the work force by the boost in income.

• Tax revenue would remain constant, even though tax rates had been cut:

o The increases in productive capacity (capital) and in productivity (labour) would shift LRAS to the right increasing the taxes collected.

• However, cuts in taxes can lead to an increase in C, causing a rightward shift in AD.

During the Reagan administration this policy was pursued: o In the short run, AD shifted to the right, opening up an inflationary gap. o The supply side shifts of LRAS were not large enough and quick enough to

counteract the aggregate demand effects. o Incomes rose, but not by enough to restore tax revenues back to what they

were: the result was bad deficits for the US govt. • The supply side effects have been harder to find:

o They were dissipated throughout the economy. o They did take place but over a longer period of perhaps 10 years or more. o However, the reforms had a major effect on improving the functioning of the US

economy, and reducing the natural rate of unemployment. o They also appear to have led to disinflation: a slowing down in the rate of

inflation. (Deflation is where prices actually fall).


Supply Side in a Nutshell The intent of supply-side policies is too push the LRAS (as well as SRAS) to the right, thus increasing output for any given level of prices which correlates to a drop in the overall price level in the economy. This may also shift the Phillips curve to the left as the policies address structural unemployment. Unemployment: The policies are based on the idea that labor markets are too rigid or imperfect. Labor is not mobile, either occupationally or geographically to respond to changes in the job market. A lack of qualifications or awareness of where the jobs are located can lead to structural unemployment and hinder the potential growth of the economy. Basically, the supply side objective here is to reduce the inelasticity of labor by making workers more responsive to changing opportunities and employers more adaptable in working with the current labor force. Inflation: If inflation is caused by cost-push pressures, supply-side policies can help to reduce these cost pressures in two ways:

a. By reducing the monopoly power of unions and firms to encourage more competition in the supply of labor or goods

b. By Encouraging increases in productivity through the retraining of workers, or by investment grants to firms, or by tax incentives.

Growth: This theory focuses on potential output. By aiming to increase the total quantity of factors of production (e.g. policies designed to encourage the building of new factories) or they are used to encourage greater productivity of the factors of production (e.g. encourage the training of labor, or incentives for people to work harder.


Two schools of thought

Market Based Interventionist

Based on incentives to increase the efficiency of markets.

Based on the idea that the free market is likely to provide too little R & D, training and investment. Consequently the government must intervene in the market to push out the LRAS.

Reduce Government expenditure so as to release more resources for the private sector.

Direct provision” investments by the government in infrastructure that can be of direct benefit to firms.

Reducing taxes so as to increase incentives to work, save and invest in K equipment.

Sponsorship of R & D by the government (prevalent in Japan, France and U.S.).

Reduce monopoly power of trade unions so as to encourage greater flexibility in both wages and working practices, and to allow labor markets to clear.

Government training schemes or education aimed at preparing students for vocational pursuits (Japan, Germany, & Sweden)

Reducing automatic entitlement to certain unemployment and welfare benefits to encourage self-reliance.

Assistance to small firms via advisory services, reduced regulatory procedures or reduced tax rates.

Encourage competition through policies of deregulation and privatization.

Government advice on ways to increase efficiency and innovation or in handling labor disputes.

Government provision of information via technical assistance, results of public research, information on markets, etc.


Strengths & weaknesses of these policies Problems with Fiscal Policy • Fiscal policies attempt to reduce the suffering encountered in a market system by

providing assistance to the less fortunate. The benefits are the counter-cyclical effects of automatic stabilizers, but the costs include: o Disincentive to work: welfare and unemployment assistance has encouraged

people supported by the govt. not to be productive by imposing a "tax" in the form of a loss of social assistance for those who go and work. This reduces the motivation to look for a job, and shifts the LRAS to the left.

o Increased taxes: the steady increase in taxes for social security have increased business costs, this has shifted the LRAS to the left.

o More regulation: greater regulation of industry protects firms from competition and leads to inefficiency which shifts the LRAS to the left.

o Substitution of capital for labour: there has been greater social regulation such as labour protection laws which have substantially increased the costs of hiring employees leading to the substitution of capital for labour which increases the natural rate of unemployment (shifting the LRAS to the left).

o Underground economy: higher tax rates have led to disincentive problems and to a significant proportion of economic activity going underground.

