Economist's View

"The New Kaldor Facts"

What does growth theory need to explain? Has there been progress?:

The New Kaldor Facts: Ideas, Institutions, Population, and Human Capital, by Charles I. Jones and Paul M. Romer, NBER WP 15094, June 2009 [open link]: 1. Introduction ...[I]t is easy to lose faith in scientific progress. ... In any assessment of progress, as in any analysis of macroeconomic variables, a long-run perspective helps us look past the short-run fluctuations and see the underlying trend. In 1961, Nicolas Kaldor stated six now famous “stylized” facts. He used them to summarize what economists had learned from their analysis of 20th-century growth and also to frame the research agenda going forward (Kaldor, 1961):

1. Labor productivity has grown at a sustained rate.
2. Capital per worker has also grown at a sustained rate.
3. The real interest rate or return on capital has been stable.
4. The ratio of capital to output has also been stable.
5. Capital and labor have captured stable shares of national income.
6. Among the fast growing countries of the world, there is an appreciable variation in the rate of growth “of the order of 2–5 percent.”

Redoing this exercise nearly 50 years later shows just how much progress we have made. Kaldor’s first five facts have moved from research papers to textbooks. There is no longer any interesting debate about the features that a model must contain to explain them. These features are embodied in one of the great successes of growth theory in the 1950s and 1960s, the neoclassical growth model. Today, researchers are now grappling with Kaldor’s sixth fact and have moved on to several others that we list below.

"The Paradox of Declining Female Happiness"

Why has women's happiness declined relative to men's?:

The Paradox of Declining Female Happiness, by Betsey Stevenson and Justin Wolfers, NBER Working Paper No. 14969, May 2009 [open link]: Abstract By many objective measures the lives of women in the United States have improved over the past 35 years, yet we show that measures of subjective well-being indicate that women’s happiness has declined both absolutely and relative to men. The paradox of women’s declining relative well-being is found across various datasets, measures of subjective well-being, and is pervasive across demographic groups and industrialized countries. Relative declines in female happiness have eroded a gender gap in happiness in which women in the 1970s typically reported higher subjective well-being than did men. These declines have continued and a new gender gap is emerging—one with higher subjective well-being for men.

Inequality and Residential Segregation

According to this research, inequality raises residential segregation. This is worrisome in part because the increase in segregation can cause problems that feedback to both amplify and perpetuate the inequality:

Inequality and the Measurement of Residential Segregation by Income In American Neighborhoods, by Tara Watson,  NBER Working Paper No. 14908, April 2009: Abstract American metropolitan areas have experienced rising residential segregation by income since 1970. One potential explanation for this change is growing income inequality. However, measures of residential sorting are typically mechanically related to the income distribution, making it difficult to identify the impact of inequality on residential choice. This paper presents a measure of residential segregation by income, the Centile Gap Index (CGI) which is based on income percentiles. Using the CGI, I find that a one standard deviation increase in income inequality raises residential segregation by income by 0.4-0.9 standard deviations. Inequality at the top of the distribution is associated with more segregation of the rich, while inequality at the bottom and declines in labor demand for less-skilled men are associated with residential isolation of the poor. Inequality can fully explain the rise in income segregation between 1970 and 2000. ...

Do Changes in Consumer Confidence Reflect Animal Spirits or Information?

There are two views of changes in consumer confidence, the animal spirits view where causality runs from changes in confidence to changes in economic activity, and the information view where changes in confidence are due to the arrival of new information about future productivity. Suppose, for example, that agents in the economy are able to observe information about future productivity, but the econometrician cannot. In this case, when new information about future output arrives, confidence will change. However, since the econometrician cannot see the information about future output, and instead only sees changes in confidence followed by changes in changes in real activity, if the information view is not considered, then the econometrician will wrongly conclude that animal spirits cause future economic activity. Ultimately, however, which view is correct - the animal spirits view, the information view, or something else entirely - is an empirical question. Here's an attempt to settle it:

Information, Animal Spirits, and the Meaning of Innovations in Consumer Confidence, by Robert B. Barsky and Eric R. Sims: Abstract Innovations to measures of consumer confidence convey incremental information about economic activity far into the future. Comparing the shapes of impulse responses to confidence innovations in the data with the predictions of a calibrated New Keynesian model, we find little evidence of a strong causal channel from autonomous movements in sentiment to economic outcomes (the "animal spirits" interpretation). Rather, these impulse responses support an alternative hypothesis that the surprise movements in confidence reflect information about future economic prospects (the "information" view). Confidence innovations are best characterized as noisy measures of changes in expected productivity growth over a relatively long horizon.

I. Introduction

In the popular press and much of the business community it continues to be an article of faith that "consumer confidence" has an important role – both prognostic and causal – in macroeconomics. On the other hand, the stance of the rather limited academic literature on confidence is far more ambiguous. The judgments range from the conclusion that confidence measures have an important role both in prediction and understanding the cause of business cycles, to the view that they contain important information but have little role in the assignment of causality, to the verdict that they have no value even in forecasting.

There are, broadly speaking, two contrasting approaches to the role of confidence in macroeconomics.

Short-Sighted?

According to this research, welfare reform caused adult women to reduce their education:

Welfare reform undermined, Free Exchange: Getting poor mothers off welfare and into employment as quickly as possible seems to be a useful policy goal. But a new paper by economists Dhaval Dave, Nancy E Reichman, and Hope Corman suggests it can be short-sighted.

The Personal Responsibility and Work Opportunity Reconciliation Act of 1996 limited the time mothers could spend on welfare and required some work as a condition for receiving it. The reforms were, by most measures, successful at reducing the number of women on welfare and increasing their levels of employment. ... But..., the authors ... found that the reforms made adult women less likely to pursue education.

The reforms do not penalise minor (under 18) women who still attend school. Actually, the reforms encourage the younger women to finish their education. To receive some of the government funds, single, minor mothers must attend high school or some training program. The authors found this incentive decreased the teen dropout rates of the population between 9 and 13%.

By contrast, the reforms aimed at adult women, which promoted work and not training, made education less attractive. The authors found the reforms decreased the probability of adult women attending high school or college by 20 to 25%.

The number of welfare claims unambiguously decreased, but at what cost? More education increases the value of your human capital which leads to higher wages and more self-sufficiency. The authors wonder if discouraging education might ultimately leave the women more dependent on state benefits than they would if education were encouraged. The trade-off is a classic example of the choice of short-term gain and long-term pain.

Krugman: The International Finance Multiplier

Paul Krugman develops an "international finance multiplier" that works through key leveraged intermediaries that connect countries together financially. His model shows that under capitalization, not liquidity is the main problem to be solved, and that "there are large cross-border externalities in financial rescues":

1. The International Finance Multiplier, Paul Krugman, October 2008: 1. Introduction The current financial crisis is remarkable in many ways, but one aspect is of special interest for international economists: even though the roots of the crisis lie in the U.S. housing market, the crisis is now very much a global affair. Figure 1 shows the decline in a number of stock market indices over the year ending October 4, 2008; essentially, all markets fell by the same amount.

The freeze on interbank lending and in the commercial paper market is affecting Europe to much the same degree that it’s affecting the United States, with the gap between Euribor and the repo rate similar to that between Libor and the Fed funds rate. Banks are failing, or needing urgent government rescue, on both sides of the Atlantic.

International economists have been interested in interdependence for a very long time – arguably too interested. Global interdependence is one of those topics people love to talk about because it sounds sophisticated – the Wall Street Journal once published a piece mocking Multilateral Man, who wants to cooperate to improve coordination and coordinate to improve cooperation. (This is as opposed to Euro Man, who wants cohesion to promote convergence …)

But the interdependence this time is real – and it seems to be operating through channels that are not yet part of standard international macro analysis. Much thinking about international linkages still relies on some version of the traditional foreign trade multiplier: country A’s GDP affects its level of imports, which are country B’s exports, so demand shocks get transmitted through international trade. As I’ll explain shortly, however, this won’t work for current events. Instead we seem to be dealing with a phenomenon I’ll call the international finance multiplier, in which changes in asset prices are transmitted internationally through their effects on the balance sheets of highly leveraged financial institutions. ...

Before we get there, however, let’s review the traditional analysis of interdependence.

"Distributional Effects of Environmental and Energy Policy: An Introduction"

Is it true that many of the effects of environmental policy are likely regressive? According to this, the answer is yes, but rebates to low-income households can offset the regressive effects. "This makes it important to use emissions taxes or the auction of permits, to raise revenue enough to cover the cost of those rebates":

Distributional Effects of Environmental and Energy Policy: An Introduction, by Don Fullerton, NBER Working Paper No. 14241 August 2008: Public economics has well developed tools for analyzing the incidence and distributional effects of ... taxes. ... Yet most pollution policy does not involve taxation at all. Instead, it employs permits or command and control (CAC) regulations such as technology standards, quotas, and other quantity constraints. ...

CAC environmental restrictions do impose costs, and an important question is who bears those costs. Moreover, those restrictions provide benefits of environmental protection, and another important question is who gets those benefits. Thus, full analysis of environmental policy could address all the same questions as in the tax incidence literature. ...

This introduction discusses some initial literature on distributional effects of environmental and energy policy. ... To identify the major effects around which this introduction is organized, consider a simple requirement that electric generating companies cut a particular pollutant to less than some maximum quota. This type of mandate is a common policy choice, and it has at least the following six distributional effects.

"That Chain E-mail Your Friend Sent to You Is (Likely) Bogus"

I get lots of questions on the claims made about economic issues in chain email pertaining to the election, and from what I've heard and from the evidence noted below, the email seems to mostly target Democrats.

I've been wondering about their effectiveness. Most of the time the claims are false or highly misleading, yet from casual observation they seem to work (don't take my word that they are mostly false, see "That Chain E-mail Your Friend Sent to You Is (Likely) Bogus. Seriously." Note that this also says "We have yet to see e-mails about John McCain, and Emery notes a decidedly anti-Democrat tilt to the bulk of the e-mail chatter.").

I don't know of any formal studies about the effectiveness of chain email (anyone?), but I did come across this NBER study of snail mail indicating that direct messaging does impact voter preferences (note, however, a point from the conclusion that the recipients of the mail were pre-selected based upon the likelihood they might be the type of voter who would change their minds, so the effect on a randomly selected voter would be smaller):

The Persuasive Effects of Direct Mail: A Regression Discontinuity Approach, by Alan Gerber, Daniel Kessler, and Marc Meredith, NBER WP 14206, July 2008 [Open Link]: 1. Introduction ...In this paper, we use a regression discontinuity (RD) approach to identify the effects on campaign activity on turnout and vote share. ... During the contest for Kansas attorney general in 2006, an organization sent out 6 pieces of mail criticizing the Republican incumbent’s conduct in office. We obtained a complete record of which households received the mailings as well as the algorithm used to select the households ... that received the mail. ... We exploit our knowledge of the selection rule to isolate a discontinuity in the targeting algorithm which resulted in substantially different amounts of mail in otherwise similar precincts. ... We find that the 6 piece mail campaign had no effect on turnout but caused a sizable increase in the vote share of the Democratic challenger. ...

7. Conclusion ...Our estimates suggest that a ten percentage point increase in the amount of mail sent to a precinct increased the Democratic challenger’s vote share by about three percentage points. Furthermore, we find no evidence that these mailings affected turnout. As a result, we conclude that these mailings persuaded individuals who were already going to turnout to switch...

These effects are quite large. ... There is only limited evidence on the persuasive effects of direct mail campaigns, but previous studies find much smaller effects... A number of factors might account for this difference. ...[T]he particular race we study is a down-ballot race; it was not the primary race mobilizing voters to the polls. Direct mail likely has a larger potential effect in such environment than in a presidential race where voters are much better informed about the issues. Third, the ... treatment effect we estimate only applies to so-called "mail eligible" voters -- namely, those who were predetermined by the vendor to be particularly susceptible to persuasion; mail almost surely would be less effective in the population at large. ...

Better informed in a presidential race? That brings us back to the chain email. Where does this email come from, and why is it so one-sided? Is it an organized effort? The email is under the radar for the most part, a somewhat silent, continuous stream of lies that flows into who knows how many inboxes every day - at best it is highly misleading information (again, see the link above) - information that is rarely rebutted effectively within the same information networks, and I wonder what impact it has on the spread of effective narratives and, ultimately, on votes.

Update: From a link provided in comments, more here:

The e-mail landed in Danielle Allen's queue one winter morning as she was studying in her office at the Institute for Advanced Study, the renowned haven for some of the nation's most brilliant minds. The missive began: "THIS DEFINITELY WARRANTS LOOKING INTO."

Laid out before Allen, a razor-sharp, 36-year-old political theorist, was what purported to be a biographical sketch of Barack Obama that has become one of the most effective -- and baseless -- Internet attacks of the 2008 presidential season. The anonymous chain e-mail makes the false claim that Obama is concealing a radical Islamic background. By the time it reached Allen on Jan. 11, 2008, it had spread with viral efficiency for more than a year.

During that time, polls show the number of voters who mistakenly believe Obama is a Muslim rose -- from 8 percent to 13 percent between November 2007 and March 2008. And some cited this religious mis-affiliation when explaining their primary votes against him. ...

Allen studies the way voters in a democracy gather their information and act on what they learn. She was familiar, of course, with the false rumors of a secret love child that helped sink McCain's White House bid in 2000, and the Swift boat attacks that did the same to Democrat John Kerry in 2004. But the Obama e-mail was on another plane: The use of the Internet made it possible to launch anonymous attacks that could reach millions of voters in weeks or even days. ...

