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Macroeconomics for Managers

Richard A. Stanford

Copyright 2011 Richard A. Stanford

All rights reserved. No part of this book may be reproduced, stored, or transmitted by any means—whether auditory, graphic, mechanical, or electronic—without written permission of the author, except in the case of brief excerpts used in critical articles and reviews.

CONTENTS

Preface

PART A. THE GLOBAL MACROECONOMIC ENVIRONMENT
Chapter 1. The Firm in Society
Chapter 2. International Commerce
Chapter 3. The Globalization of Enterprise
Chapter 4. Opportunities in Developing Economies

PART B. MACROECONOMIC FOUNDATIONS
Chapter 5. Macroeconomics "In the Beginning"
Chapter 6. Accounting for Income and Product
Chapter 7. Nominal and Real Values

PART C. MACROECONOMIC THEORY
Chapter 8. Aggregate Expenditures
Chapter 9. Leakages and Injections
Chapter 10. Monetary and Investment Theory
Chapter 11. Aggregate Demand and Supply
Chapter 12. Interest Rates
Chapter 13. Macroeconomic Implications of Growth
-- Appendix 13A. Time Series Decomposition
Chapter 14. Economic Fluctuations and Shocks
-- Appendix 14A. Multiplier-Accelerator and Inventory Replacement

PART D. MACROECONOMIC POLICY
Chapter 15. The Role of the Government
Chapter 16. Government and Macroeconomic Instability
Chapter 17. Output, Inflation, and Unemployment
Chapter 18. External Balance
Chapter 19. Exchange Rates and Macroeconomic Adjustment
Chapter 20. Stabilization Policy
Chapter 21. Deficits and Surpluses
Chapter 22. Public Debt

PART E. CONCLUSION
Chapter 23. Management and Macroeconomic Instability

Glossary

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PREFACE

Economists have learned a great deal since 1923 about how economic systems work and how policies affect their operation. Nevertheless, our opinions should be rendered with humility, for even the wisest among us can claim only an imperfect understanding of our economy’s workings. Economic Trends, 1923-1998 Commemorative Issue, Federal Reserve Bank of Cleveland, Cleveland, Ohio, September 1998, page 1.

Inflation, unemployment, the interest rate, the rate of growth, the balance of payments, the tax system, the budget deficit, the public debt . . . all macroeconomic matters that can affect the operations of commercial enterprises. There can be little doubt about the significance of such matters to the manager of an enterprise operating in the global environment of the twenty-first century.

Managerial economics devotes attention almost exclusively to the microeconomic criteria for rational decision making. Most microeconomic theory and managerial economics texts written for American students presume a national environment of market capitalism in which there is only a minimal role for government to play in establishing and enforcing the rules of competitive behavior. In this book I turn to the larger environment within which the firm is situated so that we may identify the implications for the firm when changes occur in the larger world of the global economy.

Scientific inquiry encompasses the effort to understand the "way the world works." One of the objectives of such understanding is to gain ever greater control over the environment within which we live. Two types of control may be distinguished: active and passive.

Active control is directed toward altering the direction or force of events. Indeed, active control is the object of managerial decision making in the microeconomic context of the commercial enterprise. However, very little of what happens in the larger world is amenable to management by the firm.

Even if there is no hope of altering the course of events, the manager of the firm may find it possible to exert some form of passive control in the sense of attempting to prepare for, respond to, or simply get out of the way of what is happening in the larger world. It is this possibility of exerting such passive control which is the thrust of analysis in this book.

The central thesis of this book is that the business enterprise's situation within its host macroeconomy provides innumerable opportunities that it may exploit, but also poses a variety of threats to the manager's decision making discretion, and possibly to the very existence of the enterprise as an organization independent of the society's governing authority.

I have produced the present book by abstracting, editing, and elaborating the prose content of my macroeconomics text, Macroeconomics: The Global Environment, that may be found on-line at http://www.dickstanford.com/MA/macro1.htm. My intent was to present the essential concepts without use of mathematical symbols, equations, and graphs.  Without graphs and equations we can specify directions of change, but we are unable to indicate magnitudes of change.  Little may be lost in this regard because the magnitudes of change represented in equations and graphs may lead to the illusion that we can know with too much precision the outcomes of macroeconomic changes.  For those who may wish to explore standard expositions of macroeconomic topics, I have provided at the end of each chapter a link to the corresponding on-line chapter of my macroeconomics text that elaborates the subject matter with equations and graphs.

Who might be the clients for this book? People who find themselves in managerial settings, but who have never had any formal training in macroeconomics, might find this book useful. Managers who once did take a university-level macroeconomics course might find this book useful as a refresher. Others who need better conceptual understandings of the macroeconomics subject matter but consider themselves to be “mathematically challenged” could find this book helpful.

This book is a companion to my managerial economics books, Managerial Economics: Rational Decision Criteria that can be found on-line at http://www.dickstanford.com/MI/micro1.htm, and A Managerial Economics Handbook that can be found on-line at http://www.dickstanford.com/MI/nqme1.htm.

The chapters in Part A of this book describe the settings, ranging from local to global, for the business firm's activities.

The chapters in Part B describe the foundations of modern macroeconomic theory.

Part C introduces conventional macroeconomic theory, but with references to the global economy where appropriate.

The chapters in Part D examine the case for governmental action in both the national macroeconomy and on the global scene.

The final chapter, in Part E, lays out the managerial implications of macroeconomic instability.

Richard A. Stanford
October, 2011

BACK TO CONTENTS

PART A. THE GLOBAL MACROECONOMIC ENVIRONMENT

 

 

CHAPTER 1. THE FIRM IN SOCIETY

This book is about the macroeconomic setting within which managers of microeconomic business enterprises must make operating decisions.

Microeconomics is about the individual decision making units that compose an economy. These individual decision making units include consumers, resource owners, resource employers, and producers. Microeconomic analysis extends to the structure and behavior of groupings of these individual decision making units, e.g., families, business enterprises, product and resource markets, and industries.

Macroeconomics is about the structure and behavior of an entire economy and large sub-sets (or sectors) of it, e.g., the household, producer, and government sectors. While macroeconomics today is often described in terms of nation states, it may also apply to regions of national economies, e.g., the Southeast of the United States or the State of South Carolina, and to groupings of nation states such as the European Union or even the entire world economy.

Managerial economics devotes attention almost exclusively to the microeconomic criteria for rational decision making. Active control is the object of managerial decision making in the microeconomic context of the commercial enterprise. However, very little of what happens in the larger world is amenable to such management. Even if there is little hope of altering the course of events, the manager of the commercial enterprise may find it possible to exert some form of passive control in the sense of attempting to prepare for, respond to, or simply get out of the way of what is happening in the larger world. It is this possibility of exerting such passive control that is the focus of this book.

The central thesis of this book is that the business enterprise's situation within its global setting provides innumerable opportunities that it may exploit, but also poses a variety of threats to the manager's decision making discretion, and possibly to the very existence of the enterprise as an organization independent of the society's governing authority. In this opening chapter we propose to explore the link between the microeconomic business enterprise and its macroeconomic environment by describing its societal setting.

The Micro-Macro Nexus.  The central function of the business enterprise or firm is production. We construe the term "production" broadly to include all of the functions associated with extraction, processing, assembly, packaging, and distribution; it also encompasses the provision of services. The business firm is a creation of members of society to improve the efficiency of production by enabling specialization and division of labor and management. This statement presupposes that society has organized its economic arrangements as market capitalism and that the extant government at very minimum tolerates the existence and activities of such business firms.

However, even if the society in question has adopted some authoritarian form of economic organization (e.g., fascism or socialism) rather than capitalism, efficiency in its productive relationships may still be served by organizing production in units that enable specialization and division of labor and management. In Soviet-style planned economies, such production units existed and often were referred to as "enterprises.” They were distinguished from the privately owned firms in capitalism in that they were owned by the state.  Another distinction is that their managements were required to respond to dictates of the planning authority, whereas managements of firms in market capitalism are free to respond to market incentives.

The Setting. Our further examination of the firm's situation in its societal relationships presupposes a setting of market capitalism, but the tone suggested in the paragraphs above belie alternatives that managers should keep in mind: the society, or its government, may cease to be so tolerant of the existence or activities of privately owned and managed business firms. Alternatives include governmental efforts to modify or constrain the management and operations of the privately owned enterprise, or to take over the enterprise and run it as an organ of the state.

The Firm's Roles in Society

Business firms in economies organized as market capitalism make a great many contributions to the societies that host them. First and foremost is the provision of the goods and services demanded by the society. It is indeed a high and noble activity to perceive human needs and function successfully to fill them. The private enterprises of Western market economies have demonstrated to the world their great capacities both to provide a flood of high quality goods and services, and to generate tremendous wealth in the process.

Second, in a social context where the principle avenue to consumption is by productive employment to earn spendable income, business firms are the chief providers of employment. Western market economies have demonstrated abilities to provide productive employments to well over ninety percent of their growing labor forces. The production of goods and services thereby serves to generate incomes that are distributed to both the owners and the employees of the firms. During the twentieth century in western market economies, the proportion of the generated income that has been distributed as wages and salaries has gradually risen from around two-thirds to exceed three-fourths.

Third, business firms are tax payers, and thereby constitute important sources of revenue to governments at all levels. Business-related revenue sources have included property taxes on the firms' assets, floor taxes on their inventories, value-added taxes, sales and excise taxes, import tariffs, export licenses, payroll taxes, business licenses and associated fees, and corporate income taxes. It is not unusual for business-related taxes to account for forty percent or more of governments' revenues in western market economies.

Finally, business firms themselves are citizens of their societies. Firms organized as corporations are also legal persons. Whether corporate persons or not, citizen firms have presences in their communities. Their offices, plants, and warehouses have significant impacts upon the appearances of the communities within which they are situated. Their employees are active in the schools, churches, synagogues, and mosques of their communities. Many firms make valuable monetary and in-kind contributions to their communities.

This brief discussion has not exhausted the many contributions made by business firms to their communities. As firms contribute to their communities, they also incur responsibilities in their communities. While the roles mentioned above reveal the significance of business firms to society, each is also fraught with the potential for misbehavior by firms. It is such misbehavior that may lead the society to become less tolerant of the continued unfettered operation of firms in the private sector.

 

The Firm's Societal Contacts

Business firms in market economies come into contact with a great many different types of people as they conduct their productive activities. Their raison d’être is to serve their customers by providing the goods and services demanded by them. Many business firms take only a passive role in attempting to discover demands that they may undertake to fill, but some firms aggressively attempt to create or manipulate such demands. The term consumer sovereignty describes the former case, whereas a firm that succeeds in first determining what it will produce and then creating a demand for it has exercised producer sovereignty. The host society may tolerate a significant amount of such producer sovereignty, but if it is perceived to become troublesome the government of the society may exercise state sovereignty to nationalize the firm and operate it as a state enterprise. The managerial implications of this prospect should be clear although it is much less likely to occur in the democracies of North America and Europe than in some countries of Africa, Latin America, and Asia.

Managers of private sector business firms often feel that they must answer to a number of constituencies in addition to their customers. With the process of separation of ownership and management during the nineteenth and twentieth centuries, the owners became just another constituency of the firms being managed. As long as the owners maintain effective control of their firms, the managers must meet the owners' expectations of returns or other goals, and this may be a matter of satisficing rather than maximizing. But the widespread dispersion of the ownership of corporate stock may enable the management of a corporation to so gain control over its own destiny that it can pursue its own private goals without fear of owner interference.

The firm's employees are another constituency that may constantly tug at the managers of the modern business firm. The principal employee concerns are wages, working conditions, amenities, and such benefits as health insurance and pension fund contributions. In a growing economy that experiences inflation, the interest of employees is in advancing wages at a rate fast enough to offset the effect of inflation that would decrease the purchasing power of their incomes, and to further capture as large a share of the fruits of growth as possible. The resulting tug-of-war is about the division of the growing "income pie" between the interests of labor and capital.

Each productive resource employed by the firm seeks to receive an income that is at least as large as its marginal revenue product (i.e., the addition the firm's total revenue following upon using one more unit of the resource); if it fails to do so, it becomes the subject of exploitation. A potential problem for management is that labor often can muster significant political influence over elected or appointed government officials to make them believe that labor is being exploited (whether it truly is or not), and that government should use its state sovereignty to curb the power of capital or redistribute income in the interest of labor. It is significant that in most Western democracies during the twentieth century, the proportion of national income going to wages and salaries has trended upward from sixty toward eighty percent.

The firm's suppliers may sometimes become a vocal constituency whose voices must be heard by the managers of the firm. In competitive resource markets, suppliers are always seeking to gain the attention of the firm's purchasing agents, and thereby to gain supply contracts at the expense of competitor suppliers. If suppliers gain monopolistic advantage in the control of unique resources, they may be able to exercise their monopoly powers to raise resource prices above competitive levels, and thereby capture a larger share of the "income pie" at the expense of the firm. Such circumstances often encourage firms to extend their degrees of vertical integration by attempting to acquire their suppliers and thereby gain monopolistic position in regard to unique resources. If a firm can gain a monopsony position (monopoly as a buyer) in a resource market, it may be able to dictate price and delivery schedule conditions to its suppliers. But the attainment of monopoly or monopsony position may attract the attention of governmental authorities and invite unwanted responses.

In oligopolistic markets (which may in fact encompass most real-world commercial and industrial activity), the firm's competitors certainly constitute one of its most important constituencies. Because of the relatively small number of firms in each geographic and product market, each firm must be concerned not only with what each of its competitors may do, but also with how competitors may respond to any action taken by the firm. The potential for inducing undesirable competitive response may be so great that the firm's management finds itself in a mould of decision rigidity. But even if this extreme condition does not result, the firm's managers must assess the competitive response risks attendant upon any strategy that they are contemplating.

The process of dispersion of stock ownership also opens the door to responsiveness to yet other constituencies as managers begin to feel some sense of social responsibility to "third parties,” i.e., innocent bystanders to the actions and activities of the firm. Sometimes the externalities or so-called "spillover effects" are benefits that are conferred upon neighbors due to simple proximity to the business firm. Examples include better roads and street lighting. But there are also possibilities of negative externalities such as the various forms of environmental pollution and congestion associated with the firm's activities. Positive spillovers may be rewarded with plaques given at meetings of civic organizations, but complaints about negative spillovers often attract the attention of society at large and its elected or appointed government officials who tend to become ever less tolerant of the unconstrained operations of the firm.

These and other constituencies continually pull at the managements of modern business firms. It is unrealistic for the managers to try to pursue multiple goals simultaneously. What usually happens is that the "squeaky wheel gets the grease," i.e., the most vocal constituency at the moment captures the attention of the firm's management. That constituency's interest becomes the goal selected for primary pursuit, and all other constituencies' interests are either ignored or treated as constraints upon the pursuit of the primary goal. Once the constituency's concerns have been adequately addressed, some other constituency's concern will rise to the surface to dominate the attention of the firm's management. But if the management cannot or will not satisfactorily address the voiced concerns of its constituencies, it can expect intervention by some governmental authority.

 

The Workings of Economic Mechanisms

The economics of public choice is the study of how societies decide whether economic decisions are to be made in the private or the public sectors. A brief examination of the workings of the market economy will bring us to a fundamental principle of public choice decision making.

In a market economy organized as pure capitalism (a hypothetical situation with no real-world examples), all productive assets are privately owned and all decisions concerning their use would be made by their private owners. Resource owners are presumed to be motivated by prospects of personal gain or profit. Information about changing economic conditions is disseminated throughout the market economy by prices that change in response to shifts of market demands and supplies. Competition among participants in a market economy serves to enforce compliance with the dictates of the market changes, i.e., the prospect of profit or loss invites appropriate adjustment, but competition insures that appropriate adjustment ensues. Those who perceive the emerging opportunities and act upon their perceptions are rewarded with profits and survival; those who either do not perceive the opportunities or simply ignore them are penalized with losses and failure. The perceptive, responsive, and efficient survive and prosper. The imperceptive, unresponsive, and inefficient suffer losses and fail.

Societies that favor dispersed and participatory modes of social determination are generally pleased to leave economic decision making to the members of society unless there emerges widespread belief that private decision making yields results that are detrimental to the general welfare of the society. When such perception emerges, the government of the society has two fundamental alternatives: to try to make the private decision mechanism work to the satisfaction of society, or to substitute public decision making in place of the private discretion. This is the fundamental issue of public choice. And it was consequent upon the emergence of this issue that the distinction between the private sector and the public sector was born.

The principal means for improving the functioning of private sector decision mechanisms are to reduce or eliminate market imperfections, and to curb the unbridled desires of decision makers to accumulate wealth or to gain exclusive control over their situations. These motives may lead private sector decision makers to indulge in unethical or even criminal behaviors. Market imperfections include restrictions upon the availability of information and the ability of market participants to adjust. They also encompass the achievement of monopolistic position in a product or geographic market. The relief of market imperfections may come via technological advances that improve information flows or reduce the costs and time requirements of resource mobility. But these same technological advances may also serve as bases for the achievement of monopoly position.

In Western democratic societies it often seems easier to replace the errant market mechanism with an authoritarian decision making structure than to devise means of making the market mechanism function more satisfactorily. More often than not, when a private sector decision mechanism is perceived to work unsatisfactorily, some substitute for private decision making is sought. The obvious substitute for private decision making is public or authoritarian decision making, perhaps in the form of a regulatory commission to determine such things as prices or distribution and quality of services.

An irony of this issue may be seen in societies that historically have opted for authoritarian decision mechanisms. For example, from 1918 forward in the Soviet Union, socialism became the predominant form of economic organization. In the purest form of socialism (of which there are no real-world examples), all of the society's productive assets are owned by the state, and all decisions in regard to their use are made by administrative fiat. When shortcomings are perceived in regard to the exercise of such governmental authority, some substitute for the authoritarian mechanism is sought. The obvious substitute for authoritarian decision making is individual discretion exercised by private decision makers in market mechanisms. The Soviets upon numerous occasions found themselves falling back upon market mechanisms when authoritarian decision making resulted in shortages or other problems.

There are no real-world examples of either pure capitalism or pure socialism. All economies are mixed in the sense that they incorporate varying degrees of participatory and authoritarian decision making. The U.S. economy is appropriately described as mixed capitalism to indicate that market mechanisms are the primary economic decision making vehicles, but that there is also a significant role for government to play in the economy. Before its demise, the Soviet Union could be described as mixed socialism in which authoritarian decision making in the form of central planning and direction was the primary decision vehicle, but the state relied in large measure upon market mechanisms to allocate resources and distribute products. Economies of other nations may be described as varying mixtures of private and authoritarian decision making.

 

Opportunities and Threats to the Firm

The discussion to this point is intended to support the central thesis of this book, i.e., that the firm's situation within its host society provides innumerable opportunities that it may exploit, but also poses a variety of threats to the manager's decision making discretion, and possibly to the very existence of the firm as an organization independent of the society's governing authority.

Societies through their governments may intervene in their economies in a variety of ways including:

a. determining weights and measures;

b. providing a stable money supply that can grow along with the economy;

c. providing for law and order, i.e., an environment conducive to enterprise;

d. establishing the security of private property, the conditions under which title to it may be transferred, and the means to arbitrate disputes over the ownership of it;

e. maintaining competitive conditions;

f. stabilizing the macroeconomy;

g. redistributing income and wealth; and

h. reallocating resources.

The opportunities and threats to private business firms lie in how extensively the government intervenes in the economy and how effectively it succeeds in achieving the goals of its interventions. For example, if the values of weights and measures are not certain, or if the purchasing power of the unit of money is volatile, there will be mostly threats to the success and survival of private-sector firms. If the private ownership of property is not adequately secured, firms will be threatened by declining investment in their assets. A redistribution of income will provide opportunities for firms servicing customers who receive additional income, but pose threats to firms whose clients suffer income losses. The enactment of antitrust legislation and its vigorous enforcement will constitute threats to firms bent upon achieving monopoly positions, but will enable opportunities for firms that are attempting to achieve entry into profitable markets. As noted in Chapters 17 and 21, governmental efforts to stabilize the macroeconomy are also a mixed bag of opportunities and threats to private-sector firms, especially since it is not at all clear that deliberate efforts at stabilization accomplish their ends without further destabilizing the macroeconomy.

The private sector of any economy will yield a certain allocation of resources that can be construed as efficient if there are few externalities and little exercise of monopoly power. It is efficient in the sense that under competitive conditions, output of each good will be adjusted until its marginal cost (society's valuation of the resources used to produce the good instead of some other goods) is just equal to its marginal revenue (or price, society's valuation of having one more unit of the good rather than some other goods).

But even if the allocation of resources is efficient, it still may not be satisfactory to the society, primarily because of two reasons: public goods are not produced in response to market incentives, and markets tend to over- or underproduce social goods, i.e., those resulting in externalities. It may then be said that in regard to society's preferences that resources are misallocated, and that there is a justification for government to act to reallocate resources.

 

Ethics and the Business Community

It is sometimes suggested that people in the business community are more likely to behave in illegal or unethical manners than are people in other occupations. There is no evidence that people who become managers of business enterprises are by race, ethnicity, religion, education, training, cultural conditioning, or heredity significantly different from people who enter other walks of life. Unethical people may become teachers, ministers, plumbers, doctors, politicians, or managers of business enterprises; by the same token, ethical people may likewise enter any of these occupations.

People "in business" have the same responsibilities of citizenship as do people in other fields. It may be true that business men and women, because they are trustees of corporate assets and exercise decision-making authority over other people, are subjected to temptations to engage in questionable behavior that are commensurate with their positions of authority. Does this mean that they should be held to higher standards of honesty and integrity than people in other occupations? These are certainly foundation blocks for a workable market economy. Market capitalism would cease to function efficiently, and might cease to function at all, in the absence of honor and trust in business dealings.

All people, irrespective of their occupations or positions, should be expected to behave according to the same high moral standards and ethical behavior. To this point we have described the roles that business decision makers play in their societies, and implicitly the responsibilities that they incur to their societies to provide goods and services, employment, tax revenues, and good citizenship behavior. But societies have a collateral responsibility to members of their business communities and indeed to all of their citizens, irrespective of occupation or position, to inculcate into them the virtues of honesty and integrity.

Business per se is neither ethical nor unethical, moral nor immoral. But positions of business leadership and authority may be filled with honest or dishonest people, just as can classrooms, pulpits, operating rooms, and legislatures. Society should expect no less (but also no more) of its business leaders than of its preachers, teachers, doctors, or legislators.

 

What's Ahead

The remaining chapters in Part A explore the extension of the business firm's operating environment into the global arena.

BACK TO CONTENTS

 

CHAPTER 2.  INTERNATIONAL COMMERCE

The twenty-first century business firm's operating environment is much greater than the local community or even the national economy within which its facilities are situated.  To gain an adequate understanding of this macro environment, we need to bring together concepts from the theories of international trade, development economics, and monetary economics to those of micro- and macroeconomics.  We’ll devote this chapter to those aspects of international economics that underlie the macro environment and condition managerial decisions.

We open this chapter with a half-serious apology for including a chapter that focuses upon the international dimension of business. The reason for the apology is that in much of the rest of the world outside of the United States of America, there is little significant distinction between international and domestic business operations. If one is in business at all, he or she automatically engages in international business operations. Managers of such firms hardly give second thoughts to the requisites for sourcing supplies, selling products, or locating production in countries other than that within which the firm's home office is located.

The apology is only half serious because many people in various countries, and notably the United States of America, are somewhat intimidated by the international dimension. It is a mixed blessing to the United States that it has a rich endowment of natural resources and a huge internal economy. Domestic firms have been able to rely upon the internal economy for both sources of supply and markets for their domestically-produced products. Because they have been able to look inward for over two centuries, managers of American firms have tended to regard the outside world as marginal or peripheral to their activities. Many view the international sector as possessing some mystique that requires special capabilities to penetrate. This perception is enhanced by the fact that Americans are for the most part monolingual. Although English is the only language spoken and understood by the majority of Americans, Spanish may yet overtake English as the American lingua franca.

If much of American business has seemed intimidated by international involvements, post-war American consumers have carried on a love affair with foreign-made goods and services. During much of the post World War II era, U.S. balance of payments deficits have been the rule rather than the exception. Concerns about on-going trade deficits and mounting international debt to foreigners have led various U.S. governmental agencies to devise programs to promote exports and discourage imports. American experience with protecting domestic industries from foreign commercial incursions spans more than two centuries.

On-going trade and payments deficits and official concern about them have aroused the interest of the American academic community in international commercial relations. Beginning in the 1970s, a deliberate effort was mounted by business studies programs to internationalize their curricula. By the early 1980s business studies accrediting organizations had established standards requiring any program seeking accreditation or reaccreditation to achieve a satisfactory internationalization of its curriculum. The most commonly used models for such internationalization have been to employ foreign faculty and recruit foreign students, to introduce new courses focusing upon international business problems and procedures (e.g., international marketing, international finance, international management), and to infuse international concepts into existing courses as appropriate. The latter two models have spawned a flock of new textbook titles as well as revisions of existing texts to incorporate references to the international arena.

In a sense, the recent obsession of American commerce and academia with anything international is only a transitional phase. With the passage of time, international commercial activity will become more commonplace; eventually business studies curricula will become sufficiently internationalized that special commentary about the international sector will no longer be warranted. Three phenomena militate in favor of this transition. (1) Technological advances in communications and transportation shorten the time and costs of distance, thereby diminishing market imperfections and facilitating international exchange. (2) English, the language spoken by the majority of Americans, seems to be emerging as the global language of commerce as well. (3) Efforts underway in various regions of the world to achieve both economic and political integration (the European Union, a "single market" by 1993, currency union by 1999, and possibly political union by some point in the twenty-first century) tend to render concepts of the international ever less significant. But until such transformation is completed (if ever), we shall be compelled to include chapters such as this in our texts.

 

Bases for Interregional Commerce

John Donne has said that "No man is an island, entire of itself . . . " (Devotions upon Emergent Occasions, Meditation 17). It is surely true that no nation can be an island completely unto itself either. Some have tried. After both its Revolutionary War and World War I, the United States seemed to withdraw into isolationism in order to avoid further international entanglements, both political and commercial. After its establishment in 1918, the Union of Soviet Socialist Republics (U.S.S.R.) pursued a de facto strategy of autarky, i.e., internal self-sufficiency. Of all of the nations in the world, these two might have come closest to functional autarky because of the immense richness of their natural resource endowments. But neither of these nor any other nation in the world has been able to achieve absolute autarky. There are several fundamental reasons why they have found it either necessary or beneficial to engage in international commercial relations.

 

There is a very significant difference between international and interregional commerce, but we shall defer consideration of it until a later section. For the moment we shall focus attention upon bases for interregional commerce. It is a fact of physical nature that resources are unequally distributed across the earth's geographic space. Some resources approach ubiquity (found everywhere); others are concentrated by regions. Resources that are found in only one or two places on earth may be referred to as geographic uniquities. Examples include rare elements or precious gems or metals, agricultural commodities that grow only under very special conditions, and natural tourist attractions. Populations of regions possessing such uniquities are fortunate in having access to such resources that they are able to exploit; populations elsewhere are correspondingly unfortunate. Populations of regions devoid of such uniquities may acquire them (or things produced using them) by engaging in interregional trade or military aggression to capture them.

There are few perfect ubiquities or uniquities among productive resources. Most resources are found in many places across the globe, although in greater or lesser geographic concentrations. Goods and services requiring those resources as inputs may be produced more cheaply in regions where they are found in abundance than in other regions where they are scarce.

 

The Principle of Comparative Advantage

Economists have enunciated the principle of comparative advantage to explain regional specialization in the production of goods and services. According to this principle, people in each region should specialize in producing those goods and services that can be produced most efficiently in their region compared to other regions. "Most efficiently" means at least opportunity cost (in terms of other goods and services foregone) compared to the other regions. Since the production of goods becomes geographically specialized, people in different regions must trade their specialties for the specialties of people in other regions.

Generalization in consumption is enabled everywhere through trade even though there is regional specialization in production. It can be shown with theoretical exercises as well as empirical information that those who specialize their production according to the principle of comparative advantage and trade with one another enjoy higher welfare than they would under conditions of autarky.

It is sometimes suggested that there are regions of the world that are essentially devoid of productive advantages, whereas other regions seem to possess all of the advantages (veritable "Gardens of Eden"). We can resolve this problem by further refining the definition of comparative advantage. A region's absolute advantages include all of those things that it can produce at lower costs than can be achieved in other regions. A region's absolute disadvantage is anything that can be produced elsewhere at lower costs in terms of other goods and services that must be foregone.

It may well be that opportunity costs of most things are lower in one region relative to all others, but this does not mean that the region should generalize in production. Its comparative advantages lie in those things for which it has greatest absolute advantage(s), while the comparative advantages of other regions lie in the things for which they have least absolute disadvantages. They should still specialize in production, but the one in its greatest absolute advantage and all the rest in their least absolute disadvantages. It follows logically from this definition of comparative advantage that it is not possible for a region to have no comparative advantage(s). Furthermore, it can be shown that all of the regions of the world, the sparsely-endowed as well as the abundantly endowed, will enjoy greater welfare with specialization according to the principle of comparative advantage and trade with one another unencumbered by politically imposed constraints.

Modern elaborations of the theory of comparative advantage recognize at least five bases for regional comparative advantages: resource endowments[1], cultural preferences[2], known technologies[3], scale economies, and company-specific knowledge. The first three are endogenous to locale; the last two technically are independent of geography, but may become location specific at the discretion of production decision makers.

It would be highly unlikely that perfect specialization (i.e., one good is produced in only one region and other goods are produced only in other regions) would result. In a hypothetical two-good world, both goods would continue to be produced in both regions, but in each region more of the comparative advantage good would be produced, and less of the comparative disadvantaged good. Also, the real world is composed of many regions, some of which are similar to others in respect to resource endowments, preferences, or technologies, and different from the other regions in various respects. The basis for the comparative advantage of each region may lie in one of these areas or a combination of them. Empirical evidence suggests that a larger volume of the world's trade is conducted among regions that are similar in income levels and preferences, than among regions that are widely divergent in any of these areas.

 

Qualifications to the Principle of Comparative Advantage

As noted in previous chapters, managerial opportunities and threats are to be found in almost any circumstances, including those of interregional trade. Certain qualifications to the argument presented to this point should be noted. One is that comparative advantages, whether attributable to resource endowments, preferences, or technologies, are not "struck in stone," i.e., they are changeable. Circumstances of resource depletion can terminate a former comparative advantage based on the richness of a resource endowment. The discovery of a new deposit or pool of a natural resource can confer a comparative advantage. Population growth or immigration may confer a comparative advantage in producing labor intensive goods where one formerly did not exist. By the same token, emigration may result in depletion of a former comparative advantage based on labor abundance. Natural disasters such as a volcanic eruption, a hurricane, or a freeze that destroys a crop stock may bring to an end some historic comparative advantage. Changing preferences away from "old" goods and toward newly developed ones may shift comparative advantage from regions specializing in the "old" and toward regions specializing in the "new.”

The forms of comparative advantage transition noted above follow from natural or market phenomena that are not under the control of the firm. One of the most significant forms of change in comparative advantages comes about through technological advances that develop new items or new processes that economize on scarce resources. Another significant phenomenon that may change comparative advantage is capital investment. Regions that formerly were capital scarce may become capital abundant, as for example the newly industrialized countries ("NICs") of South Asia. The reason that these two forms of comparative advantage transition are significant to managerial decision making is that they are implemented at the discretion of managers of firms. It is by mounting an effort at research and development (R&D) or by capital investment that managerial decision makers may seize entrepreneurial opportunities and deliberately change the competitiveness of their firms and the comparative advantages of their regions.

 

The International Dimension

To this point we have been discussing interregional trade; in the so-called "pure theory of trade" there is no distinction between interregional trade and international trade. The emergence of national identity and the nation state over the past four centuries has enabled two additional factors that provide for regional differentiation: nationalism and the operations of government.

The interests of governments in international commerce have necessitated another qualification to the comparative advantage theory. The government of a region may attempt to protect an old domestic industry in order to preserve a comparative advantage that is fleeing to foreign regions. An example is the cotton textile industry as it moves from the South of the United States to countries in Asia and Africa. Such protection may take the forms of subsidies to the domestic industry or quotas or tariffs imposed on imported merchandise. Or the government may promote the development of what is believed to be a latent comparative advantage of the region by subsidizing a so-called "infant industry.”

Government may attempt to neutralize another region's comparative advantage by imposing an import tariff that is intended to eliminate a foreign cost advantage ("leveling the playing field"). The government may impose an import quota as a means of limiting the damage resulting from importation of an item that can be produced at lower cost elsewhere. Or the government may take "compensatory" action in any of these areas to offset some policy being implemented by the government of another region. In any of these cases of protection, the effect will be to diminish any potential for gain by comparative advantage specialization.

National identity leads to nationalism, a sort of emotional cement that binds together people of the same cultural background. They may share a common history and heritage; they may be more-or-less homogeneous with respect to race and ethnicity; typically they subscribe to the same religion or various sects or denominations of a common religion; the vast majority of them speak the same language; and, most importantly, they share a common vision about what it means to be a citizen of the nation. The term is often used to describe a "nation of people" or simply "a people" in the biblical sense (the "Children of Israel" in the Bible are an example of a nation in this sense). The emotional cement of nationalism may reveal itself in the form of patriotism, i.e., love of homeland, its cultural and political heritage, its flag.

Other terms such as regionalism may attain almost the same sense of nationalism, but with respect to the attitudes of people in more restricted geographic locales. Belgians typically are much more nationalistic with respect to being Flemish or Walonian than they are about being Belgian. It is more important to some in the United States to be Texans or Southerners than it is to be American. The European Union is attempting to establish a sort of super-national regionalism so that citizens of the twenty-seven member states will begin to feel a sense of European nationalism that eventually may displace nation-state nationalism.[4]

Nation states are political entities defined by boundaries encompassing areas that may coincide closely with that populated by a "nation of people" in the biblical sense. Sometimes a nation state encompasses two or more nations of peoples. American Indian tribes have often been referred to as "nations"; there were many nationalities in the former Soviet Union; modern India encompasses numerous tribal peoples. In the early 1990s, the various nationalities contained by both the Soviet Union and Yugoslavia began to pull apart.

Occasionally political boundaries separating nation states divide peoples of the same nationality. The post-war political division of Europe left the German people separated by "walls" as well as borders. In South Asia, the Bengali tribal people are split by the India-Bangladesh border. The Pakistan-Afghanistan border divides the Baluchi people, while the Pakistan-India border separates Punjabi tribal people. Separatist movements in these and other areas may have as their goal the reunification of peoples of the same nationality that have been separated by political boundaries.

Nation states also may not coincide with economic regions that are characterized by the possession of natural resources. Both the United States of America and the Russian Republic include numerous uniquely definable economic regions. Sometimes national boundaries split a common resource endowment region. Europeans have often redrawn national boundaries across the rich coal and iron deposits of the Alsace-Lorraine region.

The essential characteristic of the nation state is its possession and exercise of national sovereignty by the government of the nation state. "National sovereignty" means that the government of the state has the authority and the power to do anything it wishes with respect to the peoples and resources contained within its political boundaries. This power includes the ability to determine the form of economic organization of the economy of the state (until recently, the government of the former U.S.S.R. mandated socialism), and to impose protectionist measures with respect to the industries within the economy (the government of the U.S.A. has a long history of protectionism). It includes the right to insist upon the use of a national currency within the realm and to exclude the currencies preferred by others. Sometimes this authority and power leads to human rights abuses to which people and authorities in other nation states raise objections. Such exercise of discretion by the state is constrained only by the tolerance of its citizens and by attitudes and military prowess of other nation states.   

 

Currency Diversity

One of the most critical factors that sets international trade apart from interregional trade is a consequence of the exercise of national sovereignty: the use of different currencies in different nation states. Because the dollar in used in the U.S. economy while the pound sterling is accepted exclusively in the United Kingdom, the balance of payments between the U.S. and the U.K. is important to economic and political considerations in both countries. The dollar-sterling exchange rate is critical to the volume of goods and services entering into international commerce between the two countries at any point in time.

Where the same currency is used throughout a region, these matters become irrelevant. In the United States, who is concerned about the balance of payments between South Carolina and New York? And what about the exchange rate between the currency used in South Carolina and that accepted in New York (both use the U.S. dollar)? Even though it is a member state of the European Union, the British have declined to adopt Europe's common currency, the "euro,” and they still insist upon using the pound sterling. The U.K.-French and U.K.-German balances of payments continue as important issues, as does the pound-euro exchange rate. Exchange rate issues persist with non-EU countries that insist upon stabilizing the exchange rates between their currencies and the euro. Governments of some other non-EU countries are inclined to use currency devaluation or exchange rate fluctuation as means of correcting balance of payments disequilibria.

Most EU member states have succeeded in constraining their government budget deficits, but a few, notably, Greece, Ireland, Portugal, and Spain, have incurred ever growing budget deficits that have to be financed by borrowing on local and international financial markets. As they borrow ever-increasing amounts, their international payments positions continue to deteriorate. However, as members of the eurozone, they cannot rely upon depreciation of their currencies to alleviate payments imbalances.

Currency matters spill over upon the commercial sectors of the international trading partners. We venture a guess that these issues will become irrelevant in Europe only when Europeans can adopt and accept a common fiscal regime to accompany a common currency such as the euro or one of the constituent currencies. But there will still be problems in the balance of payments between the U.S. and Europe and with the dollar-euro exchange rate until such time that Americans and Europeans can agree to use a common currency (an unlikely eventuality).

 

The Cultural Dimension

The analysis of nationalism would be much simpler if every nation state were associated exclusively with a certain nation of people. But as we have already noted, this is not the case. Whether we are speaking of the nation state or a particular nation of people who share a common heritage, the principal implication of nationalism is that there are significant differences among populations that yield important consequences for trade and the location of economic activity. These differences may spring from natural phenomena such as heritage, customs, language, etc., or they may be artificially imposed by the behavior of the governments of the nation states.

Even if political relationships are not involved, differences of national heritages and languages lead to suspicions about the customs and intentions of "foreigners," and in extreme cases to xenophobia, i.e., fear and hatred of foreigners. An extreme economic consequence of xenophobia is the attempt to achieve autarky. The important point is that nationalism, whether emanating from cultural differences or state sovereignty, tends to diminish the potential for gains from interregional and international specialization and trade. In the extreme, nationalism can completely eliminate such potential gains if sovereign national governments pursue strategies of extreme political isolation and economic autarky.

Because of nationalism, it is necessary to recognize that comparative advantage may be based upon preferences that differ by regions that are defined by national boundaries as well as by cultural heritage. It is also necessary to note that natural comparative advantages may be enhanced or neutralized by the discretionary actions of government officials.

The managerial implications of nationalism, whether based in cultural differences or the exercise of state sovereignty, is that business decision makers wishing to buy, sell, or produce in other countries must come to an understanding of the cultural characteristics and governmental practices of the other countries. It is these differences that make foreign dealings appear to be mysterious, difficult, and risky. The antidotes are acquaintance and familiarity with the foreign environments within which the firm expects to operate. Acquaintance and familiarity can be achieved through study, travel, and interaction with nationals from the target markets. The study should include examination of cross-cultural differences that lead to appreciation of customs and practices different from one's own.

One of the best ways to achieve such appreciation is to learn the languages of the peoples who live in the regions where the firm wishes to operate. Competence in the languages of the target markets may also be crucial to successful business dealings. Peoples in most countries of the world are multilingual; in some few countries (notably the United States) the norm seems to be monolinguality. A business negotiator who is knowledgeable of the trading partner's language as well as his or her own will likely have the upper hand over a negotiator who speaks only one language. Also, if one is not familiar with the trading partner's language, the partner will be able to lapse into his or her own language when speaking with associates. Finally, we may note that most people in other lands have greater appreciation of their trading partners if they can at least attempt to speak the local language.

All of these dimensions of international commerce render the macroeconomic environment within which managers of business firms must make decisions more complex than simple macroeconomic models imply. 

 

What's Ahead

In this chapter we have explored the possibilities of engaging in international commerce, i.e., exporting to or importing from other regions of the world. It is also feasible and potentially profitable to engage in foreign direct investment, i.e., to locate production in other regions of the world than the home country, and to engage in foreign direct investment to establish the foreign domiciled production facilities. Chapter 3 is devoted to the globalization of enterprise.

 

Chapter 2 Endnotes

[1] It is usual in trade theory to hypothesize a two-resource, two-commodity, two-region world. Suppose one of the regions, A, is abundantly endowed with capital resources but has only enough labor to operate its capital stock, and that the other region, B, is abundantly endowed with labor but has a small amount of capital that serves as minimal tools for the labor. The two regions produce two commodities, X which under technologies known in both regions requires a great deal of labor but not much capital, and Y which uses substantial amounts of capital but only a little labor. If the two regions employ identical technologies for producing the two goods and further have identical preference functions, region A should specialize in producing good Y, whereas region B should produce more of good X. Each should trade some of its specialty to the other in exchange for some of the other's specialty.

[2] Suppose that the two regions have identical resource endowments and know the same productive technologies. While people in both regions consume both goods, suppose that people in region A have a stronger preference for X, the labor intensive good, while people in region B like Y, the capital intensive good. In this case, it would be appropriate for region A to specialize in producing X and region B in producing Y. Each should trade some of its output to the other in order to achieve consumption generalization in both regions. In this case, the basis for comparative advantage is differential preferences rather than resource endowments.

[3] Suppose that the two regions possess identical resource endowments and share a common preference system, but that scientists and engineers in region A have advanced technology with respect to the production of X so as to economize on labor, whereas common technology continues to be used in the production of Y, the capital intensive good, in both countries. Again, intuition suggests that region A should specialize in the production of X leaving region B to specialize in production of Y. They should trade some of their respective specialties to each other. The basis of comparative advantage here is differential technologies rather than resource endowments or preferences.

[4] Although there is no good term to describe it, a similar emotional cement often exists among the students and alumni of an American state university, especially when in athletic competition with a rival state university.

BACK TO CONTENTS

 

 

CHAPTER 3. THE GLOBALIZATION OF ENTERPRISE

While regions of the world may have macro level comparative advantages, the operatives who have to discover and exploit those comparative advantages are micro level people who function as decision making agents of business firms. Toward the end of Chapter 2, we noted that business decision makers can attempt to change a region's comparative advantages through implementing technological change and capital investment. The acts of discovering, exploiting, and changing comparative advantages are essentially entrepreneurial in nature.

Macro level comparative advantages are region (or country) specific. The microecononmic vehicles for discovering, exploiting, and changing comparative advantages are competitive advantages that are company specific. Another way to say this is that no latent comparative advantages can be discovered or developed unless managers of business enterprises can establish and exploit competitive advantages over actual or potential rivals. The entrepreneurial motivations to do so are profitability, growth potential, and control over markets and production processes. How are these decision-making goals pursued?

 

The Location of Economic Activity

Some economic activity, by its very nature, must take place in close proximity to the markets that it serves. The restaurant and real estate businesses come readily to mind. In fact, most services must be rendered at the site of consumption (financial and insurance services may constitute exceptions). Other economic activity is more appropriately located nearer to sources of supply of the raw materials that are required as inputs in the final products. The over-riding principle is that under sufficiently competitive market conditions, commercial activity tends to locate relative to markets and input supplies where it can operate most profitably. Inappropriately located productive sites will yield lower returns or losses, and ultimately may result in failure and exit from the market.

Two further locational principles can be identified. In order to minimize the combination of production and shipping costs, products that lose weight in the manufacturing process tend to be produced closer to sources of supplies of the inputs of greatest weight per unit cost. Products that gain weight in the production process tend to be produced nearer to their final markets. Examples of weight-losing manufacturing processes are found in the refinement of ores to produce metals of high purity. Any product that is assembled in stages from materials or components may serve as an example of a weight-gaining process. We should note that these locational principles lose significance with on-going technological advances that lower the costs and time required for shipping raw materials, components, and final products.  If materials, components, and products could be “transported” (as in the fictional “Star Trek” television series) instantly and at zero cost, then production could be located anywhere in the world.

Economic activity may relocate for a variety of reasons. One is simply that producers realize that their former sites are uneconomic relative to other sites. This realization may be brought upon them by the subnormal returns or outright losses that they suffer compared to those realized by producers in other locales. One of the most potent forms of industry relocation is the failure of productive ventures in one region at the same time that new ventures producing the same goods or services are started in another region. Capital is withdrawn and labor displaced at the former site, and new capital is invested and employees are recruited at the new site, but rarely by the same people.

One of the principal vehicles for industry relocation is changing comparative advantage. As we have already noted, comparative advantages are not "struck in stone." When comparative advantages change, either for natural reasons or because of human intervention, industry tends to relocate away from the former locus of the comparative advantage and toward its new locus. Whether the comparative advantage has shifted regionally or from one country to others, locales where the advantage is departing may resist as strongly as possible their loss of advantage, and may solicit the offices of the governments of their countries to prevent the flight.

When a region's comparative advantages change, what business decision makers see are changing competitive advantages, not macro level comparative advantages. The entrepreneurially perceptive firm managers will see competitive opportunities in other industries or other locales sooner; the less perceptive and more risk averse will remain too long in their current industries or locales and ride their firms into decline and failure.

Economists can with confidence argue that specialization according to comparative advantage will enhance global welfare. One of the great ironies of the principle of comparative advantage is that the adjustment to a shift of comparative advantage can be extremely painful in regions that lose it, even while the gainers enjoy the ebullience associated with expanding output, employment, and profits. Usually all of the pains are suffered in one region, while all of the benefits are enjoyed in another. A loss of comparative advantage will be manifested to business firms by operating losses, business failures, distressed sales of plant and equipment, a declining tax base, and rising unemployment. It is these conditions, especially when they result in threats of political instability, that command the attention of government officials. But if international economic realities truly have changed, any governmental action to "stem the tide" of a fleeing comparative advantage can only distort the international allocation of resources and lower efficiency and welfare, both at home and abroad.

Some productive resources tend to be more mobile than do others. It is often thought that labor is the most mobile resource while capital and natural resources are less mobile. There have been historical instances of human migrations for economic reasons. From the sixteenth century forward, people have left Western Europe for North and South America, South Africa, and Australia in search of greater opportunity, i.e., richer endowments of natural resources. The nineteenth century in the United States saw a great westward migration for similar reasons. Today, people are fleeing certain Eastern European countries for both political and economic reasons.

It is also possible to extract and ship natural resources to remote locations for processing, as it is possible to take the processing to the site of the extraction. A footloose industry is one in which both materials and capital are more mobile than the labor necessary to produce the output. A footloose industry need not locate near to either sources of raw materials or to markets for the product. The cotton textile industry may be an example of a footloose industry because it seems to move continually across the earth's geographic space in search of the lowest cost labor. This seems to be a case of "the mountain going to Muhammad," i.e., the industry going to the labor. Cultural heritage tends to militate against the mobility of labor across national boundaries. Technological advances in communications and transportation tend to render all industries ever more footloose because the declining costs of shipping materials and capital resources make them ever more mobile relative to labor.

 

Opportunities in an Open Economy World

Our discussion is intended to be suggestive of the many opportunities as well as threats to business enterprises in a global macroeconomic environment characterized by open economies. The term "open economy" refers to a situation where neither cultural nor governmental hindrances to enterprise prevent international trade, requirements sourcing, the location of production, or immigration. In a closed economy, the business decision maker has only to decide where within the economy to locate the enterprise, from whom to source materials requirements, and in which domestic markets to offer the produced goods and services. An economy becomes closed either because its people are so xenophobic and isolationist that they will not interact with foreigners, or because the government acts to diminish or prohibit foreign commerce. Even if an economy is not entirely closed by xenophobic attitudes or governmental hindrances to trade, the presence of such forces tend to constrain international commerce and diminish the potential benefits.

When an economy is more-or-less open to international commerce, the range of decision options available to the business decision maker extend to considerations of

(a) whether to sell the firm's output in foreign markets;

(b) whether to source materials requirements abroad;

(c) whether to locate production in other countries;

(d) whether to raise financial capital abroad; and

(e) whether to recruit employees and managerial personnel internationally.

All of these are essentially entrepreneurial (to be distinguished from routine managerial) decisions that are conditioned by the macroeconomic environment. The motivations to such entrepreneurial decisions are profitability, growth, and control.

As we noted at the beginning of Chapter 2, business decision makers in many countries do not make serious distinctions between domestic and international commerce. But for business decision makers in a large, inward looking country such as the United States, it may take a special orientation for a decision maker even to perceive the "foreign" opportunities, and an even more special attitude toward risk to be willing to delve into the unknown or mysterious facets of foreign commerce. This is what renders international operating decisions essentially entrepreneurial in nature.

The same decision criteria may be employed by the entrepreneurial decision maker irrespective of whether domestic or international operations are at issue. If the anticipated benefits of undertaking a new international operation exceed the estimated costs, the operation is economically justifiable. In case of an anticipated expansion of an on-going activity in the international arena, an excess of marginal benefits over marginal costs warrants the expansion. Similar criteria can be specified for contracting or terminating any international operation. The additional difficulty for international considerations is identifying all of the relevant benefits and costs. Because of the uncertainty and variability associated with the international arena, risk factors may be more significant than in known domestic markets.

It is a classification of convenience to identify four types of enterprises on the basis of their engagement in international commerce:

(1) A domestic firm is one that, with respect to a particular nation state, conducts all of its business relationships exclusively in the domestic economy of that nation state; it may find itself serving an occasional foreign customer travelling in its nation state even though it does not solicit foreign business.

(2) A foreign firm is one that, with respect to a particular nation state, is organized or incorporated in a second nation state, but which is doing business by way of buying or selling in the domestic economy of the first nation state.

(3) An international firm is one that maintains principal office and productive facilities in one nation state and conducts buying and selling activity in that and other nation states.

(4) a multinational firm is one that maintains offices and productive facilities in multiple nation states and determines executive policy without preference or prejudice with respect to national origin or location.

A true multinational firm may both sell output and source materials and financing requirements internationally; it may locate production anywhere in the world that its management sees fit; it may seek financing and technologies anywhere in the world, and it may recruit employees and managerial personnel anywhere in the world. A firm has risen to the height of multinationality if in its management recruiting it can be blind with respect to nationality, race, ethnicity, language, and cultural heritage.

The more risk averse is the management of a firm, the more likely it is to remain a purely domestic firm. Venturing into the realms of international and multinational operations requires willingness to assume risk. Needless to say, the vast majority of business firms in the world are either domestic or international firms; some of the latter are in the process of becoming true multinationals; there are indeed only a few firms in the world that have achieved true multinationality.

All firms engaged in international operations facilitate the mobility of resources and goods, and thereby contribute to allocative efficiency across national boundaries. International importers and exporters do so in response to international market incentives. Franklin R. Root (International Trade and Investment, South-Western Publishing Company, Sixth Edition, 1991) characterizes the multinational enterprise as an international transfer agent. Although it responds to external market forces, the multinational enterprise employs managerial discretion rather than market incentives to direct the flows of resources, capital, product, technology, and managerial expertise within itself and among its affiliates in other countries. In so doing it surmounts both market imperfections and political hindrances to market-initiated flows. The multinational enterprise thereby achieves greater allocative efficiency through the exercise of managerial discretion than can be achieved purely through international market transactions, especially if market transactions involve externalities.

The international opportunities open to a purely domestic firm are limited exclusively to the unsolicited interaction with foreign nationals who happen into the firm's place of business. The broader horizons of the international firm include possibilities of both importing and exporting as well as licensing and participating in joint ventures. The international firm may import final products to be marketed to customers within its economy, or to be re-exported to customers in other countries. It may also import raw materials, partially processed goods, or components to which it adds value in further processing, assembly, and packaging. These goods may then be marketed domestically or re-exported for sale or further processing in other countries. Even if the international firm has not imported materials or finished goods, it may export its domestically produced goods and services.

The impetus to export domestically produced goods is the perception of market opportunities in other countries that appear more profitable (or no less so) than domestic distribution. The impetus to import materials or components is the discovery of cost advantages in international sourcing compared to domestic sourcing. The impetus to import finished goods for domestic distribution may be foreign cost advantage, the perception of domestic markets for uniquely foreign merchandise, or both. In fact, the strength of domestic demand for a foreign-made item may be great enough to outweigh its cost disadvantage; many American consumers appear willing to pay higher prices for certain foreign-made automobiles (e.g., Lexus, Mercedes Benz, BMW, Jaguar) than for comparable domestically assembled vehicles (Cadillac, Lincoln).

 

Drives to Globalization

The multinational enterprise is subject to all of these drives plus others that lead it to establish or acquire productive facilities in countries other than that where its principal office is located. The establishment of such productive subsidiaries or affiliates requires foreign direct investment that is distinguished from portfolio investment. The former involves the construction or acquisition of facilities over which the firm exercises exclusive control while the latter involves only the acquisition of a small-enough share of outstanding stock that control is not intended or possible. The motivation to foreign portfolio investment is usually found in the anticipation that foreign rates of return are higher than domestic rates of return after allowing for risk differentials. However, there is little evidence to the effect that differences in expected rates of return alone can account for foreign direct investment by multinational enterprises.

There is an extensive literature focusing upon the motives to undertake foreign direct investment. We shall here attempt only to examine the prominent theories and summarize the conclusions. Virtually all multinational enterprises are large concerns (in terms of invested capital, sales volumes, number of employees, etc.) that operate in oligopolistic markets. They therefore possess varying amounts of monopoly power in the sense of being able to exercise pricing discretion. Their monopoly power is based upon either scale economies or superior knowledge that confers firm-specific competitive advantages. Such competitive advantage may be applied anywhere in the world, and thus can serve as the basis of a region-specific comparative advantage only at those sites where management chooses to establish operations.

If the benefits of scale economies or knowledge assets are sufficient to outweigh the costs of distance, cultural differences, and dealings with foreign governments, the management of the multinational enterprise may expect greater income from operating in the foreign market than local firms can expect. To realize the larger incomes, the local firms would have to achieve comparable size (to exploit the economies of scale) or in some way acquire similar knowledge assets (which are costly to acquire).

The reason that the multinational enterprise may be able to operate more economically in the foreign market than can local firms is that their knowledge assets were developed for the "home market,” and thus are sunk costs; the marginal cost of development of the knowledge assets for the foreign market is therefore zero. But the marginal cost of acquiring such knowledge assets by local firms would be significantly non-zero. The exercise of superior knowledge by the multinational enterprise allows it to produce and sell differentiated products in the foreign market. This enables it to exercise monopoly pricing and capture economic rent for the knowledge assets.

A typical life cycle can be described for a product developed by a multinational enterprise. When the new product is introduced, production is initially retained in the home country (or where an affiliate first developed the new product) to allow close contact with design and production technical expertise. The product is sold in the domestic market and may be exported to foreign markets. However, as the product becomes standardized, the enterprise is able to shift production to affiliates in lower-cost foreign locales, most likely in other industrialized countries with large domestic and export markets so that scale economies can be exploited. A collateral phenomenon is that with standardization of the product, local firms in the host markets can imitate the product (the competitive advantage of the superior knowledge assets begins to erode) to capture some of the multinational enterprise's export market. Foreign production at lower costs may then be a defensive measure undertaken by the multinational enterprise in order to preserve market share.

In the latter stages of the product's life cycle, production in the multinational enterprise's home market may cease as the product continues to be available only as an import from its foreign affiliates. Continuing developments of new knowledge assets by the multinational enterprise are needed to sustain its home-country operations. It is in the continuing development of knowledge assets that the home country of the multinational enterprise may have its real comparative advantage.

Because the multinational enterprise is likely to be an oligopoly with wide dispersion of ownership shares, its management may be more attuned to growth and share-of-market objectives than to profit per se. The development of differentiated products and their sale in world markets is one means by which the multinational may be able to achieve an increased market share or a continually growing volume of sales. Competitor oligopolists are likely to feel compelled to follow a leader into international production and marketing as defensive measures in order to preserve their market shares. Such oligopolistic bunching of entry into foreign markets by competing multinational enterprises tends to be a common phenomenon.

Multinational enterprises may be more inclined to enter into foreign production of their products rather than exporting from the home country or licensing foreign producers. The reason is that by so doing they can internalize control of their superior knowledge assets and thereby protect them from erosion for a longer time. Because a newly developed superior knowledge tends to become a public good very quickly as others master or imitate it, the developer can capture an economic rent for it only as long as the knowledge is secret or can be held proprietary. Exporting the good from the domestic productive facilities, or licensing the production technology to foreign producers, tends to accelerate the deterioration of the proprietary nature of the knowledge assets. This may be regarded as an externality of market-organized transactions, i.e., the market price after the newly developed knowledge becomes a public good fails to reward the developer for the costs of developing the new knowledge. This market imperfection can be averted by the multinational enterprise by retaining sole proprietary exploitation of its superior knowledge assets within the firm and its foreign affiliates rather than letting the knowledge assets leak to the rest of the world through market transactions.

 

Threats in an Open Economy

While the open economy provides a whole range of opportunities for the enterprise, it also holds some threats. The principal threat to domestic producers comes from foreign producers, especially if they can achieve lower production costs or produce products that are differentiated by virtue of their foreign manufacture. Foreign producers are often perceived to dump their products in domestic markets as a means of driving domestic producers from the market, thereby conferring monopoly power upon the foreign producers.

Although lower prices of foreign products may reflect lower direct (variable) production costs, another rationale for such apparent dumping is that overhead costs typically have been fully allocated by the foreign producer to the output produced for its domestic market. In this case the price of output destined for foreign markets needs to cover only the direct (or variable) costs. Hence the price of the output produced for the foreign market (excluding any allowance for overhead costs) can be lower than the domestic price (including full allocation of overhead costs).

Technically, "dumping" means that a foreign producer is selling in a domestic market at a price below the foreign producer's full cost of production (including overhead cost allocation). However, it is virtually never possible for one who charges another with dumping to gain adequate information about the other's costs (direct or overhead) of production. For this reason, the political definition of dumping is sale by the foreign producer in the domestic market at a price below the domestic producer's full cost of production (including overhead cost allocation). Sometimes domestic producers claim that the foreign producer is dumping when the price is simply below domestic prices. This is a political definition because it usually serves as the basis for an appeal by domestic producers to their governments for protection from the foreign producers who are reputed to be engaged in dumping.

The problem with the political definition of dumping is that it really cannot be distinguished from the phenomenon of competitive pricing. For example, if another domestic producer were selling at a price below our own preferred price, or even at a price below our own per-unit cost of production including overhead cost allocation, we could hardly charge our domestic competitor with dumping. The most that we could do is complain about competitive pricing that may be predatory in nature. But if a foreign firm engages in exactly the same behavior, domestic producers are quick to charge dumping and appeal to their governments for relief.

Actions by governments are also potential sources of threats as well as opportunities. If domestic producers can enlist the authority of government to protect them by imposing tariffs or quotas, this constitutes an opportunity for domestic producers to sustain or expand production and employment (in spite of a lack of comparative advantage), but it is a threat both to foreign exporters and to domestic importers. By the same token, actions by foreign governments to protect their industries will constitute threats to domestic firms that may have real competitive advantages. As we have already noted, protection also tends to distort the world-wide allocation of resources and diminish the potential for gains from trade.

Governmentally imposed quotas implemented by import or export licensing also constitutes a source of threat for domestic firms. Import licensing is more commonly used as a means of protecting domestic producers, but governments of resource-rich regions (particularly petroleum exporting countries) may use export licensing as a means of capturing income from the foreign sale of the resource. The source of the threat is that uncertainty arises as to which firms can acquire licenses to import or export what quantities of goods. Production and shipping schedules may be significantly disrupted, and earnings from sales of imported materials or goods for export may be jeopardized.

But the greatest threat to domestic producers in any country is an adverse shift of comparative advantage. Such may come about because of a natural disaster that destroys a productive advantage, or it may result simply from depletion of an historic natural resource endowment. In the modern world, an adverse shift of comparative advantage is more likely to have been engineered by foreign competitors who develop superior knowledge assets or engage in such massive capital investment as to create a capital-abundant productive environment. Also, technical advances in communications and transportation may render capital and resources so much more mobile than labor that footloose industries move very easily from one part of the world to another in search of ever lower-cost labor. Such a fleeting comparative advantage will severely threaten the viability of firms where the industry historically has been located.

Finally, we note that in oligopolistic markets (which may characterize most of the markets in the modern world) the competitive actions by any single firm can be expected to threaten the market share and profitability of any other firm in the market. If the others do not rise to the occasion they will certainly suffer declining market shares and operating losses that may culminate in failure. This phenomenon is surely so much more intense in an open-economy world than in protected domestic economies.

Even though the threats in an open economy may appear substantial, the opportunities found in international commerce almost surely outweigh them. The evidence to support this contention lies in the expanding volume of both trade and direct foreign investment throughout the world. But as a revisitation to the opening passages of Chapter 2, we note that these concepts and problems of internationalism will tend to diminish in importance as economies become more open, as their peoples become more comfortable with international commerce, as economic and political integration ensues, and as market imperfections diminish with technological advances in communications and transportation.

As we end this chapter, perhaps it would be helpful to list some of the operational objectives that firms pursue in their quests for global competitive advantage. Firms attempt to establish market presences in other regions of the world in order to:

1. increase sales revenue and hence profitability;
2. achieve unit sales or revenue growth targets;
3. increase share of market;
4. achieve enhanced oligopolistic position by preempting competitors;
5. preserve oligopolistic position by meeting or neutralizing competitors who have already arrived;
6. diminish dependence upon mature or stagnant markets;
7. increase demand to allow spreading overhead in existing plants; and
8. increasing demand to exploit economies of scale from increasing plant size.

Firms engage in direct investment in other regions in order to:

1. surmount nationalistic preferences for domestically made goods;
2. seek higher rates of return than can be achieved elsewhere or by local competitors;
3. internalize control of knowledge assets while exploiting them;
4. acquire new knowledge resources; and
5. circumvent trade barriers.

Motivations for business firms to establish foreign market presences and engage in foreign direct investment inform and condition the macroeconomic environment, and they provide impetus to governments to intervene in their macroeconomies in pursuit of both economic and political goals.

 

What's Ahead

The next chapter extends the international scope into the realm of developing economies. Because trade and development are inextricably intertwined, we shall use the international dimension as the platform for launching our survey of entrepreneurial opportunities in developing economies.

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CHAPTER 4.  OPPORTUNITIES IN DEVELOPING ECONOMIES

The bulk of international commerce is conducted among similar countries in the more developed regions of the world. But technological advancements in communications, computing, and transportation have enabled business firms, wherever domiciled, to contemplate operations anywhere in the world. The macroeconomic environment of global commerce now includes regions that historically have been regarded as "underdeveloped.”

 

Developing Economy Terminology

We choose the term lesser developed country (LDC) as perhaps the least problematic of the terms that have been employed in the literature to refer to low-income countries in the so-called "third world.” These countries are characterized by primary product production and the use of primitive productive techniques. The "first world" consists of the industrialized market economies of Europe and North America; the "second world" encompasses the socialistic economies of the former Sino-Soviet bloc; the "third world" consists of the low-income and underdeveloped countries of the South and East. The distinction between the "first" and "second" worlds is being made obscure by the transitions from socialism to market economy in the latter, and by experimentations with statism in the former.

The concept of "lesser developed" is of course relative. All economies except some in the very most remote and primitive parts of the world have experienced some development, some income growth, some adoption of advanced technologies, some industrialization. And many technologically advanced, financially mature economies surely still are "underdeveloped" relative to their resource endowments and potentials for continued development.

We shall take the term LDC to refer to countries that lag behind the technological conditions and income levels of the typical higher income, more industrialized, more technologically advanced economies of North America, Europe, and the Pacific rim. The term "newly industrialized country" (NIC) signifies countries in an intermediate state that are making progress from conditions of underdevelopment toward development.

 

Risk Factors

Managerial and entrepreneurial decision making in LDC economies should employ the same benefit-cost criteria as employed in advanced economies when considering either domestic or international operations. The problems of LDC decision making center about even greater market imperfections, even less market information, and ever greater market externalities than are found in more advanced economies. This means that risks may be greater in any or all decision settings in the LDC economy. It also means that much of the decision making in regard to business operations in LDC economies should be characterized more as entrepreneurial than as managerial.

As we noted in Chapter 2, the decision maker must compile a storehouse of experience upon which to base assessments of risk. And as noted in Chapter 3 in discussing prospects for international operations, the best way to do this is to become as familiar as possible with the LDC decision setting. This may prove difficult without direct involvement within the LDC environment.