Lags • Discretionary policy often runs into problems with lags:

o Recognition lag: it takes some time before a gap is recognized. o Legislative lag: it takes time to decide what to do and if it requires a change in

taxes or borrowing, it takes time to get approval from parliament. o Implementation lag: it takes more time to put the policy into effect.

• The result is that stabilization policy or demand management policy has often done

more to encourage fluctuations than to remove them. Reversibility • Another problem is that policies put into effect may be very difficult to reverse:

o If there were a recessionary gap, the govt. may decide to cut corporate taxes: o After the usual lag, businesses start to increase investment. o By the time the investment shifts out the AD curve, the economy may already

have recovered and the shift in AD may open an inflationary gap. o The problem then becomes one of trying to reverse the policy. It is extremely

unpopular to raise taxes when businesses have become used to lower taxes. • To overcome this problem it has been suggested that policies be made short run:

o The govt. announces that the tax cuts will only last for two years. o This may help with investment, but many consumers will simply absorb the

increased income into savings as a result of the wealth effect.


Financing Government Expenditures • When govts. attempt to increase G, they must finance it somehow:

o They can raise taxes by the same amount as G, but this would lead to a fall in consumption and investment.

o They can borrow the money, but this leads to a rise in interest rates and a fall in investment: The demand for money shifts out, but the supply of loanable funds does not

change so interest rates rise. This is called the “crowding out” effect because private businesses wanting

to borrow money now find they have to pay more to borrow and cut investment.

o They can expand the money supply (govt. borrows from the central bank equivalent to printing money) and use the money to finance the increase in G, but this leads to inflation.

• The attempt to use fiscal policy to fine tune the economy is no longer accepted as a

valid stabilization tool. Only where there are large persistent gaps, particularly gaps associated with recessions or depressions, is it generally agreed that fiscal policy does have role to play in restoring the economy to full employment.

Problems with Monetary Policy • In the long run, because the LRAS is vertical above the full employment income

level, the major impact of monetary policy will be on the price level. o In boom times, the SRAS curve is very steep (zone 3):

Shifts in the AD curve translate into large changes in the price level and little change in income.

o At less than full employment (zone 2) demand-side policy can affect both price and income in the short run.

• Rational expectations: people do not form expectations of future inflation based on

the past; they tend to look ahead and make an estimate based on information they have available at that moment.

• Expectations can alter the speed at which adjustment takes place. A change in the

expected rate of inflation will change aggregate demand: o If inflation is expected to rise, consumers will increase current buying, o If inflation is expected to fall, expenditures may be delayed.

• If the money supply is increased, and the AD curve shifts out to the right, workers

anticipate that increasing the money supply will lead to higher prices and they will demand higher wages right away: o The general expectation of an x percent inflation creates pressures for wages to

rise by x percent and hence for unit costs and the SRAS curve to shift in by x percent.

o As AD shifts to the right, the SRAS shifts to the left.


• Rational expectations means that workers cannot be fooled, there is no “money illusion”. o Workers know that real wages remain unchanged, and real income stays the

same. o Govt. will be unable to reduce unemployment below the natural rate even in the

short run. • While it is unlikely that the effects are completely offset, expectations are yet

another reason why monetary policy may not be very effective. The Transmission Mechanism • Fiscal policy operates directly on AD through changes in G and T. • Monetary policy operates through adjustments in the money supply which then lead

to changes in interest rates and investment before impacting on AD. Problems with this transmission mechanism during depressions can make monetary policy useless: o Monetary expansion fails because Banks hold excess reserves rather than lend

money. o Interest rates may not fall because people may hold money rather than invest in

bonds (liquidity trap) o Firms may be afraid to invest: the MEI curve is vertical, large changes in interest

rates lead to only small changes in investment. Lags in Implementing Monetary Policy • The monetary transmission mechanism takes varying lengths of time from 18

months to 3 years. While there is still a recognition lag, there is no need for a legislative lag as the govt. does not have to go to parliament to get permission to change the money supply.