Allen set her sights on dissecting the modern version of a whisper campaign, even though experts told her it would be impossible to trace the chain e-mail to its origin. Along the way, even as her hunt grew cold, she gained valuable insight into the way political information circulates, mutates and sometimes devastates in the digital age. ...

"The 'Big Push' and Economic Development in the American South"

David Beckworth on evidence for The Big Push theory of economic development, the idea that "publicly coordinated investment can break the underdevelopment trap by helping economies overcome deficiencies in private incentives that prevent firms from adopting modern production techniques and achieving scale economies." Given recent debate over using infrastructure spending as a means of stimulating the economy, the long-run supply-side effects of stimulating the economy through spending on infrastructure are noteworthy:

The 'Big Push' and Economic Devlopment in the American South, by David Beckworth: One of the great stories from 20th century U.S. economic history is the great economic rebound of the American South. From the close of the Civil War up through World War II, this region’s economy had been relatively undeveloped and isolated from the rest of the country. This eighty-year period of economic backwardness in the South stood in stark contrast to the economic gains elsewhere in the country that made the United States the leading industrial power of the world by the early 20th century. Something radically changed, though, in the 1930s and 1940s that broke the South free from its poverty trap. From this period on, the South began modernizing and by 1980 it had converged with the rest of the U.S. economy. But why the sudden break in the 1930-1940 period? A new paper by Fred Bateman, Jaime Ros, and Jason E. Taylor provides a fascinating answer: the economic rebound of American South was the result of a 'Big Push' from large public capital investments during the Great Depression and World War II.

A novel contribution of this paper is that it appears to provide a real-world example of the 'Big Push' theory. Never heard of the 'Big Push' theory? Well, here is how the authors describe it:

"Housing Supply and Housing Bubbles"

Edward Glaeser, Joseph Gyourko, and Albert Saiz construct a model of housing bubbles that is consistent with movements in housing prices and quantities during the two most recent housing bubbles (the current episode and the prior episode in the 1980s). Looking at the data, they note that areas with inelastic housing supply had large price run-ups and subsequent long, drawn out crashes in both episodes. However, "The fact that highly elastic places had price booms is one of the strange facts about the recent price explosion." Because it is unprecedented, there is considerable uncertainty about how much prices might fall in the areas where supply is elastic. However, using the model as a guide, they find that "If these markets return to their historical norm..., then they will experience further sharp price declines," though there is a lot of uncertainty surrounding this prediction.

Maybe another way to think about this is that in some areas, those areas where supply is termed inelastic, the quantity response is essentially symmetric -- housing supply moves sluggishly whether prices are rising or falling. However, other areas could have housing supply that responds elastically when prices are rising (though sometimes there can be bubbles in these markets anyway - see below), but inelastically when prices are falling. In these markets, housing comes online relatively easily when prices are rising, but quantity responds much more sluggishly when prices fall, and the response could be similar to the symmetrically inelastic cases.

Why might the two sets of markets have similar responses on the down-side? Think about the inelastic markets where supply cannot increase due to geographic limitations (they use a geographic measure to sort the data). Geography limits the expansion of housing, but when there is an oversupply of housing, geography does not prevent the supply from falling, so it must be something else that prevents quantity adjustment and whatever it is could certainly be present in markets where geography is not an issue  (i.e. the markets that are elastic when prices rise). If this is right, then there's reason to believe that the two sets of markets will generate similar responses for price and quantity on the down-side, and this would explain the finding in the paper that "elasticity was uncorrelated with either price or quantity changes during the bust" (so long as other factors such as regulation are similar, e.g., it's equally easy to replace a house with a restaurant after remodeling in the two markets). This would mean that - as predicted (with qualifications) in the paper - the elastic markets may mimic the inelastic markets and be in for a sharp price decline.

One more note from the paper about elastic markets, "Even though elastic housing supply mutes the price impacts of housing bubbles, the social welfare losses of housing bubbles may be higher in more elastic areas, since there will be more overbuilding during the bubble." Thus, it's possible for markets with sharp price adjustments to fare better in a welfare sense than markets where price changes are more muted. Here's some of the introduction from the paper [can anyone find an open link?] [Update: Richard Green: Mark Thoma thinks housing supply elasticities may be asymmetric ... I have reason to think Mark is right. My 2005 paper with Mayo and Malpezzi found evidence of this; cities that appeared inelastic included Pittsburgh, Toledo, Albany, Buffalo and Providence. None of these cities had upward pressure on housing production; rather, they were losing population and the housing stock took a long time to adjust to the loss.]:

Housing Supply and Housing Bubbles, by Edward L. Glaeser, Joseph Gyourko, and Albert Saiz, NBER WP 14193, July 2008: Introduction In the 25 years since Shiller (1981) documented that swings in stock prices were extremely high relative to changes in dividends, a growing body of papers has suggested that asset price movements reflect irrational exuberance as well as fundamentals (DeLong et al., 1990; Barberis et al., 2001). A running theme of these papers is that high transactions costs and limits on short-selling make it more likely that prices will diverge from fundamentals. In housing markets, transactions costs are higher and short-selling is more difficult than in almost any other asset market (e.g., Linneman, 1986; Wallace and Meese, 1994; Rosenthal, 1989). Thus, we should not be surprised that the predictability of housing price changes (Case and Shiller, 1989) and seemingly large deviations between housing prices and fundamentals create few opportunities for arbitrage.

The extraordinary nature of the recent boom in housing markets has piqued interest in this issue, with some claiming there was a bubble (e.g., Shiller, 2005). While nonlinearities in the discounting of rents could lead prices to respond sharply to changes in interest rates in particular in certain markets (Himmelberg et al., 2005), it remains difficult to explain the large changes in housing prices over time with changes in incomes, amenities or interest rates (Glaeser and Gyourko, 2006). It certainly is hard to know whether house prices in 1996 were too low or whether values in 2005 were too high, but it is harder still to explain the rapid rise and fall of housing prices with a purely rational model.

However, the asset pricing literature long ago showed how difficult it is to confirm the presence of a bubble (e.g., Flood and Hodrick, 1990). Our focus here is not on developing such a test, but on examining the nature of bubbles, should they exist, in housing markets.

"Immigration and National Wages: Clarifying the Theory and the Empirics"

Gianmarco I.P. Ottaviano and Giovanni Peri on immigration and wages:

Immigration and National Wages: Clarifying the Theory and the Empirics, Gianmarco I.P. Ottaviano, Giovanni Peri. NBER WP No. 14188,
Issued in July 2008 [open link]: Abstract This paper estimates the effects of immigration on wages of native workers at the national U.S. level. Following Borjas (2003) we focus on national labor markets for workers of different skills and we enrich his methodology and refine previous estimates. We emphasize that a production function framework is needed to combine workers of different skills in order to evaluate the competition as well as cross-skill complementary effects of immigrants on wages. We also emphasize the importance (and estimate the value) of the elasticity of substitution between workers with at most a high school degree and those without one. Since the two groups turn out to be close substitutes, this strongly dilutes the effects of competition between immigrants and workers with no degree. We then estimate the substitutability between natives and immigrants and we find a small but significant degree of imperfect substitution which further decreases the competitive effect of immigrants. Finally, we account for the short run and long run adjustment of capital in response to immigration. Using our estimates and Census data we find that immigration (1990-2006) had small negative effects in the short run on native workers with no high school degree (-0.7%) and on average wages (-0.4%) while it had small positive effects on native workers with no high school degree (+0.3%) and on average native wages (+0.6%) in the long run. These results are perfectly in line with the estimated aggregate elasticities in the labor literature since Katz and Murphy (1992). We also find a wage effect of new immigrants on previous immigrants in the order of negative 6%.

Real-Time Assessment of the Economy

Ben Bernanke gave a speech today at a Boston Fed conference on inflation and the Phillip's curve. Part of the speech discusses the difficulties with real-time policymaking, and those remarks are repeated below. To complement the discussion, I also included an academic paper by S. Boragan Aruoba, Francis X. Diebold, and Chiara Scotti that develops "a framework for high-frequency business conditions assessment" that is an attempt to provide a solution to this problem. The paper is, essentially, a call to action on this problem and it attempts to lead the way by providing the methodology for obtaining real time assessments of economic conditions, and by providing an illustrative example (see the graph below). This is probably geekier than I realize:

Outstanding Issues in the Analysis of Inflation, by Ben S. Bernanke, FRB: ...Forecasting and controlling inflation are, of course, central to the process of making monetary policy. In this respect, policymakers are fortunate to be able to build on an intellectual foundation provided by extensive research and practical experience. Nonetheless, much remains to be learned about both inflation forecasting and inflation control. In the spirit of this conference, my remarks this evening will highlight some key areas where additional research could help to provide a still-firmer foundation for monetary policymaking.

...I will briefly touch on four topics of particular interest for policymakers:  commodity prices and inflation, the role of labor costs in the price-setting process, issues arising from the necessity of making policy in real time, and the determinants and effects of changes in inflation expectations. ...

"Macroeconomic Theory For a World of Imperfect Knowledge"

This paper by Roman Frydman and Michael Goldberg

Macroeconomic Theory For a World of Imperfect Knowledge, by Roman Frydman and Michael D. Goldberg

extends and further explains the arguments in their book, Imperfect Knowledge Economics: Exchange Rates and Risk. More particularly, the paper looks at problems that arise in contemporary macroeconomic models when the causal mechanism that underpins change is fully specified in advance (i.e., when it is assumed that the economy can only change in unforeseeable ways). The approach in the paper is intended to surmount these difficulties, and to show how allowing for unforeseeable events may give economists new insight into areas such how risk fluctuates over time in financial markets.

Here's one small part of the paper:

Modern macroeconomics constructs models of aggregate outcomes on the basis of mathematical representations of individual decision making, with market participants’ forecasting behavior lying at the heart of the interaction between the two levels of analysis. Individuals’ forecasts play a key role in how they make decisions, and markets aggregate those decisions into prices. The causal mechanisms behind both individual decisions and aggregate outcomes, therefore, depend on market participants’ understanding of the economy and how they use this knowledge to forecast the future.

By focusing on the central role of forecasting for understanding the connection between micro and macro outcomes, economists have achieved important insights. For example, building on the path-breaking work of Phelps (1968, 1970), Lucas (1976) sharply criticized econometric policy analysis that, based on Keynesian aggregate models, examined the effects of changes in tax rates, money supply, or other “policy” variables on market outcomes. This analysis presumed that the same structure – the set of causal variables and the parameters that relate them to those variables – would continue to represent adequately the causal mechanism after a change in policy. The main point of the “Lucas critique” was the untenability of that premise. He argued that changes in policy variables would alter the way market participants forecast the future – and hence their decision-making. In general, this change on the individual level would also alter the causal mechanism driving market outcomes.

Lucas offered a seemingly straightforward remedy to this fundamental difficulty. He presumed that the Rational Expectations Hypothesis (REH) would enable economists to model exactly how policy changes would affect market participants’ forecasts and aggregate outcomes. REH postulates that the economist’s aggregate model precisely represents the causal mechanism driving individuals’ forecasts and their revisions. By constraining the predictions on the individual and aggregate levels to be one and the same, REH is thought to offer a “scientific” way to predict both the micro and macro effects of policy changes. In embracing REH-based models, economists have merely replaced Keynesian policy analysis with another mechanistic approach to evaluating the consequences of policy changes.

To be sure, the Lucas critique of Keynesian models does not depend on REH: it requires only that policy changes influence forecasting strategies significantly enough to alter the causal mechanism driving market outcomes. What has been largely overlooked, however, is that Lucas’s critical arguments point to a fundamental difficulty inherent in the entire modern research program in macroeconomics. After all, while policy changes undoubtedly play a role in market participants’ alteration of their forecasting strategies, so do many other factors.2

In fact, even if one were to limit the analysis solely to policy changes, the solution that Lucas proposes is facile: REH supposes that individuals revise their forecasting strategies in mechanical ways that can be precisely specified in advance. However, in capitalist economies, individuals are strongly motivated to search for genuinely new ways to forecast the future and deploy their resources. The social context, including the institutions within which individuals make decisions, also changes in unforeseeable ways. But when the social context or how market participants’ forecast future outcomes changes, so too does the causal mechanism underpinning market outcomes. Thus, change in capitalist economies is to a significant extent non-routine, for it does not follow pre-existing rules and procedures. The premise of IKE is that leaving macroeconomic models open to such change is crucial for understanding outcomes in real-world markets.

[The paper is fairly long, but even if you only make it through the first few pages you'll have a pretty good idea of what the paper is about.]

The Social Effects of Unexpected Income

People who believe consumption is driven, in part, by the consumption of neighbors and friends will like these results [open link]. The source of the data is:

the Dutch Postcode Lottery (PCL). Each week, this lottery allocates a prize to participants in a randomly chosen postcode (containing 19 households on average). About one third of the Dutch population participates in the lottery. A participant wins €12,500 per ticket. In addition, one of the participants wins a BMW. From an experimental design perspective, the lottery provides PCL participants in the winning code with an unexpected temporary income shock equal on average to about eight months of income, while leaving all other households’ incomes unchanged.

How does winning the lottery impact on consumption of neighbors?:

Turning to social effects, we detect statistically significant effects of neighbors’ lottery winnings on car consumption and exterior home renovations. For example, PCL nonparticipants who live in winning codes are more likely to acquire a new car in the six months after the lottery win than nonparticipants living in nonwinning codes. Further, we find that nonwinning households who live next door to PCL winners are significantly more likely to purchase a car in the six months after the lottery than nonwinning households located elsewhere, and that nonwinning households living in postcodes where a large number of households won the PCL are more likely to start a major exterior home renovation in the six months since the lottery than nonwinning households located elsewhere.

