Monday, November 26, 2007

The Phillips Curve and the Federal Reserve

The Phillips Curve is a concept often covered in introductory macroeconomics. However, in some economic and political circles, the concept is considered outdated and useless. Some economists and commentators, such as Lawrence Kudlow, might go as far as to say that the Phillips Curve is dead. Why does the Phillips Curve command such controversy? Is it as irrelevant as some economists claim?

The traditional Phillips Curve is the trade-off between the inflation rate and the unemployment rate. Many economists in the 1960s thought that the Federal Reserve or Congress could permanently lower the unemployment rate by increasing the inflation rate. The trouble is, the traditional Phillips Curve violates one of the central tenets of economics: the classical dichotomy. According to the classical dichotomy, nominal variables do not affect real variables. Consider a simple example:

I hold a bag of apples that weighs 5 pounds. The weight (i.e., the force exerted on my arm) is a real variable and the unit of measurement (i.e., pounds) is a nominal variable. Suppose the U.S. government passes a new law that says all measurements must conform to the metric system. Now the same bag of apples weighs 2.27 kilograms. Notice that the nominal variable (how the weight is measured) has absolutely no effect on the real variable (the force exerted on my arm).

The traditional Phillips Curve is in direct contradiction of the classical dichotomy. The Phillips Curve implied that the government could effectively reduce the unemployment rate (a real variable) by changing how fast overall prices are growing in the economy (a nominal variable). Though the traditional Phillips Curve held up well in the 1960s, the 1970s would usher in the downfall of the traditional Phillips Curve.

In the 1970s, the trade-off between the unemployment rate and the inflation rate seemed to fall apart. The United States experienced soaring overall prices and rising unemployment. In other words, there appeared to be an upward-sloping relationship between the inflation rate and unemployment rate. Due to this fact, many economists declared the Phillips Curve to be dead.

Due to the abrupt change in the correlation between inflation and unemployment, several theories were proposed as alternatives to the Phillips Curve. These theories include the Real Business Cycle (RBC), Rational Expectations, and Monetarism. Often times these theories are called “New Classical” economics because they promote the classical dichotomy.

Under heavy pressure from competing theories and empirical evidence, a new school of thought known as “New Keynesian” economics sought microeconomic foundations for the Phillips Curve. Edmund Phelps, the Nobel Laureate in 2006, augmented the traditional Phillips Curve by adding the critical role of expectations. Under the expectations-augmented Phillips Curve model, a trade-off between inflation and unemployment does exist but only in the short run. According to the model, inflation expectations adjust to return the economy to its natural rate of unemployment (i.e., an unemployment rate consistent with non-accelerating inflation). George Akerlof, the Nobel Laureate in 2001, provided behavioral explanations for the trade-off. Subsequent works by economists, such as David Romer and Greg Mankiw, provided additional microeconomic foundations for a short-run trade-off.

Through all the intellectual turmoil, most economists agree on the following:

1. There is a short-run trade-off between the inflation rate and the unemployment rate.
2. In the long run, the inflation rate adjusts to restore the natural rate of unemployment. Hence, policy makers cannot permanently push unemployment below its natural rate by permanently increasing the inflation rate.

How well does the modern Phillips Curve describe the real world, and do practitioners actually use the modern Phillips Curve? James Stock and Mark Watson, authors of a famous introductory econometrics textbook and well-respected econometricians, empirically showed that the modern Phillips Curve bested all other alternatives in terms of forecasting inflation. Ben Bernanke, chairperson of the Federal Reserve, professed publicly here and here on the importance of the modern Phillips Curve in the Fed's inflation forecasts, which ultimately influence monetary policy.

The Phillips Curve has changed over the past 40 years, but it is very much alive as a reference for monetary policymakers.

Discussion Questions:

1. Go to the Bureau of Labor Statistics web site and pull data on the national unemployment rate and the CPI inflation rate. For your convenience, I have included the spreadsheet here. Does there appear to be a trade-off between inflation and unemployment between January 2001 and December 2001?

2. Does there appear to be a trade-off between January 1997 and October 2007?

3. Why do you think an increase in the inflation rate decreases the unemployment rate in the short run? Why do you think a decrease in the unemployment rate increases the inflation rate in the short run?

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Monday, November 19, 2007

Inflation Targeting Lite

A central bank controls the economy's money supply—the growth of which ultimately determines the growth of the economy's price level (the inflation rate). Many of the world's central banks publicly announce inflation targets. An inflation target is a specific rate (such as 2%) or a range of inflation rates (such as 1%–3%) that the central bank will try to achieve over time. By publicly announcing and consistently hitting an inflation target, these central banks hope to enhance their credibility and anchor people's expectations of future inflation. If people believe a central bank's commitment to low and stable inflation to be credible, they will expect future inflation to be low and stable—feeding a virtuous cycle of low inflation, low inflation expectations, and slow increases in overall prices and nominal wages. Confidence that inflation will remain low reduces the uncertainty surrounding saving and investment decisions, fostering a favorable climate for economic growth.

