Economics 470/570 - Monetary Theory and Policy

Lecture 17 on Tuesday 11/29/2012

Brief Outline of Topics Covered in Lecture 17

• Summary and Overview
• Answer Questions

Video

Extra Reading:

Tim Duy:

A Little Less Dovish..., by Tim Duy: In the midst of an internal debate over policy communication, Chicago Federal Reserve President Charles Evans pulled back on his 3 percent inflation threshold in a speech yesterday. Arguably, as the only policymaker suggesting guidance well above the Fed's stated 2 percent target, Evans was the last true dove at the Fed. With Evan's falling in line with his colleagues, it looks like the last sliver of hope that the Fed would tolerate slightly higher inflation to accelerate the reduction of real burden has now been dashed.

There is a lot of interesting material in Evan's speech, but here I focus only on his basic outlook and the implications for policy. Regarding growth:

That said, monetary policymakers must formulate policy for today. In the United States, forecasts by both private analysts and FOMC participants see real GDP growth in 2012 coming in at a bit under 2 percent. Growth is expected to move moderately higher in 2013, but only to a pace that is just somewhat above potential. Such growth would likely generate only a small decline in the unemployment rate.

Of course, he added earlier that this forecast is vulnerable to the possible of an austerity bomb in 2013, but for the moment assume that issue is resolved:

Having said all that, most forecasters are predicting that the pace of growth will pick up as we move through next year and into 2014. Underlying these projections is an assumption that fiscal disaster will be avoided—and with this, that some important uncertainties restraining growth should come off the table. Also, deleveraging will run its course, and as it does, the economy’s more-typical cyclical recovery dynamics will take over. As the FOMC indicated in its policy moves last September, the current highly accommodative stance for monetary policy will be kept in place for some time to come.

He then praises recent policy actions:

Tying the length of time over which our purchases will be made to economic conditions is an important step. Because it clarifies how our policy decisions are conditional on progress made toward our dual mandate goals, markets can be more confident that we will provide the monetary accommodation necessary to close the large resource gaps that currently exist; additionally, markets can be more certain that we will not wait too long to tighten if inflation were to become an important concern.

And then tackles a big question:

The natural question at this point is to ask: What constitutes substantial improvement in labor markets? Personally, I think we would need to see several things. The first would be increases in payrolls of at least 200,000 per month for a period of around six months. We also would need to see a faster pace of GDP growth than we have now — something noticeably above the economy’s potential rate of growth.

From Evan's perspective, these conditions would be sufficient to end the expansion of the balance sheet, although interest rates will remain near zero beyond that point. When should rates rise?

Of course, we will not maintain low rates indefinitely. For some time, I have advocated the use of specific, numerical thresholds to describe the economic conditions that would have to occur before it might be appropriate to begin raising rates.

On the employment mandate:

In the past, I have said we should hold the fed funds rate near zero at least as long as the unemployment rate is above 7 percent and as long as inflation is below 3 percent. I now think the 7 percent threshold is too conservative....This logic is supported by a number of macro-model simulations I have seen, which indicate that we can keep the funds rate near zero until the unemployment rate hits at least 6-1/2 percent and still generate only minimal inflation risks.

So he shifts to a 6.5 percent threshold for unemployment, and later argues that even this might be a bit conservative as his models don't foresee much inflation pressure before 6 percent. See also Federal reserve Janet Yellen's recent speech; Evans' view is consistent with the optimal path forecasts. On one hand this is somewhat of a shift to the dovish side on the inflation forecast, suggesting that inflation will not accelerate as quickly as some might expect. What about the threshold for the rate of inflation itself?

With regard to the inflation safeguard, I have previously discussed how the 3 percent threshold is a symmetric and reasonable treatment of our 2 percent target. This is consistent with the usual fluctuations in inflation and the range of uncertainty over its forecasts. But I am aware that the 3 percent threshold makes many people anxious. The simulations I mentioned earlier suggest that setting a lower inflation safeguard is not likely to impinge too much on the policy stimulus generated by a 6-1/2 percent unemployment rate threshold. Indeed, we’re much more likely to reach the 6-1/2 percent unemployment threshold before inflation begins to approach even a modest number like 2-1/2 percent.

So, given the recent policy actions and analyses I mentioned, I have reassessed my previous 7/3 proposal. I now think a threshold of 6-1/2 percent for the unemployment rate and an inflation safeguard of 2-1/2 percent, measured in terms of the outlook for total PCE (Personal Consumption Expenditures Pride Index) inflation over the next two to three years, would be appropriate.