• There is still an implementation lag. o Open market operations lead only slowly to changes in the money supply and

interest rates. o It takes time in companies to adjust investment plans in response to changes in

interest rates. o It then takes time for investment to be put in place and for the multiplier

respending chain to lead to changes in national income: Economists estimate it takes 18 months on average for half the effects to be felt in the economy.

• Lags are long and unpredictable increasing the risk that using monetary policy could

lead to destabilizing effects. • The poor record of monetary policy as a short term stabilizer has led to the

introduction of a monetary rule approach where the money supply would only be increased by a set amount. o Some countries chose the rate as equal to the population growth rate plus the

growth rate in productivity. o Experience since then shows that there have been quite sudden shifts in the

liquidity preference function, also known as the demand for money, which has made the monetary rule approach less stable than had been hoped.


• Most economists now believe that fiscal policy must be used to restore the economy to full employment during a serious recession or depression: o The labour market experiences sticky wages which means wages fall too slowly o Weaknesses in the monetary transmission mechanism plus lags mean that

monetary policy is unpredictable.

DISTRIBUTION OF INCOME Direct (Income) Taxes

• Direct taxes are taken from income before there is any expenditure.

• With personal allowances and higher rates for higher incomes, income taxes can be progressive.

• On the other hand consumption (indirect or expenditure) taxes are generally levied at a constant rate and can therefore be regressive: o Poor people pay relatively more tax as a

proportion of their income on basic necessities than rich people do.

o Several countries have exemptions or lower rates of sales or consumption taxes on things such as food and medicine in order to reduce the regressive nature of such taxes.

Indirect (Expenditure) Taxes • Indirect taxes are taxes based on expenditure (consumption), and account for 20%

of all taxes collected in OECD countries. • Value added taxes are assessed throughout the production process: each

intermediary is able to claim back the tax paid on intermediate goods. o It is more efficient because it is self policing: each link in the chain will be

claiming tax back on the input costs. o In Europe VAT has now been raised to 20% with little fear of cheating.

• An excise tax is levied on a particular commodity such as cigarettes • A sales tax is levied on all or most goods which are sold through retail outlets. • Excise and sales taxes are charged only at the time of sale to the consumer.

o The burden of collecting the tax falls entirely on the seller. o It can lead to tax cascading: some commodities effectively get taxed more than

once; this is related to the double counting problem. o It is estimated that widespread cheating will occur once the tax exceeds 10%.

• Indirect taxes are less likely to distort behaviour than income taxes:

o High income taxes may lead some to choose leisure over work.. o With indirect taxes some rich people may choose to save and invest.


Monetarism and Supply-side policies Monetarists - Introduction

Monetarists are a group of economists so named because of their preoccupation with money and its effects. The most famous Monetarist is Milton Friedman who developed much of the Monetarist theory we learn.

Monetarism is very closely allied with the classical school of thought. It is essentially an extension of classical theory which was developed in the 1960s and 1970s to try to explain a new economic phenomenon - stagflation . Stagflation was an expression coined to try to explain two simultaneous economic problems - stagnation and inflation . It could perhaps have been called 'inflanation' but that sounds more like a medical problem than an economic one.

Much of the Monetarists' work revolved around the role of expectations in determining inflation, and a key part of their theory was the development of the expectations-augmented Phillips Curve

Monetarists - Beliefs

In their work Monetarists draw a lot on Classical economics. They re-evaluated the Quantity Theory of Money and argued that increases in the money supply would cause inflation. This view was backed up by a substantial body of empirical evidence. They would therefore argue that to reduce inflation, the growth in the money supply needs to be controlled.

Monetarists vary in their precise beliefs on expectations. Some believe that expectations adjust so quickly that any policy change will immediately be taken into account by people, and there will therefore be no short-term adjustment. This school of Monetarism is known as 'rational expectations'. More moderate Monetarists accept that there may be an adjustment period, and so policy changes may have temporary or short-term effects on the level of output.