 

The Role of Entrepreneurship

A significant reason for underdevelopment in the third world is lack of entrepreneurship. A region may have a rich endowment of various natural resources, but it will not be exploited without entrepreneurs to assume risk in innovation. Another region may be essentially devoid of natural resource endowments, but an entrepreneur may still perceive a productive opportunity and "make it happen."

A prerequisite to initiating an on-going development process is to provide conditions conducive to and tolerant of entrepreneurship. Where enterprise is essentially lacking in an LDC, the avenues of international trade and investment may provide just the "jump start" necessary to promote on-going development.

An important comparative advantage of the developed part of the world lies in its endowment of entrepreneurial capacity. The exercise of entrepreneurship may be one of the most valuable contributions of the multinational enterprise to the LDC economies within which they operate. The problem for the LDC then is to endogenize the entrepreneurial process so that it will be taken over by local business interests.

 

The Cultural Environment

Foreign involvement in the LDC environment begs even greater questions about cross-cultural differences than occur when firms become involved in other economies that are similar to their own. Customs and dress are even more exotic. Business practices are likely to be even more closely tied to cultural heritage than the standards of business dealings that have emerged among European and North American countries. In many third-world countries, women do not enjoy the same acceptance in business dealings as do male managers.

Although nineteenth and early-twentieth century colonialism has left a legacy of European language blocs in the third world, a wide variety of national and tribal languages and dialects continue to be spoken. Managers of multinational enterprises attempting to do business in third-world countries should not expect to rely upon their home-country languages or those studied in high school or college even though many people in the LDC may understand it as a second or third language. Expatriate managers often find greater acceptance and facilitation of business dealings when they can speak (even meagerly) the language of the realm and avoid faux pas related to cultural differences.

 

 

Infrastructure

One of the crucial problems of the LDC decision setting is the underdeveloped nature of infrastructure facilities that are taken for granted in more advanced economies. Transportation and communications facilities may be primitive; electricity and gas generation and transmission facilities may be lacking; sanitation and health care may be at an entirely different level than in the more advanced economy. The firm may find itself having to provide various of these services or facilities simply to be able to conduct its intended lines of business. Indeed, the scarcity of such infrastructure facilities may constitute rich entrepreneurial opportunities for both domestic and foreign firms.

A consequence of infrastructure underdevelopment is that it may not be possible to rely upon the commercial environment of the LDC to provide input supplies, complementary services, maintenance and repair support, or even marketing channels for distribution of outputs. A productive facility in an LDC is much more likely to have to be more vertically integrated, self-contained, and stand-alone than needs to be planned for and achieved in a more advanced economy.

A potential positive of infrastructure underdevelopment is that business firms may find opportunities to alleviate infrastructure scarcity by engaging in foreign direct investment or by bidding on construction, equipment supply, and financing contracts in LDCs.

 

Capital Scarcity

A common problem in many LDC economies is that directly productive capital is scarce and technologies are primitive. The so-called vicious circle of poverty turns upon the capital scarcity that ensures low labor productivity. The low productivity enables only meager wages. Incomes that are near (or below) the threshold of subsistence needs limit the capacity of the society to save. Little endogenous saving limits the investment potential of the society. Finally, inadequate investment ensures that capital will remain scarce.

But the circle of poverty may be broken at numerous points, any of which may provide entrepreneurial opportunities for interests within or from outside the LDC economy. The capital scarcity itself may pose investment opportunities since interest rates should provide higher returns than available in capital abundant parts of the world. Higher interest rates should attract foreign savings either through portfolio or direct foreign investment, or through international bank lending. Foreign lenders will also insist upon even higher interest rates than warranted by capital scarcity so as to include risk premiums against the unknown and uncertain conditions in the LDC environment. Low wages should attract footloose industries from other parts of the world, but they may be perceived to be attempting to exploit an impoverished population.

 

Labor and Technology

In an LDC the manager should expect to employ labor of pre- or early-industrial attitudes and conditioning. Such a labor force may be attuned to the agricultural sector during peak planting and harvesting seasons, and may thus be absent from the commercial or industrial work place at those times. Labor in an LDC typically is not (yet) attuned to the discipline of the clock or to required manufacturing tolerances.

A critical problem of managerial decision making in the LDC setting is choice of appropriate technologies. The newest and most advanced technology employed in "the West" is not likely to be appropriate to the LDC, but numerous mistakes have been made in adopting Western technologies in LDC economies. The "appropriateness" of a technology should be judged with respect to the resource endowments of the region.

A region that enjoys an abundance of labor but a scarcity of capital should employ labor-using and capital-saving technologies. Unfortunately for many LDC economies, the technologies employed in the West have been developed in capital abundant settings to conserve upon scarce labor, and thus are not appropriate to the LDC setting without extensive adaptation.

 

Trade and Investment

International trade and foreign direct investment are recognized by development economists to be two of the potentially most effective routes to the further development of an LDC economy. Specialization according to comparative advantage and trade can allow the LDC to develop its latent potentials. Foreign direct investment may help to change comparative advantages by relieving capital scarcity and technological backwardness. It may also help to diversity the LDC economy so that it is not so reliant upon one or a few crops or industries.

The operations of international and multinational firms can bring labor skills, managerial expertise, and new technologies to the LDC when the firms function as international transfer agents. Multinational enterprises prefer to establish subsidiaries or affiliates in the foreign environment in order to earn rents form their superior knowledge assets while maintaining control over them. The LDC economy will be the beneficiary of the employment and training provided by the multinational firm, and inevitably knowledge asset transfers to people in the LDC will occur deliberately or by leakage.

 

The Role of the Government

The government of the LDC may pose additional dimensions in the managerial decision setting that are not significant factors in the Western economy. An enlightened government will welcome both international trade and foreign direct investment by multinational enterprises; some have been willing to provide "tax holidays" as inducements to new foreign investment. However, governments of some LDC economies are suspicious of foreign involvements in their economies to the point of regulating and constraining the operations of foreign firms in their economies. One reason is that a multinational enterprise may generate larger gross revenues from its worldwide operations than the annual gross domestic product of the LDC.

It is not unusual for LDC host governments to subsidize domestic "infant industries" in their economies, and to protect them from foreign competition with restrictive import quotas or tariffs. The government of the LDC may limit foreign investors to only minority (less than 50 percent) positions in domestic ventures, and may also impose a "sunset law" requiring the foreign investor to withdraw within a specified time period. Laws may also require the progressive endogenization of the labor force and the management. Affiliates of multinational enterprises may find difficulties in importing materials requirements or needed machinery.

The multinational firm is likely to face high taxes in lesser-developed countries on inventories, sales, and plant and equipment. Tax rates may be unexpectedly increased after local operations are started. The multinational enterprise may also encounter difficulties in repatriating profits earned by its affiliate in the LDC.

Finally, we should note that in some LDCs there are distinct risks of nationalization of foreign-owned facilities, and there is no guarantee that the host government will provide adequate (or any) compensation for the assets nationalized.

 

Entrepreneurial Opportunities

Our discussion of the LDC setting has of course not been exhaustive; it is intended only to give the reader an overview of some of the problems to be encountered in decision settings in lesser developed countries. But we do not intend with this overview to discourage the manager from considering operations within the LDC. There are great opportunities to be considered in the LDC decision setting. A rational approach to such involvement is to identify all of the relevant benefits and costs emanating from such involvement, carefully assess the attendant risks, make adjustments to estimates of benefits and costs to account for the risks, and proceed if the involvement appears viable after allowing for the risks.

 

What's Ahead

Our survey of the global environment of business decision making has set the stage for discussing the foundations of macroeconomic analysis in Part B.

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PART B. MACROECONOMIC FOUNDATIONS

 

 

CHAPTER 5. MACROECONOMICS

“IN THE BEGINNING”

The survey of the global environment of business in Part A has set the stage for undertaking our study of how macroeconomic phenomena affect the modern business firm. First, we need to consider some foundational matters.

 

In the Beginning

"In the beginning," i.e., prior to the fourth decade of the twentieth century, the concept of macroeconomics did not exist. What in retrospect could be called macroeconomic conditions or macroeconomic phenomena have been observed through the ages, but the adjective "macroeconomic" was not used to describe them. References to region-wide economic phenomena, mostly associated with seasonal and cyclical agricultural phenomena and crises, may be found in ancient literature, including Judeo-Christian and Hindu scriptures.

Economics as a systematic study is only a couple of centuries old. A review of the history of western economic thought confirms that people began to think seriously and systematically about economic matters only during the eighteenth century. In these early days of Adam Smith, Thomas Malthus, and David Ricardo, there was no distinction between the behavior of individual economic units (microeconomics) and the larger context within which they operated (macroeconomics). By default, fledgling economic thinkers presumed, without deliberately thinking about it, that the larger world was simply a macrocosm of the economic circumstances available close at hand for their observation. In so doing, they engaged in the logical fallacy known as the "fallacy of composition,” i.e., that the whole is like the parts which compose it. The danger in indulging in this fallacy about the economy is the potential inability to perceive or explain phenomena that affect the larger whole differently than the individual parts of it.

Most of the basic microeconomic concepts of demand, supply, competition, and monopoly were fully developed by the time that English mathematician-economist Alfred Marshall published his Principles of Economics (the first work to be so entitled) in 1890. Details of these concepts and further development of microeconomics have continued to unfold during the twentieth century.

 

Enabling Conditions

<>Several preconditions for the emergence of distinctly macroeconomic ideas may be identified. Ancient Greek and Roman thinkers in their city states and extended empires might have distinguished macroeconomic ideas from microeconomics, but no such distinctions have been found in their literatures. The first modern enabling condition to the specification of macroeconomics was accomplished with the emergence of the nation states of Western Europe in the sixteenth and seventeenth centuries. The emergence of the nation state provided a political identity for a region about which economic concerns could be expressed. This nation state-making era was contemporaneous with the emergence of a mode of national policy which became known as mercantilism (see Comment 5-1).

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Comment 5-1. Macroeconomics Under Mercantilism

While no macroeconomic theories per se are attributed to thinkers prior to John Maynard Keynes, a certain type of nationalistic policy began to emerge in the sixteenth and seventeenth centuries in the form of mercantilism. No systematic body of mercantilist thought can be identified, but mercantilist policy may be inferred from the writings of various political and commercial interests of those centuries. It may be summed up in six points:

1. The objective of state commercial policy is to enhance the wealth of the nation (actually, the monarch).

2. Agriculture, manufacturing, local commerce, and international trade should be regulated by the state to the end of enhancing the wealth of the nation.

3. Adventurers should be commissioned by the monarch to go out "into the world" to seek wealth and claim new lands containing it for the crown.

4. Colonies should be established in the newly claimed lands to serve as sources of raw materials (including precious metals), markets for manufactures of the home country (or "motherland" or "fatherland"), and bases of taxation (often without representation).

5. Nations should strive for a favorable balance of trade, i.e., an excess of their exports over their imports should be pursued as a means of accumulating wealth in the form of precious metals. A favorable balance of trade for one nation would mean unfavorable balances of trade for its trading partners who would have to pay gold or silver to the successful nation for the excesses of their imports over their exports.

6. Should colonies and trade insufficiently enhance the wealth of the nation to the extent desired by the crown, "privateers" might be commissioned to procure wealth for the crown by capturing it on the high seas (state sponsored piracy) from those who have found it in their newly-claimed lands.

It was in reaction to mercantilist policy as practiced by various of the emerging nation states of western Europe that Adam Smith penned An Inquiry Into the Nature and Causes of the Wealth of Nations, published in 1776. Smith's principal objective was to correct the mercantilists' erroneous notion that the "wealth of the nation" was comprised of its hoard of precious metals. Smith advocated laissez faire (i.e., free trade and minimal regulation of commerce and industry by the state) as the means of enhancing the real wealth of the nation in the form of its productive capacity.

Mercantilism might properly be classified as a combination of commercial, industrial, colonial, and imperial policy, but there is little doubt that the implementation of mercantilistic policy had significant macroeconomic effects (income, employment, and prices) on the nation states practicing it and their trading partners as well, even if they were not active practitioners of mercantilism.

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A second enabling condition to the emergence of macroeconomic concepts occurred late in the mercantilist era in the form of Industrial Revolution in Western Europe. Phenomena affecting nation states had for centuries included agricultural cycles and crises as well as such fortuitous circumstances as discoveries of veins of precious metal ores. By the second half of the nineteenth century, noticeable macroeconomic phenomena began to emerge in the form of industrial and commercial cycles apart from agricultural seasonality and crises.

A third enabling condition consisted in the development of a new form of taxation. Prior to the twentieth century, the nation state's favorite means of raising revenue was to impose tariffs, usually upon imports into the nation, but occasionally on exports from it. In North America, there was some early experimentation with income taxation by both the Union and the Confederate governments to finance military requirements during the U.S. Civil War, but such efforts were only temporary expedients which expired at the end of the war. The first "permanent" income tax legislation was enacted by the U.S. Congress in 1916 with the intent of ensuring a flow of revenues sufficient to finance participation by the U.S. in the impending war in Europe. As the newly enacted income tax law came into operation by 1918, a mounting flow of information about the tax payers, their incomes, and their spending/saving behaviors resulted as a byproduct of the revenue collection process. What at first was lacking were the concepts necessary to compile and interpret the information.

A fourth enabling condition was the solution to the puzzle of how to organize and interpret the information becoming available from tax reports. This puzzle was gradually solved in the United States during the 1920s. By the eve of the "Great Depression" the necessary concepts had been defined and the procedures derived for organizing and aggregating the data. The procedures and concepts became known as the National Income and Product Accounts. Authorities of other nations adopted many of the conventions as they implemented their own permanent income tax systems. They too began to collect national income and product accounting data as by-product of the inflow of income tax revenues.

The final condition for the separation of macro- from microeconomic ideas came with the exigencies of the 1930s Great Depression. As contraction and deflation worsened in Europe as well as North America during the early 1930s, economists on both sides of the Atlantic struggled to understand what was happening and design policies for dealing with it. Although a number of economic thinkers were making progress toward a resolution of the puzzle, Cambridge economist John Maynard Keynes reached the market first in 1936 with the publication of his book, The General Theory of Employment, Interest, and Money. Keynes' ideas fomented a veritable revolution in thought about economic causation. This revolution in thought became known as "the Keynesian Revolution.”

The salient characteristic of Keynes' ideas was a recognition that the economy of a region taken as a unified whole might not behave simply like the constituent parts of it (individual decision makers organized into markets). In effect, Keynes ideas averted the fallacy of composition in which his predecessors, whom he called "Classical Economists," had indulged during the nineteenth century and the early decades of the twentieth century. Although other economists were pursuing similar ideas when The General Theory was published in 1936, today Keynes is generally accorded recognition as the "Father of Modern Macroeconomics."

 

Precursors of Modern Macroeconomics

A number of precursors of modern macroeconomic concepts may be identified in the history of economic thought. The French Physiocrats were eighteenth century proponents of the notion that agriculture was the only source of wealth. In 1758, Francois Quesnay, a physician in the French court of Louis XV, introduced the concept of circular flow in his Tableau Economique. Using a chart in a primitive matrix format, Quesnay described a French landlord's circular and repetitive flow of agricultural activity.

Adam Smith published his Inquiry Into the Nature and Causes of the Wealth of Nations in 1776. Smith accepted Quesnay's notion of circular flow, but he thought that wealth was produced by industry and commerce in addition to agriculture. Smith's objective in The Wealth of Nations was to correct what he perceived to be the mercantilists' crude notion that wealth consisted of the state's hoard of precious metals.

Pitching much of his discourse at the macro level of the national economy, Smith advanced the view that the true wealth of any nation lay in its productive capacity which yielded a continuing flow of goods and services. Smith suggested that the wealth of the nation would continue to grow with increasing specialization and division of labor to the extent of the domestic market. Once the domestic market of the nation was fully saturated with domestic production, further growth was possible through trade with other nations.

In his 1798, Thomas Robert Malthus took an essentially macro perspective in An Essay on the Principle of Population as It Affects the Future Improvement of Society. Malthus advanced the idea that ever growing human populations would eventually press upon the "carrying capacity" of the land. With the quantity of available land fixed, total output could increase only at a decreasing rate (the phenomenon of diminishing returns). Eventually per capita income must fall to the level of subsistence and the population would stabilize at the maximum which could be sustained by the earth's productive capacity. Malthus took the forces limiting population growth to be the "Four Horsemen of the Apocalypse" (pestilence, plague, famine, and war). Upon reading Malthus' Essay, philosopher Thomas Carlyle dubbed economics "the dismal science.”

David Ricardo, in his 1817 Principles of Political Economy and Taxation, suggested that Malthusian diminishing returns might be forestalled by "agricultural improvements" (capital investments) paid for by landlords out of their rents. The fact that per capita incomes have not fallen in modern market economies is attributable to capital investment and technological advance, central tenets in the modern theory of economic growth.

Malthus' other major pre-macro contribution was the notion of the possibility of underconsumption which appeared in his 1820 Principles of Political Economy. Malthus was concerned that underconsumption might result in a "glut" of commodities across markets generally. A variant of the notion, oversaving, became a centerpiece of Keynes' General Theory.

Contemporary with Malthus and Ricardo was a French economist, John Baptiste Say, who popularized the idea that acts of production incurred costs that became incomes to the producers when the products were sold. This notion was elaborated into what became known as Say's Law of Markets, a crude form of which is that "supply creates its own demand." A more reasoned version is that every act of production for the market is implicitly a demand for something from the market. Productive activity in the aggregate should yield enough total demand capacity to clear all markets. The generalization of this idea admitted that localized and temporary market gluts were possible, but denied the likelihood that a general glut would occur. Though never explicitly stated in discussions of the time, Say's Law of markets was based upon assumptions that prices and wages were sufficiently and symmetrically flexible.

 

The Birth of Modern Macroeconomics

It is precisely these unspoken assumptions that served as a point of departure for John Maynard Keynes in a critique of his predecessors' economic thinking, and in particular Say's Law of Markets. Keynes referred with some sense of derision to his predecessors as "classical,” implying that their ideas were outmoded. In The General Theory of Employment, Interest, and Money published in 1936, Keynes asserted that wages and prices were asymmetrically flexible because monopolistic business interests in product markets and monopolistic unions in labor markets had emerged to resist decreases in prices and wages. Monopolistic businesses and unions could, however, be counted upon to raise prices and push for higher wages upon any excuse to do so. This downward inflexibility of prices and wages meant that oversaving ("underconsumption" to Malthus) could occur, and that, contrary to Say's Law, a "general glut" was possible, as evidenced by the exigencies of the Great Depression.

Keynes further argued that workers were sophisticated enough to pay attention to their real wages rather than to their nominal wages (i.e., they would not suffer "nominal wage illusion"). The real wage may be measured as the ratio of the nominal wage to an index of the price level. If the price level should rise, the cost of living to workers would increase, thus decreasing the purchasing power of their nominal wages. Keynes suggested that during a general economic decline, workers might be willing to accept lower nominal wages in order to keep their jobs and earn some income, but they might not be able to achieve the lower real wages by accepting lower nominal wages if prices should be falling at the same rate as nominal wages are falling. Worse, if prices should fall faster than nominal wages decrease, the real wages would rise and constitute increasing costs to employers who would further cut back on their employment of workers. Thus, real wages may be inflexible downward during a general economic decline.

In distinguishing macroeconomics from microeconomics, Keynes advanced two radical ideas. First, he shifted attention from price as the main determinant of demands for specific products to income as the principal determinant of the aggregate expenditure on the output of the whole economy. Second, he asserted the possibility that the offices of government might be brought to bear upon the perceived instability of the macroeconomy. It is to the managerial implications of this paradigm shift that this book is devoted.

 

The Macroeconomic Environment of Managerial Decision Making

The microeconomic criteria for rational decision making are properly the subject matter of managerial economics. There can be little doubt about the significance of the macroeconomic environment to managers of enterprises operating in either market or authoritarian economies.

Scientific inquiry encompasses the effort to understand "the way the world works." One of the objectives of such understanding is to gain ever greater control over the environment within which we live. Two types of control may be distinguished, active and passive. Active control is directed toward altering the direction or force of events. Indeed, active control is the object of managerial decision making in the microeconomic context of the commercial enterprise. However, very little of what happens in the larger world is subject to control by managements of business firms.

Even if there is no hope of altering the course of events, the managers of firms may find it possible to exert some form of passive control in the sense of attempting to prepare for, respond to, or simply get out of the way of what is happening in the outside world. It is this possibility of exerting such passive control which constitutes the relevance of macroeonomics to managerial decision making.

 

What's Ahead

Chapter 6 elaborates the modern concepts of income and product and the procedures for compiling measures of them. Chapter 7 distinguishes between nominal and real values and explains how real values may be derived from nominal values.

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CHAPTER 6.  ACCOUNTING FOR INCOME AND PRODUCT

 

In Chapter 5 we noted that the concepts for national income and product accounting developed during the 1920s decade in the U.S. after a permanent income tax system began to yield data as a byproduct of revenue collection. Keynes’ macroeconomic ideas of the mid-1930s employed many of these national income accounting concepts.  Although governments of different countries possess different levels of ability to compile data for their national economies, most now attempt to conform to the procedures and conventions fostered by the United Nations and used by the United States. This chapter is devoted to elaboration of the U.S. National Income and Product Accounts (NIPA), the concepts underlying them, and the procedures for compiling them as they have evolved by the turn of the twenty-first century.

 

National Income and Product Accounting

Table 6-1 is adapted from tables in the 2010 and 2011 issues of the Statistical Abstract of the United States. In this chapter we will pay attention primarily to the structure of the NIPA accounts of the United States. We will refer to the data contained in Table 6-1 in subsequent chapters.

From the late 1920s until the early 1990s, NIPA accounting in the U.S. culminated in a measure of the annual Gross National Product even though most other countries compiled measures of their Gross Domestic Products. The difference was that the U.S. employed a national definition for compiling income and product statistics, whereas most other countries used a domestic definition. This means that all output produced by U.S.

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Table 6-1.
 
GDP in Current Dollars: 2003 to 2009 [In billions of dollars (11,142 represents $11,142,000,000,000).
 
                          2003    2004    2005    2006    2007    2008    2009
CURRENT DOLLARS
 
Gross domestic
   product (GDP).....   11,142  11,868  12,638  13,399  14,078  14,441  14,256
 
A. Personal consumption
     expenditures....    7,804   8,285   8,819   9,323   9,826  10,130  10,089
   Durable goods.....    1,015   1,062   1,106   1,133   1,161   1,095   1,035
   Nondurable goods..    1,713   1,831   1,968   2,089   2,205   2,308   2,220
   Services..........    5,077   5,393   5,745   6,101   6,461   6,727   6,834
 
B. Gross private domestic
     investment......    1,730   1,969   2,172   2,327   2,289   2,136   1,629
   Fixed investment..    1,713   1,904   2,122   2,267   2,269   2,171   1,750
   Change in business
     inventories.....       16      65      50      60      19     -35    -121
 
C. Net exports of goods
     and services....     -504    -619    -723    -769    -714    -708    -392
   Exports...........    1,041   1,180   1,305   1,471   1,656   1,831   1,564
   Imports...........    1,545   1,799   2,028   2,240   2,370   2,539   1,957
 
D. Government consumption
     expenditures and gross
     investment......    2,113   2,233   2,370   2,518   2,677   2,883   2,931
   Federal...........      757     825     876     932     977   1,083   1,145
     National defense..    498     551     589     625     662     738     779
     Nondefense            259     274     287     307     315     345     366
   State and local...    1,356   1,408   1,494   1,587   1,700   1,801   1,786
 

Source: Table Number 666, Statistical Abstract of the United States: 2011, U.S. Bureau of the Census.

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nationals or all income earned by U.S. nationals anywhere in the world was included in the U.S. Gross National Product compilations. Those countries using the domestic definition included in their Gross Domestic Products all output produced or income earned within their territorial boundaries, irrespective of nationality of the producer or income earner.

The conceptual and procedural differences resulted in non-comparability of U.S. Gross National Product with other countries' Gross Domestic Products. It was also true that some of the world's output or income was double counted (e.g., the output produced and income earned by employees of U.S. subsidiaries in Germany was counted by both the U.S. and by Germany), whereas some other of the world's output was not counted at all (e.g., the output produced and income earned by employees of German subsidiaries in the U.S.). International statistical publications such as the U.N. Statistical Yearbook achieved comparability among member nations by making statistical adjustments to U.S. Gross National Product data to convert it to the equivalent of the Gross Domestic Product data compiled by most other countries. Beginning in 1992, the U.S. shifted to the domestic definition and procedures, so that now U.S. NIPA compilation procedures culminate in annual Gross Domestic Product totals. We shall return to the Gross National Product concept in regard to the data contained in Table 6-2.

A working definition for Gross Domestic Product is the total market value of all final output (services as well as goods) produced within the region during an accounting period, conventionally the year. The term "region" was used deliberately in the previous sentence even though Gross Domestic Product is most often thought of in regard to national entities. The concept can be applied as well to other political entities such as provinces, states, counties, and even cities and towns. It can also be applied to non-political entities such as regions of a nation (e.g., the Gross Domestic Product of the Southeast of the United States), or to groups of nations (e.g., the Gross Domestic Product of the West African countries). The concept can even be applied to the whole world economy, in which case the distinction between Gross Domestic Product and Gross National Product becomes irrelevant (at least until the earth begins commercial intercourse with societies on other heavenly bodies).

Gross Domestic Product data are compiled by aggregating information from personal and corporate income tax reporting forms and from other sources. There are two basic approaches to compiling a measure of Gross Domestic Product, the Expenditures Approach and the Incomes Approach. The fundamental identity of the Expenditures Approach is that Gross Domestic Product is the sum of personal consumption expenditures, gross private domestic investment expenditures, net exports of goods and services (i.e., exports less imports), and government consumption expenditures and gross investment. We will specify a fundamental identity for the Incomes Approach after elaborating the Expenditures Approach.

 

The Expenditures Approach

Section A of Figure 6-1 details personal consumption expenditures as composed of expenditures on all final goods and services produced within the nation during the year. Three categories of personal consumption expenditures are durable goods, non-durable goods, and services. All goods have tangible characteristics and lives of non-zero duration. Because of this fact, business enterprises attempt to maintain prudent inventories of both the goods that they produce and the inputs that go into the production processes. Conventionally, nondurable goods are those which have lives typically less than one year. Examples include foodstuffs and apparel. Durable goods have lives typically exceeding a year. Examples of durable goods include appliances and automobiles. Although all types of goods are classified as durable or nondurable on the basis of typical life duration experience, inevitably some "nondurables" last longer than a year and some "durables" cease to be functional before a year of life is reached.

In contrast, services have tangible effects and lives that approach zero in duration (i.e., the time during which the service is being rendered). Because of this fact, services may not be produced in advance of sale and inventoried. Examples include personal services (beautician and barber services), repair services, wholesale and retail sales services, government employments, and real estate and financial transactions services. One should not make too much of the distinction between goods and services because in the final analysis goods are desired not for themselves per se, but because of the services that they render. In fact, the asset (or capital) value of any good may be estimated to be the sum of the values of the services rendered by the good over its lifetime. However, the distinction between goods and services has become significant to macroeonomic theory because of the fact that the former are subject to inventory variation, but the latter are not.

Soon after the middle of the twentieth century, the total value of services became greater than the value of all tangible goods produced in the U.S. economy. Although macroeconomic theory has traditionally focused exclusively upon the personal consumption expenditures total, the predominance of services in the composition of the Gross Domestic Product means that inventory accumulation and depletion has become ever less important to the macroeconomic health of the nation than it was when the economy was dominated by industrial production. In subsequent elaboration of macrotheory we will speak of consumption as the non-differentiated total of "expenditures on goods and services.”

Section B of Table 6-1 indicates that the largest component of gross private domestic investment is fixed investment, which itself is composed of two subdivisions. The largest component of fixed investment usually is investment in plant and equipment, i.e., purchases of tools, assembly line and warehouse equipment, rolling stock, data processing equipment, and the expenditures on new buildings (the "plant") to house the equipment. The smaller component of fixed investment consists of new residential construction.

The third component of gross private domestic investment is change in business inventories from the end of the previous accounting period. Though small in comparison to fixed investment, inventory change has been extremely important to macroeconomic theory. Inventory accumulation (positive change) is regarded as a form of investment because businesses that produce or sell tangible goods do have to maintain prudent amounts of inventories of inputs and final products if they are to continue production and remain in business. Deliberate increases in inventory holdings obviously constitute business investment. Inventory accumulation resulting from inability to sell all of the output produced likewise must be regarded as a form of investment, however unintentional. By the same token, inventory depletion (negative change), whether deliberate or unintentional, is regarded as a form of disinvestment (or divestment) for purposes of national income and product accounting.

Inventory change constitutes a prime decision criterion for business decision making in regard to output and employment in an economy with a substantial manufacturing sector. During the second half of the twentieth century, two phenomena have served to diminish the significance of inventory change as an output/employment decision criterion. Technological advances in communications and computing have enabled more efficient inventory control. And for countries like the U.S., since service production accounts for an ever growing portion of total output, industrial production becomes an ever smaller proportion of total output. Management of the inventories associated with industrial production thus becomes ever less significant to the modern service-based economy.

Section C of Table 6-1 exhibits the nation's Trade Balance, which is part of the Current Account in its Balance of Payments. The trade balance may be designated as exports less imports if it is in surplus. If imports exceed exports, the trade balance is said to be in deficit. The implication of a trade balance surplus is that foreigners are spending more on the output of the nation than its citizens are spending on the outputs of other nations. In Chapter 9 we shall note that a trade surplus causes a "net injection" of spending into the income stream of the economy. A growing trade surplus has the effect of increasing the nation's Gross Domestic Product. Should the nation suffer a trade deficit, we shall refer to it in Chapter 9 as a "net leakage" of spending from the nation's income stream. Growing trade deficits have the effect of decreasing the nation's GDP.

Section D of Table 6-1 exhibits information about government consumption expenditures and gross investment on goods and services produced in the economy during a year. Public accounting practices in the U.S. at the federal level and in most states do not distinguish between government's current consumption expenditures (things and programs which are used up during the year) and investment in long-lasting publicly-owned assets. All of this is lumped together in the general heading.

Much of macrotheory presumes that there is a single government authority that implements a unified and coherent set of macropolicy actions. However, the data in Section D of Table 6-1 reveal that aggregated state and local government spending in the U.S. is greater than federal government spending. The Constitutional separation of powers between the federal and sub-level governments imposes a strict balanced budget requirement that is supposed to prevent state and local governments from being able to implement deliberate fiscal policies. To the extent that state and local governments fail to balance their budgets, the total of their net budget balances may have non-trivial fiscal effects that may amplify or offset the fiscal measures intended by the federal government. Even if every state and local government in the U.S. succeeds in balancing its budget, the total of all such spending may increase or decrease to have significant fiscal effects.

The problem of macropolicy unification and coherence may be even more acute in the European Union during the twenty-first century because the EU is organized as a confederation of governments rather than as a federal government. While the member states of the EU have ceded monetary policy to the European Central Bank, the governments of the member states have retained authority to implement fiscal policy within their national economies. With its present structure, the only possibility of a unified or coherent EU-wide fiscal policy depends upon the ability of EU member states to achieve sufficient coordination (or "harmonization") of national fiscal policies. Otherwise, macropolicy unification in the EU may require it to move beyond economic union to full political union with a federal structure.

Data in Section D of Table 6-1 also reveal that national defense accounts for a substantial portion of federal expenditures in the U.S. While macrotheory does not delve into the composition of government spending at either federal or state level, an important fact of the late twentieth century U.S. federal finance is that emerging U.S. federal budget surpluses were facilitated by declining defense spending following the end of the "Cold War" in the early 1990s. The fact that total U.S. federal spending during the 1990s fell at a slower rate than has defense spending suggests that other uses of federal tax revenues were taking up much of the federal budgetary slack. Both of these facts have been reversed during the early twenty-first century as defense expenditures increased to finance prosecution of the "war against terrorism.”

 

Deliberate Omissions

GDP is intended to be a measure of the value of all final goods and services produced within the nation during the year. Intermediate goods, i.e., raw materials, components, sub-assemblies, and other partially processed items, should not be included in the compilation of consumption or investment expenditure totals for a year because they will be included in consumption or investment expenditure totals during the same or a subsequent year. Inclusion of the values of intermediate goods would involve double counting.

Since Gross Domestic Product is intended to include only new current output, there are three categories of expenditures that should be excluded by virtue of their having been produced originally in previous years. Expenditures on used consumer goods, plant and equipment, and housing are not included in any year's compilation of Gross Domestic Product data since these items were produced in previous years and should have been included in Expenditures Approach to the compilation of the Gross Domestic Products of those years. However, commissions and fees earned in conducting real estate and financial transactions are included in the Incomes Approach (as noted below) to each year's Gross Domestic Product compilation.

Since the Expenditures Approach to compiling a measure of Gross Domestic Product employs a domestic definition of income and product, it is important to note that direct investment by foreigners on plant and equipment within the nation should be included in the nation's gross private domestic investment, but foreign direct investments by citizens of the nation in other nations should not be included in the gross private domestic investment of the nation. A crucial characteristic of a direct investment is that it confers upon the investor the ability to exercise control over the acquired asset.

Also omitted from a nation's investment expenditure total are all purely financial transactions including any portfolio investment, i.e., expenditures on assets of domestic or foreign business entities which are not sufficient to allow exercise control over them. Portfolio investments in equities (shares) and liabilities (bonds) are purely financial transactions which are excluded from Gross Domestic Product compilations. However, all foreign investment transactions, whether direct (controlling) or portfolio (non-controlling) are included in the Capital Account of the nation's Balance of Payments.

 

Other National Income Accounting Concepts

Table 6-2 is adapted from tables in the 2010 and 2011 issues of the Statistical Abstract of the United States. It shows other useful income accounting concepts that may be derived from Gross Domestic Product. Once these other income accounting concepts have been identified, we can elaborate the Incomes Approach to Gross Domestic Product compilation.

The Gross Domestic Product data on line A of Table 6-2 are identical to those at the top of Table 6-1. When receipts of income earned by U.S. nationals in the rest of the world (i.e., outside the territorial boundaries of the U.S.) are added to Gross Domestic Product, and payments of incomes earned in the United States by foreign nations are deducted from Gross Domestic Product, we have a measure of Gross National Product (line B) which is equivalent to the U.S. compilation prior to 1992. Information for incomes earned by Americans abroad and foreigners in the U.S. are taken from the Current Account section of the Balance of Payments.

Prior to World War I, foreigners (particularly the British) owned a substantial portion of the capital assets of the U.S. By the end of that war, foreigners had sold much of their U.S. holdings to Americans in order to finance war expenses. As a general rule, U.S. Gross Domestic Product has exceeded Gross National Product from the end of World War I and until 1997 because during this period Americans have been able to earn more income from their overseas assets than foreigners have earned from theirs in the U.S. This relationship has been reversed in years subsequent to 1996, a fact which suggests that foreign investments in the U.S. have been increasing relative to U.S. investments in other countries.

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Table 6-2.
 
Relation of GDP, GNP, Net National Product, National Income, Personal Income, Disposable Personal Income, and Personal Saving: 2003 to 2009 [in billions of dollars (5,743.8 represents $5,743,800,000,000)].
 
Item                            2003    2004    2005    2006    2007    2008    2009
 
A. Gross domestic product...  10,961  11,868  12,638  13,399  14,078  14,441  14,256
 
   Plus: Receipts of factor
      income from the rest
      of the world..........     337     449     573     721     862     809     589
   Less: Payments of factor
      income to the rest of
      the world.............     280     357     476     649     746     667     485
 
B. Equals: Gross national
      product...............  11,018  11,959  12,736  13,471  14,193  14,583  14,361
 
   Less: Consumption of
      fixed capital.........   1,337   1,433   1,541   1,661   1,760   1,847   1,864
 
C. Equals: Net national
      product...............   9,681  10,526  11,194  11,811  12,433  12,736  12,497
 
   Less:
     Statistical Discrepancy      49      -8     -80    -221     -15     101     209
     Taxes on production and
       imports less subsidies    759     817     869     936     974     994     964
 
D. Equals: National income     8,873   9,717  10,405  11,095  11,474  11,641  11,324
 
   Less:
     Corporate profits 1....     993   1,247   1,456   1,608   1,542   1,360   1,309
     Contributions for govern-
       ment social insurance     779     827     873     922     959     991     967
     Net interest and miscelan-
       eous payments on assets   525     462     543     652     739     815     788
     Business current transfer
       payments..............     84      82      96      83     102     119     134
     Current surplus of govern-
       ment enterprises......      2       1      -4      -4      -7      -7      -8
     Wage accruals less dis-
       bursements............     15     -15       5       1      -6      -5       5
   Plus:
     Personal income receipts
       on assets               1,337   1,409   1,542   1,830   2,032   1,994   1,793
     Personal current trans-
       fer receipts            1,351   1,416   1,509   1,605   1,718   1,876   2,105
 
E. Equals: Personal income..   9,164   9,937  10,486  11,268  11,894  12,239  12,026
 
   Less: Personal current
       taxes................   1,001   1,048   1,209   1,352   1,491   1,432   1,103
 
F. Equals: Disposable
     personal income........   8,163   8,889   9,277   9,916  10,403  10,806  10,924
 
   Less: Personal outlays...   7,988   8,586   9,150   9,681  10,224  10,520  10,459
 
G. Equals: Personal saving..     175     304     128     235     179     286     465
 
1 Corporate profits with inventory valuation and capital consumption adjustments.
 

Source: Table Number 657, Statistical Abstract of the United States: 2010 and Table Number 672, Statistical Abstract of the United States: 2011.

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Net National Product (line C) is computed by deducting Consumption of Fixed Capital from Gross National Product. The significance of Net National Product is that it is a measure of total new output of the nation after allowing for replacement of that portion of the capital stock which was "used up" by depreciation during the previous year. Depreciation (i.e., "capital consumption") is a real economic phenomenon attributable to wear and weathering, but not to obsolescence per se. The real phenomenon of depreciation occurs on a continuing basis whether or however it is accounted for. The Consumption of Fixed Capital allowance is compiled as an aggregation of all depreciation expenses claimed by business enterprises on business income tax reports.

The Consumption of Fixed Capital total is an accurate representation of the real phenomena of wear and weathering only to the extent that the depreciation schedules established by accountants and allowed by the tax authority (the Internal Revenue Service in the U.S.) are accurate measures of the real processes of wear and weathering. If real capital equipment has continuing functionality after all allowed depreciation expenses have been claimed, then the Consumption of Fixed Capital total may be an overstatement relative to the real phenomenon. If real capital equipment has worn or weathered to non-functionality before all allowable depreciation expenses have been claimed on the schedule permitted by the tax authority, the Consumption of Fixed Capital total may be an understatement relative to the real phenomenon. Although the aggregation process tends to "wash out" the over- and understatements, the tax authority's current policy may cause a bias in one direction or the other. As the Consumption of Fixed Capital is over- or understated, the Net National Product will be an under- or overstatement of actual new output.

Although Table 6-2 does not show it, the Consumption of Fixed Capital total may be deducted from Gross Private Domestic Investment to get a measure of Net Private Domestic Investment. Net Private Domestic Investment may likewise be over- or understated as the Consumption of Fixed Capital total is under- or overstated. The significance of Net Private Domestic Investment is that it is the net addition to the nation's stock of capital after the portion of the capital stock that wore out during the previous year is replaced. Since Net Private Domestic Investment is usually greater than Consumption of Fixed Capital, it is normally a positive amount that makes the capital stock greater in the subsequent period than it was in the previous period. This fact is indicative of an economy with an increasing capital stock, one of the requisites of economic growth.

There have been two occasions during the twentieth century when Net Private Domestic Investment in the U.S. decreased and became less than Consumption of Fixed Capital. The first was during the "Great Depression" when, as Keynes described it, there was a collapse of investment spending. We will delve into this phenomenon in subsequent chapters. When this happened, the capital stock of the U.S. decreased and the total output of the U.S. economy declined between 1929 and 1933. The second occasion of negative Net Private Domestic Investment occurred during World War II when private investment spending was displaced by public investment in war materials productive capacity.

A measure of National Income (Line D) may be derived by deducting Indirect Business Taxes and non-tax liabilities (e.g., license fees and penalties for late- or underreporting of income to tax authorities) from Net National Product. Direct taxes are those which are levied directly upon persons (e.g. a head or poll tax) or upon what they earn (e.g., income taxes). Indirect taxes are levied upon what they have or do (e.g., property taxes and sales and excise taxes). The significance of National Income is that it is earned income, i.e., the total of all income which is earned by nationals of the country during the year.

The significance of Personal Income (line E) is that it is received income. Personal Income is computed by deducting a number of components of earned income (National Income) that are not received, and adding a number of items which are construed as not being earned. Some of these items partially offset each other. All of corporate profits before taxes are deducted from National Income, but the dividend portion is added back because it is actually received by income earners. This implies that the difference, corporate profits taxes and retained earnings, are earned incomes that are not received by income earners. Gross personal interest income is added back to National Income after net interest is deducted. The difference, interest paid on the public debt, is a pure transfer payment which is income received but not earned. Contributions for social insurance are withheld by employers, so they are deducted from National Income since they too are earned incomes that are not received. Wage accruals less disbursements, normally a small net amount, consist of earned incomes that have not yet been paid by the end of the accounting period, so they are deducted from National Income.

Finally, government transfer payments and subsidies to persons are added to National Income since they are construed as unearned incomes that are received by the population. Transfer payments and subsidies are the conceptual opposites of taxes. Taxes are unilateral payments by members of society to governments. They are unilateral since there is no counter flow of value (i.e., no quid pro quo). Transfer payments and subsidies are unilateral payments by governments to members of society. Transfer payments are governmental payments to persons that have the effect of relieving some undesirable condition. Subsidies are payments that have the effect of offsetting some private cost suffered by the recipient. Examples of transfer payments include welfare benefits, social security benefits (OASDHI, i.e., Old Age, Survivors, Disability, and Health Insurance benefits) Medicare and Medicaid benefits, G.I. Bill benefits, and government worker and military retirement benefits. Examples of subsidies include rent subsidies and food stamps.

With the obvious exception of interest on the public debt and subsidies to businesses, most of the U.S. government's other transfer payments and subsidies have the effect of ameliorating the degree of inequality in the distribution of income in the U.S. because as a general rule they are received by lower-income members of American society. Interest on the public debt is received by holders of the public debt, most of whose incomes tend to be from the middle toward the upper end of the income spectrum. Interest on the public debt thus tends to aggravate the degree of inequality in the U.S. income distribution.

Historically, U.S. earned income (National Income) has been greater than received income (Personal Income) because more in social insurance taxes were collected than was distributed as transfer payments. During the mid-1970s the magnitudes of National Income and Personal Income were roughly equivalent, but by the end of the 1970s Personal Income regularly exceeded National Income, i.e., received income had become larger and has remained larger than earned income. This phenomenon has come about because in a democratic polity, the society has discovered that it can vote itself benefits. Indeed, it has discovered that more benefits are better than fewer benefits.

Disposable Personal Income (Line F) results from deducting personal income taxes from Personal Income (Line E). The conceptual significance of Disposable Personal Income is that it is income over which income recipients finally can exercise personal discretion. Basically, they have only two options, to spend it (personal outlays) or to save it. Table 6-2 treats spending as the discretionary quantity so that Personal Saving (Line G) is the residual. Casual inspection of the data on Line G reveals that Personal Saving has been decreasing in the U.S. economy during the early years of the twenty-first century, both in absolute terms and as a proportion of Personal Disposable Income. Personal Saving is also substantially smaller than both Gross Investment (Table 6-1) and net investment (inferred from data in Table 6-2). As will be noted in Chapter 21, this saving deficit must be paid for by some combination of a government budget surplus and a trade deficit.

 

The Incomes Approach

As noted above, one method of arriving at a measure of National Income is to deduct indirect business taxes from Net National Product and add subsidies to it. The alternative method is to compile a National Income total by aggregating from income tax reports all wage, rent, interest, and profit income earned by nationals of the nation during the year. Table 6-3 shows the compilation of such totals for the U.S. from 2003 through 2009. These totals differ from the National Income amounts in Table 6-2 due to statistical discrepancies.

Once this alternate approach to measuring National Income is recognized, it becomes possible to arrive at a measure of Gross Domestic Product by the so-called Incomes Approach. This approach starts with a compilation of National Income as exhibited in Table 6-3, and then involves subtracting subsidies, adding indirect business taxes and consumption of fixed capital, and subtracting net income earned abroad (i.e., receipts of factor income from the rest of the world less payments of factor incomes to the rest of the world). The careful reader will recognize that these are the opposite arithmetic operations to those required to derive Gross National Product, Net National Product, and National Income from Gross Domestic Product.  

Net Income Earned Abroad may be positive if Americans earn more in foreign employments than foreigners earn in their employments in the U.S. The balance on Net Income Earned Abroad was positive but declining through the 1990s until it became negative in 1998 when for the first time foreigners earned more in the U.S. than Americans earned abroad. As seen in Table 6-2, it has been positive during the 2000s.

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Table 6-3.

National Income and Disposable Personal Income (Billions of dollars)
 
                               2003    2004    2005    2006    2007    2008    2009   
 
Compensation of employees     6,310   6,708   7,060   7,476   7,863   8,042   7,787
 
Plus:
  Proprietors' income
    Farm                         29      50      44      29      39      49      29
    Nonfarm                     782     984   1,026   1,104   1,057   1,058   1,012
  Rental income of persons      133     198     178     147     145     210     268
  Personal interest income      914     860     987   1,128   1,266   1,308   1,239
  Personal dividend income      423     548     555     702     765     686     554
 
Equals:  National income      8,591   9,348   9,850  10,586  11,135  11,353  10,889
 
Plus: Personal current
  transfer receipts           1,351   1,416   1,509   1,605   1,718   1,876   2,105
Less: Contributions for
  government social insurance   779     827     873     922     959     991     967
Less: Personal current taxes  1,001   1,048   1,209   1,352   1,491   1,432   1,103
 
Equals: Disposable Personal
 Income                       8,163   8,889   9,277   9,916  10,403  10,806  10,924
 
Less:  Personal outlays       7,988   8,586   9,150   9,681  10,224  10,520  10,459
 
Equals:  Personal Saving        175     304     128     235     179     286     465
 

 

Source: Table Number 662 and Table 673, Statistical Abstract of the United States: 2010; Table 672 and Table Number 677, Statistical Abstract of the United States: 2011.

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Inevitably, there will be a discrepancy each year between National Income derived from Gross Domestic Product and National Income compiled from incomes data. By the same token, a similar discrepancy each year can be expected between Gross Domestic Product compiled as the sum of Consumption, Investment, Government Purchases, and Net Export spending, and Gross Domestic Product derived by first compiling a measure of National Income, and then subtracting or adding the requisite non-income allocations. These discrepancies are attributable in large part to omissions and double countings that occur in aggregating information from literally millions of tax reporting forms.

Another possible source of the discrepancies lies in a potential weakness in the data with respect to the Consumption of Fixed Capital total since its accuracy depends upon the realism of the depreciation allowances allowed by the tax authority and claimed by business firms. This suggests that a more accurate measure of Gross Domestic Product may be compiled using the Expenditures Approach, but a more accurate measure of National Income may be compiled using the Incomes Approach.

 

What's Ahead

This completes our survey of National Income and Product accounting concepts and procedures. Chapter 18 reviews the essentials of Balance of Payments accounting and identifies the interface of the Balance of Payments to NIPA. In Chapter 7 we distinguish real growth from inflation and lay out the procedures for deriving real values from nominal values.

BACK TO CONTENTS

 

CHAPTER 7. NOMINAL AND REAL VALUES

Business firm managers need to learn as much a possible about changing conditions in the macroeconomic environments within which they operate. Fortunately, governments of most countries compile macroeconomic data on their economies following conventions established by the United Nations and presented annually in the United Nations Statistical Yearbook[1]. This chapter describes procedures for converting the data found in the U.N. Statistical Yearbook and the U.S. National Income and Product Accounts into “real” values that are compatible with Keynesian macroeconomic theory.

 

Nominal and Real

One of the most important uses of National Income and Product Accounts data is to examine changes in the level of well being of an economy over time. A problem of assessment is that observed changes in the level of any NIPA aggregate may be attributable to real phenomena or to changes in the general level of prices in the economy. One who is concerned with the real aspects of the growth or contraction of an economy would like to have the effects of price level changes removed from the data. By the same token, one who is concerned with the effects of inflation or deflation would like to have the effects changes of real causes removed from the data.

The NIPA of any country whose procedures conform to United Nations conventions are nominal values, which means that they are compiled from original sources (mostly tax reports) denominated in currency units (dollars in the U.S.) of the current purchasing power at the time of compilation. A time series of any NIPA aggregate exhibits the joint effects of both real changes (e.g., changes of real output) and price level changes. The need to separate out the real from the price-level effects has led to the development of statistical devices and approaches which can be used to remove the unwanted effects from a sequential nominal-value data series.

A “real value” is a nominal value from which the effects of price level change (inflation or deflation) have been removed. If the descriptive adjective "real" does not precede an NIPA aggregate, e.g., Gross Domestic Product, then the aggregate should be understood to be a nominal value. Once the effects of inflation (or deflation) have been removed from an aggregate data series, it may be referred to as a "real" value series, e.g., "real Gross Domestic Product.” Column (1) of Table 7-1 contains nominal Gross Domestic Product data for the U.S. economy spanning the years from 1929 through 2009. Column (5) shows the corresponding real values derived using techniques described in the next section. Columns (1') and (5') show the computed annual growth rates of the nominal and real Gross Domestic Products, respectively.

Notations of the behaviors of prices of specific commodities appear in ancient writings. Recognition of changes in the general level of prices seems to correspond to the emergence of the nation state in the fifteenth and subsequent centuries. The influx of precious metals into Western Europe during the Mercantilist era caused widely observed price inflation. Wars often have been accompanied by general inflations. The American Revolutionary War, the War of 1812, and the Civil War all resulted in well-documented increases in the general level of prices. Fortuitous discoveries of precious metals in California in 1849, in Colorado in the 1880s, and in the Yukon in the 1890s caused sharp inflations. Episodes of price deflation have been observed in conjunction with general collapses of economic activity, particularly during the 1870s and the 1930s.

Reliable price data series began to appear during the eighteenth and nineteenth centuries, and the concept of a price index had emerged by the middle of the nineteenth century. The macrohistory data base maintained by the National Bureau of Economic Research contains a wholesale price index compiled in Germany beginning with 1851.[3]  Prior to the

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Table 7-1.  Current GDP, GDP Deflated by CPI, and Chained GDP, 1929-2009.

         Nominal GDP.....  CPI 1982-84................. GDP deflated by    GDP   Chained GDP (1996)...........
         Current  Annual   index infla-  index  base    1982-84 CPI....   1996           implied..............
         dollars  Growth  '82-84  tion   /100   1996    dollars  growth  dollars dollars growth  defla- infla-
          (bill)   Rate    =100   rate                   (bill)   rate   (bill)  (bill)   rate    tor    tion
                                      (2)/100 (3)/1.569 (1)/(3)         (1)/(4)                 (1)/(7)  rate
 
            (1)    (1')     (2)   (2')    (3)    (4)      (5)    (5')      (6)      (7)    (7')    (8)   (8')
 
1929...    103.7           17.1          .171   .109    606.43           951.4    822.2          .1261                                                                                            
 
1930...     91.3  -11.96   16.7  -2.34   .167   .106    546.71  -9.85    861.3    751.5   -8.59  .1215  -3.65                                                                           
1931...     76.6  -16.10   15.2  -8.98   .152   .097    503.94  -7.82    791.8    703.6   -6.37  .1089 -10.37                                                                                 
1932...     58.8  -23.22   13.7  -9.86   .137   .087    429.20 -14.83    675.9    611.8  -13.04  .0961 -11.85                                                                            
1933...     56.4   -4.08   13.0  -5.11   .130   .083    433.85   1.08    679.5    603.3   -1.38  .0935  -2.71                                                                            
1934...     66.0   17.02   13.4   3.08   .134   .085    492.54  13.53    776.5    668.3   10.77  .0987   5.56                                                                           
 
1935...     73.3   11.06   13.7   2.24   .137   .087    535.04   8.63    842.5    728.3    8.98  .1006   1.93                                                                           
1936...     83.7   14.19   13.9   1.46   .139   .089    602.16  12.54    940.5    822.5   12.93  .1017   1.09                                                                            
1937...     91.9    9.79   14.4   3.59   .144   .092    638.19   5.98    998.9    865.8    5.26  .1061   4.33                                                                           
1938...     86.1   -6.31   14.1  -2.08   .141   .090    610.64  -4.32    956.7    835.6   -3.49  .1030  -2.92                                                                           
1939...     92.0    6.85   13.9  -1.42   .139   .089    661.87   8.39  1,033.7    903.5    8.13  .1018  -1.17                                                                           
 
1940...    101.3   10.11   14.0   0.72   .140   .089    723.57   9.32  1,138.2    980.7    8.54  .1033   1.46                                                                            
1941...    126.7   25.07   14.7   5.00   .147   .094    861.90  19.12  1,347.9  1,148.8   17.14  .1103   6.78                                                                           
1942...    161.8   27.70   16.3  10.88   .163   .104    992.64  15.17  1,555.8  1,360.0   18.38  .1190   7.89                                                                           
1943...    198.4   22.62   17.3   6.13   .173   .110  1,146.82  15.53  1,803.6  1,583.7   16.45  .1253   5.29                                                                            
1944...    219.7   10.74   17.6   1.73   .176   .112  1,248.30   8.85  1,961.6  1,714.1    8.23  .1282   2.31                                                                            
 
1945...    223.0    1.50   18.0   2.27   .180   .115  1,238.89  -0.75  1,939.1  1,693.3   -1.21  .1317   2.73                                                                           
1946...    222.3   -0.31   19.5   8.33   .195   .124  1,140.00  -7.98  1,792.7  1,505.5  -11.09  .1477  12.15                                                                           
1947...    244.4    9.94   22.3  14.36   .223   .142  1,095.96  -3.86  1,721.1  1,495.1   -0.68  .1635  10.70                                                                            
1948...    269.6   10.31   24.1   8.07   .241   .154  1,118.67   2.07  1,750.6  1,560.0    4.34  .1728   5.69                                                                           
1949...    267.7   -0.70   23.8  -1.24   .238   .152  1,124.79   0.55  1,761.2  1,550.9   -0.58  .1726   0.01                                                                           
 
1950...    294.3    9.94   24.1   1.26   .241   .154  1,221.16   8.57  1,911.0  1,686.6    8.75  .1745   1.10                                                                           
1951...    339.5   15.36   26.0   7.88   .260   .166  1,305.77   6.93  2,045.2  1,815.1    7.62  .1870   7.16                                                                            
1952...    358.6    5.63   26.5   1.92   .265   .169  1,353.21   3.63  2,121.9  1,887.3    3.98  .1900   1.60                                                                           
1953...    379.9    5.94   26.7   0.75   .267   .170  1,422.85   5.15  2,234.7  1,973.9    4.59  .1925   1.32                                                                           
1954...    381.1    0.32   26.9   0.75   .269   .171  1,416.73  -0.43  2,228.7  1,960.5   -0.68  .1944   0.99                                                                            
 
1955...    415.2    8.95   26.8  -0.37   .268   .171  1,549.25   9.35  2,428.1  2,099.5    7.09  .1978   1.75                                                      
1956...    438.0    5.49   27.2   1.49   .272   .173  1,610.29   3.94  2,531.8  2,141.1    1.98  .2046   3.44                                                                           
1957...    461.5    5.37   28.1   3.31   .281   .179  1,642.35   1.99  2,578.2  2,183.9    2.00  .2113   3.27                                                                        
1958...    467.9    1.39   28.9   2.85   .289   .184  1,619.03  -1.42  2,542.9  2,162.8   -0.97  .2163   2.37                                                                            
1959...    507.4    8.44   29.1   0.69   .291   .185  1,743.64   7.70  2,742.7  2,319.0    7.22  .2188   1.16                                                                           
 
1960...    527.4    3.94   29.6   1.72   .296   .189  1,781.76   2.19  2,790.5  2,376.7    2.49  .2219   1.42                                                                           
1961...    545.7    3.47   29.9   1.01   .299   .191  1,825.08   2.43  2,857.1  2,432.0    2.33  .2244   1.13                                                                            
1962...    586.5    7.48   30.2   1.00   .302   .192  1,942.05   6.41  3,054.7  2,578.9    6.04  .2274   1.34                                                                            
1963...    618.7    5.49   30.6   1.32   .306   .195  2,021.90   4.11  3,172.8  2,690.4    4.32  .2300   1.14                                                                           
1964...    664.4    7.39   31.0   1.31   .310   .198  2,143.23   6.00  3,355.6  2,846.5    5.80  .2334   1.48                                                                            
 
1965...    720.1    8.38   31.5   1.61   .315   .201  2,286.03   6.66  3,582.6  3,028.5    6.39  .2378   1.89                                                                            
1966...    789.3    9.61   32.4   2.86   .324   .207  2,436.11   6.57  3,813.0  3,227.5    6.57  .2446   2.86                                                                           
1967...    834.1    5.68   33.4   3.09   .334   .213  2,497.31   2.51  3,916.0  3,308.3    2.50  .2521   3.07                                                                           
1968...    911.5    9.28   34.8   4.19   .348   .222  2,619.25   4.99  4,105.6  3,466.1    4.77  .2629   4.28                                                                           
1969...    985.3    8.10   36.4   4.60   .364   .232  2,706.87   3.35  4,247.0  3,571.4    3.04  .2759   4.94                                                                            
 
1970...  1,039.7    5.52   38.8   6.59   .388   .247  2,679.64  -1.00  4,209.3  3,578.0    0.18  .2906   5.33                                                                           
1971...  1,128.6    8.55   40.5   4.38   .405   .258  2,786.67   3.99  4,374.4  3,697.7    3.35  .3052   5.02                                                                           
1972...  1,240.4    9.91   41.8   3.21   .418   .266  2,967.46   6.49  4,663.2  3,898.4    5.43  .3182   4.26                                                                           
1973...  1,385.5   11.70   44.4   6.22   .444   .283  3,120.50   5.16  4,895.8  4,123.4    5.77  .3360   5.59                                                                            
1974...  1,501.0    8.34   49.3  11.04   .493   .314  3,044.62  -2.43  4,780.3  4,099.0   -0.59  .3662   8.99                                                                           
 
1975...  1,635.2    8.94   53.8   9.13   .538   .343  3,039.41  -0.17  4,767.3  4,084.4   -0.36  .4004   9.34                                                                           
1976...  1,823.9   11.54   56.9   5.76   .569   .363  3,205.45   5.46  5,024.5  4,311.7    5.56  .4230   5.64                                                                            
1977...  2,031.4   11.38   60.6   6.50   .606   .386  3,352.15   4.58  5,262.7  4,511.8    4.64  .4502   6.43                                                                           
1978...  2,295.9   13.02   65.2   7.59   .652   .416  3,521.32   5.05  5,519.0  4,760.6    5.51  .4823   7.13                                                                           
1979...  2,566.4   11.78   72.6  11.35   .726   .463  3,534.99   0.39  5,543.0  4,912.1    3.18  .5225   8.34                                                                           
 
1980...  2,795.6    8.93   82.4  13.50   .824   .525  3,392.72  -4.02  5,325.0  4,900.9   -0.23  .5704   9.17                                                                            
1981...  3,131.3   12.00   90.9  10.32   .909   .579  3,444.77   1.53  5,408.1  5,021.0    2.45  .6236   9.33                                                                           
1982...  3,259.2    4.08   96.5   6.16   .965   .615  3,377.41  -1.96  5,299.5  4,919.3   -2.03  .6625   6.24                                                                           
1983...  3,534.9    8.46   99.6   3.21   .996   .635  3,549.10   5.08  5,566.8  5,132.3    4.33  .6888   3.97                                                                           
1984...  3,932.7   11.25  103.9   4.32  1.039   .662  3,785.08   6.65  5,940.6  5,505.2    7.27  .7144   3.72                                                                            
 
1985...  4,213.0    7.13  107.6   3.56  1.076   .686  3,915.43   3.44  6,141.4  5,717.1    3.85  .7369   3.15                                                                           
1986...  4,452.9    5.69  109.6   1.86  1.096   .699  4,062.86   3.76  6,370.4  5,912.4    3.42  .7531   2.20                                                                           
1987...  4,742.5    6.50  113.6   3.65  1.136   .724  4,174.74   2.75  6,550.4  6,113.3    3.40  .7758   3.01                                                                            
1988...  5,108.3    7.71  118.3   4.14  1.183   .754  4,318.09   3.43  6,775.0  6,368.4    4.17  .8021   3.39                                                                           
1989...  5,489.1    7.45  124.0   4.82  1.240   .790  4,426.69   2.52  6,948.2  6,591.8    3.51  .8327   3.81                                                                           
 
1990...  5,803.2    5.72  130.7   5.40  1.307   .833  4,440.09   0.30  6,966.6  6,707.9    1.76  .8651   3.89                                                                           
1991...  5,986.2    3.15  136.2   4.21  1.362   .868  4,395.15  -1.01  6,896.5  6,676.4   -0.47  .8966   3.64                                                                            
1992...  6,318.9    5.57  140.3   3.01  1.403   .894  4,503.85   2.47  7,068.1  6,880.0    3.05  .9184   2.43                                                                           
1993...  6,642.3    5.12  144.5   2.99  1.445   .921  4,596.75   2.06  7,212.1  7,062.6    2.65  .9405   2.41                                                                           
1994...  7,054.3    6.20  148.2   2.56  1.482   .945  4,759.99   3.55  7,464.9  7,347.7    4.04  .9600   2.07                                                                           
 
1995...  7,400.5    4.91  152.4   2.83  1.524   .971  4,855.97   2.02  7,621.5  7,543.8    2.71  .9810   2.19                                                                         
1996...  7,813.2    5.58  156.9   2.95  1.569  1.000  4,979.73   2.55  7,813.2  7,813.2    3.57 1.0000   1.94                                                                        
1997...  8,318.4    6.47  160.5   2.29  1.605  1.023  5,182.80   4.08  8,131.3  8,159.5    4.43 1.0195   1.95
1998...  8,790.2    5.67  163.0   1.56  1.630  1.039  5,392.76   4.05  8,460.3  8,508.9    4.37 1.0322   1.25
1999...  9,299.2    5.79  166.6   2.21  1.666  1.062  5,581.75   3.50  8,756.3  8,859.0    4.23 1.0477   1.50
 
2000...  9,817      5.57  172.2   3.36  1.722  1.098  5,700.93   2.14  8,940.8  9,194.4    3.79 1.0678   1.92
2001... 10,128      3.17  177.1   2.85  1.771  1.129  5,718.80   0.32  8,970.8  9,214.5    0.22 1.0991   2.93
2002... 10,470      3.38  179.9   1.58  1.799  1.147  5,819.90   1.77  9,128.2  9,439.9    2.44 1.1091   0.91
2003... 10,961      4.69  184.0   2.28  1.840  1.173  5,957.07   2.35  9,344.4  9,675.6    2.50 1.1328   2.14
2004... 11,868      8.27  188.9   2.66  1.889  1.204  6,282.69   5.47  9,857.1 10,021.2    3.57 1.1843   4.54
2005... 12,638      6.49  195.3   3.39  1.953  1.245  6,471.07   2.99 10,151.0 10,326.8    3.05 1.2238   3.34
2006... 13,399      6.02  201.6   3.23  2.016  1.285  6,646.33   2.70 10,427.2 10,603.0    2.67 1.2637   3.26
2007... 14,078      5.07  207.3   2.83  2.073  1.321  6,791.12   4.89 10,657.1 10,830.2    2.14 1.2999   2.86
2008... 14,441      2.58  215.3   3.86  2.153  1.372  6,707.39  -1.24 10,525.5 10,877.6    0.44 1.3276   2.13
2009... 14,256     -1.28  214.5  -0.04  2.145  1.367  6,646.15  -0.90 10,428.7 10,612.0   -2.44 1.3434   1.03
 
Mean rates:
   1930-2009        4.91          3.30                           3.17                      3.34          3.07
   1950-2009        5.91          3.78                           3.03                      3.24          3.50
   1980-2009        6.76          3.72                           2.24                      2.63          3.21
   1990-2009        6.50          2.80                           2.20                      2.41          2.42
   2000-2009        4.40          2.60                           2.05                      1.84          2.51        
 
Sources:  Bureau of Labor Statistics, CPI 1982-84=100, 1913-2000; Bureau of Economic Analysis, National Income and Product Accounts, Gross Domestic Product, Current and Chained (1996) Dollars, 1929-2009.