Notice that he really doesn't have a reason to shift his threshold; he doesn't even expect to hit the inflation threshold before hitting the employment threshold. His reason for essentially is that the 3 percent threshold makes people "anxious." Anxious about what? Anything that is perceived to be a threat to the Fed's credibility.

Does this shift on Evans' part really change anything? Probably not. He was always an outlier among Fed policymakers, with a tolerance for inflation as high as 3 percent making him a true dove. But he was never going to get any additional traction on that front from his colleagues. The 2 percent target is set in stone, and it is too much to expect the Fed will tolerate any meaningful deviations from that target. Of course, it is questionable that 3 percent is a meaningful deviation to begin with, but that is question is almost irrelevant at this point.

Bottom Line: By shifting his threshold on inflation, Evan's concedes to the political realities within the Fed. There was never much support for anything like tolerance for 3 percent inflation; for most policymakers, I suspect anything above 2.25 percent would be considered a threat to credibility. By falling in line with the rest of the FOMC, Evan abandons his role as a true dove, someone willing to tolerate substantially higher inflation. He is a dove now in the modern sense - a policymaker with a lower inflation forecast that allows for a longer period of easier policy.

Lecture 16 on Tuesday 11/27/2012

Brief Outline of Topics Covered in Lecture 16

Chapter 24 The Role of Expectations in Monetary Policy [continued]

The Lucas Critique of Econometric Policy Evaluation

Rules versus Discretion

• Discretion and Time-Inconsistency
• Types of rules
• The case for rules
• The case for discretion
• Constrained Discretion

The role of credibility and a nominal anchor

Credibility and aggregate demand shocks

• Positive and negative  AD shocks
• AS shocks
• Credibility and anti-inflation policy

Video

Extra Reading:

This Economic Letter from the SF Fed is on government spending multipliers:

Highway Grants: Roads to Prosperity?, by Sylvain Leduc and Daniel Wilson, FRBSF: Increasing government spending during periods of economic weakness to offset slower private-sector spending has long been an important policy tool. In particular, during the recent recession and slow recovery, federal officials put in place fiscal measures, including increased government spending, to boost economic growth and lower unemployment. One form of government spending that has received a lot of attention is public investment in infrastructure projects. The 2009 American Recovery and Reinvestment Act (ARRA) allocated $40 billion to the Department of Transportation for spending on the nation’s roads and other public infrastructure. Such public infrastructure investment harks back to the Great Depression, when programs such as the Works Progress Administration and the Tennessee Valley Authority were inaugurated.

One criticism of public infrastructure programs is that they take a long time to put in place and therefore are unlikely to be effective quickly enough to alleviate economic downturns. The fact is, though, that surprisingly little empirical information is available about the effect of public infrastructure investment on economic activity over the short and medium term.

This Economic Letter examines new research (Leduc and Wilson, forthcoming) on the dynamic effects of public investment in roads and highways on gross state product (GSP), the total economic output of a state. This research focuses on investment in roads and highways in part because it is the largest component of public infrastructure in the United States. Moreover, the procedures by which federal highway grants are distributed to states help us identify more precisely how transportation spending affects economic activity.

We find that unanticipated increases in highway spending have positive but temporary effects on GSP, both in the short and medium run. The short-run effect is consistent with a traditional Keynesian channel in which output increases because of a rise in aggregate demand, combined with slow-to-adjust prices. In contrast, the positive response of GSP over the medium run is in line with a supply-side effect due to an increase in the economy’s productive capacity.

We also assess how much bang each additional buck of highway spending creates by calculating the multiplier, that is, the magnitude of the effect of each dollar of infrastructure spending on economic activity. We find that the multiplier is at least two. In other words, for each dollar of federal highway grants received by a state, that state’s GSP rises by at least two dollars.

The Federal-Aid Highway Program

The federal government’s involvement in financing road construction goes back to the early part of the past century. Although initially small, this involvement became much more significant in 1956 with the enactment of the Federal-Aid Highway Act, which authorized almost $34 billion in 1956 dollars over 13 years for the construction of the Interstate Highway System. At the time, The New York Times noted that “the highway program will constitute a growing and ever-more-important share of the gross national product … (affecting) every phase of economic life in this country.”