"Who Gentrifies Low-Income Neighborhoods?"

This examines the distributional impacts of gentrification. The results may not be what you expect:

Who Gentrifies Low-Income Neighborhoods?, by Terra McKinnish, Randall Walsh, and Kirk White NBER Working Paper No. 14036 May 2008 JEL No. J15,J60,R23 [Open Link]: Abstract This paper uses confidential Census data, specifically the 1990 and 2000 Census Long Form data, to study the demographic processes underlying the gentrification of low-income urban neighborhoods during the 1990's. In contrast to previous studies, the analysis is conducted at the more refined census-tract level with a narrower definition of gentrification and more closely matched comparison neighborhoods. The analysis is also richly disaggregated by demographic characteristic, uncovering differential patterns by race, education, age and family structure that would not have emerged in the more aggregate analysis in previous studies. The results provide no evidence of displacement of low-income non-white households in gentrifying neighborhoods. The bulk of the increase in average family income in gentrifying neighborhoods is attributed to black high school graduates and white college graduates. The disproportionate retention and income gains of the former and the disproportionate in-migration of the latter are distinguishing characteristics of gentrifying U.S. urban neighborhoods in the 1990's.

I. Introduction

"Concern, and anger, over gentrification has grown in communities across the country as housing rental and sales prices have soared .… there are numerous reports of resident displacement from neighborhoods long ignored that now attract higher-income households."¹ -2006 Urban Institute Report

Over the past several decades, there has been substantial gentrification of low-income neighborhoods in many U.S. urban areas. These neighborhoods typically experience large increases in household income and housing prices. Some laud the revitalization of decayed neighborhoods and others criticize the displacement of low-income, often minority, households.

The distribution of benefits from neighborhood change is a crucial policy issue. Since 1974 the U.S. Department of Housing and Urban Development (HUD) has allocated nearly $120 Billion in Community Development Block Grants.² These grants, that are intended to benefit low and moderate-income individuals by eliminating slums or blight and addressing urgent community development needs, have been allocated to more than 1000 U.S. cities. While public investment in neighborhood revitalization is ubiquitous, the consequences of neighborhood gentrification for low-income and minority individuals remain an open question.

Menu Costs and Phillips Curves: The CalvoPlus Model and Intermediate Inputs

Awhile back, I posted a summary of a paper by Golosov and Lucas. The paper is important because it raises questions about the ability of New Keynesian models to explain fluctuations in real output. As I stated at the time:

A lot of you don't believe in a Phillips curve, but I've argued that there is a short-run inflation-output tradeoff and I've cited New Keynesian models along with supporting empirical evidence to reinforce that position. But when I make that argument, you should cite this paper by Golosov and Lucas to argue against the existence of a significant inflation-output tradeoff. The paper argues that if there is a Phillips curve, the inflation-output tradeoff is pretty steep, steep enough so that nominal shocks are "nearly neutral":

And since we believe nominal shocks matter for real GDP - there is empirical evidence in support of that claim - the fact that nominal shocks (think monetary policy) aren't able to explain much of the movement in output in the class of theoretical macroeconomic models used to assess policy and learn about the economy is a problem.

As a review, here's part of the introduction and conclusion from the Golosov and Lucas paper:

Menu Costs and Phillips Curves, by Mikhail Golosov and Robert E. Lucas Jr., Journal of Political Economy, 2007, vol. 115, no. 2 [open link]: I. Introduction This paper develops a model of a monetary economy in which firms must pay a fixed cost—a "menu cost"—in order to change nominal prices. Menu costs are interesting to macroeconomists because they are often cited as a microeconomic foundation for a form of "price stickiness" assumed in many New Keynesian models. Without sticky prices these models would not exhibit the real effects of monetary shocks—Phillips curves—that they are designed to analyze.

Under menu costs, any individual price will be constant most of the time and then occasionally jump to a new level. Thus the center of the model will be the firm's pricing decision to reprice or not to do so. Many New Keynesian models do not examine this decision but instead rely on a simplifying assumption proposed by Calvo (1983) that the waiting time between repricing dates is selected at random from an exponential distribution: Firms choose the size of price changes but not their timing.

As many others are, we are skeptical that the Calvo model provides a serviceable approximation to behavior under menu costs.[1] One reason is that the assumption of a constant repricing rate cannot fit the fact that repricing is more frequent in high-inflation environments. But a second, more important, reason was discovered by Caplin and Spulber (1987), who constructed a theoretical example of an economy with menu costs in which only a small fraction of firms reprice yet changes in money growth are neutral. In their example, there is a stationary distribution of firms' relative prices, and as a monetary expansion proceeds, the firms at the low end of this distribution reprice to the high end. The repricing rate is very low—prices are very "sticky"—but no price stickiness can be seen at the aggregate level. The key to the example is that the firms that change price are not selected at random but are rather those firms whose prices are most out of line.

The Caplin and Spulber example is well designed to exhibit this selection effect, but it is unrealistic in too many respects to be implemented quantitatively. In this paper we capture the selection effect in a new model of menu cost pricing, designed so that it can be realistically calibrated...

Our main finding is that even though monetary shocks have almost no impact on the rate at which firms change prices, the shocks' real effects are dramatically less persistent than in an otherwise comparable economy with time-dependent price adjustment. Simulations of the model's responses to a one-time impulse of inflation show small and transient effects on real output and employment..., in contrast to much larger and more persistent responses of the same model with Calvo pricing. ... In the menu cost model, a positive aggregate shock induces the lowest-priced firms to increase prices. At the same time, it offsets negative idiosyncratic shocks, and some firms that would otherwise have decreased prices choose to wait. As a result, the lowest-priced firms do most of the adjusting, their adjustments are large and positive, and the economywide price level increases quickly to reflect the aggregate shock. In the Calvo setting, in contrast, firms get the opportunity to reprice randomly, many firms reprice even though they were already close to their desired price, and the average response of prices to the shock is much smaller. It takes longer for the monetary shock to be reflected in prices, and impulse responses become more persistent. ...

VII.      Conclusions ... In summary, the model we proposed and calibrated to microeconomic evidence on U.S. pricing behavior ... does not appear to be consistent with large real effects of monetary instability. These results seem to us another confirmation of the insight provided by the much simpler example of Caplin and Spulber (1987) that even when most prices remain unchanged from one day to the next, nominal shocks can be nearly neutral...

But not so fast. The paper below develops a multi-sector "CalvoPlus Model" that maintains the mathematical simplicity of the Calvo approach, but allows state dependent pricing. In particular, in the standard Calvo model of price rigidity, firms are allowed to change prices with probability a, and prices remain fixed with probability 1-a (with the parameter a chosen based upon empirical results on the average frequency of price changes). Essentially, with probability a the cost of changing the price in a given period is zero, and with probability 1-a, the cost to change price is infinite. The CalvoPlus model changes this so that with probability a, the cost of changing a price is very low, and with probability 1-a the cost is high, but not infinite (the high-low costs vary across sectors). This introduces an element of state dependency because if a price is far enough away from its optimal value, it may be worthwhile to pay the high cost to change it since the benefit of changing the price would be even larger than the cost. It introduces heterogeneity due to the multi-sector set up (the degree of non-neutrality goes up as the number of sectors is increased, and the model is calibrated so that around 75% of price changes occur in the low cost states).

However, allowing heterogeneity across sectors in the frequency and size of price changes by itself is not enough to allow the model to generate non-neutralities large enough to be consistent with actual fluctuations in real GDP. Thus, the model also adds a second change, the introduction of intermediate inputs. As the authors note, "Intuitively, in the model with intermediate inputs, firms that change their price soon after a shock to nominal aggregate demand choose to adjust less than they otherwise would because the prices of many of their inputs have not yet responded to the shock." In the model, the price of these inputs depends directly upon the price of other goods in the economy (they are "strategic complements"). Because intermediate input prices adjust sluggishly, an increase in aggregate demand of 1%  increases input costs by less than 1%, and prices do not rise by as much as they would if intermediate inputs were not present (i.e. if input costs were completely flexible). This extra price sluggishness results in larger real effects and doubles the degree of non-neutrality in the model (i.e. the output movements attributable to CalvoPlus pricing and to the presence of intermediate inputs are about equal, and total around 25% of the total variation).

Here's part of the introduction to the paper (it's been keeping me occupied today):

Monetary Non-Neutrality in a Multi-Sector Menu Cost Model, by Emi Nakamura and Jon Steinsson, NBER WP 14001, May 2008: [Open Link] 1 Introduction Much applied work in monetary economics relies on models in which nominal rigidities are the key friction that generates monetary non-neutrality. The workhorse models in this literature - e.g., the Calvo (1983) model and the Taylor (1980) model - make the simplifying assumption that the timing of price changes is independent of firms' incentives to change prices. It has been recognized at least since Caplin and Spulber (1987) that models based on this assumption can yield very different conclusions about monetary non-neutrality than models in which nominal rigidities arise due to a fixed cost of changing prices (see...). Golosov and Lucas (2007) calibrate a menu cost model based on newly available micro-data on the frequency and size of price changes and conclude that nominal rigidities due to menu costs yield monetary non-neutrality that is "small and transient".

Given the importance of nominal rigidities as a source of monetary non-neutrality in most models that analyze the transmission of monetary policy, this conclusion poses a serious challenge for monetary economics. If realistically modeled nominal rigidity yields monetary non-neutrality that is small and transient, much of our understanding of the transmission of monetary policy is called into question. It is therefore of great importance for monetary economics to assess whether the implications of highly stylized menu cost models hold up in a richer, more realistic setting. ...

In this paper, we ... extend a simple benchmark menu cost model to include two features for which there exists particularly clear empirical evidence: 1) Heterogeneity across sectors in the frequency and size of price changes; 2) Intermediate inputs. We show that when we subject our model to calibrated nominal shocks it generates fluctuations in real output that can account for 26% of the U.S. business cycle.[1] This result of our model accords well with empirical evidence on the importance of nominal shocks for business cycle fluctuations.

Shapiro and Watson (1988) attribute 28% of the variation in output at short horizons to nominal shocks. In contrast, the Golosov and Lucas model generates fluctuations of real output that can account for only roughly 2% of the U.S. business cycle. Roughly half of the difference in monetary non-neutrality in our model relative to the model of Golosov and Lucas (2007) is due to the introduction of heterogeneity in the frequency of price change; the remaining half is due to the introduction of intermediate inputs. ...

Monetary Policy at the Zero Interest Rate Bound

If Bernanke believes his own research, and if the zero interest rate bound begins to come into play, we should expect to hear lots of discussion from FOMC members about the future course of monetary policy. Here are a few excerpts from papers on the topic of "Monetary Policy Alternatives as the Zero Bound":

Bernanke, Reinhart, and Sack:

Monetary Policy Alternatives at the Zero Bound: An Empirical Assessment (2004): Non-technical summary ...[S]uccess over the years in reducing inflation and, consequently, the average level of nominal interest rates has increased the likelihood that the nominal policy interest rate may become constrained by the zero lower bound on interest rates. When that happens, a central bank can no longer stimulate aggregate demand by further interest-rate reductions and must rely instead on “non-standard” policy alternatives. ...

In this paper, we apply the tools of modern empirical finance to the recent experiences of the United States and Japan to provide evidence on the potential effectiveness of various nonstandard policies. Following Bernanke and Reinhart (2004), we group these policy alternatives into three classes: (1) using communications policies to shape public expectations about the future course of interest rates; (2) increasing the size of the central bank’s balance sheet, or “quantitative easing”; and (3) changing the composition of the central bank’s balance sheet through, for example, the targeted purchases of long-term bonds as a means of reducing the long-term interest rate. We describe how these policies might work and discuss relevant existing evidence. ...

Our results provide some grounds for optimism about the likely efficacy of nonstandard policies. In particular, we confirm a potentially important role for central bank communications to try to shape public expectations of future policy actions. Like Gürkaynak, Sack, and Swanson (2004), we find that the Federal Reserve’s monetary policy decisions have two distinct effects on asset prices. These factors represent, respectively, (1) the unexpected change in the current setting of the federal funds rate, and (2) the change in market expectations about the trajectory of the funds rate over the next year that is not explained by the current policy action. In the United States, the second factor, in particular, appears strongly linked to Fed policy statements, probably reflecting the importance of communication by the central bank. If central bank “talk” affects policy expectations, then policymakers retain some leverage over long-term yields, even if the current policy rate is at or near zero.

We also find evidence supporting the view that asset purchases in large volume by a central bank would be able to affect the price or yield of the targeted asset.

"Highly Predictable Volume Leads to Highly Predictable Returns"

In the paper described below, the "attention-grabbing" hypothesis plays a key role:

A specific story involving irrational or cognitively constrained investors is the "attention-grabbing" hypothesis... According to this hypothesis, individual investors both have limited attention, and rarely sell short. When a stock which they currently do not own grabs their attention, these individual investors are more likely to buy the stock (compared to a stock which does not grab their attention). Institutional investors are less attention constrained....

Do these investors cause an "announcement premium" by rushing to buy stocks that are in the news?:

Stocks Rise Around Earnings Announcements, by Matt Nesvisky. NBER Digest: It has long been observed that when firms announce their quarterly earnings, as they are required to do, considerable price volatility and increases in trading volume are evident. In addition, in the days around earnings announcements, stock prices usually rise. In The Earnings Announcement Premium and Trading Volume..., Owen Lamont and Andrea Frazzini explore why these phenomena occur. ...