---

twentieth century, it had become well recognized that inflation has the effect of diminishing the purchasing power of the unit of the currency. By the end of the twentieth century, government agencies in many countries were compiling a variety of price index series, typically including those for consumer prices and producer prices.

 

Fixed-Weight Price Indexes

The statistical device which historically has been most commonly employed in the removal of the effects of price level change from a nominal value data series is the price index. A price index is an expression of the price of an item or a collection of items in one period as a proportion of the price of the same item or collection in another period. Correspondingly, a quantity index is an expression of the quantity of an item or a collection of items in one period as a proportion of the quantity of the same item or collection in another period. The "other" period is usually referred to as the base period. An index series is a list of consecutive price or quantity indexes (or indices). The base period for the index series may be for the first item in the series, the last item, or any one of the other items in the series.

The base period for U.S. Consumer Price Index series computations has been changed a number of times. Column (2) of Table 7-1 shows Consumer Price Index numbers based upon the three-year period 1982-84. Over this period, the average of the three Consumer Price Indexes is approximately 100. This is true of the value of any index for its base period. The fact that Consumer Price Index numbers for years later than 1984 increase monotonically and are all numbers greater than 100 means that inflation has ensued continually since 1984. The Consumer Price Index for 1995, 152.4, may be interpreted in either of two ways. Prices on average in 1995 were 152.4 percent of prices in the three-year base period 1982-84, or 1995 prices were 52.4 percent higher than were prices in the base period.

Until the 1990s, virtually all price and quantity indexes were compiled as fixed-weight indexes. More recently, variable-weight price indexes, described below, have been employed in more developed countries. A fixed-weight index is one in which the weighting factors applied to the prices are not changed for an extended period of time. In the U.S., both the Producer Price Index and the Consumer Price Index are examples of a fixed-weight price index. Column (2) of Table 7-1 contains the Consumer Price Index series for the U.S. from 1929 through 2009.[2]

The selected collection of items, often referred to as a "market basket,” is usually representative of those purchased toward the beginning of the series being compiled. A problem is that the initial collection of items may become progressively less representative as preferences and technology change over the time for which the series is being compiled. Since most compiled index number series are open-ended at the leading edge, this problem becomes ever more critical as the series is lengthened. Changing the contents of the representative collection may make index numbers computed for later periods not comparable to index numbers computed for earlier periods in the series or the base period. However, if the representative collection content is not changed, the index numbers added at the end of the series will become ever less meaningful. It may thus be necessary to make occasional content changes with the provision that they are clearly identified to users of the index series. The U.S. Consumer Price Index has been revised in 1940, 1953, 1964, 1978, 1987, and 1998. In a strict sense, only Consumer Price Index numbers for years during a revision interval, e.g., 1940 through 1952, are comparable to one another. Similar statements may be made with respect to the other revision intervals.

The inflation rate between any two years may be computed as the difference between the Consumer Price Index numbers for the two years divided by the Consumer Price Index for the first year. The inflation   rate for the two consecutive years 1995 to 1996 is computed as               (156.9 - 152.4) / 152.4 = 0.0295, or 2.95 percent. The inflation rate over a longer time span, e.g., from 1989 to 1998, may be computed similarly as (163.0 - 124.0 ) / 124.0 = 0.3145, or 31.45 percent. Column (2') of Table 7-1 contains consecutive-year inflation rates computed from the Column (2) Consumer Price Index data.

All Consumer Price Index numbers for years prior to 1982 are less than 100, but this fact itself does not imply deflation. The fact that the Consumer Price Index series increases monotonically from 1939 forward (with two minor exceptions, 1949 and 1955) through to the end of the series in 1999 implies that inflation has been an almost continuous phenomenon in the U.S., albeit at varying rates, since 1939. Rates of inflation between years prior to the base year or spanning the base year may be computed as described above.

Deflation has been experienced during the span of the data shown in Table 7-1. The evidence is that Consumer Price Index numbers decreased from 1929 until 1933, again from 1937 until 1939, and in 1949 and 1955. The rate of inflation between 1930 and 1933 may be computed as (13.0 - 16.7) / 16.7 = -0.2846. Since the result is a negative number, it is a 28.46 percent rate of deflation.

 

Construction of a Fixed-Weight Price Index

The procedures for constructing a fixed-weight price index series may be outlined in rudimentary terms:

1. Select a base period to serve as the reference for compiling the series.

2. Choose an object group for the index series, e.g., consumers, producers, wholesalers, etc.

3. Choose a geographic region for which the index series is to be compiled.

4. Select a collection of items that are representative of those associated with the object group in the region.

5. For each period in the index series, price all goods in the selected collection.

6. Choose appropriate weights and multiply the prices times their respective weights.

7. For each period, total the weighted prices for all selected items.

8. For each period, divide each weighted price total by the base period weighted price total.

9. Multiply each period ratio by 100 to raise it to index number format.

The period for a price index conventionally is the year, although quarterly and monthly intervals are not uncommon for price indexes. There are no objective criteria for selecting a base period. In so far as possible, it is advisable to choose a period of relative normalcy. Periods in which there occur severe natural disasters, wars, or political upheavals within the region should be avoided. The selected base period may be at or near the beginning or the end of the series, or anywhere within the series. The base period may even be outside of the series which is being compiled, e.g., some convenient earlier time for which the necessary information is available.

Prices for all included items are acquired typically by conducting surveys of members of the relevant object group in the region. The prices taken from the surveys are then averaged for each item. Since the average prices may range from a few cents to many thousands of dollars, it is necessary to apply appropriate weights to the average prices. Quantities of the representative items transacted during the base period or during the period at the beginning of a revision interval are commonly used as weights. In a fixed-weight price index such as the Consumer Price Index, the weights at the beginning of a revision interval are used in the computation of all index numbers in the series until the next revision point. Changing the weights at the beginning of a revision interval is also a reason that index numbers computed for one revision interval are not strictly comparable to index numbers computed for a different revision interval.

Deflating the Nominal Data

On the presumption that inflation has been the dominant phenomenon affecting a nominal value GDP series, the process of computing Real Gross Domestic Product is usually described as "deflating the nominal value series" to correct for inflation. Had deflation been the dominant phenomenon, the process might have been called "inflating the nominal value series" to correct for deflation. Until the 1990s, real Gross Domestic Product values were derived most commonly by using the Consumer Price Index to deflate nominal Gross Domestic Product values. To illustrate the process and some of the associated problems, the values in Column (5) of Table 7-1 were derived by using the Consumer Price Index to deflate the nominal Gross Domestic Product data in Column (1). In preparation for accomplishing the deflation process, the Consumer Price Index numbers in Column (2) of Table 7-1 were divided by 100 to convert them to decimal equivalents for computational purposes. The decimal equivalents of the Consumer Price Index numbers are shown in Column (3) of Table 7-1. The process of deflating nominal Gross Domestic Product values was accomplished by dividing each number in Column (1) of Table 7-1 by the corresponding number in Column (3), and writing the quotient on the same row in Column (5). The numbers in Column (5) may be interpreted as "real Gross Domestic Product" in the sense that the deflation process has removed the effects of inflation (or deflation, which is negative inflation).

Since the early 1990s, a new Gross Domestic Product Deflator price index series has been introduced by the U.S. Bureau of Economic Analysis. The Gross Domestic Product Price Index series differs from the Consumer Price Index series in two significant respects. First, since the U.S. is an "open economy" for which international transactions are important, consumers purchase a broader variety of items than are produced within the U.S., and there are some items produced in the U.S. exclusively for export. The Gross Domestic Product Price Index includes a collection of market basket items which are more representative of the U.S. Gross Domestic Product than is the collection of market basket items included in constructing the Consumer Price Index. Second, as described below, the Gross Domestic Product Price Index is constructed as a "chain-type annual weights" price index.

We are now in position to distinguish the phenomenon of real output growth from the effects of inflation. The mean annual growth rate of nominal Gross Domestic Product spanning 1929-1999 is 6.91 percent. Part of this average increase is attributable to the changing price level. The mean annual Consumer Price Index inflation rate spanning the entire period is 3.78 percent. The mean real Gross Domestic Product (deflated by the Consumer Price Index) growth rate is only 3.38 percent. The sum of the mean Consumer Price Index inflation rate and the mean real Gross Domestic Product growth rate does not add precisely to the mean nominal Gross Domestic Product growth rate because of roundings. Even so, the process of deflating the nominal Gross Domestic Product data to derive real Gross Domestic Product has achieved separation of the real growth phenomenon from the inflation phenomenon. Mean inflation and growth rates for sub-spans of years are also shown at the bottom of Table 7-1. It appears that inflation has accounted for more than half of the growth of nominal Gross Domestic Product in all time spans represented in Table 7-1.

 

Problems with Fixed-Weight Price Indexes

Three problems with fixed-weight price indexes have been identified.

1. The item content of the market basket tends to get out of date over time as some formerly popular items become progressively less popular and may even drop from current usage. It is also true that with technological advances, new products come into use and become popular. The solution to this problem is to modify the item content of the price index market basket as needed. As noted above, the U.S. Bureau of Labor Statistics has in fact done this in regard to the U.S. Consumer Price Index in 1940, 1953, 1964, 1978, 1987, and 1998. The 1998 update adjusted the market basket item content to reflect purchasing patterns over the 1993-95 period, but the base period remained 1982-84.

2. A price index series that employs the fixed weights of the base period does not account for substitution effects. Rational consumer behavior is to shift purchases away from items with increasing prices and toward substitutes whose prices are stable, not increasing as fast, or decreasing. Since fixed weights do not change for periods subsequent to the base period, the index numbers computed with respect to the base period do not reflect substitution effects. As people purchase ever fewer of the items whose prices are increasing the fastest, the quantity weights should be decreased. The fact that they are not decreased in a fixed-weight index causes the effect of the price increases to be overstated. In 1996, the U.S. Congress established an Advisory Commission on the Consumer Price Index, chaired by economist Michael Boskin. The Commission concluded that changes in the Consumer Price Index may overstate the change in the cost of living by slightly more than one percentage point per year.

3. Unless deliberate attention is devoted to the problem, no price index will reflect changes in the quality, function, or performance of the items contained in the market basket.

 

Chain Type Annual Weights Price and Output Indexing

Because the Consumer Price Index likely overstates the actual rate of inflation, the U.S. Bureau of Economic Analysis has developed a new approach to constructing both price and quantity indexes.[4] The new BEA procedure in effect computes a two-element geometric moving average of consecutive year index pairs, each employing weights for the respective year. Using this approach, a moving-average index of real output can be computed employing price weights. Or, a moving-average index of prices can be computed employing quantity weights. In this approach, the year in which the moving-average weighting process was begun may be identified, but there is no unique "base period.” Also, it is not proper to speak of "real Gross Domestic Product" in so many billions of dollars of base-period purchasing power. The total rate of real output growth over a span of time can be computed by "chaining together" (i.e., adding up) the consecutive annual output rate increases. Likewise, the total rate of inflation over a span of time can be computed by "chaining together" the consecutive-year price rate increases.

Rather than first computing a price index and using it to deflate nominal Gross Domestic Product, beginning with data for 1996 the Bureau of Economic Analysis has constructed a direct measure of inflation-adjusted Gross Domestic Product using a geometric moving average of price-weighted quantities of items included for the index. The series has been constructed backward from 1996 as well. The portion of the series spanning 1929 through 1999, described by the Bureau of Economic Analysis as "Chained Gross Domestic Product (1996)" is shown as Column (7) in Table 7-1. The computed annual Chained Gross Domestic Product growth rates are shown in Column (7'). An "implicit Chained Gross Domestic Product deflator" series was computed as the ratio of nominal Gross Domestic Product numbers in Column (1) divided by the row-wise corresponding Chained Gross Domestic Product numbers in Column (7). The corresponding implied annual inflation rates were computed and are shown in Column (8').

 

The CPI as a Political Issue

Although a chain-type annual weights price index is thought to yield a more accurate measure of inflation, liberties were taken in Table 7-1 to use CPI to deflate nominal Gross Domestic Product in order to allow comparisons to be made between Real Gross Domestic Product (deflated by the Consumer Price Index) with Chained Gross Domestic Product. Two additional columns were also included to facilitate comparison. The “CPI/100” series in Column (3) was "translated" to a 1996 base by dividing each number in Column (3) by 1.569, the 1982-84 Consumer Price Index for 1996. The translated-base 1996 Consumer Price Index is shown in Column (4). This 1996-base Consumer Price Index was then used to compute Real Gross Domestic Product by dividing each number in Column (1) by its row-wise corresponding number in Column (4). The 1996-base deflated Gross Domestic Product numbers in Column (6) can be directly compared to the row-wise corresponding "Chained GDP (1996)" numbers in Column (7).

Some interesting observations may be made on the data in Columns (6) and (7). The Column (7) Chained Gross Domestic Product values are generally smaller in magnitude than the Column (6) Gross Domestic Product (deflated by the Consumer Price Index) values prior to 1996, and they increase faster. The 1996 values are of course identical. After 1996, the Chained Gross Domestic Product values are larger than the Consumer Price Index deflated values, and continue to increase at a faster rate. This phenomenon may be attributed to the fact that the Consumer Price Index has overstated the true rate of inflation, and hence understated the true rate of real growth.

The inflation rate misstatement phenomenon can further be illustrated by comparing Column (2') mean annual Consumer Price Index inflation rate, 3.39 percent for the entire series, to the Column (8') Chained Gross Domestic Product implicit deflator mean inflation rate of 3.15 percent for the entire series. The fact that the Consumer Price Index overstates the Chained Gross Domestic Product implicit deflator inflation rate confirms the findings of the Congressional Advisory Commission on the Consumer Price Index. Similar conclusions result from comparisons of means spanning the entire post-World War II era (1950-99), the most recent two decades (1980-1999), and the most recent decade (1990-1999).

As the Consumer Price Index overstates the inflation rate, it also understates the true real output growth rate. This can be seen in comparisons of the Consumer Price Index deflated Gross Domestic Product growth rates with the Chained Gross Domestic Product growth rates. The Column (5') mean annual Consumer Price Index deflated Gross Domestic Product growth rate spanning the entire period from 1929 to 1999 is 3.43 percent, compared to the Column (7') mean annual Chained Gross Domestic Product growth rate of 3.60 percent. It is clear that for the most recent two decades the Consumer Price Index used as deflator understates the real growth rate of the U.S. economy by more than 0.6 percentage point.

The relevance of the Consumer Price Index overstatement of the rate of inflation, and corresponding understatement of the rate of real growth, is due to the fact that so many public and private sector benefits and incomes are indexed to the Consumer Price Index. In the U.S. (and in most other countries as well), Social Security, government worker, and military retirement benefits are indexed to the Consumer Price Index. Many private pension program benefits also are indexed to the Consumer Price Index. It is not uncommon for "escalator clauses" to be included in multi-year labor contracts to provide for automatic increases in wages at the rate of the Consumer Price Index increase in the years between contract negotiations.

Particularly with respect to Social Security retirement benefits, this has become an intergenerational issue since most of the taxes that support the benefits are paid by younger members of the society who are still working, but most of the benefits are received by older members of society who are retirees. Since benefits are indexed to the Consumer Price Index and the Consumer Price Index overstates the true rate of inflation, the benefit receivers are gaining at the expense of the tax payers. Further complicating the political issue are estimates that the U.S. Social Security System will eventually become bankrupt as the benefit liabilities continue to increase at a faster rate than tax revenues increase.

There are only two ways to fix this problem, either to increase tax rates (on younger, working people) or to reduce or delay benefits (for the older, retired people). It should be no surprise that the American Association of Retired Persons, one of the most vigorous pressure groups in the U.S., is resistant to using the Gross Domestic Product Price Index in place of the Consumer Price Index or otherwise fixing the Consumer Price Index inflation-overstatement problem.

 

Hedonic Price Indexing

The productivity-enhancing wave of technological advances during the late-1990s has brought attention to the third problem with the Consumer Price Index noted above, i.e., the Consumer Price Index fails to account for improving quality, function, or performance of the goods and services produced in the economy. The solution has been to introduce so-called "hedonic price indexing" into the Gross Domestic Product Price Index.

The newly-introduced process of hedonic price indexing is controversial because the choice of characteristics and the price-decreasing value of them are highly subjective. Another problem is the presumption that this year's goods can be described in terms of the same characteristics as last year's goods. However, once the details of hedonic pricing have been settled and generally accepted internationally, the process promises to diminish the rate of measured price inflation to the extent that product price increases are offset by enhanced quality, function, and performance.

 

What's Ahead

Chapter 8 introduces the basic theory of macroeconomic causation on the presumption that only real values are relevant. Price level issues are reintroduced in Chapter 11.

 

Chapter 7 Endnotes:

[1] United Nations Statistical Yearbook, http://unstats.un.org/unsd/syb/.

[2] Detailed descriptions of these index series may be found at the PPI home page at address http://www.bls.gov/ppi/, the CPI home page at address http://www.bls.gov/cpi/, and in the Statistical Abstract of the United States: 1999 at address http://www.census.gov/prod/99pubs/99statab/sec15.pdf.

National Bureau of Economic Research, macrohistory data base, http://www.nber.org/databases/macrohistory/contents/chapter04.html.

[4] "Preview of the Comprehensive Revision of the National Income and Product Accounts: BEA's New Featured Measures of Output and Prices," Survey of Current Business, July 1995.

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PART C. MACROECONOMIC THEORY

 

 

CHAPTER 8. AGGREGATE EXPENDITURES

The exigencies of the so-called “Great Recession” beginning in 2008 have given economists pause to reconsider what they thought that they knew about the macroeconomy, and what they thought could be done to manage it.  Because macroeconomic relationships often diverge from those that macroeconomic theory leads us to expect, we must launch our exposition of macroeconomic theory with some degree of humility.  In this and following chapters, we will both lay out our theoretical understandings and try to identify the reasons that what we thought should be happening may in fact not turn out as expected.

Business decision makers need to have information about both the real and the price-related components of the macroeconomic data that they examine for their supply source and target markets. Chapter 7 distinguished real from nominal values and described the construction of price and output indexes. The objective in this chapter is to elaborate the basic features of the Keynesian macroeconomic model in which all values are presumed to be real.

The Keynesian model predates the Aggregate Demand-Aggregate Supply model that we will take up in Chapter 11. Although the Keynesian approach to macroeconomic policy has been much maligned during the Great Recession and its aftermath, the Keynesian macroeconomic model contains significant elements of truth that can be grafted onto the AD-AS model as we shall see in Chapter 11.

In both a circular flow sense and a national income sense, real income and real output are the same magnitudes since during each production period the income is generated in producing the output. It is then expended in purchasing the output during the next period, and the process is repeated period after period.

 

Aggregate Income and Expenditures

In the Keynesian conception, aggregate expenditure consists of the sum of consumption, investment, government purchases, and the net of imports less exports.  The rate of aggregate spending is dominated by its largest component, consumption spending, which increases as income increases, but at a slower rate than the increase of income.  Other components of aggregate spending that typically do not vary with the level of income (but may vary with other determinants) include business investment, government purchases, and net exports.  The rate of aggregate spending might diverge from the rate of consumption spending if a progressive income tax takes larger proportions of increasing incomes, if import spending increases along with income, and if private sector investment spending varies with the income level.

While income is the principal determinant of the level of consumption spending, non-income determinants include the price level and the interest rate.  In the Keynesian conception, non-income determinants of consumption spending are assumed constant until some endogenous or exogenous force causes them to change, or they are arbitrarily changed at the discretion of the analyst.  Both price level increases and interest rate increases tend to decrease consumption spending.

Keynesians assume that disposable income can be used for only two purposes, spending for consumption or saving, and these two possibilities exhaust disposable income. Keynes called the rate of spending relative to increments of disposable income the “marginal propensity to consume,” which for most consumers is less than 100 percent of any increment of their incomes.  The portion of an increase of disposable income not spent is saved, and the rate of saving relative to the increment of income Keynes called the “marginal propensity to save.”  Keynes took both the marginal propensity to consume and the marginal propensity to save to be constants, and complements to each other relative to 100 percent of disposable income increments.

Logic suggests that the marginal propensity to consume may not be perfectly constant. Since for most people as incomes rise it becomes progressively more difficult to spend additions to incomes on consumer goods, the marginal propensity to consume may tend to decrease as successively higher income levels are reached.

 

Income and Expenditure Dynamics

The Keynesian system may be perceived as a circular flow process that repeats from period to period.  The period is usually taken to be a calendar or fiscal year.

In the Keynesian conception, income and output in any period are by definition equivalent since income equal to the value of output is generated in producing the output.  Equilibrium in the Keynesian conception occurs when aggregate spending completely absorbs the output of the economy.  If aggregate spending falls short of output, the unsold output accumulates in inventories and motivates producers to cut back their rates of production in the next operating period.  If aggregate spending exceeds current output, inventory depletion motivates businesses to increase rates of output in order to replace inventory.

Because inventory accumulation in excess of desired levels is costly to firms, their managements might consider efforts to stimulate next-period sales by cutting prices (reducing list prices, offering discounts off list, or running sales). However, it is thought by Keynesian macroeconomists that prices tend to be relatively flexible upward, but fairly rigid downward. Downward price rigidity may be attributable to a reluctance of managers to lower prices, or to the durability of prices while published catalogs or menus are in effect.

If firm managements cannot or are not willing to reduce prices, they may have to reduce their rates of production by cutting back on the usage of material inputs and the employment of labor. Reduced labor usage can be accomplished by attrition (making no new hires as old workers quit, retire, or die), cutting back on the length of the work day (cutting out overtime or eliminating shifts), or laying off or firing workers. As more and more firms respond to the inventory pile-ups by cutting back on production rates and employment, the economy's output rate will adjust toward the equilibrium level again. We will survey possible explanations of such overexpansion in Chapter 11.

One might wonder how such a situation of inventory accumulation might have come about. A previous-period decrease of aggregate expenditure attributable to any of its components creates a disequilibrium characterized by inventory accumulation in the current period. As a general rule, any change of the rate of aggregate spending creates a disequilibrium situation and calls into operation an inventory adjustment processes.

Another important managerial implication follows from any excess of spending relative to output, manifested by inventory depletion. Firms experiencing falling inventories and rising order backlogs should increase production rates by employing more labor and increasing materials usage, and they may consider raising prices. Increased labor employment can be accomplished by calling back to work people who have been laid off, by extending the work day or work week with overtime or additional shifts, or by hiring additional workers. Such decisions should be based upon comparisons of expected increases of revenue from selling the additional product compared to the additional resource costs.

How might the economy have gotten to an output rate characterized by inventory depletion? A previous-period increase of aggregate expenditure creates an inventory depletion condition in the current period and calls into operation the inventory adjustment process. An increase of any of the components of aggregate spending may have caused it to increase.

 

What's Ahead

The next tasks are to detail various types of injections into and leakages from the income stream of a macroeconomy, and to delve into how changes of leakages and injections affect the macroeconomy.

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CHAPTER 9. LEAKAGES, INJECTIONS, AND MULTIPLIERS

Leakages and Injections

Keynesians identify several types of leakage from the income stream.  “Leakage” means that some part of the income generated during the period is not recycled back into the income stream in the next period.   Import spending, taxes paid, and saving after taxes constitute leakages from the income stream. The rate of leakage from the income stream is dominated by the rate of saving which is that portion of after-tax income that is not spent for current consumption.

Offsetting the leakages from the income stream are injections in the form of private sector investment, government purchases, and purchases of exports by foreigners. “Injection” means that new spending occurs in the current period that was not present in the previous period.  The total of these injection components usually is taken to be constant with respect to income because no one of the injection components is thought to be functionally related to the level of income to any significant degree.

 

Disequilibrium and Adjustment in the Keynesian System

The equilibrium rate of output occurs when the injection total just balances and offsets the leakage total.  Coincidentally, the equivalence of injections with leakages occurs at the same level of output for which aggregate expenditure fully absorbs current aggregate output. 

A macroeconomic disequilibrium occurs at any output level greater than the equilibrium level where the leakage total exceeds the injection total by the same amount that inventories are accumulating.  This occurs because even if the injection total is constant, the leakage total increases along with income by virtue of the fact that one of its components, saving, varies with the level of disposable income.  The excess of leakages over injections has the effect of dampening aggregate expenditure so that output falls back toward the equilibrium level. 

At any output level less than the equilibrium level, the injection total exceeds the leakage total by the same amount that inventories are depleting.  The excess of injections over leakages has the effect of stimulating aggregate demand so that output increases toward the equilibrium level.

Keynesians perceive that the combination of a leakage-injection imbalance with inventory accumulation or depletion (actually two sides of the same coin) constitutes a self-equilibrating process that is built into the macroeconomic system.  The occurrence of an inventory or leakage-injection imbalance returns the economy to its equilibrium state.

In the Keynesian conception, an increase or decrease of any aggregate demand, leakage, or injection component (consumption, business investment, government purchases, tax collections, exports, or imports) can create a disequilibrium situation.  The disequilibrium automatically invokes a self-adjustment process which, if the adjustment processes are not hindered or arrested by structural or external forces, can bring the economy back to its equilibrium state.

Keynes hypothesized that consumption spending is a fairly stable function of income and that it would not often increase or decrease by great magnitudes. Other components of aggregate expenditure, particularly investment and net exports, were thought by Keynes to be more volatile. Government purchases could also change, but at the discretion of government policy makers. Aggregate expenditure thus changes in the same direction and by the same amount as the change in any of these non-consumption components of aggregate expenditure.

 

Simple Multipliers

In the Keynesian macroeconomic model, a simple multiplier may be computed under the assumption that household saving is the only type of leakage from the income stream. A change of aggregate expenditure may be caused by a change of consumption, business investment spending, government purchases, or net export spending. Any change of aggregate expenditure can be expected to induce (via the inventory adjustment mechanism described above) a same-direction change of aggregate output that is larger in magnitude than the change of aggregate expenditure.

<>The ratio of the change of aggregate output to the initiating change of aggregate expenditure is the ex post or realized value of the simple expenditure multiplier. It is "ex post" because it is result (after the fact) of the equilibrating adjustment of the economy to the change of aggregate expenditure. It is sometimes said that the expenditure multiplier is a "double-edged sword" because it "cuts in both directions." This means than when aggregate expenditure increases, output increases by a larger amount. When aggregate expenditure decreases, output decreases by a larger amount.

Why does the value of the expenditure multiplier exceed unity (1)? This phenomenon occurs because of the process of respending throughout the economy. Keynes called the rate of additional spending consequent upon an increase of income the “marginal propensity to consume,” abbreviated “MPC.”  He called the tendency to increase saving when income increases the “marginal propensity to save,” abbreviated “MPS.” The MPC and MPS are complements to each other.  When there is an increase of spending in the economy, the initial recipient tends to respend the MPC proportion of the increase of spending if he or she is typical of all persons in the economy. For example, if a $100 increase of aggregate expenditure occurs when the MPC is 0.8 and MPS is 0.2, then respending would be $80 and saving would be $20.  This amount is received as income by a second party in the economy who likewise tends to increase spending by the MPC proportion of the increase in income, or $64.  This amount then is received as income by a third party who then spends the MPC proportion of it, or $51.20. As this process continues through the economy in infinite rounds of respending, the increments of spending decrease toward zero.  Since the successive respending amounts approach zero, the sum of them approaches a finite total which is a multiple of the original amount of additional spending. This simple multiplier can be predicted by computing the reciprocal of the MPS, 5 (i.e., 1 divided by 0.2).

Since this simple multiplier can be predicted in advance of the equilibrating adjustment process, we will refer to it as the ex ante or predicted value of the simple multiplier. The ex ante simple multiplier value of 5 in the above example implies that X dollar's worth of additional spending in the economy will lead to 5X dollars worth of additional output in the economy. If aggregate expenditure increases by $100, the respending process will eventually result through successive rounds of respending in $500 increase of output.  

Whether the ex post multiplier matches the ex ante multiplier depends on whether income recipients are typical of their society in spending the MPC proportions of their incomes during the respending process.  If along the way any income recipients choose to spend less than the typical MPC proportion of the increase of their incomes, the ex post respending total in the economy will fall short of the ex ante predicted total.  If along the way any income recipients choose to spend more than the typical MPC for the society, the ex post respending total may exceed the ex ante predicted total.

 

Effective Multipliers, Predicted and Realized

Actual multipliers are more complex than implied above. The ex ante effective multiplier for a macroeconomy can be predicted as the reciprocal of the sum of the historic leakage propensities in the economy. Propensities for leakages from the income stream include household saving, business saving (also known as "retained earnings" or "undistributed corporate profits"), paying taxes, and imports. If the household saving propensity is 0.05, the business saving propensity is 0.10, the tax rate is 0.15, and import purchases are 10 percent of disposable income, then the predicted ex ante value of the effective multiplier is 1 divided by 0.05 + 0.10 + 0.15 + 0.10, or 2.5. This is in fact close to the ex ante effective multiplier of the U.S. economy in the early twentieth-first century.

As in the case of the simple multiplier, there is potential for the realized or ex post effective multiplier to differ rather significantly from the predicted or ex ante effective multiplier. This may occur because individuals and businesses may change behavior relative to the historical marginal propensities that are typical of their society. For example, if people begin to spend greater proportions of increases of their incomes than their historic MPC average for the economy, the actual MPS will be smaller, and the ex post multiplier will become larger than the ex ante multiplier value predicted from historic information. The opposite would be true if people began to spend smaller proportions of increases of income than their historic MPC, causing the MPS to be larger than its historic average. Similarly, if businesses begin to distribute more of their profits after taxes in the form of dividends, business saving will decrease relative to the historic propensity, and the ex post value of the multiplier will be greater than the ex ante value computed from historic information. The opposite would occur if businesses should begin to retain more of their profit after taxes.

Imports into an economy must be paid for by exports of goods and services or capital assets such as stocks, bonds, or money balances. If the economy's imports increase or its exports decrease, the leakage from its income stream to foreign economies will increase. The net foreign leakage will decrease if imports decrease or exports increase. If these trends differ from historic propensities, this is yet another reason why an ex post multiplier value may diverge from an ex ante value computed from historic information.

Rising interest rates or rising prices during a period of economic expansion may also have the effect of snubbing or dampening the respending process, thereby diminishing the value of the ex post multiplier relative to an ex ante value computed from historic information.

 

What's Ahead

Our next task is to examine how the money market and the demand for investment affect the macroeconomy and the business firms operating in it.

 

BACK TO CONTENTS

 

 

CHAPTER 10. MONETARY THEORY AND INVESTMENT

Nominal and Real Interest Rates

A “nominal” interest rate is the rate of return on a financial instrument that is determined in the market for the instrument and is actually paid by the issuer of the financial instrument to the holder of the instrument.  A “real” interest rate is a nominal interest rate from which the inflation rate has been netted out by subtraction.  For example, if the nominal interest rate on a financial instrument is 6 percent at the same time that inflation is ensuing at the rate of 2 percent per annum, the real interest rate on the financial instrument is 4 percent. 

Economists often speak of “the” interest rate as if there is only one interest rate, but in reality there is a range of nominal interest rates that differ from one another due to risk differentials and the differing durations of the lives (terms) of financial instruments.  Typically, the lowest interest rate is that specified by the central bank on loans that it issues to commercial banks, but this may not always be the case.  In the U.S. the Federal Reserve’s so-called “discount rate” is an administered price in the sense that it is dictated by authority and does not vary with market conditions (we will reconsider this statement in Chapter 20). 

The Federal Funds Rate, typically slightly higher than the discount rate, is the rate that commercial banks charge when they lend excess reserves to other commercial banks on a short-term basis. It is a market-determined interest rate, although it often is the object of “management” (i.e., manipulation) by the Federal Reserve through its open market operations (the purchase and sale of government bonds). 

Above these two interest rates is the array of nominal interest rates on financial instruments that are linked to each other and the Federal Funds Rate through the process of arbitrage (the simultaneous purchase and sale of financial instruments to take advantage of interest rate differentials).  Because of arbitrage, when the Federal Reserve alters its discount rate or manipulates the Federal Funds Rate, market interest rates (nominal rates) on financial instruments usually move in the same direction.

When we speak of “market interest rates” on financial instruments we do not mean to imply that interest rates themselves are bid and offered in financial markets.  What is meant is that interest rates are the yield rates that are computed from information about the market prices of the financial instruments.  In a simple example, suppose that a bond that will be worth $100 at maturity a year from now can be purchased today for $94.  Its nominal yield is $6 and its rate of return (understood as its interest rate) is $6/$94, or 6.38 percent.  If the price of the bond is bid up on the market to $95 (due to an increase of the demand for the bond or a decrease of the supply of the bond), its nominal yield falls to $5, and its yield rate is $5/$95, or 5.26 percent.  This example reveals that yield rates on financial instruments vary inversely with their market prices, a truism that will be important to subsequent discussion.

 

The Demand for Money

<>Although economists no longer hold in high esteem Keynes' tripartite specification of motives for holding money balances (transactions, precautionary, and speculative), the modern theory of the demand for money does identify three important determinants, the real income level, the real interest rate, and the price level. 

Keynesian monetary theory is based upon the so-called “real” demand for money.  A representation of the real demand for money starts with the nominal demand (the actual amount of money that people wish to hold) and divides it by an index of the price level to eliminate the effects of inflation or deflation.  For example, if society currently is holding a nominal $400 billion of money when the inflation rate is 2 percent per annum (i.e., 1.02 relative to the previous period), the real demand for money is around $392 billion.

<>The real demand for money varies directly with the income level on the premise that at higher aggregate income levels, people will need to hold larger money balances to meet greater transactions requirements. It is thought to vary inversely with the real interest rate if people economize on their non-interest-bearing cash holdings when yield rates on financial instruments rise.

Money may be held in a variety of forms, including wallets and purses, bank accounts, cookie jars, mattresses, and cans buried in the back yard.  The propensity of a society to hold money in any of these and other places is determined by the society's payments conventions as well as its perceptions of need for liquidity. The less often people are paid, e.g., monthly rather than weekly, the greater are the amounts of money needed to meet transactions liquidity needs, and the larger the proportion of their period incomes that they will want to hold in cash balances.

Technological advances in computing and communications, such as the advent of automatic teller machines (ATMs), electronic funds transfers (ETFs), and credit and debit cards, may enable people to economize on their money holdings, and tend to diminish their need to hold money balances. Legislative changes which fundamentally change the definition of money (such as the Depository Institutions Deregulation and Monetary Control Act of 1980) can also have an effect on the society’s inclination to hold money balances.

If the society’s average income level increases or people feel compelled to hold more money as a proportion of their incomes, the quantity of money demanded will increase; it will decrease if the income level decreases or if people feel more comfortable holding smaller money balances.

Modern monetary theory predicates that the demand for money exhibits an inverse relationship relative to the real interest rate because of the opportunity cost of holding money which yields no interest income (or interest income which is less than available on other interest-bearing assets). The higher the interest rates (yields) on non-money assets, the greater the opportunity cost of holding low- or no-interest money balances, hence the smaller the quantity of such balances held. People are willing to hold larger money balances at lower interest rates on non-money assets because the opportunity cost is lower in terms of the interest income foregone.

 

The Money Supply

The quantity of money in circulation may be presumed to be determined by actions of the central bank when a monetary aggregate is taken to be the object of monetary policy. But the supply of money also may vary directly with the real interest rate due to aspects of commercial bank behavior that are not directly controllable by the central bank, and in the absence of which the money supply would be inelastic (i.e., non-responsive) with respect to the interest rate. One is the tendency of commercial banks to hold smaller excess reserves at higher interest rates because of the opportunity cost of foregone income since the reserves yield no interest income to banks, and they do not support additional lending. When commercial banks commit their excess reserves by issuing additional loans, money is created as a by-product, thus rendering the money supply interest elastic (i.e., responsive to the interest rate).

A second and perhaps more significant effect is that when market interest rates (e.g., the Federal Funds Rate) rise relative to the central bank's discount rate (i.e., the rate at which it lends to commercial banks), commercial banks tend to increase their borrowings of reserves from the central bank in order to support additional lending. Again, money creation is a by-product of the lending activity, and this also renders the supply of money interest elastic. We should also note that the central bank could make the money supply function appear to be perfectly elastic with respect to the interest rate by targeting a particular interest rate rather than a monetary aggregate. (The Federal Reserve has done this during the “Great Recession recovery period by taking the Federal Funds rate target to near zero.) 

Yet another reason that the money supply might vary directly with the real interest rate is that the public tends to economize on its cash holdings as interest rates rise on yield-bearing assets.  This leaves more reserves within the banking system that could support additional lending.

 

Equilibrium in the Money Market

Given a money supply that is basically determined by the central bank but which may exhibit some interest rate elasticity, there is only one interest rate that can equilibrate the demand for money with the supply of money.  Any other interest rate will be one of disequilibrium with an excess quantity demanded or supplied of money. At any interest rate above that equilibrium rate, the quantity supplied of money exceeds the quantity demanded to be held by the population. In the Keynesian view, people, in their efforts to rid themselves of the excess money balances, will buy other financial instruments (e.g., bonds), increasing the demands for them relative to their supplies, bidding their market prices upward and depressing their yield rates (i.e., their interest rates).

A falling interest rate in the market for any single financial instrument will be transmitted to markets for other financial instruments by arbitrage, i.e., the simultaneous purchase and sale of instruments in different markets. (This is the justification for speaking in subsequent discussion of “the” interest rate instead of an array of nominal interest rates.)  Thus, an interest rate above the equilibrium rate will continue to fall until it reaches the equilibrium rate, the rate at which people will be pleased to hold the supply of money in circulation.

Keynes did not recognize that people may also attempt to rid themselves of any excess money balances by purchasing consumer goods, increasing the demands for them relative to their supplies. If this happens, it will have the effect of increasing aggregate expenditure relative to aggregate output, depleting inventories, and thereby causing real output to increase.

Alternately, if the interest rate happens to be at some level below the equilibrium rate, the quantity of money demanded to be held by the society would be greater than the quantity supplied by the banking system. In their efforts to get more money to hold, people may sell other financial instruments, thereby increasing the supply of them coming onto their markets, depressing their prices, and increasing their yield rates (i.e., yield rates on financial instruments vary inversely with their market prices). These rising rates will be transmitted to other financial instrument markets via arbitrage, causing interest rates to continue to rise until the equilibrium level is reached. People may also attempt to get more money to hold by cutting back on their consumption expenditures relative to their income receipts; this will tend to lower aggregate expenditure relative to current aggregate output, causing inventory accumulation, and thereby decreasing real output.

 

Money Market Dynamics

We have thus far begged the question of why the interest rate might be above or below its equilibrium level. Such a situation occurs naturally as a result of an increase or decrease of money demand or money supply. For example, if the demand for money increases, the former equilibrium interest rate instantly becomes too low for money market equilibrium and sets in motion an adjustment process as described above. The principal reasons for money demand to increase are increases in real income or changes in income receipt patterns. The same disequilibrium situation would emerge consequent upon a decrease of the supply of money, which is most likely brought about by monetary policy actions. The opposite disequilibrium situation (where the interest rate is too high for equilibrium) would emerge if either the demand for money decreases or supply of money increases. The latter possibility constitutes the Keynesian basis for the exercise of monetary policy.

 

The Demand for Investment

In the Keynesian view, the business sector demand for investment spending exhibits an inverse relationship with the real interest rate. This inverse relationship reflects the fact that interest is a cost to the investor, irrespective of whether financing is from external sources (selling stock, issuing bonds, borrowing from banks) or internal sources (retained earnings, depreciation allowances).

Keynes referred to the investment demand schedule as the “marginal efficiency of investment,” and noted that it is likely to be a highly volatile relationship much influenced by the psychological expectations of private sector investors. If investment decision makers have confidence in the economy, investment demand will increase and tend to become more interest elastic. But if business confidence collapses, investment demand will decrease and become much more interest inelastic. This latter phenomenon is often suggested as an initiating factor in the great depression of the 1930s.

A rising interest rate (caused by an increase of money demand or a decrease of money supply) would induce business managers to cut back, cancel, or delay investment plans, thereby reducing the volume of investment spending from its previous level. A falling interest rate would reduce the cost of borrowing, thereby increasing the level of investment spending.

In completing our discussion of the demand for investment, we must note that the volume of investment spending is one of the components of aggregate expenditure as well as one of the injections included within the injections total. For example, when aggregate expenditure increases to cause the income level to rise, the demand for money increases, causing the interest rate to rise.  The rising interest rate decreases the volume of investment spending, which decreases the injections total relative to the leakage total, and elicits a decrease of the equilibrium level of income that offsets the earlier increase.

We should also note that in a dynamic world, equilibrium is a moving target, a condition that is ever pursued but perhaps never actually achieved.

 

What's Ahead

Our discussions of Keynesian theory in the past three chapters provide a platform for analysis of macroeconomic disruptions of the economy in subsequent chapters. Chapters 11 and 12 are devoted to consideration of how changes that are endogenous to the economy impact the management of the firm

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CHAPTER 11. AGGREGATE DEMAND AND SUPPLY

The Keynesian analysis elaborated in Chapters 8 through 10 can go a long way toward explaining macroeconomic phenomena, but it contains a serious deficiency. It is not convenient to analyze the causes or consequences of inflation or deflation since the price level is not incorporated explicitly in the analysis. In Keynesian theory, price level changes must be inferred from other relationships, and the consequences of price level changes can only be "talked into the analysis." This omission led during the 1960s to the development of another vehicle for macroeconomic analysis that some have taken to displace Keynesian analysis, but which actually complements it. This newer approach may be employed to examine the implications for the price level in a normally operating and growing economy.

The newer approach, known as AD-AS analysis, employs different descriptors of macroeconomic aggregates to relate them to the price level rather than to the income level, and to distinguish them from Keynesian concepts.  This analysis depicts the economy's aggregate demand, its long-run aggregate supply, and its short-run aggregate supply relative to the price level (actually an index of the price level such as the Consumer Price Index).

The conventional notion is that for a market-driven economy like that of the United States, a normal operating capacity is achieved when its installed plant and equipment are operating at about 80 to 85 percent of rated capacity, and unemployment is no more than 5 or 6 percent of the labor force. This is the irreducible amount of unemployment attributable to structural changes and frictions of adjustment in a dynamic market economy such as that of the early-twenty-first century United States.

 

Aggregate Supply

It may appear to be a contradiction in terms, but in its short-run manifestation, the long-run aggregate supply is fixed and perfectly inelastic (i.e., not responsive) with respect to the price level at the economy’s normal operating capacity.

In the AD-AS conception, the long-run real productive capacity of an economy does not vary with respect to changes of the price level, a nominal amount, but it may vary with long-run changes of real phenomena, i.e., real matters such as resource availability, productivity, and technological changes. The long run changes of these real phenomena may be perceived in the short-run analysis as discrete increases of real productive capacity with on-going growth, or as decreases of productive capacity consequent upon supply-shocks that may have lasting adverse effects on the economy's output capacity.

The AD-AS analysis acknowledges the possibility of a short-run relationship between real output and the price level. Short-run aggregate supply may be coincident with long-run aggregate supply if input price changes match the pace of output price changes. But short-run aggregate supply may diverge from long-run aggregate supply and attain some degree of positive elasticity with respect to the price level if input prices adjust more slowly than do output prices.

 Although the normal operating capacity of the economy can be exceeded temporarily, it is likely that short-run aggregate supply becomes ever more inelastic with respect to the price level the farther the economy attempts to operate above its normal capacity. Also, short-run aggregate supply may become quite elastic with respect to price if managers become resistant to cutting prices or if published price lists must be honored until new catalogs or menus can be printed.

In The General Theory of Employment, Interest, and Money, Keynes asserted that both wages and prices tend to behave asymmetrically, i.e., they freely rise in response increases of demand or decreases of supply, but they are "sticky" in the downward direction when demand decreases or supply increases. Keynes focused upon the monopoly power exerted by big business enterprises and labor unions as his explanations of downward stickiness of both prices and wages.

A more recent hypothesized reason for downward wage stickiness is that in some industries there appears to be an implicit contract (or at least an understanding) between management and labor to the effect that managements will not do anything overtly to cause deterioration of the purchasing power and working conditions of their labor forces. Multi-year contracts may limit the adjustability of prices or wages in some industries. Prices may be sticky in either direction because of the costs and seldomness of reprinting menus, price lists, and catalogs. Whatever the cause, to the extent that wages and prices are more inflexible in the downward direction than in the upward direction, short-run aggregate supply may tend to be more elastic (i.e., responsive) for price level changes below the current level, but more inelastic (non-responsive) for price level changes above the current level.

How do the paces of change of prices of final goods and productive inputs compare? An important concept here is that everybody's price is someone else's cost. Wages are a cost to business employers, but final goods prices figure into the costs of living of laborers. It is possible that wage rates and other input prices lag behind increases of final goods prices. This is likely because the majority of resource owners are thought to indulge in so-called default forecasting, i.e., the presumption that tomorrow will be much like today since today was a lot like yesterday. Some people may engage in adaptive forecasting when they adjust their forecasts of the near future by some proportion of their recent-past errors in forecasting the present. Both default and adaptive forecasters tend to incur systematic forecast errors because they are slow to recognize and adjust to changes in the prices of final goods.

A consequence of these systematic forecast errors is that during a period of inflation, the wages of labor and the prices of non-labor inputs tend to rise more slowly than do final-goods prices. With input costs rising more slowly than output prices, the profit margins of producers increase and they attempt to hire more inputs in response. Because input owners may be slow to perceive the increases in their costs of living, they acquiesce in offering larger quantities of their inputs to the employers than they might if they were fully cognizant of the increases in their costs of living. The net effect is to cause a divergence between short-run aggregate supply and long-run aggregate supply. Because of the slowness of response of input owners relative to output producers in adjusting their respective prices, short-run aggregate supply attains some degree of elasticity with respect to the price level, even though long-run aggregate supply remains inelastic with respect to price at the long-run natural rate of real output.

Economists have theorized that if the world were populated exclusively by people who form expectations rationally, there would be no divergence of short-run aggregate supply from long-run aggregate supply. But in the imperfect world in which we live, only the few people who form expectations rationally are able to adjust their prices apace with producer prices. It is likely that only a small proportion of any population forms expectations rationally, primarily because only a few possess the requisite intelligence, knowledge, and perceptiveness. Those who do possess these requisites attempt to use all available information in forming expectations of future states. Their forecasts tend to be more accurate and timely than are default and adaptive forecasts, and forecast errors tend to be random (rather than systematic).

To the extent that their forecasts are more accurate, rational expectations decision makers can protect themselves from negative events or take advantage of entrepreneurial opportunities. In so doing, they tend to adjust their own prices apace with the prices of final goods. For rational expectations decision makers, the short-run aggregate supply would be perfectly inelastic (i.e., non-responsive) with respect to the price level and coincident with the long-run aggregate supply. Even so, to the extent that other members of the population indulge in default and adaptive forecasting behavior, short-run aggregate supply diverges from long-run aggregate supply to attain some positive degree of elasticity above the current price level.

Short-run aggregate supply probably experiences changes in price level elasticity over time. If inflation has not been a problem recently and is not expected in the near future, when it does occur the short-run aggregate supply may become quite price elastic. This is the same as to say that the majority of the population is surprised by the rising prices. But as inflation becomes an on-going problem which is recognized and expected by even those who form expectations adaptively or by default, short-run aggregate supply likely will become ever more inelastic with respect to the price level and converge upon long-run aggregate supply. We might also hypothesize that if more people were to begin to form expectations rationally, short-run aggregate supply would become more inelastic with respect to the price level and eventually converge upon long-run aggregate supply.

 

Aggregate Demand

If we were to graph it, aggregate demand would appear to be similar to a microeconomic demand curve (i.e., downward sloping left-to-right, with respect to price on the vertical axis). However, while it is possible to aggregate individual consumer demands for a particular item into a market demand curve or a demand curve faced by a single seller of the item, it is not feasible to extend the aggregation process to the whole economy because of the so-called "adding-up" problem. In such an aggregation it would be necessary to add unlike units of different goods. Therefore, aggregate demand must be perceived with respect to the general price level (actually, an index of it) rather than the price of any single good or service.

Given our experience with inflation and deflation, we should approach aggregate demand from the perspective of price level increases rather than price level decreases. This is because we have had so very little experience with price deflation in recent decades. From the "Great Depression" forward our experience mostly has been with price inflation.

There are several possible reasons for the negative price-level elasticity of aggregate demand. One is the so-called “real wealth effect,” i.e., at higher price levels people tend to feel a sense of impoverishment since their real wealth has less purchasing power; vice versa, if price levels were to fall, they might feel more affluent due to the fact that their real wealth has greater purchasing power. People probably adjust their purchases with respect to these feelings of affluence and impoverishment.

Another reason to focus the discussion of aggregate demand on price level increases lies in the Fisher effect, the tendency for nominal interest rates to rise as prices rise in order to compensate lenders for the loss of purchasing power that they would experience over the term of the loans which they extend to borrowers. Interest sensitive purchases (e.g., houses, automobiles) tend to vary inversely with interest rates, so the aggregate demand for the economy's output tends to diminish with higher prices and consequently higher nominal interest rates.

Yet another reason to consider aggregate demand with respect to price level increases lies in the trade balance effect, the likelihood that at higher domestic prices relative to foreign prices, exports of goods produced in the country will decrease at the same time that imports of foreign goods increase.

 

Aggregate Demand and Supply Dynamics

In the long run, the economy's normal operating capacity tends to increase with economic growth, i.e., as population grows and productivity increases with technological advance and capital investment. Recent experience in Western market economies indicates that the normal operating capacity increases on average between 2 and 3 percent per annum, but varies significantly with cyclical or irregular macroeconomic fluctuations that increase or decrease long-run aggregate supply.  Long-run aggregate supply also increases as the normal operating capacity increases, carrying with it the short-run aggregate supply relationship to the price level.

Economists known as “supply-siders” have hypothesized that the pace of increase of long-run aggregate supply in the United States may have been retarded in the post World War II period due to the disincentive effect of progressive taxation and the costs to the business community of governmental regulation. Some supply-siders have even suggested the possibility that both long-run and short-run aggregate supply have actually decreased at an almost imperceptible pace in response to these forces. But we should recall that short-run aggregate supply may also change in response to supply shocks and changing perceptions of costs by producers when inflation or deflation occurs.

Both the output level and the price level of the economy tend to change in response to changes of the aggregate demand and aggregate supply curves. Similar to the Keynesian conclusion concerning a decrease of aggregate expenditure relative to aggregate output, either a decrease of aggregate demand or an increase of short-run aggregate supply can result in an excess of output relative to demand at the current price level, with the consequence of inventory accumulation. Businesses incur both explicit and implicit costs when inventories accumulate above planned or intended levels. The explicit costs result from the additional storage and security facilities required to contain the additional stocks. The implicit costs are the opportunity costs of the firm's working capital which is tied up in inventory and thus not available to meet other expenses (payroll, energy bills, etc.) until inventory can be disposed of. The effort by firms to "move" the accumulating stocks will tend to put downward pressure upon prices which may be manifested in reduced list prices, increased discounts off of list prices, or sales.

 

Increases of Aggregate Demand and Aggregate Supply

Aggregate Supply Increases. If an increase of long-run aggregate supply is attributable to a growth phenomenon, then the normal operating capacity of the economy will increase and with it the short-run aggregate supply. The macroeconomic adjustment to the increase of short-run aggregate supply relative to aggregate demand is a decline of the price level which elicits an increase of the quantity of output demanded. The managerial implications of an increase of long-run aggregate supply are clear: productive capacity can be expanded and output increased, although prices may have to be lowered.

Aggregate Demand Increases. An increase of aggregate demand relative to normal operating capacity (and long-run aggregate supply) can be expected to increase the price level, produce an excess of quantity demanded relative to output at the current price level, and result in inventory depletion. If inventories have become swollen in the past, the depletion may be desirable and occasions no immediate response. However, eventually firms must respond to the depleting inventories or "stock-out" and be “out of business” in those items.

One way to adjust to an inventory draw-down is to take the occasion of the strong market to raise prices, although in many cases it may not be possible to implement desired price increases until new menus or catalogs can be distributed. Another means of stemming the inventory depletion is to increase output rates by accelerating assembly processes and using more labor and material inputs. Increased labor usage can be accomplished by extending work hours with overtime, adding shifts, calling back to work employees who have been laid off, or hiring new employees. Temporarily increasing resource usage beyond the economy’s normal operating capacity may occur, but it is not sustainable in the long run unless the growth process increases the normal operating capacity of the economy.

If the normal operating capacity is exceeded by an increase of aggregate demand, “demand pull inflation” is likely to ensue because the availability of additional materials inputs is limited by supply bottlenecks which will eventually result in rising materials costs. Also, an output expansion likely will tighten the labor market and bid wage rates upward. When this first state of upward price pressure eventually becomes translated into rising input costs, managers may respond by revising production targets and schedules downward, with a consequent decrease of short-run aggregate supply. This second stage of price level increase may be understood as “cost-push inflation” which is attributable to the decrease of short-run aggregate supply.  The cost-push inflation comes to an end only when the output level has returned to the economy's normal operating capacity which is sustainable in the long run. The aggregate demand increase achieved no lasting increase of real output, but resulted in price inflation.

What is the managerial implication of an increase of aggregate demand that attempts to take the economy beyond its normal operating capacity? Increasing costs may lead to price increases, but it would be inappropriate to consider expanding plant capacity. The aggregate demand increase results in inflation, but no permanent output increase. 

Will an increase of aggregate demand relative to aggregate supply always elicit inflationary pressures?  Not necessarily.  If the economy has been suffering recessionary conditions such that current output is well below the normal operating capacity of the economy, an increase of aggregate demand can be expected to elicit an increase of output with little or no inflation if short-run aggregate supply is quite elastic as it might be during a protracted recession.

 

Decreases of Aggregate Demand and Aggregate Supply

Aggregate Demand Decreases.  When aggregate demand decreases relative to the economy’s normal operating capacity, inventories begin to accumulate. Unemployment worsens as production levels are cut in response to the increasing inventories, and prices begin to soften. The price level decrease may be regarded as demand-pull deflation since it resulted from a decrease of aggregate demand.  However, as we have noted above, prices may be somewhat sticky in the downward direction. If prices cannot change to absorb some of the aggregate demand collapse, the brunt of the adjustment must be borne by falling output and rising unemployment.

If some price deflation does occur, the lower prices eventually are translated into lower production costs. In response, employers and production planners may alter their plans to increase output, especially after inventories have begun to deplete. This will have the effect of increasing short-run aggregate supply, causing output to increase until it returns to the normal operating capacity of the economy. In such a soft or weakening economy, managers should expect to slow production rates and orders of materials, and may have to cut prices. This second stage of price level decline might be thought of as cost push deflation since it follows from the increase of short-run aggregate supply.  However, since output tends to return to its level before the demand collapse, it may be more appropriate for managers to try to hold production rates constant while letting inventory variation absorb the effects of the demand collapse.

Aggregate Supply Decreases.  An aggregate supply decrease due to a supply shock (the causes of supply shocks are explored in Chapter 14) results in product shortages that cause inventories to begin to shrink. In such a market environment, prices become firmer and managers may be tempted to take the occasion to raise prices.  The rising prices may be translated into increasing production costs as firms increase production in the effort to replenish their inventories.  The rising prices may be thought of as cost-push inflation that was initiated by the aggregate supply decrease. With worsening unemployment that lowers spendable income, aggregate demand can be expected to fall, tending to bring prices back toward original levels before the shock but at a lower level of output and some unemployment.  The ensuing demand-pull deflation at least partially reverses the cost-push inflation.

A further adjustment to the supply shock may occur as the falling prices become translated into decreasing production costs.  In response, managers may revise production plans upward. This will cause short-run aggregate supply to increase back toward its earlier level. With falling prices and the decreasing unemployment, aggregate demand can increase toward its original level, and output can return to the normal operating capacity of the economy. Since both aggregate output and prices will tend to return to their pre-shock levels, a better management strategy for responding to a supply shock may be to try to weather the storm by maintaining both prices and production levels while letting inventories serve as the shock absorber.

Supply-siders have hypothesized that continuing decrease of short-run aggregate supply (possibly attributable to the disincentive effects of progressive income taxation and to the costs of governmental regulation of business) results in on-going cost-push inflation. The growth of real output may slow, or output may decrease absolutely. Economists have referred to the combination of on-going inflation combined with slow output growth as “stagflation.” There appears to be no automatic mechanism that will tend to return the economy to its normal operating capacity when short-run aggregate supply continues such a gradual decline. The on-going inflation may create an “inflation psychology” in which managers begin to raise their prices in anticipation of future cost increases. We shall explore in Chapter 14 the role of the government in enabling and in treating such a phenomenon.

 

Aggregate Expenditure and Aggregate Demand

The Keynesian aggregate expenditure and the more recent AD-AS analyses are actually about the same phenomenon.  The difference is that the Keynesian relationships are income relationships specified in real terms, i.e., without reference to prices, while the AD-AS relationships are output relationships specified with respect to the price level.  But the two sets of relationships taken together provide more and better insights into the macroeconomic functioning of a market economy than can either set by itself.

Aggregate Demand and Supply analysis coupled to Keynesian Income and Expenditure analysis point to several important macroeconomic conclusions:

1.  Any initiating shift of aggregate demand or aggregate expenditure in a market economy is likely to induce a subsequent opposite-direction shift of short-run aggregate supply as people "wake up" to what is happening to their incomes and costs of living.  A comparable conclusion may be stated with respect to an initiating shift of short-run aggregate supply.

2.  A first-stage of demand-pull inflation (or deflation) in a market economy is likely to elicit a second-stage of cost-push inflation (or deflation).  A comparable conclusion may be stated with respect to a first-stage of cost-push inflation (or deflation).

3.  A market economy may be induced by an aggregate demand or aggregate expenditure increase to produce temporarily at a rate of output exceeding its normal operating capacity, but subsequent adjustment forces will tend to return the output rate to its normal operating capacity.

4.  A collapse of aggregate expenditure (as may have occurred in the Great Depression of the 1930s) will result in falling output and price level, but subsequent adjustment forces will tend to return both the output rate and the price level to their former levels.  However, the time required for recovery may be excessive relative to political realities.

5.  A supply shock in a market economy will lead to a temporary decrease of the rate of output and corresponding increase of the price level, but subsequent adjustment forces will tend to return both the output rate and the price level to their former levels.  No such conclusion follows from progressive decreases of aggregate supply attributable to excessive regulation or progressive taxation.

6.  Although the market economy's output rate tends to gravitate toward its normal operating capacity, increases of aggregate demand or aggregate supply may lead to permanent changes of the price level.

 

What's Ahead

We now have in place complementary macroeconomic concepts which are sufficient to many of the needs of identifying the managerial implications of macroeconomic change. In subsequent chapters we may apply these concepts to matters of growth, inflation, shocks, and policy.

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CHAPTER 12. INTEREST RATES

Interest rates are important to business firms, both because they need to borrow funds to finance capital acquisitions, and because they may need to invest liquid funds in the short run to earn interest as the funds await future investment or debt amortization. Even if the firm has accumulated funds internally by retaining earnings and does not have to borrow to finance a planned investment, the interest rate is important because it represents interest income that will be foregone by using it for the intended investment purpose.

As noted in Chapter 10, economists often speak of "the" interest rate as if there is only one interest rate, but in reality there is a range of nominal interest rates that differ from one another due to risk differentials and the differing durations of the lives (terms) of financial instruments.  Also, when we speak of "market interest rates" on financial instruments we do not mean to imply that interest rates themselves are bid and offered in financial markets.  What is meant is that the interest rates are the yield rates that are computed from information about the market prices of the financial instruments. 

So what determines interest rates and why do they change? This is a perplexing question since principles of economics textbooks typically retail to students of economics half a dozen explanations of interest rate determination. The media (print, audio, video) seem to fixate upon the conventional wisdom that the central bank (in the U.S., the Federal Reserve) sets and changes interest rates.

Theories typically elaborated in economics textbooks are that (1) the scarcity of real capital determines the true interest rate, (2) the interest rate is determined by the demand for and supply of money, (3) in the bond market, the demand for and supply of bonds determines bond prices, and hence yield rates, (4) the loanable funds market determines market interest rates, (5) nominal interest rates vary with changes in the expected rate of inflation, and (6) changing risk factors cause nominal interest rates to vary.

We emphasize that there is no such thing as "the interest rate.” Globally there are as many different interest rates as there are yield bearing circumstances. In each locale there is a whole structure of interest rates which differ by investment type, term, risk, and yet other circumstances. In the following discussion, unless otherwise specified, the term "the interest rate" is used to refer to the general level of the structure of interest rates. A brief elaboration is presented for each of the usual interest rate theories, followed by an attempt at reconciliation and integration of the theories.

 

The Scarcity of Real Capital

Economists conventionally identify four “factors of production,” land, labor, capital, and entrepreneurship, and the so-called returns to them, respectively, rent, wage, interest, and profit. Since interest is the return to real capital (real productive capacity, e.g., plant, equipment, housing), the interest rate in any region is a measure of the scarcity of capital in the region relative to the demand for it. This “true” (or scarcity) interest rate is higher in regions where capital is scarce and lower in regions where capital is more abundant. Interest rates typically are lower in capital-abundant developed regions of the world and higher in capital-scarce third-world countries. The true interest rate should fall as capital becomes more abundant. It would rise if capital were to become scarcer, e.g., when equipment is destroyed by a natural disaster or war, or if gross investment in the region should become less than depreciation so that the capital stock actually shrinks.

 

The Demand for and Supply of Money

As noted in Chapter 10, money balances earn little or no interest, so interest may be construed as the return to financial instruments other than money. The demand for money is thought to be an inverse function of the interest rate (i.e., as the interest rate rises, people demand less money to hold) due to the opportunity cost of income from financial instruments not held in order to hold money that yields little or no interest. The supply of money is usually represented as a direct relationship to the interest rate.  It is presumed to be determined by the central bank of the region and is thought to be highly inelastic (i.e., non-responsive) with respect to the interest rate. In reality, commercial bankers and borrowers play some role so as to render the money supply slightly responsive to the interest rate.

Interest Rate Increases.  An increase of the price level or the income level likely increases the demand for money relative to the supply of money.  This causes the quantity of money demanded to exceed the quantity supplied at the existing interest rate and elicits a rise of the interest rate. The interest rate continues to rise until the quantity of money demanded has decreased to match the amount that is in circulation.

A decrease of the supply of money has an effect similar to that of an increase of the demand for money.  When the central bank implements a tighter monetary policy with open market purchases of bonds, the money supply decreases relative to the demand for money. At the current interest rate, there is less money in circulation than people wish to hold. This induces the interest rate to rise until the society is pleased to hold the smaller amount of money in circulation.

Interest Rate Decreases.  A decrease of either the price level or the real income level likely causes the demand for money to decrease, i.e., the quantity of money demanded at every possible interest rate is smaller. At the existing interest rate, there is now more money in circulation than people want to hold. This puts downward pressure on the interest rate. The interest rate continues to fall until the society is pleased to hold the amount of money in circulation.

An increase of the money supply has a similar effect to that of a decrease of the demand for money.  An easier (or looser) monetary policy implemented through open market purchases of bonds by the central bank increases the money supply relative to the demand for money. At the current interest rate, there is likely to be more money in circulation than people want to hold. This induces the interest rate to fall until the society is pleased to hold the new larger quantity of money in circulation.

The Efficacy of Monetary Policy.  A cautionary note is warranted at this point. Efforts by a central bank to increase interest rates by decreasing the supply of money (or reducing the rate of increase of it) may not have the intended effect if people choose to get more money to hold by cutting back on their purchases of goods and services rather than by selling financial instruments. Likewise, central bank efforts to cause interest rates to fall by expanding the money supply may not be effective if people use their excess money balances to purchase goods and services rather than buy financial instruments. In both cases, the impacts may be more upon the price level than upon interest rates, but this may have been the ultimate objective of central bank policy anyway.

The conventional wisdom is that increases of the money supply relative to the demand for money likely will elicit inflationary pressures as people spend their excess money balances in the markets for goods and services.  This may well happen if the economy is operating close enough to its natural rate of real output.  But if the economy has been suffering recessionary conditions such that current output is well below the normal operating capacity of the economy, an increase of the money supply may succeed in inducing an increase of output with little or no inflation if short-run aggregate supply is quite elastic with respect to the price level as it might be during a protracted recession.