The Interstate Highway System was completed in 1992. Since then, the federal government has continued to provide funding to states mostly through a series of grant programs collectively known as the Federal-Aid Highway Program (FAHP). The FAHP helps fund construction, maintenance, and other improvements on a wide range of public roads beyond the interstate highways. Local roads are often considered federal-aid highways and are eligible for federal funding, depending on how important the federal government judges them to be.

Because road projects typically take a long time to complete, advance knowledge of future funding sources can help smooth planning. Congress designs transportation legislation to minimize uncertainty. First, it enacts legislation that typically extends five to six years. Second, it apportions funds to states according to set formulas. Thus, a typical highway bill will specify an annual national amount for each highway program over the life of the legislation and spell out the formula by which that program’s national amount will be apportioned to states. Importantly, these formulas are based on road-related metrics measured several years earlier. That means that changes to current and future highway funding are not driven by current economic conditions.

Highway bills generally include information that helps states forecast relatively accurately the amount of grants they are likely to receive while the legislation is in effect. For the past two highway bills, the Federal Highway Administration (FHWA) published forecasts of each state’s annual future grants under each program.

Estimating the effects of road spending

We conduct a statistical analysis to estimate the effects of federal highway spending on state economic activity. Specifically, we construct a variable that captures revisions to forecasts of current and future highway grants to the states, based on information from highway bills since 1991. We closely follow, but also expand on, the FHWA’s methodology for forecasting each state’s future grants.

These forecast revisions serve as proxies for changes in expectations about current and future highway spending in a given state. In economic terms, these changes can be regarded as shocks, that is, unanticipated events that affect economic activity.

We study forecast revisions rather than changes in actual highway spending for two reasons. First, actual spending may both affect and be affected by current economic conditions, making it difficult to sort out the true causal effects of the spending.

Second, changes in actual spending are most likely to be anticipated years in advance. For that reason, some of their economic effects may be felt before the spending changes actually take place. For instance, a state government and other important players, such as construction and engineering firms, may decide to spend more today if they expect the state to receive more highway grants in the future. In this way, changes in expectations regarding future grants to the states may be important for current economic activity. Failing to account for changes in expectations may lead to incorrect conclusions about how government spending affects economic activity (see Ramey 2011a).

Figure 1
Average response of state GDPs to unexpected grants

In our analysis of how changes in forecasts of highway grants to the states affect state GSP, we control for lags in state GSP, lags in receipt of highway grants, average state GSP levels, and national movements of gross domestic product (GDP) over the sample period from 1990 to 2010.

In Figure 1, the solid line shows the average percentage change in a state’s GSP following a 1% increase in forecasted future highway grants to the states. The shaded area around the line represents a 90% probability range. The horizontal axis indicates the number of years after the unanticipated change in forecasted highway grants to the states. The figure shows that changes in the forecasts have a significant short-term effect on state output in the first one to two years. This effect fades, but then increases sharply six to eight years after the forecast revisions, before declining again. This pattern holds up well with alternative estimation techniques, the inclusion of different control variables, and with different data samples.

This pattern is consistent with New Keynesian theoretical models in which public infrastructure, such as roads, are used by the private sector in the production of goods and services and take time to be built (see Leduc and Wilson, forthcoming). In this framework, the initial impact is due to a traditional Keynesian effect of an increase in aggregate demand. The medium-term effect on output arises once the public infrastructure is built, thus increasing the economy’s productive capacity.

The highway grant multiplier

One concept often used to assess the effectiveness of government spending is the multiplier. The fiscal multiplier represents the dollar change in economic output for each additional dollar of government spending. Thus, a multiplier of two implies that, when government spending increases by one dollar, output rises by two dollars.

Based on the results shown in Figure 1, we find that multipliers for federal highway spending are large. On initial impact, the multipliers range from 1.5 to 3, depending on the method for calculating the multiplier. In the medium run, the multipliers can be as high as eight. Over a 10-year horizon, our results imply an average highway grants multiplier of about two.

Our estimated multipliers are noticeably larger than those typically found in the literature on the effects of government spending. For instance, in a recent survey, Valerie Ramey reports multipliers between 0.5 and 1.5 (see Ramey 2011b). One possible reason for the wide differences is that we consider a very different form of government spending. Most of the literature concentrates on the multiplier effect of military spending. But such spending is arguably nonproductive in an economic sense. By contrast, government investment in infrastructure, such as roads, can raise the economy’s productive capacity. In that respect, it can have a higher fiscal multiplier. Another difference is that we concentrate on the multiplier effect on GSP, while the literature typically studies the effect on U.S. GDP as a whole.

