Lecture 19 November 28, 2005 The classical dichotomy: a reprise Keynesian perspectives on monetary and fiscal policies and their evolution Comparison with the mainstream The Phillips Curve: is there a trade-off between inflation and unemployment?

The Classical Dichotomy The classical dichotomy is the theoretical separation between real and nominal magnitudes. Real magnitudes are determined in one sphere, nominal magnitudes in another, separate, sphere. Nominal magnitudes are those measured in money, like the dollar value of pizzas consumed by Harvard students per day, or the price of a pizza. Real magnitudes are those with a physical dimension, such as P / W The mainstream position is that the classical dichotomy holds in the long run but not necessarily in the short run Policy implications of the classical dichotomy Fiscal policy is ineffective. Attempts to stimulate (or restrain) the economy will only “crowd out” (or “crowd in”) investment or consumption demand, and lead to higher (lower) prices. Monetary policy too is ineffective. Attempts to stimulate the economy will only lead to higher prices, and restraint will lead only to lower prices.

Keynesian Perspectives on Monetary and Fiscal Policies I: Limitations of Monetary Stimulus The Keynesian critique led Keynes and his followers to be skeptical of monetary policy as a means of stimulating a sluggish economy. Monetary stimulus lowers interest rates and provides banks with reserves to increase lending. But neither of these forms of stimuli address the main problem with business investment, the pessimism of businesspeople (pushing on a string)

Keynesian Perspectives on Monetary and Fiscal Policies II: Monetary Contraction Keynesians were always more disposed towards monetary policy as a means of restraining the economy Higher interest rates may discourage some investment, but probably not very much if businesspeople are determinedly optimistic (“irrational exuberance,” in Alan Greenspan’s phrase) More importantly, reducing bank reserves makes it more difficult for banks to lend—whether or not businesspeople are optimistic Thus restrictive monetary policy bites harder on small business than on large business Why?

Keynesian Perspectives on Monetary and Fiscal Policies III: Fiscal Policy in Hard Times Keynesians originally focused on fiscal policy as a means of stimulating the economy Government expenditure not only adds directly to output and income, but indirectly via the multiplier Tax cuts do not add directly to output and income but do lead to successive rounds of expenditure, output, and income, again via the multiplier

Keynesian Perspectives on Monetary and Fiscal Policies IV: in Good Times Keynesians also believed that fiscal policy could be used to restrain the economy Reducing government expenditures and increasing taxes could hold aggregate demand down when it pressed on aggregate supply

Keynesian Perspectives on Monetary and Fiscal Policies V: Fine Tuning Fine tuning is the adjustment of policy to offset relatively small changes in private demand to maintain a continuously high level of employment and output. Early on, Keynesians had high hopes for fine tuning. Problems with fine tuning fiscal policy Recognition lags Legislative lags Implementation lags Monetary policy is more supple Recognition lags are present, but not legislative and implementation lags

The abandonment of fine tuning Keynesian Perspectives on Monetary and Fiscal Policies VI: The Evolution of Keynesian Policy Perspectives The abandonment of fine tuning The growth of the market for owner-occupied housing and the mortgage market has made monetary policy more effective in stimulating the economy During the recent recession, falling interest rates stimulated consumption by encouraging people to re-finance mortgages, either with higher debt (“cash-out” mortgages) or with lower monthly payments. Either way people increased consumption Observe that when households re-finance their mortgages with a bigger loan and spend the cash they take out, they are generally acting more like habitual spenders than like rational calculators. Lower interest rates also encouraged investment in housing; residential construction was the one component of gross domestic investment that actually increased between 2000 and 2002 (Lecture 16)

Limitations to Monetary Stimulus A major problem is that the stimulus to consumption demand from falling (as distinct from low) interest rates is not sustainable: interest rates can remain low indefinitely if need be, but they can’t fall indefinitely. A second problem is that household debt has increased rapidly.

Two Potential Problems with Higher Debt The economy continues to recover, interest rates go up, and households are stretched to meet higher debt servicing costs (interest and principal payments). A housing bubble. If housing prices were to fall dramatically, loan-to-(house)-value (LTV) ratios would rise. So what? A rise in the LTV ratio could wipe out the equity homeowners have in their houses and weaken the financial health not only of households and agents (banks, insurance companies and others) who hold residential mortgages.