Equilibrium.  There is only one interest rate that can equilibrate the demand for money with the supply of money. Any interest rate above the equilibrium level results in an excess quantity of money supplied relative to the amount that people want to hold at that interest rate. By the same token, any interest rate below the equilibrium level results in an excess quantity of money demanded relative to the amount in circulation. However, the money demand-supply relationship does not contain within itself a mechanism to cause the interest rate to change or to achieve equilibrium. A connection to the bond market must be made for this purpose.

 

The Bond Market

The yield rates on financial instruments, euphemistically designated as “bonds,” vary inversely with the prices of those instruments. The bond yield rates are understood to be the interest rates on the bonds. Although there are numerous formulas for computing yields on bonds, examples based upon the "effective yield" formula reveal most simply the inverse relationship between the price of a bond and its yield rate.  The effective yield may be computed by subtracting the current market price of the bond from the face value at maturity and dividing the difference by the current price.

Suppose that a bond has a $10,000 face value, provides no coupon interest payments, and is sold and traded at some price which is discounted from face value. At a current market price of $9,000, the effect yield is ($10,000 - $9,000) / $9,000, or approximately 11.1 percent. If the market price should rise to $9,100, the effective yield, ($10,000 - $9,100) / $9,100, would fall to approximately 9.9 percent.

Bond Yield Decreases.  In the bond market, the demand for bonds is thought to vary inversely with bond prices (i.e., as bond prices rise, the quantity of bonds demanded decreases), and bond supply to vary directly with bond prices (as bond prices rise, quantity of bonds supplied increases). Since financial instruments exhibit a wide range of denominations, the "quantity of bonds" traded should be understood not in terms of a number of such financial instruments, but rather as an amount of financing demanded or supplied by such instruments. An increase of the demand for bonds relative to the supply can be expected to cause bond prices to rise, and corresponding decreases of their yield rates. A decrease of the supply of bonds relative to the demand for bonds would have similar effects.

Bond Yield Increases.  Newly-issued bonds are supplied by corporations seeking funds to finance investments, and by governments needing to finance budget deficits.  Existing bonds that have been issued in the past but not yet redeemed may also come onto the bond market.  If the supply of bonds coming onto the market increases relative to the demand for them, the prices of bonds can be expected to fall and the yield rates to rise.  A decrease of the demand for bonds relative to the supply of them would have similar effects.

The Bond Market and the Money Market.  This last relationship provides the needed explanation in the money market for why the interest rate changes when the demand for or supply of money changes. When the demand for money decreases relative to the supply of money, there will be an excess quantity of money supplied relative to the amount that people want to hold.  In attempting to rid themselves of their excess money balances, they can purchase goods and services in those markets, or they can purchase financial instruments in the bond market. If they do the former, aggregate demand will increase relative to the normal operating capacity of the economy, causing the prices of real goods and services to rise. To the extent that they do the latter, the demand for bonds increases relative to the supply of bonds, pushing bond prices higher and yield rates lower. It is likely that both the bond market and the markets for real goods and services are affected by a decrease of the demand for money.  An increase of the supply of money relative to the demand for it may also cause interest rates to fall:  people and businesses use the extra cash to buy bonds, bidding up bond prices and depressing their yield rates.

When the demand for money increases relative to the supply of it, people and businesses may sell bonds to get more money to hold, causing bond prices to fall and their yield rates to rise. They may also get more money to hold by cutting back on their purchases of real goods and services, causing aggregate demand to decrease relative to the normal operating capacity of the economy.  This may have the effect of slowing inflation or even precipitating deflation.  Again, it is likely that both the bond market and the markets for goods and services are affected.

In addition to the money demand-supply relationship, the supply of bonds may also be affected by the desires of businesses to finance capital investments, the needs of governments to finance deficits or dispose of surpluses, and the intent of the central bank to execute monetary policy. Changing interest rate differentials between domestic and foreign locales may also induce bond demand or supply changes in the respective markets and precipitate interregional or international flows of funds.

Arbitrage.  Changes of the prices of bonds (and thus their yield rates) become transmitted to the prices (and yields) of other types of financial instruments via the process of arbitrage, i.e., the simultaneous purchase and sale of different types of financial instruments. Arbitrage is the means by which changes of yield rates on individual financial instruments become generalized to most other interest rates, and thus to what economists refer to as “the” interest rate.  Arbitrageurs are successful if they are able to operate by the criterion of “buy low, sell high.” If they are successful, they will both capture profits and precipitate convergence of prices (and yields) across the financial markets. Unsuccessful arbitrageurs will suffer losses and tend to destabilize markets, and they may cause interest rates on different types of financial instruments to diverge.

A Disclaimer.  Regrettably, a disclaimer notice is in order.  We have gone to some lengths to describe the likely effects resulting from bond market demand or supply changes, but we have been careful to specify changes on one side of the bond market relative to conditions on the other side of the market.  It is important to note that any of the effects described above may not actually occur if offsetting or neutralizing changes occur on the opposite side of the bond market.

 

The Market for Loanable Funds

The forces of demand and supply in the bond markets determine bond prices, bond yield rates, and implicitly interest rates, but the loanable funds market encompasses more than just the bond market.  Home mortgages, installment loan contracts, and credit card purchases are also demands for credit from the loanable funds market.

Business Demand for Loanable Funds.  When business firms increase their demands for loanable funds, they increase the supply of corporate bonds coming onto the market relative to the demand for bonds, putting downward pressure on bond prices and causing bond yield rates to rise.  Yield rates can be expected to fall in response to a business sector decrease of the demand for loanable funds (evidenced by a decrease of the supply of bonds relative to the demand for bonds, causing bond prices to rise) or if the business sector retires more bonds at their maturities than it issues.

Since the business sector demand for loanable funds is a derived demand, it must be a function of the demand for the final goods and services that can be produced with the real capital financed by the loanable funds. Real interest rates (i.e., nominal rates that have been adjusted to eliminate the effects of price inflation or deflation) on long-term riskless instruments therefore cannot diverge significantly or for long from the true interest rate specified in regard to the scarcity of real capital. This calls into question the ability of a central bank to “twist” the structure of interest rates or to maintain a twist for more than a short time.  The U.S. Federal Reserve achieved only marginal success with its “Operation Twist” in 1961 when it attempted to decrease the spread between long- and short-term interest rates.  The strategy was to adjust the Federal Reserve’s holdings of government bonds by conducting open-market sales of shorter-term securities while buying longer-term securities.  In September of 2011, the Federal Reserve announced its intention to implement another rate-structure twisting operation. It remains to be seen whether this strategy will be any more successful than it was in 1961.

Government Demand for Loanable Funds. Another source of demand for loanable funds is government. When governments at any level run budgetary deficits or otherwise mount capital spending programs that require borrowed funds, the resulting increase of the demand for loanable funds (evidenced by an increasing supply of government bonds to the market) can be expected to put downward pressure on bond prices, hence upward pressure on yield rates.  Decreasing budget deficits would decrease the demand for loanable funds, and budgetary surpluses might even add to the supply of loanable funds. In either case, the interest rate would tend downward.

Consumer Demand for Loanable Funds.  Consumers may also add to the demand for loanable funds. Because "big ticket items" such as homes and motor vehicles usually cannot be purchased out of the normal flow of income, purchasers must resort to credit markets to finance them. Yet another source of the demand for loanable funds consists of the use by consumers of their credit cards to make purchases.  Consumer interest rates often are higher than interest rates on funds loaned for investment purposes since consumers have to bid funds away from investment uses. An increase of consumer demand for credit can thus be expected to increase the demand for loanable funds and raise interest rates.

Supply of Loanable Funds.  The supply of loanable funds consists of household sector savings, undistributed corporate profits in the business sector (business saving), governments’ budgetary surpluses that are used to retire debt, and bank issued credit.  When the supply of loanable funds increases relative to the demand, the nominal interest rate can be expected to fall. A decrease of the supply of loanable funds would induce nominal interest rates to rise.

Another Disclaimer.  An noted above in regard to the bond market, we have also gone to some lengths to describe the likely effects resulting from loanable funds demand or supply changes, but we have been careful to specify changes on one side of the loanable funds market relative to conditions on the other side of the market. It is important to note that any of the effects described with respect to the loanable funds market may not actually occur if offsetting or neutralizing changes occur on the opposite side of the loanable funds market.

 

The Fisher Effect

The so-called “real interest rate” on a financial instrument may be computed as the nominal (market determined) interest rate less an allowance for the expected rate of inflation over the term of the instrument.  Implicitly, if the real interest rate is known, the nominal rate can be determined by adding an allowance for the rate of inflation to the real rate.

It is incumbent upon any lender to determine the nominal interest rate on a loan by adding an inflation allowance (sometimes referred to as an “inflation risk premium”) to the real rate that she/he wishes to receive after inflation has reduced the purchasing power of the funds loaned. The so-called “Fisher effect” is that nominal (or market) interest rates tend to rise with increases of the rate of inflation, and to fall with decreases of the rate of inflation.

If the actual inflation rate over the term of a loan turns out to be greater than the anticipated rate, the computed real interest rate may be low, zero, or even negative. This is of course incongruent with the “true” interest rate concept noted above with respect to the scarcity of real capital since zero or negative “true” interest rates imply abundance or super-abundance of capital, a fact which is not in evidence anywhere in the world.

Nominal interest rates may be expected to rise with the expectation of accelerating inflation, and to fall with the expectation of deflation or a lower rate of inflation. Nominal interest rates likely will be higher in regions with higher rates of inflation, and lower in regions experiencing deflation or lower rates of inflation. Such interest rate differentials may motivate capital flows and, in turn, changes of exchange rates.

 

Risks, Terms, and Amounts at Loan

Inflation is only one type of risk that may threaten lenders. Political risks include the possibility of tax rate or base changes, expropriation of capital assets, or even repudiation of debts. Natural disasters may threaten the physical structures of capital assets or the earnings flowing from the capital assets. Economic risks include advances of technology that render capital assets obsolete, shifts in the structure of demand, and adverse exchange rate variation. Risk premiums may be added to the nominal interest rate to compensate for any of type of risk. Nominal interest rates in any region are likely to rise with increasing risks, and to fall when risks diminish.

Interest rates may vary among different investment opportunities (including financial instruments) according to the perceived risks, the duration of investment term, and the amount at loan. As a general rule, the nominal interest rate on a financial instrument is higher the greater the risk, the longer the term, and the larger the amount at loan. This matters pertains more to the structure of interest rates than to determination of the level of the structure.

 

The Central Bank's Role

Finally, the media (print, audio, video) and a few economics textbooks foster the notion that the central bank of the region determines interest rates and causes them to change as the vehicle for implementing monetary policy. This is a fiction, although a convenient one for reporting the actions of the central bank and assessing its monetary policy intent. A central bank wishing to implement a “tight” monetary policy may make public announcement that it is raising some interest rate, e.g., the Federal Funds rate, by some percent (usually expressed as a number of basis points, e.g., 50 for a half-percent change). What it is in fact doing is announcing a new rate target.

Changing financial market conditions precipitate the need or opportunity for lenders to change interest rates. However, market-determined interest rates may become “sticky” if lenders are conditioned by periodic central bank announcements of interest rate target changes. If the central bank is widely predicted or expected to announce a target rate change in the near future, lenders may wait for the announcement as the excuse or trigger for changing their actual rates. When this happens, it indeed gives the appearance that the central bank has been able to dictate a change of interest rates. But it is also true that the central bank has waited on market pressures for a rate change to build, and it is thus following the market rather than leading the market to cause rates to change.

If rates are in fact not “sticky,” once a target rate change has been announced the central bank must act behind the scenes to cause market-determined rates to approach the newly-announced target. The requisite actions are for the central bank (or its “open market committee”) to function as a bond market trader. It must enter the market to purchase bonds in order to induce bond prices to rise (yield rates to fall), or to sell bonds in order to induce bond prices to fall (yield rates to rise).

 

Reconciliation

Which of these seven theories seems to be true or useful? Can they be integrated into a coherent whole? The baseline for determination of the level of the interest rate has to be the scarcity of real capital, but the vehicle for establishing the scarcity of real capital appears to be the loanable funds market. Indeed, the loanable funds theory appears to be the most comprehensive model of interest rate determination.

In the loanable funds model, the supply of loanable funds comes principally from two sources: saving (household and business) and bank-created credit, i.e., increases of the money supply. In the money demand-supply model, an excess supply of money when the interest rate increases and becomes too high for equilibrium simply adds to the supply of loanable funds. An excess demand for money when the interest rate decreases and becomes too low for equilibrium would decrease the supply of loanable funds. However, changes of money demand in one country or one central bank's changes of money supply are not the only possible influences on loanable funds in a financially open global economy. The money demand-supply model thus can provide only a partial view of interest rate determination, and it relies upon the bond market to provide the vehicle for interest rate change.

But the bond market model also feeds into the loanable funds model since any increase in the supply of bonds by businesses or government is implicitly an increase in the demand for loanable funds. However, an increase in the supply of bonds constitutes only part of any increase in the global demand for loanable funds. An increase in the demand for bonds is implicitly an increase in the supply of loanable funds, but this likewise constitutes only a part of any increase in the supply of loanable funds. The loanable funds market encompasses more than just the bond market.  Home mortgages, installment loan contracts, and credit card purchases are also demands for credit from the loanable funds market.

The Fisher effect theory that nominal (or market) interest rates vary with the expected rate of inflation also pertains to the loanable funds model. With an increase in the inflation rate, more funds are required to finance any particular investment opportunity. A lower rate of expected inflation would diminish the demand for investment funds, allowing market interest rates to fall. Similar statements may be contrived with respect to changing risk, term, and amounts at loan.

 

Managerial Implications of Interest Rate Determination

The conclusion is that all theories of interest rate determination other than the loanable funds model are partial and subsidiary to the loanable funds model. The other theories may be useful for specific purposes, but no one of them can provide a sufficient explanation of interest rate determination.

What does this mean for public policy? In the U.S. the Federal Reserve attempts to implement monetary policy by targeting interest rate changes, but it either follows the market or it has to work behind the scenes to induce market interest rates to move in the direction of the announced target rate changes. The Fed's open market operations may not be successful because it is operating on the supply of money which is only one part of the global mechanism of interest rate determination. The actual locus for the determination of interest rates is the global market for lonable funds, not the supply of money relative to the demand for it in any national market. But there are too many other determinants of the demand for and supply of loanable funds that are not under the control or influence of the Federal Reserve, the European Central Bank, or any other national or central bank.

What does this mean for managerial decision making? Business firms need access to financial markets to "park” liquid funds and earn interest while awaiting investment or debt amortization, and to raise capital by borrowing in order to accomplish investment. With globalization of financial markets, loanable funds may be placed or sourced almost anywhere in the world. While the loanable funds model seems most appropriate for explaining interest rate movements, it is virtually impossible for managers of business firms to monitor changes in the total amounts of loanable funds supplied from all global sources and demanded from different users for different purposes everywhere in the world.

However, interest rate changes in the regional bond and money markets provide clues as to what is happening in both the local and global markets for loanable funds. Central bankers may attempt to manipulate interest rates in their own countries, but central banks can affect only small portions of the global supply of money, which is only a part of the total amount of loanable funds. The mighty U.S. Federal Reserve may have some ability to push around U.S. interest rates by exercise of monetary policy, but in an open financial world it may have little influence over global financial markets.

Financial officers of business firms must monitor interest rate changes on a global scale and be prepared to move funds and select sources for borrowning in order both to manage risk and minimize borrowing costs.

 

What's Next

Chapters 13 and 14 delve into the managerial implications of growth, business cycles, and shocks to the macroeconomy.

BACK TO CONTENTS

 

CHAPTER 13. THE MACROECONOMIC IMPLICATIONS OF GROWTH AND DECLINE

The Stability of the Macroeconomy

In a dynamic world, equilibrium is a moving target which is ever pursued but rarely achieved. The movement of the equilibrium target is attributable both to the normal processes of growth and to exogenous shocks to the macroeconomy.  Virtually all of microeconomic theory of the firm leads to the inference that there are forces of adjustment present in the market economy that work with some degree of automaticity to pursue moving equilibrium targets. But there is a long-running and yet unresolved debate among macroeconomists as to whether the microeconomic adjustment forces extend to the macroeconomy in degree sufficient to provide stability and achieve macroeconomic equilibria. And even if an equilibrium should be achieved by the system, there is still a question of whether it will be a desirable state.

An unsettling view of the stability of the economic system emerged soon after the middle of the nineteenth century when Karl Marx and others fostered the view that the capitalistic economy (i.e., one organized around markets and involving private ownership of property) tends to be inherently unstable (it was reputed to contain internal contradictions). Marx also asserted it to be prone to crises of escalating proportions which could only culminate in violent political revolution to establish an authoritarian socialist state (a "dictatorship of the proletariat"). In the absence of imminent revolutions, the English Classical economic tradition of the late-nineteenth century tended to focus upon harmony and stability rather than conflict and instability in economic mechanisms.

Given the exigencies of the Great Depression, and following the publication of Keynes' General Theory in 1936, Keynesians were led to the inference that the macroeconomy was indeed drawn to an equilibrium of aggregate income and expenditures, but one which would not necessarily (indeed, not likely) coincide with full employment. In this view, the macroeconomy can reach an income-expenditure equilibrium far short of full employment, and there appear to be no endogenous forces in the private sector that can return the macroeconomy to full employment. As the so-called “Great Recession” (that began in 2008) continued to wear on, some twenty-first century economists began to wonder if in fact the U.S. economy was stuck in an income-expenditure equilibrium well below full employment.

If there are indeed full-employment restoring forces in a market economy, Keynesian economists suggest that they may be weak and work too slowly. Keynesians have concluded that the private sector economy cannot be relied upon to take care of itself. There would have to be some counterbalance to offset the deficiencies and instability of the private sector. The only force apparently large and powerful enough to serve this function is, of course, the government. In the extreme Keynesian view, the problem of instability in the macroeconomy lies in the private sector, and the solution lies in the public sector. In Chapter 16 we shall examine further both this argument and its counter, i.e., the private sector works itself well enough, but that the source of instability lies in the public sector.

Classical economists prior to Keynes assumed that the normal state of the economy would be equilibrium, and that it would coincide with full employment. New Classical economists in recent times generally have presumed that the economy tends to gravitate toward a “normal operating capacity” (also referred to the in the literature as the "natural rate of real output") that entails a “natural rate of unemployment” consisting of an irreducible amount of frictional and structural unemployment.  The normal operating capacity itself tends to change over time with grown or decline of the economy. Until the turn of the millennium, the normal operating capacity of the U.S. economy was thought to entail an unemployment rate of 5 or 6 percent.   If this could be achieved, it might be construed as an equilibrium that is also desirable.

The persistence of high levels of unemployment during the slow recovery from the Great Recession has led some macroeconomists to wonder if a "new normal" natural rate of unemployment nearer to 10 percent should be acknowledged. Natural rates of unemployment may vary significantly among countries. Those of many European economies appear to be closer to 10 percent than 5 percent. And natural unemployment rates of some lesser developed economies may be substantially higher than 10 percent.

Some economists are inclined to place emphasis upon the automatic, self-adjusting properties of the market economy at both the micro and macro levels of performance, but only if the market economy is largely unencumbered by governmental regulation or other constraints. Many economists think  that these properties, unless impeded by government, provide a modicum of stability. We shall adopt this view as a working premise so that in this chapter and the next we may examine the managerial implications of three categories of disturbance to the macroeconomy: economic growth, cyclical behavior, and shocks to the economy.

 

The Macroeconomic Implications of Growth and Recession

A time series of data for a micro- or macroeconomic phenomenon may be decomposed into its constituent components: trend, cyclical, seasonal, and irregular variations. Time series decomposition procedures are described in the appendix to this chapter. The trend component in the time series for some macroeconomic aggregate, such as Net Domestic Product, may serve as an identification of the historic secular change pattern of the economy. Prior to the Great Recession, the secular trends of real Net Domestic Product for many Western market economies were rising at rates of 2 to 3 percent per annum.

The growth rates of many developed nations have diminished significantly as the Great Recession has ensued.  In September of 2011, the growth rate of U.S. Net Domestic Product hovered in the neighborhood of 1 percent per annum.  The U.S. unemployment rate exceeded 9 percent, excluding so-called “discouraged workers,” and the net job growth rate (new job creation less job elimination) was in the neighborhood of zero.  Some estimates of the “true” rate of unemployment, including discouraged workers, exceeded 16 percent of the labor force.   In order to absorb the growing U.S. labor force and reduce the U.S. unemployment rate toward what has been regarded historically as de facto full employment (around 6 percent of the labor force), the secular trend of the U.S. Net Domestic Product would need to rise at a rate exceeding 3 percent per annum for a decade or more.

There are three possibilities for the long-term or secular trend of economic activity in an economy: growth, stagnation, and retrogression. Unless blocked by some natural circumstance or the activity of government, it appears that growth at some rate is a normal behavioral pattern for any economy. The basis for this supposition may be nothing more than on-going population growth. But natural resource exploitation or technological advance (or its adoption from other societies) will also militate in favor of growth rather than stagnation or retrogression.

Economists of the nineteenth century expected the economy eventually to reach a stationary state as its growth potential is exhausted. The economy might even begin to contract as incomes fall toward subsistence due to population growth which, according to Malthus, would press upon the carrying capacity of the earth. Modern scenarios for stagnation or retrogression may lie in an aura of population decline, resource depletion, environmental pollution, policy mistakes made by democratic governments, or stultification imposed by authoritarian governments.

Although growth may be presumed to be a normal pattern of macroeconomic behavior in a Western-style market economy, it will almost certainly be disruptive of the adjustment forces at work in an economy, as well as the equilibrium targets which are being pursued. In fact, growth is certainly one of the factors causing movement of the equilibrium targets. Growth requires change, and changes in the social, political, and economic orders are always disruptive. It is in this sense that we include an analysis of the macroeconomic implications of growth in a chapter on disruptions to the macroeconomy.

We may distinguish two classes of growth. Simple output growth occurs when the aggregate real productive capacity of the economy increases. If output growth only matches the rate of population growth, per capita output (and hence income) remains essentially unaffected. However, advancing productivity can be the source for what we shall call income growth, i.e., an increase of aggregate productive capacity at a rate faster than population is increasing which enables a rise in the per capita income of the economy.

A caveat to this possibility is that productivity growth during a recession may diminish labor requirements, perpetuate or increase unemployment, and cause per capita income to stagnate or even fall.  This prospect may have become reality in the U.S. during the Great Recession that began in 2008.

 

Productivity and Competition

The conditions enabling both advancing productivity and the increase of per capita income provide threats and opportunities for firms in the growing economy. When physical productivity increases, either more output can be produced with the same physical inputs as previously used, or the same output can be produced with smaller quantities of the physical inputs. When economic productivity increases, the ratio of the value of output to the costs of inputs increases, whether the numerator of the ratio increases or the denominator decreases. Most economic productivity improvements can be attributed to some advance of technology, or the adoption of one which has been developed elsewhere. The implementation of any technological advance is via capital investment to install the novel technology.

In a growing economy, managers of firms find opportunities to improve profitability by adopting and installing cost-saving technological advances. It is also possible during a recession characterized by slowing growth that managers will take the occasion to install labor-saving technological advances that enable them to avoid calling back laid-off workers as the recession moderates.  As seems to be the case at mid-2011 in the U.S., this phenomenon may cause high levels of unemployment to persist even as the economy begins to resume the growth process. 

If managers are unable or unwilling to consider adoption of new technologies, they will suffer threats of declining profitability from competitors who do embrace new technologies which enable price reductions and foster price competition. Managers may be tempted to continue operation of technologically obsolete equipment that has not yet been fully depreciated. However, since competitors can be expected to shift to the newer and more efficient technologies, it could be a costly strategy to stick with the obsolete equipment simply because it has not yet been fully depreciated.

 

Income Elasticity of Demand

Income growth can also pose threats or provide opportunities for managements of firms. The market demands for normal goods, those with positive income elasticities of demand (i.e., the ratio of the percentage change of demand to the percentage change of income that elicited the change of demand), can be expected to increase. If the income elasticity ratio of a good exceeds unity, demand for it can be expected to grow faster than income is increasing. For a normal good with a positive income elasticity of demand that is less than unity, demand will increase, but at a rate slower than the rate of income growth. Inferior goods have negative income elasticity ratios, which means that the demands for such products can be expected to decrease with income growth.

If economic growth is an on-going process, products with higher income elasticities of demand should be selected and retained in the product line. Products with low or negative income elasticities should be avoided or deleted. However, inferior goods may be appropriate to a retrogressing economy since demands for such products can be expected to increase with falling incomes.

 

Aggregate Demand and Supply Growth Rates

As we noted in Chapter 11, population growth and productivity advance tend to cause the normal operating capacity of the economy to increase at some rate. This rate has ranged from 1 to 3 percent per annum in Western market economies during the last half of the twentieth century. This growth of the normal operating capacity of the economy can be expected to increase long run aggregate supply at the same rate, carrying with it  short-run aggregate supply. We should recall from Chapter 11 that the short-run aggregate supply may be quite elastic with respect to the price level if people generally do not expect inflation and are surprised when it occurs. If inflation is an on-going phenomenon that is fully anticipated by the majority of people, short-run aggregate supply will be more inelastic with respect to the price level, and may converge upon long-run aggregate supply. The equilibrium path that the economy follows depends critically upon whether aggregate demand also increases at some rate greater than, approximately equal to, or less that the rate of growth of aggregate supply and the normal operating capacity of the economy.

Growth increases long-run aggregate supply as the natural rate of real output of the economy increases. Short-run aggregate supply increases along with long-run aggregate supply. If aggregate demand grows at a relatively slow pace, output may remain well below the new natural rate of real output and unemployment correspondingly above the natural rate of unemployment. Output potential increasing faster than demand likely results in deflation. As expectations begin to catch up with the falling price level, suppliers of resources may begin to accept lower prices and wages (in order to avert unemployment) so that costs of production fall, inducing short-run aggregate supply to increase even more. As prices continue to fall, output may gradually approach the natural rate of real output. If aggregate demand continues to increase more slowly than the natural rate of real output in subsequent periods, there will be a tendency in the economy toward chronic deflation and a lagging of output behind the expanding capacity. This is a phenomenon that economists refer to as a “growth recession” if it is perceived to be a temporary phenomenon, or “secular stagnation” if it appears to be a permanent condition.

Alternately, if aggregate demand increases faster than the natural rate of real output, the actual rate of unemployment may fall below the natural rate of unemployment.  If aggregate demand continues to increase in such a fashion relative to the long-run aggregate supply in subsequent periods, there will be a tendency for chronic inflation as the economy attempts to sustain production in excess of its normal operating capacity.  As resource owners gradually become aware of the rising output prices (i.e., their costs of living) and begin to push up their own prices and wage rates, production costs rise. The initial demand-pull inflation thus induces further cost-push inflation as short-run aggregate supply slows its rate of rightward advance and may even begin to decrease toward the equilibrium of aggregate demand with long-run aggregate supply. 

A path that avoids both inflationary and deflationary pressures requires that aggregate demand continue to increase at approximately the same rate as the normal rate of real output and long-run aggregate supply.  Under such growth conditions, the economy may enjoy relative price stability, not unlike that experienced by the U.S. economy during the late-1990s.

 

Aggregate Expenditures Growth Rate

Roy Harrod's analysis of growth in the Keynesian context suggests that there is an appropriate, or "warranted,” rate of growth of the economy to allow sustained growth of output without inflation. Suppose that the economy is presently in equilibrium and operating at output level that is below the full-employment output level. An increase of investment spending that also increases aggregate expenditure results in inventory depletion. This sets in motion a process of expansion in the economy until it reaches a new equilibrium level of output level which coincides with the former full employment output level. However, the additional investment spending has created additional productive capacity by adding to the stock of productive capital in the economy, thereby increasing the full-employment output level so that even more investment is needed in order to achieve the new full employment level of output. The additional investment creates additional capacity and the economy continues to suffer unemployment.

Because the marginal propensity to consume is less than 100 percent, there is a growing leakage "wedge" between spending and income that must be absorbed or "filled up" with various types of injections, including investment spending, in order to keep the economy growing and at full employment. Because the leakage wedge widens as income rises, Harrod concluded that investment must increase again in the next period, and keep on increasing period after period to keep the economy growing and prevent rising unemployment. The conclusion may be generalized to the sum of all types of injections, including export spending and government purchases as well as investment.

The problem of the wedge of saving may be exacerbated if progressive income taxation or some other phenomenon tends to make the consumption function flatten out at higher income levels. In this case, the wedge will become an ever-widening funnel which must filled-up with injections of spending.  If the wedge cannot be so filled-up with additional spending, an economy with a growing labor force will suffer a tendency toward stagnation characterized by persistently high unemployment and flat or falling average incomes.

Harrod's analysis concludes that the right or "warranted" rate of output growth can be estimated by computing the ratio of the marginal propensity to save to the marginal capital-output ratio (the amount of additional capital needed to produce specified output increase). Any output growth rate in excess of the warranted rate will result in chronic inflationary pressures; any output growth rate less than the warranted rate will produce chronic recession and deflationary pressures (i.e., growth recession or secular stagnation).

 

Implications of Demand and Expenditure Growth

Is there any a priori reason to expect either aggregate demand or aggregate expenditures to increase at fast-enough rates? Aggregate demand can be counted upon to shift to the right when population grows simply because there are more mouths to feed. This same phenomenon will cause aggregate expenditures to increase because one of its components, consumption spending, increases. And if per capita incomes are increasing due to productivity advances, there will be an additional impetus for further increases of aggregate expenditure. Also, it is not unreasonable to expect investment spending to increase in some proportion to the growth of the economy, simply to increase capacity by enough to meet the requirements of population growth and income increase. These three factors might be expected to yield a continuing demand increase that paces or outruns any aggregate output increase.

However, there is another matter, the fact that democratic governments have tended to run budgetary deficits on a continuing basis due to increasing government purchases. The increasing government purchases further increase aggregate expenditures. Should governments succeed in balancing their budgets, this source of aggregate expenditure increase will disappear. Governmental budget surpluses that are not used to retire public debt would siphon purchasing power from the economy and thus constitute a drag on the increase of aggregate expenditures.

What are the managerial implications of this seeming bias of the market economy with democratic government toward chronic inflation and an attempt to grow faster than real conditions permit? Managers should be aware of the growth factors which yield inflationary pressures (i.e., they should use all available information and form expectations rationally) and be prepared to revise price lists apace with increasing costs. They should also keep in mind the possibility that the demand-pull inflationary pressures may also induce cost-pushing increases of short-run aggregate supply, which may produce the characteristics of a growth recession. This requires great care in the planning of investment for both capital replacement and capacity expansion.

It would seem that governments’ propensities to run budget deficits would ensure that aggregate demand always increases fast enough to absorb any increases of aggregate supply.  However, both aggregate demand and aggregate supply collapsed during the Great Recession beginning in September, 2008.  The U.S. government’s large stimulus spending programs during 2009-2011 have prompted aggregate demand to begin to increase slowly during the recovery, but by late-2011 they had not been sufficient to bring output up to the pre-recession level, nor the rate of unemployment rate below 9 percent of the labor force.  The budget deficit of over $1 trillion during the government’s 2010-2011 fiscal year has brought the public debt of the U.S. up to around $14 trillion, nearly the same as the nation’s Gross Domestic Product in fiscal year 2010-2011.  As Congress debated until just before a deadline whether to approve yet another increase in the public debt limit, concerns about the ability and willingness of the U.S. government to continue to honor its outstanding debt led a debt rating agency, Standard and Poors, to downgrade the U.S. public debt from AAA to AA+ in July of 2011.

As evidenced by the experience of the Great Recession, uncertainty and low levels of business and consumer confidence may cause aggregate demand to increase too slowly relative to even a slow rate of increase of aggregate supply during the recovery.  This may occur if unemployment benefits are “too rich” relative to the prospects for earning income in work, if technology is advancing so that out-of-work persons lack the requisite skills for the available jobs, or if people who are unemployed are reluctant to take jobs below their skill levels or at wages less than they earned in their prior employments. 

Aggregate demand may also increase too slowly if business decision makers are pessimistic about future market growth potential, if they suffer uncertainty about the regulatory environment, or if they are increasing labor productivity by investing in labor-saving technologies to avoid calling back workers who have been laid off earlier in the recession.  When aggregate demand stagnates or increases at a slower pace than aggregate supply, the economy may suffer persistent high unemployment and stagnant or even declining average incomes.

 

What's Ahead

As noted above, growth is best illustrated as a movement along a positively-sloped secular trend. However, there usually occur a variety of disturbances of the economy around the secular trend. These disturbances are examined in Chapter 14.

BACK TO CONTENTS

 

 

APPENDIX 13A. TIME SERIES DECOMPOSITION

Pioneering development of the techniques for decomposing a time series into constituent components was conducted for and by the U. S. Bureaus of Census and Labor Statistics during the first half of the twentieth century. The object of such work was the seasonal adjustment of time series data. A beneficial spin-off has been the ability to analyze cyclical behavior. The two approaches emerging from the early pioneering work are today formally known as the Census Method II (in several variants) and the BLS method. The two methods are similar except in the ways in which they isolate one of the components.

The ensuing discussion in this appendix follows the procedures of the BLS Method for decomposing a monthly time series, but we will note how the Census Method II accomplishes the same end. While the objective of governmental agencies may be the seasonal adjustment of time series data, the techniques which have been developed can also constitute a powerful approach to analyzing and forecasting time series behavior.

 

Components of a Time Series

The fundamental underlying assumption of this approach is that every time series is composed of a number of component parts which are in some way related to one another or the whole. The conventionally defined component parts are trend (T), cyclical (C), seasonal (S), and irregular (I) or random variation. It is possible that these four components are each independent of all of the others, so that the behavior of the series is simply the sum of its parts, which are additively related. The majority of analysts familiar with the approach seem to be of the opinion that the component parts are unlikely to be perfectly independent of one another, and are therefore multiplicatively related.

Perhaps the easiest way to explain the process of time series decomposition is to describe the way in which a monthly time series, known as the object series, may be decomposed into the component parts. From an object series written to column 1 of a data matrix are generated six additional series, four of which are the T, C, S, and I components. The seven series taken together constitute a "decomposition matrix.”

 

Decomposition Techniques

The techniques used to decompose the object series are trend regression and "ratio to moving average" computations as developed by the Department of Commerce and the Bureau of Labor Statistics. The objective of these techniques is to identify both seasonality and cyclical behavior so that the former may be removed and the latter isolated for other purposes. Once the components of the time series have been separated into their own series, the reverse of the decomposition process, or recomposition, may be employed to construct forecasts of future values of the object series.

Before the decomposition process is started, the analyst should generate a sequence plot to identify the range over which trend is unidirectional. The trend estimation should then be conducted only over this range. The steps employed in the decomposition process are as follows:

a. The original or object series, regarded as containing all four components which are assumed to be multiplicatively related, i.e., OBJECT = T x C x S x I, is written to column 1 of the decomposition matrix.

 b. A second series, written to column 2 of the decomposition matrix, is generated by smoothing the object series with a centered moving average. This is the first of two smoothing stages. If the smoothing is to be done by moving average, it is conventional to specify from 12 to 15 elements in the moving average set. The elements may be unweighted or weighted (user specified), or the user may choose a computed weight set. The problem of loss of data at the end of a centered moving average series may be handled by letting the number of elements in the set diminish to the number of remaining rows as the end of the series is approached. The interpretation is that seasonal and irregular influences are smoothed from the object series, leaving a combination TxC series which is written to column 2 of the decomposition matrix. The column 2 entries are numbers of the same magnitude as the column 1 object series.

 c. A third series, written to column 3 of the matrix, is generated by computing the ratios of entries in column 1 (the object series, TxCxSxI) to the corresponding entries in column 2 (TxC), which by cancellation (or division) leaves a combination SxI series. This process is thus the basis for the name of the technique, "ratio-to-moving average." The column 3 entries are index numbers which vary about unity (1).

 d. A fourth series, written to column 4 of the decomposition matrix, is generated by smoothing the SxI series in column 3 to eliminate the irregular influences, leaving an isolated seasonal series, S. This is the second-stage smoothing process. If the analyst opts for a moving average to accomplish the second-stage smoothing, it is conventional to employ about half as many elements as in the first-stage moving average. Again, the elements may be unweighted or weighted as specified by the user. All entries in the S series are totaled and averaged by months to constitute a set of twelve seasonal adjustment factors. The column 4 entries are index numbers that vary about unity.

 e. A fifth series, written to column 5 in the decomposition matrix, is generated by computing the ratios of entries in column 3 (SxI) to the corresponding entries in column 4 (S), which by cancellation (or division) yields an isolated irregular, I, series. The column 5 entries are index numbers that vary about unity. (The Census Method accomplishes this by dividing a seasonally-adjusted original series, TxCxI, by a trend-cycle series, TxC, thus isolating the irregular component.)

 f. A sixth series, written to column 6 in the decomposition matrix, is generated by trend regression on the unidirectional range of the object series. This series is interpreted as an isolated T series. The column 6 entries are numbers of the same magnitude as the object series numbers.

 g. Finally, a seventh series, written to column 7 of the decomposition matrix, is generated by computing the ratios of the entries in the second column (TxC) by the corresponding entries in the sixth column (T), which by cancellation yields an isolated cyclical, C, Series. The column 7 entries are index numbers that vary about unity.

Table 13A-1 contains a decomposition matrix resulting from applying these procedures to a monthly time series. Columns 4 and 7 exhibit clearly-defined seasonal and cyclical patterns, respectively, and that column 5 contains few runs of numbers above or below unity. Therefore, it may be judged that the smoothings employed in this decomposition were relatively effective.

 

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Table 13A-1.  Time series decomposition matrix for Series Y1.
 
DECOMPOSITION OF SERIES, 12 & 5 ELEMENT UNWEIGHTED MOVING AVERAGE
THE CALCULATED LINEAR TREND EQUATION IS:
   Y =   228.3455 +     0.4058 * X
 
         ORIGINAL  12 MONTH  RATIO  5 MTH   RATIO   REGRESS    RATIO
          SERIES    MV.AV.  (1)/(2) MV.AV. (3)/(4)  EST (1)   (2)/(6)
 X DATE  TxCxSxI      TxC     SxI     S      I         T         C
           (1)        (2)     (3)    (4)    (5)       (6)       (7)
 
 1  1   233.4000
 2  2   236.6000
 3  3   239.8000
 4  4   242.7000
 5  5   245.2000
 6  6   252.2000
 7  7   252.3000   246.7080 1.0227
 8  8   252.2000   248.0420 1.0168
 9  9   251.1000   247.4250 1.0149 1.0199 0.9951   231.9980   1.0665
10 10   251.1000   246.5670 1.0184 1.0211 0.9973   232.4030   1.0609
11 11   252.2000   245.6170 1.0268 1.0226 1.0041   232.8090   1.0550
12 12   251.7000   244.6580 1.0288 1.0087 1.0199   233.2150   1.0491
13  1   249.4000   243.5250 1.0241 0.9950 1.0293   233.6210   1.0424
14  2   229.2000   242.4750 0.9453 0.9820 0.9625   234.0260   1.0361
15  3   229.5000   241.5500 0.9501 0.9714 0.9781   234.4320   1.0304
16  4   231.3000   240.4580 0.9619 0.9665 0.9952   234.8380   1.0239
17  5   233.7000   239.6000 0.9754 0.9791 0.9962   235.2440   1.0185
18  6   238.6000   238.6000 1.0000 0.9929 1.0072   235.6500   1.0125
19  7   239.7000   237.8170 1.0079 1.0014 1.0065   236.0550   1.0075
20  8   241.1000   236.5420 1.0193 1.0096 1.0096   236.4610   1.0003
21  9   238.0000   236.9500 1.0044 1.0121 0.9924   236.8670   1.0004
22 10   240.8000   236.9670 1.0162 1.0148 1.0013   237.2730   0.9987
23 11   240.2000   237.1580 1.0128 1.0084 1.0044   237.6780   0.9978
24 12   242.3000   237.1920 1.0215 1.0051 1.0163   238.0840   0.9963
25  1   234.1000   237.1750 0.9870 0.9961 0.9909   238.4900   0.9945
26  2   234.1000   236.9500 0.9880 0.9911 0.9968   238.8960   0.9919
27  3   229.7000   236.5420 0.9711 0.9852 0.9857   239.3020   0.9885
28  4   233.6000   236.4670 0.9879 0.9901 0.9978   239.7070   0.9865
29  5   234.1000   236.0250 0.9918 0.9943 0.9976   240.1130   0.9830
30  6   238.4000   235.6750 1.0116 1.0007 1.0108   240.5190   0.9799
31  7   237.0000   234.8830 1.0090 1.0048 1.0042   240.9250   0.9749
32  8   236.2000   235.4330 1.0033 1.0055 0.9977   241.3300   0.9756
33  9   237.1000   235.2000 1.0081 1.0020 1.0060   241.7360   0.9730
34 10   235.5000   236.5000 0.9958 0.9953 1.0004   242.1420   0.9767
35 11   236.0000   237.4080 0.9941 0.9956 0.9985   242.5480   0.9787
36 12   232.8000   238.6580 0.9755 0.9863 0.9890   242.9540   0.9823
37  1   240.7000   239.6000 1.0046 0.9902 1.0145   243.3590   0.9846
38  2   231.3000   240.5250 0.9616 0.9930 0.9684   243.7650   0.9867
39  3   245.3000   241.5580 1.0155 1.0025 1.0130   244.1710   0.9893
40  4   244.5000   242.5580 1.0080 1.0058 1.0022   244.5770   0.9917
41  5   249.1000   243.5500 1.0228 1.0154 1.0073   244.9820   0.9942
42  6   249.7000   244.5670 1.0210 1.0143 1.0066   245.3880   0.9967
43  7   248.1000   245.7170 1.0097 1.0142 0.9956   245.7940   0.9997
44  8   248.6000   246.1250 1.0101 1.0096 1.0005   246.2000   0.9997
45  9   249.1000   247.2580 1.0074 1.0054 1.0020   246.6060   1.0026
46 10   247.4000   247.5080 0.9996 1.0019 0.9976   247.0010   1.0020
47 11   248.2000   248.1250 1.0003 0.9969 1.0035   247.4170   1.0029
48 12   246.6000   248.5250 0.9923 0.9913 1.0010   247.8230   1.0028
49  1   245.6000   249.4080 0.9847 0.9896 0.9951   248.2290   1.0048
Table 13A-1 continued.
 
         ORIGINAL  12 MONTH  RATIO  5 MTH   RATIO   REGRESS    RATIO
          SERIES    MV.AV.  (1)/(2) MV.AV. (3)/(4)  EST (1)   (2)/(6)
 X DATE  TxCxSxI      TxC     SxI     S      I         T         C
           (1)        (2)     (3)    (4)    (5)       (6)       (7)
 
50  2   244.9000   249.9920 0.9796 0.9901 0.9894   248.6340   1.0055
51  3   248.3000   250.5920 0.9909 0.9933 0.9975   249.0400   1.0062
52  4   251.9000   251.1500 1.0030 1.0026 1.0004   249.4460   1.0068
53  5   253.9000   251.8250 1.0082 1.0083 0.9999   249.8520   1.0079
54  6   260.3000   252.4000 1.0313 1.0119 1.0192   250.2580   1.0086
55  7   255.1000   253.0420 1.0081 1.0125 0.9957   250.6630   1.0095
56  8   255.8000   253.5830 1.0087 1.0114 0.9974   251.0690   1.0100
57  9   255.8000   254.2670 1.0060 1.0052 1.0008   251.4750   1.0111
58 10   255.5000   254.7670 1.0029 1.0028 1.0001   251.8810   1.0115
59 11   255.1000   255.0500 1.0002 0.9987 1.0015   252.2860   1.0110
60 12   254.3000   255.2580 0.9962 0.9957 1.0006   252.6920   1.0102
61  1   252.1000   255.1830 0.9879 0.9940 0.9939   253.0980   1.0082
62  2   253.1000   255.3830 0.9911 0.9935 0.9976   253.5040   1.0074
63  3   254.3000   255.7420 0.9944 0.9946 0.9998   253.9100   1.0072
64  4   255.3000   255.8670 0.9978 0.9997 0.9980   254.3150   1.0061
65  5   256.4000   255.9750 1.0017 1.0026 0.9990   254.7210   1.0049
66  6   259.4000   255.8500 1.0139 1.0068 1.0070   255.1270   1.0028
67  7   257.5000   256.0920 1.0055 1.0082 0.9973   255.5330   1.0022
68  8   260.1000   256.1920 1.0153 1.0083 1.0069   255.9380   1.0010
69  9   257.3000   256.1000 1.0047 1.0033 1.0014   256.3440   0.9990
70 10   256.8000   256.2580 1.0021 1.0027 0.9995   256.7500   0.9981
71 11   253.6000   256.4000 0.9891 0.9966 0.9925   257.1560   0.9971
72 12   257.2000   256.6420 1.0022 0.9915 1.0108   257.5620   0.9964
73  1   253.3000   257.1830 0.9849 0.9900 0.9948   257.9670   0.9970
74  2   252.0000   257.3830 0.9791 0.9913 0.9877   258.3730   0.9962
75  3   256.2000   257.5250 0.9949 0.9913 1.0036   258.7790   0.9952
76  4   257.4000   258.1330 0.9956 0.9992 0.9964   259.1850   0.9959
77  5   259.3000   258.7670 1.0021 1.0033 0.9988   259.5900   0.9968
78  6   265.9000   259.5250 1.0246 1.0051 1.0193   259.9960   0.9982
79  7   259.9000   260.0830 0.9993 1.0083 0.9910   260.4020   0.9988
80  8   261.8000   260.7000 1.0042 1.0096 0.9946   260.8080   0.9996
81  9   264.6000   261.5700 1.0116 1.0046 1.0069   261.2140   1.0014
82 10   264.4000   262.1670 1.0085 1.0052 1.0033   261.6190   1.0021
83 11   262.7000   262.8130 0.9996 1.0055 0.9941   262.0250   1.0030
84 12   263.9000   263.3140 1.0022 1.0034 0.9988   262.4310   1.0034
 
AVERAGE SEASONAL ADJUSTMENT FACTORS:
MONTH    SEASONAL
  1      0.9921
  2      0.9898
  3      0.9894
  4      0.9937
  5      1.0002
  6      1.0050
  7      1.0079
  8      1.0087
  9      1.0072
 10      1.0059
 11      1.0031
 12      0.9971
 
FOR ORIGINAL SERIES, MEAN SQUARED ERROR IS:    5.8641
STANDARD ERROR OF THE ESTIMATE:                2.4216

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BACK TO CONTENTS

 

CHAPTER 14. ECONOMIC FLUCTUATIONS AND SHOCKS

In the previous chapter we examined the macroeconomic implications of a positive secular trend that we regarded as economic growth. Historical experience has show that the economies in which business firms operate also will be buffeted by macroeconomic disturbances about the secular trend, whether the economies are organized around markets or as authoritarian dictatorships.

At mid-twentieth century the literature contained references to "cyclical" behavior in the macroeconomy, but this terminology has given way to the term "economic fluctuations" in recognition that the ups and downs of macroeconomic activity are not so regular in either duration or amplitude that they can be regarded as cyclical.

                    

The Characteristics of Economic Fluctuations

As noted in Appendix 13A, the procedures for decomposing a time series yield data for its trend, cyclical, seasonal, and irregular components. Since our concern at present is not with seasonal or irregular variation, we shall suppose that they may be isolated and removed from the series employing commonly available techniques. What remains in the time series after removal of the seasonal and irregular variations is a trend-cycle series.

Most macroeconomic trend-cycle series that are long enough (i.e., spanning several decades) exhibit what appear to be oscillating paths above and below their plotted trend paths. Although such oscillations rarely exhibit regularity of either duration or amplitude, the general repeating pattern of ups and downs in the series has given rise to terminology such as business cycles (American usage) or trade cycles (British usage). Much attention has been devoted by economic analysts during the nineteenth and twentieth centuries to describing and identifying such macroeconomic cyclical behavior in various sectors and of various durations.

In the usual exposition, a complete cycle includes four phases: contraction, trough, expansion, and peak. The most commonly observed cyclical phenomenon in the U.S. economy has been the so-called business cycle with average duration of more than four years. This average has been lengthening with the expansions of the 1980s and 1990s.  On average during the post-World War II era, expansion phases have been roughly twice as long as contraction phases.  The “Great Recession” that began in 2008 may increase the average duration of contraction phases. The estimated average duration is deceptive, however, because no two such U.S. cycles in the twentieth century have been alike. Cycle analysts have detected yet longer cyclical phenomena which may lap or encompass two or more such business cycles. Cycle analysts have identified inventory cycles that appear to last a dozen or so years, construction cycles that extend 18 to 20 years, and the so-called Kondratief cycle (after its discoverer) that may span a half century or more.

Although the aggregate demand-supply analysis elaborated in Chapter 11 is intended to provide only short-run analysis of the macroeconomy, it can be extended to illustrate cyclical behavior. Starting from an equilibrium between aggregate demand and aggregate supply, suppose that one of the determinants of aggregate demand changes (a newly-enacted government program is one possibility) to increase aggregate demand relative to long-run aggregate supply, setting in motion an adjustment process that causes the output of the economy to increase beyond its normal rate of real output. This results in some unanticipated demand-pull inflation that sets in motion a cost-pushing increase of short-run aggregate supply as was described in Chapter 11. This adjustment results in a decrease of output as the economy returns to its sustainable normal operating capacity. After this adjustment is completed, no permanent real change has occurred in the economy, but if the aggregate demand increase is sustained, the price level remains higher than the former equilibrium price level.

This may complete the adjustment process, but we may carry the scenario forward in either of a couple of plausible directions. Suppose that the increase of aggregate demand resulted from a one-time "spurt" of additional spending in the economy that is not sustained. In this case aggregate demand might well return to near its former level, resulting in some further decrease of output to a level temporarily below the natural rate of real output and at a price level lower that the previous equilibrium level. As the lower price level becomes translated into lower production costs, businesses likely begin to increase production, causing aggregate supply to increase and the economy to return to the natural rate of real output and to the former equilibrium price level. The bold-faced terms in the previous paragraph and this one describe a complete cyclical process of expansion, upper turning point, contraction, lower turning point, and expansion to near the starting point of the process.

An alternative scenario, and one that seems even more plausible, is that the restored equilibrium is difficult to recognize so that during the cost-push adjustment there is an overreaction of business and labor decision makers. This results in a further increase of short-run aggregate supply relative to aggregate demand, causing more cost-pushing inflation and output to fall below the natural rate of real output. When the overreaction is finally recognized, short-run aggregate supply returns to where it again equilibrates with aggregate demand at the normal operating capacity of the economy and a price level near the former equilibrium level. But this little episode of overreaction has also resulted in another possible explanation of a cyclical contraction followed by expansion.

Other changes of aggregate demand and aggregate supply may likewise set in motion adjustment processes which, when examined in time sequence, reveal what appears to be cyclical behavior. An initial increase of short-run aggregate supply (possibly a result of a so-called “supply shock") may precipitate ensuing shifts of aggregate demand and supply that would also yield the appearance of cyclical behavior.

 

Efforts to Forecast Cyclical Turning Points

Cycle analysts have expended great effort in examining the circumstances of the troughs and peaks, perhaps better identified as the lower and upper turning points. Perhaps the best hope for predicting reversals of macroeconomic change lies in a list of so-called leading indicators for a cyclical phenomenon. In the United States, the National Bureau for Economic Research (N.B.E.R.) has analyzed the cyclical characteristics of more than a hundred series, some of which may serve as leading indicators of cyclical aggregate economic behavior of the U.S. economy.[1] The Conference Board has selected ten series to be included in a composite index of leading indicators.[2]

Efforts to explain and predict turning points have not been very productive in yielding criteria for predicting either the amplitude of a cyclical expansion or contraction, or the timing of the turning points. A case in point is the expansion dating from 1982 and continuing through mid-1990. Cycle analysts had been forecasting the end of the expansion and the onslaught of recession for more than six years when the downturn finally came. The conventional identification that a downturn/upturn has occurred is that the aggregate time series exhibits contraction/expansion for two consecutive quarters (i.e., a half of a year). A period of expansion/contraction may be declared ended only when the time series has exhibited contraction/expansion for two consecutive quarters. The longest expansion on record, that begun in 1992, finally came to an end in February 2001.

It appears that psychological expectations of business managers must play a very large part in precipitating change at turning points of cyclical processes. But in order to effect a change in the direction of economic activity, expectations of different future economic conditions must become shared by a large proportion of the business decision makers in the economy.

There is little doubt that psychological expectations change in a cumulative manner. At first only a few people expect different conditions than presently obtain, and these views are regarded by the majority of business decision makers as renegade or maverick views. Such views may be advanced by academics, professional prognosticators, or others who are not themselves business decision makers, but rather are peripheral to the business community. But as the renegade views find their ways into commentaries in respected business publications and video media, ever more business decision makers begin to pay attention to them as the maverick views become the prevailing orthodoxy. They read the same newspaper editorials, hear and watch the same radio and television reports, attend the same civic club speeches, and eventually begin to deliver the same speeches. Once decision makers begin to believe the predictions, they predicate their decisions upon the forecasts, and the forecasts become self-fulfilling prophesies.

 

Efforts to Model Cyclical Behavior

There have been extensive efforts to develop mathematical models of cyclical behavior. Such models, consisting of systems of equations, yield tabular or graphic results that may exhibit regularity of amplitude and duration, i.e., stability of cyclical behavior in the model. Models can also be devised, with appropriate parameter values, to demonstrate increasing amplitude or lengthening duration of oscillation. Or, with other parameter values, the models can demonstrate decreasing amplitude or shortening duration of oscillation. The former behavior is described as explosive, while the latter as dampening. The crucial problem in the effort to model cyclical behavior is the regularity of variation in any model that can be constructed, compared with the irregularity present in any series under examination, i.e., the problem of "fit." Appendix 14A elaborates such a model, with illustrations of stable, dampening, and explosive cyclical behavior.

With the advent of Keynesian analysis of the multiplier, economists theorized that the derived demands for capital goods tend to increase and decrease at faster rates (and by larger percentages) than the demands for the final goods produced by the capital goods, i.e., derived demands accelerate relative to final demands. In a seminal article on the acceleration thesis, Paul Samuelson identified ranges of the acceleration factor which would result in stable, dampening, and explosive oscillation of the output of an economy in response to changes in final demand and concomitant accelerated changes in derived demand.[3]  These ranges are illustrated in the cases examined in Appendix 14A.

The normal presumption about inventories is that managements of firms attempt to control their inventories within rather narrow bounds. If inventories increase excessively, the explicit and implicit costs of inventory maintenance tend to become prohibitive. If inventories fall to very low levels (or zero), firms will in effect go out of business by having little or no product to sell. It is therefore reasonable to believe that managers will feel compelled to exercise rather tight control over their product and materials inventories.

Simulations employing the model described in Appendix 14A lead to a number of propositions about the behavior of the economy. One is that an economy in equilibrium will continue in equilibrium until disturbed. This is a straight-forward application of the physics principle of inertia. A corollary of this proposition is that something must happen in the economy to disturb the equilibrium and set in motion a discrete fluctuation or an on-going cyclical process.

It is clear from repeated simulations employing wide ranges of parameter values that either inventory management policies or multiplier-accelerator interaction can perpetuate or aggravate a cyclical process, once started. Parameters in either the inventory management or multiplier-accelerator model can be set to yield dampening or explosive oscillation.

In the accelerator model, the smaller the accelerator factor, i.e., the marginal capital-output ratio, the smaller the amplitude of the ensuing cyclical process, and vice-versa. Capital-output ratios (both marginal and average) tend to be lower in more developed economies, higher in less developed economies.  Capital-output ratios (both average and marginal) tend decline as the capital base grows and technology advances to increase productivity.

In the inventory management model, management policies to stabilize inventories (including “just-in-time” inventory management systems) tend to increase the amplitude of oscillation, and thus to aggravate a cyclical process. However, the more inventories are allowed to vary, in effect serving as a "shock absorber,” the smaller will be the amplitude of oscillation in the cyclical process. Thus, there appears to be an inherent conflict between the perceived microeconomic compulsion experienced by business firm managers to control their inventories, and the macroeconomic need for stability. But as an economy matures, its industrial sector accounts for a diminishing proportion of the economy's output while the service sector's output proportion increases. A macroeconomic consequence (or benefit) is that the smaller the proportion of the economy's output accounted for by manufacturing, the less significant are inventory management policies, either for materials or final goods, to the stability of the economy.

 

Recent Experience of Responses to Shocks

Paralleling the inference from inventory management simulations, Martin Wolf writing in the Financial Times has noted that the UK response to the "Great Recession" financial crisis has been less drastic than the US response.[4]  He observes that as US unemployment increased from 4.8 percent in early 2008 to 10.1 percent at mid 2009, US output per person employed rose by 5.1 percent between 2007 and 2010. In comparison, UK unemployment increased over the same period from 5.2 percent to only 7.7 percent as output per person employed in UK fell by 2.5 percent. The US economy reduced hours of work primarily by laying off workers; the UK economy reduced hours of work more by reducing the number of hours worked per employee. Unemployment rose by less in UK than in US.

Wolf points out that the UK response is not unique, but rather is similar to responses of several Continental European countries, including France, Germany, and Italy. But the Spanish experience parallels that of the US in that its output per hour worked rose over the specified period and its unemployment rate escalated similar to that of the US.

The macroeconomic implication of these observed responses is that a shock that is absorbed in productivity decrease can have a smaller adverse impact on the macroeconomy than does a shock that is accompanied by on-going productivity increase. The seeming compulsion to lay off workers as economic contraction ensues will have a greater negative impact on the economy than if managers would cut back on hours worked per employee rather than lay off employees. The managerial implication is that workers whose hours are reduced continue to be available to the employer and maintain their company-specific knowledge and work skills.  When the economy picks up again, the company doesn’t have to train and acculturate new employees to company procedures.

 

Initiators and Terminators of Cyclical Behavior

The analysis of cyclical phenomena requires examination of factors that initiate, perpetuate, and terminate a cyclical process. It is becoming ever clearer that the cycle is not a self-generating or perpetuating phenomenon. Something has to start it and keep it going. Cycle analysts have focused upon shocks to the economy that may be either endogenous or exogenous to it. Such shocks may include monetary expansion due to discoveries of new stocks of precious metals or creation by monetary authorities, the building and bursting of “bubbles” (real estate, dot-com, housing, commodity), technological advance and the innovation that implements it, natural phenomena such as volcanic eruption, hurricanes, and crop freezes, and political phenomena such as wars or even threats of wars.

Factors that tend to perpetuate economic instability in an economy include repeated policy blunders, managerial practices oriented toward the benefit of the firm but to the detriment of the larger economy, excessive optimism or pessimism on the parts of investors, perception lags or errors, response lags or errors, and perverse parameter values (e.g., high marginal capital-output ratios as are typical of lesser-developed economies).

Cycle analysts have identified various possible terminators of cyclical activity, or factors that serve to reverse the direction of change of the economy. These include the natural dampening effects of management policies that allow inventories to vary in response to changing demand, and "congenial" parameter values (e.g., small enough acceleration factors) that foster dampening of oscillation.

Cycle analysts have also suggested overbuilding, excessive production resulting in inventory buildup, and bank credit exhaustion as possible reversers or terminators of cyclical activity. During the last couple of decades of the twentieth century, economists advanced the so-called “rational expectations hypothesis,” i.e., that intelligent and perceptive economic decision makers do not simply extrapolate past behavior, but rather analyze, predict, and adjust their decision criteria.[5] This thesis applied to the business cycle context may provide the most cogent explanation yet of any tendency for amelioration of cyclical activity.

 

Recent Thought about Economic Instability

The U.S. economy has undergone structural transition over the past couple of centuries. Prior to the turn of the twentieth century, the U.S. economy could rightly be described as a predominantly agrarian in structure since the majority of the labor force was employed in agriculture, and the bulk of the output of the economy was produced by it. Most of the variations in economic activity prior to the turn of the twentieth century could be attributed to the vagaries of the weather, to phenomena such as sun spots, or to wars. The economy had undergone a substantial transformation by the 1920s when more than half of the labor force was employed in industry, and more than half of the value of the output of the economy consisted of manufactures. As the U.S. economy became ever more industrial in character, the role of inventories became increasingly more important. During the second half of the twentieth century, the industrial output of the U.S. economy continued to grow, but the output and employment in the service sector continued to grow to become a larger proportion of the economy than the industrial sector.

Variability of both materials input inventories and product inventories can serve the economy well as a shock absorber for variations in the in the level of economic activity. Management practices to control inventories within narrow bounds tend to both aggravate and perpetuate economic variation. As the U.S. economy continues its transition from industrial production to becoming predominantly a service economy, inventory management policies will be ever less significant to the stability of the economy.

During the 1960s the economics discipline allowed itself to experience a sense of euphoria at what was regarded at the time as great and nearly complete knowledge of economic phenomena and the ability to exercise policy to control them. Much rhetoric was devoted to the fine tuning of the economy, and some even went so far as to declare the business cycle obsolete. However, events of the late 1960s and 1970s confirmed that the announced mastery of the macroeconomy and consequent demise of the business cycle may have been a bit premature. A much more humble economics profession went "back to school" during the 1970s and 1980s again to try to learn what it thought that it had known in the 1960s.

The long durations of the expansions during the 1980s and 1990s led some economists to wonder if the business cycle is becoming obsolete, but this time not because of illusions of any great mastery of knowledge or the ability to exercise policy. Rather, there is a growing recognition that as an economy advances and matures, a declining proportion of employment goes into the agrarian and manufacturing sectors, and correspondingly a declining proportion of the value of output is produced by them. It is the service sector in the maturing economy which accommodates the rising proportion of employment and accounts for the growing proportion of income generated in the economy. As this process continues, the U.S. economy should become ever less responsive to natural phenomena, or dependent upon inventories to absorb shocks, or subject to inventory management practices that aggravate and perpetuate disturbance. Even so, the 1990s economic expansion fomented by a technological revolution in computing and communications, the bursting of the so-called "dot-com bubble” late in the 1990s, and the financial collapse of 2008 have emphasized other causes of economic fluctuations.

Another factor intended to ameliorate cyclical behavior in the economy is the installation of automatic fiscal stabilizers by governments. Two examples are progressivity of income taxation and transfer payments which vary automatically with the level of economic activity. A progressive tax rate system tends to take purchasing power out of the income stream during an economic expansion when incomes are rising; it also tends to leave more purchasing power in the income stream during an economic contraction as aggregate income is falling due to shorter working hours or rising unemployment. The unemployment compensation systems in place in most Western economies serve to inject additional purchasing power into contracting economies (or at least to prevent it from falling as much as it would have done in the absence of such systems), and to withdraw some purchasing power from expanding economies as unemployment falls and aggregate income rises.

An offset to such automatic stabilization has been the enactment of tax reform legislation that has the effect of diminishing the degree of progressivity in the name of improving the incentive structure of the economy. A possible undesirable side effect may have been damage to the automatic stabilization property provided by the previously more steeply progressive income tax system.

Finally, we note that the term "cycle" seems to be falling into disrepute among economists as more of them become skeptical that there are inherent in the economy any forces which tend automatically to perpetuate oscillating behavior. The term preferred by many economists today to describe variations in the level of economic activity is business fluctuations. There is an emerging consensus that variations in the level of macroeconomic activity are more likely to be episodic rather than cyclical, i.e., that expansions and contractions are attributable to specific events or shocks that occur within the economy or impinge upon it from outside. In this view, turning points in macroeconomic activity are attributable to specific causes rather than to any internal factors that limit the extent of expansion or contraction, and thus mandate that contractions or expansions follow in any cyclical fashion.

 

Managerial Implications of Economic Instability

Economic instability, whether cyclical or episodic, is such an extremely complex phenomenon that it is very difficult to draw significant managerial implications in regard to it. However, we may note two important implications with respect to long-run change that unfolds gradually. First, since there is a tendency for maverick views to become orthodoxies with cumulative adoption, the business firm manager should monitor closely both the real phenomena as he or she perceives them, and the emergence of views expressed in the media and in academic sources. The manager should be prepared to adjust business policies when it appears that the views are widely enough accepted that people are beginning to predicate their economic decisions upon them.

Second, the manager can rely only to a point upon the prognostications of others. Ultimately the manager must become his or her own economic analyst and forecaster. The effectiveness of this role can develop only with experience and sharpened perceptiveness of changing phenomena in the economy.