The American Recovery and Reinvestment Act

The deep recession of 2007–09 led to the enactment of ARRA, which included a large one-time increase of $27.5 billion in federal highway grants to states. ARRA was designed to have strong short-term effects. In general, infrastructure projects are not viewed as effective forms of short-term stimulus because of the long lags between authorization, planning, and implementation. By the time the projects get under way, a recession may be over. The extra spending could ultimately end up feeding an already booming economy. To address this problem, ARRA stipulated that state governments had to fully use their share of federal highway grants by March 2010.

It is conceivable that highway spending during a major downturn, when productive capacity is underutilized, may affect output in a substantially different way than spending during more normal times. To test this, we examined whether unanticipated changes in highway spending in 2009 and 2010 had a different effect on GSP than in other years in our sample. We found that spending in 2009 and 2010 was roughly four times as large as the peak response shown in Figure 1. This suggests that highway spending can be effective during periods of very high economic slack, particularly when spending is structured to reduce the usual implementation lags.

Conclusion

Surprise increases in federal investment in roads and highways appear to have had positive effects on gross state product in both the short and medium run. The short-run impact is akin to the traditional Keynesian effect that stems from an increase in aggregate demand. By contrast, the positive impact on GSP in the medium run is probably due to supply-side effects that boost the economy’s productive capacity. Infrastructure investment gets a good bang for the buck in the sense that fiscal multipliers—the dollar of increased output for each dollar of spending—are large.

References

Leduc, Sylvain, and Daniel J. Wilson. Forthcoming. “Roads to Prosperity or Bridges to Nowhere? Theory and Evidence on the Impact of Public Infrastructure Investment.” NBER Macroeconomics Annual 2012.

Ramey, Valerie A. 2011a. “Identifying Government Spending Shocks: It’s all in the Timing.” Quarterly Journal of Economics 126(1), pp. 1–50.

Ramey, Valerie A. 2011b. “Can Government Purchases Stimulate the Economy?” Journal of Economic Literature 49(3), pp. 673–685.

Homework 7

Economics 470/570
Monetary Theory and Policy
Homework 7

1. Use the Phillips curve model to explain the SR and LR effects of expected and unexpected changes in the inflation rate..

2. Does stabilizing the inflation rate stabilize the economy? Explain.

3. What problems are encountered in the pursuit of activist policies?

4. Explain how demand pull inflation can occur.

5. What is the Lucas critique of econometric policy evaluation?

6. What are the arguments for and against rules over discretion?

7. Show that credibility of the Fed helps to stabilize the economy when there are negative AD shocks.

Lecture 15 on Tuesday 11/20/2012

Brief Outline of Topics Covered in Lecture 15

Chapter 23 Monetary Policy Theory [continued]

Response of monetary policy to shocks

• Response to an AD Shock
• Response to a permanent supply shock
• Response to a temporary supply shock
• Summary

How active should policymakers be?

Is inflation always a monetary phenomenon?

• Causes of inflationary monetary policy

Chapter 24 The Role of Expectations in Monetary Policy

The Lucas Critique of Econometric Policy Evaluation

Rules versus Discretion

• Discretion and Time-Inconsistency
• Types of rules
• The case for rules
• The case for discretion
• Constrained Discretion

The role of credibility and a nominal anchor

Credibility and aggregate demand shocks

• Positive and negative  AD shocks
• AS shocks
• Credibility and anti-inflation policy

Video

Extra Reading:

I mentioned thresholds versus triggers last class:

Distinguishing Between a Fed Threshold and Trigger, by Neal Lipschutz, WSJ: Break out the dictionaries. We are likely to be hearing a lot about the word threshold, and how it is different from the word trigger...

Eric S. Rosengren, president of the Federal Reserve Bank of Boston, took on the threshold versus trigger issue at some length in a Nov. 1 speech.

“I think of a trigger as a set of conditions that necessarily imply a change in policy,” he said in the speech text. “A threshold, unlike a trigger, does not necessarily precipitate a change in policy.”

Later he added, “A threshold precipitates a discussion and more thorough assessment of appropriate policy, versus a trigger which starts a change of policy.”

Why wouldn’t the Fed immediately shift policy if its thresholds for employment and inflation were met?