The Federal Reserve System (the Fed) is a notable holdout on inflation targeting. Most people understand that one of the Fed's policy mandates is price stability, or low and stable inflation, but the Fed has never publicly described exactly what "low and stable inflation" means. Fed chairman Ben Bernanke recently announced a change in Fed practices that will move U.S. monetary policy a bit closer to the inflation targeting ways of the rest of the world. The Fed will now publish three-year economic forecasts four times per year (rather than two). More importantly, the Fed will tell us how it thinks economic output, unemployment, and inflation will take shape over the next few years based on its application of monetary policy. The Fed will essentially say, "Here's what we expect inflation to be if we implement sensible monetary policies over the next three years."

That's not quite the same as explicitly stating a target, but it sounds pretty similar. The American public will now have a better sense of the inflation rate that the Fed seeks to restore in the event of economic disturbances that move the inflation rate away from the Fed's projection. Read this New York Times article or Bernanke's speech to learn more about the Fed's efforts to increase transparency.

Discussion Questions

1. Many central banks face a sole mandate of price stability, whereas the Fed faces a dual mandate of price stability and full employment. Over which part of its dual mandate does the Fed exercise more influence, price stability or full employment?

2. Chairman Bernanke, an advocate of inflation targeting, mentions in his speech that "a superficial drawback of inflation targeting is its very name, which suggests a single-minded focus on inflation to the exclusion of other goals." He goes on to point out that most central banks practice flexible inflation targeting that allows them to focus on other policy goals. The former chairman of the Federal Reserve, Alan Greenspan, was generally opposed to inflation targeting. As the Times article points out, Greenspan felt that "explicit public commitments would hobble the Fed's ability to respond nimbly to unexpected developments." Do you think a publicly announced inflation target would help or hamstring the Fed's dual mandate?

3. Monetary policy has become more transparent over the past couple of decades. The Fed's latest move to publicly offer more frequent and in-depth economic analysis is a continuation of this trend. How will the additional information help households and firms make economic decisions and plan for the future? How can monetary policy become more transparent over time? Should it? For example, would televised meetings of the Federal Open Market Committee (FOMC, the Fed's policymaking arm) help firms and households to make better saving and investment decisions?

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Monday, November 12, 2007

Krugman vs. Mankiw on Health Care

Two of the bestselling economics textbooks are by Paul Krugman of Princeton and Greg Mankiw of Harvard. Reading the textbooks, it’s not abundantly clear that the authors would disagree about much: both illustrate supply and demand, the gains from trade, the deadweight loss caused by taxes, the market failure that results from the existence of externalities.

So what could these two very smart men possibly disagree on? As it turns out, a lot.

Mankiw’s blog and Krugman’s New York Times op-ed column have become the sources of economic talking points for conservatives and liberals, respectively. As Brandon noted in a previous Aplia Econ Blog post, Mankiw recently wrote a column about American health care problems that are, in his opinion, overblown by some proponents of a national health insurance program. Krugman responded in his column a few days later. You can read Mankiw’s original article here, Krugman’s response here, and a rebuttal Mankiw wrote to his critics here. There’s plenty of blog chatter from both economists and non-economists as well.

There are several reasons why economists can disagree about public policy. These disagreements can be broadly categorized as follows:

  1. They may disagree as to which economic theories are valid and which are not. This is fairly rare. Theories start with assumptions and derive conclusions from them. As long as they are mathematically accurate, most theories are valid for the assumptions on which they are based.

  2. They may disagree as to which theories are best suited to addressing a particular problem. Another way of thinking about this is that since different theories are based on different assumptions, economists may disagree as to the validity of certain assumptions when applied to a particular problem.

  3. They may disagree on a normative level rather than a positive one. Even if economists agree about the nature of a problem and which economic theories are most relevant, they may have different normative perspectives. For example, two economists may agree on a particular tradeoff between efficiency and equity, but one may prefer the more efficient outcome, while the other may prefer the more equitable one.
Discussion Questions

1. Which of the arguments made by Mankiw and Krugman do you find to be strongest? Which do you think are weakest? Why?

2. Based on the categories above (or any others you may come up with), what do you think is the nature of the disagreement between Mankiw and Krugman? How does each of them portray their differences with the opposing viewpoint? Why is there a disconnect between the true nature of their argument and the motives they ascribe to their opponents?

3. Mankiw and Krugman clearly have strongly held viewpoints based in part on differences in political ideology. What impact do you think this has on their teaching and research? For an academic economist, what is the appropriate level of ideology?

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Wednesday, November 07, 2007

Tricky Truths in the Health Care Debate

Economist Greg Mankiw recently took aim at three misunderstood truths in the health care debate. Consider the truths:

1. Canada, a country with national health insurance, has a longer life expectancy and a lower infant mortality rate (measured in deaths per 1,000 births) than the United States.

2. Forty-seven million Americans lack health insurance.

3. Health care costs account for an ever-growing share of American incomes.

Whether the U.S. health care system should look more like Canada's is a big open question. Mankiw asks us to look at these three truths more closely to see how much clarity they actually add to our national debate on health care. Read his column to learn more.