Managerial reaction to economic shocks is another matter. Shocks are phenomena that are unpredictable and which often unfold in a very short periods of time. Economic shocks constitute disasters for some and opportunities for others. They induce both inventory and price effects soon after their impacts. Those most directly affected by the shocks will have to respond as seems appropriate at the moment. As we have seen from the simulation exercises, the macroeconomy will be better off if business decision makers do not respond to shocks by changing rates of production, inventory management practices, or employment levels. The vast majority of firms, assuming that the shock impact will be short-lived, will probably also be better off to adjust prices and let inventories change to absorb the shock, but not alter production rates or employment levels. Only if it appears that the effects of a shock will unfold over a longer period of time should the manager give consideration to adjusting output and employment levels.

Finally, we note that the exigencies of macroeconomic instability will almost certainly provide occasions for entry into or exit from industries. A growing economy, or one enjoying cyclical expansion, will involve buoyant market conditions that may encourage entrepreneurial interests to undertake new ventures and enter expanding industries. Such conditions will also be propitiated if the economy possesses newly-recognized or developed comparative advantages vis-a-vis the rest of the world.

But a stagnating or contracting economy likely will be accompanied by depressed market conditions that result in declining sales and falling profits in many industries, especially those for which the economy no longer has international comparative advantages. In such a business climate, the weaker competitors in the various markets are more likely to fail. Unfortunately, it appears to be much easier for an entrepreneur to perceive an opportunity to enter a market than to recognize the need to exit it, and many entrepreneurs stay too long before finally being forced out by failure. 

While failure certainly is painful for former owners and employees of failed firms, it may have cathartic effects for the economy as a whole as weaker firms fail but financially viable firms survive. As painful as it may be to owners and employees, the failure of weaker firms releases resources for use in stronger sectors of the economy.  And there are entrepreneurial opportunities even in a contracting economy. Technological advances that enable decreased costs are especially appropriate to the declining economy, and market demands may actually increase in cases of goods with low or negative income elasticities of demand.

 

Managerial Implications of Unemployment

The two most prominent features of macroeconomic instability in the modern world are inflation and unemployment. There always will be some amount of frictional unemployment in any economy due to the fact that some workers leave their former employments before they have found suitable subsequent employments. A moderate amount of such frictional unemployment may even be taken as an indication of the health of an economy since workers have enough confidence that they can find new employments that they are willing to leave their old jobs.

An economy enjoying growth attributable to technological advance will also experience unemployment since some products and processes (and the skills required to produce them) will be rendered obsolete by the development of new products and processes that require new job skills. Some amount of structural unemployment can also be taken to be an indication of the health of the economy. The fact that workers become involuntarily unemployed due to technological change serves to keep job markets "looser" than might have been the case in the absence of frictional and technological unemployment. This phenomenon provides opportunities to managements of firms to replace leaving workers or expand their work forces under more favorable skills or wage conditions. However, the labor released by technological change will almost certainly not possess the skills required by the newly-developed technologies, and will thus have to be retrained.

Cyclical unemployment naturally follows from adverse comparative advantage changes or from cyclical or episodic contractions of the economy. During such times employers diminish the use of inputs in production processes as the means for reducing output rates or levels. The compulsion for such reduced resource utilization follows from falling demand and inventory accumulations which become regarded as intolerable. In the case of adverse changes of comparative advantages, the contraction and ensuing unemployment is localized to the industries that are moving to foreign shores. While this may be a very painful process for firms and workers in those industries, it also has the effect of releasing labor to other industries that are able to exploit developing comparative advantages in the local economy.

On the other hand, involuntary unemployment resulting from episodic or cyclical contraction is a general phenomenon that releases labor for which there are no natural endogenous employments until the economy recovers from the downturn. But even in a general economic contraction, there will always be some industries that are able to develop and exploit technological advances and require additional labor. The looser labor markets of the contracting economy will provide staffing opportunities for those firms that are fortunate enough to discover and exploit technological opportunities even in a contracting economy.

 

Managerial Implications of Inflation

Prices rise and fall in response to market conditions of demand and supply. Economists generally recognize that an increase of demand or a decrease of supply in the market for a particular good will result in an increase of the price of the good, but this does not constitute inflation. Yet if the good is a widely-used input in numerous production processes (e.g., petroleum), an increase in the market price of it may set in motion a sequence of price increases, and hence cost increases, as a more general phenomenon throughout an economy.

More properly understood, then, inflation is a phenomenon of a general increase in prices on average across all goods and services. Such a phenomenon may accommodate falling prices for some items (e.g., high definition televisions, tablet computers, and other "high-tech" consumer goods) that are more than offset by rising prices of other goods. The principal impacts of inflation are rising costs of living on average for workers/consumers and increasing costs of production on average for employers/producers.

Until the middle of the twentieth century, economists regarded unemployment and inflation to be mutually-exclusive phenomena. Historical experience indicated that a stagnating economy or one in contraction exhibited price stability or deflation along with mounting unemployment. Growing or recovering economies were accompanied by price inflation and diminishing unemployment. Economists could analyze inflation in these circumstances as attributable to increases of aggregate demand relative to aggregate supply, or by expansions of monetary aggregates.

Beginning with the 1957-59 recession in the U.S. economy, it and most subsequent recessions exhibited rising unemployment accompanied by increasing prices. This inflationary phenomenon could not be analyzed with reference to increasing aggregate demand, and it could be analyzed only partially with reference to monetary expansion. This inflationary phenomenon became known as stagflation, i.e., the combination of inflation and stagnation. It was in response to the need to analyze this phenomenon that so-called "supply-side" economists advanced the thesis that on-going decreases of short-run aggregate supply relative to  aggregate demand could be responsible for the dual phenomena of falling output (with rising unemployment) and price inflation.

As noted in Chapter 11, sources of such decreases of short-run aggregate supply include supply shocks and the deleterious effects of governmental regulation, transfer payments, progressive income taxation, and the taxation of capital gains. Such decreases of short-run aggregate supply can produce inflation as a general phenomenon without monetary expansion, or in spite of a deliberate governmental effort to control monetary aggregates. This is because the falling level of economic activity in the economy reduces the transactions demands for money at the same time that the emerging shortages of goods in the economy result in their price increases across a broad front.

Since the 1930s depression, there has been very little significant deflation anywhere in the world (except in Japan during the 1990s decade). Managers of business firms have had to learn to live with inflation, whether sourced in aggregate demand increases, monetary expansions, or adverse aggregate supply shifts. Unanticipated inflation results in profit squeezes because costs of production increase faster than managements can raise the prices of the goods and services that they produce and sell. If inflation can be fully anticipated by the managements of firms in the economy, they can plan orderly increases in list prices and publication of new price lists, menus, and catalogs. However, from a macroeconomic perspective, this tends to institutionalize the inflationary process because the planned increases in prices serve to insure the next round of price increases. This is yet another point at which microeconomic interests and macroeconomic needs may come into conflict.

Monetary economists argue that such cost-pushing inflation can become institutionalized only if the monetary authority accommodates the process by allowing adequate increases of monetary aggregates. However, cost-pushing pressures may yield inflation without monetary expansion if the velocity of circulation of money in the economy rises. This process is tempered by any effort on the part of monetary authorities to limit increases or actually decrease monetary aggregates. If such institutionalized inflation develops in an economy (e.g., as during the late 1970s in the U.S.), it can likely be broken only by an effort on the part of the monetary authority to impose strict control over increases of the monetary aggregates (as was done by the Volker Federal Reserve in the U.S. economy in the early 1980s) to break the cycle of inflationary expectations. This puts the managers of commercial enterprises in the position of having to monitor not only macroeconomic conditions of expansion and contraction, inflation and unemployment, but also the possible and likely actions of governmental authorities in their efforts to address what they perceive to be unsuitable macroeconomic conditions.

 

What's Ahead

In Part D we shall explore the managerial implications of efforts by government to ameliorate the force and duration of economic disturbances. We shall also examine its role in initiating and perpetuating economic instability.

 

Chapter 14 Endnotes:

[1] The National Bureau of Economic Research, “Economic Indicators and Releases,” http://www.nber.org/releases/.

[2] The Conference Board, “Global Business Cycle Indicators, http://www.conference-board.org/data/bcicountry.cfm?cid=1.

[3] Paul Samuelson, "Interactions Between the Multiplier Analysis and the Principle of Acceleration,” The Review of Economics and Statistics, Vol. 21, No. 2, May, 1939.

[4] Martin Wolf, "Britain's curiously continental job market,” Financial Times, June 17, 2011, http://www.ft.com/intl/cms/s/0/89e3f070-9848-11e0-ae45-00144feab49a.html?ftcamp=rss&ftcamp=crm/email/2011616/nbe/InTodaysFT/product#axzz1PXpYA6qA).

[5] The 2011 Nobel Prize in Economics was awarded to economists Thomas Sargent and Christopher Sims for their work during the 1970s and ‘80s in analyzing and modeling rational responses of society to macroeconomic changes, particularly interest rates.


BACK TO CONTENTS

 

APPENDIX 14A. MULTIPLIER-ACCELERATOR AND INVENTORY REPLACEMENT

In order to examine the stability characteristics of a macroeconomy, a simulation model was designed around a Keynesian consumption function that relates changes of the level of consumption to changes of the level of income.

Total investment spending is the sum of autonomous investment (not related to the income level) and induced investment (that does vary with the income level) is determined as the difference between income in each period and the previous period multiplied by the marginal capital-output ratio, which is the model's accelerator factor.

Actual sales in any period is then the sum of consumption and investment spending. Production  in each period is the sum of sales in the previous period, plus an inventory replacement factor multiplied by the change in inventories between each period and the previous period.

The model is designed for sequential implementation over a specified number of periods. At the beginning of a simulation exercise, the analyst may determine the number of periods to run, the value of the marginal capital output ratio, the value of the inventory replacement factor, increments of the autonomous consumption and investment spending, and the period number in which to introduce the autonomous spending increments. The results of the simulation computations are presented in tabular form.

Repeated simulations using the model reveal the values of the marginal capital-output ratio and the inventory replacement factor that yield dampening, perpetuating, and explosive oscillation of the hypothetical economy in response to increments of autonomous consumption or investment spending. As shown in the display of results for Case 1 with a marginal capital-output ratio of 1.66 and no inventory replacement production, the economy is stable (i.e., it exhibits no cyclical behavior) through period 3. An increment of autonomous consumption by 10 in period 3 sets in motion a cyclical process which exhibits stable oscillation of both income and inventory through period 60. When the value of the marginal capital-output ratio  increases above 1.66, (Case 2 illustrates the effects of a marginal capital-ouput ratio of 1.8, the oscillation of income gradually increases in amplitude. Any value of the marginal capital-output ratio in excess of 2.0 yields explosive oscillation. Values of the marginal capital-output ratio below 1.66 (Case 3 illustrates the effects of a marginal capital-output ratio of 1.45) result in gradually diminishing oscillation. With a marginal capital-output ratio of 1.45, oscillation dampens nearly to zero by period 40. We note in passing that marginal capital output ratios tend to be lower in more developed economies, and to decline with capital investment and technological advances that increase the productivity of capital.

Simulations to test the effects of changes in the inventory replacement production factor assume no acceleration factor (marginal capital-output ratio of zero. As illustrated in the display for Case 4, with no production to replace inventory depletion in the previous period, an increment to autonomous investment of 30 in period 3 results in nearly complete adjustment to a higher income level by period 10. Case 5 illustrates the effect of increasing the inventory replacement production factor to 100 percent. As the proportion of inventories replaced increases toward 100 percent, the economy's income level becomes more unstable but dampening of oscillation continues to occur.

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Case 1.  MULTIPLIER-ACCELERATOR-INVENTORY CYCLE MODEL

(1)  INVENTORY TO REPLACE:       0
(2)  MPC:                        .6
(3)  INITIAL AUTON CONS:         100
(4)  INCREMENT AUTO CONS:        10
(5)  INCREMENT AUTON INVEST:     0
(6)  PERIOD TO CHANGE:           3
(7)  CAPITAL/OUTPUT RATIO:       1.66
(8)  PERIODS TO RUN:             40

      PRODUCTION  FOR         INVESTMENT       TOTAL  ACTUAL   INVEN   SAV-
PER   SALES     INVEN    AUTON INDUCED TOTAL  INCOME   SALES  STOCKS   ING
  1    700          0      300       0   300    1000     700     600   300
  2    700          0      300       0   300    1000     700     600   300
  3    700          0      300       0   300    1000     700     600   300
  4    700          0      300       0   300    1000     710     590   290
  5    710          0      300      17   337    1027     726     584   301
  6    726          0      300      26   326    1052     741     584   311
  7    741          0      300      26   326    1057     750     591   317
  8    750          0      300      15   315    1055     749     601   316
  9    749          0      300      -2   298    1047     738     611   309
 10    738          0      300     -18   282    1020     722     616   298
 11    732          0      300     -27   273     995     707     615   288
 12    707          0      300     -25   275     982     699     608   283
 13    699          0      300     -13   287     987     702     597   285
 14    702          0      300       4   304    1006     714     588   293
 15    714          0      300      19   319    1033     730     584   303
 16    730          0      300      27   327    1057     744     586   313
 17    744          0      300      23   323    1068     751     594   317
 18    751          0      300      11   311    1061     747     604   314
 19    747          0      300      -6   294    1040     734     612   306
 20    734          0      300     -21   279    1013     718     616   295
 21    718          0      300     -27   273     991     705     613   287
 22    705          0      300     -22   278     983     700     605   283
 23    700          0      300      -9   291     991     705     595   286
 24    705          0      300       8   308    1013     718     587   295
 25    718          0      300      22   322    1040     734     584   306
 26    734          0      300      26   326    1060     746     588   314
 27    746          0      300      21   321    1067     750     596   317
 28    750          0      300       6   306    1057     744     606   313
 29    744          0      300     -10   290    1034     730     614   303
 30    730          0      300     -23   277    1008     715     616   293
 31    715          0      300     -26   274     988     703     611   285
 32    703          0      300     -19   281     984     700     603   284
 33    700          0      300      -4   296     996     708     593   288
 34    708          0      300      12   312    1020     722     586   298
 35    722          0      300      23   323    1045     737     585   303
 36    737          0      300      25   325    1063     748     590   315
 37    748          0      300      17   317    1065     749     599   316
 38    749          0      300       2   302    1051     741     608   311
 39    741          0      300     -14   286    1027     726     614   301
 40    726          0      300     -24   276    1002     711     615   291

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Case 2.  MULTIPLIER-ACCELERATOR-INVENTORY CYCLE MODEL

(1)  INVENTORY TO REPLACE:       0
(2)  MPC:                        .6
(3)  INITIAL AUTON CONS:         100
(4)  INCREMENT AUTO CONS:        10
(5)  INCREMENT AUTON INVEST:     0
(6)  PERIOD TO CHANGE:           3
(7)  CAPITAL/OUTPUT RATIO:       1.8
(8)  PERIODS TO RUN:             40

      PRODUCTION  FOR         INVESTMENT       TOTAL  ACTUAL   INVEN   SAV-
PER   SALES     INVEN    AUTON INDUCED TOTAL  INCOME   SALES  STOCKS   ING
  1    700          0      300       0   300    1000     700     600   300
  2    700          0      300       0   300    1000     700     600   300
  3    700          0      300       0   300    1000     700     600   300
  4    700          0      300       0   300    1000     710     590   290
  5    710          0      300      18   318    1028     727     583   301
  6    727          0      300      30   330    1057     744     583   312
  7    744          0      300      31   331    1076     755     589   320
  8    755          0      300      20   320    1075     755     600   320
  9    755          0      300      -0   300    1055     743     612   312
 10    743          0      300     -22   278    1021     723     620   298
 11    723          0      300     -37   263     986     702     621   284
 12    702          0      300     -38   262     964     688     613   275
 13    688          0      300     -24   276     964     688     600   276
 14    688          0      300       1   301     989     703     585   286
 15    703          0      300      27   327    1030     728     575   302
 16    728          0      300      45   345    1073     754     575   319
 17    754          0      300      46   346    1100     770     584   330
 18    770          0      300      29   329    1099     769     601   329
 19    769          0      300      -1   299    1068     751     618   317
 20    751          0      300     -33   267    1018     721     630   297
 21    721          0      300     -54   246     967     690     631   277
 22    690          0      300     -56   244     934     671     619   264
 23    671          0      300     -35   265     936     772     599   264
 24    672          0      300       2   302     973     694     578   279
 25    694          0      300      40   340    1034     730     563   304
 26    730          0      300      66   366    1096     768     563   328
 27    768          0      300      67   367    1135     791     577   344
 28    750          0      300       6   306    1057     744     606   313
 29    744          0      300     -10   290    1034     730     614   303
 30    730          0      300     -23   277    1008     715     616   293
 31    715          0      300     -26   274     988     703     611   285
 32    703          0      300     -19   281     984     700     603   284
 33    700          0      300      -4   296     996     708     593   288
 34    708          0      300      12   312    1020     722     586   298
 35    722          0      300      23   323    1045     737     585   303
 36    737          0      300      25   325    1063     748     590   315
 37    748          0      300      17   317    1065     749     599   316
 38    749          0      300       2   302    1051     741     608   311
 39    741          0      300     -14   286    1027     726     614   301
 40    726          0      300     -24   276    1002     711     615   291

---

Case 3.  MULTIPLIER-ACCELERATOR-INVENTORY CYCLE MODEL

(1)  INVENTORY TO REPLACE:       0
(2)  MPC:                        .6
(3)  INITIAL AUTON CONS:         100
(4)  INCREMENT AUTO CONS:        10
(5)  INCREMENT AUTON INVEST:     0
(6)  PERIOD TO CHANGE:           3
(7)  CAPITAL/OUTPUT RATIO:       1.45
(8)  PERIODS TO RUN:             40

      PRODUCTION  FOR         INVESTMENT       TOTAL  ACTUAL   INVEN   SAV-
PER   SALES     INVEN    AUTON INDUCED TOTAL  INCOME   SALES  STOCKS   ING
  1    700          0      300       0   300    1000     700     600   300
  2    700          0      300       0   300    1000     700     600   300
  3    700          0      300       0   300    1000     700     600   300
  4    700          0      300       0   300    1000     710     590   290
  5    710          0      300      15   315    1025     725     585   300
  6    725          0      300      21   321    1046     738     587   308
  7    738          0      300      19   319    1056     744     594   313
  8    744          0      300       9   309    1053     742     602   311
  9    742          0      300      -3   297    1039     733     609   305
 10    733          0      300     -12   288    1021     722     611   298
 11    722          0      300     -15   285    1007     714     608   293
 12    714          0      300     -12   288    1002     711     603   291
 13    711          0      300      -4   296    1007     714     597   293
 14    714          0      300       4   304    1019     721     593   297
 15    721          0      300      10   310    1031     729     592   302
 16    729          0      300      11   311    1040     734     595   306
 17    734          0      300       7   307    1041     735     599   306
 18    735          0      300       1   329    1099     769     601   329
 19    732          0      300      -4   296    1027     726     605   301
 20    726          0      300      -8   292    1019     721     605   297
 21    721          0      300      -7   293    1014     718     603   295
 22    718          0      300      -4   296    1014     718     600   296
 23    718          0      300       0   300    1019     721     597   297
 24    721          0      300       4   304    1025     725     596   300
 25    725          0      300       6   306    1031     729     597   302
 26    729          0      300       5   305    1033     730     598   303
 27    730          0      300       2   302    1032     729     601   303
 28    729          0      300      -1   299    1028     727     602   301
 29    727          0      300      -3   297    1024     724     603   299
 30    724          0      300      -4   296    1020     722     602   298
 31    722          0      300      -3   297    1019     721     601   298
 32    721          0      300      -1   299    1020     722     599   298
 33    722          0      300       1   301    1023     724     598   299
 34    724          0      300       3   303    1027     726     598   301
 35    726          0      300       3   303    1029     727     599   302
 36    727          0      300       2   302    1029     728     600   302
 37    728          0      300       0   398    1028     727     601   301
 38    727          0      300      -1   299    1025     725     601   300
 39    725          0      300      -2   298    1023     724     601   299
 40    724          0      300      -2   298    1022     723     601   299

---

Case 4.  MULTIPLIER-ACCELERATOR-INVENTORY CYCLE MODEL

(1)  INVENTORY TO REPLACE:       0
(2)  MPC:                        .6
(3)  INITIAL AUTON CONS:         100
(4)  INCREMENT AUTO CONS:        0
(5)  INCREMENT AUTON INVEST:     30
(6)  PERIOD TO CHANGE:           3
(7)  CAPITAL/OUTPUT RATIO:       0
(8)  PERIODS TO RUN:             40

      PRODUCTION  FOR         INVESTMENT       TOTAL  ACTUAL   INVEN   SAV-
PER   SALES     INVEN    AUTON INDUCED TOTAL  INCOME   SALES  STOCKS   ING
  1    700          0      300       0   300    1000     700     600   300
  2    700          0      300       0   300    1000     700     600   300
  3    700          0      300       0   300    1000     700     600   300
  4    700          0      330       0   330    1030     718     582   312
  5    718          0      330       0   330    1048     729     589   319
  6    729          0      330       0   330    1059     735     594   324
  7    735          0      330       0   330    1065     739     596   326
  8    739          0      330       0   330    1069     742     598   328
  9    742          0      330       0   330    1072     743     599   329
 10    743          0      330       0   330    1072     744     599   329
 11    744          0      330       0   330    1074     744     599   329
 12    744          0      330       0   330    1074     745     600   330
 13    745          0      330       0   330    1075     745     600   330
 14    745          0      330       0   330    1075     745     600   330
 15    745          0      330       0   330    1075     745     600   330
 16    745          0      330       0   330    1075     745     600   330
 17    745          0      330       0   330    1075     745     600   330
 18    745          0      330       0   330    1075     745     600   330
 19    745          0      330       0   330    1075     745     600   330
 20    745          0      330       0   330    1075     745     600   330
 21    745          0      330       0   330    1075     745     600   330
 22    745          0      330       0   330    1075     745     600   330
 23    745          0      330       0   330    1075     745     600   330
 24    745          0      330       0   330    1075     745     600   330
 25    745          0      330       0   330    1075     745     600   330
 26    745          0      330       0   330    1075     745     600   330
 27    745          0      330       0   330    1075     745     600   330
 28    745          0      330       0   330    1075     745     600   330
 29    745          0      330       0   330    1075     745     600   330
 30    745          0      330       0   330    1075     745     600   330
 31    745          0      330       0   330    1075     745     600   330
 32    745          0      330       0   330    1075     745     600   330
 33    745          0      330       0   330    1075     745     600   330
 34    745          0      330       0   330    1075     745     600   330
 35    745          0      330       0   330    1075     745     600   330
 36    745          0      330       0   330    1075     745     600   330
 37    745          0      330       0   330    1075     745     600   330
 38    745          0      330       0   330    1075     745     600   330
 39    745          0      330       0   330    1075     745     600   330
 40    745          0      330       0   330    1075     745     600   330

---

Case 5.  MULTIPLIER-ACCELERATOR-INVENTORY CYCLE MODEL

(1)  INVENTORY TO REPLACE:       1
(2)  MPC:                        .6
(3)  INITIAL AUTON CONS:         100
(4)  INCREMENT AUTO CONS:        0
(5)  INCREMENT AUTON INVEST:     30
(6)  PERIOD TO CHANGE:           3
(7)  CAPITAL/OUTPUT RATIO:       0
(8)  PERIODS TO RUN:             40

      PRODUCTION  FOR         INVESTMENT       TOTAL  ACTUAL   INVEN   SAV-
PER   SALES     INVEN    AUTON INDUCED TOTAL  INCOME   SALES  STOCKS   ING
  1    700          0      300       0   300    1000     700     600   300
  2    700          0      300       0   300    1000     700     600   300
  3    700          0      300       0   300    1000     700     600   300
  4    700          0      330       0   330    1030     718     582   312
  5    718         18      330       0   330    1066     740     578   326
  6    740         22      330       0   330    1091     755     585   335
  7    755         15      330       0   330    1100     760     595   340
  8    760          5      330       0   330    1095     757     603   338
  9    757         -3      330       0   330    1084     751     607   334
 10    751         -7      330       0   330    1074     744     606   330
 11    744         -6      330       0   330    1068     741     603   327
 12    741         -3      330       0   330    1068     741     600   327
 13    741         -0      330       0   330    1070     742     598   328
 14    742          2      330       0   330    1074     744     598   329
 15    744          2      330       0   330    1076     746     598   330
 16    746          2      330       0   330    1077     746     599   331
 17    746          1      330       0   330    1077     746     600   331
 18    746         -0      330       0   330    1076     746     601   330
 19    746         -1      330       0   330    1075     745     601   330
 20    745         -1      330       0   330    1074     745     600   330
 21    745         -0      330       0   330    1074     745     600   330
 22    745         -0      330       0   330    1074     745     600   330
 23    745          0      330       0   330    1075     745     600   330
 24    745          0      330       0   330    1075     745     600   330
 25    745          0      330       0   330    1075     745     600   330
 26    745          0      330       0   330    1075     745     600   330
 27    745          0      330       0   330    1075     745     600   330
 28    745         -0      330       0   330    1075     745     600   330
 29    745         -0      330       0   330    1075     745     600   330
 30    745         -0      330       0   330    1075     745     600   330
 31    745         -0      330       0   330    1075     745     600   330
 32    745          0      330       0   330    1075     745     600   330
 33    745          0      330       0   330    1075     745     600   330
 34    745          0      330       0   330    1075     745     600   330
 35    745          0      330       0   330    1075     745     600   330
 36    745          0      330       0   330    1075     745     600   330
 37    745         -0      330       0   330    1075     745     600   330
 38    745         -0      330       0   330    1075     745     600   330
 39    745         -0      330       0   330    1075     745     600   330
 40    745          0      330       0   330    1075     745     600   330

---

BACK TO CONTENTS

PART D. MACROECONOMIC POLICY

 

CHAPTER 15. THE ROLE OF GOVERNMENT IN THE MACROECONOMY

The macroeconomic theory surveyed in Part C suggests that government might have a role to play in attempting to stabilize the economy, and that government's efforts to this end may have important consequences for business firms. We have made numerous allusions in previous chapters to the interrelations between the firm and the government. Our purpose in this chapter is to delve into these relationships, but our task is made all the more interesting and challenging by the recent events transpiring in Eastern Europe, the former Soviet Union, China, and other parts of the world where authoritarian socialism was the predominant form of economic organization for a half century or more.

 

Forms of Economic Systems

The nature of the relationship between the microeconomic productive unit (i.e., the enterprise or the firm) and the state depends critically upon the form of economic system in place in the society. Although it is possible to identify a wide range of economic system types (including communalism, tribalism, feudalism, and traditionalism), we shall limit consideration to the three that seem to be most pertinent to circumstances of the modern world: socialism, capitalism, and fascism.

In the extreme form of authoritarian socialism, the microeconomic productive unit may be little more than an appendage of the state. Indeed, there is little point in making distinctions among micromanagement (i.e., the management of the productive unit), industrial organization and policy, and the macromanagement (i.e., the implementation of macropolicy) of the entire economy. They are all tied up together. For all intents and purposes, there is virtually no freedom of enterprise in authoritarian socialism.

Efforts at centralized and authoritarian direction of the economy seem to have revealed inefficiencies almost everywhere they have been tried. However, societies employing such forms of economic organization seem to be backing away from them in favor of capitalism. Capitalism is distinguished by private ownership of productive resources that are organized by markets. Rather than being highly centralized, decision making in capitalism is widely dispersed to the managements of a myriad of microeconomic productive units, i.e., individuals and the firms or enterprises that compose the economy.

In most forms of capitalism there is a cleavage between the microeconomic productive units and the state that functions as government. In the purest form of capitalism, the state owns no productive resources and engages in no productive activity. Its role is closely circumscribed to providing a legal and social environment that is hospitable to the functioning of the private economy. By the same token, the privately-owned productive units have no significant governing responsibility or authority, but they enjoy a maximum of freedom of enterprise. It is these entities that have been the focus of managerial economic analysis thus-far in this text.

Between the extremes of authoritarian socialism and pure capitalism is possible a wide range of governmental productive activity as well as the use of market mechanisms in conjunction with central planning. The terms mixed capitalism and mixed socialism are used to described these intermediate forms of economic organization. The exercise of decision-making authority by the managers of enterprises depends critically upon the nature of the relationship between their organizations and the government.

Fascism is a curious combination of the characteristics of authoritarian socialism and market capitalism. Resources remain privately owned as in capitalism, but the state (often in the form of a dictatorship) exercises centralized authority to impose production quotas to be met by the privately-owned enterprises. In fascism, freedom of enterprise is severely restricted. Although fascism has an infamous twentieth-century history, the most prominent examples of it have been eliminated from the world stage. But there almost certainly are examples of functional fascism in today's "third world.” And some Western societies are experimenting with a softer variant, statism, that involves increasing willingness to rely upon the powers of the state to treat social, political, and economic problems.

 

Points of Contact between the Firm and the Government

Because capitalism (or market economy) is the form of economic organization to which the world seems to be drawn, we shall presume its general characteristics in subsequent discussion of the role of government. Given this presumption, there are six principal points of contact between firms and the government.

(1) Along with other entities in the economy, the government is a demander of goods and services from private-sector business firms; i.e., firms function as suppliers to the government. Since the government is likely to be the single largest economic entity in any economy, the prospect of supplying the government should provide market opportunities for a great many firms in the economy. However, firms seeking to function as suppliers to government should beware of becoming too highly dependent upon government orders.

(2) Firms pay taxes to the government. The taxes may be related to the firms' profits, their sales, their inventories or other assets, or the wages that they pay to their employees. Tax-related record keeping and reporting often become burdensome to business firms, and tax liabilities and rates are subject to change at the dictatorial or parliamentary whims of the state.

(3) Depending upon the government's particular political, social, and military programs, various firms in the economy may become objects of support by the government. Such support may take the forms of subsidies, approval of licenses, preferential contracts, or other encouragements. The government may attempt to structure such activity as a coherent industrial policy for the promotion of international competitiveness of domestic companies.

(4) In pursuit of its agenda, government's interests in firms may extend beyond support to efforts to control the activities of firms. Objects of governmental controls may include directions of research and development efforts, determination of product mixes and item specifications, selection of capital investment alternatives, eligibilities for import or export licenses, and employment practices. These activities may become elements in a more comprehensive industrial policy.

(5) The private sector may become an object of regulation by the government in the interest of employees, consumers, or other interests in the economy. Such regulation almost always imposes additional costs upon business firms, and consequently squeezes profits or results in higher market prices.

(6) And finally, the private sector may become the object of efforts either to promote and encourage competition, or to stifle or prevent competition. In the former case, "antitrust" or "antimonopolies" laws may be enacted and enforced; in the latter case the government may become the prime mover in the effort to "rationalize" or cartelize industry (also a possible component of industrial policy).

In their extreme manifestations, points (1) and (4) above may devolve to the characteristics of fascism. We may also note that the government can effect a ready transformation to the characteristics of socialism simply by nationalizing private-sector firms so that they become government-owned and directed enterprises. Our purpose in making these observations and otherwise identifying the various points of contact between firms and the government is to note that the operation of government in a capitalistic economy may pose threats to private sector firms as well as provide opportunities that they may attempt to exploit.

 

Rationales for Governmental Involvement in the Market Economy

The most fundamental role for government to play in the market economy is the maintenance of an environment that is hospitable to the functioning of market economy and the exercise of entrepreneurship. At very minimum this means establishing the rules for holding, transferring, and arbitrating disputes over the possession of private property, determining weights and measures, providing a stable money supply, insuring the sanctity of contracts, and otherwise maintaining law and order. John Stuart Mill during the nineteenth century referred to these minimal roles for government as the “night-watchman functions.”

Beyond the night-watchman functions are four other significant rationales for governmental involvement in the market economy: to maintain competition, to reallocate resources, to redistribute incomes, and to stabilize the economy. Each of these rationales is founded upon some fault, shortcoming, or failure in the functioning of the market.

From this perspective it may be noted that any problem in the functioning of a market may invite some response from government to address the perceived problem. And if market mechanisms exhibit traumatic failure or become fundamentally distrusted by the political leadership of the society, these constitute the rationales for shifting to fascism by conferring product-mix decision making upon a central authority, or to socialism by nationalizing privately-owned productive resources and imposing central planning and direction. By the same token, failure of authoritarian socialism constitutes the rationale for shifting from authoritarian control to some form of market economy. It appears that this latter phenomenon is being widely experienced in several Eastern European countries even as some countries of the West experiment with more statist orientations.

 

The Maintenance of Competitive Conditions

Viable competition among business firms in each market is the sine qua non of market capitalism. It is competition that ensures that firms efficiently produce only those goods and services demanded by the consumers of the society. But there is an inherent divergence of interest between the firms in an industry and their customers. Although customers surely benefit from adequate competition (lower prices, higher quality merchandise, greater product variety), firms might achieve greater profits in cooperation with each other or as sole monopolists of their respective markets.

Firm managements find incentive to attempt to achieve monopoly by internal growth, acquisition of competitors, or engaging in practices to destroy the abilities of competitors to effectively compete. If the achievement of monopoly is blocked by public policy (e.g., antitrust law and its effective enforcement), they may attempt to cartelize the industry. If cartelization is prevented, firms may attempt to collude with competitors to set prices or allocate sources of materials or markets. If all of these avenues are blocked, the firms in an industry may engage in price leadership-followership behavior.

Governments of democratic societies thus find rationale to undertake the promotion and preservation of competitive conditions in their economies. This is usually done by enacting legislation that declares the existence of monopoly to be unlawful (in the U.S. this is accomplished by Section 1 of the Sherman Antitrust Act) and the perpetrator of monopoly to be guilty of an unlawful act (Sherman, Section 2), or that enumerates specific acts or activities that diminish competition and which are thus unlawful (the Clayton, Robinson-Patman, and Wheeler-Lea acts). But the enactment of legislation alone is not enough. The government must further establish an enforcement authority (in the U.S., the Federal Trade Commission and the Antitrust Division of the Department of Justice) and resolve to make effective the enforcement of the relevant legislation. This resolve may differ significantly according to the political party in office and the particular agenda that it is attempting to implement.

 

Rationales for Reallocation and Redistribution

The governmental rationale for reallocating resources in the economy is based upon the conclusion that the particular allocation of resources resulting from the normal functioning of the market economy is not satisfactory and needs adjustment. This conclusion may emerge if there are so-called public goods desired by society but not producible in response to market incentives, or if there are positive or negative externalities (or "spillovers") resulting from the market production of goods or services. The managerial implication of this rationale is that declining profits or losses will likely emerge in industries from which resources are diverted, but profitable opportunities should be found in industries toward which resources are reallocated.

The income redistribution rationale follows from a social and political judgment that incomes are being inequitably distributed across the population of the society by the normal functioning of the market economy. There is little doubt that any market economy distributes incomes unequally because of the fundamental reward mechanism of capitalism: to each according to his or her contribution to the process of production of demanded goods and services. Since members of any population possess differential abilities and experience varying intensities of drive and motivation, there will occur different contributions to the production process, and as a consequence an unequal distribution of income.

Social action becomes warranted only when it is judged that the inequality of distribution is also inequitable. The governmental vehicles for redistribution include progressivity of income and profits taxation, the taxation of capital gains, and any of a wide range of possible transfer payments. One managerial implication of governmental redistribution is that business net incomes, assets, and wages paid are likely to be objects of taxation to raise revenue for redistribution to lower-income members of society. Another is that businesses catering to transfer recipient clienteles may benefit from the redistributions. However, there may be little hope for managements of business firms to exert significant control or influence upon the political process that determines how incomes are to be redistributed.

 

The Government's Potential for Stabilizing the Economy

The rationale for bringing the offices of government to bear upon the stability of the economy is based upon the view that market economies are naturally unstable, that the degree of instability is intolerable, and that some force must be applied to counteract the natural instability of the market economy. Of course, the only entity in the economy that can possibly bring enough force to bear upon the problem of instability is the government.

 

What's Next

It is to the possibility that government might be able to stabilize the macroeconomy that we turn in Chapter 16.

BACK TO CONTENTS

 

CHAPTER 16.  GOVERNMENT AND MACROECONOMIC INSTABILITY

There's no way around it. Any economy organized around markets experiences macroeconomic swings in the form of expansion and contraction of output, falling and rising unemployment levels, greater or lesser rates of inflation, and variations of interest rates, more-so for short-term rates than for long-term rates.  Macroeconomic instability creates uncertainty that constrains enterprise freedom.  And instability that diminishes welfare more on the downswings than it increases welfare on the upswings has the potential to limit consumer sovereignty.

Marxians and other critics of capitalism have advocated the replacement of the capitalist form of economic organization with authoritarian socialism, both as a means for achieving distributional equity and as a way of ending macroeconomic instability. However, neither of these goals was accomplished, and other problems with authoritarian economic organization during the twentieth century resulted in the failure of central planning experiments.  Following these failures there has been a wholesale return to market economy, even with all of its "wrinkles, scars, and warts."

After the Great Depression and World War II, the British and American governments were the first to assume responsibilities for trying to stabilize their predominantly market economies by maintaining high-enough levels of employment, i.e., low-enough levels of unemployment. Over the next half-century, these governments gradually took on responsibilities for other dimensions of macroeconomic stability, particularly the control of the price level in order to avert excessive inflation. Soon after the turn of the third millennium, the prospect of deflation became a serious concern. Governments of other countries also began to assume macroeconomic stability responsibilities.
 

Fiscal Policy

Possibilities for exercising macroeconomic policy lie in two broad realms, fiscal policy and monetary policy. Fiscal policy entails manipulation of the government's own budget to counterbalance swings of spending in the private sector, i.e., in the business and consumer sectors. The idea, proposed by John Maynard Keynes in The General Theory of Employment, Interest, and Money (1936), is to deliberately cause the government's budget to go into deficit (disbursements exceeding revenues) as the macroeconomy contracts. This may be accomplished by reducing taxes, increasing purchases or transfer payments, or some combination of the two. Tax cuts leave more purchasing power in the hands of taxpayers to spend, and increased government purchases and transfer payments actually inject more purchasing power into the economy. If such fiscal policy actions work as expected, the economic contraction will come to an end and the economy will begin to expand, returning production, employment, and income generation to more normal conditions.

Sometimes the turn-around from macroeconomic contraction goes too far, and the expanding economy begins to "overheat" as it approaches and exceeds its normal operating capacity.  Or, quite apart from any action by government to bring about recovery from a recent downswing, the private sector of the macroeconomy may expand of its own volition (as may have happened in the US economy during the 1990s).  Excessive inflationary pressures, lower than usual rates of unemployment, and plant operation above normal capacities are evidences of macroeconomic overexpansion. 

When the economy overexpands, a Keynesian approach would require that the government deliberately take its budget into surplus by increasing taxes and decreasing purchases and transfer payments.  These actions are intended to siphon purchasing power out of the economy so as to curb excessive spending, alleviate inflationary pressures, and bring the macroeconomy to more normal conditions of production, employment, and inflation. Of course, there is always the risk of overdoing the fiscal dampening to precipitate undesirable economic contraction.
 

Monetary Policy

The same risk of overdoing policy also applies to monetary policy.  Monetary policy is the effort by a government’s monetary authority to determine and control the quantity money in circulation and the interest rate (the “price of money”).  In most countries monetary policy is the province of a central bank, and lately there has been a growing global consensus that a nation's central bank should be as independent as possible of the political process in order to avert pressures for inflationary money supply increases as governments run budgetary deficits that have to be financed.

Monetary policy may be implemented primarily in two ways: by manipulating the interest rate or by changing the nation's money supply. Without doubt, a central bank can change its own interest rate, i.e., the one that it charges to commercial banks when they borrow from the central bank, but it is not at all clear that the central bank's changing its own lending rate causes market-determined interest rates to change. A central bank interest rate change might precipitate market interest rate changes in the same direction if banks and other lenders have been holding their lending rates constant in anticipation of a central bank rate change.

It's much more likely that market interest rates can be manipulated indirectly by the central bank with actions to change the quantity of money in circulation. The Federal Reserve Bank is the name of the central bank of the United States. The "Fed" increases the US money supply when it buys US Treasury bonds from the bond open market, paying for them with deposits to the sellers' bank accounts and additions to commercial bank reserves. Bank reserves are highly liquid assets that commercial banks, by legal requirement or banker volition, maintain in order to meet demands by depositors for withdrawals of funds. The bond sellers' increased bank deposits are additions to the money supply. When banks sell bonds, the increases of their reserves enable them to increase lending to customers, and thereby to increase the quantity of money in circulation. The Fed reduces the US money supply as it sells bonds in the open market because non-bank buyers have to pay for the bonds that they purchase by giving up some of their bank deposits, and banks that buy bonds have to give up reserves to pay for the bonds that they purchase.

The enabling conditions for the conduct of open market operations by a central bank is the existence of a large mass of public debt and an open market in which that debt is traded. But very few of the other nations' central banks are so fortunate as the US Federal Reserve in its ability to conduct open market operations to manage the US money supply. While many nations' governments chronically have run budgetary deficits, the deficits often have been financed by direct money creation (printing it) rather than issuing bonds, so there is no mass of public debt in the form of bonds and no open market in which it is traded. Some governments have financed their public debts by issuing bonds, but the bonds have been sold and are traded in open markets elsewhere in the world. There is little point in their central banks engaging in open market purchases and sales of bonds (theirs or others) in an ever more global open market because such open market transactions mostly affect money supplies in other countries or the global money supply rather than the local money supply.

Central banks that enforce reserve requirements but do not have access to the facilities of open markets in their own countries are constrained to executing monetary policy by adjusting the reserve requirement ratio that they impose on their commercial banks. This is something that the U.S. Federal Reserve is empowered by law to do, but the Fed seldom changes reserve requirements because of the potentially large and disruptive effects on the nation's money supply.

Some nations' central banks do not specify legal reserve requirements for their commercial banks to meet, leaving the determination of the amounts of such reserves to the discretion of individual commercial bankers. In these nations, monetary policy is executed by the central bank primarily in manipulating the central bank's lending rate or by engaging in open market operations.

The process of globalization with ever more-open economies, instantaneous communications, and round-the-clock bond market trading has rendered the conduct of monetary policy largely ineffectual to all but a very few central banks in the very largest economies, notably the U.S. and the E.U. It is heroic to presume that a central bank in a third-world country can significantly affect its own money supply through open market operations, reserve ratio adjustments, or central bank lending rate changes. Smaller countries are looking ever more to the US Federal Reserve or the European Central Bank as the global makers of monetary policy.

To an ever-increasing extent, the money supplies of most countries are affected more by the respective government's budgetary policies and how it finances its deficits than by its central bank. Lack of fiscal discipline resulting in chronic budgetary deficits that are monetized directly by treasury departments (or indirectly by central banks under the domination of treasury departments) causes inflation--too much money chasing too few goods. This has become such a serious problem worldwide that governments of a growing number of nations are “dollarizing” or “euroizing” their currencies (or at least considering doing so). This means that they are adopting the dollar or the euro as the local currency and proceeding to replace their local currencies with dollars or euros as international trade and financial conditions permit. What they gain in dollarizing or euroizing their currencies is the monetary discipline that the US Fed or the European Central Bank exercise in restraining the growth of dollars and euros. What they lose is local control of their domestic money supplies, but it may be an illusion that they actually ever had effective control over their domestic money supplies.

Problems with Government’s Efforts to Address Macroeconomic Instability

At the middle of the twentieth century, macroeconomists thought that by engaging in fiscal and monetary policies they could fine tune a market economy to avert both cyclical swings and oscillating pressures of inflation and deflation. But experience has demonstrated in both developed and less-developed economies that government budgets are much more attuned to the requisites of program finance than to the needs of macroeconomic stability.  Especially in democratic polities, legislative assemblies often perceive the need or the desire to mount new programs or enhance existing programs. But each expanded program or newly enacted program has to be financed.  If financing provision is not made by way of increasing some tax or cutting back on other programs, new or expanded programs contribute to growing deficits. The deficits result in inflationary pressures if they are financed with direct money creation or if the central bank feels compelled to expand the money supply to prevent interest rates from rising (i.e., by “targeting” some interest rate). Program-oriented budget finance thus has an inherent inflationary bias.

Even if a government does attempt to manage its budget in the interest of economic stability, a growing number of economists have come to believe that deliberate fiscal actions by the government may elicit counterproductive changes in the private sector that tend to neutralize the deliberate fiscal stimulus. For example, increases of government spending to alleviate recession may increase the budget deficit, causing interest rates to rise, thus crowding out private sector borrowing to finance investment or interest-sensitive consumer spending. Or, decreases of government spending during a period of contraction may so lower market interest rates as to elicit crowding in of private sector borrowing to finance more investment or consumer spending. Both crowding-out and crowding-in effects in the private sector tend to neutralize the deliberate fiscal policy actions taken in the public sector.

 

Deliberate Policy Activism

During the late-twentieth and early in the twenty-first centuries, governments in a number of Western countries attempted to use monetary and fiscal policies in efforts to stabilize their economies. Experience with these efforts has convinced many economists that deliberate policy activism often involves policy overreactions due to time lags in recognizing changing conditions, initiating policy actions, and the completion of adjustments. Today, economists are not so sure that deliberate manipulation of the government's budget in efforts to diminish macroeconomic instability doesn't inject more instability into the economy than would be present if the government simply left the macroeconomy to manage itself.

Similar statements can be made with respect to monetary policy actions by the central bank that are intended to stabilize the economy, but which, because of various time lags, may tend to destabilize the economy. The financial turbulence of the Great Recession that began in 2008, together with the efforts by the U.S. and other governments to stem the recession tide, may provide an interesting test case of this proposition.

When unemployment or inflation have “reared their ugly heads,” politicians usually have felt compelled to follow the admonition, “Don’t just sit there, do something!”  Because discretionary policy overreactions may tend to destabilize a macroeconomy rather than stabilize it, a growing number of macroeconomists have become discretionary policy skeptics.  But politicians have difficulty following the reverse admonition:  “Don’t just do something, sit there!”  The ability to wait patiently is simply not in the genes of political animals.  Political inaction may be worse for a politician’s career than policy overreaction.

 

Automatic Stabilizers

Discretionary policy skeptics have more faith in the automatic self-correcting features that are inherent to any well-functioning market economy than in the ability of government officials to exert stabilizing macropolicies.  Policy skeptics have come to favor so-called automatic stabilizers such as a progressive tax rate system. During a period of economic expansion as more people gain employment, wages and salaries increase due to rising wage rates and overtime work, and bonuses increase.  Because people's incomes reach ever-higher tax brackets, the increase of tax payments to the government has the effect of siphoning purchasing power out of the economy to dampen the expansion.  The process also works in reverse to leave more purchasing power in the economy during an economic contraction.

An unemployment compensation system also can act as an automatic stabilizer.  During an economic contraction, ever more people lose employment and become eligible for unemployment compensation.   The unemployment compensation benefits serve as an injection of purchasing power into the economy that replaces some of the earned income that was lost due to unemployment. The system also works in reverse to diminish the injection of purchasing power into the economy when it expands and people go back to work.

But unemployment compensation is not necessarily the automatic stabilizer panacea that many had hoped for.  Some economists argue that unemployment compensation benefits that are “too rich” (i.e., an amount that is too large as a proportion of the previously earned income) can have a job-search disincentive effect if they make staying of work too comfortable.  A matter of continuing debate during the protracted 2008-2011 recession is whether extending the duration of unemployment benefits from twelve months to 99 weeks will have the effect of prolonging unemployment.  The rationale of this argument is that unemployment compensation benefit recipients have little incentive to seek work until their benefits are about to run out.

It may be possible to moderate macroeconomic instability with successful implementation of monetary and fiscal policies, but there is an emerging view among a growing number of macroeconomists that imperfect governmental efforts to moderate instability may actually have the effect of amplifying the instability, thereby threatening consumer sovereignty and enterprise freedom.

 

Managerial Implications of Policy Activism

The political theater unfolding in the interactions of liberal and conservative interests in the U.S. Congress during the Great Recession have injected uncertainty into the business decision making arena.  And, the fiscal and monetary actions that have been taken during 2008-2011 appear to have had far less effect in precipitating recovery and stabilizing the U.S. economy than either Keynesian or AD-AS theory suggest.  Investment and employment decision making in the business sector are greatly impaired by the political uncertainty and seeming impotence of the political decision makers to effect stabilizing policy.  When business decision makers are skeptical of the ability and willingness of government to implement effective stabilizing policy, and faced with political uncertainty about whether and how government may act, they will respond rationally by delaying both investment and employment decisions.  Unfortunately, a widespread managerial “wait-and-see” attitude tends to prolong a recession. 

 

What's Ahead

Chapter 17 explores the macroeconomic problems that the offices of government might address.

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CHAPTER 17. OUTPUT, INFLATION, AND UNEMPLOYMENT

Societies generally are concerned with four principal macroeconomic conditions: the degree of price stability enjoyed by the society, the proportion of the society's labor force having adequate employment, the rate at which the society's output is growing, and the condition of the society's external economic relations. No one of the four permanently tops the priority listing for every society. Each may become the top priority when the object condition becomes a critical problem for the society.

During the depression decade of the 1930s, unemployment rose to the top of the macroeconomic priority list in most industrial countries. Unemployment again became the object of government macropolicy during the Great Recession that began in 2008.  Early in the 1960s after Russian Premier Nikita Khrushchev pounded his shoe on the podium at the United Nations General Assembly and promised to bury the United States economically, growth for a while became the overriding concern in the U.S. From the late 1960s until the early 1980s in the U.S., the overriding priority became inflation control. The balance of payments occasionally "rears its ugly head" when trade or investment flows are perceived to be adverse and excessive. Chapter 17 is devoted to the first three of these conditions and relations among them. External balance and its relationship to the other three is the focus of Chapter 18.

 

Lessons From the Equation of Exchange

One of the great puzzles of twentieth century macroeconomic inquiry is whether there are systematic relationships among these macroeconomic conditions. The earliest ideas derived from a Monetarist relationship known as the equation of exchange,

(1)      MV = PY,

an identity which is multiplicative on both sides of the equal sign. In this identity, M is a monetary aggregate, V is the velocity of circulation of money, P is measured by an index of the price level, and Y is the aggregate total of real output. When converted to rates of change, the relationship becomes additive in the form

(2)      %∆M + %∆V = %∆P + %∆Y

This statement may be read, “The percentage change of the money supply plus the percentage change of the velocity of circulation of money is just equal to the percentage change of the price level plus the percentage change of real output.”

Each term of equation (2) can be interpreted as a respective rate of growth. The equation can be solved for any of the four terms. We shall not do so for %DM because monetary aggregates are objects of policy and thus do not "behave" in response to other macroeconomic aggregates. Nor shall we solve equation (2) for %DV since it is thought to be relatively stable in the short run and seems to change only gradually over the long run in response to changing payments conventions and institutional changes in the economy rather than in response to changes in M, P, or Y.

When equation (2) is solved for %DP, the rate of inflation, it becomes

(3)      %∆P = %∆M + %∆V - %∆Y.

Equation (3) implies that the rate of inflation varies directly with the rate of growth of the money supply and the rate of change of velocity, but inversely with the rate of growth of real output. The first direct relationship supports Milton Friedman's contention that inflation is essentially a monetary phenomenon; the second direct relationship supports the Keynesian contention that inflation can occur in response to increases in the velocity of circulation of money. Both hypotheses are of course subject to the ceteris paribus condition (i.e., assuming other things unchanged) with respect to the real output growth rate. If the rate of real output growth were to approximately match the rates of monetary growth and velocity increase during a period of expansion, inflation might be contained to low levels as witnessed in the U.S. during the late 1990s. If real output were to increase faster than the rates of monetary growth and velocity increase, deflation could result. Economists contemplated this possibility for Japan during the 1990s decade, for the U.S. toward the end of the 1990s decade, and for a number of economies as the Great Recession has persisted.

Actual deflation has not been experienced in the U.S. since before World War II. It would be more likely to result from a negative rate of monetary growth (i.e., a decrease in the money supply) or a negative rate of velocity change, other things remaining the same for output growth. Equation (3) implies that during a period of contraction, even with decreases of monetary aggregates and a negative rate of velocity change, a rapid-enough rate of output contraction could yield inflation. Indeed, the "stagflation" episodes of the early 1970s and early 1980s involved declining real output and on-going inflation.

The perverse conclusions implied by equation (3) should be emphasized. During an economic contraction, inflation may be a consequence of a negative rate of growth of real output that outweighs positive rates of change of monetary aggregates and velocity. By the same token, during a period of economic expansion, a faster positive rate of growth of real output than the rates of growth of the money supply and velocity could result in deflation. During the late 1990s in the U.S., the "torrid rate of growth" of the real output of the U.S. economy (5 percent or greater per annum) may have succeeded in outweighing the rates of growth of monetary aggregates and velocity to keep inflation in check.

A similar phenomenon may have occurred in the U.S. during the “Great Recession” that began in 2008.  Inflation measured by the Consumer Price Index and the GDP Deflator remained quite low (less than 2 percent per annum) even though the monetary authorities reduced interest rates toward zero and greatly increased the rate of growth of monetary aggregates under the guise of “quantitative easing.”  A possible explanation is that the velocity of circulation of money decreased as uncertainty led business firms to “neutralize” some of the monetary expansion by increasing their holdings of cash.  More of the monetary expansion sat in the accumulating excess reserves of commercial banks.  Although measured inflation remained low, commodity price bubbles (gold, copper, zinc, etc.) also absorbed much of the monetary expansion. The bursting of these commodity price bubbles may yet have deleterious effects on the U.S. economy.

Equation (2) may be solved for %DY, the rate of growth of real output:

(4)      %∆Y = %∆M + %∆V - %∆P.

In equation (4), real output growth varies directly with the rates of change of monetary aggregates and velocity, but inversely with the price level. Since the velocity growth rate is thought not to change much in the short run, the principal burden of determination of %DY appears to fall upon %DM and %DP which probably co-vary (same direction) but offset each other in their effects on the rate of growth of output. An important implication here is that too-rapid a rate of inflation may stifle real output growth if the growth rates of monetary aggregates and velocity are insufficient.

During the Great Recession that began in 2008, the U.S. rate of growth of output (%DY) fell below 1 percent per annum in spite of the “quantitative easing” efforts of the Fed, possibly because the monetary aggregate increases (%DM) have been absorbed in corporate cash hordes, commercial bank excess reserves, and commodity price bubbles.

Given our microeconomic understanding of production functions, it is a reasonable presumption that output rates vary with usage of inputs, both labor and capital, although not necessarily with perfect simultaneity. Input usage rate changes may be expected to lead output rate changes, and such a relationship often is a basis for forecasting. During an economic expansion, increased plant and equipment capacity utilization and increased employment of labor are the vehicles for increasing real output. However, the possibility of further increasing real output is always constrained by the capacity of the plant and equipment and the full employment of the labor force, i.e., the economy’s natural rate of real output. When employment increases during a period of economic expansion, the unemployment rate may fall, remain the same, or rise depending upon whether the labor force is growing at a slower, the same, or a faster rate. In the long run, productivity increasing at a fast enough pace may enable increases of real output, even if plant, equipment, and labor utilization rates are stagnant or decreasing.

During an economic contraction, real output decreases with falling employment and decreased usage of available plant and equipment. Decreasing employment results in a rising unemployment rate unless the labor force is also decreasing at a commensurate rate. The latter phenomenon might occur in the short run as workers become discouraged in their job-search efforts and leave the labor force.  It may also happen in the long run when, as a population ages, the retired portion of the population increases and the labor force participation rate falls

The inevitable inference to be drawn from consideration of the equation of exchange is that there are no consistent relationships among the rate of inflation, the rate of real output growth, and the rate of unemployment. A positive rate of change of any one of these rates may be consistent with positive or negative rates of change of the others, depending upon a myriad of other factors.

 

Lessons from Keynesian Theory

One of the deficiencies of Keynesian aggregate expenditures analysis is that all income and output quantities are presumed to be expressed in real terms. The price level is not included or analyzed explicitly. Even so, certain price level change implications can be "talked into the analysis," even if not explicitly illustrated by Keynesian graphics.

Assuming a full-employment level of income and output in a Keynesian setting, the only level of aggregate expenditure that is consistent with equilibrium at full employment is the one for which it is just equal to aggregate output.

The economy might have reached its full-employment equilibrium output rate "from below" as aggregate expenditure increased toward the equilibrium level. With the increase of aggregate expenditure, inventory depletion induced business decision makers to increase output rates by increasing the usage of inputs, including labor. Other things remaining the same, the increasing output rate is preceded or accompanied by increased employment and a falling unemployment rate. But in the Keynesian conception there is no reason to expect prices to rise in the run up to the full-employment equilibrium output until full employment is actually achieved. Hence, Keynesian theory contains no explanation of inflation short of full employment.

If aggregate expenditure were to increase further, the output rate could not reach a new equilibrium since resources are already being used to capacity.  A gap of spending in excess of output would persist. This spending gap would be characterized by persistent inventory depletion which cannot be alleviated by increasing output in the fully-employed economy. Business decision makers, particularly those with monopoly power, could be expected to raise prices. In conventional Keynesian parlance, the excess spending is referred to as an inflationary gap. Since the price level is not explicitly represented in the analysis, the amount of price level increase and the resulting rate of inflation cannot be determined from the analysis. The resulting inflation is a single episode consequent upon the discrete increase of aggregate expenditure. An on-going process of inflation would follow from continuing increases of aggregate expenditure that would try to take the economy beyond its full-employment output level.

Keynesian analysis anticipates asymmetry with respect to increases and decreases of aggregate expenditure. A decrease of aggregate expenditure when the economy is at a full employment output level would result in inventory accumulation. Business decision makers could be expected to cut back production to relieve their inventory build-up problems. The means for doing this would be to decrease the usage of inputs, including labor. Hence, with a collapse of aggregate expenditure, employment would likely decrease and the unemployment rate rise.

Would business decision makers also cut prices in the effort to rid their stock rooms of excessive inventories? Keynes thought that businesses with monopoly power would take any occasion to raise prices when demand increases, but would resist cutting prices by letting inventories and output levels serve as the shock absorbers when demand decreases. Keynesian analysis referred to as a recessionary gap rather than a "deflationary gap" since output is more likely to decrease than are prices. To the extent that monopoly power is characteristic of the business sector, deflation is less likely when aggregate expenditures decrease that is inflation when aggregate expenditures increase. Price level asymmetry thus depends upon the extent of monopoly power wielded by businesses in the economy. The more competitive are market conditions, the more symmetrical will be price changes when aggregate expenditures change.

 

The Phillips Curve

During the 1970s, the economics profession took a diversion onto a hopeful policy route. In 1958, A. W. Phillips published an article which suggested a trade-off relationship between money wage rates in the U.K. and the U.K. unemployment rate.[1]  Readers of the article promptly dubbed the graphic representation of the inverse relationship the "Phillips curve.” 

American economists were keen to discover such a relationship for the U.S. economy, because if it existed and was stable it might serve as a basis for determining macropolicy. The policy menu would include variations on two possibilities. The relationship suggested that high unemployment could be alleviated by implementing policies that would increase the rate of inflation. Alternately, if inflation were the dominant problem, the relationship suggested that inflation could be relieved by implementing policies to increase the unemployment rate. The relationship thus implied a policy trade-off between inflation and unemployment. Indeed, economic analysts discovered the apparent existence of an American version of the Phillips curve in the scatter diagram of data for the 1960s.

The Phillips curve fitted to the 1960s U.S. inflation-unemployment data revealed a decade-long period of economic expansion characterized by falling unemployment rates and accelerating inflation. When the recessionary conditions emerged in the early 1970s, the expectation was that the economy would "back down" the Phillips curve as unemployment rates rose and inflation decreased. But in fact the economy did not back down the 1960s Phillips curve. Rather, inflation continued into the early 1970s only slightly lower than the 1969 inflation rate even as the unemployment rate rose.

This experience suggested a new inflation-unemployment trade-off relationship for the early 1970s that entailed higher rates of unemployment for each possible rate of inflation. This phenomenon gave rise to the term “stagflation” to refer to ensuing recession accompanied by persisting unemployment and continuing inflation. As more time passed and efforts were made to identify Phillips-type relationships for subsequent periods, economists became disappointed that the inflation-unemployment trade-off of the 1960s was not stable. The graphic depiction of the trade-off relationships appeared to shift over time, and the looser "fits" of the curves to the plotted points implied less reliable trade-off relationships. The shift and fit phenomena cast doubt upon the policy usefulness of a trade-off relationship between inflation and unemployment.

In a presidential address to the American Economic Association, economist Milton Friedman suggested that when all of the inflation-unemployment rate points were taken together, a vertical line plotted at about 6 percent rate of unemployment appeared to be as good a fit to the scatter of points as any other line which could be fitted to the data.[2]  Friedman's 6 percent unemployment rate has become institutionalized in macroeconmic theory as the level of output associated with the natural rate of unemployment.

The natural rate of unemployment is understood to be the minimum amount of unemployment achievable in an economy, given structural shifts, changing demands for products, and frictions of adjustment in the labor markets. The 6 percent rate dominated macroeconomic analysis until the mid-1990s when the actual rate of unemployment in the U.S. fell below 6 percent and remained between 4.5 and 4 percent until the early 2000s. The implication was that institutional and structural changes in the U.S. economy may have improved the efficiency of U.S. labor markets to the extent that the natural rate of unemployment might be closer to 4 percent than to 6 percent of the labor force.  However, the very slow recovery of the U.S. economy to the Great Recession has given pause to this conclusion.  Some economists have begun to think that more recent structural changes in the U.S. economy may have caused the natural rate of unemployment to gravitate upward toward 10 percent of the labor force.

Another approach to the inflation-unemployment relationship is to “connect the dots” in a scatter diagram of points representing combinations of inflation and unemployment since the 1960s.  The connected dots give a counter-clockwise spiraling appearance. 

In any case, it is clear that the Phillips curve is not a relationship that is sufficiently stable to serve as a basis for macropolicy in regard to inflation and unemployment. Indeed, it appears that there are multiple short-run Phillips curves or a shifting-curve or a spiraling phenomenon. There appears to be no long-run trade-off between inflation and unemployment.  This implies that monetary policy cannot permanently reduce unemployment below its long-run “natural rate” level.

 

Lessons from Aggregate Supply and Demand Analysis

The Phillips curve is a sometimes empirical relationship in search of an explanation. The puzzle of the spiraling or shifting inflation-unemployment relationship may be resolved with AD-AS analysis. Since in a growing economy both aggregate demand and aggregate supply are continually increasing, the relative paces of increase are critically important to the rate at which the price level increases or decreases. The issue really settles upon the former since the U.S. (and most other western nations) has had extensive experience with inflation but virtually no experience with deflation since the 1930s decade. The sequence of events during the phases of the business cycle also turns out to be important to the explanation of the spiraling behavior of inflation and unemployment rates.

During the 1960s period of economic expansion, aggregate demand probably accelerated at a faster pace than did aggregate supply. When aggregate demand is accelerating and aggregate supply is stable (or increasing at a slower pace), real output increases and the price level rises at an accelerating rate. The output increase requires usage of more inputs, including labor. This implies that as the employment level increases, the unemployment rate falls. A falling unemployment rate coupled to an accelerating inflation rate yields the appearance of an inflation-unemployment tradeoff, counter-clockwise around the bottom of a spiral. Macroeconomic conditions similar to this occurred in the U.S. economy during the decade of the 1960s.

During the waning phase of a cyclical expansion, the pace of aggregate demand begins to slow and inventories start to pile up. In response to the inventory accumulation, producers cut back on output rates, causing aggregate supply to increase at a slower pace or to decrease. As aggregate supply decreases, input usage decreases, unemployment rates rise, and inflation persists. This behavior suggests a shift in the inflation-unemployment tradeoff, continuing in the counter-clockwise direction toward the top of the spiral.  Circumstances similar to this occurred from 1969-71, 1973-74, 1979-80, and 1988-90.

As an economic contraction ensues, aggregate demand begins to decrease at a faster pace than does aggregate supply. With product demand falling or increasing slowly, employers cut back on their use of labor and the unemployment rate continues to rise. This gives the appearance of continuing the counter-clockwise movement downward from the top of the spiral.  In their efforts to unload swelling inventories, some sellers cut prices and the inflation rate tends to fall.  This implies another shift of the inflation-unemployment relationship as the counter-clockwise movement around the spiral continues toward its bottom where the economy is ready to start another trip around the spiral. Circumstances similar to this occurred during 1974-75, 1980-82, and 1990-92.