Mr. Rosengren offered one example. “Suppose we reach one’s threshold unemployment rate but at that time the economy is slowing, and no further improvement in the unemployment rate is expected in the short to medium term,” he wrote in the Nov. 1 speech text. “This hypothetical situation would not necessarily imply a change in policy stance …”

Banking in 1947

[via]

Lecture 14 on Thursday 11/15/2012

Brief Outline of Topics Covered in Lecture 14

Chapter 22 - Appendix - The Phillips Curve and the SRAS Curve

The Phillips curve 

• The PC in the 1960's: A permanent tradeoff
• The Friedman-Phelps augmented PC
• The modern PC (adds supply shocks)
• The modern PC with Adaptive Expectations
• Okun's law and the SRAS

Chapter 23 Monetary Policy Theory [probably won't get very far into this chapter]

Response of monetary policy to shocks

• Response to an AD Shock
• Response to a permanent supply shock
• Response to a temporary supply shock
• Summary

How active should policymakers be?

Is inflation always a monetary phenomenon?

• Causes of inflationary monetary policy

Video

Extra Reading:

Tim Duy:

Yellen Supports Explicit Guideposts, by Tim Duy: Today Federal Reserve Vice Chair Janet Yellen discussed the evolution of policy communications. As might be expected from Yellen, there was a dovish tone to the speech. She provides a very nice overview of the Fed's changing communication strategy before shifting to her preferred path for the future. Along the way, she reiterates her estimated optimal path for monetary policy:

The notable feature of the optimal path is that inflation glides to its long-run target from above while unemployment does the opposite. These path are achieved by holding down interest rates longer than the level implied by a Taylor-type rule. Yellen explains that it is challenging to communicate such a rule, particularly in the current circumstances:

The fact that simple rules aren't as useful in current circumstances as they would be for the FOMC at other times poses a significant challenge for FOMC communications, especially since private-sector Fed watchers have frequently relied on such rules to understand and predict the Committee's decisions on the federal funds rate...

...Now, however, the federal funds rate may well diverge for a number of years from the prescriptions of simple rules. Moreover, the FOMC announced an open-ended asset purchase program in September, and there is no historical record for the public to use in forming expectations on how the FOMC is likely to use this tool. Thus, the current situation makes it very important that the FOMC provide private-sector forecasters with the information they need to predict how the likely path of policy will change in response to changes in the outlook...

How can the Fed augment the current communication strategy of an expected time frame for exceptionally low rates coupled with broad economic objectives to be met prior to changing policy? First, more explicit forecasts:

One logical possibility would be for the Committee to publish forecasts akin to those I've presented in figure 1. That is, the Committee could provide the public with its projections for inflation and the unemployment rate together with what it views as appropriate paths both for the federal funds rate and its asset holdings, conditional on its current outlook for the economy.

Yellen notes, however, that the Fed's institutional structure relies on 19 forecasts, which is challenging to synthesize into a single forecast. Research in this area is ongoing. She then supports the basic approach advocated by Chicago Federal Reserve President Charles Evans and Minneapolis Federal Reserve President Narayana Kocherlakota:

Another alternative that deserves serious consideration would be for the Committee to provide an explanation of how the calendar date guidance included in the statement--currently mid-2015--relates to the outlook for the economy, which can and surely will change over time. Going further, the Committee might eliminate the calendar date entirely and replace it with guidance on the economic conditions that would need to prevail before liftoff of the federal funds rate might be judged appropriate. Several of my FOMC colleagues have advocated such an approach, and I am also strongly supportive. The idea is to define a zone of combinations of the unemployment rate and inflation within which the FOMC would continue to hold the federal funds rate in its current, near-zero range.

While I like explicit targets in theory, I have been concerned that monetary policy is too complex to summarize in two numbers, thus making it a communications nightmare rather than a dream. Perhaps I am too pessimistic. Yellen offers a response:

Under such an approach, liftoff would not be automatic once a threshold is reached; that decision would require further Committee deliberation and judgment.