Household Debt and GDP, 1993-2003

Limits on Fiscal Policy: Mainstream and Keynesian Perspectives There is more agreement between the mainstream and Keynesian critics than disagreement—as long as we stick to the short run. The mainstream has always been skeptical of managing aggregate demand through fiscal policy: not only do problems of fine tuning make it difficult to use government expenditures to compensate for fluctuations in private demand The mainstream is more disposed towards tax cuts to stimulate an economy in recession, but the rational consumer frustrates the ability to manage consumption demand with temporary tax changes. Mainstream economists often have a dual agenda when it comes to tax policy in recession: stimulating demand à la Keynes and stimulating supply by reducing “deadweight” losses A critical, Keynesian, perspective has similar reservations about government expenditure, except in a prolonged and deep recession, but finds tax policy, especially when directed at the bottom of the income distribution, more congenial.

Mainstream and Keynesian Views of Fiscal Policy: the Case of Taxes Effects of tax cuts (or increases) depend on how households and businesses respond. Habitual spenders and rational calculators react differently. As do algorithmic and experiential investors. If tax policy is used to stimulate the economy when private aggregate demand is insufficient (or to restrain demand when private aggregate demand is excessive), then tax cuts (or increases) must be temporary.

The Effects of a Tax Cut of $50 billion on Habitual Spenders 45° line Income (Y) Expenditure (E) ID + GD = 150 CD + ID + GD C' D = 0.75(Y – T) = 0.75(Y – 50) C' D + ID + GD CD = 0.75Y

The Effects of a Temporary Tax Cut of $50 billion on Rational Calculators Expenditure (E) ED = Y CD + ID CD= 450 ID + GD = 150 45° line Income (Y)

The Effects of Tax Cuts on Two Kinds of Savers ID + GD = 150 CD= 450 ED = Y 45° line Income (Y) Expenditure (E) CD + ID Rational Calculators Habitual Spenders Expenditure (E) CD + ID + GD C' D + ID + GD CD = 0.75Y C' D = 0.75(Y – T) = 0.75(Y – 50) ID + GD = 150 45° line Income (Y)

(Ricardian Equivalence) The Effects of a Permanent Tax Cut of $50 billion on Ultra-Rational Calculators (Ricardian Equivalence) Expenditure (E) ED = Y CD + ID CD= 450 ID + GD = 150 45° line Income (Y)

Supply Side Arguments for Tax Cuts From a supply side point of view, tax cuts eliminate deadweight losses, and move the AS schedule to the right.

A Reduction of a Tax on Labor AS Price level AS with reduced tax Supply of goods, W = W0 Supply of labor, W = W0, with reduced tax Supply of labor, W = W0 Real Output

Another Supply Side Argument for Tax Reduction A separate argument for tax cuts is that it will oblige Congress and the Administration to hold down government spending (starving the beast).

Limitations on Monetary Policy: Mainstream and Keynesian Perspectives The main difference between the mainstream and Keynesian perspectives is on the relative weights to be given to the objective of price stability and the objective of high employment and output The mainstream focuses on price stability Keynesians focus more on employment and output The difference is partly political (Keynesians tend to be to the left, the mainstream to the right), partly due to differences in analysis and understanding of the possibilities of affecting employment and output

The Phillips Curve The Phillips Curve is a negative relationship between inflation and unemployment It can be understood with the help of aggregate demand and aggregate supply So can the limitations of the Phillips Curve The Phillips Curve and its limitations provide a good test between the Keynesian and mainstream views of the macroeconomy

The Phillips Curve Inflation Rate Unemployment Rate

Aggregate Demand and Aggregate Supply: The Effects of Changes in Demand wage = const AS “Demand Shocks”—shifts in the AD Schedule—increase output and income by moving up a given short-run AS Schedule. Observe that prices move in the same direction as income and output—and employment. Prices move in the opposite direction as unemployment. AD Y