In general, of course, stocks tend to rise on high volume and to decline on low volume, but Lamont and Frazzini say that whether this happens because of the interpretation of the announcements or because of irrational or random traders is uncertain. What may well be in play is that certain earnings announcements simply "grab attention," with the result that individual investors are motivated to buy in.

The researchers focus on this "attention-grabbing" hypothesis, because stocks that make news - whether good, bad, or neutral -- have both high volume and high net buying by individuals. Lamont and Frazzini note that arbitrageurs might be expected to eliminate this anomaly, but this would require substantially increased trading activity, which is costly. In addition, the highly idiosyncratic volatility around earnings announcements could deter traders who, for whatever reason, cannot sufficiently diversify. If idiosyncratic risk is somehow preventing arbitrage activity, then in this limited sense the premium may be viewed as a reward for bearing risk. Lamont and Frazzini see evidence that ... arbitrageurs are trading on the anomaly, but simply have not yet eliminated it. Whatever the case, because earnings announcements occur frequently and regularly and generate substantial volume, they provide a good opportunity for testing ... whether predictable volume generates predictable returns. ...

The researchers demonstrate that the strategy of buying every stock expected to announce within the coming month and shorting every stock not expected to announce yields a return of over 60 basis points per month. The announcement premium is thus substantial, particularly among large cap securities, lasts about four weeks, and is evident in samples going back to 1927. At the same time, stocks with the largest predicted volume increases in announcement months ... tend to have higher subsequent premiums. These stocks also tend to have the highest imputed buying around announcement dates by small investors.

Lamont and Frazzini add that the evidence increasingly shows that individual investors seem to make uninformed trading decisions. In line with the attention-grabbing hypothesis, ... small-investor buys ... soar on announcement day. ... One explanation for these phenomena is that some securities attract small attention-constrained investors around earnings announcement dates. Since such investors rarely sell short, the predictable rise in volume boosts prices around announcement dates, thus generating a seasonal component in the stock's expected return.

These results fit with the broader research on the connection between trading activity and prices. Elements such as liquidity, information flow, heterogeneous beliefs, and short sale constraints arguably are all important in understanding this connection. Lamont and Frazzini's findings impose an additional requirement on any theory attempting to connect volume and prices. Any hypothesis, the researchers assert, must now explain why highly predictable volume leads to highly predictable returns. Their ... explanation is uninformed or irrational demand by individual investors, coupled with imperfect arbitrage by informed traders.

Price Rigidity

New Keynesian models rely upon price and wage rigidity to generate movements in macroeconomic variables that match, approximately, movements in actual variables over time. In order to match the movements in actual data, a particular degree of price/wage rigidity must be assumed. Thus, it is important that estimates of the actual degree of price and wage rigidity match the degree of rigidity imposed upon these models.

What does the evidence say about prices? When econometricians look at aggregated prices, they tend to find a great deal of stickiness, enough to justify the degree assumed in the models. However, when disaggregated prices are examined, prices appear to be much more flexible. For example, this is from "Reference Prices and Nominal Rigidities," by Martin Eichenbaum, Nir Jaimovich, and Sergio Rebelo, March 2008:

[T]he recent literature ... uses micro data sets to measure the frequency of price changes. The seminal article by Bils and Klenow (2004) argues that prices are quite flexible. Using monthly CPI data, they find that median duration of prices is 4.3 months. This estimate has became a litmus test for the plausibility of monetary models. In contrast, Nakamura and Steinsson (2007) focus on non-sale prices and argue that these prices are quite inertial. When sales are excluded, prices change on average every 8 to 11 months.

Kehoe and Midrigan (2007) also examine the impact of sales on price inertia. They use an algorithm to define sales prices that they apply to weekly supermarket scanner data. They find that, when sales observations are excluded, prices change once every 4.5 months. When sales are included, prices change every 3 weeks.

So there is quite a bit of variation in the estimates of stickiness derived from disaggregated data, and even more variation when more aggregate prices are examined. As the paper notes, whether or not sales are included in the price data is a key issue for the results from disaggregated data:

Excluding 'sales prices' from the data has a major impact on inference about price inertia. Not surprisingly, there is an ongoing debate in the literature about how to define a sale and whether one should treat 'regular' and 'sales' prices asymmetrically.

The paper makes a contribution to this debate by using the concept of "reference prices":

An advantage of working with 'reference prices' is that we do not need to take a stand on what sales are or whether they are special events that should be disregarded by macroeconomists.

But that is not the only reason to use this concept. They find that although disaggregated prices are quite flexible, they are flexible around an inflexible reference point, and that inflexibility can produce substantial nominal rigidities:

We argue that our evidence is inconsistent with the three most widely used pricing models in macroeconomics: flexible price models, standard menu cost models, and Calvo-style pricing models. There is, however, a simple pricing rule that is consistent with our evidence. This rule can be described as follows. Prices do not generally change unless costs change. For any given good the nominal reference price is on average a particular markup over nominal reference cost. The retailer sets the frequency with which they reset the reference price so as to keep the actual markup within plus/minus twenty percent of the desired markup over reference cost. ... With this rule reference prices can exhibit substantial nominal rigidities even though weekly prices change frequently.

Maybe pictures will help - the variability of the prices and the inflexibility of the reference points are both evident. This is two of the 60,000 prices they examine:

And, finally, the conclusion:

We present evidence that is consistent with the view that nominal rigidities are important. However, these rigidities do not take the form of sticky prices, i.e. prices that remain constant over time. Instead, nominal rigidities take the form of inertia in reference prices and costs. Weekly prices and costs fluctuate around reference values which tend to remain constant over extended periods of time.

Reference prices are particularly inertial and have an average duration of roughly one year. So, nominal rigidities are present in our data, even though prices and cost change very frequently, roughly once every two weeks. We document the relation between prices and costs and argue that our findings pose a challenge to the most commonly pricing models used in macroeconomics.

The challenge is not to the idea that wage and price rigidity cause unintended price dispersion and resource misallocations that bring about short-run variation in the macroeconomy present in the New Keynesian framework. The challenge is to the particular form of price and wage rigidity that has been imposed upon New Keynesian models (e.g. the Calvo rule). The pricing rules have always been a weak part of these models, they are often imposed rather than derived from first principles, so perhaps this will motivate progress on this front.

[One final note. This is part of the debate described in the post on the natural rate of unemployment. If prices are sticky, then shocks can move the economy away from its long-run  optimal (equilibrium) path, and this opens up the possibility for monetary or fiscal policy to intervene and make people better off by redirecting the economy back to its long-run optimum. But if prices are perfectly flexible (or close enough, and there are no other rigidities, including information problems), then all movements are changes in the equilibrium path for the economy rather than deviations from it. In this case there is nothing for policymakers to do since any change in output would take the economy away from its optimal level making people worse rather than better off. However, the results in this paper are consistent with the idea that policy intervention can provide positive benefits.]

The Natural Rate of Unemployment

In the post below this one, Tim Duy talks about what the Fed will do. However, others are more worried about what the Fed ought to do, and Willem Buiter suggests that perhaps a rate increase is needed.

So let me argue against the types of interventionist policies I have been advocating, and present an argument that supports Willem Buiter. One of the keys is his contention that the natural rate of unemployment has been rising:

The natural rate of unemployment in the US is rising: the Fed should consider raising rates, by Willem Buiter: ...The latest labour market figures show a large fall in employment and an even larger fall in labour supply, resulting in an actual decline in the unemployment rate to 4.8%. There is also evidence to support the view that the natural (equilibrium) rate of unemployment in the US is increasing. The combination of a declining actual unemployment rate and a rising natural unemployment rate means that there are now higher domestic inflationary pressures associated with any observed level of employment and unemployment than before. ...

It makes economic sense that the US natural rate of unemployment is increasing, if only because of compositional changes in the labour force that are reducing, on average, its quality and employability. The post-9/11 imposition of additional obstacles to the immigration of skilled labour are one factor reducing labour force flexibility. So is the long-standing decline in the numeracy and literacy standards of the high-school graduates.

At the same time, the need for greater changes in the mix of skills and in the geographical and industrial distribution of employment associated with globalisation and accelerating technological change, have raised the degree of flexibility required to maintain the same amount of labour market pressure. The US is not responding, except defensively by threatening a retreat into protectionism. With mismatch unemployment and frictional unemployment rising, the natural rate of unemployment is rising in the US.

We can look at the evidence for a higher natural rate of unemployment also from the perspective of the path of potential output. Underlying total factor productivity growth in the US appears to be slowing down and with it the trend growth rate of potential output, raising the output gap corresponding to any level of observed output.

The reduction in labour supply is highly unlikely to reflect the so-called discouraged worker effect. ... The recession ... is far too young to have created an increase in discouraged worker disengagement from the labour force.

So with inflation too high and the natural rate of unemployment rising, the Fed should be thinking of hiking rates, not lowering them further.

Whether you believe Buiter's reasoning or not (see below for estimates of the factors that appear to change the natural rate), there is evidence from the academic journals that the natural rate of unemployment is highly variable over time. For example, consider this article by Thomas King and James Morley from the March, 2007 edition of the Journal of Monetary Economics:

In search of the natural rate of unemployment, by Thomas B. King and James Morley, JME, March 2007: ...1. Introduction The natural rate of unemployment is the long-run equilibrium in the labor market, and economists often appeal to it as a proxy for broader macroeconomic equilibrium. A measure of the natural rate is therefore potentially useful... In this paper, we present an estimate of the natural rate...

Our approach to estimating the natural rate [relies]... on the following definition given in Phelps (1994, p. 1):

[The 'natural rate of unemployment' is defined as] the current equilibrium steady-state rate, given the current capital stock and any other state variables. (It is the unemployment rate that, if it were the actual rate at the moment, would make the current rate of change of the associated equilibrium unemployment rate path equal zero.) In [this] theory, then, the equilibrium path of the unemployment rate is driven by a natural rate that is a variable of the system rather than a constant or a forcing function of time. The endogenous natural rate becomes the moving target that the equilibrium path constantly pursues.

Under this definition, which is closely related to Friedman's (1968) idea of the natural rate as the value “ground out by the Walrasian system,” the unemployment rate is determined by a stable dynamic process and, in the absence of exogenous shocks, converges to a unique steady-state equilibrium. Importantly, this equilibrium is itself endogenous, determined by technological, institutional, and demographic factors, and is therefore not necessarily constant over time. ...

We ... estimate the natural rate under Phelps's definition as the time-varying steady state of the unemployment rate. ... In contrast to many previous studies, our results suggest that the natural rate is quite volatile and support the idea that most macroeconomic activity reflects movements in long-run equilibrium, not from equilibrium. Indeed, movements in the natural rate account for over half of the variation in the post-War US unemployment rate. ...

To examine our estimated natural rate further, we consider whether it relates to a number of variables that economic theory suggests may be relevant. Consistent with recent search-based models of equilibrium unemployment, the most important determinants are unemployment benefits, labor productivity, real wages, and sectoral shifts in the labor market, with sectoral shifts having the largest estimated impact. Also, consistent with the short-run Phillips Curve, there is a strong negative relationship between inflation and the corresponding measure of cyclical unemployment.

Here is a picture of their estimate (actual unemployment is the faded line):

Here's the estimated Phillips curve:

And here's the bottom line:

7. Conclusion ...The results ... provide further support to the already large body of literature validating the existence of the short-run Phillips Curve. ... However, the results also clearly suggest that any tradeoff between cyclical unemployment and inflation is an issue of secondary importance when compared to the effects of movements in the natural rate itself. If one views unemployment at the natural rate as evidence of a market-clearing outcome, it must be inferred that shifts in labor-market equilibrium constitute the bulk of the variation in the unemployment rate. Thus, while movements away from the steady state are governed by a strong Phillips Curve relationship, a sizeable proportion of macroeconomic activity is governed by changes in the steady state, even over short horizons. To the extent that achievement of equilibrium in the labor market proxies for broader macroeconomic efficiency, this finding suggests that business cycles primarily reflect market-clearing adjustments to exogenously changing conditions.

With regard to macroeconomic policy, if the goal is to maintain the economy at full employment, the results in this paper yield a frustrating conclusion: the natural rate is a quickly moving target. If the economy responds slowly and uncertainly to monetary shocks, policymakers will have a hard time predicting the effects of policy. In order to do so accurately, one needs not only a model describing the response of economic variables to monetary changes, but also a model describing the behavior of the natural rate over time. From the analysis in this paper, relevant variables for such a model include changes in sectoral composition, unemployment benefits, and, to a lesser extent, productivity growth and real wages. ...

Again, this is not the only view -- there is a lot more evidence on both sides of the issue. From my reading of the evidence, I do not believe that a passive policy response to current conditions is warranted (and, given the current problems in the economy, I certainly don't think an increase in the target rate is needed to bring the real interest rate up to its natural level). The point is that it is possible to make a case for the view that much of the variation we see in the macroeconomy is an equilibrium response - and hence there is no need for policy intervention other than to control inflation - rather than a deviation from the equilibrium path that can be corrected through monetary and fiscal policy.

I hold the New Keynesian view that fluctuations we see are predominantly deviations from the equilibrium path rather than the Real Business Cycle view that fluctuations are mostly changes in equilibrium. Much of the split you hear from analysts - some advocating an aggressive policy response and others taking a hands off let it correct itself perspective - is due to this difference in beliefs about whether fluctuations are variations in equilibrium or deviations from equilibrium.