Once the economy has reached the trough of a contraction, recovery is initiated by an increase of aggregate demand which causes inventories to deplete. Producer response to the depleting inventories is to increase output by using more inputs.  Aggregate supply increases and the unemployment rate begins to fall. When aggregate supply increases along with aggregate demand, the price level may rise, remain steady, or fall, depending upon the relative paces of increase.

The falling rate of unemployment coupled with a lower but positive rate of inflation suggests another shift of the inflation-unemployment trade-off relationship to lower levels of both. Circumstances similar to this occurred over the ranges of 1971-72, 1975-76, 1982-83, and 1992-94. The low unemployment rates coupled with low inflation rates during 1999-2000 in the U.S. may be explained by aggregate supply increasing nearly as fast as aggregate demand was increasing. The rapid pace of increase of aggregate supply resulted because of a technological revolution in computing and communications which enabled rapidly increasing productivity.

Taken together, these descriptions of aggregate demand and aggregate supply changes describe the counter-clockwise spiraling behavior of inflation and unemployment over the course of a business cycle.

 

Conclusions

Several conclusions emerge from the aggregate demand and supply analysis of the relationships among output, inflation, and unemployment.

1. When aggregate demand changes relative to aggregate supply (e.g., when aggregate demand increases at a faster pace than does aggregate supply), a short-run Phillips-type inflation-unemployment trade-off relationship may occur.

2. When aggregate supply shifts in either direction relative to aggregate demand (e.g., when aggregate supply increases at a faster pace than aggregate demand), the short-run Phillips-type inflation-unemployment relationship evaporates, or the relationship appears to shift.

3. Stagflation (i.e., lagging output, increasing unemployment, and on-going inflation) results from decreases of aggregate supply relative to aggregate demand.

4. There is no consistent relationship between inflation and unemployment. Higher or lower rates of inflation may be consistent with higher or lower rates of unemployment. The relationship depends completely upon the relative directions and rates of shift of aggregate demand and aggregate supply.

5. The short-run Phillips inflation-unemployment trade-off relationship, an essentially demand side phenomenon, fails to take into account shifts of aggregate supply. It cannot serve as an adequate basis for macropolicy. In spite of this fact, it appears that central banks around the world continue to base interest rate targeting upon some concept of a Phillips-type unemployment-inflation trade-off.

 

What's Next

Chapter 17 has addressed three of the "big four" macroeconomic concerns of most nations. Chapter 18 delves into the fourth, external balance, and its relationships to the other three.

 

Chapter 17 Endnotes:

[1] "The Relationship between Unemployment and the Rate of Change of Money Wages in the United Kingdom, 1861-1957," Economica, Vol. 25, 1958, pp. 238-299.

[2] Milton Friedman, “The Role of Monetary Policy,” Presidential Address, 1967 Annual Meeting of the American Economic Association, The American Economic Review, Vol. 58. No. 1 (March, 1968), pp. 1-17.

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CHAPTER 18. EXTERNAL BALANCE

“External balance” refers to a nation's trade, investment, and official reserves transactions with the rest of the world. A nation with an absolutely “closed economy,” i.e., one that is perfectly isolated from the rest of the world, would have no external transactions to balance. The external balance for an open economy that enjoys substantial private sector trade and investment discretion is indicated by its Balance of Payments.

 

Balance of Payments Accounting

Balance of Payments accounting, strictly speaking, is not part of the process of accounting for National Income and Product, but Balance of Payments accounting information feeds into the NIPA process of compiling data for Gross Domestic Product. Table 18-1 has been designed to illustrate the structure of the Balance of Payments accounts. Information for Table 18-1 was downloaded from the Bureau of Economic Analysis website (http://www.bea.gov/international/), but the information has been reorganized and reformatted to exhibit a structure that is more easily interpreted.

<>For purpose of conceptual analysis, a nation's Balance of Payments presentation requires only three sections, a Current Account section, a Capital Account section, and an Official Reserves section. Table 18-1 exhibits a fourth section, Discrepancy, for reasons that will be indicated below.
 

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Table 18-1.

U. S. International Transactions, by Type of Transaction: 2003 to 2009 [In millions of dollars
(1,340,353 represents $1,340,353,000,000). Minus sign (-) indicates debits.]
 
CURRENT ACCOUNT                                 2003       2004       2005       2006       2007       2008       2009
 
A.  Exports of goods and services
          and income receipts..............1,340,353  1,572,315  1,816,449  2,135,004  2,478,267  2,635,540  2,159,000
    1.  Exports of goods and services......1,019,897  1,158,576  1,281,186  1,452,783  1,648,665  1,839,012  1,570,797
          Goods, balance of payments basis.  728,258    819,870    909,016  1,035,868  1,160,366  1,304,896  1,068,499
          Services ........................  291,639    338,707    372,171    416,916    488,299    534,116    502,298
    2.  Income receipts ...................  320,456    413,739    535,263    682,221    829,602    796,528    588,203
          Income receipts on U. S.-owned
            assets abroad .................  317,643    413,379    532,373    679,338    826,632    793,484    585,256
          Direct investment receipts ......  186,417    250,606    294,538    324,816    370,712    403,225    346,073
          Other private receipts ..........  126,529    157,313    235,120    352,122    453,687    385,353    234,458
          U. S. Government receipts .......    4,697      2,998      2,715      2,400      2,233      4,906      4,724
          Compensation of employees .......    2,813      2,822      2,890      2,883      2,971      3,044      2,977
 
B.  Imports of goods and services
          and income payments.............-1,789,227 -2,114,441 -2,458,268 -2,846,159 -3,080,813 -3,182,368 -2,412,489
    1.  Imports of goods and services.....-1,514,080 -1,767,921 -1,995,362 -2,212,023 -2,350,763 -2,537,814 -1,945,705
          Goods, balance of payments basis-1,269,802 -1,485,501 -1,692,817 -1,875,324 -1,983,558 -2,139,548 -1,575,443
         Services......................... -244,278   -282,420   -302,546   -336,700   -367,206   -398,266   -370,262
    2.  Income payments ................... -275,147   -346,519   -462,905   -634,136   -730,049   -644,554   -466,783
          Income payments on foreign-owned
            assets in the U. S............. -266,635   -337,556   -453,615   -624,646   -719,983   -634,190   -456,027
          Direct investment payments ......  -73,750    -99,754   -121,333   -150,770   -129,134   -115,538    -94,010
          Other private payments .......... -119,051   -155,266   -228,408   -338,897   -426,501   -352,053   -218,020
          U. S. Government payments .......  -73,834    -82,536   -103,874   -134,979   -164,348   -166,599   -143,997
          Compensation of employees .......   -8,512     -8,963     -9,290     -9,490    -10,066    -10,364    -10,757
 
C.  Unilateral current transfers, net .....  -71,794    -88,362   -105,772    -91,481   -115,548   -122,026   -124,943
      U. S. Government grants..............  -22,173    -23,823    -33,647    -27,733    -34,437    -36,003    -41,638
      U. S. Government pensions
        and other transfers ...............   -5,341     -6,264     -6,303     -6,508     -7,323     -8,390     -8,874
      Private remittances and other
        transfers .........................  -44,280    -58,275    -65,822    -57,240    -73,788    -77,633    -74,431
 
D.  Balance on current account (A + B + C). -520,668   -630,488   -747,590   -802,636   -718,094   -668,854   -378,432
    1.  Balance on goods................... -541,544   -665,631   -783,801   -839,456   -823,192   -834,652   -506,944
    2.  Balance on services................   47,361     56,286     69,625     80,216    121,093    135,850    132,036
    3.  Balance on trade................... -494,183   -609,345   -714,176   -759,240   -702,099   -698,802   -374,908
    4.  Balance on income..................   45,309     67,219     72,358     48,085     99,553    151,974    121,419
 
 
CAPITAL ACCOUNT                                 2003       2004       2005       2006       2007       2008       2009
 
E.  Foreign assets in the U. S., excluding
      Financial derivatives,
      (increase/financial inflow (+)) .....  858,303  1,533,201  1,247,347  2,065,169  2,107,655    454,722    305,736
 
    1.  Foreign official assets in the U. S. 278,069    397,755    259,268    487,939    481,043    550,770    450,030
          U. S. Government securities .....  224,874    314,941    213,334    428,401    269,897    591,381    441,056
            U. S. Treasury securities .....  184,931    273,279    112,841    208,564     98,432    548,653    561,125
            Other .........................   39,943     41,662    100,493    219,837    171,465     42,728   -120,069
          Other U. S. Government liabilities    -723       -134       -421      2,816      5,436      8,912     57,971
          U. S. liabilities reported by
            U. S. banks, n. i. e. 1 .......   48,643     69,245     26,260     22,365    109,019   -153,423    -70,851
          Other foreign official assets ...    5,275     13,703     20,095     34,357     96,691    103,900     21,854
 
    2.  Other foreign assets in the U. S...  580,234  1,135,446    988,079  1,577,230  1,626,612    -96,048   -144,294
          Direct investments in U. S. .....   63,750    145,966    112,638    243,151    271,210    328,334    134,707
          U. S. Treasury securities .......   91,455     93,608    132,300    -58,229     66,845    161,411     22,781
          U. S. securities other than
            U. S. Treasury securities .....  220,705    381,493    450,386    683,245    605,414   -166,490         59
          U. S. currency flows.............   10,591     13,301      8,447      2,227    -10,675     29,187     12,632
          U. S. liabilities to unaffiliated
            foreigners reported by U. S.
            nonbanking concerns ...........   96,526    165,872     69,572    244,793    182,355    -36,522     -1,460
          U. S. liabilities reported by
            U. S. banks, n. i. e. 1 .......   97,207    335,206    214,736    462,043    511,463   -411,968   -313,013
 
F.  U. S. assets abroad, excluding financial
        derivatives
        (increase/financial outflow (-))... -325,424 -1,000,870   -546,631 -1,285,729 -1,475,719    156,077   -140,465
 
    1.  U. S. private assets, net.......... -327,484 -1,005,385   -566,266 -1,293,449 -1,453,324    690,540   -629,552
          Direct investments abroad ....... -149,564   -316,223    -36,235   -244,922   -413,993   -351,141   -268,680
          Foreign securities............... -146,722   -170,549   -251,199   -365,129   -366,512    197,897   -208,213
          U. S. claims on unaffiliated
            foreigners reported by U. S.
            nonbanking concerns............  -18,184   -152,566    -71,207   -181,299    -23,089    421,153    124,428
          U. S. claims reported by U. S.
            Banks and securities brokers...  -13,014   -366,047   -207,625   -503,099   -649,730    422,631   -277,087
 
    2.  U. S. Govt. assets, other than
            official reserve assets, net...      537      1,710      5,539      5,346    -22,273   -529,615    541,342
          U. S. credits and other long-term
            assets ........................   -7,279     -3,044     -2,255     -2,992     -2,475     -2,202     -4,069
          Repayments on U. S. credits and
            other long- term assets .......    7,981      4,716      5,603      8,329      4,104      2,202      2,133
          U. S. foreign currency holdings and
            U. S. short- term assets, net       -165         38      2,191          9    -23,902   -529,766    543,278
 
G.  Financial derivatives, net.............     <NA>       <NA>       <NA>     29,710      6,222    -32,947     50,804
 
H.  Balance on Capital Account (E + F + G).  532,879    532,331    700,716    809,150    638,158    577,852    216,075
 
 
OFFICIAL RESERVES TRANSACTIONS:                 2003       2004       2005       2006       2007       2008       2009
 
I.  U. S. official reserve assets, net......   1,523      2,805     14,096      2,374       -122     -4,848    -52,256
    Gold..................................       0          0          0          0          0          0          0
      Special drawing rights ...............     601       -398      4,511       -223       -154       -106    -48,230
      Reserve position in the
        International Monetary Fund.........   1,494      3,826     10,200      3,331      1,021     -3,473     -3,357
      Foreign currencies ...................    -572       -623       -615       -734       -989     -1,269       -669
 
 
DISCREPANCY                                     2003       2004       2005       2006       2007       2008       2009
 
J.  Discrepancy (D + H + I, with sign
      reversed) ...........................  -13,734     95,352     32,778     -8,888     80,058     95,850     21,613
 
 
1 Not included elsewhere.
 
<NA> Transactions are possible, but all data are not available.
 
Source: U. S. Bureau of Economic Analysis, http://www.bea.gov/international/.

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It is the Balance on Trade (line D3) in the Current Account that becomes part of the Gross Domestic Product compilation each year as exports less imports. The positive signs and increasing values of the entries for Balance on Services (line D2) through 2008 indicate that services trade has been increasingly favorable for the U.S. since services exports have been increasing faster than have services imports. However, the negative signs and the increasing values of the entries for Balance on Goods through 2008 mean that the trade deficit on tangible goods worsened as goods imports have increased at a faster rate than have goods exports. The trade deficit began to decrease in 2009.  The favorable growth of trade in services has been swamped by the worsening deficit on trade in goods. The negative signs and increasing values of all of the line D3 entries in Table 18-1 mean that the overall trade balance has been in continuing deficit, and the trade deficits increased until 2006 and decreased thereafter. The negative trade balance values have the effect of depressing Gross Domestic Product from what it would have been had the economy been closed to trade or had the economy enjoyed a trade balance or surplus.

In principle, for a nation that allows its exchange rates to freely flex or float in response to changing market forces, the Balance of Payments presentation needs only two sections, Current Account and Capital Account. In the long run and in equilibrium, the totals for these two sections should perfectly offset each other because exchange rates should adjust to stimulate trade and capital flows to offset market induced changes. If in long-run equilibrium the Current Account balance has a positive sign, the Capital Account balance would be of equal magnitude but have a negative sign, and vice versa. In the short run, discrepancies (adjustment rather than statistical) might occur between the magnitudes of the two section balances until exchange rate changes bring the magnitudes of the two sections into equivalence (though with opposite signs).

The Balance of Payments presentation might have a third section, Official Reserves Transactions, even if the nation allows its exchange rates perfect flexibility. But the balance totals would be zeros since no government agency would be using the official reserves to manipulate or fix the exchange rates. Since the demise of the Bretton Woods international exchange system in 1971, the global economy nominally has been on a flexible or floating exchange rate system, although it has never been a so-called "clean-float" system because governments, singly or in concert with other nations (like the G7 or G10 ad hoc groupings of nations), occasionally have attempted to manipulate exchange rates or prevent further changes of them. That the Official Reserves Transactions totals (Line I) in Table 18-1 are not zeros betrays the fact that the federal government of the United States has engaged in occasional efforts to cause exchange rates between the dollar and other currencies to change in desired directions, or to prevent further undesirable changes.

In Table 18-1, the Current Account balances (line D) and Capital Account balances (line E) do have opposite signs, but do not precisely offset each other in magnitude. This implies either that exchange rates do not change (or not fast enough) to balance the Current and Capital accounts totals, or that the government is using its Official Reserves (line I) to manipulate or fix some exchange rates. The non-zero Official Reserves Transactions totals imply the existence of government activity to exert some control over exchange rates, but they can account for only part of the discrepancy between the Current and Capital account balance totals.

The non-zero "Discrepancy" balances (line J) in Table 18-1 are attributable to at least three causes. One is of course the possibility that they represent only short-term disequilibria in the interim between when some market phenomena occur and exchange rates have changed by enough to bring the Current and Capital Account balance totals into opposite-sign equivalence. A second possible cause is that governmental efforts to manipulate or fix exchange rates prevent exchange rates from accomplishing equilibration.

A third possible explanation lies in the imperfections in the procedures by which Balance of Payments data are collected and aggregated. Nominally, Balance of Payments accounting is accomplished by double-entry bookkeeping procedures that ensure that debit entries are always fully offset by credit entries. This should also ensure that the nation's Balance of Payments actually balances, i.e., that the sum of its Current Account, Capital Account, and Official Reserves Transactions totals net out to zero. While double-entry bookkeeping is a reliable process at the microeconomic level of the firms engaged in international transactions, data for Balance of Payments totals are aggregated from tax reports which are, in effect, single-entry sources. Since there are literally tens of thousands of such single-entry sources of Balance of Payments information that have to be aggregated into the totals, it is very likely that some information is missed and other information is double counted.

Unfortunately, it is not possible to distinguish the portions of the Discrepancy totals that are attributable to information reporting, collection, and aggregation problems from those that are attributable to interim disequilibria or to governmental efforts to manipulate or fix exchange rates.

Several aggregates listed in Table 18-1 are notable for their relative stability. Although the U.S. Trade Balance has been in continuous deficit during the years shown (line D3), both imports and exports have been growing steadily. Since imports have been growing at a faster rate than have exports, the trade deficits also have been growing and at a relatively steady pace. In the U.S. Capital Account, both direct investment by Americans abroad and direct investment by foreigners in the U.S. have been growing steadily, with the latter outpacing the former. As the so-called “Great Recession” ensued after 2008, both exports and imports fell.  Imports decreased more than exports in 2009 compared to 2008 so that the 2009 trade deficit diminished relative to that in 2008.

As can be seen in line I of Table 18-1, the discrepancies between U.S. Capital Account, Current Account, and Official Reserves Transactions totals exhibit a great deal more year-to-year variability than can be accounted for in the Current Account alone. Discrepancy totals often are small, but occasionally become quite large. The principal source of this variability appears to lie in the Capital Account, particularly in both private and official holdings of U.S. Treasury securities by foreign interests, and in American holdings of foreign securities. This fact suggests that short-term capital flow volatility may be a more significant source of payments instability than inflation rates and employment levels in trading partner economies. Short term capital flow volatility may be associated with central bank activity in regard to interest rate changes.

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Comment 18-1. The Balance of Payments in History

During the eras of the Gold Standard (mid-nineteenth century until the Great Depression) and the Bretton Woods system (after World War II until 1971), official reserves (particularly gold and foreign currency stocks) were used by governments attempting to fix the exchange rates between their currencies and other currencies (or gold). Governments of nations suffering payments deficits (Current Account deficits not fully offset by Capital Account surpluses) prevented their currencies from depreciating by entering the exchange markets to purchase their own currencies with gold and foreign currencies possessed by them. The persisting disequilibria between Current and Capital Account balance totals elicited changes in domestic incomes, employment levels, and price levels since exchange rates could not change to accomplish the needed adjustments to international phenomena.

In order to slow the depletion of their gold and foreign currency reserves, governments of nations suffering payments deficits occasionally devalued their overvalued currencies. This was accomplished by officially increasing the mint parity ratios (number of units of currency per ounce of gold) at which they would buy and sell gold. Governments stocking out of gold or foreign currencies could no longer continue to keep their currencies from depreciating. Governments of nations enjoying payments surpluses felt little compulsion to revalue their currencies upward, and they could easily prevent their currencies from appreciating relative to gold or other currencies since they could create (or print) more of their own currencies to purchase gold or foreign currencies.

During the 1960s the U.S. was faced with persisting Balance of Payments deficits that caused continuing depletion of its gold and foreign currency stocks as it attempted to keep the dollar-gold exchange rate fixed. The Nixon administration in the U.S. finally suspended disbursements of gold to foreign interests in August of 1971. This marked the end of the Bretton Woods system and the beginning of the present era of floating exchange rates.

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The Composition of Imports and Exports

Even though the Balance of Payments statement makes distinction between Current Account transactions (imports and exports of merchandise, services, and gifts) and Capital Account transactions (changes in the international ownership of its assets and liabilities), implicitly everything listed in a nation's Balance of Payments is some form of export or import. Nations may export and import a variety of things. "Things" include tangible merchandise, intangible services, gifts, currencies, the ownership of assets, claims against itself (liabilities), and gold. What matters for a nation's continued operation in the world's global trading system is that its imports (of all types) have to be paid for by exports (of a variety of types) of equivalent value.

In principle, the composition of things composing the nation's imports or exports does not matter. If the nation imports more of one type of thing, say merchandise, than it exports, it follows that it in order to pay for its excess of merchandise imports over merchandise exports, it must export enough of other types of things, like services, the ownership of real assets, equity interests in its commercial enterprises, claims against its enterprises or government units (liabilities), its own currency (claims against its central bank), foreign currencies that it may hold, or gold. Although often reported with alarm in the media, the trade balance on any one type of exportable or importable thing is largely irrelevant.

While the focus of the previous paragraph was upon the merchandise trade balance, it is important to note the same relationship with respect to Capital Account transactions. Suppose that a nation exports the ownership of more of its assets to foreigners (a capital inflow) than it imports from foreigners (a capital outflow) so that there is a net surplus on Capital Account during the year. It follows that the nation must import enough of other things, say merchandise and services, to compensate itself for its capital exports. A merchandise and services import deficit is a natural concomitant of a capital export surplus.

Since the discussions in the previous two paragraphs are congruent, we can say that it is possible that at times what happens to the trade balance (the largest part of the Current Account) “drives” the Capital Account balance, but at other times what happens in the Capital account drives the trade balance.

 

Payments Imbalances

A nation's Balance of Payments statement must always balance, in principle by the requisites of double-entry bookkeeping when there are no errors or omissions, but in practice by inclusion of a Discrepancies line in the amount by which the Current Account total is not fully offset by the sum of the Capital Account and Official Reserves Transactions totals. Since the Balance of Payments always balances, an imbalance in the nation's external payments can be detected only by examining some parts of the statement in comparison to other parts of it. By convention, this has been accomplished by figuratively (if not literally) drawing a line across the Balance of Payments statement at a selected place, and then comparing totals "above the line" and "below the line."

Early in the twenty-first century, the line is most commonly drawn below the Balance on Current Account (line D in Table 18-1). Abstracting from the Discrepancy line (i.e., assuming that the Discrepancy line total is zero), the Current Account is in surplus or in deficit depending upon whether the sum of the nation's imports, gifts by citizens to foreigners, and incomes earned by foreigners in the nation (all of which involve fund outflows) is greater or lesser than the sum of the nation's exports, gifts by foreigners to citizens, and incomes earned by citizens overseas (all of which involve fund inflows). True balance of a nation's Current Account occurs only when these two sums are equal and the Discrepancy line amount is zero.

The presence of non-zero amounts on the Discrepancy line in a nation's Balance of Payments statement renders the meaning of its Currency Account balance uncertain. The Discrepancy line amount usually is not zero. When it is positive, a Current Account surplus is probably larger than reported or a Current Account deficit is smaller than reported. When the Discrepancy line amount is negative, a Current Account surplus is probably smaller than reported or a Current Account deficit is larger than reported. The United States typically has found its Current Account to be in deficit during most of the post-Bretton Woods era (since 1971). The actual deficits may not have been quite as large as indicated in the official Balance of Payments statements.

The significance of a Current Account deficit is that it must be offset or "paid for" by a surplus in the Capital Account if exchange rates are perfectly flexible, or by a net surplus in the Capital and Official Reserves accounts if exchange rates are fixed or manipulated by government authority.

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Comment 18-2. Early Concepts of Payments Imbalance

Today the Balance on Current Account serves most commonly as the basis for identifying imbalance in the international payments of nations. Historically, several other concepts of imbalance have been used, and there continue to be occasional references to them in the media and in trade literature.

The Basic Balance was computed as the sum of the Balance on Current Account plus long-term capital flows (the net of long-term foreign assets held by Americans less the long-term U.S. assets held by foreigners). The Basic Balance was thought to be more responsive to real underlying economic changes, and less influenced by short-term international disturbances or shocks to the global economy. The belief was that because any nation's holdings of short-term assets are limited, it cannot continue to finance a Basic Balance deficit out of short-term capital flows. Prior to 1977, the U.S. government distinguished long- from short-term assets and liabilities in official Balance of Payments statements, so it was possible both to compute and report the Basic Balance. During the last quarter of the twentieth century, financial markets in the U.S. and elsewhere have matured to the point that holdings of financial instruments which previously were classified as long term (equities and medium- and long-term bonds) may be sold quickly and easily on ever more efficient open markets that are global in scope. This development has obscured the distinction between long- and short-term financial instruments, thereby rendering the concept of Basic Balance obsolete. While it continues to be possible for anyone to make judgmental distinctions between short- and long-term financial instruments, there is no official and unambiguous international standard for such a distinction. Nor is it so clear that nations cannot continue to finance a Basic Balance deficit out of short-term capital flows.

The Liquidity Balance was defined as the sum of U.S. Official Reserves Transactions plus changes in official U.S. liquid liabilities to foreigners. It was intended to indicate the extent of the ability of the U.S. government to cover payments deficits by depleting its official reserves and increasing its liabilities to foreigners while keeping dollar exchange rates fixed. The end of the fixed-rate Bretton Woods regime in 1971 rendered the Liquidity Balance concept obsolete. Also, during the last quarter of the twentieth century it became no longer possible to unambiguously distinguish between liquid and non-liquid liabilities to foreigners. And, even when the Liquidity Balance concept was in use, it was flawed by the fact that it omitted consideration of U.S. holdings of foreign liquid assets.

The Official Settlements Balance was computed as the sum of U.S. Official Reserves Transactions (i.e., changes in U.S. official reserves) plus official liquid liabilities to foreign central banks. The concept was intended to show the vulnerability of the U.S. gold stock to depletion since prior to 1971 foreign central banks could convert their holdings of dollar-denominated balances (official liquid liabilities to foreign central banks) to gold upon demand. This privilege was suspended by U.S. authorities in August of 1971, thereby rendering the Official Settlements Balance concept obsolete. Like the Liquidity Balance concept, the Official Settlements Balance concept was flawed in that U.S. official holdings of foreign liquid assets were ignored.

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The Relevance of the Balance of Trade

Current U.S. official Balance of Payments statements show balances on goods (merchandise trade or "visibles"), on services (or "invisibles"), and on trade (the sum of the balances on goods and services) in addition to the Balance on Current Account. During the last quarter of the twentieth century, the U.S. incurred substantial and growing deficits on merchandise trade that were only partially offset by growing surpluses on trade in services. Prospects are for service trade surpluses to continue to grow and eventually to eclipse the trade deficits during the early decades of the twenty-first century. The phenomenon is part and parcel of a long-term transition of the U.S. economy from an industrial economy to a service based economy. Historically, merchandise trade has been focal and services trade has been discounted. The print and video media today often report and despair over what are perceived to be adverse changes in the balances on merchandise trade.

The only relevant distinctions between a good and a service are the tangible characteristics and the duration of life of a good compared to the intangible nature and shortness of life (approaching zero) of a service. These distinctions can be reconciled by noting that goods are desired not for themselves or their innate characteristics, but for the stream of services that can be rendered over the lives of the goods. Services have to be produced (or provided) no less so than do goods have to be produced. Costs are incurred in rendering and delivering the services, no less so than in the production and delivery of goods. This is to argue that the distinction between goods and services in Balance of Payments accounting is an irrelevancy. Americans should not bemoan the passing of the industrial economy or the rising merchandise trade deficit, and they should celebrate the emergence of the service economy and a growing surplus on trade in services.

An even greater irrelevancy, but one which often is reported and disparaged in the media is the bilateral trade balances between pairs of countries or with respect to particular categories of goods or services. While the U.S. runs a cotton textile trade deficit with the rest of the world, the U.S. runs trade surpluses with the rest of the world in many other goods and services. Specific commodity trade imbalances are natural concomitants of specialization according to comparative advantages. The relevance of such commodity level trade imbalances lies with the vested interests who perceive themselves to be harmed by the nation's despecialization in a commodity for which they no longer have a comparative advantage.

It is irrelevant that the U.S. runs a bilateral merchandise trade deficit with China for at least two reasons. One is that the U.S. enjoys a substantial services surplus with China. A second is that the U.S. runs trade surpluses with other countries while China runs trade deficits with many of those same countries. Bilateral trade balances are increasingly irrelevant in a multilateral trading world. In an open global economy, what matters for each country is its overall Current Account and Capital Account balances vis-a-vis the rest of the world.

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Comment 18-3. The Global Current Account Deficit

Until trade with other bodies in the universe becomes possible, the world is in effect a closed economy. This means that the total of the world's output must be absorbed by the world's total spending. It is an accounting truism that the current account deficits run in many of the world's countries must be offset by current account surpluses in other countries so that during any single year the total of the deficits cannot be greater or less than the total of the surpluses.

However, current account data published by the International Monetary Fund (World Economic Outlook, various editions ) indicate that the world as a whole persistently runs current account deficits that are larger than can be explained by simple statistical discrepancies.

A 1987 International Monetary Fund report (Final Report of the Working party on the Statistical Discrepancy in World Current Account Balances, Washington D.C.: International Monetary Fund, September 1987) indicates that the global current account imbalance is attributable to several factors. Part of the explanation is misreporting of trade data due to the fact that at the ends of accounting periods, goods remain in transit that have already been recorded as exports from the source countries, but have not yet been received or recorded as imports in the destination countries.

A larger part of the explanation appears to lie with foreign interest earnings that are not reported to home-country data collection authorities. A substantial portion of such foreign interest incomes may not even be repatriated (or not within the same income period), but rather are held in accounts in foreign banks for reinvestment overseas or repatriation at later dates.

Yet another factor is that many merchant ships are registered in countries different from the nationalities of their owners. Countries of registration often do not report maritime freight earnings to the IMF.

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Inflows and Outflows of Funds

Under a regime of floating exchange rates, a Capital Account surplus to offset a Current Account deficit results in a capital inflow as foreigners acquire ownership of domestic assets or decrease their liabilities to the nation. The capital inflow involves an outflow of funds to "pay for" the Current Account deficit (i.e., imports in excess of exports, gifts to foreigners in excess of foreign gifts to citizens, and incomes earned by foreigners in the nation in excess of incomes earned by citizens overseas). The capital inflow may also be understood to be an export of ownership of domestic assets or a decrease of foreign liabilities to the nation. The Capital Account surplus that offsets a Current Account deficit thus inevitably results in an increase of indebtedness of the nation to foreign interests or a decrease of the ownership of foreign assets by citizens of the nation.

A nation enjoying a Current Account surplus under a regime of floating exchange rates must experience a Capital Account deficit that results in a capital outflow as citizens of the nation acquire ownership of foreign assets or their liabilities to foreigners decrease. The capital outflow involves an inflow of funds to "pay for" the Current Account surplus (e.g., exports in excess of imports, gifts from foreigners in excess of gifts to foreigners, or incomes earned abroad in excess of incomes earned in the nation by foreigners). The capital outflow may also be understood to be an import of the ownership of foreign assets or a decrease of liabilities to foreigners. The Capital Account deficit that offsets a Current Account surplus thus inevitably results in a decrease of indebtedness of the nation to foreign interests or an increase in the ownership of foreign assets by citizens of the nation.

 

Payments Imbalance Adjustment Mechanisms

In the case of a Current Account deficit (i.e., a corresponding Capital Account surplus), the concomitant trade and financial flows elicit an increase of the supply of the nation's currency relative to the demand for it on the foreign exchange markets to cause the nation's currency to depreciate. This means that the foreign currency price of the domestic currency (e.g., the euro price of the dollar) falls as the domestic currency becomes cheaper to foreigners.  It also means that the domestic currency price of the foreign currency (the dollar price of the euro) rises, making foreign goods and services appear more expensive to citizens of the nation.  The currency depreciation will tend to return the nation's payments to a condition of balance as foreigners purchase more of the nation’s goods and services and citizens of the nation import fewer goods and services from foreigners.

 If a nation's currency value is fixed by government action, a Current Account deficit cannot be relieved by exchange rate depreciation. Unless prevented by government exercise of domestic macropolicy, the adjustment to the Current Account deficit must be brought about by some combination of domestic price deflation and contraction of output and employment. If government succeeds both in fixing its currency values on foreign exchange markets and employing macropolicy to stabilize domestic prices and incomes, there can be no adjustment to the Current Account deficit. Under these circumstances, a Current Account deficit may persist indefinitely, with consequent increases of international indebtedness.

Macropolicy tends to be asymmetrical with respect to Current Account deficits and Current Account surpluses. A Current Account deficit entails a leakage of spending from the income stream.  Unless the leakage is offset by investment injection in excess of saving, a nation suffering a Current Account deficit under a fixed exchange rate regime can expect output to contract, unemployment to rise, incomes to fall, and its domestic price level to fall (unless it is “sticky” downward). Government is likely to employ macropolicy tools in the effort to stimulate the economy, prevent unemployment from worsening, and avert deflation. 

A Current Account surplus results in an injection of spending into the income stream.  Unless the injection is offset by a saving leakage in excess of investment, a nation enjoying a Current Account surplus under a fixed exchange rate regime can expect its domestic price level to rise as output expands, unemployment declines, and incomes increase. In this case, government is likely to employ macropolicy tools in the effort to avert price inflation, but otherwise may be happy to allow the ensuing expansion to correct the surplus.

 

Sustainability of Current Account Imbalances

Given these considerations, the questions arise as to whether either a Current Account surplus or a Current Account deficit is "good" or "bad," and whether either condition is sustainable in the long run (i.e., over years stretching into decades). Eighteenth century mercantilists might have answered that a Current Account surplus is good because it increases the "wealth of the nation" by enabling citizens to acquire foreign assets. Correspondingly, a Current Account deficit would be bad because it decreases the wealth of the nation by enabling foreigners to acquire more of the nation's assets. The modern answer is that, with caveats to be noted, neither imbalance condition is good. However, it does not necessarily follow that either imbalance condition is unequivocally bad. And for most nations, neither imbalance situation is sustainable in the long run. There appear to be at least a few exceptions to this generalization.

One of the "up-sides" of a Current Account deficit is that citizens of the nation are able to consume (or absorb) a larger portion of the world's output of goods and services than they are able to produce. Another positive is that the Capital Account surplus that must accompany a Current Account deficit supplies savings to the nation from foreign sources. This is especially important if the nation has been experiencing savings deficits (relative to investment requirements) because domestic saving rates are especially low. Since this situation has been typical of the U.S. economy during the last decade of the twentieth century and the early years of the twenty-first century, the foreign savings supplied via the Capital Account surplus (i.e., the Current Account deficit) have sustained the phenomenal growth of the U.S. economy until the onset of the Great Recessing in 2008. (This topic is further elaborated in Chapter 19).

The conventional approach to analyzing the badness or unsustainability of a Current Account deficit has been to presume that trade decisions are discretionary and that they dominate the nation's international payments situation. The Capital Account must accommodate to "pay for" whatever happens in the Current Account. It is indeed true that the act of importing goods and services requires payment to foreign exporters. To the extent that foreign exporters are willing to accept domestic currency or bank balances denominated in domestic currency units, there is a short-term capital inflow (an outflow of funds) that increases the indebtedness of the nation to foreign interests.

For most nations, there are indeed limits to the willingness of foreigners to accept the nation's currency or to build ownership of bank balances denominated in the nation's currency units because, ultimately, the nation's currency can be used only to acquire goods and services produced by the nation. This constraint is relieved to the extent that citizens of third party nations are willing to acquire some of the first party nation's currency or bank balances from second party nation exporters.

But it is also true that a substantial portion of the Capital Account activity of any nation, whether involving short- or long-term financial instruments, is discretionary. Citizens and foreigners make deliberate decisions to acquire or sell financial instruments irrespective of where they were issued and irrespective of the need to finance trade activity. This discretionary Capital Account activity causes changes of demand for and supply of currencies on foreign exchange markets, with consequent changes of exchange rates (if they are not fixed).

Taken from the perspective of discretionary decision making affecting the Capital Account, a Capital Account surplus (a capital inflow involving an export of the ownership of domestic assets) may require a Current Account deficit (e.g., an excess of imports over exports) to "pay for" the Capital Account surplus. A nation with a discretionary Capital Account deficit requires a Current Account surplus to offset the Capital Account deficit. To the extent that discretionary Capital Account activity outweighs Capital Account activity that accommodates the Current Account activity, it may be said that the Capital Account "drives" the current account rather than the converse.

The sustainability of a Current Account imbalance of any nation ultimately depends upon the global demand for and supply of financial instruments issued by citizens (including businesses, financial institutions, and government units) of the nation. If the global demand for the nation's stocks and bonds continues to keep pace with the increasing supply of them, it is possible for the nation's Current Account deficit (or its Capital Account surplus) to persist indefinitely. However, once the global financial markets become saturated with the nation's debt and equity issues, the Current Account deficit (Capital Account surplus) imbalance is no longer sustainable, and the nation must allow the international adjustment mechanisms (either exchange rates or domestic price level and incomes) to alleviate the imbalance.

A clue as to the sustainability of a Current Account deficit (or a Capital Account surplus) may be found in how its exchange rates are changing. As long as its currency is stable or appreciating on foreign exchange markets, the world is willing to accept ever more of the nation's debt and equity issues, and its Current Account deficit (or its Capital Account surplus) is sustainable. Once its currency begins to depreciate, the implication is that the global demand for the nation's financial issues has slowed or begun to decrease relative to the supply of them, and the Current Account deficit (or Capital Account surplus) is no longer sustainable.

The comments in the previous two paragraphs that have pertained to the sustainability of Current Account deficits (Capital Account surpluses) may of course be recast as to the sustainability of Current Account surpluses (Capital Account Deficits). The reader is urged to do so in order to discern the implications.

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Comment 18-4. An Exception to the Rule?

The United States may be an exception to the generalization that a Current Account deficit cannot be sustained indefinitely. This is due to the fact that the dollar has become an international reserve currency which is being used to effect both bilateral trade and financial transactions between citizens of the United States and foreign interests, and as a global currency to effect transactions among third parties (i.e., other than the United States and its bilateral trading or financial transactions partners).

Reinforcing this phenomenon is the fact that the dollar unofficially has become the preferred currency in a number of nations (e.g., Peru, Cuba), and the "dollarization" currency specified by government authority in some nations (Argentina, Ecuador). As the deliberate or de facto dollarization processes ensue, the global demand for U.S. currency (i.e., dollar-denominated short-term debt issued by the U.S. central bank) will continue to rise, thereby accommodating sustained U.S. Current Account deficits (or Capital Account surpluses).

Few other nations in the world are so fortunate as the United States in this regard, and the U.S. good fortune may evaporate  in the future.  Continuing annual government budget deficits ($4 trillion in the 2010-2011 fiscal year) that have to be financed by issuing government bonds has caused the public debt of the U.S. government to increase to over $14 trillion by 2011, nearly as large as the U.S. GDP.  A substantial portion of the U.S. public debt is held by foreign interests in Asia and the Middle East.  A number of southern European nations (Greece, Spain, Italy) have run such large and persistent current account deficits by issuing ever more government bonds that northern European holders of a large portion of their bonds (Germany, the Netherlands) are concerned about sovereign debt defaults.

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What's Ahead

Chapter 19 continues consideration of macroeconomics in the global economy with an examination of exchange rate determination and macroeconomic adjustment under different exchange rate regimes.

BACK TO CONTENTS

 

CHAPTER 19. EXCHANGE RATES AND MACROECONOMIC ADJUSTMENT

An exchange rate is the price of one currency expressed in terms of another currency. During part of the twentieth century, the exchange rates of many countries' currencies were relatively stable during some periods, but more volatile during other periods. What causes exchange rates to change, and how do changing exchange rates affect macroeconomies?

 

Exchange Rate Determination

Under a fixed exchange regime, exchange rates are determined by government fiat. Exchange values are fixed or stabilized either by intervention of a government agency in exchange markets, or by exercise of the police power of the state to dictate official rates and punish transactions at rates other than the official rates. Under a flexible exchange regime, exchange rates are determined in the global foreign exchange market by interaction of suppliers and demanders. Exchange rates vary in response to changes of demand for and supply of foreign exchange. We shall first examine the macroeconomic implications of market determination of exchange rates. Later in the chapter we shall return to the implications of governmental determination of exchange rates.

Although any exchange rate can be expressed as either the foreign currency price of the domestic currency (e.g., the euro price of a dollar, €/$) or its reciprocal, the domestic currency price of the foreign currency (e.g., the dollar price of a euro, $/€), the former should be used in order to make sense of appreciation and depreciation of the domestic currency. At the inception of the euro in January of 1999, the foreign exchange market priced the dollar at €0.85, i.e., $1.17 per euro. 

The quantity of dollars demanded on the foreign exchange market varies inversely with the euro price of the dollar, €/$, as its principal determinant. The higher the euro price of the dollar, the smaller the quantity of dollars that will be demanded.  The demand for a nation’s domestic currency derives from two sources, citizens of the nation and foreigners. Citizens of the nation may demand their own currency on the foreign exchange market if they wish to exchange the foreign currencies that they have acquired in trade, as earnings on investments, or as gifts. The foreign demand for the domestic currency is equivalent to the foreign supply of the foreign currency. Foreigners may supply their own currencies to purchase the nation's domestic currency on the foreign exchange market in order to make gifts to citizens of the nation, import goods and services from the nation, or invest in the nation.

The principal non-price determinants of the total demand (domestic and foreign) for the domestic currency on the foreign exchange market are foreign incomes, foreign preferences, relative rates of inflation, comparative interest rates, U.S. tariff barriers, and U.S. non-tariff barriers. All of the non-price determinants of demand are assumed constant (ceteris paribus) in order to specify the demand relative to price alone. A change of any of the non-price determinants of demand for dollars changes the quantity demanded of dollars at every possible euro price of the dollar. The demand for dollars on the foreign exchange market might increase if European incomes rise, European preferences for American goods improve, European price levels rise relative to the U.S. price level, or U.S. interest rates rise relative to European interest rates. The foreign exchange demand for dollars might also increase if U.S. trade barriers were to decrease.

Assuming that the supply of dollars does not change, the increased demand for dollars on the foreign exchange market induces the euro price of the dollar to rise. This means that the dollar appreciates relative to the value of the euro, or the euro depreciates relative to the value of the dollar. A change in any of the non-price determinants of demand in the opposite directions to those specified above would decrease the foreign exchange demand for dollars. Again, assuming that the supply of dollars does not change, the demand decrease would induce the euro price of the dollar to fall. This means that the dollar depreciates relative to the euro, or the euro appreciates relative to the dollar.

The assumption that the supply of dollars does not change is unnecessarily stringent. The same conclusion obtains in each case if the supply of dollars changes in the same direction as the demand for dollars, but by a smaller amount, or if the supply of dollars changes in the opposite direction to the change in the demand for dollars.

The quantity of dollars supplied to the foreign exchange market varies directly with its price, €/$, as its principal determinant. The higher the euro price of the dollar, the larger the quantity of dollars that will be supplied to the market. The principal non-price determinants of the domestic supply of the domestic currency to the foreign exchange market (i.e., the domestic demand for the foreign currency) are domestic incomes, domestic preferences, relative rates of inflation, comparative interest rates, eurozone tariff barriers, and eurozone non-tariff barriers. A change of any of the non-price determinants of the supply of dollars to the foreign exchange market would change the quantity supplied of dollars at every possible euro price of the dollar. The supply of dollars to the foreign exchange market might increase if U.S. incomes increase, U.S. preferences for European goods improve, the U.S. price level rises relative to European price levels, or European interest rates rise relative to U.S. interest rates. Decreases of European trade barriers also might increase the supply of dollars to the foreign exchange market. If any of these non-price determinants of supply should change in the opposite direction to those specified above, the supply of dollars to the foreign exchange market would decrease.

These demand-supply principles allow the following generalizations about the likely direction of change of an exchange rate. Each statement should be read through twice, once with the word to the left of the slash in each pair, and a second time with the word to the right of the slash in each pair. Careful attention should be paid to the ceteris paribus conditions. If "other things" do not remain the same, the conclusion of the generalization may not obtain.

1. Short-run (i.e., within the trading day, within a trading week) changes of exchange rates are random and rarely predictable.

2. Increases/decreases in the foreign demand for the domestic currency, ceteris paribus, in the long run (over months and quarters) likely will lead to appreciation/depreciation of the domestic currency.

3. Increases/decreases in the domestic supply of the domestic currency, ceteris paribus, in the long run likely will lead to depreciation/appreciation of the domestic currency.

4. Increases/decreases of domestic incomes, ceteris paribus, in the long run likely will lead to depreciation/appreciation of the domestic currency. Increases/decreases of foreign incomes, ceteris paribus, in the long run likely willlead to appreciation/depreciation of the domestic currency.

5. Improving/deteriorating preferences for domestic goods, ceteris paribus, in the long run likely will lead to appreciation/depreciation of the domestic currency. Improving/deteriorating preferences for foreign goods, ceteris paribus, will in the long run likely lead to depreciation/appreciation of the domestic currency.

6. Domestic inflation at a faster/slower pace than that of foreign inflation, ceteris paribus, in the long run likely will result in depreciation/appreciation of the domestic currency.

7. Domestic interest rates which are higher/lower than foreign interest rates, ceteris paribus, in the long run likely will result in appreciation/depreciation of the domestic currency.

8. Increasing/decreasing foreign/domestic trade barriers, ceteris paribus, in the long run likely will result in appreciation/depreciation of the domestic currency.

Needless to say, any of these statements can be recast in terms of what is likely to happen to the foreign currency when any of the stipulated conditions change.

 

Interest Rate Parity

A cautionary note with respect to interest rate differentials is in order. Foreign interest rates that are higher than domestic rates likely will induce an outflow of funds (i.e., a capital inflow as the domestic ownership of foreign assets increases) to earn a greater interest income than possible in the domestic market.  This increases the domestic supply of the domestic currency (i.e., the domestic demand for the foreign currency) on the foreign exchange market, thereby precipitating depreciation of the domestic currency. However, when the principal plus interest is returned, the increased foreign demand for the domestic currency (i.e., increased foreign supply of the foreign currency) likely will induce appreciation of the domestic currency. Other things remaining the same, the net effect on the exchange rate should be approximately nil or only slight appreciation since more funds are repatriated than originally went abroad.

Changing non-price determinants of demand or supply in the foreign exchange market may cause the domestic currency to appreciate between the time funds were sent abroad to take advantage of the higher foreign interest rate and when they are repatriated after the interest is earned. If this happens, the foreign interest rate advantage will be at least partially offset by the domestic currency appreciation since the foreign currency will now buy fewer units of the domestic currency. Should the domestic currency depreciate in the interim due to other things not remaining the same, the investor's foreign interest earnings will be augmented in the currency exchange, i.e., the investor will gain both on the interest earned and on the currency exchange since the foreign currency will now buy more units of the domestic currency. In either case, the increase in the supply of loanable funds abroad, ceteris paribus, will tend to decrease the foreign interest rate, and thereby to eliminate the foreign interest advantage.

Interest investors will continue to send funds abroad to earn higher foreign interest rates until appreciation of the domestic currency fully offsets the foreign interest advantage, i.e., until interest rate parity occurs. The decision criterion for sending funds abroad to take advantage of higher foreign interest rates is to continue to do so as long as the foreign interest rate minus the expected percentage appreciation of the domestic currency is greater than the domestic interest rate.

 

Spot and Forward Exchange Rates

Spot exchange trading is for immediate (or next day) delivery. Forward exchange markets have emerged for some heavily-traded pairs of currencies. In currencies for which forward markets have emerged, it is possible to contract to purchase or sell quantities of exchange (i.e., sell or purchase the domestic currency) 30, 60, or even 90 days forward. Risk of adverse changes of exchange rates can be managed by hedging, i.e., entering into forward contracts to buy or sell quantities of exchange needed or expected in the future. Hedged positions are offsetting or covered positions. For example, a quantity of exchange may be purchased spot (the domestic currency supplied) and sold forward (the domestic currency demanded), with interest earned in the interim in a foreign market. Another example is that of a domestic exporter who ships merchandise to a foreign importer in anticipation of receipt in the foreign currency at a future date; the domestic exporter "covers" his open position by contracting for the forward sale of the quantity of exchange when its receipt is expected.

Speculators deliberately assume risk in uncovered or open positions in the forward exchange market in hopes of a favorable exchange rate change; if their predictions are right/wrong they will win/lose. Successful speculation likely will facilitate foreign exchange market adjustment toward a new equilibrium; unsuccessful speculation may destabilize foreign exchange markets.

                       

Macroeconomic Adjustment to International Disturbances

As the world economy becomes progressively more open and economically integrated, the vehicles for macroeconomic adjustment to internationally-sourced disturbances attain ever greater significance. Basically, there are only three macroeconomic adjustment vehicles: exchange rates, domestic prices (including interest rates), and domestic employment (and incomes). A progression of "if statements" identifies the relevant adjustment possibilities:

1. If exchange rates are allowed sufficient flexibility, they may serve as "shock absorbers" for the domestic economy against internationally-sourced disburbances.

2. If exchange rates are fixed by government authorities, domestic prices and incomes assume the burden of adjustment.

3. If domestic prices are insufficiently flexible, the adjustment process must descend upon domestic employment and incomes.

4. If government authorities employ macropolicy to stabilize domestic prices and incomes, exchange rate flexibility must serve as the adjustment vehicle.

5. If government authorities attempt both to stabilize domestic prices and employment and to fix exchange rates, there is no effective vehicle of macroeconomic adjustment to international disturbances. In the absence of an effective adjustment vehicle, payments imbalances will persist.

An important conclusion emerges from these considerations: the degree of domestic macroeconomic stability of a nation may depend upon the degree of flexibility that its government accords to rates of exchange between its currency and other currencies. As a general rule, we may expect domestic macroeconomic conditions in any economy to be more volatile in response to international disturbances the less flexible are its exchange rates. Fixing or stabilizing exchange rates forces the adjustment to international disturbances upon domestic macroeconomic conditions of prices and employment.

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Comment 19-1. Macroeconomic Adjustment Within an Economically Integrated Region.

The United States of America is a geographically large nation with political subdivisions (states) that are organized in a federal system, and which uses a common currency (the dollar) throughout the nation. Since the same currency is used everywhere in the U.S. and its dependencies, there are no explicit internal exchange rates. Implicitly, however, currency units used in each state exchange for currency units used in other states at 1:1 fixed exchange rates. Differences of macroeconomic conditions among the states, or some disruption (or shock) that impacts one of the states, become manifested in price, interest rate, or income differentials among the states. However, the interstate macroconomic adjustment to an emerging difference or local shock cannot be absorbed by interstate exchange rate flexibility. And, the federal nature of the system prohibits state governments from attempting to employ fiscal or monetary policy to address local inflation or unemployment problems.

Within the U.S., the interstate macroeconomic adjustment process must rely upon changing prices, interest rates, employment levels, and incomes. Interstate free trade in goods and services, and unencumbered interstate mobility of labor and capital tend to bring about nation-wide convergence of prices, interest rates, and incomes. Only the costs of mobility constrain the achievement of absolutely common prices, interest rates, and income levels across the nation. This adjustment process works to the benefit of states with higher prices or lower incomes; it may be thought to work to the detriment of states with lower prices or higher incomes. It may be argued that the interests of states with lower prices or higher incomes would have been better served by exchange rate flexibility which might have let them preserve their favored conditions.

It may also be argued that the degree of interstate macroeconomic instability in the U.S. may have been greater with a common currency and implicitly fixed exchange rates than it might have been with state-specific currencies and flexible exchange rates among them. This is of course an untestable hypothesis. 

Western Europe has evolved in the post-World War II era from a fractured and nationally divided continent through various phases of a common market and a customs union to a full economic union in which a single market enables mobility of goods, resources, capital, and labor throughout the region. The evolutionary process has thus far stopped short of a full political union with either a federal organization or a unitary government. The European Union is organized as a confederation of twenty-seven nation states, each retaining independent fiscal discretion. The seventeen eurozone member states that have committed to a common currency have ceded monetary discretion to a supranational European Central Bank that exercises monetary policy designed for the entire EU.

Since macroeconomic adjustment to shocks or differences among the seventeen eurozone member states cannot be brought about by exchange rate, the adjustment process must rely upon changes of domestic prices, interest rates, and income levels brought about by interregional trade and mobility of labor and capital resources. Unless the national governments of the eurozone member states can effectively wield fiscal policy to achieve macroeconomic stability, it is possible that the degree of macroeconomic instability of the eurozone member states will become greater with locked exchange rates and a common currency than before the establishment of the European monetary union and the common currency. Several southern European nations in the eurozone (Greece, Spain, Portugal, Italy) are demonstrating the consequences of the fixed exchange rates in a common currency as they cumulate their public debts by running persistent government budget deficits.  As long as they stay in the eurozone, their currencies cannot depreciate and they cannot devalue their currencies.

There is yet another process at work in the Western Hemisphere that may eventually establish a common currency centering upon the U.S. dollar. In a process that has become known as "dollarization,” national governments of certain Latin American countries (Argentina, Equador), unable to exercise sufficient fiscal and monetary discipline to prevent inflation within their borders, have decided to tie their currency values rigidly to the U.S. dollar, and eventually to replace their currencies with dollars. In so doing, they hope to replace their own lack of monetary discipline with that of the U.S. Federal Reserve.

There are also countries in which the dollar is becoming the preferred local currency even though no deliberate political decision has been taken to replace the local currency with the dollar. Although the process of dollarization may have great promise to achieve the goal of monetary discipline, a potential negative is that with fixed exchange rates and ultimately a common currency, international adjustment to disturbances in the regions using the dollar can no longer be accomplished by exchange rate flexibility. Rather, it must be accomplished by changes in prices, interest rates, and income levels across the nations using the dollar, just as among the states within the United States.

Should only one of the major international currencies (the dollar, the euro, the yen, the yuan) survive in the distant future, exchange rate flexibility would disappear from the globe as a vehicle to facilitate interregional macroeconomic adjustment.

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The Demand for Money and the Demand for Exchange

It is important to note that the demand for exchange on the foreign exchange market is not coincident with the demand for money as analyzed in Chapters 10 and 11. Nor is the supply of exchange on the foreign exchange market coincident with a nation's supply of money. Only a portion of the quantity of a nation’s money supply denominated in units of its currency will be offered on the global foreign exchange market at any one point in time, and only a portion of the money supply denominated in units of the nation's currency will be demanded for international transactions purposes. However, during any particular foreign exchange trading period (such as a trading day), the total volume of transactions denominated in units of a particular national currency may exceed the nominal amount of the of the nation's money supply by virtue of the fact that the same quantities may be traded many times over during the trading period.

While the demand for and supply of a nation's money are not coincident, with the demand for and supply of the domestic currency on the global foreign exchange market, they are linked by what eighteenth century economist David Hume called the “price-specie flow” mechanism. Hume of course was concerned with inflows and outflows of gold and silver (specie) from a nation. Modern money supplies are more diverse, consisting not only of coin and paper currencies but also of balances on deposit at financial institutions. These balances, though physically resident as liability accounting entries "on the books" of financial institutions within the nation, may be owned by foreigners as well as by citizens of the nation.

In a globally-integrated world economy, balances denominated in units of one nation's currency may have "escaped the nation" in the sense of being held as deposits at financial institutions in other nations. So-called "euro-dollars" and "petro-dollars" are examples of dollar-denominated balances held externally to the United States. Such foreign balances denominated in units of the domestic currency may have served as fractional reserves to the foreign financial institutions, enabling them to create even more deposits denominated in units of the domestic currency than originally escaped the nation. The global amount of money denominated in units of a nation's domestic currency may thus have become greater than the amount issued by the central bank and financial institutions within the nation. The total amount of such money globally may not even be knowable with any degree of precision.

Deposits at financial institutions within the nation as well as domestic currency deposits residing in foreign financial institutions may be owned by citizens of the nation or by citizens of other nations. In a globally-integrated financial system, domestic interests may borrow from foreign financial institutions balances denominated in the domestic currency. In following discussion, we shall use the convention of identifying the relevant domestic money supply of a nation as those pocket currency amounts and deposit balances denominated in the currency unit of the nation that motivate the behavior of citizens of the nation, irrespective of where they reside. This concept of the relevant domestic money supply may not correspond closely to official designations of M1 or M2 since portions of either may be held by foreigners.

 

Macroeconomic Adjustment to a Current Account Deficit

The possible causes of an emerging or growing Current Account deficit of a nation are the same items listed above that cause depreciation of its domestic currency. Three of the most prominent causes are domestic incomes increasing at a faster pace than foreign incomes, domestic inflation at a faster pace than foreign inflation rates, and domestic interest rates that are lower than foreign interest rates.

An emerging or growing Current Account deficit is likely to increase the supply of domestic money to the forex market (i.e., increase the demand for the foreign currency). Assuming that the demand for domestic money has not changed, the resulting excess supply likely will induce depreciation of the domestic currency on the forex market. The depreciation of the domestic currency makes the nation's exportables look cheaper to foreigners and imports from abroad appear more expensive to citizens, thereby alleviating the Current Account deficit.

How forex market transactions affect the domestic money supply of a nation depends upon the identities of the purchasers and sellers of the exchange. With a Current Account deficit, one source of the increased supply of the domestic currency to the forex market is foreigners who have acquired the domestic currency as export earnings, as income from investments in the nation, or as unilateral transfers (gifts) from citizens or the government of the nation. If foreigners supply quantities of the domestic currency to other foreigners through the forex market, the relevant domestic money supply (that which motivates the behavior of citizens of the nation) does not change.

Another source of the increased supply of domestic currency to the foreign exchange market is efforts by citizens of the nation to convert quantities of the domestic currency into foreign currencies in order to purchase imports from foreign sources, to invest overseas, or make unilateral transfers (gifts) to foreigners. To the extent that foreign interests acquire money balances denominated in units of the domestic currency from citizens of the nation, the nation's relevant domestic money supply (that which motivates the behavior of citizens of the nation) decreases. Assuming that the domestic demand for money does not change, the domestic money supply decrease may result in falling domestic prices, rising domestic interest rates, and decreasing employment. The falling domestic prices of tradeables tend to increase the volume of exports and reduce the volume of imports. The rising domestic interest rates tend to decrease the volume of investment by citizens in other countries and increase the volume of investment by foreigners in the nation. The decreasing domestic employment decreases incomes in the nation and thus curbs imports.

One view is that the burden of adjustment borne by domestic prices, interest rates, and employment is lessened by the currency depreciation. Another view is that these three phenomena supplement the depreciation of the domestic currency in alleviating a Current Account deficit. But if depreciation of the domestic currency is prevented by government authorities who are resolved to "defend the currency" from further "weakening," the full burden of adjustment to the Current Account deficit will descend upon domestic prices, interest rates, and employment.

Some of the domestic money that is supplied to the foreign exchange market may be acquired by citizens of the nation who wish to convert foreign currency denominated export earnings, investment income, or gifts from foreigners into the domestic currency for repatriation. Such currency transactions between citizens of the same nation do not affect the domestic money supply, even though they pass through the foreign exchange market. Although the usual presumption is that a Current Account deficit will decrease the domestic money supply, if the volume of citizen-to-citizen or foreigner-to-foreigner transactions in the domestic currency is large enough, the domestic money supply may be little affected by a Current Account deficit. In this case, the domestic macroeconomic adjustment will be minimal and the correction of the imbalance will depend largely upon depreciation of the currency if the government will let it ensue.

The depressive macroeconomic effects of a decrease of the domestic money supply in response to a Current Account deficit may motivate the government of the nation to attempt to neutralize (or sterilize) the monetary contraction with off-setting purchases of bonds in the domestic open market. If domestic macroeconomic contraction is prevented, the full burden of adjustment to the Current Account deficit must fall upon exchange rate depreciation. If the government also resolves to prevent its currency from depreciating by intervening in foreign exchange market to purchase quantities of the domestic currency, no mechanism of adjustment is allowed to function, and the Current Account deficit may persist indefinitely. It may be inferred that a fixed exchange rate system (like the Gold Standard or the Bretton Woods system) is fundamentally incompatible with the exercise of modern macroeconomic policy designed to stabilize the domestic economy.

The exposition in this section may be recast in terms of decreases in the supply of or demand for the domestic currency to the global foreign exchange market, and the reader is invited to think through such relationships.

 

Exchange Rate Policy

As noted above, the central bank may passively allow the net effects on the domestic money supply to have their natural price and interest rate effects, or it may attempt to neutralize the impact on the domestic money supply with off-setting monetary actions in the open markets for financial instruments in the nation.

Under a nominally flexible exchange rate regime, monetary authorities may at times attempt to influence the direction of exchange rate change by purchasing other currencies (i.e., supplying the domestic currency) to induce depreciation or prevent appreciation of the domestic currency. Or they may sell other currencies (i.e., demand the domestic currency) to induce appreciation or prevent depreciation of the domestic currency.

When they do either they may forego the ability to exert monetary policy in pursuit of domestic goals. When authorities attempt to manipulate flexible exchange rates, the regime may be described as a "dirty float.”

In a fixed exchange rate regime (such as the Gold Standard or the Bretton Woods System), the principal responsibility of the monetary authority becomes the control of the exchange rate within narrow tolerances of a target rate. In such a situation, monetary policy cannot be directed toward domestic problems, and the "tail wags the dog," i.e., the interest of the domestic economy is made subsidiary to the need to stabilize the exchange rate.

 

Scenarios Resulting in Balance of Payments Deficits

In this section we consider scenarios which, starting from an initial equilibrium, eventually result in balance of payments deficits.

We start with a scenario in which the initiating change occurs in the private sector rather than by macropolicy. Starting from a situation of equilibrium in all markets, assume that the domestic demand for money to hold decreases.  This results in an excess supply of money at the current interest rate in the sense that there is more money in circulation than people wish to hold.

In a similar scenario, but one for which the initiating factor occurs as a matter of macropolicy, the central bank, in an effort to implement an expansionary (or “loose”) monetary policy, increases the money supply by conducting open market purchases of treasury bonds. This also results in an excess supply of money at the current interest rate.

The Keynesian conclusion is that people can rid themselves of their excess money balances by buying “bonds” (a Keynesian euphemism for all kinds of financial instruments) to hold in their portfolios of assets. This causes and increase of the demand for bonds relative to the supply of bonds. Other things remaining the same, bond prices will rise, causing bond yields to fall.  The falling bond yield rates will be transmitted to all other financial markets through the process of arbitrage.

Monetarists suggest that the bond market is not the only place where people can rid themselves of excess money balances. They may do so by increasing their consumption spending relative to the flow of their incomes so as to decrease their saving. When people increase their consumption spending, aggregate demand increases. Other things remaining the same for aggregate supply, the increased spending will induce output (and income) to increase.  The price level will tend to rise as well.

In a closed economy, the adjustment to an excess supply of money will be played out completely in the bond and real markets. When the economy is open to international transactions, both Current Account (goods and services) and Capital Account (bank account balances and currencies as well as portfolio investments and direct investments) responses may result as well. When there is an excess supply of money, the supply of dollars to the foreign exchange market may increase. This results in an excess supply of dollars on the foreign exchange market at the current exchange rate. This excess supply may result in a Balance of Payments deficit because the supply of dollars to buy “things” (merchandise, services, dollar-denominated bank balances, treasury bonds, stock shares, plant and equipment, etc.) from foreign sources exceeds the demand for dollars on the foreign exchange market to purchase “things” domestically. The same result might have resulted from a decrease of the demand for dollars as people attempt to exchange less of the foreign currencies (i.e., to acquire fewer dollars) in the effort to eliminate the excess supply of money.

Flexible Exchange Rates.  If exchange rate flexibility is permitted, a Balance of Payments deficit causes the foreign currency price of the local currency to fall, i.e., the domestic currency depreciates, which is the same as to say that the foreign currency appreciates. The adjustment process plays out in the form of rising domestic output and price level, increasing bond prices, and falling interest rates. The domestic adjustment process occurs just as it would in a closed economy since in a cleanly floating exchange rate system there are no international flows of reserves or changes of the domestic money supply.

Fixed Exchange Rates. But suppose that the government resolves to prevent depreciation of its currency on the foreign exchange market. One way in which to do this is to specify an official exchange rate, and then to employ the police power of the state to punish transactions at any exchange rate other than the official rate. Under this type of fixed exchange regime, a Balance of Payments deficit will persist. Imports of ”things” (any type, current or capital account) exceed exports of “things” with the result that the trade deficit has to be paid for by an outflow of money. In David Hume’s 19th century discussion of the price-specie flow mechanism, gold would flow out in payment for the imports. In the twenty-first century, this outflow of money takes the form of foreigners acquiring ownership of domestic currency denominated bank account balances. The money outflow thus decreases the account balances of local citizens and the reserves of their commercial banks. This outflow of money and reserves has the effect of decreasing the domestic money supply. This diminishes the excess supply of money and prevents the interest rate from falling. If the outflow of money and reserves is sufficient to eliminate the excess supply of money, bond prices won’t rise, interest rates won’t fall, output won’t increase, and the price level won’t rise. This implies that in the case of a fixed exchange rate regime (like the 19th century Gold Standard or the 20th century Bretton Woods regime) the Balance of Payments deficit will persist and there is no effective mechanism to relieve international disequilibria.

Exchange Rate Policy.  An alternative implementation of a fixed exchange rate regime is that a designated government agency (central bank or treasury department) enters the open market for foreign exchange when the exchange rate departs too far from the official rate (i.e., above or below specified boundaries on either side of the official rate). The exchange control authority purchases or sells foreign exchange by selling or purchasing the domestic currency.