Not a fixed target that requires action, just consideration of action. Whether the rest of the FOMC follows suit with this approach is another question, but the winds are definitely blowing in that direction. On average then, this is relatively dovish. The Fed is heading toward a policy direction that would explicitly allow for inflation somewhat above target and unemployment below target as long as inflation expectations remained anchored. One would think this should put upward pressure on near term inflation. But Ryan Avent notes the opposite is occuring:

But since mid-October, there has been an unmistakable reversal in the inflation-expectations trend. Based on 5-year breakevens, all of the September spurt has been erased. And 2-year breakevens are back at July levels. Given my optimism over the Fed's September moves and the apparent strength of underlying fundamentals in the economy, I would like to disregard this trend, but one should be very reluctant to abandon guideposts that have served one well just because they've moved in an inconvenient way.

Graphically:

Avent has a point here (with the caveat that TIPS-based inflation expectations might be less than perfect). He also expressed concern about a broader array of assets:

Other proxies for demand—equity prices, bond yields, and the level of the dollar—have also moved, albeit modestly, in worrying ways. The S&P 500 is down a bit over 5% from its September high, the 10-year Treasury yield has fallen more than 20 basis points since October, and the trade-weighted dollar, which plunged after the Fed's September meeting, has been strengthening since the middle of last month.

I would add that Yellen's speech did not even generate a knee-jerk response in the stock market today. I remember a time not long ago when any hint of dovishness was good for a 1% rally. Which, combined with Avent's thoughts, leaves me wondering if open-ended QE is the last of the Fed's monetary tools. We now know the Fed will continuously exchange cash for Treasury or mortgage bonds until the Fed's economic objectives are met. Uncertainty about the course of monetary policy as been largely eliminated. There is not likely to be a premature policy reversal. What if the pace of the economy does not accelerate, sustaining a large, persistent output gap and a low inflation environment? The Fed could increase the pace of purchases, but would this really change expectations? Can we get more "open-ended?"

Bottom Line: Yellen delivers a dovish speech, siding with Evans and Kocherlakota who had previously advocated explicit inflation and unemployment guidelines for policy change. The Fed is moving in this direction, promising to further lock-in a program of aggressive large scale asset purchases. But is this the end of the road for policy? "Open-ended" sounds much like "unlimited." And unlimited sounds like the end of the road. If the economy stumbles, will the Fed pull a new trick out of its policy bag, or is that bag finally empty? And if that bag is empty, then we will need to turn to fiscal policy if the economy stumbles. This is worrisome given the expected path of fiscal policy - tighter, just degrees of tighter. Which means for the moment we just cross our fingers and hope the economy gains traction on the back of housing and accelerates as 2013 progresses.

Homework 6

Economics 470/570
Monetary Theory and Policy
Homework 6

1. How does the effectiveness of monetary policy change when there is a decrease in the responsiveness of investment to the interest rate? What does this imply about the effectiveness of monetary policy over the business cycle?

2. Derive the SRAS and LRAS curves from  labor supply-labor demand and production function diagrams (alternatively, do it mathematically as we did in class).

3. Use AD-AS and IS-MP diagrams to examine the short-run and long-run effects of an increase in business confidence.

4. Use AD-AS and IS-MP diagrams to examine the short-run and long-run effects of the Fed tightening monetary policy.

5. Use AD-AS and IS-MP diagrams to examine the short-run and long-run effects of a temporary increase in the price of oil. How does the result differ if the change in the price of oil is permanent?

6. Use AD-AS and IS-MP diagrams to examine the short-run and long-run effects of an increase in the capital stock.

Lecture 13 on Tuesday 11/13/2012

Brief Outline of Topics Covered in Lecture 13

Chapter 22 Aggregate Demand and Supply Analysis [continued]

The Aggregate Supply Curve 

• LRAS curve
• SRAS curve
• Shifts in the LRAS curve
• Shifts in the SRAS curve
• Equilibrium of AS and AD
• SR and LR response to AD shocks
• SR and LR response to AS shocks

Chapter 22 - Appendix - The Phillips Curve and the SRAS Curve

The Phillips curve 

• The PC in the 1960's: A permanent tradeoff
• The Friedman-Phelps augmented PC
• The modern PC (adds supply shocks)
• The modern PC with Adaptive Expectations
• Okun's law and the SRAS

Video

Not yet available

Extra Reading:

I mentioned this tendency for people to overstate inflation in class:

Getting the Questions Right, by David Altig, Atlanta Fed: Among the plethora of post-election exit-poll results, the CNBC website highlights a particularly interesting response, linked from the mega-blog Instapundit with the title "Voters Worry More About Inflation Than You Think." The CNBC article itself, written by Allison Linn, describes the poll results in more detail:

It's no surprise that voters in Tuesday's presidential election identified the economy as the No. 1 issue in the campaign, far ahead of health care and the federal budget deficit.
But it was a surprise that so many voters identified rising prices as the biggest economic problem they face.

