Current Events:
April 08, 2010 — April 8 (Bloomberg) -- David Gordon, head of research at Eurasia Group, talks with Bloomberg's Deirdre Bolton about the outlook for China's currency policy and U.S. Treasury Secretary Timothy Geithner's closed-door meeting with Chinese Vice Premier Wang Qishan in Beijing today. (Source: Bloomberg)
Chapter Overview
This chapter begins with a consideration of the Phillips curve in both the short run and the long run, and then discusses rational expectations and its influence on policy formation. Critiques of rational expectations are also covered. The chapter concludes with a section on jobless recoveries.
Chapter Outline
The Long-Run Phillips Curve
Accelerating Inflation
Phillips Curves and Disinflation
Checkpoint: Unemployment and Inflation: Phillips Curves
Rational Expectations and Policy Formation
Defining Rational Expectations
Policy Implications of Rational Expectations
A Critique of Rational Expectations
Checkpoint: Rational Expectations and Policy Formation
Are Recoveries Becoming "Jobless" Recoveries?
Ideas for Capturing Your Classroom Audience
What is the Fed's view of the economy at present and going forward? Read the latest press release from the FOMC. Visit its Web site at: http://www.federalreserve.gov/FOMC/#calendars and click on the "Statement" link for the most recent date on the calendar. For earlier dates you can also read the more detailed "Minutes."
Talk about how much students expect tuition to go up next year and how they
intend to deal with the increase. Use that as a lead-in to discuss inflationary
expectations as a whole.
Chapter Checkpoints
Unemployment and Inflation: Phillips Curves
Question: In the last decade, productivity growth has been unusually high, arguably because of technical advances in microcomputers, cellular phones, and Internet service. Have these advances made it easier for the Federal Reserve to contain inflationary pressures?
The point is to check that students can: apply their knowledge of the relationship
between productivity and inflation.
Rational Expectations and Policy Formation
Question: If efficiency wages are widespread throughout the economy but most
workers feel they are significantly underpaid, does paying workers more prevent
them from striking?
The point is to check that students can: apply the concept of efficiency wages to
the scenario presented.
Extended Example in the Chapter
Are Recoveries Becoming "Jobless" Recoveries?
Globalization, new technologies, and improved business methods are making the
jobs of policymakers much more difficult and may even be changing the nature of
the business cycle. The two most recent recessions have deviated significantly from what has happened in past business cycles; they were minor, but more important, during the recoveries that followed the expected gains in employment did not materialize.
Such jobless recoveries could be the result of rapid increases in productivity,
a change in employment patterns, and outsourcing. The latest recession and
subsequent slow job growth may have something to do with the overinvestment
that occurred during the previous boom, which has stifled investment in this subsequent recovery. The biggest difficulty is trying to know whether what is observed is peculiar to these particular circumstances or indicative of what the business cycle will look like going forward.
Examples Used in the End-of-Chapter Questions
Questions 1, 10, and 14 reference the importance of inflationary expectations. To
learn more about expectations and Federal Reserve Chairman Ben Bernanke’s
views see this April 3, 2006 story from Business Week titled “Inflation: What You
Foresee Is What You Get,” available on the Web at: http://www.businessweek.com/
magazine/content/06_14/b3978035.htm. The article refers to the importance of central bank “credibility.”
Question 11 discusses the slope of the Phillips curve. This article from The
Economist suggests that the Phillips curve may be getting more attention. See the
story titled “Economics Focus: Curve Ball: A Link Between Unemployment and
Inflation is Fashionable Again,” available on the Web at: http://www.economist.
com/finance/displaystory.cfm?story_id=7967976.
For Further Analysis
What Difference Does It Make if the Fed Has Credibility?
This example can be used as an in-class small group exercise or as an individual inclass exercise. It is designed to complement the text’s material by employing the graphical analysis of the AS/AD model to illustrate the importance of central bank credibility in the face of a supply shock.
Students are asked to compare the likely results of a supply shock when the central bank has credibility in terms of its inflation goals and when it does not. The issue of inflation targeting and the Fed’s dual mandate is also considered.