Effects of Changes in Demand: From AD-AS to the Phillips Curve wage = const Inflation Rate AS The Phillips Curve AD Y Unemployment Rate

The Effects of Changes in Supply wage = const AS A “supply shock” is a shift in the AS Schedule along a given AD Schedule. Prices and output move in opposite directions. Here a rise in prices is coupled with a fall of output (stagflation). The most important supply shocks in the last 40 years have been the oil shocks of 1973 and 1979. AD Y

The Effects of Changes in Supply, cont’d AS1 (W = W1 > W0) AS0 (W = W0) Another reason why the AS curve will shift upwards is that inflation becomes generalized and expected. In this case the wage rate will increase and as in microeconomics the supply curve will move upwards with (marginal) costs. AD Y

Effects of Changes in Demand: From AD-AS to the “Anti-Phillips” Curve wage = const Inflation Rate AS The “Anti-Phillips” Curve AD Y Unemployment Rate

The Phillips Curve: Mainstream vs Keynesian Views The mainstream view of the Phillips Curve is that it reflects a short-run trade-off between employment and output on the one hand and price stability on the other. Short run because if policymakers exploit this trade-off, it evaporates. The long-run Phillips Curve is vertical. The Keynesian view is that the trade-off represented by the Phillips Curve has important consequences for the long run as well as for the short run.

Effects of Changes in Demand: When Inflation Becomes Generally Anticipated, the AS Schedule Shifts and so Does the Phillips Curve P AS1 (W = W1 > W0) Inflation Rate Anti-Phillips Curve ● C ● C AS0 (W = W0) B ● ● D ● B Phillips Curve ● A ● D ● A AD1 AD0 Y Unemployment Rate

The Classical Dichotomy Implies a Vertical Phillips Curve AS1 (W = W1 > W0) Inflation Rate C C   AS0 (W = W0) B   B Long-Run Phillips Curve A  A  AD1 AD0 Y Unemployment Rate

Unemployment and Inflation, 1961-2002 Inflation Rate (percent per year) 10 1981 1975 1980 ● ● ● ● 1974 ● 1979 8 ● 1978 1977 ● ● 1982 ● 1976 6 1973 ● 1970 1971 1969 1991 ● 1972 1983 4 1968 ● ● ● 1990 1984 1989 ● ● 2001 ● 1988 ● 1985 1966 2000 1967 1996 1987 ● ● ● 1986 ● 1995 1994 1992 1997 ● ● ● 2 ● ● 1993 1965 ● ● 1999 1962 ● ● 1998 1961 1963 2002 1964 1 2 3 4 5 6 7 8 9 10 Unemployment Rate (percent) Copyright © 2004 South-Western

The Phillips Curve in the 1960s Inflation Rate (percent per year) 10 8 6 1968 4 1966 1967 2 1965 1962 1964 1961 1963 1 2 3 4 5 6 7 8 9 10 Unemployment Rate (percent) Copyright © 2004 South-Western

The Breakdown of the Phillips Curve Inflation Rate (percent per year) 10 8 6 1973 1970 1971 1969 4 1972 2 1 2 3 4 5 6 7 8 9 10 Unemployment Rate (percent) Copyright © 2004 South-Western

The First Oil Shock 10 8 6 4 2 1 2 3 4 5 6 7 8 9 10 Inflation Rate (percent per year) 10 1975 1974 8 6 1976 1973 4 2 1 2 3 4 5 6 7 8 9 10 Unemployment Rate (percent) Copyright © 2004 South-Western

Consumer Prices, 1973-74

Consumer Prices, 1974-78

The First Oil Shock: AD and AS and the Phillips and Anti-Phillips Curves Inflation Rate ● AS 1974, 1976 1975 ● 1974 AS 1973 Anti-Phillips Curve ● ● 1973 1976 ● ● 1975 1974 ● 1973 ● 1976 AD 1973, 1974 AD 1975, 1976 Phillips Curve Y Unemployment Rate