Linn notes something of a disconnect between this view and the facts on the ground:

...inflation has generally been running well under 2 percent, and Federal Reserve bankers repeatedly have said they feel comfortable that low inflation allows them to keep interest rates at rock-bottom levels.

Yet in an exit poll of more than 25,000 voters conducted by NBC News, 37 percent identified rising prices as the biggest problem facing people like them.

Unemployment was cited by 38 percent, only slightly more than the number who said inflation was their top economic concern. Taxes were named by 14 percent and the housing market was the top concern of 8 percent.

The policy stakes on understanding these responses are pretty high. In the end, the cost of inflation comes in the form of how it may distort behavior and the allocation of resources. So the expectation or perception of significant inflation is at least as pernicious as the measurement itself.

But what, exactly, does this concern about "inflation" actually reflect? Probably not what we think. Some time ago, my colleagues Mike Bryan and Guhan Venkatu (from the Cleveland Fed) made note of "The Curiously Different Inflation Perspectives of Men and Women." Their findings are pretty informative:

Over the past few years, the Federal Reserve Bank of Cleveland, with assistance from the Ohio State University, has studied household inflation perceptions and expectations using a monthly survey of approximately 500 Ohioans (the FRBC/OSU Inflation Psychology Survey). This survey, which records respondents' perceptions of price changes over the past 12 months as well as their expectations for price changes over the next 12 months, has uncovered a surprising result. The data indicate that the public's estimates and predictions of inflation are significantly and systematically related to the demographic characteristics of the respondents. People with high incomes perceive and anticipate much less inflation than people with low incomes, married people less than singles, whites less than nonwhites, and middle-aged people less than young people. This Commentary describes what is perhaps the most curious observation of all: Even after we hold constant income, age, education, race, and marital status, men and women hold very different views on the rate at which prices are changing.

...[S]tatistical tests reveal that even after we adjust for the respondents' age, race, education, and income, women in our survey tended to think inflation was 1.9 percentage points higher than men. A similar examination of respondents' predictions of future inflation yields the same basic result: After we account for other major demographic factors, on average, women expected prices to rise 2.1 percentage points more than men.

It is important to note that this result was not unique to the Cleveland Fed study:

An examination of survey data collected by the University of Michigan (which has recorded the inflation forecasts of U.S. households on a monthly basis since 1978) reveals that women consistently hold higher inflation expectations than men, even after we hold constant other important demographic characteristics of the respondent.

Most intriguing of all, the systematic overstatement of inflation by all consumers, relative to official statistics, and the difference in responses between men and women are not a result of ignorance about the facts, according to those official statistics:

In the August 2001 FRBC/OSU survey, we sought an answer to this question by asking, "Have you heard of the Consumer Price Index (CPI) before?" and "By about what percentage do you think the CPI went up (or down), on average, over the last 12 months?"

A significantly higher proportion of men had heard of the CPI compared to women (75 percent versus 61 percent, respectively). For those who had heard of the CPI, the average perception about how much it had risen over the past 12 months was surprisingly accurate—a perceived increase of 2.9 percent compared to an actual increase of 2.7 percent. It is also very interesting that men and women perceived the CPI's growth rate nearly identically (2.8 percent versus 3.1 percent, respectively.) However, of those who knew of the CPI, the average perception of price increases was 6.7 percent. And even within the subgroup of respondents who knew of the CPI, men had a significantly lower perception of price increases than did women (6.0 percent vs. 7.4 percent). In other words, the public believes that prices are rising more than the CPI reports, and women more so than men.

There are a couple of hypotheses that could be advanced to explain results like this. One is that the conspiracy crowd is correct and the official statistics are rigged and vastly understate true inflation. But that wouldn't get us anywhere near an understanding of why survey responses about inflation would be systematically different across men and women, higher- and low- income individuals, and just about any other demographic cuts we might make.

A second possibility it is that individuals' responses reflect price changes in their own personal market basket, which may differ from that of the average urban wage earner whose habits are reflected in the Consumer Price Index (CPI).That might explain why any demographic sub group could arrive at different inflation perceptions, but it doesn't explain why respondents as a whole systematically overstate inflation relative to the CPI.