Why don't we know which it is? The simplest way to think about it is that we have one series, the unemployment rate, and we want to extract two pieces of information from it, trend movements in unemployment and the cycles in unemployment around the trend. However, we can't get two pieces of information from a single series without making identifying assumptions, and the assumptions that are made - all of which are defensible - change the answer that you get in terms of what is trend and what is cycle. There's a little more to it than this, but that's the heart of the problem.

Borjas, Grogger, and Hanson: Immigrant and Native Complementarity

George Borjas, Jeffrey Grogger, and Gordon Hanson have a new paper, and it's not good news for the Ottaviano and Peri result that immigration can cause native wages to increase due to strong complementarities between native and immigrant labor:

Immigrant-Native Complementarity Revisited, by George Borjas: I’ve often been asked what I think about the Ottaviano-Peri finding that there are strong complementarities between comparably skilled immigrants and natives—complementarities that lead them to conclude that immigration raises wages for many natives.

I’ve always been a little skeptical of the Ottaviano-Peri evidence. ... Here’s the abstract to our new paper:

What is Political Economics?

Alberto Alesina describes political economics:

Political Economy, by Alberto F. Alesina, NBER Reporter: The Political Economy Program is new at the NBER, and thus needs an introduction. What is political economics? And, why has the NBER chosen to have a program in it?

The best way to answer is to set back the clock to the mid-1980s. This was a time of great turmoil and transformation in the American economy. President Reagan was in the middle of his "revolution": there were large deficits, taxes were being cut, and the economy was being deregulated. Continental Europe, in contrast, was entering a long period of sclerosis: some countries in Europe (but not all) had accumulated debt that was rising towards wartime levels. The need for structural reforms and liberalization in Europe was evident, but they were delayed. A dozen European countries were heading towards uncharted territories of monetary, and some sort of political, union. Latin America was in the midst of a huge debt crisis and a "lost decade", with very high or even hyperinflations, foreign debt defaults, and large budget deficits. Unavoidable policy reforms were delayed, increasing the economic costs and leading to crisis. The Soviet Bloc was about to collapse; when it did, it opened a Pandora's box of politico-economic questions.

It was increasingly difficult to fit all of these complexities and varieties of experiences into traditional model of economic policy in which benevolent social planners maximize the utility of a representative individual. Some economists started exploring how political forces affected the choice of policies, paying special attention to distributive conflicts and political institutions, which are absent in representative agent models.

Measuring Pure Inflation

Here are Ricardo Reis and Mark Watson who will tell you what they have done and why it matters. This is interesting work:

Relative Goods' Prices and Pure Inflation, by Ricardo Reis and Mark W. Watson, NBER WP 13615, November 2007 [open link]: ABSTRACT This paper uses a dynamic factor model for the quarterly changes in consumption goods' prices to separate them into three components: idiosyncratic relative-price changes, aggregate relative-price changes, and changes in the unit of account. The model identifies a measure of "pure" inflation: the common component in goods' inflation rates that has an equiproportional effect on all prices and is uncorrelated with relative price changes at all dates. The estimates of pure inflation and of the aggregate relative-price components allow us to re-examine three classic macro-correlations. First, we find that pure inflation accounts for 15-20% of the variability in overall inflation, so that most changes in inflation are associated with changes in goods' relative prices. Second, we find that the Phillips correlation between inflation and measures of real activity essentially disappears once we control for goods' relative-price changes. Third, we find that, at business-cycle frequencies, the correlation between inflation and money is close to zero, while the correlation with nominal interest rates is around 0.5, confirming previous findings on the link between monetary policy and inflation.

...

6. What have we done and why does it matter? In this paper, we ... used different estimation techniques and specifications to robustly estimate pure inflation, and proposed a simple method to compute macroeconomic correlations while controlling for goods’ relative price changes.

Our first finding was that pure inflation can differ markedly from other conventional measures of inflation, like the PCE deflator or its core version. It is smoother, less volatile, and in particular in the 1990s, its ups-and-downs are quite different from those in other measures of inflation. This should be useful to economic historians since it provides an alternative account of the movements in inflation in the last half-century. Relative to existing measure of inflation, pure inflation has the virtue of separating absolute from relative-price changes, which is a crucial distinction in economic theory. Moreover, pure inflation matches more closely the concept that many economists seem to have in mind when discussing aggregate movements in prices and monetary policy (typically based on intuition that comes from a one-good world).

Fed Plans to Increase Transparency

The Fed is moving to increase transparency:

Fed Plans Transparency Steps, by Greg Ip, WSJ: Federal Reserve officials are nearing consensus on several steps to make their deliberations more transparent to the public, but are likely to defer one of Chairman Ben Bernanke's longstanding goals: an explicit inflation target.

The centerpiece of their new communications steps would be the release of economic forecasts of policy makers four times a year, instead of the current two times, with additional detail and background... Moreover, the horizon for those forecasts would be extended to three years from two.

The ... Fed had hoped to finalize them by this month. But the fallout of the market turmoil that erupted in August has complicated the agenda of next week's meeting of the policy-making Federal Open Market Committee and it may defer decisions on its communications policy to a later meeting. ...

While the idea of setting an inflation target hasn't been shelved, officials say it needs more discussion. ... For Mr. Bernanke, deferral of an inflation target represents a setback, but he can chalk up a tactical victory for forging a consensus on other steps. ...

At his nomination hearing in 2005, Mr. Bernanke restated his preference for a target while promising "extensive discussion and consultation" and "no precipitate steps." ...

The FOMC as a whole is still not ready to take the step. One concern is that Congress, having taken a more populist turn since Democrats took power in 2006, could perceive a target as subordinating the Fed's responsibility for employment, despite Mr. Bernanke's insistence to the contrary. Another is that officials don't think the current system is broken.

At present, the FOMC meets eight times a year, and at two of its meetings, members submit forecasts for the current and next year on growth, inflation and unemployment that are included in a report to Congress. The "central tendency" of those forecasts -- a range that excludes the extreme projections -- garners the most attention. ...

At present, the post-meeting FOMC statement and the minutes aren't expected to be altered significantly.

A recent paper by Orphanides and Wieland is related to the release of the economic forecasts more often and with more detail. According to this paper from a recent conference at the St. Louis Fed, the "midpoints of the central tendencies" used as "proxies for the modal forecasts of FOMC" are better at explaining policy decisions and deviations from the Taylor rule than data on actual economic conditions. Simply put, if you want to understand the Fed's policy decisions, look at the FOMC forecasts, not the actual data on the economy available at the time:

Economic Projections and Rules-of-Thumb for Monetary Policy, by Athanasios Orphanides and Volker Wieland, October 2007: Abstract Monetary policy analysts often rely on rules-of-thumb, such as the Taylor rule, to describe historical monetary policy decisions and to compare current policy to historical norms. Analysis along these lines also permits evaluation of episodes where policy may have deviated from a simple policy rule... One interesting question is whether such rules-of-thumb should draw on policymaker forecasts of economic conditions or recent outcomes of key variables such as inflation and unemployment. ... We investigate this proposition in the context of FOMC policy decisions over the past 20 years using publicly available FOMC projections from the biannual monetary policy reports to the Congress (Humphrey-Hawkins reports). Our results indicate that FOMC decisions can indeed be predominantly explained in terms of the FOMC's own projections rather than recent economic outcomes. Thus, a forecast-based rule-of-thumb better characterizes FOMC decision-making. We also confirm that many of the apparent deviations of the federal funds rate from an outcome-based Taylor-style rule may be considered systematic responses to information contained in FOMC projections.

John Taylor's Contributions to Monetary Theory and Policy

Papers from the Dallas Fed Conference held to honor of John Taylor's contributions to monetary theory and policy:

Golosov and Lucas: Menu Costs and Phillips Curves

A lot of you don't believe in a Phillips curve, but I've argued that there is a short-run inflation-output tradeoff and I've cited New Keynesian models along with supporting empirical evidence to reinforce that position. But when I make that argument, you should cite this paper by Golosov and Lucas to argue against the existence of a significant inflation-output tradeoff. The paper argues that if there is a Phillips curve, the inflation-output tradeoff is pretty steep, steep enough so that nominal shocks are "nearly neutral":

Menu Costs and Phillips Curves, by Mikhail Golosov and Robert E. Lucas Jr., Journal of Political Economy, 2007, vol. 115, no. 2
[open link]: I. Introduction This paper develops a model of a monetary economy in which firms must pay a fixed cost—a "menu cost"—in order to change nominal prices. Menu costs are interesting to macroeconomists because they are often cited as a microeconomic foundation for a form of "price stickiness" assumed in many New Keynesian models. Without sticky prices these models would not exhibit the real effects of monetary shocks—Phillips curves—that they are designed to analyze.

"Is The 'Surge' Working? Some New Facts"

This NBER paper by MIT's Michael Greenstone reinforces Paul Krugman's message (in the post below this one) that the "smart money" is betting against Iraq's survival. According to this analysis of the Iraqi state bond market, since the Surge began there has been "a 40% increase in the market's expectation that Iraq will default. This finding suggests that to date the Surge is failing to pave the way toward a stable Iraq and may in fact be undermining it." Here's the abstract, introduction, and conclusion the paper:

Is The 'Surge' Working? Some New Facts, by Michael Greenstone, SSRN, September 14, 2007: Abstract There is a paucity of facts about the effects of the recent military Surge on conditions in Iraq and whether it is paving the way for a stable Iraq. Selective, anecdotal and incomplete analyses abound. Policy makers and defense planners must decide which measures of success or failure are most important, but until now few, if any, systematic analyses were available on which to base those decisions. This paper applies modern statistical techniques to a new data file derived from more than a dozen of the most reliable and widely-cited sources to assess the Surge's impact on three key dimensions: the functioning of the Iraqi state (including civilian casualties); military casualties; and financial markets' assessment of Iraq's future. The new and unusually rigorous findings presented here should help inform current evaluations of the Surge and provide a basis for better decision making about future strategy.

The analysis reveals mixed evidence on the Surge's effect on key trends in Iraq. The security situation has improved insofar as civilian fatalities have declined without any concurrent increase in casualties among coalition and Iraqi troops. However, other areas, such as oil production and the number of trained Iraqi Security Forces have shown no improvement or declined. Evaluating such conflicting indicators is challenging.

There is, however, another way to assess the Surge. This paper shows how data from world financial markets can be used to shed light on the central question of whether the Surge has increased or diminished the prospect of today's Iraq surviving into the future. In particular, I examine the price of Iraqi state bonds, which the Iraqi government is currently servicing, on world financial markets. After the Surge, there is a sharp decline in the price of those bonds, relative to alternative bonds. The decline signaled a 40% increase in the market's expectation that Iraq will default. This finding suggests that to date the Surge is failing to pave the way toward a stable Iraq and may in fact be undermining it.

Olivier Blanchard and Jordi Gali: The Macroeconomic Effects of Oil Shocks. Why are the 2000s So Different from the 1970s?

Why did the economy respond differently to oil price shocks in the 2000s as compared to the 1970s?:

The Macroeconomic Effects of Oil Shocks. Why are the 2000s So Different from the 1970s?, by Olivier J. Blanchard and Jordi Gali, NBER WP 13368, September 2007 [open link]: Abstract We characterize the macroeconomic performance of a set of industrialized economies in the aftermath of the oil price shocks of the 1970s and of the last decade, focusing on the differences across episodes. We examine four different hypotheses for the mild effects on inflation and economic activity of the recent increase in the price of oil: (a) good luck (i.e. lack of concurrent adverse shocks), (b) smaller share of oil in production, (c) more flexible labor markets, and (d) improvements in monetary policy. We conclude that all four have played an important role.

Goldin and Katz: Long-Run Changes in the U.S. Wage Structure: Narrowing, Widening, Polarizing

This paper by Claudia Goldin and Lawrence F. Katz documents the sources of the growing disparity in economic outcomes in recent decades. They find that "the majority of the increase in wage inequality since 1980 has come from rising educational wage differentials, particularly rising returns to post-secondary schooling." But the reason is interesting. They find it's not because of an increase in the growth of demand for skilled workers, i.e. from an increase in demand driven by skill-based technical change. Instead, "the growth of the supply of skills slowed considerably after 1980 and the wage structure, in consequence, widened. The slowdown in the relative supply of skills of the working population came about largely from the slowdown in the growth in the educational attainment of U.S. natives for cohorts born since around 1950."

This is the introduction and (part of) the conclusion to the paper:

Long-Run Changes in the U.S. Wage Structure: Narrowing, Widening, Polarizing, Claudia Goldin and Lawrence F. Katz, September 2007: From the close of World War II to 1970 ... America enjoyed widespread prosperity. Not only did the nation grow rapidly, all parts of the income distribution expanded at fairly similar rates. America was “growing together.” But in the mid-1970s, economic growth slowed. By the early 1980s the wage structure began a period of widening that has lasted until the present day. Even though productivity growth surged again starting in the mid-1990s, the benefits of economic growth have been concentrated at the top end of the distribution.[1] America has been “growing apart.”

Click on figure to enlarge

The “growing together” and “growing apart” patterns are shown in Figure 1, which compares real income growth across the family income distribution for the postwar period before and after 1973. For the pre-1973 period, real income growth was fastest near the bottom of the income distribution and slowest near the top, making the changes modestly equalizing. In sharp contrast, for 1973 to 2005 family incomes virtually stagnated for the lowest quintile but grew more than three times as rapidly for the top 5 percent as for the middle group.