In the foreign exchange market the excess supply of the domestic currency can be eliminated by a central bank purchase of the domestic currency by selling foreign currencies, but its ability to do this is limited by the amounts of foreign currencies in its inventory. This amounts to an open market sale in the foreign exchange market, the side effect of which is to destroy money and bank reserves. This has the effect of decreasing the domestic money supply to eliminate the excess supply of money caused by the decrease of money demand.  If the central bank keeps the local currency from depreciating by selling foreign currency, no domestic changes will occur to domestic bond prices, interest rates, the output level, or the price level. The Balance of Payments deficit persists and there is no effective mechanism to alleviate international disequilibria. Since domestic monetary policy has been dedicated to fixing the exchange rate, the central bank cannot use it to address domestic macroeconomic issues such as inflation or unemployment.

Although there is no technical limit to the ability of a central bank to supply its own currency in an effort to relieve a Balance of Payments surplus and prevent appreciation of its own currency, the opposite possibility is severely limited. Suppose that a Balance of Payments deficit emerges for non-monetary reasons and the prospect is for the currency to depreciate. The central bank can prevent depreciation only as long as it is able to supply the foreign currency to the foreign exchange market in buying back its own currency (thereby reducing the domestic money supply and the reserves of domestic commercial banks). Once the central bank stocks out of the foreign currency, it can no longer prevent depreciation of its currency. Depreciation ensues until the Balance of Payments deficit is alleviated. Experience during the post-Bretton Woods era (since 1972) suggests that central banks, singly or in coordination with other central banks, rarely have the will or enough foreign exchange reserves to fully alleviate Balance of Payments deficits.

A nominally flexible exchange rate regime has been in place since the early 1970s. Under a flexible exchange regime international adjustment to changing international circumstances is automatic (though not necessarily immediate as claimed by some writers). The exchange rate falls until an emerging Balance of Payments deficit is eliminated. This means that the domestic adjustment to an incipient Balance of Payments deficit is increase of domestic output, prices, and employment, just as would occur in a closed economy. Of course, these increases may be prevented by exercise of contractionary macropolicy. Unlike a fixed exchange rate regime in which monetary policy must be dedicated to keeping the exchange rate fixed, under a flexible exchange rate regime monetary policy is free to be applied to domestic macropolicy problems.

 

The Insulation Properties of Exchange Rate Regimes

Can exchange rate flexibility insulate the domestic economy from international disturbances? Suppose that there has occurred an externally-sourced (foreign) decrease of demand for domestically produced "things" (anything, including merchandise, services, financial instruments, direct investments, etc.). If this decreased demand impacts primarily the current account (merchandise and services), the result is a decrease of exports. The resulting decrease of the demand for dollars on the foreign exchange market to purchase such things precipitates an incipient Balance of Payments deficit and portends a depreciation of the exchange rate.

While our objective is to consider the insulating properties of exchange rate flexibility relative to foreign disturbances, we should note that the same incipient Balance of Payments deficit and exchange rate depreciation pressure would result from an internally-sourced increase of the demand for foreign made things which increases the supply of dollars to the foreign exchange market. If the increased demand for foreign things impacts primarily the current account, the result is an increase of imports.

In either case, net exports decreases, causing a decrease of aggregate demand. To the extent that aggregate demand decreases, real output falls and unemployment rises.

 

Insulation under Flexible Exchange Rates. 

Under a flexible exchange rate regime, if depreciation occurs concurrently with the decreased demand for exports or increased demand for imports, the lower foreign price of the domestic currency makes domestic goods appear cheaper to foreigners and foreign-made goods appear more expensive to domestic consumers. Both effects offset the decrease of aggregate demand. In the best-case scenario, the exchange rate depreciation serves to insulate the domestic economy completely from the effects of decreased demand for domestically produced things or the effects of increased domestic demand for foreign-made things. Output doesn't fall and unemployment doesn't rise.

Exchange rates respond to a variety of influences other than what is happening in the Current Account (exports less imports), and they often respond sluggishly to changing international conditions. If the exchange rate falls too slowly or doesn't fall far enough to prevent a net decrease of aggregate demand, output and employment may fall, at least temporarily. In such less-than-ideal scenarios, exchange rate flexibility may not be sufficient to completely insulate the domestic economy from foreign disturbances.

 

Insulation under Fixed Exchange Rates. 

In contrast, under a fixed exchange rate regime there is virtual certainty that international disturbances will impact the domestic economy. How they do so depends critically upon the strengths of secondary effects. One way in which exchange rates may be fixed is to specify an official exchange rate and then to employ the police power of the state to punish transactions at any exchange rate other than euro1. With an overvalued currency which cannot depreciate, increasing imports or decreasing exports cause a growing Current Account deficit that decreases aggregate demand.  Output and income fall and unemployment rises.

Secondary effects may ameliorate the contraction. Consequent upon the falling incomes, the demand for money decreases, causing an excess supply of money at the current interest rate. In the Keynesian transmission mechanism, the excess supply of money causes the demand for bonds to increase, raising bond prices and depressing interest rates. As interest rates fall, interest-sensitive consumer and business investment spending increase. In the monetarist transmission mechanism, some to the excess money supply goes directly to consumption spending, irrespective of interest rates. In either case, the increased spending causes aggregate demand to recover toward its earlier level, thereby ameliorating the initial contraction.

But other secondary effects may dampen the amelioration. The emerging Balance of Payments deficit has to be paid for by an outflow of money, represented by the excess supply of dollars to the foreign exchange market. The money outflow usually is accomplished by foreigners acquiring ownership of dollar-denominated bank balances in payment for the excess of imports over exports. The money outflow decreases the account balances of local citizens and the reserves of their commercial banks. This outflow of money and reserves has the effect of decreasing the money supply. This diminishes the excess supply of money and may prevent the interest rate from falling. If the outflow of money and reserves is sufficient to eliminate the excess supply of money, bond prices won’t rise, interest rates won’t fall, output won’t increase, and the price level won’t rise. This implies that when exchange rates are fixed, an international disturbance is likely to have adverse impact on the domestic economy when all of the secondary effects are taken into account. This also implies that in the case of a fixed exchange rate regime a Balance of Payments deficit will persist and there is no effective mechanism to relieve international disequilibria.

In the more liberal (market oriented) implementation of a fixed exchange rate regime, a designated government agency (central bank or treasury department) enters the open market for foreign exchange when the exchange rate departs too far from the official rate (i.e., above or below specified boundaries on either side of the official rate). The exchange control authority purchases or sells foreign exchange by selling or purchasing the domestic currency. The net exports decrease also decreases aggregate demand.  Output and income falls, and unemployment rises. As income falls, the demand for money decreases.  In the foreign exchange market the excess supply of dollars can be eliminated by a central bank purchase of dollars by selling euros. This amounts to an open market sale in the foreign exchange market, the side effect of which is to destroy money and bank reserves. This has the effect of decreasing the money supply to eliminate the excess supply of money caused by the decrease of money demand. If the central bank keeps the local currency from depreciating by selling foreign currency, the domestic economy is likely to be impacted adversely by the external disturbance. As long as the Balance of Payments deficit persists, there is no effective mechanism to alleviate international disequilibria. And, since domestic monetary policy has been dedicated to fixing the exchange rate, the central bank cannot use it to address domestic macroeconomic issues such as inflation or unemployment.

Unfortunately, there is a severe limit to the ability of a central bank to prevent depreciation of its own currency. It can prevent depreciation only as long as it is able to supply the foreign currency to the foreign exchange market in buying back its own currency (thereby reducing the domestic money supply and the reserves of domestic commercial banks). Once the central bank stocks out of the foreign currency, it can no longer prevent depreciation of its currency. Depreciation ensues until the Balance of Payments deficit is alleviated. Experience during the post-Bretton Woods era (since 1972) suggests that central banks, singly or in coordination with other central banks, rarely have the will or enough foreign exchange reserves to fully alleviate Balance of Payments deficits.

What's Ahead

Chapter 20 considers the possibility of effecting macropolicy to stabilize the economy.

BACK TO CONTENTS

 

 

CHAPTER 20. STABILIZATION POLICY

The rationale for bringing the offices of government to bear upon the stability of the economy is based upon the view that market economies are naturally unstable, that the degree of instability is intolerable, and that some force must be applied to counteract the natural instability of the market economy. From the Keynesian perspective, the only entity in the economy that can possibly bring enough force to bear upon the problem of instability is the government. It is to this thesis that Chapter 20 is devoted.

 

The Government's Potential for Stabilizing the Economy

It was shown in Chapter 11 that when the economy experiences either an increase or a decrease of aggregate demand or a decrease of aggregate supply, there is a natural tendency for the adjustment process to return the economy to its normal operating capacity, although there may be lasting effects upon the rate of price inflation. However, the natural adjustment process takes time, perhaps extending beyond a few quarters and to several years. Belated responses or overreactions by business decision makers may set in motion cyclical oscillations that are felt with dampening effects for years, especially if managers attempt to control inventories within narrow limits. As we noted above, the modern industrial or post-industrial economy typically takes four or more years to complete all of the phases of a business cycle. Even though the economy possesses significant self-correcting properties, the burning questions debated by economists for decades are whether government can prevent such instability, hasten natural adjustment processes, or diminish the amplitude of oscillation.

Analyses in previous chapters have suggested that it is adverse changes of aggregate demand or aggregate supply that inject instability into the macroeconomy. If this is true, then it must follow that the government's best hope of eliminating or diminishing instability lies in influencing the components of aggregate demand and aggregate supply. Short of taking over the private sector by nationalizing business enterprises, the means by which the government can influence aggregate demand and supply is through its various points of contact with households and firms in the private sector. The two principal ways of doing this are to affect aggregate demand through the government's monetary and fiscal policies, and to influence aggregate supply by doing things that diminish market imperfections.

Monetary policy, the control of the money supply and interest rates, affects interest-sensitive business and consumer purchases and any consumer spending that is motivated by financial liquidity. Fiscal policy is implemented by changing the government's purchases from the private sector, or the taxes and other fees which businesses and income recipients pay to the government. Fiscal policy may also impact aggregate supply through its effects on the society's incentive structure. Various governmentally sponsored programs may be designed to facilitate the flows of information and resources, and to support or enhance incentives to work and invest.

For the moment, we shall indulge in the presumption that it is the principal objective of the government to stabilize the economy; in a subsequent section we shall consider the implications of some objective other than this. If government officials could perfectly predict private sector changes of aggregate demand or supply, they could devise offsetting changes of the government's budget which would neutralize the private sector shifts.

Fiscal Policy and Aggregate Demand.  Suppose that a decrease of aggregate demand is sourced in the private sector (a collapse of investment or consumption spending) and can be perfectly predicted. In order to prevent output from falling with an attendant increase of unemployment, the government could increase its own purchases by the same amount as the decrease of aggregate demand. Or it might reduce tax collections by enough to stimulate a corresponding increase of consumption spending. The effect would be to return aggregate demand to its former level after some multiplier lag.

A private-sector sourced increase of aggregate demand, if perfectly predicted, could be neutralized by a same-magnitude decrease of government purchases or an increase of tax collections that would reduce consumption purchases by the required amount. With such perfect offsets of spending changes in the private and public sectors, inventories would not change and the macroeconomy would be stabilized.

Monetary Policy and Aggregate Demand.  Monetary policy might be used to effect off-setting changes of aggregate demand. In order to counter a predicted aggregate demand decrease, the monetary authority would have to pursue an expansionary monetary policy by lowering bank reserve requirements, lowering the short-term bank rate (in the U.S., the discount rate, i.e., the interest rate charged by the central bank to commercial banks when they borrow from it), or buying bonds or other financial instruments from banks or parties in the private sector. The resulting monetary expansion, if it is not otherwise offset, results in falling interest rates to stimulate interest-sensitive expenditures and increased liquidity to stimulate liquidity-sensitive consumption purchases.

Monetary policy might offset a predicted aggregate demand increase by implementing a restrictive monetary policy, i.e., by raising bank reserve requirements, increasing the discount rate, or selling financial instruments. The ensuing monetary contraction, if it is not otherwise neutralized, will result in rising interest rates and diminishing liquidity to elicit the desired offset to the increase of aggregate demand.

Aggregate Supply Changes.  Changes of aggregate supply in a market economy are even more difficult for government to offset by manipulating its own budget since it has no direct control over production capacity or cost conditions (it would have such control in a regime of socialism). It may be able to exert some influence over the long run by taking actions to make markets work more efficiently, to remove market imperfections which impede the mobility or availability of resources, to diminish reporting or compliance costs, or to remove disincentives to work or assume risks. These are all actions typically advocated in a Supply-Side approach.

It may be possible to implement a fiscal policy stimulus that will counter an adverse aggregate supply shift. Suppose that a supply shock causes the aggregate supply to decrease. The ensuing consequence is a fall of real output below the normal operating capacity accompanied by rising unemployment and cost-push inflation. If the government can be patient, it is possible that the aggregate supply curve will recover to its earlier position after the shock has abated so that output can return to the normal operating capacity and the rate of inflation diminish. However, if this does not happen, or if it takes too long to happen, the government may implement a fiscal stimulus (i.e., increasing purchases or cutting taxes) to increase aggregate demand. While this may hasten the return of real output to the normal operating capacity of the economy and relieve unemployment, it will likely also result in some more inflation, this time demand-pull.

 

Problems in the Implementation of Stabilization Policy

Unfortunately, the world does not work like this in many respects. For one, changes of government purchases or tax collections have impacts on the government's budget. If an expansionary fiscal policy causes the budget to go into deficit (i.e., expenditures in excess of revenue), the deficit must be financed. This can be done in only two fundamental ways, either by creating money or by borrowing from private sector capital markets. The former will likely cause inflationary pressures, while the latter will result in rising interest rates that may crowd-out some private sector investment, thereby offsetting the fiscal stimulus so that there is only a partial recovery. Also, there may be further changes of aggregate demand or supply to disrupt the best-laid plans to neutralize adverse demand changes.

Even if it were possible to accurately predict the magnitude of an autonomous aggregate demand or supply change, with our present knowledge and limited ability to control fiscal variables, it is highly unlikely that the right fiscal change can be implemented with any degree of precision. Thus, the fiscal measure taken would likely be either inadequate or excessive relative to the amount of autonomous change to be offset. If the government "over does it" by precipitating an excessive aggregate demand increase and there is no significant crowding-out effect, the economy may attempt to produce above its normal operating capacity with even more demand pull inflation.

It is even more difficult to use monetary policy as a means of attempting to offset private-sector changes of aggregate demand because the linkages between money-supply changes and spending are only indirect and imprecise. The monetary policy transmission mechanism works either through changing interest rates that affect interest-sensitive purchases, or through the so-called “real-balance effect” of a change in liquidity which induces consumer spending changes. At this stage of our understanding, it is not possible with any degree of precision to effect the right change of any monetary aggregate to elicit just the appropriate offsetting change of aggregate demand.

Even more troubling than these minor difficulties is the fact that it is never possible to perfectly predict changes of aggregate demand or supply, and it may not be possible to predict such changes at all. More often than not, the first evidence of a change of aggregate demand or supply becomes evident some number of months or quarters after the fact. This puts the government in the position of reacting to such changes rather than concurrently offsetting them.

 

Lags in the Adjustment Process

Economists refer to the time between when a macroeconomic change occurs and when it is recognized by government officials as the “recognition lag,” and the time between recognition of such a change and the taking of some action to offset it as the “response lag.” Needless to say, the lags are both variable in duration and themselves unpredictable. The response lag for monetary policy may be a matter of days or weeks, while that for fiscal policy may be months or quarters. In democratic societies, fiscal policy actions must be proposed, debated, and legislated, processes that often are very time consuming.

There is yet another lag which may eclipse the first two in duration. It is the so-called “reaction lag,” the period between when an action is taken and the effects of the action fully work through the economy. The reaction lag usually involves a multiplier process of consecutive rounds of respending. Experience in the U.S. economy suggests that the multiplier effect of a fiscal policy action may be completed in as little as a year, but may not be fully worked out in more than two years. The duration of the reaction lag is therefore even less predictable than are the recognition and response lags. The three lags together may span a period of as little as a year, or as much as three or more years. These lags taken together put the government in the position of having to implement a compensating policy even before some event shocks the economy.

This brings us to the most serious problem of implementing any government policy in the interest of stabilizing the economy. It is that the natural adjustment mechanisms of the economy will likely have reversed the direction of change of the economy by the time that the policy designed to deal with the original problem finally has its effect. For example, in a contracting economy, expansionary fiscal and monetary policies are called for. But by the time the contraction can be confirmed, expansionary policy implemented, and the multiplier process completed, the economy of its own volition will likely have begun its recovery. So the expansionary monetary policy impacts an already-expanding economy. A similar, but reversed, scenario can be depicted for an economy entering a period of expansion. Because of variable and unpredictable time lags in the implementation of macropolicy, government's well-intentioned efforts to stabilize the economy often end up destabilizing it--"booming the boom," or "depressing the depression."

 

A Supply-Shock Scenario

Suppose that the economy has enjoyed a modicum of stability for some number of quarters until at quarter t an unexpected supply shock occurs (for example, a foreign power embargoes an essential resource, a major proportion of which has come from the foreign source).

This precipitates a contraction for the next three quarters, but the contraction is suspected at quarter t+1 and verified at quarter t+2 when the ministry of finance submits to parliament a bill which would increase government spending to counter the rising unemployment. Parliament debates the issue until finally enacting the bill at quarter t+4. However, the natural adjustment mechanisms inherent in the economy effect a reversal at quarter t+5, after which output begins to expand and unemployment fall.

The fiscal stimulus begins to be felt by quarter t+7 as the multiplier process ensues from the injection of new spending in the economy. So, from quarters t+7 through t+10 the already-expanding economy is further buoyed by the fiscal stimulus. But by this time the ministry of finance has realized that the economy is now in expansion and inflation is threatening, so it proposes an upward adjustment of tax rates to siphon some purchasing power out of the over-expanding economy. It of course takes two more quarters of debate before the increased tax rates are enacted, and three more quarters before the negative multiplier effect begins to work, by which time the economy is already in contraction.

It is just such unhappy scenarios as that which lead many economists to become policy skeptics. Theoretically we should be able to design and implement macropolicies to stabilize an economy, but practically we do not (yet) have the knowledge or technical expertise to effectively implement such stabilizing policies.

Those who suffer from policy skepticism are not necessarily economic-stability nihilists. Many economists maintain confidence that the inherent automatic adjustment mechanisms of the market economy are sufficient to achieve stabilization naturally, if only the social and political processes can allow sufficient patience. A shocked economy will eventually "right itself," much in the same way that a listing ship will return to an "even keel" if it has adequate ballast. The ballast of the market economy consists in the automatic adjustment mechanisms in the microeconomic decision units that compose the markets of the economy. The political problem is that reliance upon the natural stabilization properties of the market economy requires that elected or appointed officials to "don't just do something, stand there" and wait patiently while the economy takes care of itself. And this is something which neither government officials seem able to do, nor their electorates tolerate.

 

Other Government Priorities

Finally, we must note the distinct possibility that domestic macroeconomic stabilization may not be the highest priority of the government, or at least not until the economy becomes seriously destabilized by excessive inflation or unemployment or both. Under more normal circumstances, particularly in democratic societies, the government's agenda may require it to become oriented mainly to program needs rather than economic stability. Program needs may include social, military, or infrastructure projects. A democratic government may enact such programs almost irrespective of their financing requirements.

The dominant fiscal motivation of the democratically elected government may be conducting and financing the programs to which it has become committed, irrespective of the fiscal requirements of economic stability. The principal evidence of this phenomenon is that the government's budget tends to be in chronic deficit when the economy is both contracting and expanding. When the needs of fiscal finance dominate public policy, the government loses its capacity to manipulate its budget in the pursuit of economic stability. The U.S. government finds itself precisely in this position at mid-2011.

In a flexible exchange rate world, domestic economic performance may come in at a lower priority level than attempting to stabilize the value of the nation's currency vis-a-vis one or more other currencies. Exchange rate stabilization may be accomplished with an exercise of the police power of the state to punish parties buying or selling the nation's currency at any rate other than announced "official rates." This approach, no longer in vogue in the western world, may still be used in a few "third-world" countries. In modern Western market economies, exchange rate stabilization is usually attempted by a fiscal or monetary authority intervening in the foreign exchange market to purchase the domestic currency with foreign exchange reserves in order to prevent further depreciation (or to cause it to appreciate), or to sell the domestic currency for foreign currencies in order to cause the domestic currency to depreciate (or to prevent it from appreciating). Inevitably there are side-effects of such currency purchases and sales that affect the domestic macroeconomy, often adversely. The general conclusion is that when a government is attempting to stabilize the external value of its currency, it is unable to employ macropolicy to address domestic stability concerns.

 

The Role of Expectations

The stability of the macroeconomy depends critically upon the expectations of decision makers concerning future macroeconomic conditions. The economy can remain stable only as long as decision makers' expectations match actual conditions fairly closely, i.e., when there are no surprises. One of the important messages of aggregate demand-supply analysis is that real output can rise above the normal operating capacity of the economy only when the actual rate of price inflation exceeds the price expectations of decision makers, i.e., when decision makers are surprised by the price inflation.

An illustration of a divergence between an actual rate of inflation and expectations of it may be occasioned by an increase of aggregate supply curve that would increase output beyond the normal operating capacity of the economy. Real output may fall below the normal operating capacity of the economy only when the actual rate of inflation is below decision makers' price expectations, i.e., when they are surprised by less inflation than expected. This occurs when there is a decrease of aggregate supply that takes the output of the economy below the normal operating capacity. A more general conclusion is that any ensuing period of expansion or contraction must be attributable to something unexpected which results in wrong guesses by decision makers about future conditions.

In order to make rational microeconomic decisions, the manager of a microeconomic decision unit (a business firm or a household) must be able to predict not only what is likely to happen in the macroeconomy, but also what government officials are likely to try to do about any macroeconomic problem that emerges. The first predictive problem is difficult enough; the second adds a further dimension of uncertainty. The second dimension might not be so serious except that the actions of neither monetary nor fiscal authorities turn out to be very predictable. And there are good reasons for their lack of predictability, i.e., their propensity to implement policy surprises.

Two economic theories shed light on the lack of predictability of public policy makers. The so-called “adaptive expectations hypothesis” is that intelligent decision makers learn from historical experience which they extrapolate into expectations of future states. For example, suppose that the monetary authority decides to try to increase the real output of its economy above the normal operating capacity by increasing the money supply, but it implements the expansionary monetary policy as a surprise, i.e., without making any public announcement. This action stimulates liquidity-sensitive purchases and increases aggregate demand. The demand stimulus does indeed induce an increase of output above the normal operating capacity, but it also sets in motion a process of demand-pull inflation. In a short time, consumers realize that prices are higher today than they were yesterday, and they were higher yesterday than the day before. It therefore appears reasonable to expect prices to be higher tomorrow than today, and even higher the day after tomorrow. Thus, it would be wise to go ahead and make anticipated purchases today rather than wait for the higher future prices, even if the items are not needed until a future date. The current purchases add to today's demand for those items and virtually insure rising prices tomorrow. But as noted earlier, when decision makers are surprised by the realization that prices are higher than they had counted on when they made their employment and output decisions, they will tend to adjust their employment and output plans to lower levels so that the aggregate supply decreases. This results in further inflation, but of the cost-push variety, until the economy adjusts to its normal operating capacity.

According to the so-called “rational expectations hypothesis,” decision makers reason and analyze as well as extrapolate. This view accords the decision maker the presence of mind to take into account what government policy makers might do in regard to any emerging situation, and thus to modify their behavior in response both to the situation and what the policy makers might do in response to it. Suppose that, instead of surprising the economy with a demand stimulus, the government makes public announcement that it is implementing an expansionary monetary policy with the intention of increasing the output of the economy above its normal operating capacity. Rational decision makers will deduce that an inflationary process will ensue, but they will be skeptical that the policy can sustain output above the normal operating capacity for long. Thus, when they make their employment and output decisions for the future months, they adjust their list prices and issue wage increases in anticipation of the ensuing inflation without ever increasing real output.[1]

A comparison of the two scenarios reveals that the real output of the economy does not change, even temporarily, when the government policy is publicly announced or correctly predicted. It is only when the public policy surprises the economy or is not predictable that real output changes, however temporarily. If this theory is correct in its premise that rational decision makers analyze as well as extrapolate, then it is only by surprising the economy, or behaving unpredictably, that a government authority can have any real effect on the economy. And it is for this reason that governments tend to take unexpected policy actions and thereby interject an additional degree of instability into their economies.

 

Rules and Discretionary Policy

The exercise of discretionary policy is fraught with the potential for inflation, especially in response to supply shocks. For example, suppose that some natural disaster such as a massive hurricane has caused aggregate supply to decrease, setting in motion a process of contraction accompanied by cost-push inflation and rising unemployment. In order to alleviate the ensuing unemployment, government authorities will be tempted to compensate for the supply shock with an expansionary fiscal or monetary policy that will stimulate aggregate demand by enough to offset the decrease of aggregate supply. While such a policy action may stem the tide of rising unemployment, an unintended and undesired side effect will be some demand pull-inflation.

An alternative policy response by the government, and one that will avert further inflation, is to ignore the unemployment effects of the supply shock and simply wait for the economy to naturally recover and return the aggregate supply curve to its earlier level. But we can expect that most government officials would find this strategy repugnant because it requires them to "Don't just do something, stand there!" Such a response makes them appear to be either incapable or unwilling to respond to an ensuing crisis.

An even tougher policy alternative would be to greet the supply shock with a contractionary fiscal or monetary policy to cause aggregate demand to decrease. This would tend to reverse the cost-push inflation of the supply shock, but at the cost of even more unemployment. However, the recovery of the economy from the supply shock would tend to return aggregate supply to its original position with no inflationary ill effects at all. Needless to say, such a policy would likely appear to be too harsh to be politically tolerable, especially in a democracy.

Considerations such as these lead many economists to oppose the exercise of discretion by government officials, and to favor the institution of rules to govern fiscal and monetary matters. We have already described in Chapter 16 the so-called automatic fiscal stabilizers such as progressive taxation and unemployment compensation. These devices function in market economies to ameliorate swings in the levels of economic activity. Economists who prefer such devices over the exercise of discretionary policy may also advocate a monetary rule (or constitution). A monetary rule in the form of a formula would govern changes of monetary aggregates, and thereby remove the ability of discretionary policy makers to surprise the economy with unpredictable policy actions. While automatic fiscal stabilizers have become standard features of modern economies, government officials otherwise have been extremely reluctant to surrender their powers to exercise discretionary fiscal and monetary policies, and it appears that they will continue to be sources of instability into the foreseeable future.

 

Managerial Implications of Stabilization Policy

Where does this leave the manager of the business firm or other microeconomic decision unit? Unfortunately, we have little help to offer the manager in predicting either supply shocks or government policy surprises, or in dealing with the vagaries of the lags resulting from the implementation of discretionary fiscal and monetary policies. Ultimately, the manager must gain wisdom and insight from experience with such phenomena, and then transfer the experience to new circumstances as they emerge. It is those managers who are both successful and a bit lucky that may achieve survival for their organizations. Managerial decision making is facilitated when a government behaves predictably and rationally, and is willing to let the economy "mind itself." But we can be fairly confident that government officials, whether in democratic or authoritarian societies, will have agenda to pursue, and that the fiscal requirements of such agenda will likely usurp any capacity of the government to stabilize its economy.

The Great Recession.  The so-called Great Recession began late in 2007 and worsened significantly by the end of the third quarter of 2008.  It nominally ended around the middle of 2009, but output had not risen to the pre-recession level by late 2011, nor had unemployment fallen below 9 percent of the labor force.  The causes of the Great Recession will continue to be debated for a long time.  Our concern here is why government policy seems not to have had intended effects to alleviate the recessionary conditions, or at least not fast enough.  By third quarter of 2011, there was even talk of a “double-dip” or a second recession even before recovery from the first recession of the new millennium was complete.

 

If economists’ understandings of macroeconomic relations are sufficient, it should be possible for government to design macropolicies to alleviate the recessionary conditions and promote a return to the normal operating capacity of the economy.  Both monetary and fiscal measures have been directed at the recessed conditions of the economy.  The fiscal measures have included both tax cuts and increased government spending, neither of which have succeeded in restoring full employment.  This may be because business sector decision makers have continued to suffer uncertainty about the recovery of demand conditions and the actions that government may or may not take to address the persisting high-level of unemployment. 

      

Monetary stimulus has entailed both cutting interest rates and open market purchases of bonds (“quantitative easing”).  The Federal Reserve’s discount rate was set only slightly above zero, and apparently will be held there until 2013.  Monetary theory would suggest that serious price inflation should follow.  However, some of the money supply expansion appears to have been trapped in accumulating cash hordes of business firms whose managers are reluctant to increase investing and hiring until aggregate demand first increases.  Some of the monetary expansion appears trapped in the excess reserves of banks whose managers are reluctant to issue more mortgages and increase business lending, particularly to smaller businesses.  The goods and services inflation rate has remained low (less than 2 percent per annum) through 2009 and 2010, but is approaching 3 percent by the end of 2011.  However, price increases have begun to appear in other sectors.  Much of the expanded money supply has gone to commodities markets and precipitated commodities (gold, other metals, some agricultural products) price bubbles as financial market uncertainty has induced investors to seek the safety of real assets rather than financial instruments.  Little of the monetary expansion has reached the housing market to finance either new mortgages or refinanced mortgages. Housing market prices have remained depressed, and only late in 2011 have begun to rise a bit.

 

What's Ahead

In Chapter 21 we consider the macroeconomic implications of governmental surpluses and deficits.  

 

Chapter 20 Endnotes

[1] The 2011 Nobel Prize in Economics was awarded to economists Thomas Sargent and Christopher Sims for their work during the 1970s and ‘80s in analyzing and modeling rational responses of society to macroeconomic changes, particularly interest rates.

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CHAPTER 21.  DEFICITS AND SURPLUSES

Twin Deficits

During the 1980s and '90s it was fashionable in the media and in economics texts as well to describe the U.S. trade deficit and the U.S. federal government's budget deficit as the "Twin Deficits" and to hypothesize the latter to be the cause of the former. At the turn of the millennium, the U.S. government's budget deficits shrank to the point that budget surpluses appeared possible, with forecasts of cumulative surpluses over the next couple of decades sufficient to retire the entire federal public debt of more than $4 trillion. However, early twenty-first century decreases in tax revenues and increases of government spending caused the prospect of budget surpluses to evaporate and deficits to become chronic and growing. By 2011, the government’s annual deficit had exceeded $4 trillion, and the cumulative public debt was almost $15 trillion, nearly as large as the U.S. GDP.

Since the trade and the budget deficits were reputed to be twins, one might suppose that as the government's budget turned toward surplus around the turn of the century the trade deficit might also have declined or become a surplus, but this supposition would be wrong.  Each month in the new millennium seemed to bring a new trade deficit record and the government's budget relapsed into deficit as well, thus seeming to reconfirm the twin relationship between the budget deficit and the trade deficit.  With vague allusions about causation, the media hardly knew how to handle the reporting of these matters.  And apparently economists were not giving the media reporters much help in explaining the persistent and growing trade deficit. There's still something missing from the deficits equation that needs to be brought into the discussion.

 

Leakage-Injection Relationships

Perhaps the most straight-forward approach to explaining these matters lies with Keynesian leakage-injections concepts.  

Budget Deficit.  The government’s budget situation can be specified as the total of the government’s purchases (an injection into the income stream) less the total of its tax revenues (a leakage from the income stream).  The typical state of the U.S. government budget in the early twenty-first century has been deficit, i.e., its purchases exceed its revenues.

Trade Deficit.  The trade balance is computed as exports less imports.  It is positive assuming that exports exceed imports.  But the typical situation for the U.S. economy in the early twenty-first century has been trade deficit, i.e., its imports exceed its exports. 

Saving Deficit.  Typical for the U.S. economy in the early twenty-first century is for business investment to exceed the sum of household and business saving.  Alternately, this investment surplus can be regarded as a saving deficit.  In a sense, the larger the investment surplus the better because investment is the vehicle for implementing new technologies, adding to the capital stock, and generally enhancing the productivity of the labor force.  But the investment surplus also has a negative implication when domestic saving is inadequate to finance all of the investment that is being undertaken.  Additional investment financing sources are needed.

Thus there are actually three deficits that need to be accounted for: the government budget deficit, the trade deficit, and the saving deficit.

We will not recount it here, but by rearrangement of the Keynesian leakage-injection identities it can be shown that the government’s budget deficit plus the trade deficit must be equal to the economy’s saving deficit. 

 

Deficit Triplets

One interpretation is that a combination of the saving deficit and the government’s budget deficit must equal (or be financed by) a trade deficit.  Alternately, a trade deficit enables either or both of a saving deficit and a budget deficit. 

Another interpretation of the leakage-injections relationships is that an excess of investment over saving, i.e., a saving deficit, must be satisfied by some combination of a government budget surplus (i.e., government saving) and a trade deficit.

Yet another interpretation is that a government budget deficit must be financed by some combination of a saving surplus and a trade deficit.

As long as the saving deficit is trivial in magnitude, then it follows that the trade deficit must be approximately equal to the budget deficit, hence the idea of “twin deficits.”  While it is not clear that either is dominant and the other accommodative, a seemingly safe presumption is that the U.S. government's post-World War II budget deficits resulted from the political process, and that the trade deficits emerged to finance the budget deficits.  In any case, since the saving deficits were trivial during the 1980s and ‘90s, the government budget deficits and the import deficits appeared to be twins, with a change in the budget deficit eliciting a same-direction (though not necessarily simultaneous) change in the trade deficit.

During the late 1990s, the U.S. government's budgetary deficits shrank with on-going economic growth (often described in the media as a "torrid pace" which exceeded 7 percent per annum during some quarters toward the end of the decade).  By 1999, the U.S. government's budget approached the realm of surplus. 

As the twentieth century wore on to its conclusion, the saving deficits ceased to be trivial.  During the last couple of decades of the twentieth century, U.S. gross private domestic investment grew faster than domestic saving as officially measured. Early in the twenty-first century, the measured U.S. saving rate approached an historic low (negative during some quarters) even as investment boomed. With the onslaught of the Great Recession beginning in 2008, the growing saving deficits have been accompanied by federal government budget deficits of increasing magnitudes.  The two together require a commensurate trade deficit to finance them. Around the turn of the third millennium the deficits became triplets.

 

Interest Rate Policy

The dominating factor of the late 1990s in the U.S. appeared to be a communications and computing revolution of force similar to that of the Industrial Revolution in late nineteenth-century England.  The salient economic feature of this “New Industrial Revolution” was an ever-growing U.S. saving deficit that had to be financed by a combination of a growing trade deficit or an increasing government budget surplus.  The late '90s declining budget deficits were produced by an increase of tax revenues as both the personal and corporate income tax bases increased with the "torrid pace" of U.S. economic growth.  Supply-side restructuring of the U.S. economy during the 1980s also may have been an enabling condition to the unfolding of the "New Industrial Revolution" of the 1990s.

Declining budget deficits during the late 1990s decreased the government's demand for loanable funds in the U.S.  The potential for budget surpluses (net government saving) at the turn of the century began to decrease the demand for loanable funds as the government required smaller amounts from the capital markets.  The decreasing deficits of the late 1990s might have been expected to decrease U.S. interest rates.  However, soon after the turn of the new century the U.S. central bank (the Federal Reserve) resolved to increase nominal interest rates in an effort to slow the pace of growth of the U.S. economy to a "sustainable level" and avert inflationary pressures.

A by-product of the Federal Reserve's actions to increase nominal U.S. interest rates is that they became higher than comparable rates in Europe and the Pacific Basin, and this relationship induced a flow of funds into the U.S. in search of higher returns.  The inflow of funds increased the demand for dollars and the supplies of other currencies on the foreign exchange markets, thereby causing the dollar to appreciate relative to other currencies.  In addition, the administration continued to indulge in rhetoric favoring a "strong dollar policy." By 2005 there was growing concern in some quarters that the dollar had become overvalued. The dollar appreciation made American goods appear more expensive to foreigners, with a consequence of declining U.S. exports.  At the same time, the stronger dollar made foreign goods look cheaper to Americans, thereby causing U.S. imports to increase.  The combination of the tighter monetary policy and the dollar appreciation resulted in growing trade deficits that served to finance both the growing saving deficits and the increasing government budget deficits.

And then the U.S. economy suffered the so-called Great Recession that began in 2008.  Macropolicy stimulus programs swelled the government’s budget deficits and accordingly increased the public debt to historic levels. As the recession ensued, business investment collapsed, reducing the saving deficit.  The U.S. economy’s trade deficits began to ameliorate as the U.S. income level fell, but continued to help finance the government’s growing budget deficits.

 

The Trade Deficit

It may be obvious how a government budget surplus can help to finance a saving deficit, particularly when the surplus is used to retire public debt, but how can a trade deficit help to finance a saving deficit?  In order to explain this, it would be a convenience to interpret the trade balance as the Current Account in the nation's Balance of Payments.  The nation's Balance of Payments is comprised of three sections, the Current Account, the Capital Account, and the Official Settlements Account.  The Current Account is comprised of three subsections:  the Trade Balance, Net Unilateral Transfers (i.e., the net of gifts by citizens of the nation to foreigners less foreign gifts to citizens of the nation), and Net Income Earned Abroad (i.e., the net of income earned abroad by citizens of the nation less income earned in the nation by foreigners).  Since net transfers and net income earned abroad are of relatively minor magnitudes and tend to offset each other in the U.S. economy, the trade balance accounts for the bulk of the U.S. Current Account.  We shall thus ignore net transfers and net income earned abroad so as to treat the Current Account balance solely as the trade balance.

In a fixed exchange rate system such as the pre-Depression Gold Standard or the post-World War II Bretton Woods System, flows of gold or international reserves were necessary to keep the exchange rates of the subscriber nations' currencies unchanged vis-à-vis gold or other currencies.  A byproduct of the process of fixing exchange rates was that the Current Account and the Capital Account balances for a nation could differ in amount totals, with the difference being made up in the Official Settlements Account.  Since the early 1970s, the world has been on a nominal flexible exchange rate system, though one in which governments of nations occasionally attempt to manipulate exchange rates.

If exchange rates were completely free to vary in response to market forces, the Official Settlements Account total for each nation would be zero because exchange rates would change to bring about an equivalence of the Current Account total with the Capital Account total, or vice versa.  If a nation imports more from the rest of the world than it exports to the rest of the world, the nation must export the ownership of enough capital to "pay for" the trade deficit.  In fact, the U.S. has experienced trade deficits through most of the years beyond the early seventies when flexible exchange rates became a reality.  The Current Account deficits necessarily have been offset by Capital Account surpluses.

A Capital Account surplus may be comprised of a combination of long term capital exports (e.g., foreign purchases of stocks, bonds, and real assets in the U.S.) and exports of short term instruments (e.g., increased foreign ownership of U.S. bank account balances and other liquid financial obligations).  The Capital Account balance must be the negative of the Current Account balance when exchange rates are flexible.  It is in this sense that a Current Account deficit (most of which is composed of the trade deficit) can help to finance a saving deficit.  The corresponding Capital Account surplus involves a net export of the ownership of capital, which is the same as to say an inflow of funds from abroad.  A trade deficit (a Capital Account surplus) is thus a natural concomitant of a saving deficit, and is necessary to help (along with a government budget surplus) with the financing of the saving deficit.

A saving deficit can be financed by a combination of budget surplus and trade deficit.  But if the budget is also in deficit, there is an even greater burden on the trade deficit to finance both the saving deficit and the budget deficit.  How is this "financing" of the saving and budget deficits brought about by a trade deficit? Market economies contain within themselves adjustment forces that are invoked when prices or incomes are too high or too low for equilibrium.  These forces of adjustment are the unmet intentions of market participants.  Prices are the primary adjusters of the market economy, but if prices change too slowly or are fixed or manipulated by government authority, income (and correspondingly output and employment) will become the shock absorbers of the market economy.

 

Interest Rates and Exchange Rates

Two prices that play crucial roles in the macroadjustment of the market economy are interest rates and exchange rates.  Interest rates vary in response to changes in the demand for and supply of loanable funds, and the interest rate changes elicit equilibrating changes in saving, investment, output, and employment.  However, if interest rates are fixed or manipulated by government authority, excess demand or supply in the loanable funds market will persist.  The natural and inherent forces within the economy will be prevented from bringing the trade balance into equivalence with the sum of the saving and government budget balances.

Much the same can be said for exchange rates because they are no less than the prices of the nation's currency expressed as quantities of other currencies for which it can be exchanged.  Exchange rates vary in response to changes in the demand for and supply of the nation's currency on foreign exchange markets.  Currency demand and supply changes are invoked by changes in income levels, price levels, and interest rates among nations.  Exchange rate changes are the crucial vehicles of adjustment of the trade balance to the saving balance and the government's budget balance.  Changes in either the saving balance or the budget balance will initiate changing demand or supply for the nation's currency, and thereby elicit exchange rate changes that ensure equilibrating (and offsetting) changes in the Current Account and the Capital Account of the nation's balance of payments.  If exchange rates are fixed or adversely manipulated by government authority, excess demand for or supply of the nation's currency will persist, and the Current and Capital Accounts will not be brought into balance with each other or with the saving and budget balances.

 

The Early Twenty-First Century

We can offer several comments on the prospects for stability of the U.S. economy during the early years of the twenty-first century. 

1.  At the turn of the third millennium, the U.S. government budget surpluses did not become large enough to provide significant financing of the growing U.S. saving deficit.  The burden of financing the increasing saving deficit thus still falls principally upon the trade deficit and is aggravated by the persistent and increasing government budget deficits.[1]  Early twenty-first century tax cuts and expenditure increases appear to have eliminated the possibility of budget surpluses and the retirement of public debt.  Even though the tax cuts may have given the population some more disposable income, it appears that the saving rate has not increased relative to the investment rate so as to diminish the saving deficit. Indeed, the national saving rate has continued to fall as the economy has weathered the Great Recession that ensued in late 2008. The political issue became whether to let the 2002 tax cuts lapse, which would amount to a tax increase as the economy continues to suffer recessionary conditions.

2.  The "New Industrial Revolution" boom came to an end by the turn of the third millennium, but the U.S. growth rate was sustained moderately well until the start of the Great Recession in 2008.  After an actual decline of GDP during 2009, weak growth resumed in spite of massive monetary policy injections of liquidity into the U.S. economy. Persistent unemployment and stagnant or falling incomes have resulted in declining trade deficits as imports have decreased.

3.  A rising tide of protectionism in the U. S. has elicited demands for new or higher tariffs, new or more stringent import quotas, and other non-tariff barriers that might force a decline of the trade deficit.  The regrettable side effect of this protectionism would be to force a diminishment of the saving deficit (due to a decrease of investment spending) that propelled the "New Industrial Revolution" boom unless the government's budget can be brought into surplus (which seems highly unlikely).

4.  The U.S. government acting solo or in concert with a group of other nations (e.g., the G8 or some other number of cooperating nations) may resolve to prevent further appreciation or precipitate depreciation of the U.S. dollar relative to other currencies.  The dollar has experienced moderate depreciation during the Great Recession, and the dollar depreciation has stimulated U.S. exports and constrained U.S. imports to cause the trade deficits to decrease. The U.S. government has urged appreciation of other currencies (particularly, the Chinese yuan) in the interest of promoting U.S. exports and constraining its imports.  With rising government budget deficits, future growth of the U.S. economy continues at risk unless the U.S. saving rate can somehow be increased to finance continuing domestic investment.

5.  If the Federal Reserve is given responsibility for forcing further depreciation of the dollar, it can do so only by sacrificing domestic monetary policy to the achievement of the exchange rate goal.  The foreign currencies can be purchased only with monetary expansion that inevitably will elicit global inflation as a byproduct of the forced dollar depreciation.  With recent monetary expansion, U.S. interest rates have fallen to historic lows, inducing an outflow of funds in search of higher yields abroad.  For better or worse, the dollar has edged ever closer to becoming a global common currency even as the dollar depreciates.

If the saving rate cannot be increased so as to diminish the saving deficit, the trade deficit might be diminished by sustained and accelerating growth (another "New Industrial Revolution"?) that yields governmental budget surpluses that can help to finance the saving deficit. However, by late 2008, the U.S. economy had entered the Great Recession and budget deficits increased. By 2011 the cumulative public debt eclipsed $14 trillion, but trade deficits were diminishing.

With persisting U.S. government budget deficits and governmental manipulation of interest rates and exchange rates, the economy's automatic adjustment mechanisms may not be able to bring about either a falling U.S. saving deficit or a declining U.S. trade deficit. If not, the triple deficits will persist into the foreseeable future and are likely to aggravate imbalances.

Chapter 21 Endnotes:

[1] If the budget surpluses had continued to mount and the U.S. public debt had diminished, the trade deficits might have declined as the burden of financing the saving deficit shifted toward the budget surplus.  A budget surplus thus could have played a positive role in substituting public saving (forced by taxation) for inadequate private saving, and if the public saving were returned to the loanable funds market in the form of public debt retirement.

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CHAPTER 22.  PUBLIC DEBT

Democracy is perhaps the form of political organization most congenial to capitalism and to the process of economic growth.  Capitalism may be construed to be a form of democracy in the sense that market mechanisms, the decision making and motivating vehicles of capitalism, have the effect of democratizing consumer decision making.  Market economy enables those with income or wealth to vote their dollars (or whatever is the currency du jour) on what they most want to purchase. 

Market economy does not provide economic universal suffrage because the unemployed and the propertyless have few dollars to vote in the market.  Nor does it promote equality in the political sense of “one man, one vote” because those with greater wealth and higher incomes have more dollars to vote, while the poor and the indigent have fewer dollar votes. 

 

Public Debt Increase

Political democracy can attempt to make up for these economic democratic deficits through the legislative process.  Parliaments, congresses, and legislatures enact legislation to level incomes and wealth via progressive income taxation and property taxes, and by establishing “safety nets” that have the effect of providing dollar-voting ability to those with no property and low or no incomes.  

Americans in particular are a humane people.  They do not want to see their citizens suffer hunger, inadequate housing, the income-decreasing effects of unemployment, lack of medical care when needed, the hazards of calamities like fires and automobile accidents, or the destructiveness of natural disasters like earthquakes, tsunamis, tornados, or hurricanes.  The democratically enacted solutions to these threats have included socialized medical insurance, old-age pension benefits, unemployment compensation insurance, subsidized hazard insurance, and welfare benefit floors for the indigent. By the early years of the twenty-first century, a culture of entitlement to these benefits had emerged. 

The problem with political democratic relief of the democratic deficit of market economy has manifested itself in the form of increasing government budget deficits that cumulate as ever-increasing public debt.

It should be no surprise that the public debt of a society that prefers democratic polity has become a serious political issue.   The prospect was noted nearly two centuries ago by a Frenchman visiting in America.  In 1835, after traveling for two years in the United States, Alexis de Tocqueville wrote De la Démocratie en Amerique  (Democracy in America).[1]  In his Chapter on “Government of the Democracy of the United States,” Tocqueville noted that when universal suffrage provided legislative empowerment to the poor and propertyless, society would soon discover that it could vote itself benefits quite apart from any ability of government to finance the provision of them.  If some benefits are good, then more (and ever more) benefits must be better.  Voila!  The basis for out-of-control public debt in American democratic polity was noted as early as 1835 by a French visitor to the United States.  The wonder is that it took nearly two more centuries for the problem to materialize. 

Over and above social spending programs implemented by the U.S. government during the twentieth century and the early years of the twenty-first century, military spending in Iraq and Afghanistan and stimulus programs implemented by the government in addressing the Great Recession beginning in 2008 have added substantially to the U.S. public debt.  Deficits in the amounts of $1 trillion in the 2007-2008 fiscal year, $1.9 trillion in 2008-2009, and $1.7 trillion in 2009-2010 have caused the U.S. federal debt to exceed $14.7 trillion by September, 2011.[2]  This is nearly as large as the U.S. GDP, estimated to be nearly $15 trillion at mid-2011.[3]  The U.S. public-debt-to-GDP ratio is only slightly less than 100 percent.

Policy to Deal with Mounting Public Debt

Basically, there are only two ways to finance government deficits:  the creation of money (issued by the central bank or printed by the treasury department of government) or the issuance of debt (government bonds) by the treasury department of government.  There is no special or reserved place for government to place its bonds; they have to be sold in the same financial markets in which private sector companies are hoping to raise investment funds by selling the bonds that they issue. 

Money issuance to finance government spending virtually ensures elevating rates of inflation that reduce the purchasing power of incomes.  A few lesser-developed countries still use the printing presses to meet their spending needs, and nearly universally pay the inflation price for their profligacy. 

The issuance of additional government bonds relative to the existing demand for bonds virtually ensures that bond prices fall, causing their yield rates to rise.  The rising yield rates can be expected to raise interest rates in all financial markets by the process of arbitrage.  The rising interest rates are likely to crowd-out private sector borrowers from the financial markets.  As their interest costs rise, businesses can be expected to cut back, delay, or cancel investment plans. Increasing unemployment is an inevitable follow-on consequence. 

Compounding the bond issuance problem is the fact that the increasing public debt may become “monetized” as the central bank engages in open market bond purchases in the effort to avert rising interest rates.  A central bank purchase of bonds adds to the reserves of commercial banks and increases their capacity to create money as a by-product of lending.  The monetization of debt increases the money supply no less so than does the direct creation of money to finance government spending.  The likely consequence in either case is accelerating inflation that reduces the purchasing power of wage earners. 

The mounting U.S. public debt became one of the prime political issues of the 2012 presidential election campaign season.  Proposals for addressing the mounting public debt of the U.S. have included raising taxes (advocated by the political left and opposed by the political right) and cutting expenditures (insisted upon by the political right).  The problem came to a head in July of 2011 as a debt ceiling limit was approached.  The unwillingness of the political parties in Congress to reach compromise threatened to shut-down the operations of the U.S. federal government.  A temporary arrangement reached in Congress enabled the continued operation of the government. A “supercommittee” consisting of members of both houses of the U.S. Congress was appointed to come up with proposals to reduce the public debt by as much as $4 trillion over a ten-year period.  If the supercommittee fails to come up with adequate deficit- and debt-reduction  proposals, automatic across-the-board cuts would be implemented after the first of 2012.

Managerial Implications of Increasing Public Debt

The mounting U.S. public debt descends upon its market economy by imposing constraints on consumer sovereignty and enterprise freedom. Efforts to slow the cumulative increase of U.S. public debt must entail decreasing benefit entitlements or increasing taxes on income earners and business enterprises. Increased taxes on businesses can be expected to curb entrepreneurial risk taking and give incentive to move productive activity offshore.  Curbing benefits inevitably will dampen market demand by those who have been receiving benefits.  A follow-on effect in the short run likely will be to inhibit the recession recovery process, and in the long run to curb economic growth by slowing the rates of production of goods and services commonly purchased by benefit recipients.  Slowing growth has had deleterious effects on the economy’s ability to recover from the 2008-2011 recession and the persisting high unemployment rate. 

Although the price level is rising by only moderate amounts (around 3 percent per annum in late 2011), many economists worry about the long-run inflation prospects.  Prices rising at rates faster than incomes increase can be expected to decrease consumer purchasing power.  This will slow the rate of aggregate demand increase, with obvious implications for the business sector of the economy.

Chapter 22 Endnotes:

[1] Alexis de Tocqueville, Democracy in America, 1835, http://xroads.virginia.edu/~HYPER/DETOC/toc_indx.html. 

[2] United States Department of the Treasury, Bureau of the Public Debt, “Government – Historical Debt Outstanding – Annual 200-2010,” http://www.treasurydirect.gov/govt/reports/pd/histdebt/histdebt_histo5.htm.

[3] United States Department of Commerce, Bureau of Economic Analysis, “National Economic Accounts:  Gross Domestic Product:  Current-dollar and ‘real’ GDP,” http://www.bea.gov/national/index.htm#gdp.

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PART E. CONCLUSION

 

 

CHAPTER 22.  PUBLIC DEBT

Democracy is perhaps the form of political organization most congenial to capitalism and to the process of economic growth.  Capitalism may be construed to be a form of democracy in the sense that market mechanisms, the decision making and motivating vehicles of capitalism, have the effect of democratizing consumer decision making.  Market economy enables those with income or wealth to vote their dollars (or whatever is the currency du jour) on what they most want to purchase. 

Market economy does not provide economic universal suffrage because the unemployed and the propertyless have few dollars to vote in the market.  Nor does it promote equality in the political sense of “one man, one vote” because those with greater wealth and higher incomes have more dollars to vote, while the poor and the indigent have fewer dollar votes. 

 

Public Debt Increase

Political democracy can attempt to make up for these economic democratic deficits through the legislative process.  Parliaments, congresses, and legislatures enact legislation to level incomes and wealth via progressive income taxation and property taxes, and by establishing “safety nets” that have the effect of providing dollar-voting ability to those with no property and low or no incomes.  

Americans in particular are a humane people.  They do not want to see their citizens suffer hunger, inadequate housing, the income-decreasing effects of unemployment, lack of medical care when needed, the hazards of calamities like fires and automobile accidents, or the destructiveness of natural disasters like earthquakes, tsunamis, tornados, or hurricanes.  The democratically enacted solutions to these threats have included socialized medical insurance, old-age pension benefits, unemployment compensation insurance, subsidized hazard insurance, and welfare benefit floors for the indigent. By the early years of the twenty-first century, a culture of entitlement to these benefits had emerged. 

The problem with political democratic relief of the democratic deficit of market economy has manifested itself in the form of increasing government budget deficits that cumulate as ever-increasing public debt.

It should be no surprise that the public debt of a society that prefers democratic polity has become a serious political issue.   The prospect was noted nearly two centuries ago by a Frenchman visiting in America.  In 1835, after traveling for two years in the United States, Alexis de Tocqueville wrote De la Démocratie en Amerique  (Democracy in America).[1]  In his Chapter on “Government of the Democracy of the United States,” Tocqueville noted that when universal suffrage provided legislative empowerment to the poor and propertyless, society would soon discover that it could vote itself benefits quite apart from any ability of government to finance the provision of them.  If some benefits are good, then more (and ever more) benefits must be better.  Voila!  The basis for out-of-control public debt in American democratic polity was noted as early as 1835 by a French visitor to the United States.  The wonder is that it took nearly two more centuries for the problem to materialize. 

Over and above social spending programs implemented by the U.S. government during the twentieth century and the early years of the twenty-first century, military spending in Iraq and Afghanistan and stimulus programs implemented by the government in addressing the Great Recession beginning in 2008 have added substantially to the U.S. public debt.  Deficits in the amounts of $1 trillion in the 2007-2008 fiscal year, $1.9 trillion in 2008-2009, and $1.7 trillion in 2009-2010 have caused the U.S. federal debt to exceed $14.7 trillion by September, 2011.[2]  This is nearly as large as the U.S. GDP, estimated to be nearly $15 trillion at mid-2011.[3]  The U.S. public-debt-to-GDP ratio is only slightly less than 100 percent.

Policy to Deal with Mounting Public Debt

Basically, there are only two ways to finance government deficits:  the creation of money (issued by the central bank or printed by the treasury department of government) or the issuance of debt (government bonds) by the treasury department of government.  There is no special or reserved place for government to place its bonds; they have to be sold in the same financial markets in which private sector companies are hoping to raise investment funds by selling the bonds that they issue. 

Money issuance to finance government spending virtually ensures elevating rates of inflation that reduce the purchasing power of incomes.  A few lesser-developed countries still use the printing presses to meet their spending needs, and nearly universally pay the inflation price for their profligacy. 

The issuance of additional government bonds relative to the existing demand for bonds virtually ensures that bond prices fall, causing their yield rates to rise.  The rising yield rates can be expected to raise interest rates in all financial markets by the process of arbitrage.  The rising interest rates are likely to crowd-out private sector borrowers from the financial markets.  As their interest costs rise, businesses can be expected to cut back, delay, or cancel investment plans. Increasing unemployment is an inevitable follow-on consequence. 

Compounding the bond issuance problem is the fact that the increasing public debt may become “monetized” as the central bank engages in open market bond purchases in the effort to avert rising interest rates.  A central bank purchase of bonds adds to the reserves of commercial banks and increases their capacity to create money as a by-product of lending.  The monetization of debt increases the money supply no less so than does the direct creation of money to finance government spending.  The likely consequence in either case is accelerating inflation that reduces the purchasing power of wage earners. 

The mounting U.S. public debt became one of the prime political issues of the 2012 presidential election campaign season.  Proposals for addressing the mounting public debt of the U.S. have included raising taxes (advocated by the political left and opposed by the political right) and cutting expenditures (insisted upon by the political right).  The problem came to a head in July of 2011 as a debt ceiling limit was approached.  The unwillingness of the political parties in Congress to reach compromise threatened to shut-down the operations of the U.S. federal government.  A temporary arrangement reached in Congress enabled the continued operation of the government. A “supercommittee” consisting of members of both houses of the U.S. Congress was appointed to come up with proposals to reduce the public debt by as much as $4 trillion over a ten-year period.  If the supercommittee fails to come up with adequate deficit- and debt-reduction  proposals, automatic across-the-board cuts would be implemented after the first of 2012.

Managerial Implications of Increasing Public Debt

The mounting U.S. public debt descends upon its market economy by imposing constraints on consumer sovereignty and enterprise freedom. Efforts to slow the cumulative increase of U.S. public debt must entail decreasing benefit entitlements or increasing taxes on income earners and business enterprises. Increased taxes on businesses can be expected to curb entrepreneurial risk taking and give incentive to move productive activity offshore.  Curbing benefits inevitably will dampen market demand by those who have been receiving benefits.  A follow-on effect in the short run likely will be to inhibit the recession recovery process, and in the long run to curb economic growth by slowing the rates of production of goods and services commonly purchased by benefit recipients.  Slowing growth has had deleterious effects on the economy’s ability to recover from the 2008-2011 recession and the persisting high unemployment rate. 

Although the price level is rising by only moderate amounts (around 3 percent per annum in late 2011), many economists worry about the long-run inflation prospects.  Prices rising at rates faster than incomes increase can be expected to decrease consumer purchasing power.  This will slow the rate of aggregate demand increase, with obvious implications for the business sector of the economy.

Chapter 22 Endnotes:

[1] Alexis de Tocqueville, Democracy in America, 1835, http://xroads.virginia.edu/~HYPER/DETOC/toc_indx.html. 

[2] United States Department of the Treasury, Bureau of the Public Debt, “Government – Historical Debt Outstanding – Annual 200-2010,” http://www.treasurydirect.gov/govt/reports/pd/histdebt/histdebt_histo5.htm.

[3] United States Department of Commerce, Bureau of Economic Analysis, “National Economic Accounts:  Gross Domestic Product:  Current-dollar and ‘real’ GDP,” http://www.bea.gov/national/index.htm#gdp.

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GLOSSARY

absolute advantage, the benefit possessed by a region in being able to produce a good or service at the lowest absolute cost relative to other regions as denominated in the same currency unit; to be distinguished from comparative advantage that is based on opportunity costs rather than absolute money costs.

acceleration, in Keynesian analysis, the demand for capital goods tends to increase and decrease at faster rates (i.e., to accelerate) than the demands for the final goods produced by the capital goods.

accommodative monetary policy, the response of a central bank to a governmental fiscal stimulus to the economy by increasing the money supply to facilitate the effectiveness of the fiscal stimulus; a central bank expansion of the money supply to prevent interest rates from rising when government runs a budgetary deficit that is financed by issuing bonds which would drive bond prices down and yield rates up.

active control, the object of managerial decision making in the microeconomic context of the commercial enterprise.

aggregate demand, the total of spending by members of a society on the output of its economy; aggregate demand is understood in post-Keynesian thought to be a function of the price level rather than the level of the society’s income.

aggregate expenditure, the total of spending by members of a society on the output of its economy; aggregate expenditure is understood in Keynesian thought to be a function of the society’s level of income rather than the price level; aggregate expenditure consists of the sum of consumption, investment, government purchases, and the net of exports less imports. 

aggregate supply, long-run, the quantity of output produced at the normal operating capacity of the economy entailing 80-85 percent usage of capital resources and 90-95 percent of the labor force employed; long-run aggregate supply is thought to be inelastic with respect to the price level.

aggregate supply, short-run, the quantity of output of an economy that may vary directly with the price level; short-run aggregate supply will be coincident with long-run aggregate supply if resource owners are fully cognizant of price-level changes in the economy; short-run aggregate supply may diverge from long-run aggregate supply and attain some degree of price-level elasticity due to lags of recognition by resource owners that prices of goods and services are changing.

allocative efficiency, the use of resources in industries among geographic regions that minimizes production costs and maximizes the welfares of the societies using the products produced by the industries; allocative efficiency is achieved when regions specialize in producing goods and services according to their comparative advantages and engage in unconstrained trade with one another.

appropriate technology, the technical means of production that uses the most abundant (least expensive) resources of a region and conserves on the scarcest (most costly) resources of the region; for many lesser-developed economies, the technologies employed in the West have been developed in capital abundant settings to conserve upon scarce labor, and thus are not appropriate to the LDC setting without extensive adaptation.

arbitrage, the simultaneous purchase and sale of financial instruments to take advantage of interest rate differentials; because of arbitrage, when a central bank alters its discount rate or manipulates the interest rate that banks charge to each other when lending excess reserves, market interest rates (nominal rates) on financial instruments usually move in the same direction.

autarky, a policy intended to achieve the internal self-sufficiency of a regional geographic or political entity.

authoritarian capitalism, a.k.a. “fascism,” a form of economic organization that involves investment in capital for profit by private owners who respond to the dictates of an state planning agency that determines product mix, product characteristics and qualities, and production quotas.

automatic stabilizers, mechanisms installed by legislative action into economies that work automatically to offset macroeconomic swings; once installed, automatic stabilizers require no further human intervention; examples include a progressive tax rate system that leaves more purchasing power in citizens pockets as an economic downswing decreases incomes, and unemployment compensation that increases the spendable income of eligible recipients as unemployment rises; both system automatically decrease the injection of purchasing power into the economy as it recovers.

Balance of Payments, an accounting of a nation’s external transactions with the rest of the world; the Balance of Payments of a nation with an open economy and flexible exchange rates requires two sections, a Current Account section and a Capital Account section; if the nation maintains fixed exchange rates of its currency with respect to other currencies, a third section, an Official Reserves section, is also required.

base period, in a price or quantity data series, the arbitrarily-selected number in the series that serves as the denominator for computing ratios of numbers in the series to the selected number; the values of the ratios so computed are regarded as “indexes” relative to the base period value of 1.00; there are no objective criteria for selecting a base period; periods in which there occur severe natural disasters, wars, or political upheavals should be avoided; the selected base period may be at or near the beginning or the end of the series, anywhere within the series, or even outside of the series which is being compiled.

benefit-cost analysis, an analytical process used by economists for comparing the sum of the benefits (B) of a contemplated action to the sum of the costs (C) that are likely to result in undertaking the action; if the B is greater than C, or if the value of the ratio B/C is greater than 1, the contemplated action is desirable or justifiable on economic grounds, abstracting from moral implications unless the values of moral outcomes have been imputed and included in the benefit or cost totals; the contemplated action is undesirable if B is less than C, or if the value of the B/C ratio is less than 1; benefit-cost analysis is fraught with the potential for abuse if conducted by interested parties, e.g., advocates are likely to overstate benefits and understate or omit some costs, while opponents are likely to omit or understate benefits and overstate some costs.

budget deficit, the excess of expenditures by an entity (person, company, government) over its revenues during an accounting period, usually the year; governments typically run budget deficits more often than budget surpluses; government budget deficits are financed either by direct money creation or by issuance of government bonds that often results indirectly in new money creation and inflation as a consequence.

budget surplus, the excess of the revenues of an entity (person, company, government) over its expenditures during an accounting period, usually the year; governments rarely run budget surpluses, but a surplus occurs there usually is a political debate over whether to increase spending, decrease outstanding debt, or impound the surplus.

capital, human made means of production that can be replicated and augmented by human effort; the stock of capital is increased by investment in excess of depreciation.

capital consumption, a.k.a. “depreciation,” the real economic phenomenon attributable to wear and weathering, but not to obsolescence per se; the Consumption of Fixed Capital allowance in the National Income and Products Accounts of the United States is compiled as an aggregation of all depreciation expenses claimed by business enterprises on business income tax reports.

 capital goods, "man-made" means of production that can be used to produce consumer goods or other capital goods; capital goods are durable and typically have multi-year lives over which a stream of productive services are yielded, but which depreciate (deteriorate) due to use and weathering during their useful lives; capital includes plant (the buildings within which production takes place) and equipment (the machines and tools used to convert raw materials into finished consumables).

capital inflow, in the Balance of Payments, the consequence of a Capital Account surplus that offsets a Current Account deficit as foreigners acquire ownership of domestic assets or decrease their liabilities to the nation; a capital inflow results in an outflow of funds to “pay for” the Current Account deficit; a capital inflow may be understood to be an export of the ownership of domestic assets or a decrease of foreign liabilities to the nation; the Capital Account surplus results in an increase of indebtedness of the nation to foreign interests or a decrease of the ownership of foreign assets by citizens of the nation.

capital outflow, in the Balance of Payments, the consequence of a Capital Account deficit that offsets a Current Account surplus as citizens of the nation acquire ownership of foreign assets or decrease their liabilities to foreigners; a capital outflow results in an inflow of funds to “pay for” the Current Account surplus; a capital outflow may be understood to be an import of the ownership of foreign assets or a decrease of liabilities of citizens of the nation to foreigners; the Capital Account deficit results in an increase of indebtedness of foreigners to domestic interests or a decrease of the ownership of domestic assets by foreigners.

capitalism, a form of economic organization that involves investment in capital for profit; in market capitalism, means of production are privately owned and decisions regarding product mix, methods of production, resource allocation, and output distribution are dispersed to members of society who participate as demanders and suppliers in resource and final goods markets; in authoritarian capitalism, a.k.a. “fascism,” the means of production are in private hands, but producers must respond to the dictates or requisites of central authorities who make the relevant economic decisions.

chain-type price index, an index number series that computes the total rate of inflation over a span of time by "chaining together" the consecutive-year price rate increases; “chaining” is accomplished by computing geometric moving average of consecutive year index pairs, each employing weights for the respective year; the year in which the moving-average weighting process was begun may be identified, but there is no unique "base period.”