The First Oil Shock ● ● ● ● 10 8 6 4 2 1 2 3 4 5 6 7 8 9 10 Inflation Rate Inflation Rate (percent per year) Anti-Phillips Curve 10 ● ● 1975 1975 1974 1974 8 ● 1973 6 ● 1976 1973 1976 4 Phillips Curve 2 1 2 3 4 5 6 7 8 9 10 Unemployment Rate Unemployment Rate (percent) Copyright © 2004 South-Western

In Between the Two Oil Shocks Inflation Rate (percent per year) 10 1979 8 1978 6 1977 1976 4 2 1 2 3 4 5 6 7 8 9 10 Unemployment Rate (percent) Copyright © 2004 South-Western

The Second Oil Shock 10 8 6 4 2 1 2 3 4 5 6 7 8 9 10 Inflation Rate (percent per year) 10 1981 1980 1979 8 6 4 2 1 2 3 4 5 6 7 8 9 10 Unemployment Rate (percent) Copyright © 2004 South-Western

Consumer Prices, 1978-1981

The Volcker Cure, Part 1 Inflation Rate (percent per year) 10 1981 8 1982 6 4 1983 Interest rates in 1981 reached levels as high as 19% for the Fed Funds rate and over 15% for 1-year and 10-year Treasury securities 2 1 2 3 4 5 6 7 8 9 10 Unemployment Rate (percent) Copyright © 2004 South-Western

The Volcker Cure, Part 2 Inflation Rate (percent per year) 10 8 6 1984 4 1983 By 1986 short term interest rates had fallen to about 6% and the 10-year T-bond rate to between 7 and 8% 1985 2 1986 1 2 3 4 5 6 7 8 9 10 Unemployment Rate (percent) Copyright © 2004 South-Western

Consumer Prices, 1981-87

The Greenspan Era, Part 1 (1986-1992) Inflation Rate (percent per year) 10 8 6 1991 1992 1986 1988 1987 1989 1990 4 2 1 2 3 4 5 6 7 8 9 10 Unemployment Rate (percent) Copyright © 2004 South-Western

The Greenspan Era, Part 2 (1993-1998) Inflation Rate (percent per year) 10 8 6 4 1995 2 1997 1994 1993 1998 1996 1 2 3 4 5 6 7 8 9 10 Unemployment Rate (percent) Copyright © 2004 South-Western

The Greenspan Era, Part 3 (1998-2002) Inflation Rate (percent per year) 10 8 6 4 2001 2000 2 1999 2002 1998 1 2 3 4 5 6 7 8 9 10 Unemployment Rate (percent) Copyright © 2004 South-Western

Lecture 20 November 30, 2005 40 years of the Phillips Curve Lessons Social Security Privatization

Two Anomalies 1969-1972 1993-1998

The Breakdown of the Phillips Curve Inflation Rate (percent per year) 10 8 6 1973 1970 1971 1969 4 1972 2 1 2 3 4 5 6 7 8 9 10 Unemployment Rate (percent) Copyright © 2004 South-Western

The Greenspan Era, Part 2 (1993-1998) Inflation Rate (percent per year) 10 8 6 4 1995 2 1997 1994 1993 1998 1996 1 2 3 4 5 6 7 8 9 10 Unemployment Rate (percent) Copyright © 2004 South-Western

The End of the “Golden Age”: the late ’60s What went wrong at the end of the ’60s? Productivity growth slowed down, but real wage growth did not. The share of capital income fell sharply. It took a recession to restrain wage growth.

Real Wages, Productivity, and Capital-Income Share, 1947-1966

Real Wages, Productivity, and Capital-Income Share, 1966-1973

The Exceptional ’90s Expansive “animal spirits”—optimism of business people. End of the Cold War, the quick (First) Gulf War. Relatively high productivity growth coupled with relatively low labor militancy meant that the benefits of productivity growth flowed largely to corporate profits, which fueled the investment boom. High profits led to the expectation of high profits in the future (expanding investment demand). High profits provided the resources for business investment (adding to the supply of saving). Strong dollar relative to European and Japanese currencies meant low import prices, which kept the lid on pricing power of firms.