Perhaps one of the best known quotes from Friedman's work is that:

"Inflation is always and everywhere a monetary phenomenon"

This quote is perhaps the best indication of the reason why Monetarists are called Monetarists!


Monetarists - Theories

Much of the Monetarists' theory is a development of earlier Classical theoretical work. Their main contribution is in updating many of these ideas to fit them into a more modern context. The two key areas of Monetarist work that we will look at are:

• Quantity Theory of Money • Expectations-augmented Phillips Curve

Quantity Theory of Money

The Quantity Theory of Money was a bit of Classical theory based around the Fisher Equation of Exchange . This equation stated that:

MV = PT

where: M is the amount of money in circulation V is the velocity of circulation of that money P is the average price level and T is the number of transactions taking place

Classical economists suggested that V would be relatively stable and T would (as we have seen above) would always tend to full employment. Friedman developed this and tested it further, coming to the conclusion that V and T were both independently determined in the long-run. The conclusion from this was that:

M P

If the money supply grew faster than the underlying growth rate of output there would be inflation. Inflation would be bad for the economy because of the uncertainty it created. This uncertainty could limit spending and also limit the level of investment. Higher inflation may also damage our international competitiveness. Who will want to buy UK goods when our prices are going up faster than theirs?

Quantity theory of money

The classical economists view of inflation revolved around this theory, and this theory was in turn derived from the Fisher Equation of Exchange. This equation says that:

MV = PT where: M is the amount of money in circulation

V is the velocity of circulation of that money P is the average price level and

T is the number of transactions taking place

Classical economists suggested that V would be relatively stable and T would (as we have seen above) would always tend to full employment. Therefore they came to the conclusion that:

M P

In other words increases in the money supply would lead to inflation. The message was simple; control the money supply to control inflation.


Monetarists - Policies

Since the work of Monetarists is mainly limited to their view of inflation, their policy recommendations are pretty much on inflation only as well. They tend to believe that if you control inflation as the main priority, then this will create stability and the economy will be able to grow at its optimum rate.

The key policy is therefore control of the money supply to control inflation. The government should certainly not intervene to try to reduce unemployment as the economy will automatically tend to the natural rate of unemployment . The only way to change the natural rate is through the use of supply-side policies .

All of this makes Monetarists' policy recommendations pretty similar to those of the classical economists.

Supply-side policies

Supply-side policies can be used to reduce market imperfections. This should have the effect of increasing the capacity of the economy to produce (in other words the long-run aggregate supply ). They should therefore reduce the natural rate of unemployment. This will be the only non-inflationary way to get increases in output.

Using supply-side policies has increased the level of output from Qfe1 to Qfe2, but the price level has remained stable. Supply-side policies as we have said are ones that reduce market imperfections. They may include:

• Improving education & training to make the work-force more occupationally mobile • Policies to make people more geographically mobile (scrapping rent controls, simplifying house

buying to speed it up, ......) • Reducing the power of trade unions to allow wages to be more flexible • Getting rid of any capital controls • Removing unnecessary regulations

Money supply policies

The real key to Monetarist policy though is the control of monetary growth. In this way (as predicted by the Quantity Theory of Money ) the Monetarists would be able to maintain low inflation. Policies might include:

• Open-market operations • Funding • Monetary-base control • Interest rate control


Monetarists - AS & AD

Moderate Monetarists would argue, as Classical economists do, that the economy may behave slightly differently in the short run from in the long run.

Short run

In the short run any increase in the money supply may lead to an increase in aggregate demand. This may, in turn, lead to more employment, but before long people's expectations will catch up and as we saw with the expectations augmented Phillips Curve the effects of the boost will only be short-lived. Inflation picks up and wipes out any short-term gains. The following diagram shows this:

Output grows a bit, but inflation is pushed up and once the inflation is in the system people will begin to anticipate it.

Long-run

In the long run, any attempts to reduce unemployment below its natural rate will result in inflation. This means that there is no long-run trade-off between unemployment and inflation, and the long-run aggregate supply curve will be vertical.

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