Classical Economics, the school of economic thought in the U.K. and U.S. that preceded the so-called “Keynesian Revolution” of the 1930s that ushered in the concept of macroeconomics and rationalized an expanded role for the government to play in stabilizing the economy; John Maynard Keynes coined the term “Classical” to refer to what he regarded as the obsolete ideas of his intellectual predecessors; Classical economists had perceived no significant distinction between individual economic units and the collection of them that constituted what later would be referred to as the macroeconomy; Classical economists understood equilibrium to be coincident with full employment and that there are forces in the economy that naturally yield equilibrium conditions, so that no critical role for government was envisioned.

comparative advantage, the economic principle that individuals, groups, regions, or nations should specialize in producing those goods or services that can be produced at lowest opportunity cost compared to others so that welfare gains can be realized by exchanging those goods or services with trading partners whose comparative advantages lie with other goods for which the individual, group, region or nation is a higher opportunity cost producer; comparative advantages are region or nation specific; to be distinguished from competitive advantage, which is company specific.

competitive advantage, the benefit possessed by a specific company due to its production or distribution efficiencies, product characteristics or identity, or marketing prowess; to be distinguished from comparative advantage, which is region or nation specific; companies may have to discover or acquire competitive advantages in order for a region in which they operate to discover its comparative advantage.

components of a time series, the trend, cyclical, seasonal, and irregular or random variation elements that may be separated out of the time series by statistical procedures described in Appendix 13A.

consumer sovereignty, the personal liberty of the individual to choose how to spend (or not spend) his or her disposable income.

corporation, one of three principal forms of business organization, the other two being single proprietorship and partnership; under incorporation laws in most countries, a corporation is a legal person that can sue and be sued in courts of law; the corporation has a life apart from its owners that begins with the legal process of incorporation and ends with final bankruptcy; in the US, corporate charters are issued and supervised by state governments, usually the office of Secretary of State; the other forms of business organization are coincident with the lives of the owners and thus suffer unlimited liability in regard to what the owners do, but the corporate form of business organization enjoys limited liability in the sense that shareholders of a corporation cannot be sued for what the corporate legal person does; hence the assets of the shareholders of a corporation are protected from suit; the officers of a corporation can be prosecuted for criminal activity or subjected to civil suits for damages that are attributable to decisions made by the corporate officers; corporate net incomes (revenues less allowable expenses) usually are taxed at “flat rates” (rather than progressive rates) in most US states and by the US federal government; corporations enjoy financing advantages over other forms of business organization because corporations can issue additional shares in themselves or indebtedness claims (corporate bonds) against their assets; in most market economies, the corporate form of business organization is becoming more popular to take advantage of its limited liability and capital financing features even though business and tax reporting requirements are more stringent and costly for corporations.

cost push inflation, an increase of the general price level attributable to a decrease of short-run aggregate supply relative to the aggregate demand of an economy; short-run aggregate supply decreases may be attributable to supply shocks or to monopolistic actions by owners of resources (including labor) to increase their prices (or wages) in order to increase their incomes.

crowding-out effect, the decrease of private sector investment consequent upon an increase of interest rates due to an increase of government expenditures that require financing a deficit by borrowing from the capital markets; decreases of government spending during a period of contraction may so lower market interest rates as to elicit crowding in of private sector borrowing to finance more investment or consumer spending.

currency, the money that is commonly and widely used in a region, nation, or group of nations; precious metals served as the currencies of ancient realms, but modern currencies take the forms of coin and paper fiat money (promises to pay by the issuer of the currency); typically, a modern nation’s currency supply comprises no more than a fifth of its total money supply, the larger part consisting of commercial bank deposit balances.

cycle, the implied regularity of variation of commercial activity in an economy that entails a sequence of contraction, trough, expansion, and peak; this term has given way to the term "economic fluctuation" in recognition that the ups and downs of macroeconomic activity are not so regular in either duration or amplitude that they can be regarded as cyclical.

cyclical unemployment, involuntary unemployment attributable to cyclical downturns or episodic contractions of the economy that result in inventory accumulation to which businesses respond by reducing rates of production and laying-off or otherwise terminating workers.

decomposition, a statistical procedure for separating out the trend, cyclical, seasonal, and irregular components of a time series as described in Appendix 13A.

deflation, the negative of inflation, occurs when the general price level falls; sometimes referred to a “too little money chasing to many goods,” deflation often occurs during the recession phase of a business cycle due to declining incomes that cause demand for goods and services to decrease relative to supplies; deflation may be a consequence of a decrease of the money supply of a region or a decrease of the rate at which money is being spent.

demand, the desire for a good or service backed up by possession of the purchasing power to make the desire effective, plus the willingness to part with the purchasing power.

demand for investment, in Keynesian macroeconomic theory, business sector investment spending (i.e., the demand for it) is thought to vary inversely with the real interest rate; the inverse relationship reflects the fact that interest is a cost to the investor, irrespective of whether financing is from external sources (selling stock, issuing bonds, borrowing from banks) or internal sources (retained earnings, depreciation allowances); Keynes referred to a single firm’s demand for investment spending as the “marginal efficiency of investment,” and the business sector’s aggregate demand for investment as the “marginal efficiency of capital.”

demand for loanable funds, the sum of the corporate bonds issued by business firms needing funds for investment or to finance  operations, plus bonds issued by governments requiring funds due to budget deficits, plus the household sector’s issuance of mortgages and other promissory notes to borrow funds to finance purchases of houses, motor vehicles, and other “big ticket” items that cannot be purchased out of the ordinary flow of income.

demand for money, the nominal quantity of money that the members of society wish to hold; money may be held in a variety of forms, including wallets and purses, bank accounts, cookie jars, mattresses, and cans buried in the back yard; the propensity of a society to hold money in any of these and other places is determined by the society's payments conventions as well as its perceptions of need for liquidity; see also “real demand for money.”

demand-pull inflation, an increase of the general price level attributable to an increase of aggregate demand relative to the normal operating capacity of an economy.

depreciation, a.k.a. "capital consumption,” the real economic phenomenon attributable to wear and weathering, but not to obsolescence per se; depreciation occurs on a continuing basis whether or however it is accounted for; the Consumption of Fixed Capital allowance in the National Income and Products Accounts of the United States is compiled as an aggregation of all depreciation expenses claimed by business enterprises on business income tax reports.

depreciation, of a currency, the market-determined decrease in the foreign-currency price of the domestic currency; the opposite of appreciation of the currency.

derived demand, the need for a product that depends upon the need for one or more other products; the demand for capital goods is derived from the demand for the goods that can be produced using the capital goods; in Keynesian analysis, the derived demands for capital goods tend to increase and decrease at faster rates (and by larger percentages) than the demands for the final goods produced by the capital goods, i.e., derived demands accelerate relative to final demands.

devaluation, of a currency, the decrease of the foreign-currency price of a the domestic currency as determined by the administrative fiat of the government; the opposite of an upward revaluation of the currency.

discretionary policy skepticism, negative attitude on the parts of some macroeconomists to the implementation of government stabilization policy in expectation that overreactions may tend to destabilize rather than stabilize the economy.

disequilibrium, in Keynesian macroeconomic theory, the condition of the economy in which aggregate spending the society is greater or lesser than the aggregate output of the economy, resulting in inventory depletion or accumulation, respectively; also, the macroeconomic condition in which the spending leakage total is greater or lesser than the injection spending total, corresponding to the aggregate spending-aggregate output condition of the economy.

divestment, the act of liquidating or otherwise disposing of real or financial assets; in National Income and Product Accounting, inventory accumulation and depletion are regarded as forms of investment and divestment, respectively.

dollarization, either the deliberate or unintentional substitution of another nation’s currency (often the dollar, sometimes the euro) for the domestic currency of a nation; the main reason for dollarization of a nation’s currency is the inability of its government to effect fiscal discipline or control its money supply to prevent inflation; when a nation’s currency becomes dollarized, the government of the nation loses control of domestic monetary policy that is in effect ceded to the central bank of the foreign nation whose currency becomes used in the nation.

domestic definition, in the National Income and Product Accounts of the United States, the compilation of income and output data for all productive activity conducted within the territorial boundaries of the nation, irrespective of the nationalities of the producers; to be distinguished from the national definition which compiles income and output data for all productive activity conducted by nationals (citizens) of the nation wherever they are in the world.

domestic firm, a company that, with respect to a particular nation state, conducts all of its business relationships exclusively in the domestic economy of that nation state; it may find itself serving an occasional foreign customer travelling in its nation state even though it does not solicit foreign business.

double-entry bookkeeping, accounting procedures that ensure that debit entries are always fully offset by credit entries so as to maintain the integrity of the book-keeping system; while double-entry bookkeeping is a reliable process at the microeconomic level of the firms engaged in international transactions, data for Balance of Payments totals are aggregated from tax reports which are, in effect, single-entry sources.

dumping, the sale by a foreign producer in a domestic market at a price below the foreign producer's full cost of production (including overhead cost allocation); since it is virtually never possible for one producer to gain adequate information about another producer's costs (direct or overhead) of production, the political definition of dumping is sale by the foreign producer in the domestic market at a price below the domestic producer's full cost of production (including overhead cost allocation); domestic producers may claim that the foreign producer is dumping when the price is simply below domestic prices; such claims often serve as basis for an appeal by domestic producers to their governments for protection from the foreign producers.

durable goods, tangible products that have lives typically exceeding a year; examples of durable goods include appliances and automobiles; to be distinguished from non-durable goods, those that have lives typically less than one year; examples of non-durable goods include foodstuffs and apparel.

earned income, National Income in the National Income and Product Accounts, is derived by deducting Indirect Business Taxes and non-tax liabilities (e.g., license fees and penalties for late- or underreporting of income to tax authorities) from Net National Product; earned income  has been greater than received income because more in social insurance taxes were collected than was distributed as transfer payments; during the mid-1970s the magnitudes of National Income and Personal Income were roughly equivalent, but by the end of the 1970s Personal Income regularly exceeded National Income, i.e., received income had become larger than earned income.

economic development, a change in the social structure of society; the various dimensions of social structure include economic, social, political, moral, religious, and environmental; development is both a requisite of growth and a consequence of economic growth.

economic growth, an improvement in the material well being of humans, usually measured as the rate of increase of per capita real income or output of a society, and usually accompanying or preceded by a change in the structure of society, a.k.a. “economic development.”

economic integration, the process of removing territorial barriers to the transaction of goods and services and the movement of materials, capital, and people across historical territorial boundaries; economic integration enables trade creation in pursuit of indigenous comparative advantages within the integrating region, but may entail trade diversion as trade (imports, exports) are shifted away from true comparative advantages that lay outside the integrating region.

economic productivity, the ratio of the value of output to the costs of inputs; economic productivity increases when the ratio of the value of output to the costs of inputs increases, whether the numerator of the ratio increases or the denominator decreases.

economic region, a geographic area that is characterized by the possession of a natural resource (or a natural resource complex) or for which there is an identifiable market for a specified product.

economic system, the set of social, political, and economic arrangements by which a society determines its product mix, how goods and services are to be produced, allocates its scarce resources to alternative uses, and distributes its product to its members.

efficiency, the relationship between the output of a productive processes and the inputs necessary to produce the output; efficiency is served by reducing the quantity of inputs necessary to produce a specified quantity of output; there often are trade-offs between efficiency and equity in pursuit of either.

elastic, responsive; e.g., the quantity demanded of money is thought to be elastic with respect to the interest rate.

elasticity of demand, the ratio of the percentage change of quantity demanded of a good or service to the percentage change of its price or the incomes of buyers; elasticity measures the relative responsiveness of quantity demanded to a change of price or income.

entrepreneur, the “moving force” in the market economy; one who assumes risk in the process of innovation by introducing a new product, process, or organizational structure; a successful entrepreneur is rewarded by profit in a market economy, but since there is no guarantee of success, the entrepreneur might suffer loss if the innovation is unsuccessful.

entrepreneurship, the process of innovation and assumption of risk in the effort to launch a new business venture or alter the structure or functioning of an existing business; there is no guarantee of success in a truly entrepreneurial venture; success of a private-enterprise entrepreneurial venture is rewarded by profit; failure is punished by loss which may be personal and emotional as well as financial; from a sociological perspective, entrepreneurship is a form of social deviance.

entry, the ability of a firm to become an active market participant; entry may be easy into purely competitive and monopolistically competitive markets, but is likely to be difficult into an oligopolistically competitive market, and blocked into a monopoly’s market.

equation of exchange, an identity in monetary theory that specifies that the money supply multiplied by the velocity of circulation of money must be equivalent to the price level multiplied by the level of real output of an economy.

equilibrium, product market, the equivalence of quantity demanded to quantity supplied so that there is neither inventory depletion nor accumulation; competitive pressures and entry tend to adjust market price for a product toward an equilibrium combination of price and quantity transacted, and to eliminate supernormal profits; once an equilibrium state occurs in a market, it may persist until disturbed by changes of non-price determinants of demand or supply; in a dynamic world, market equilibrium is an ephemeral state that is so short lived that it may actually never be observed.

equilibrium, Keynesian theory, the macroeconomic state in which aggregate spending completely absorbs the aggregate output of the economy; if aggregate spending falls short of current output, the unsold output accumulates in inventories and motivates producers to cut back their rates of production in the next operating period; if aggregate spending exceeds current output, inventory depletion motivates businesses to increase rates of output in order to replace inventory; in Keynesian theory, the processes of inventory accumulation and depletion culminate in macroeconomic equilibrium.

exchange rate, the price of one currency in terms of another currency; exchange rates may be determined in markets by interactions of suppliers and demanders (flexible exchange rates), or they may be determined by the administrative fiat of a government at some level other than that which would result from market forces (fixed exchange rates).

exit, the departure of a firm from a market, possibly by choice of the entrepreneur, but more likely by failure or acquisition by a competitor; exit is easy and of low cost from purely competitive and monopolistically competitive markets, more costly from an oligopolistically competitive market if the oligopolist cannot find a merger partner or a competitor to acquire its business and assets, and most costly of all for a monopolist that suffers bankruptcy and distribution of assets to claimants.

exploitation, the phenomenon of one human taking advantage of or controlling the productive abilities of other humans; the ability to capture value greater than warranted by one’s own contribution to a production process; exploitation occurs if a resource receives compensation that is less than the value of its marginal contribution to the production process.

externality, a.k.a. “spillover,” a so-called “market failure” consisting of positive and negative side-effects of consumption or production activity that impinge upon innocent by-standers to market transactions and thus are not recognized by markets; negative externalities resulting from the production or consumption of a good result in the market over-allocating resources to production of the good; positive externalities resulting from the production or consumption of a good result in the market under-allocating resources to production of the good; examples of positive externalities include the benefits of public health care and public education; examples of negative externalities include various kinds of environmental pollution.

ex ante, before the fact of an event; ex post, after the fact of the event; an ex ante or predicted effective multiplier for a macroeconomy can be computed as the reciprocal of the sum of the historic leakage propensities in the economy; the ex post or realized value of the multiplier may be computed as the ratio of the actual increase of income in the economy to the initiating increase of leakages from the income stream that elicited the increase of income.

external balance, the relationships of a nation's trade, investment, and official reserves transactions with the rest of the world; a nation with an absolutely closed economy, i.e., one that is perfectly isolated from the rest of the world, would have no external transactions to balance; the external balance for an open economy that enjoys substantial private sector trade and investment discretion is indicated by its Balance of Payments.

fascism, a.k.a. “authoritarian capitalism,” a form of economic organization that involves investment in capital for profit by private owners who respond to the dictates of an state planning agency that determines product mix, product characteristics and qualities, and production quotas.

fine tuning, the belief held by many economists in the second half of the twentieth century that fiscal and monetary policies could be managed with such precision as to eliminate business cycle swings and the oscillating pressures of inflation and deflation; economists of the late-twentieth century have come to the realization that fiscal and monetary policies are not so amenable to fine tuning as to eliminate or even ameliorate cyclical swings.

firm, business, an organization intended to produce or provide goods or services for sale on markets; a.k.a. enterprise.

fiscal, pertaining to government policy, expenditures, non-spending disbursements, taxation and other sources of revenue that compose the government’s budget.

fiscal discipline, the ability and willingness of a political administration to restrain its expenditures to the revenues that are available to be used during the period, e.g., to balance its budget.

fiscal policy, the deliberate manipulation by the government of its own budget to counterbalance swings of spending in the private sector, i.e., in the business and consumer sectors; fiscal policy action involves increasing spending or decreasing taxation during a downswing in order to counterbalance decreased spending in the private sector, and vice versa for an upswing; if a fiscal policy stimulus works as expected, an economic contraction will come to an end and the economy will begin to expand, returning production, employment, and income generation to more normal conditions; implementation of a fiscal policy change usually is a time-consuming and cumbersome process that requires legislative action; a growing number of macroeconomists have become skeptical of the ability of government policy makers to implement fiscal policy changes without overreaction that aggravates macroeconomic instability.

Fisher effect, the increases of nominal (or market) interest rates due to increases of the rate of inflation; nominal interest rates also tend to fall with decreases of the rate of inflation.

fixed exchange rate, the price of one currency in terms of another currency as determined by the administrative fiat of a government at some level other than that which would result from market forces.

fixed-weight price index, an index number series for which the weighting factors applied to the prices are not changed for an extended period of time.

flexible exchange rate, the price of one currency in terms of another currency as determined in markets by interactions of suppliers and demanders.

fluctuation, the irregularity of variation of commercial activity in an economy that entails a sequence of contraction, trough, expansion, and peak; this term has succeeded the term "cycle" in recognition that the ups and downs of macroeconomic activity are not so regular in either duration or amplitude that they can be regarded as cyclical.

footloose industry, one in which both materials and capital are more mobile than the labor necessary to produce the output; a footloose industry need not locate near to either sources of raw materials or to markets for the product.

foreign direct investment (FDI), the establishment or acquisition of productive facilities in countries other than the home country of the investor (person or company), and in which the investor acquires and retains a controlling interest in the investment; in the case of an acquired company with widely dispersed shareholding, a controlling interest may be as little as (or even less than) ten percent of the outstanding shares of an acquired entity; in distinction to foreign portfolio investment (FPI) in which the investor has a non-controlling interest, typically less than ten percent of outstanding shares of the acquired company.

foreign firm, a company that, with respect to a particular nation state, is organized or incorporated in a second nation state, but which is doing business by way of buying or selling in the domestic economy of the first nation state.

foreign portfolio investment (FPI), the acquisition of non-controlling interest in a foreign company or financial instrument; typically less than ten percent of outstanding shares of an acquired company.

forward exchange trading, contracting for delivery or receipt of foreign exchange at a future date; in currencies for which forward markets have emerged, it is possible to contract to purchase or sell quantities of exchange (i.e., sell or purchase the domestic currency) 30, 60, or even 90 days forward.

free market economy, a market economy with no significant role played by government in the processes of determining product mix, methods of production, resource allocation, or output distribution; a term used mostly by non-economists and particularly by critics of market capitalism who wish to point out the faults and failures of market capitalism; technically, there is no such thing as a free market economy since virtually all economies throughout history have been mixed economies.

frictional unemployment, the portion of the labor force that is out of work due to the fact that some workers leave their former employments before they have found suitable subsequent employments; a rising level of frictional unemployment may be taken as indicative of the health of an economy since workers are willing to leave jobs that they hold to search for other jobs that they might prefer.

general price level, a macroeconomic measure of the average of all commodity prices in a region or nation; in computing the general price level average, the included components are usually weighted by the quantities of the goods purchased.

globalization, the increased mobility of humans in search of better job opportunities and living conditions (immigration and emigration) and the quest by business firms to locate production geographically at the least-cost and most efficient production sites; globalization has been fostered by technological advances in transportation, communications, and computing; the process of globalization has entailed both off-shoring (shifting production to foreign locales) and out-sourcing (acquiring materials, parts, and components from foreign producers).

goods, things with tangible characteristics that are consumable by humans; some matter taken from the natural environment are directly consumable; other consumer goods are processed or manufactured from matter taken from the natural environment.

government budget, the net balance of the government’s revenues less its disbursements during an accounting period; the government budget is said to be in surplus if revenues exceed disbursements, or in deficit if disbursements exceed revenues; the balance on the U.S. government’s budget makes no distinction between purchases of goods and services, welfare and other unilateral disbursements, and investments in government owned infrastructure facilities that have multi-year lives.

government consumption, purchases by government of goods and services during an accounting period that are used during that accounting period and are not inventoried for carry-over to subsequent accounting periods.

government failure, the inability of government to alleviate or repair perceived market failures with market modification approaches; examples include failing to enact and enforce laws or directives that support and enhance the functioning of market economy; failing to account for secondary (and tertiary, etc.) effects of well-intentioned government actions, resulting in unintended consequences; basing programs and policy actions upon the requisites of political expediency rather than economic realities; basing political actions upon the requisites of regime preservation rather than the needs of public welfare; inability or unwillingness to exercise fiscal or monetary discipline; policy overreactions that increase economic instability; ceasing to function purely as a neutral or disinterested umpire in the market economy; overstepping the role of rule-maker and umpire to become a player in the market; attempting to controvert natural comparative advantages, and enacting legislation that invites moral hazard.

government saving, the difference between government disbursements and revenue during an accounting period; the net balance on the government’s budget during an accounting period; government saving is said to be in surplus if revenues exceed disbursements, and in deficit if disbursement exceed revenues; the balance on the U.S. government’s budget makes no distinction between purchases of goods and services, welfare and other unilateral disbursements, and investments in government owned infrastructure facilities that have multi-year lives.

Great Depression, a term that has referred to deep economic contractions in the U.S. economy in the 1870s and the 1930s; beginning late in 1929 with a stock market collapse, the decline of productive activity accompanied by rising unemployment (in the U.S., nearly 25 percent of the labor force) and price deflation that continued through much of the 1930s decade; many social welfare safety nets were initiated during the Great Depression.

Great Recession, the deepest economic contraction since the Great Depression; beginning with a financial collapse in September, 2008, the decline of productive activity accompanied by rising unemployment (in excess of 9 percent of the labor force); although the National Bureau of Economic Research declared the recession to be over by mid-2009, some consider that recessionary conditions persisted through 2011 since output and employment had not yet returned to pre-2008 levels.

Gross Domestic Product (GDP), a measure of the market value (at current prices) of all final goods and services (excluding all purely financial transactions) produced within a country and sold legally (including the imputed value of rents, but excluding illegal transactions and Do-It-Yourself activity) in a given time period (excluding used goods produced in prior periods); GDP is admittedly an imperfect measure of the value of the output of a country due to many omitted types of activity (e.g., the output of informal and underground economic activity), but it is used nearly universally by multinational organizations to make international comparisons of well-being at the level of the aggregate economy and is at present regarded as the best available measure of macroeconomic output.

growth recession, the phenomenon of aggregate demand increasing more slowly than the natural rate of real output in the economy, accompanied by price stability or deflation and a lagging of output behind the expanding capacity; may be referred to as secular stagnation if it appears to be a permanent condition accompanied by a tendency toward chronic deflation.

hedging, entering into forward contracts to buy or sell quantities of commodities or foreign exchange needed or expected in the future; hedging is a means of managing risk; hedged positions are offsetting or covered positions.

hedonic price index, a measurement of inflation intended to account for improvements in quality, function, and performance of goods and services produced in the economy by assigning prices to product characteristics rather than to the products selected for inclusion in the price index market basket; the hedonic index approach is reputed to enhance reported real output while dampening reported price inflation.

income, the monetary purchasing power received by a human factor of production; any income may a composite of wage (labor income), interest (capital income), rent (return due to unique ability), and profit (a residual of total income less all other incomes).

income distribution, the range of income received by a population quintiles or deciles arranged from lowest to highest.

income elasticity of demand,  a measure of the responsiveness of demand to a change of income; the ratio of the percentage change of quantity demanded to the percentage change of income that elicited the change of quantity demanded.

index series, a list of consecutive price or quantity indexes (or indices); the base period for the index series may be for the first item in the series, the last item, or any one of the other items in the series.

inelastic, non-responsive; e.g., the money supply is thought to be inelastic with respect to the interest rate.

inequality of the distribution of income, a factual description of the proportions of the income of a society received by successive deciles or quintiles from lowest to highest; to be distinguished from distributional inequity which is a matter of perception that the degree of factual inequality is socially unacceptable; the merit-based distributional mechanism of capitalism virtually ensures that income is unequally distributed.

inequity of the distribution of income, the perception or judgment that the degree of factual inequality in the distribution of income is socially unacceptable; the merit-based distributional mechanism of capitalism virtually ensures that income is unequally distributed, but it is an object of debate as to whether the existing distribution is inequitable.

inferior good, a product with a negative income elasticity of demand, such that the demand for such a product decreases with income growth.

inflation, an increase of the general price level as measured by consecutive period quantity-weighted averages of the prices of a selected “market basket” of goods and services that are representative of the goods and services that the general population consumes; an increase of the price of a single good does not constitute inflation.

inflation rate,  the rate of general price level change computed as the difference between the price index numbers for any two years divided by the price Index number for the first year.

inflation risk, the likelihood that the price level will rise over the life of an investment opportunity.

inflation risk premium, an allowance for anticipated inflation that is added to the nominal yield rate on a financial instrument; the allowance for anticipated inflation that is added to the discount rate that is used to compute the present value of a financial instrument in order to specify a “risk-adjusted discount rate.”

infrastructure, the built environment of a region that facilitates productive and trading activity within or between regions; infrastructure facilities include roads and railways, airports, ship ports and harbors, electrical generation and transmission facilities, gas and oil pipelines, communications networks, and banking and financial market facilities.

injection, in Keynesian macroeconomic theory, new spending that occurs in the current period that was not present in the previous period; injections include private sector investment, government purchases, and purchases of exports by foreigners; the total of these injection components usually is taken to be constant with respect to income because no one of the injection components is thought to be functionally related to the level of income to any significant degree.

interest, the return (or income) to any human-made productive resource, i.e., capital.

interest rate, the price for using a dollar’s worth of money for a specified time period, usually the year; computed as the rate of yield on a financial instrument; yield rates vary inversely with the price of a financial instrument; a change of the yield rate on a financial instrument in one financial market becomes transmitted to interest rates in other financial markets through the process of arbitrage; in monetary theory, “the” interest rate is a euphemism for the array or structure of interest rates on all financial instruments.

interest rate parity, the offset to a foreign interest rate advantage by the appreciation of the domestic currency; interest investors will continue to send funds abroad to earn higher foreign interest rates until appreciation of the domestic currency fully offsets the foreign interest advantage.

international business, commercial activity that spans national boundaries; international business may include exporting product, sourcing materials overseas, outsourcing manufacturing activity to firms in other countries, and offshoring production by establishing processing facilities in other countries.

international firm, a company that maintains principal office and productive facilities in one nation state and conducts buying and selling activity in that and other nation states.

interregional commerce, a.k.a. “interregional trade,” the commercial activity within a geographically or economically defined region; a region may be part of a nation state or coincident with a nation state, or it may span multiple nation states or parts of multiple nation state; the economic theory of trade, based on interregional commerce, may be extended to the international dimension, i.e., “international trade.”

inventory, stocks of materials and components to be used in production processes, or stocks of final goods awaiting distribution and sale; in Keynesian macroeconomic theory, inventory accumulation and depletion are the processes that lead to changes of aggregate output relative to aggregate spending so as to take the economy to a state of equilibrium, though not necessarily with full employment; in National Income and Product Accounting, inventory accumulation and depletion are regarded as forms of investment and divestment, respectively.

investment, the process of acquiring additions to the stock of capital by diverting some portion of earned income from consumption to enable the purchase of real capital assets (plant and equipment); investment in a financial sense is the use of savings to purchase financial instruments (stock shares, bonds, etc.).

Keynesian Revolution, the introduction of economic concepts by John Maynard Keynes in his 1936 book entitled The General Theory of Employment, Interest, and Money; Keynes’ ideas ushered in the concept of macroeconomy and rationalized an expanded role for the government to play in stabilizing the macroeconomy; Keynes coined the term “Classical” to refer to what he regarded as the obsolete ideas of his intellectual predecessors; Classical economists had perceived no significant distinction between individual economic units and the collection of them that comprised the macroeconomy; Classical economists understood equilibrium to be coincident with full employment and that there are forces in the economy that naturally yield equilibrium conditions, so that no critical role for government was envisioned; Keynes perceived that collapse of spending (consumer and business investment) could occur in the private sector, that the macroeconomy could reach a state of equilibrium at less than full employment, and that the only solution to the under-full-employment condition is that government must increase its spending by taking its budget into deficit in order to make up for the decrease of spending in the private sector.

labor, the productive resource inherent to the human being; the physics concept of “work” (mass times distance moved) accomplished by the human agent; the more modern term for labor is “human resources.”

leading indicators, in the U.S. a list of macroeconomic data series compiled by the National Bureau of Economic Research that change direction in advance of important macroeconomic data series such as output, employment, and the price level.

leakage, in Keynesian macroeconomic theory, the part of the income generated during an accounting period is not recycled back into the income stream in the next period; import spending, taxes paid, and saving after taxes constitute leakages from the income stream; the rate of leakage from the income stream is dominated by the rate of saving which is that portion of after-tax income that is not spent for current consumption.

legal reserve requirement, the requirement mandated by law or administrative fiat for commercial banks to hold reserves in the form of very liquid assets (usually vault cash and government bonds) that can be quickly liquidated to meet sudden and unexpected cash withdrawals by depositors; in the US the required reserve ratio usually ranges between 7 and 12 percent of a bank’s outstanding deposit liabilities, depending upon the size of the bank; the required reserve ratio may be changed by the central bank in implementing monetary policy, but this has become a rare occurrence in the US due to the amplified effects of a reserve ratio change on the volume of bank deposits.

loanable funds ( more grammatically correct, “lendable funds”), the sum of household savings, undistributed corporate profits (business savings), governments’ budgetary surpluses that are used to retire debt, and bank-issued credit that provide funds that can be borrowed to meet funding requirements to finance business investment or operations expenses, government budget deficits, home mortgages, installment loans, and credit card purchases.

long run, a period of time that allows all resources used  by an organization to be changed; changes made in the long run with respect to resources that in the short run are fixed in availability (e.g., plant and capital equipment) are entrepreneurial in nature.

loss, the negative of profit; managerial decision makers are presumed to attempt to avoid losses or to try to minimize losses by adjusting rates of production and finding lower cost inputs into the production process.

macroeconomics, the study of the structure and behavior of an entire economy and large sub-sets (or sectors) of it, e.g., the household, producer, and government sectors; while macroeconomics is often described in terms of nation states, it may also apply to regions of national economies, e.g., the Southeast of the United States or the State of South Carolina, and to groupings of nation states such as the European Union or even the entire world economy.

macroeconomic instability, expansion and contraction of output of a regional or national economy accompanied by falling and rising unemployment levels, greater or lesser rates of inflation, and variations of interest rates, more so for short-term rates than for long-term rates; macroeconomic instability creates uncertainty that constrains enterprise freedom.

Malthusian prospect, the idea advanced in 1798 by Thomas Robert Malthus in An Essay on the Principle of Population as It Affects the Future Improvement of Society that ever growing human populations would eventually press upon the "carrying capacity" of the land; with the quantity of available land fixed, total output could increase only at a decreasing rate (the phenomenon of diminishing returns); eventually per capita income must fall to the level of subsistence and the population would stabilize at the maximum which could be sustained by the earth's productive capacity; Malthus wrote before the Industrial Revolution of the nineteenth century and missed the possibility that technological advances and capital investment might increase productive efficiency to overcome the phenomenon of diminishing returns.

management, the routine oversight, coordination, and control of on-going production processes once they have been established on commercial scale; to be distinguished from the functions of invention and entrepreneurship, although there are a few examples of all three functions be accomplished by the same person, e.g., Thomas Edison.

managerial decision, a determination by a manager or a management team of a business organization to adjust rates of production or resource allocation within the organization to the end of enhancing productivity, achieving greater efficiency, or increasing profitability; relatively low-risk, routine choices in regard to processes that change in smooth, continuous fashion, about which much can be known or discovered, and to which marginal analysis is applicable; short-run decisions about rates of activity or resource allocation within a firm generally are managerial in nature

managerial economics, the study of the microeconomic criteria for rational decision making.

marginal change, the change in the value of an object of pursuit consequent upon the smallest possible change in the value of a causative influence (realistically, one indivisible unit). 

marginal propensity to consume, abbreviated “MPC,” in Keynesian macroeconomic theory, the tendency of a society to increase its consumption spending consequent upon an increase of the society’s income; the MPC is estimated from empirical data to be a high percentage of income increases, typically between 80 percent (in cross-sectional studies) and 95 percent (in time-series studies); the MPC is the complement to the “marginal propensity to save” (“MPS”) such that the sum of MPC and MPS is 100 percent.

marginal propensity to save, abbreviated “MPS,” in Keynesian macroeconomic theory, the tendency of a society to increase its saving consequent upon an increase of the society’s income; the MPS is estimated from empirical data to be a small percentage of income increases, typically around 10 percent or less (in time-series studies); the MPS is the complement to the “marginal propensity to consume” (“MPC”) such that the sum of MPC and MPS is 100 percent.

marginal revenue product, the addition the firm's total revenue following upon using one more unit of the resource.

market, a social phenomenon entailing participation of individuals or groups (including business firms) as buyers and sellers who are perceived to engage in bids and offers to effect voluntary transactions of the ownership of goods or services; on analogy with political democracy, markets enable buyers to vote their incomes or wealth on the goods and services that they need or want.

market basket, the selected collection of items that are representative of those purchased during the base year of a price or quantity index number series; a problem is that the initial collection of items may become progressively less representative as preferences and technology change over the time for which the series is being compiled; changing the contents of the representative collection may make index numbers computed for later periods not comparable to index numbers computed for earlier periods in the series or the base period.

market capitalism, a form of economic organization that involves investment in capital for profit and employs market processes as the principal decision-making and motivating vehicle; market capitalism entails private ownership of the means of production and participatory decision-making through market mechanisms.

market failure, a term often used by critics of market capitalism to refer to faults or shortcomings in the functioning of capitalism; reputed market failures include externalities not recognized by markets, public goods not provided by the private sector in response to market price and profit signals, the accumulation of monopoly power by producers of goods or services, and macroeconomic instability.

market mechanism, the decision-making and motivating vehicle of market capitalism; a market mechanism involves the interaction of demanders and suppliers to determine market price of a good when its quantity demanded is matched to its quantity supplied.

market price, the valuation of a good transacted in a market as determined by interaction of demanders and suppliers; the nominal price of a good or service.

mercantilism, a government policy advocating state regulation of industry and trade, originally practiced in the sixteenth to nineteenth century era of nation state-making, but persistent into the twenty-first century in the form of protectionism and industrial planning.

microeconomics, the study of individual decision making units that compose an economy. These individual decision making units include consumers, resource owners, resource employers, and producers; microeconomic analysis extends to the structure and behavior of groupings of these individual decision making units, e.g., families, business enterprises, product and resource markets, and industries.

mixed economy, an economy entailing a combination of market mechanisms and authoritarian direction to determine product mix, methods of production, resource allocation, and output distribution; mixed capitalism, predominantly a market economy in which government implements various market modification actions to address perceived market flaws or failures; mixed socialism, an economy that is predominantly planned and directed by centralized authority to determine product mix, but which may employ market mechanisms to determine methods of production, resource allocation, or output distribution.

monetary policy, the deliberate manipulation by the government (usually its agent, the central bank) of the money supply or the interest rate (the so-called “price of money”) in the interest of offsetting macroeconomic swings in the economy; while monetary policy changes can be implemented by decisions of the monetary authority (rather than by legislative action) more quickly than can fiscal policy changes, a growing number of macroeconomists have become skeptical of the ability of central bankers to implement monetary policy.

money supply in circulation, narrowly construed (M1 in the U.S.), the quantity of coin, currency, and checkable deposits owned as assets by the general public, i.e., outside of the banking system; checkable deposits are liabilities of commercial banks, but are owned as assets by depositors, hence are part of the money supply in circulation; any coin and currency held as assets of the banking system, i.e., in  the cash drawers and vaults of commercial or central banks, are not part of the money supply in circulation; broader definitions of the money supply (M2, M3) may include other financial instruments that have some degree of liquidity but may not be directly spendable.

monopoly, a market populated by a single seller of a product for which there are no close substitutes; monopolized markets often entail barriers to entry by prospective competitors.

monopoly power, the ability of a producer or seller to exercise pricing or other discretion by virtue of being the only producer or seller in the market for a good.

monopsony, a market for a good or service in which there is only one buyer, i.e., monopoly on the buyer’s side of the market.

multinational firm, a company that maintains offices and productive facilities in multiple nation states and determines executive policy without preference or prejudice with respect to national origin or location.

multiplier, in Keynesian macroeconomic theory, the ratio of the change of the aggregate income of an economy to  an initiating change of aggregate spending in the economy; any change of aggregate expenditure is expected to induce via the inventory adjustment mechanism a same-direction change of aggregate output that is larger in magnitude than the change of aggregate expenditure; a multiplier process ensues because of the process of respending throughout the economy; as this process continues through the economy in an infinite number of iterations, the increments of spending decrease toward zero so that the sum of them approaches a finite total which is a multiple of the original amount of additional spending; a simple multiplier can be predicted by computing the reciprocal of the marginal propensity to save; an effective multiplier may be predicted by computing the reciprocal of the sum of the historic leakage propensities from the income stream that include household saving, business saving (also known as retained earnings or undistributed corporate profits), paying taxes, and import spending.

nationalism, a sort of emotional cement that binds together people of the same cultural background; they may share a common history and heritage; they may be more-or-less homogeneous with respect to race and ethnicity; typically they subscribe to the same religion or various sects or denominations of a common religion; the vast majority of

them speak the same language; and they share a common vision about what it means to be a citizen of the nation.

nationalization, an action by the government of a nation state to acquire the assets of private sector producers operating within the nation; nationalization without adequate compensation of the former owners constitutes confiscation.

national definition, in the National Income and Product Accounts of the United States, the compilation of income and output data for all productive activity conducted by nationals (citizens) of the nation wherever they are in the world; to be distinguished from the domestic definition which compiles income and output data for all productive activity conducted within the territorial boundaries of the nation, irrespective of the nationalities of the producers.

natural rate of unemployment, an irreducible amount of frictional and structural unemployment at the normal operating capacity of the economy; until the turn of the millennium, the normal operating capacity of the U.S. economy was thought to entail a natural rate of  unemployment of 5 or 6 percent; as the Great Recession ensued, the unemployment rate rose above 9 percent, excluding so-called “discouraged workers,” and the net job growth rate (new job creation less job elimination) decreased toward zero; some estimates of the “true” rate of unemployment, including discouraged workers, have exceeded 16 percent of the labor force; some economists have suggested that structural changes in the U.S. economy have caused the natural rate of unemployment to have increased toward 10 percent of the labor force.     

natural resources, non-manmade materials in nature that can be used in economic production of consumer goods or capital goods.

Net National Product, a measure of total new output of a nation after allowing for replacement of that portion of the capital stock which was "used up" by depreciation during the previous year; in the National Income and Product Accounts, computed by deducting Consumption of Fixed Capital from Gross National Product.

night-watchman functions, the routine functions that government must undertake on behalf of a market economy, including enacting a system of law, providing for the protection of property, ensuring domestic serenity with well-organized, trained, and restrained police forces, providing for national security by maintaining an efficient military establishment for defensive purposes, maintaining and enforcing a system of weights and measures, and providing a reliable and elastic money supply.

nominal interest rate, the rate of return on a financial instrument that is determined in the market for the instrument and is actually paid by the issuer of the financial instrument to the holder of the instrument. 

nominal price, the monetary value of an economic good as determined in markets by the forces of demand and supply; a value that has not been adjusted to remove the effects of inflation or deflation.

non-durable goods, products that have lives typically less than one year; examples include foodstuffs and apparel; to be distinguished from durable goods which have lives

typically exceeding a year; examples of durable goods include appliances and automobiles.

non-tariff barriers, trade restraints including quotas, subsidies, and restrictions on product performance, dimensions, packaging, package content, safety, quality, country of origin, etc., that may hinder the free flow of international commerce.

normal good, a product with a positive income elasticity of demand such that as income increases, demand also increases; an inferior good has a negative income elasticity of demand, which means that the demand for such a product decreases with income growth.

normal operating capacity, for the U.S. economy, until the Great Recession begun in 2008, thought to entail a capacity utilization rate of around 85-90 percent and a natural rate of unemployment of 5 to 6 percent; as the Great Recession has ensued, some economists have suggested that structural changes in the U.S. economy have caused the normal operating capacity to have declined toward 75-80 percent and the natural rate of unemployment to have increased toward 10 percent of the labor force.     

oligopoly, a market structure populated by a relatively small number of sellers who know each others’ identities, feel the effects of each others’ actions, react to each others’ actions, and implement strategies to achieve market dominance.

open economy world, an international trading context in which governmentally-imposed hindrances to trade (tariffs, quotas, subsidies, etc.) are minimal.

open market operations, purchases or sales of bonds in the bond market by the central bank of a nation, the side effects of which are to increase or decrease, respectively, the quantity of money in circulation; only the treasury department of a government can issue government bonds, but the central bank of a nation usually is empowered to buy and hold previously-issued government bonds in its inventory, and then to sell bonds as it deems necessary to meet the needs of macroeconomic stability.

opportunity cost, that which must be given up in order to acquire something; the usual presumption is that the true opportunity cost of something acquired is the highest-valued item or activity given up; a.k.a. “real cost.”

passive control,  the attempt to prepare for, respond to, or simply get out of the way of what is happening in the larger world.

Phillips Curve, a relationship between the rate of unemployment and the wage level first identified in 1958 by A. W. Phillips in data for the U.K. economy; subsequently generalized by American economists to unemployment and inflation data for the U.S. economy during the 1960s; subsequently recognized not to apply to post-1970 U.S. macroeconomic experience.

policy activism, the deliberate manipulation of the government’s budget and the money supply in the effort to achieve and maintain macroeconomic stability.

political economy, the complex of the political system and the economic system in place in a region; typically, a mixed market economy is coupled with a democratic polity, or a socialist form of economic organization is paired with a centralized and authoritarian polity; historically, political economy referred to the undivided study of economics and politics before the two disciplines drifted apart around the turn of the twentieth century.

political integration, the process of establishing a super-national or super-regional political administration encompassing a number of nation states or regions and entailing the surrender of elements of national sovereignty to the super-national or super-regional political entity; a politically-integrated super-state may be organized as a unitary state (with no significant political subdivisions), a confederation of constituent states that retain significant elements of sovereignty, or a federal state that is fully sovereign but which may allow elements of sovereignty to constituent political subdivisions; the United States of America is a politically integrated region with a constitution, governed by a presidential-congressional polity, and organized as a federal system with centralized fiscal (including taxation and spending) and monetary policy powers; the “eurozone” (twelve of the current fifteen member states of the European Union) has a super-national monetary authority (the European Central Bank) that coordinates monetary policy among the central banks of the eurozone member states, a parliamentary assembly, a high court, and a “commission” that oversees regulatory harmonization, but it has yet to achieve full political integration that would enable either coordinated or centralized fiscal policy; with the approval of a constitution, the EU seems to be moving toward becoming a federal political entity.

polity, the political system in place in a region or nation state.

price index, an expression of the price of an item or a collection of items in one period as a proportion of the price of the same item or collection in another period, referred to as the base period.

private goods, goods produced in a market economy in response to market price and profit signals, and which have prices low enough that individual members of society can purchase them and secure them for their exclusive use.

producer sovereignty; the ability of the management of a company with sufficient monopoly power to impose its product-mix will on consumers by first deciding what they wish to produce, and then through manipulative marketing efforts attempt to convince consumers to want those products.

production, the transformation of elemental inputs into more complex products or services that meet human needs and are demanded by members of society; the central function of the commercial enterprise; broadly construed, production includes all functions associated with extraction, processing, assembly, packaging, and distribution; it also encompasses the provision of services.

productivity, the relationship between the physical outputs of production processes and the physical inputs used to produce the outputs; productivity is increased when the quantity of output that can be produced by given amounts of inputs into the production process increases; economic productivity increases when the ratio of the value of output to the costs of inputs increases, whether the numerator of the ratio increases or the denominator decreases.

product life cycle, the stages through which a product passes while it is still in production; production is initiated typically in the producer’s home country to allow close contact with design and production technical expertise; the product initially is sold in the domestic market and may be exported to foreign markets; as the product becomes standardized, production may be shifted to affiliates in lower-cost foreign locales, most likely in other industrialized countries with large domestic and export markets so that scale economies can be exploited; with further standardization of the product and production processes, local firms in the host markets may imitate the product and begin to export the product back to the originating country where production has declined; the product life cycle may come to an end when technological advances render the product obsolete or when the demand for the product ceases.

profit, the net difference between revenue and the total of all production costs, including both explicit (monetary) and implicit (psychic and opportunity) costs;  the return (or income) to an entrepreneur for achieving success in innovation and attendant risk assumption of risk; before the fact of innovation the expectation of profit serves as a motivation to assume risk; after the fact of innovation profit is a reward for the assumption of risk if the innovation is successful, but a negative profit (a loss) is a penalty for assumption of risk if the innovation is unsuccessful.

profit maximization, the behavioral premise usually taken by economists to govern the behavior of business decision makers.

program finance, the determination of the government’s budget to achieve program goals rather than to manipulate the government’s budget in the interest of macroeconomic stability.

progressive income taxation, the application of a progression of higher income tax rates to successively higher brackets of income; the social justification for progressive income taxation is “fairness,” i.e., the presumption that higher income recipients should pay more in taxes than lower income recipients; a macroeconomic feature of progressive income taxation is that it may serve as an automatic stabilizer of the economy.

protectionism, a political strategy to “level the playing field” by offsetting or neutralizing the cost or performance advantages enjoyed by foreign producers; protectionism is usually implemented by imposing tariffs, quotas, and other so-called non-tariff barriers (NTBs) upon the imports of foreign merchandise; special interest groups (a.k.a. “rent seekers”) typically lobby law-making bodies to impose protectionist trade restraints.

psychological expectations, the future anticipations of business managers that precipitate change at turning points of cyclical processes; negative psychological expectations about demand conditions or about the likely actions of government officials may precipitate the downturn at the peak of a business cycle; positive expectations of business managers may be instrumental in precipitating the upturn at the trough of a business cycle.

public choice, the analysis of whether any particular decision is most effectively taken in the private sector or in the public sector.

public debt, the cumulation of annual government budget deficits that have been financed by issuing bonds that have not yet been redeemed.

public goods, goods that are “large and lumpy” in the sense that they are of large-enough scale and cost that individual members of society are unlikely to be able to afford to purchase them alone; public goods are an example of a so-called “market failure”; public goods are not subject to the so-called “exclusion” principle, i.e., individuals cannot acquire the good and exclude others from its use; public goods are also not subject to the “more for me, less for you” principle, i.e., use by an individual leaves no less of the public good for others to use; public goods are not provided in response to market price and profit signals; a collective action is required by the society to finance and produce a public good or to commission its production by private sector producers; examples of public goods include streets and highways, water and sewer systems, ship ports and airports.

quantity index, an expression of the quantity of an item or a collection of items in one period as a proportion of the quantity of the same item or collection in another period, referred to as the base period.

quota, a form of trade restraint that imposes an absolute quantity limitation upon the volume of imports allowed to enter a nation; quotas generate no revenue to the government unless the government auctions licenses to import the allowable quota quantity to the highest bidders.

rational expectations decision maker (REDM), one who possesses high intelligence, a good understanding of "the way the world works," awareness (perceptivity) of what is going on, a long-enough time horizon (i.e., concern for what the future holds), and a drive to use all available information in forecasting future states; REDMs are not always right in their forecasts, but their forecast errors tend to be random rather than systematic; to the extent that their forecasts are accurate, REDMs can make decisions to take advantage of opportunities and avoid (or manage) risks.

rational expectations hypothesis, the theory that intelligent and perceptive economic decision makers do not simply extrapolate past behavior, but rather analyze, predict, and adjust their decision criteria;  the 2011 Nobel Prize in Economics was awarded to economists Thomas Sargent and Christopher Sims for their work during the 1970s and ‘80s in analyzing and modeling rational responses of society to macroeconomic changes, particularly interest rates.

real, a descriptive adjective that in economics means that adjustments have been made to nominal data values to eliminate the effects of inflation (or deflation) so that the real component of data change values can be examined.

real balance effect, predicated upon the assumptions that money is a normal good that is accumulated by normal people under conditions of diminishing marginal utility (decreasing additional satisfaction) , the tendency of people to increase their spending when they have accumulated enough money that the marginal utility of another unit of the money has fallen below the the marginal utility that would be enjoyed by spending the unit of money on some good or service; money is not a normal good to misers are reputed to accumulate money under conditions of increasing marginal utility (cf. George Eliot’s fictional character Silas Marner).

real demand for money, the nominal demand (the actual amount of money that people wish to hold) divided it by an index of the price level to eliminate the effects of inflation or deflation.

real interest rate, a nominal interest rate that has been adjusted to eliminate the effect of inflation by subtracting the rate of inflation from the nominal rate.

real wealth effect, the tendency of people to increase spending when their real wealth increases explicitly by accumulative processes, or when it increases implicitly due to a decrease of the nominal prices of goods and services that can be purchased with their wealth holdings.

received income, in the National Income and Product Accounts, Personal Income is derived by deducting a number of components of earned income (National Income) that are not received, and adding a number of items that are construed as not being earned; received income  has been smaller than earned income because more in social insurance taxes were collected than was distributed as transfer payments; during the mid-1970s the magnitudes of National Income and Personal Income were roughly equivalent, but by the end of the 1970s Personal Income regularly exceeded National Income, i.e., received income had become larger and has remained larger than earned income.

redistribution, the governmental policy that follows from a social or authoritarian judgment that the income or wealth of a society is inequitably distributed; redistribution policies in democratic polities are implemented by combining progressive income taxation with welfare safety nets; in authoritarian polities, redistribution may be implemented by confiscation of property from wealthier members of society and allocation to poorer members of society, as in a land reform process; nationalization of foreign-owned assets, with or without sufficient compensation, may be a part of a redistribution program.

required reserve ratio, the proportion of outstanding deposit liabilities that a commercial bank is required to maintain in the form of very liquid assets (usually vault cash and government bonds); in the U.S. the required reserve ratio usually ranges between 7 and 12 percent of a bank’s outstanding deposit liabilities, depending upon the size of the bank; the required reserve ratio may be changed by the central bank in implementing monetary policy, but this has become a rare occurrence in the US due to the amplified effects of a reserve ratio change on the volume of bank deposits.

return, the income to a productive resource; nineteenth century economists designated the return to labor as “wage,” the return to capital as “interest,” and the return to land as “rent”; modern economists also designate the return to successful entrepreneurship as “profit.”

risk, the variability in the possible outcomes of an event; risk may be measured as the standard deviation of the values of the possible outcomes; risk may be diminished by gaining additional information about the possible outcomes; risk may be managed in a number of ways, including diversification, scheduling activities, and purchasing insurance; assumption of risk that cannot be managed is the essence of entrepreneurial behavior; most business managers are thought to be typically risk averse.

safety net, a government welfare program intended to put a “floor” under the well-being of the lower-income members of its society.

satisficing, to achieve an adequate level of performance rather than the maximum possible; term coined by economist/psychologist Herbert Simon to describe the behavior of many real-world business decision makers; an example of satisficing behavior is to pursue a target rate of return on invested capital.

saving, Personal Saving in the National Income and Product Accounts, is the residual from deducting Personal Consumption Expenditures from Disposable Personal Income; Personal Saving has been decreasing in the U.S. economy during the early years of the twenty-first century, both in absolute terms and as a proportion of Personal Disposable Income; in the U.S. during the early years of the twenty-first century there is a saving deficit since saving is less than net investment.

saving deficit, typical for the U.S. economy in the early twenty-first century, business investment exceeds the sum of household and business saving; an investment surplus can be regarded as a saving deficit.

Say’s Law of Markets, a nineteenth century idea advanced by French economist John Baptiste Say that acts of production incurred costs that became incomes to the producers when the products were sold; a crude form of Say’s Law is that "supply creates its own demand"; a more reasoned version is that every act of production for the market is implicitly a demand for something from the market; productive activity in the aggregate should yield enough total demand capacity to clear all markets.

secular stagnation, a continuing condition of aggregate demand increasing more slowly than the natural rate of real output in the economy, accompanied by a tendency toward chronic deflation.

self-equilibrating process, in microeconomic theory, the inventory adjustment process by which differences between quantity demanded and quantity supplied of a product at the current product price motivates producers to adjust product price and/or output level until an equivalence of quantities demand and supplied is achieved; in macroeconomic theory, the adjustment process that motivates producers to increase or decrease the aggregate output level to the current level of aggregate spending on output so as to alleviate inventory accumulation or depletion.

self-interest, the orientation of individual humans to protect themselves and enhance their own welfare by acquiring consumable goods and durable assets.

services, activities without tangible characteristics in themselves and with short lives that expire when their benefits are immediately consumed; examples include repair services and personal services such as haircuts and pedicures.

shock absorber, in macroeconomic theory, the features of the economy that may tend to dampen the amplitude and duration of economic disturbances; examples include inventory variability and exchange rate flexibility.

social goods, goods that entail positive externalities not recognized by markets; an example of a so-called “market failure” because markets tend to under-allocate resources to the production of social goods; governments often attempt to correct for the under-allocation of resources to social goods by subsidizing the production or consumption of them.

socialism, authoritarian, a form of economic organization in which the means of production are owned by the state and authority to determine product mix, means of production, allocation of resources, and distribution of product are vested in a state planning authority.

specialization, the determination of the identity of the appropriate good or service to be produced in a region based upon the criterion of comparative advantage.

speculation, deliberately assuming risk in an uncovered or open position in the forward exchange market in hope of a favorable exchange rate change; if their predictions are right, speculators will gain; if not they will lose; successful speculation may facilitate foreign exchange market adjustment toward a new equilibrium; unsuccessful speculation may destabilize the foreign exchange market.

spillovers, a.k.a. “externalities,” a so-called “market failure” consisting of positive and negative side-effects of consumption or production activity that impinge upon innocent by-standers to market transactions and thus are not recognized by markets; negative spillovers resulting from the production or consumption of a good result in the market over-allocating resources to production of the good; positive spillovers resulting from the production or consumption of a good result in the market under-allocating resources to production of the good; examples of positive spillovers include the benefits of public health care and public education; examples of negative spillovers include various kinds of environmental pollution.

spot exchange trading, exchange rate transactions for immediate (or next day) delivery.

stagflation, the combination of increasing inflation, falling output, and rising unemployment resulting from decreases of short-run aggregate supply relative to aggregate demand; stagflation may result after a bout of elevated inflation as unemployment increases faster than the price level falls (a failure of the reputed Phillips Curve inflation-unemployment trade-off); some economists have attributed stagflation to increasing governmental regulation of economic activity.

state sovereignty, the authority and power of a political entity to do whatever it wills to do with the resources contained within its boundaries, including the human resources of its population; in authoritarian economies, state sovereignty entails the power to determine product mix, methods of production, resource allocation, and output distribution.

sticky wages and prices, the idea advanced by John Maynard Keynes in The General Theory of Employment, Interest, and Money, 1936, that wages and prices were asymmetrically flexible because monopolistic business interests in product markets and monopolistic unions in labor markets resisted decreases of wages and prices, but could be counted upon to push for higher wages and prices upon any excuse to do so; this downward inflexibility of prices and wages, referred to as “sticky” by Keynes, meant

that oversaving could occur, and that, contrary to Say's Law, a "general glut" was possible.

structural unemployment, the portion of the labor force that is out of work due to shifts of demand away from products produced by the unemployed workers, or advances of technology that render existing skills obsolete; a rising level of structural unemployment may be indicative of the dynamism of an economy.

subsidy, a payment by a government to a private-sector productive unit to offset some portion of the costs of production as an encouragement to increase the volume of production; a subsidy may be paid to consumers to offset some portion of the price of an item the consumption of which the government wishes to encourage; subsidies to domestic producers can be a form of protectionism in the sense that they offset or neutralize the competitive advantages of foreign producers.

supply shock, an unexpected phenomenon that precipitates a short-run output response in an economy; usually represented in macroeconomic analysis as a change (shift) of short-run aggregate supply; although supply shocks may be positive in the sense of increasing short-run aggregate supply, most supply shocks have negative implications of decreasing output below the normal operating capacity of the economy and causing unemployment and inflation; negative supply shocks often are caused by natural phenomena such as tornados, hurricanes, volcanic eruptions, tsunamis, etc.; modern macroeconomic analysis perceives that market economies tend to recover naturally from such supply shocks if given enough time; macroeconomic policy directed at alleviating supply shocks may help an economy to recover more quickly to normal output and employment levels, but often with undesired side effects in the form of inflation or deflation.

supply of bonds, the total of liability claims issued by corporations seeking funds to finance investments and by governments needing to finance budget deficits that is offered on bond markets; the supply reaching the market may include both previously issued and newly issued bonds; a change of the supply of bonds relative to the demand for bonds will cause bond prices to change, and correspondingly their yield rates (interest rates) to change.

supply of loanable funds, the sum of household sector savings, undistributed corporate profits inj the business sector (i.e., business savings), government budget surpluses that are used to retire debt, and bank issued credit; a change of the supply of loanable funds relative to the demand for loanable funds will cause the interest rate to change.

tariff, a form of tax imposed upon merchandise that moves across national boundaries; tariffs usually are imposed upon imports into a nation, but some nations that export large quantities of raw materials (agricultural, mineral, or petroleum products) also impose tariffs on exports; tariffs may be imposed by a government to raise revenue or to protect its domestic industry from competition by foreign producers; given elasticities of demand for and supply of imports, there is an optimal tariff that maximizes the tariff revenue; a protectionist tariff usually is higher than a revenue tariff, and often high enough to choke off all imports; a protectionist tariff often elicits reciprocal imposition of  tariffs by trading partners.

technological advance, discovery or development of new ways of making a material good or improving the function or quality of the good.

technology, the known ways of making a material good or providing a service; primitive technology is the most basic method of doing something and using the most rudimentary tools, often of wood, stone, or shell construction, and powered by humans, animals, or water; advanced technology is the most recent or most efficient or most productive technology available, employing steel or other metals and alloys as well as complex chemicals, and powered by electricity, combustion of fossil fuels, or nuclear fission.

third-world country, a now archaic term that refers to low-income countries using primitive technologies, and typically relying on one or a few crops or mineral resources for income at or near a subsistence level; the term originally accompanied “first world” which referred to the high-income democratic, industrial, market economies of the West that develop and use advanced technologies, and the “second world” which referred to the authoritarian socialist countries of Eastern Europe (the Soviet Union and its satellites); the failure of the Soviet Union in the 1990s has rendered “second world” irrelevant as the Russian Republic and many of the former satellite countries of Eastern Europe are in the process of becoming “first world” countries; contemporary and more politically correct terms are “low-income countries’, “poor countries,” and “developing economies.”

time series, a list of sequential numeric values (data) describing a phenomenon over a period of time; to be distinguished from cross-sectional data  describing a phenomenon, but for a number of constituent entities at a point in time.

time series decomposition, the statistical process of separating out the component elements of a time series, usually identified as trend, cyclical, seasonal, and irregular variations.

trade balance, the difference between a nation’s total exports and its total imports of goods and services during an accounting period; the trade balance is said to be in surplus if exports exceed imports, or to be in deficit if imports exceed exports.

trade restraint, a form of protectionist government policy intended to limit the importation of foreign merchandise that competes with domestically-produced merchandise; domestic producers typically lobby law-making bodies to impose trade restraints.

transfer payment, a unilateral payment (i.e., there is no counter flow of value) by government to a member of society that has the effect of relieving some undesirable condition; transfer payments and subsidies are conceptual opposites of taxes.

underconsumption, a concept that appeared in T. R. Malthus’  1820 Principles of Political Economy; Malthus was concerned that inadequate spending by a society might result in a "glut" of commodities across markets generally; a variant of the notion, oversaving, became a centerpiece of Keynes' General Theory that was published in 1936.

unemployment compensation, government transfer payment to a member of the labor force who has become involuntarily unemployed; unemployment compensation benefits may be set at some proportion of the unemployed worker’s last income level, and eligibility may be for a stipulated number of weeks; an unemployment compensation system also can act as an automatic stabilizer of macroeconomic activity.

unilateral transfer, a one-way transfer of value with no corresponding counter transfer of value; in distinction to a quid pro quo two-way exchange of values; examples of unilateral transfers include gifts, charitable contributions, church contribution, foreign aid.

uniquity, a resource that is available in a single economic region; distinguished from a ubiquity, a resource that is commonly available everywhere.

vicious circle of causation, a condition that prevents improvement because of the lack of lack of enabling conditions that are missing due to lack of previous improvements; a so-called vicious circle of poverty turns upon the scarcity of capital that ensures low labor productivity; low productivity enables only meager wages; incomes that are near (or below) the threshold of subsistence needs limit the capacity of the society to save; little endogenous saving limits the investment potential of the society; inadequate investment ensures that capital will remain scarce; the opposite, a virtuous circle of causation, would result in accelerating approach to a desirable outcome.

wage, the return (or income) to labor, the human factor of production; to be distinguished from rent, interest, and profit income.

warranted rate of growth, the non-inflationary rate of economic growth of an economy hypothesized by economist Roy Harrod; may be estimated by computing the ratio of the economy’s marginal propensity to save to its marginal capital-output ratio (the amount of additional capital needed to produce specified output increase).

wealth, material things of value and financial instruments that are accumulated and held in ownership by humans; wealth-holdings are increased when some portion of earned income is diverted from consumption spending to purchase assets such as houses and real estate; “real wealth” is increased by investment in capital that enhances productive capacity; “financial wealth” is said to be “created” by earned interest, asset value appreciation, and market trading that takes advantage of price differentials; an individual may include both real and financial wealth in his or her personal balance sheet, but including both real wealth and financial wealth in a national or global accounting of wealth would entail double counting since financial wealth is only a claim on real wealth.

xenophobia, the fear and hatred of foreigners.

yield rate, on a financial instrument, the ratio of the coupon return (if any) plus the appreciation in the value of the financial instrument between the time that it is purchased and the time that it is sold or matures to the purchase price; a yield rate on a financial instrument is understood to be the interest rate on the financial instrument; yield rates vary inversely with the prices of financial instruments; a change of the yield rate on a financial instrument in one financial market becomes transmitted to interest rates in other financial markets through the process of arbitrage.