Real Wages, Productivity, and Capital-Income Share, 1993-1997

A Key Difference Between the ’60s and the ’90s Reasons for lower labor militancy in the ’90s: Diminished power of trade unions Enhanced fear of job loss, especially for employees of firms moving operations abroad

Union Membership in the 20th Century

Lessons What can we learn from a comparison of the ’60s and the ’90s?

Real Wages, Productivity, and Capital-Income Share, 1947-2003

Lessons The US does pretty well at managing an economy with a working class that will accept stagnant wages over a long period of time. Can we manage an economy in which wages grow at the same rate as productivity? The jury is still out.

Social Security: The Privatization Debate Social Security Privatization From Two Perspectives on Macroeconomics Mainstream: SSP will increase saving and investment Keynesian: SSP may or may not increase S and I, depending on the buoyancy of animal spirits

Social Security: Some Nuts and Bolts Financed by a payroll tax (FICA, for Federal Insurance Contribution Act), currently 6.2% on wages up to $87,900, matched by a 6.2% payment by employers. In addition, a Medicare tax of 1.45% on all wages, again matched by employers’ contributions. Total for most people is 15.3%. Self-employed people pay the entire amount. Payments depend on a complicated formula depending on earnings and their distribution over time and age of retirement. Currently, the max for a retiree at age 65 yrs, 6 mths is $1861 per month. A pay-as-you-go system, current workers finance current retirees. The difference between contributions and payments goes into a “Social Security Trust Fund,” which holds US govt bonds. A combination of insurance and redistribution, Social Security provides income for disabled people (SSI, for Supplemental Security Income) as well as benefits to dependents of retired and deceased workers.

Social Security: Why Do We Need It? Why not leave retirement and insurance planning to the market?

Does Social Security Need Fixing? Implications of longer life span: Higher payroll tax rates Broadening of tax base Lower benefit rates Later retirement

Is Privatization the Solution? Privatization means the (partial) replacement of pay-as-you-go with funded accounts, more or less like private pension plans or 401(k) plans. The devil is in the details: Who bears the risk of stock-market fluctuations? How is the transition from the present system to the new one paid for? (Talk about double taxation!) What assumptions about stock-market returns? What happens to the redistributive element in social security? “Starving the beast.” Will higher (desired) saving increase investment?

Privatization of Social Security (1) Strong Private Investment Demand Mainstream Privatization will increase desired saving and thus actual investment. The long-run AS schedule will move to the right. Keynesian The effect of privatization on actual investment depends critically on “animal spirits.” The most favorable case for privatization is when business is optimistic to the point that the Central Bank restricts the money supply to restrain investment. An increase in desired saving, which implies a decrease in desired consumption, will reduce the pressure of AD and allow the Central Bank to ease up on its restrictive policies

The Mainstream View: Privatization Increases the Supply of Saving Interest Supply, S1 S2 Rate Demand 1. Incentives for saving increase the supply of saving… 5% $1,200 2. . . . which reduces the equilibrium interest rat e . . . 4% $1,600 Saving and Investment 3. . . . and raises the equilibrium quantity of saving and investment. (in billions of dollars) Copyright©2004 South-Western

The Mainstream Model: When SD Increases, the Interest Rate Falls and ID Increases… Expenditure (E) 5000 ED = Y 4000 CD2 + ID2 = CD1 + ID1 3000 2000 CD1 = 1800 ID2 = 1600 CD2 = 1400 1000 ID1 = 1200 45° line 1000 2000 3000 4000 5000 Income (Y)

(Wages Move With Prices) The Mainstream View of How Privatization Affects Long-Run Aggregate Supply Price Level (Wages Move With Prices) Long-run aggregate supply The long-run AS schedule moves to the right Natural rate Quantity of of output Output Copyright © 2004 South-Western

The Keynesian Model Suppose the economy is near full employment and the Fed is restricting the money supply to keep a damper on animal spirits. If SD increases, the Fed can relax monetary policy. This allows ID to increase without leading to greater pressure on prices. Expenditure (E) 5000 ED = Y CD1 + ID1 4000 CD2 + ID2 CD1 = 0.6 Y 3000 CD2 = 0.53 Y 2000 ID2 = 1600 1000 ID1 = 1200 45° line 1000 2000 3000 4000 5000 Income (Y)