CEO Pay: The Outrage Constraint

Here's more from the paper by Robert Gordon and Ian Dew-Becker, "Unresolved Issues  in the Rise of American Inequality." This section addresses whether the principle agent model of CEO pay is valid, i.e. whether the best interests of boards of directors, CEOs, and shareholders are in alignment and finds "a substantial amount of evidence that the principal-agent setting cannot explain the salient facts about CEO pay." This important because, according to this evidence, the manner in which CEO pay is set is inconsistent with the best interests of shareholders:

6.4 Firm‐Level Models of CEO Pay The Gabaix and Landier model can be thought of as a general equilibrium model of CEO pay. It involves firms that are differentiated only by size and does not consider any sort of bargaining. However, there is an extensive literature that studies exactly how CEO compensation is set, in particular, the interactions between CEOs, boards of directors, and shareholders (see Murphy (1999), for a survey of this literature). The classic principal-agent model treats directors as chosen by shareholders, and then studies the optimal contracts they set up for CEOs. This framework requires that boards have only the shareholders' interests in mind. As we have discussed above, this assumption seems at best implausible.

Bebchuk and Fried (2004) provide a substantial amount of evidence that the principal-agent setting cannot explain the salient facts about CEO pay.[14] They propose an alternative model in which CEOs have control over boards of directors and are mainly restricted by an "outrage constraint" where shareholders retaliate if they perceive executive compensation to be excessive. Weisbach's (2007) review notes a number of especially convincing pieces of evidence that the Bebchuk-Fried model is superior to the principal-agent model. Specifically, they provide evidence that CEO contracts are far from optimal, that CEOs control directors, and that directors put substantial effort into disguising the size of CEO compensation packages. Their proposal obviously has been met with some criticism, notably in the Chicago Law Review with articles by Bebchuk, Fried, Walker (2002), and Murphy (2002).

The key assumption that directors are independent turns out to be highly questionable. To start, their pay is far from negligible-an average of $152,000 per year in the top 200 firms. While directors also usually own stock in the companies they oversee, presumably the amount they stand to gain from good governance is smaller than the salary they would lose if they were not renominated. Moreover, directors receive substantial non-salary benefits in the form of perks, or in business directed to their own firms. Also, as we have noted before, if a CEO is also on the boards of any of his directors, there are ample opportunities for tit-for-tat relationships.

Bebchuk and Fried also provide compelling evidence that CEO contracts are in no sense optimal.

Gordon and Dew-Becker: Unresolved Issues in the Rise of American Inequality

Whenever one discusses inequality and CEO pay, the results from a paper by Gabaix and Landier inevitably come up as rebuttal to the idea that CEO pay is unjustified in the sense of being disconnected from underlying economic fundamentals. Here's a summary of their work from Tyler Cowen (repeats part of this post):

A Contrarian Look at Whether U.S. Chief Executives Are Overpaid, by Tyler Cowen, Economic Scene, NY Times: ...Not surprisingly, many people think ... American executives are overpaid. ...

But in a new paper "Why Has C.E.O. Pay Increased So Much?," the economists Xavier Gabaix of the Massachusetts Institute of Technology and Augustin Landier of the Stern School of Business at New York University ... suggest that the higher salaries for chief executives can largely be explained by increases in the value of the stock market. Viewed as a whole, these salaries are a result of competitive pressures rather than the exploitation of shareholders.

Their core argument is simple. If we look at recent history, compensation for executives has risen with the market capitalization of the largest companies. For instance, from 1980 to 2003, the average value of the top 500 companies rose by a factor of six. Two commonly used indexes of chief executive compensation show close to a proportional sixfold matching increase (the correlation coefficients are 0.93 and 0.97, respectively; 1.0 would be a perfect match). ...

[T]he debate over chief executives' salaries has moved a step forward. Yes, there are numerous examples of corporate malfeasance. But it is not obvious that the American system of executive pay — taken as a whole — is excessive or broken. ...

But a new paper by Robert Gordon and Ian Dew-Becker ("Unresolved Issues  in the Rise of American Inequality") challenges these results:

6.3 The Conflict among Hypotheses ...[I]t is worth considering the simple equilibrium explanation of Gabaix and Landier (2006) that executive pay moves in proportion to market capitalization.

"More Inequality, Less Social Mobility"

There's been discussion of inequality and social mobility lately, e.g. Tyler Cowen says:

Here is the latest, by Emmanuel Saez and co-authors... Here is one key sentence:

...we find that short-term and long-term mobility among all workers has been quite stable since the 1950s.

...In [Saez'] view a constant level of mobility means that no force is offsetting ongoing inequality. ... I believe he would likely read his own paper as support for ... concern with income inequality. He would not read his work as reason to dismiss the mobility issue. My view differs, as I worry about mobility -- can a hard-working person get ahead? -- but I do not worry about inequality per se, nor do I require of mobility that it overturn a particular level of inequality.

There may be a connection between mobility and inequality. Dan Andrews and Andrew Leigh find that countries that are more unequal are also countries where social mobility is lower:

More Inequality, Less Social Mobility by Andrew Leigh: Dan Andrews and I have a short paper out on the relationship between inequality and intergenerational mobility (aka social mobility). By contrast with the view that inequality is offset by more income mobility across generations, it turns out that in more unequal countries it is actually harder to move from rags to riches (or vice-versa). ...

We’re pretty sure that we’re the first to test for a statistically significant relationship between the two variables, but our results do accord with other studies that have shown that there is less intergenerational mobility in the US than in the Scandinavian countries.

Here's the abstract, introduction, and conclusion to the paper:

More Inequality, Less Social Mobility, by Dan Andrews and Andrew Leigh: Abstract We investigate the relationship between inequality and intergenerational mobility. Proxying fathers' earnings with using detailed occupational data, we find that sons who grew up in countries that were more unequal in the 1970s were less likely to have experienced social mobility by the late-1990s.

Glenn Rudebusch and John Williams: Using the Yield Curve to Forecast Recessions

The WSJ Economics blog notes this paper from the San Francisco Fed on the usefulness of the yield curve as an indicator of coming recessions. It may be more useful than we thought:

Forecasting Recessions: The Puzzle of the Enduring Power of the Yield Curve, by Glenn D. Rudebusch and John C. Williams, July 2007: Abstract We show that professional forecasters have essentially no ability to predict future recessions a few quarters ahead. This is particularly puzzling because, for at least the past two decades, researchers have provided much evidence that the yield curve, specifically the spread between long- and short-term interest rates, does contain useful information at that forecast horizon for predicting aggregate economic activity and, especially, for signalling future recessions. We document this puzzle and suggest that forecasters have generally placed too little weight on yield curve information when projecting declines in the aggregate economy.

Here's more from the introduction:

1. Introduction The word "recession" conjures a variety of fears -- for workers who suffer job losses, for investors who endure asset price declines, for entrepreneurs who risk bankruptcy. Recessions are periods of greater dislocation and anxiety, higher unemployment and suicide rates, and lower output and profits. In the United States, recessions have become less frequent and less severe in the past two decades; however, non-recessionary episodes have also become more stable, so in relative terms, as the market sensitivity in the epigraph suggests, recessions appear to many to be as perilous as before. Therefore, any ability to predict recessions remains highly profitable to investors and very useful to policymakers and other economic agents. Accordingly, there remains a keen and widespread interest in predicting recessions, and our paper examines what economic forecasters know about the likely occurrence of a recession and, most importantly, when do they know it.

David Card on Immigration and U.S. Cities

David Card on "How Immigration Affects U.S. Cities". Here is the abstract, introduction, and conclusion:

How Immigration Affects U.S. Cities, by David Card, June 2007 [via]: Abstract In the past 25 years immigration has re-emerged as a driving force in the size and composition of U.S. cities. This paper describes the effects of immigration on overall population growth and the skill composition of cities, focusing on the connection between immigrant inflows and the relative number of less-skilled workers in the local population. The labor market impacts of immigrant arrivals can be offset by outflows of natives and earlier generations of immigrants. Empirically, however, these offsetting flows are small, so most cities with higher rates of immigration have experienced overall population growth and a rising share of the less-skilled. These supply shifts are associated with a modest widening of the wage gap between more- and less-skilled natives, coupled with a positive effect on average native wages. Beyond the labor market, immigrant arrivals also affect rents and housing prices, government revenues and expenses, and the composition of neighborhoods and schools. The effect on rents is the same magnitude as the effect on average wages, implying that the average “rent burden” (the ratio of rents to incomes) is roughly constant. The local fiscal effects of increased immigration also appear to be relatively small. The neighborhood and school externalities posed by the presence of low-income and minority families may be larger, and may be a key factor in understanding native reactions to immigration.

Introduction The U.S. is once again becoming a country of immigrants. Immigrant arrivals – currently running about 1.25 million people per year – account for 40% of population growth nationally, and a much larger share in some regions.[1] The effects of these inflows are controversial, in part because of their sheer size and in part because of their composition. Something like 35-40% of new arrivals are undocumented immigrants from Mexico and Central America with low education and limited English skills (Passel, 2005). Although another quarter of immigrants – from countries like India and China – are highly skilled, critics of current immigration policy often emphasize the presumed negative effects of lower-skilled people in the overall economy (e.g., Rector, Kim and Watkins, 2007). Moreover, even the most highly skilled immigrants are predominately non-white, contributing to the growing presence of visible minorities in the U.S. population.

Michael Woodford: Globalization and Monetary Control

Another paper from Michael Woodford. In this one, he asks if globalization means that the Fed will lose the ability to influence inflation:

Globalization and Monetary Control, by Michael Woodford, NBER WP 13329, August 2007: Abstract It has recently become popular to argue that globalization has had or will soon have dramatic consequences for the nature of the monetary transmission mechanism, and it is sometimes suggested that this could threaten the ability of national central banks to control inflation within their borders, at least in the absence of coordination of policy with other central banks. In this paper, I consider three possible mechanisms through which it might be feared that globalization can undermine the ability of monetary policy to control inflation... These three fears relate to potential changes in the form of the three structural equations of a basic model of the monetary transmission mechanism: the LM equation, the IS equation, and the AS equation respectively.

What are the three factors that potentially change the IS, LM, and AS curves?

On the one hand, it might be thought that in a globalized world, it is "global liquidity" that should determine world interest rates rather than the supply of liquidity by a single central bank (especially a small one); thus one might fear that a small central bank will no longer have any instrument with which to shift the LM curve. Alternatively, it might be thought that changes in the balance between investment and saving in one country should matter little for the common world level of real interest rates, so that the "IS curve" should become perfectly horizontal even if the LM curve could be shifted. It might then be feared that loss of control over domestic real interest rates would eliminate any leverage of domestic monetary policy over domestic spending or inflation. Or as still another possibility, it might be thought that inflation should cease to depend on economic slack in one country alone (especially a small one), but rather upon "global slack"; in this case the AS curve would become horizontal, implying that even if domestic monetary policy can be effectively used to control domestic aggregate demand, this might not allow any control over domestic inflation.

And he finds that:

I take up each of these possibilities, by discussing the effects of openness (of goods markets, of factor markets, and of financial markets) on each of these three parts of a "new Keynesian" model of the monetary transmission mechanism. I first consider each argument in the context of a canonical open-economy monetary model..., and show that openness need not have any of the kinds of effects that I have just proposed. In each case, I also consider possible variants of the standard model in which the effects of globalization might be more extreme. These cases are not always intended to be regarded as especially realistic, but are taken up in an effort to determine if there are conditions under which the fear of globalization would be justified. Yet I find it difficult to construct scenarios under which globalization would interfere in any substantial way with the ability of domestic monetary policy to maintain control over the dynamics of domestic inflation.

It is true that, in a globalized economy, foreign developments will be among the sources of economic disturbances to which it will be appropriate for a central bank to respond, in order for it to achieve its stabilization goals. But there is little reason to fear that the capacity of national central banks to stabilize domestic inflation, without having to rely upon coordinated action with other central banks, will be weakened by increasing openness of national economies.

Does Immigration Cause Lower Prices?

According to this paper that is forthcoming in the Journal of Political Economy, "a one percentage point increase in the ratio of immigrants to natives in a city decreases prices by 0.5 percentage points on average":

Study: Immigration can lower prices of consumer products, EurakAlert: An important new study examines how immigration influences the prices of consumer goods. The study, forthcoming in the Journal of Political Economy, challenges the predictions of the perfectly competitive model – that an increase in demand leads to higher prices. Instead, the study finds that immigration can lower the prices of food, clothing, furniture, and appliances and have a significant moderating effect on inflation.

Immigration to Israel from the Former Soviet Union (FSU) increased dramatically in 1990, growing from about 1,500 immigrants a month in October 1989 to about 35,000 a month in December 1990.

Using the large variation in the number of new immigrants across Israeli cities (e.g., some Arab towns reported no new immigrants from the FSU), Saul Lach (Hebrew University of Jerusalem and the Centre for Economic Policy Research), compared the relative size of the FSU immigrant population with monthly, store-level prices for 915 products. These products were sold in more than 1,800 retail stores in 52 Israeli cities during 1990.

Controlling not only for native population size and overall city size, as larger cities may have more competitive markets, but also for the effects of religious holidays on prices during a certain month, Lach finds that a one percentage point increase in the ratio of immigrants to natives in a city decreases prices by 0.5 percentage points on average.

In other words, prices in a city with an average proportion of new immigrants were 2.6 percent lower in December 1990 than in cities where no immigrants settled.

While the effect was consistent for almost all product categories, Lach found that the immigration effect was significantly stronger for products for which FSU immigrants constituted a larger share of the market, such as pork and vodka.