Discussion Questions

1. According to the column, how do the incidences of accidents, homicide, and obesity in the United States help to explain the differing life expectancies in Canada and the U.S.? How would changing the U.S. health care system address the incidence of accidents, homicides, and obesity in America? Can you think of alternative policies that might close the life expectancy gap by reducing the incidence of accidents, homicide, or obesity?

2. According to Mankiw, the prevalence of low-birth-weight babies in the U.S. contributes to its relatively high infant mortality rate (infant mortality is universally higher among low-birth-weight babies than it is among babies born at normal weights). What factors explain the higher rates of low-weight births in the United States? Will an overhaul of the U.S. health care system address the number of low-weight births in the U.S.? What alternative policies might reduce the number of low-weight births in America?

3. Approximately 47 million Americans (of about 300 million total) lack health insurance. For what reasons does Mankiw argue that this number significantly overstates the problem of the uninsured in the United States? How do uninsured people receive care under the existing health care system? What policies might provide insurance to the group of American citizens who simply cannot access health insurance? How would national health insurance change the pool of the uninsured and the cost of treating them?

4. Why do we spend a larger share of our incomes on health care than previous generations? Clearly, health care is a normal good (increases in income lead to increases in the quantity of health care we demand). But is it also a luxury good (increases in income lead to relatively large increases in quantity demanded)? Is the growing share of income that we devote to health care a bad thing? In what way are increasing health care costs associated with increasing health care benefits? Read this David Leonhardt column for more on this topic.

5. Hopefully, a closer look at the three truths above will help to clarify the debate over health insurance in the United States. That said, understanding how a change to our health insurance system can or cannot influence these outcomes doesn't point to a specific policy prescription. What do you think?

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Monday, November 05, 2007

The Ethanol Bubble?

The New York Times reports that in less than one year, ethanol prices have plummeted over 30%. As a result, there is even talk of a government bailout for ethanol producers in case the price of ethanol falls too low!

So, why did price spikes in last year's ethanol market give way to falling prices this year? To understand the price fluctuations, we need to know how the short-run behavior of firms in competitive industries (such as ethanol) differs from their long-run behavior. In the textbook model of perfectly competitive industries, an increase in demand causes the equilibrium price of ethanol to increase in the short run—from P1 to P2 in the diagram below. In the short run, higher ethanol prices lead to higher profits for ethanol producers.

In the long run, the lure of profits attracts new ethanol producers. The long-run entry of additional ethanol producers expands the supply of ethanol, causing the price to fall back to its initial level:

Notice that economic profits converge to zero in the long run. As explained by most textbooks, zero economic profit does not mean that ethanol producers barely have enough to eat. Zero economic profit means that ethanol producers are earning incomes that compensate them for the next best salary they had to give up to go into producing ethanol.

Ultimately, in competitive environments, a surge in demand causes an initial spike in prices, but the equilibrium price gradually falls back toward initial levels. In the end, the long-run price of ethanol may not even change, but more ethanol will be produced than before.

Discussion Questions

1. Referring to the diagram on the left above, why does it take only a short period for prices to spike, but a long period for prices to fall again?

2. Referring to the diagram on the right above, why is the quantity of ethanol fixed for a period in the very short run?

3. Corn is a key ingredient to the production of ethanol. The New York Times article points out that corn prices have remained high over the past year even as the price of ethanol has declined. How might developments in the ethanol market have contributed to the rising price of corn?

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Thursday, November 01, 2007

No Free Lunches? What About Taco Tuesday?

In the second game of the World Series, Jacoby Ellsbury's second-base steal triggered Taco Bell's "Steal a base, steal a taco" promotion. Between 2:00 PM and 5:00 PM on Tuesday, October 30, Taco Bell made good on a promise of free tacos to anyone in America.

Discussion Questions

1. As with most free stuff, the taco promotion involved some hidden costs for the would-be freeloaders. What are some of the costs associated with taking Taco Bell up on its offer? Did the promotion involve external costs (costs borne by people who were not part of the taco transaction)?

2. An ABC News article pointed out that there has been at least one stolen base in every World Series since 1990. Taco Bell must have expected to make good on the promotion. Why would a profit-maximizing business offer this type of promotion?

3. A free taco isn't exactly "lunch" when you can only get it between 2:00 PM and 5:00 PM. Why were people willing to stand (or drive) in line at odd dining hours in order to get a taco that would normally run you less than a buck?

4. Sunk costs are costs that have been incurred and cannot be recouped, such as the time it took you to get to Taco Bell before realizing there was a long line. Were people sticking out a 20-minute wait for a $1 taco because they failed to ignore sunk costs?

5. In his new book, Tyler Cowen offers the following explanation of signaling: "We signal every time we incur a cost to send a message about ourselves to the outside world." Often, the higher the cost incurred, the stronger the signal. Think of the costs people incur to signal to prospective employers that they have an MBA from Wharton, or to signal to acquaintances that they attended Game 2 of the World Series. Were people signaling their devotion to the Red Sox or, more improbably, to Taco Bell? If the tacos were truly free, would anyone be able to make a strong statement about their baseball fanaticism? Might signaling help to explain the long lines in the final days before the release of products like Apple's iPhone and Microsoft's Xbox?

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