The format of the exercise provides an opportunity for students to demonstrate
their mastery of the text material by considering a scenario that differs from that given in the text but for which the reasoning and the analysis are parallel.
You may want to supplement this assignment with student research on credibility and the current discussions about having the Fed set an inflation-rate target (thereby letting unemployment adjust accordingly). The assignment provides a framework in which to evaluate rational expectations (theory or ideology?) and is a chance for students to explore and to discuss the political nature of economic theory.
Web-Based Exercise
The example below can be used as a small group exercise or as an individual exercise.
The exercise provides an opportunity for students to apply the material in the
chapter to an actual conversation between Federal Reserve Chairman Ben
Bernanke and House Financial Services Committee Chairman Barney Frank
(Democrat from Massachusetts).
In a story by Nell Henderson titled “Bernanke Rebuffs Frank on Rate Cut:
Congressman Questions Inflation Concern” (The Washington Post, February 16,
2007, page D02) the Fed Chairman explains the forecasts for the economy and why
interest rate increases are more likely than decreases.
The exercise asks students to “translate” Bernanke’s statements based on their
knowledge of the terms and concepts from the chapter. You may choose to extend
this assignment by having students read more of the testimony given. The story and
links to more information are provided on the page at: http://www.washingtonpost.
com/wp-dyn/content/article/2007/02/15/AR2007021501750.html.
Politicians and Policymakers
In a story from The Washington Post (February 16, 2007, page D02), Nell Henderson
quotes Federal Reserve Chairman Ben Bernanke’s responses to questions posed by
the House Financial Services Committee Chairman Barney Frank (Democrat
from Massachusetts). The story and links to more information are available on
the Web at: http://www.washingtonpost.com/wp-dyn/content/article/2007/02/15/
AR2007021501750.html.
Read the story and explain the following excerpts from Bernanke’s remarks using
the terms and concepts from the chapter:
1) Nell Henderson writes, “There is no specific level of unemployment that
automatically triggers inflation, Bernanke, a former chairman of the
Princeton University economics department, said in response to several lawmakers’
questions.”
2) According to Henderson, “Bernanke also said rising wages are not necessarily
inflationary, as was widely believed in the 1970s when high inflation was
blamed partly on unions’ salary demands.”
Answers:
1) This means that Bernanke does not believe there is a specific value for the
NAIRU, the natural rate of unemployment, meaning the unemployment
rate when inflationary pressures are nonexistent. If there were a specific
value for the NAIRU then once the economy got to that low level or even
went below it inflation would necessarily set in. The story goes on to mention
that at the time the unemployment rate was forecast to stay below 5%
and that Federal Reserve policymakers were “comfortable with joblessness
so low.”
2) We can interpret this remark in terms of the equation p = w – q, where p
represents inflation, w stands for wages, and q represents productivity.
As we have seen in the text, if q is high, wage (w) increases can be high
without any real pressures on inflation (p).
Tips from a Colleague
You may wish to review the basics of the business cycle before covering the last section of this chapter as the material on “jobless recoveries” is really a question as to whether or not the business cycle is changing.
The Burden of the Public Debt
Question: Is crowding-out an inevitable result of deficit spending if the Federal
Reserve does not buy back an equivalent amount from the market?
The point is to check that students can: understand the different impacts of deficit spending when the economy is slack as opposed to when it is at or close to full employment.
Extended Example in the Chapter
How Much Debt Can We Carry?
Alan Greenspan, former Chairman of the Federal Reserve Board, cautioned about
the future threat from growing budget deficits, and at other times backed away from that position. The reason seems to be that his views changed as to how much debt the government can comfortably take on. The higher level of that “danger point” may in part be due to lower interest rates and improved financial markets.
This section references an article by Edmund Andrews titled “Greenspan Shifts
View on Deficits,” from The New York Times (March 16, 2004, pages A1 and C2).
Examples Used in the End-of-Chapter Questions
Question 3 refers to the Laffer curve. You may wish to review the material from the chapter on fiscal policy.