As Lach argues, newly arrived immigrants may be more price sensitive because of lower income and lack of brand loyalty. Immigrants, who may initially be unemployed, may also have more time to compare prices, and stores will tend to lower their prices to attract these new customers. [Saul Lach. “Immigration and Prices,” Journal of Political Economy, 115:4.]

Michael Woodford: How Important is Money in the Conduct of Monetary Policy?

Michael Woodford, who knows more than a little bit about this topic, discusses the use of monetary aggregates as a basis for setting monetary policy.

His bottom line is that monetary aggregates should not be used as targets of monetary policy, or even play a prominent role in policy discussions, but they do have their uses. Many macroeconomic variables are unobservable and, to the extent that monetary aggregates are correlated with these unobservables, monetary aggregates can be used to extract information about them and thus help to determine the potential evolution of the macroeconomy. Thus, Woodford believes that monetary aggregates may contain useful information about the economy, but there is currently no good reason to assign target values to monetary aggregates in the conduct of policy.

This is the abstract, introduction, and conclusion - the paper itself is a bit technical:

How Important is Money in the Conduct of Monetary Policy?, by Michael Woodford, NBER WP 13325, August 2007 [open link]: Abstract: I consider some of the leading arguments for assigning an important role to tracking the growth of monetary aggregates when making decisions about monetary policy. First, I consider whether ignoring money means returning to the conceptual framework that allowed the high inflation of the 1970s. Second, I consider whether models of inflation determination with no role for money are incomplete, or inconsistent with elementary economic principles. Third, I consider the implications for monetary policy strategy of the empirical evidence for a long-run relationship between money growth and inflation. And fourth, I consider reasons why a monetary policy strategy based solely on short-run inflation forecasts derived from a Phillips curve may not be a reliable way of controlling inflation. I argue that none of these considerations provides a compelling reason to assign a prominent role to monetary aggregates in the conduct of monetary policy.

Introduction

It might be thought obvious that a policy aimed at controlling inflation should concern itself with ensuring a modest rate of growth of the money supply. After all, every beginning student of economics is familiar with Milton Friedman's dictum that "inflation is always and everywhere a monetary phenomenon" (e.g., Friedman, 1992), and with the quantity theory of money as a standard account of what determines the inflation rate. Yet nowadays monetary aggregates play little role in monetary policy deliberations at most central banks. King (2002, p. 162) quotes then-Fed Governor Larry Meyer as stating that "money plays no explicit role in today's consensus macro model, and it plays virtually no role in the conduct of monetary policy."

John Campbell: Who are the Noise Traders?

John Campbell on "Households, Institutions, and Financial Markets":

Households, Institutions, and Financial Markets, by John Y. Campbell, NBER Reporter: Economists studying asset pricing have begun to grapple seriously with the extraordinary diversity of financial market participants. Investors, including both households and financial institutions, differ in their overall resources, current and future labor income, housing and other assets that are expensive to trade, tax treatment, access to credit, attitudes towards risk, time horizons, and sophistication about financial markets. My recent research measures and models this heterogeneity, with a particular focus on time horizons and financial sophistication.

Behavioral finance emphasizes that some investors are likely to be more sophisticated about financial markets than others. Early behavioral models emphasized a distinction between "noise traders" and sophisticated arbitrageurs, the former trading randomly and creating profits for the latter.1 This of course raises the question of who can be described as a noise trader. Discussions at conferences are sometimes reminiscent of the old verse "It isn't you, it isn't me, it must be that fellow behind the tree". Recent literature has argued that institutional investors act as arbitrageurs, while the household sector as a whole may play the role of noise traders.

FRB Richmond: Do Nicotine Replacement Therapy Ads Encourage Smoking?

Vanessa Sumo of the Richmond Fed looks at research on the relationship between smoking and advertising for nicotine replacement products:

Ad Intervention, FRB Richmond, Region Focus, By Vanessa Sumo: Next Safety, a West Jefferson, N.C., company that specializes in high-tech respirators, recently introduced a handheld nicotine inhaling device that promises to help smokers kick the habit. About the size of a pack of cigarettes (but more closely resembling an iPod), the device is said to deliver nicotine into the bloodstream and to the brain more effectively than a cigarette can. So, smokers trying to quit can still get the nicotine fix that they crave, but without the dangerous effects of smoking tobacco.

Next Safety's pulmonary drug delivery device is one of many smoking cessation products available that aim to make it easier for people to quit. Most work by delivering nicotine — the addictive substance in tobacco — through a variety of methods such as inhalers, sprays, gums, and patches. A Surgeon General's report in 2000 said that there is "strong and consistent" evidence that such treatments can help people quit.

But what if the very existence of such products — publicized to the masses via advertising campaigns — actually causes some smokers to prolong the habit? A new study suggests that young smokers in particular can get the "wrong" message from ads promoting smoking cessation products because they may give the impression that quitting can be achieved easily. This is consistent with earlier research, which finds that people may become less careful about keeping a healthy lifestyle when, through advertising, they learn about a new drug treatment that can, for instance, treat high blood pressure or cholesterol. In other words, why exercise today when you can take a pill tomorrow?

Robert Barro: Sketch of a Model of Microsoft’s Social Value

One thing many people don't realize is that there is often a lot more behind the opinion pieces written by people like Paul Krugman, Greg Mankiw, Hal Varian, Dani Rodrik, Tyler Cowen, George Borjas, Robert Barro, Martin Feldstein, and others than it appears on the surface. That's not true in every case, but it is generally true when reputable economists weigh in on an issue.

For example, I recently had questions about calculations by Robert Barro in this editorial in the WSJ on Microsoft's social value. In response, he sent me this model that, though he does not regard it as definitive, explains the basis of his arguments.

In the model, production of goods requires intermediate products like software. The level of output, as explained below, depends upon the variety of these intermediate goods, i.e. how many different types are available. Thus, as we discover more "idea-type goods" such as Windows, we are able to produce more output. Therefore, in this model, the invention of Windows and other products adds to the variety of intermediate goods, the increased variety allows more goods to be produced, and the increased output adds social value by allowing higher consumption levels. Here's the analysis:

Sketch of a Model of Microsoft’s Social Value, by Robert Barro, June 2007 [pdf version]:  Goods are produced by competitive firms using the freely accessible production function:

where A>0, L is labor input, x_j is the quantity of intermediate input of type j, and N is the number of varieties of intermediates that exist.  The quantity L is in fixed aggregate supply.  Although L is called labor, it really represents all of the usual rival inputs to production (unskilled labor, skilled labor, capital—all treated here as in fixed aggregate supply).  Software and other idea-type goods are modeled as the intermediates.  These goods are treated, for simplicity, as non-durables.  The parameter α (0<α<1) will be the income share for intermediates.  The parameter σ (0<σ<1) measures substitutability among types of intermediates.  The presence of the last term in Eq. (1) will imply that total gross output, Y, is proportional to N, and this property will allow for endogenous growth in dynamic models where N grows due to R&D activity.  The present analysis considers only one-time shifts in N.

Suppose that an intermediate of type j is priced at P_j>0.  Competitive, profit-maximizing producers of final output equate the marginal product of x_j to P_j.  This condition yields the demand function:

Hence, if N is large, the elasticity of demand for x_j is approximately constant and equal to ‑1/(1-σ), which exceeds one in magnitude.  (Competitive producers of final goods hire labor at a given wage rate, w.  In equilibrium, w equals the marginal product of labor, and each producer of final goods earns zero profit.)

Each type of intermediate, x_j, is produced at constant marginal (and average) cost, c>0.  Without loss of generality, assume c=1.  Thus, physically, a unit of x_j is “produced” by taking a unit of final output and placing a j-type label on it.  This labeling is assumed to be the exclusive province of intermediate firm j, which owns the rights to produce that intermediate.  (This exclusive holder may be the inventor or developer.)  The perpetual profit flow for intermediate firm j is:

Will "The Productivity Miracle of the 1990s" Continue?

In this Economic Scene column, Austan Goolsbee discusses a paper by Nick Bloom, Raffaella Sadun and John Van Reenen and uses the results to argue against any move toward increased protectionist measures:

How the U.S. Has Kept the Productivity Playing Field Tilted to Its Advantage, by Austan Goolsbee, Economic Scene, NY Times: Americans’ anxiety level over competitiveness with other nations has grown in recent years. A large number of Americans appear to believe that the United States will not be able to succeed in an open world market, and they argue in favor of reducing our exposure to the outside. ...

For all the collective hand-wringing, the United States is still home to the most productive workers of all the major economies... Granted it started from the pole position, but the United States still kept the lead in what some economists have come to call the productivity miracle of the 1990s.

Normally, because it is easier to copy someone else’s innovation than to generate new ideas, as countries get richer and more productive, their growth rates slow. Other countries may have much faster growth than the United States, but once their income gets close to ours, their growth slows substantially. This is the law of convergence.

The data has mostly backed up the notion of convergence among rich countries for decades. The United States miracle of the 1990s was that our productivity began growing faster than that of other countries, even though we were the richest to start with.

The popular explanation, of course, pointed to information technology and, specifically, to the fact that the price of semiconductors began falling at an even more rapid rate ... starting in the 1990s. ... Low computer prices drove mass adoption of technology and, hence, the productivity miracle was born. Or so the story goes.

The only problem is, the explanation doesn’t work, according to John Van Reenen at the London School of Economics. ... He said that the prices of information technology fell in Europe, too. And Europeans bought information technology. But they had no productivity miracle.

To explain the experience in the United States, one would have to believe that Americans have some better way of translating the new technology into productivity than other countries. And that is precisely what Professor Van Reenen’s research suggests.

His paper “Americans Do I.T. Better: U.S. Multinationals and the Productivity Miracle,” (with Nick Bloom ... and Raffaella Sadun ...) looked at the experience of companies in Britain that were taken over by multinational companies with headquarters in other countries. ... [I]n the huge service sectors — financial services, retail trade, wholesale trade — they found compelling evidence ... that. ... [w]hen Americans take over a business in Britain, the business becomes significantly better at translating technology spending into productivity than a comparable business taken over by someone else. ...

The real question is whether this advantage will last. In an interview, Professor Van Reenen observed that there are two possible outcomes. One is that the last 10 years were an aberration...

But there is a chance that the 1990s represent a fundamental shift in the global economy. Perhaps the greater amount of uncertainty and churn in the world economy in the 1990s is the new norm. Perhaps the 21st century will continually favor those who adjust best to changes. As Professor Van Reenen put it, “If the world has become one in which everyone is trying to hit a moving target, it certainly helps to be the best at changing one’s aim.”

But that is, of course, the paradox of the American position. We hate experiencing major adjustments ... that force people to look for new jobs. That experience has made many skeptical about the future of the United States in the world economy. Yet the evidence seems to show that for all our dissatisfaction, we are the most flexible economy around and may be best poised to take advantage of the coming changes on a global scale precisely because we are so good at adjusting. ...

I agree that the disutility of "experiencing major adjustments" needs to be considered and minimized to avoid the rise of protectionist sentiment. But an issue that isn't mentioned, the distribution of the gains from trade and from technologically induced structural change, is also part of the political forces driving the opposition to trade liberalization. If faster response to change means that losers from the adjustment process are churned out more quickly, the politics will continue to build against globalization.

[Hal Varian also looks at work by Nick Bloom, Raffaella Sadun and John Van Reenen in an Economic Scene from January 2006, and he talks a little more about some of the reasons why U.S. companies might have an advantage in making using of information technology.]

"Spatial Mismatch or Racial Mismatch?"

David Neumark of UC Irvine, and Judith Hellerstein and Melissa McInerney of Maryland find that “racial mismatch” affects low-skill employment ["Spatial Mismatch or Racial Mismatch?," NBER W1361]:

Race, not space, key to lower black male employment rate, Today@UCI: A new study finds that in areas where low-skilled jobs are predominantly held by whites, black men who live nearby are less likely to get hired.

“The problem is not lack of jobs at appropriate skill levels where blacks live, but lack of jobs available to blacks,” said UC Irvine economist David Neumark, co-author of the study.

For years, it’s been widely accepted that space is a primary barrier to employment – meaning there are not enough low-skilled jobs where less-skilled black workers live. But by analyzing the employment, education level and location of more than 533,000 black males across the United States, Neumark and his colleagues found that the issue is not simply whether jobs are available nearby, but whether they are available to one’s own race.

“It’s an exaggeration to say blacks don’t live where the jobs are,” said Neumark. “In reality, there are many jobs held by non-blacks in areas where blacks live – including at lower education levels.”

And the greater the proportion of those jobs that are held by whites, the lower the chance the local blacks will get hired into those jobs.

“The jobs simply are not available to their race,” Neumark added.

The study does not answer the question of why this happens, but the researchers suggest discrimination or lack of labor market networks are likely causes.

Jobs for low-skilled workers are often advertised informally through word of mouth in social networks, such as among friends or church members, Neumark explained. In many communities, this means that blacks may not have good information about job openings in businesses employing mainly whites.

Neumark and his colleagues call this effect “racial mismatch,” a new spin on the term “spatial mismatch,” which has been used to describe the lack of the right jobs in the right place.

Recently, programs like “Wheels to Work” and “Moving to Opportunity” have emphasized getting the workforce to the appropriate jobs by providing transportation or relocation. But when Neumark and his colleagues ran a simulation based on their data, they found that eliminating location differences between blacks and whites would only close the racial employment gap for low-skilled individuals by 10 to 15 percent.