Aggregate Supply is “Path Dependent”: Higher Investment Shifts the AS Schedule Outward Price Level Relative to Wages The position of the AS schedule also depends on the history of investment: the more capital available to each worker, the greater is productivity. AS1 AS2 Real Output

Privatization of Social Security (2) Weak Private Investment Demand Mainstream Privatization will increase desired saving but will not increase actual investment if desired investment is unresponsive to a fall in the interest rate. The long-run AS schedule will not move to the right. Keynesian View If animal spirits are not buoyant, then an increase in desired saving will not lead to greater investment. In this case the Fed is not going to be holding investment demand in check and a relaxation of monetary policy will have little effect on business investment. Suppose that the elasticity of investment demand is zero

The Mainstream View: Privatization Increases the Supply of Saving Interest S2 Rate Investment Demand S1 1. Incentives for saving increase the supply of saving… 5% 2. . . . which reduces the 2% equilibrium interest rat e . . . $1,200 Saving and Investment (in billions of dollars) 3. . . . but does not raise the equilibrium quantity of saving and investment. Copyright©2004 South-Western

The Mainstream Model: When SD Increases, the Interest Rate Falls but ID Does Not Increase… Expenditure (E) 5000 ED = Y 4800 CD1 + ID1 4000 CD1 = 3600 3000 2000 1200 1000 ID1 = 1200 45° line 4800 1000 2000 3000 4000 5000 Income (Y)

(Wages Move With Prices) The Mainstream View of How Privatization Affects Long-Run Aggregate Supply Price Level (Wages Move With Prices) Long-run aggregate supply The long-run AS schedule does not move to the right × Natural rate Quantity of of output Output Copyright © 2004 South-Western

The Keynesian View: Privatization Increases the Supply of Saving Interest S2 Rate Investment Demand S1 1. Incentives for saving increase the supply of saving… 5% $1,200 Saving and Investment (in billions of dollars) Copyright©2004 South-Western

The Keynesian View: Privatization Increases the Supply of Saving Interest S2 Rate Investment Demand S1 1. Incentives for 5% saving increase the supply of saving… SHORTFALL OF DESIRED CONSUMPTION 2. Unless the Fed acts decisively, income will fall because of the shortfall of aggregate demand: an increase in desired saving means a decrease in desired consumption $1,200 Saving and Investment (in billions of dollars) Copyright©2004 South-Western

Without Central Bank Intervention Interest S2 Rate Demand 5% $1,200 Saving and Investment (in billions of dollars) Copyright©2004 South-Western

The Paradox of Thrift Attempts to save more may lead to less income and output (and conceivably—though not in this example—less saving)

The Keynesian Model Suppose pessimism reigns, the economy is nowhere near full employment, and the Fed is not running a tight monetary policy. If SD increases, CD falls, and income and output will fall unless the Fed takes very decisive measures to ease interest rates. Expenditure (E) 5000 ED = Y CD1 + ID1 4000 CD2 + ID2 CD1 = 0.6 Y 3000 CD2 = 0.53 Y 2000 1000 ID1 = 1200 45° line 1000 2000 3000 4000 5000 Income (Y)

Aggregate Supply is “Path Dependent”: Outward Shifts in AS Depend on Buoyant Animal Spirits Price Level Relative to Wages The position of the AS schedule also depends on the history of investment: the more capital available to each worker, the greater is productivity. In the present case, not only will the AS schedule not move outward, but a persistent decline in consumption demand may lead to a fall in investment demand and an inward shift in the AS schedule. AS1 × AS2 Real Output

Transition Costs, Saving, and Investment The outflows from the SS system to retirees under the existing system will not be covered by inflows from workers when privatization takes place since a portion of the inflows will be devoted to private accounts. This will, even in the mainstream story, reduce the beneficial effects on overall saving, investment and capital formation. In the Keynesian story this transitional adjustment is problematic only in the case that investment demand is strong. When investment demand is weak, the stimulus to consumption demand from the outflows to retirees will offset the drag on consumption demand that accompanies the attempt of current working folk to save more.