Question 5 references the history of the U.S. government’s budget position, noting
that it has been in surplus on average about one year in every decade. You can illustrate the history of the deficit with the graph from the Web at:
http://www.uuforum.org/deficit.htm.
Question 11 references an open letter from Ben Stein to Henry Paulson after
Paulson was appointed as U.S. Treasury Secretary. The piece is titled “Everybody’s
Business: Note to the New Treasury Secretary: It’s Time to Raise Taxes,” and it
appeared in The New York Times on June 15, 2006. For more on Secretary Paulson,
see the Web site of the U.S. Department of Treasury at: http://www.ustreas.gov/.
Question 14 refers to the roles of Congress and the Executive Branch in managing
the budget. For more about the agencies involved, visit the sites of the Office of
Management and Budget at: http://www.whitehouse.gov/omb/ and the Congressional
Budget Office at: http://www.cbo.gov/.
For Further Analysis
Understanding Crowding-Out
This example can be used as an in-class small group exercise or as an individual inclass exercise. It is designed to complement the text’s material on crowding-out by examining the effect of the deficit on interest rates through the workings of the money market and the bond market. This treatment ties the topic back to the analysis used in Chapter 21, and you may wish to expand the assignment by delving more deeply into the effects in the money market.
Web-Based Exercise
This example can be used as a small group exercise or as an individual exercise.
The exercise provides an opportunity for students to apply the material in the chapter about the Federal Reserve and the government’s budget deficit to an analysis of comments by the current Fed Chairman, Ben Bernanke. The third question provides an opportunity to reinforce students’ understanding of the role of the Fed with regard to Congress and the Executive Branch.
Boomers and the Budget Deficit
In an AP story from January 18, 2007, titled “Bernanke Warns of ‘Vicious Cycle’ in
Deficits: Wave of Retiring Boomers Will Put Growing Strain on Budget, Fed Chief
Says” (available on the MSNBC site at http://www.msnbc.msn.com/id/16688089/)
the Fed Chairman outlines his concerns about future deficits. (Note that he was testifying to the Senate Budget Committee.)
After reading the article, answer the following:
1) Why is the retirement of the baby boomers a problem for the budget deficit?
2) What is the “vicious cycle” about which Bernanke is concerned?
3) What suggestions, if any, does Bernanke make about what Congress and the
administration should do?
Tips from a Colleague
Students are often unclear about the relationship between an annual budget deficit
and the accumulated debt. Using data to illustrate the changes that have occurred
over time helps clarify this. Also, students are not likely to grasp how much they
hear about the deficit at any point in time is based on projections. Comparing the
information on the Web sites of the Office of Management and Budget and the
Congressional Budget Office can point out the differing assumptions being made.
Finally, be sure that students understand the process. The media give presidents too much credit and too much blame.
Email HW to gmsmith@shanahan.org
1. Be sure to review Chapters 20-23 (we will have Tests on this material as well, TBA). Some students have asked to be tested as close as possible after covering the material.
2. Ch. 23
Chapter Checkpoints
The Burden of the Public Debt
Question: Is crowding-out an inevitable result of deficit spending if the Federal
Reserve does not buy back an equivalent amount from the market?
The point is to check that students can: understand the different impacts of deficit spending when the economy is slack as opposed to when it is at or close to full employment.
3. Questions and Problems, #1-5.
4. As review for HW, typical questions that you may encounter on the actual AP Economics Macro Test are included daily:
Review Questions (Princeton):
a) an increase in the real interest rate
b) increased investment in capital
c) an increase in aggregate demand
d) an increase in the unemployment rate
e) an increase in the exchange rate
8. Operating in the intermediate range of the aggregate supply curve, an increase in aggregate demand results in an increase in
a) price level only
b) real GDP only
c) neither price level nor real GDP
d) nominal GDP only
e) price level and real GDP
9. Unplanned investment occurs when
a) aggregate expenditure exceeds real GDP
b) injections equal leakages
c) injections exceed leakages
d) aggregate expenditure falls short of real GDP
e) exports exceed imports