“That’s not a significant improvement in employment,” Neumark said. “Policies focused on getting people to the jobs miss the bigger barriers facing low-skilled blacks.”

Demographics and the Great Moderation

Many reasons for the Great Moderation - the substantial decline in economic volatility and inflation in the mid 1980s - have been given, including better technology (e.g. information processing allowing better inventory control and management), better policy (e.g. inflation targeting), a run of good luck where no big shocks hit the economy, and financial innovation and deregulation.

The paper discussed in this article from the Minneapolis Fed proposes another reason for the Great Moderation, demographic changes, and finds changes in the demographic composition of the labor force can account for around one fifth to one third of the decline in output variability:

Demographics and Economic Volatility, by Douglas Clement, Editor, The Region, Minneapolis Fed: In 2004, then Fed Governor Ben Bernanke addressed the “Great Moderation”—the remarkable decline in economic volatility observed in the United States and other advanced economies over the past two or three decades. He reviewed evidence for three explanations: structural change, good luck and improved policy, and then he focused on the last: the role that better monetary policy has played, particularly in the United States...

In a recent paper, ... Henry Siu of the University of British Columbia and Nir Jaimovich of Stanford University develop a new theory to help explain the Great Moderation in not only the United States but other industrialized economies. “Specifically,” write Jaimovich and Siu, “we find that changes in the age composition of the workforce account for a significant fraction of the variation in business cycle volatility.”

What's Life Worth?

What is the economic value of life and health?

Pinning Down the Money Value of a Person’s Life, by Alex Berenson, NY Times: How much is your life worth? How about a year of life? How much is your vision worth? What about being pain-free? Able to walk unassisted? ... Unanswerable questions all. Or maybe not.

Economists ... are trying to answer ...[a] difficult question... — the price of health. The exercise has enormous real-world implications ... as health care technology becomes more expensive and health care spending becomes a bigger burden on companies, taxpayers and patients. The price of health is part of the calculus in determining whether a new medicine or treatment is worth the cost.

While making such determinations may seem unsavory, ... “The reality is we have to make these comparisons, and we either do them implicitly or explicitly,” said Dana Goldman, director of health economics at the RAND Corporation...

To make the process more explicit, economists want to compare the cost-effectiveness of different treatments in a single measurement, one that doctors and policy makers will trust enough to use.

So, how much is your life worth? You may think the answer is infinity, that no amount of money could compensate you for the loss of your life.

But people do put a price tag on their existence. Workers accept riskier jobs for higher pay, for example. And the rich tend to think their lives are worth more than poor people’s.

Studies of real-world situations produce relatively consistent results, suggesting that average Americans value a year of life at $100,000 to $300,000, said Peter J. Neumann ... at Tufts...

So a year of life is worth at least $100,000. But that figure only begins to answer the question of what health is worth. ... [M]ost medical care has a ... modest goal: back surgery is performed to relieve the pain..., and drugs are given to lift depression or end an asthma attack more quickly. Those treatments are meant to improve — not necessarily to save — lives. Can their value actually be compared?

Has Globalization Changed Inflation?

Laurence Ball challenges several recent claims about the source of changes in the U.S. inflation rate [Update: Brad DeLong says "I'm on Larry Ball's side of this argument." I'm with him on the theoretical points, and I also agree with Larry Ball's characterization of the empirical evidence, i.e. that globalization has had little effect on the rate of inflation, but I'm remaining open-minded on the question since the econometric evidence is not strong enough to fully settle the issue.]:

Has Globalization Changed Inflation?, NBER Digest: Many observers have suggested that the behavior of U.S. inflation has been changed by the "globalization" of the economy. In 2005, for example, The Economist declared that recent experience "makes a mockery of traditional economic models of inflation, which ignore globalization." According to such commentators, globalization has helped to reduce inflation in the recent past and will help it to remain low in the future.

In "Has Globalization Changed Inflation?" (NBER Working Paper No. 12687), ... Laurence Ball questions this view. He reviews theory and evidence on the behavior of U.S. inflation, and concludes that globalization has had little effect on the rate of inflation in the United States.

Ball first questions the extent of globalization. Commentators suggest that inflation has been influenced by increasing trade between the United States and other countries. While trade has increased, however, this has occurred slowly over many decades. The last quarter century, when U.S. inflation has been tamed, is not noteworthy for particularly rapid increases in trade.

Ball then turns to arguments about why increased trade might influence inflation, and finds them flawed. One argument, suggested by Kenneth Rogoff of Harvard, is based on the idea that globalization has changed the Phillips curve, the short-run tradeoff between output and inflation. In this story, the tradeoff has become less favorable, with a given increase in output causing a larger rise in inflation. In theoretical models of inflation, such a change reduces the incentive for the Federal Reserve to pursue expansionary policies, leading to lower inflation.

This argument is questionable on theoretical grounds, but the biggest problem is empirical. The literature on the Phillips curve suggests that this relation has changed, but in the wrong direction. A given change in output has a smaller effect on inflation today than it did in the 1970s or early 1980s. Therefore, if the slope of the Phillips curve (the output-inflation tradeoff) were a key determinant of inflation, we should have seen rising inflation in recent decades.

Ball then examines another claim about the effects of globalization, which also relates to the output-inflation tradeoff. This claim is that globalization has weakened the link between U.S. inflation and the level of output in the U.S. economy, with economic booms causing less upward pressure on inflation. According to this view, what matters for inflation is output in the entire global economy.

Once again, Ball raises questions about the alleged effects of globalization. Empirically, there continues to be a close association between the level of U.S. output and changes in U.S. inflation, with at most a secondary role for output in other countries. A well-known study from the Bank for International Settlements has reported large effects of foreign output, but the statistical claims in that study do not withstand careful scrutiny.

Finally, Ball examines the role of falling prices for imported goods. Many policymakers and journalists cite increases in imports of low-cost goods from countries such as China and India. To many observers, it seems obvious that lower prices for imports contribute to lower inflation, since inflation is an average of the economy's price changes.

However, this idea rests on a confusion between relative prices and the aggregate price level. As Milton Friedman pointed out long ago, changes in the price level – that is, the inflation rate – depend on monetary factors. Trade with China and India reduces the relative prices of certain goods, which increases U.S. living standards, but there is no obvious effect on inflation.

There appear to be some historical episodes, such as the oil-price increases of the 1970s, when changes in relative prices did affect inflation. However, these involved large, sudden shocks to the economy. The steady rise in foreign trade has caused downward trends in some relative prices, but such smooth changes are unlikely to affect inflation significantly.

NBER: TV Appearance and Electoral Success

What's the best way to predict the winner in an election? Not by listening to what the candidates have to say, these results suggest that "that the less one hears a candidate, the better one can assess his or her chances of winning":

NBER: TV Appearance and Electoral Success, by Laurent Belsie, NBER Digest: Forget the campaigns. Disregard the position papers and attack ads. One of the best ways to tell who's going to win an election is to see the candidates on TV, watching them for 10 seconds and keeping the sound off. That's how more than 260 Harvard undergraduates, watching gubernatorial candidates in 58 races, compiled a rather impressive record of forecasting elections. They picked the winner an average 58 percent of the time, according to Thin-Slice Forecasts of Gubernatorial Elections (NBER Working Paper No. 12660 [Note: open link]). The students were more accurate than any economic measure that the paper's co-authors, Daniel Benjamin and Jesse Shapiro, tested. They were far more accurate than the Harvard students who actually heard what the candidates had to say.

If this gut-level, insta-pick method seems disturbing, take heart. At least Americans aren't alone in skin-deep politics. A study of the 1996 presidential race in Romania found that people could predict the outcome of the first round of voting based merely on photographs and video clips of the candidates. A study last year of Finnish elections found that ratings of candidates' physical attractiveness predicted their success better than ratings of their competence.

Following these foreign and other similar U.S.-based studies, the NBER paper offers several new insights. It quantifies how much of a role personal appeal plays in relation to other economic and political factors. It tries to single out the quality behind such appeal. It suggests, strikingly, that the less one hears a candidate, the better one can assess his or her chances of winning. That last finding "may help to explain why expert forecasters, who are highly informed about and attentive to policy matters, are often found to perform no better than chance in predicting elections," the authors write.

The thrust of the NBER research was to ensure that the subjects knew as little as possible about the candidates they were seeing. ... The results were consistent. Students who saw silent videos picked the right candidate 58 percent of the time, whereas those viewers who heard full sound or muddled sound were only right 52 and 48 percent of the time, respectively, no better than the results of random guessing. Moreover, the predictions from the no-sound videos closely mirrored the results of the actual elections. So, the larger the majority of students that a candidate "won," the larger the share of voters he or she was likely to have won at the ballot box.

Their forecasts were far more accurate than elections based on various economic measures of voter well-being, such as per capita income, unemployment, or state fiscal health. Even when such state and local data was significantly better or worse than national trends, the predictive power of economics was limited.

But if it's not "the economy, stupid" -- if, indeed, Bill Clinton was wrong about the key to a winning campaign message -- then what winning quality were the Harvard students detecting when they picked winning candidates?

The authors looked at the influence of candidates' race, gender, and height to see if students were swayed by these factors. Gender and race weren't a factor, since students were just as accurate predicting races involving two white males as they were in the races overall. Height played a small role but was statistically insignificant. So were qualities such as likeability and physically attractiveness. Candidates the students judged to be good leaders had a slightly better chance of winning than those not rated as good leaders, but the correlation was marginal. Finally, the researchers looked into whether a candidate's confidence influenced students. But in the 22 races that were considered close, where presumably the two candidates were equally confident ..., the students' accuracy in picking winners was roughly on par with the overall sample.

Thus, the research suggests that some factor beyond the students' own preferences or the vagaries of a particular race -- the authors call it candidate charisma or personal appeal -- is communicable, even during a 10-second silent video clip.

Two political factors turned out to be more accurate than the students' picks. One is incumbency, which accounted for about 23 percent of the voting outcome compared with about 20 percent for the student predictions. Campaign spending was even more accurate, accounting for about 33 percent of the outcome.

These findings come with their own chicken-and-egg complexity. If good fundraising causes election success, then candidates' charisma plays a smaller though still significant role in predicting their success. But if good fund-raising is caused by other factors, as other researchers have found, then charisma may play a larger role than this research suggests. The same dilemma conundrum applies to incumbency. The best that can be said is that charisma and ballot box success are related in ways that economic factors cannot come close to matching.

Price Measurement for Monetary policy

This is unlikely to be of much interest generally - it's a set of papers I want to have in the archives:

Economic Prosperity: Human Capital or Protestant Work Ethic?

From Andrew Leigh (via Tim Worstall):

Martin Luther’s Legacy, by Andrew Leigh [open link]: I’ve always found the studies that look at the effect of religion on economic growth a bit fluffy. But this very clever paper goes far further than previous work in explaining why Protestant countries and regions might grow faster. If you learn to read the bible, you can read other things too.

Was Weber Wrong? A Human Capital Theory of Protestant Economic  History, by Sascha Becker & Ludger Woessmann: Max Weber attributed the higher economic prosperity of Protestant regions to a Protestant work ethic. We provide an alternative theory, where Protestant economies prospered because instruction in reading the Bible generated the human capital crucial to economic prosperity. County-level data from late 19th century Prussia reveal that Protestantism was indeed associated not only with higher economic prosperity, but also with better education. We find that Protestants’ higher literacy can account for the whole gap in economic prosperity. Results hold when we exploit the initial concentric dispersion of the Reformation to use distance to Wittenberg as an instrument for Protestantism.

Axel Leijonhufvud: Life Among the Econ

Continuing the discussion on economic orthodoxy, this is Axel Leijonhufvud with what Chris Hayes calls "the ur-text for writings about the particularities of the economics profession." It's longer than usual, but worth it:

Life among the Econ,* by Axel Leijonhufvud: The Econ tribe occupies a vast territory in the far North. Their land appears bleak and dismal to the outsider, and travelling through it makes for rough sledding; but the Econ, through a long period of adaptation, have learned to wrest a living of sorts from it. They are not without some genuine and sometimes even fierce attachment to their ancestral grounds, and their young are brought up to feel contempt for the softer living in the warmer lands of their neighbours. such as the Polscis and the Sociogs. Despite a common genetical heritage, relations with these tribes are strained-the distrust and contempt that the average Econ feels for these neighbours being heartily reciprocated by the latter-and social intercourse with them is inhibited by numerous taboos. The extreme clannishness, not to say xenophobia, of the Econ makes life among them difficult and perhaps even somewhat dangerous for the outsider. This probably accounts for the fact that the Econ have so far-not been systematically studied. Information about their social structure and ways of life is fragmentary and not well validated. More research on this interesting tribe is badly needed.

Martin Feldstein: Why is the Dollar so High?

In this paper, Martin Feldstein gives and explanation for why the dollar is so high:

Why is the Dollar so High?, by Martin Feldstein, NBER WP 13114: Abstract The level of the dollar is part of a complex general equilibrium system. Nevertheless, it is helpful to recognize that the high level of the dollar is necessary to generate the current account deficit equal to the difference between national saving and investment. Understanding the high level of the dollar therefore requires understanding the reasons for the low level of national saving in the United States. Reducing the large current account deficit will require both a higher rate of national saving and a more competitive dollar. Although the necessary decline in the real value of the dollar can in theory occur without a decline in the dollar's nominal value, the implied magnitude of the fall in the domestic price level is implausible. A decline of the real value of the dollar that is large enough to reduce the current account deficit significantly requires a significant decline in the nominal value of the dollar.

Link to paper