I think the most likely explanation is that the survey respondents are expressing a much different concern than whether they believe food, gas, autos, banking services, or whatever are increasing or are likely to increase faster than the official statistics indicate. My guess is that they are telling us that they are concerned that their real—or inflation-adjusted—incomes are not rising fast enough to comfortably sustain their desired spending:

(enlarge)

As I noted, the policy stakes are high. In the current environment, the policy prescription for fighting an incipient rise in inflation expectations would be much different than one deployed to address the reality of the chart above. All the more reason to make sure we understand the questions we are asking and the responses we get back.

Just to be sure, we monitor inflation trends and inflation expectations from a number of perspectives: Treasury Inflation Protected Securities (TIPS), forecasts, and the Business Inflation Expectations (BIE) survey, to name just three. And all are available on the Atlanta Fed's Inflation Project for the terminally curious to monitor with us.

Lecture 12 on Thursday 11/8/2012

Brief Outline of Topics Covered in Lecture 12

Chapter 22 Aggregate Demand and Supply Analysis

The Aggregate Supply Curve 

• LRAS curve
• SRAS curve
• Shifts in the LRAS curve
• Shifts in the SRAS curve
• Equilibrium of AS and AD
• SR and LR response to AD shocks
• SR and LR response to AS shocks

Video

Extra Reading:

About those jobless recoveries:

Jobless recoveries and the disappearance of routine occupations, by Henry Siu and Nir Jaimovich, Vox EU: Economic recoveries aren’t what they used to be. Since the end of the Great Recession in June 2009:

• US real GDP per capita grew by 3.6%,
• but per capita employment fell by 1.8% over and above the 5.5% that was lost during the recession.

This malaise in the US labor market has been the subject of countless economic policy debates. The fact that employment is recovering much slower than GDP is a relatively new phenomenon; jobless recoveries have only really occurred after the recessions of 1991 and 2001. These last three recoveries represent a distinct break from previous postwar episodes of recession when both GDP and employment would vigorously rebound following recessions (Schreft and Singh 2003; Groshen and Potter 2003; Bernanke 2009).

Our current research indicates that a jobless recovery is not simply an ‘economy-wide‘ delay in firms hiring again. Instead, it can be traced to a lack of recovery in a subset of occupations; those that focus on “routine” or repetitive tasks that are increasingly being performed by machines (Jaimovich and Siu 2012).

Job polarization

The fact that employment in routine occupations has been disappearing is well documented by recent job polarization literature (Acemoglu 1999, Autor et al. 2006, Goos and Manning 2007, Goos et al. 2009, Autor and Dorn 2012). This literature finds that occupations focused on routine tasks tend to be middle-waged. Thus, the disappearance of routine occupations in the past 30 years represents a ‘polarization’ of employment because the middle of the wage distribution has been hollowed out.

As recently as the mid-1980s, about one in three Americans over the age of 16 was employed in a routine occupation. Currently, that figure stands at one in four. The fact that polarization is occurring should not surprise anyone who understands the influence of robotics and automation on machinists and machine operators in manufacturing. Indeed, the influence of robotics is increasingly being felt on routine occupations in transportation and warehousing. Of equal importance is the disappearance of routine employment in ‘white-collar’ occupations - think bank tellers being replaced by ATMs, or secretarial work being replaced by personal computers and Siri, Apple’s iPhone-integrated ‘intelligent personal assistant’. Thus, all of the per capita employment growth of the past 30 years has either been in ‘non-routine’ occupations located at the high-end of the wage distribution, such as software engineers and economists, or in low-paying jobs, such as service occupations like restaurant waiters and janitors. For this last set of occupations, this has been especially true in the past decade.

Jobless recoveries

What is surprising is the link between job polarization and the business cycle. Figure 1 highlights our simple point; it plots per capita employment in routine occupations (in log levels) from 1967 to the end of 2011. Since about 1990, there is an obvious 28 log point decline in routine employment. What is equally clear is that this fall has not happened gradually over time but that the decline is concentrated in economic downturns. 92% of the 28 log point fall occurred within a 12 month window of NBER-dated recessions.

Figure 1

Following each of the 1991, 2001, and 2009 recessions, per capita employment in routine occupations fell and never recovered. This lack of recovery in routine employment accounts for the jobless recoveries experienced in the aggregate. Indeed, prior to job polarization, routine job losses in recessions were accompanied by strong routine job recoveries. This is evidenced in Figure 1 after the recessions of 1970, 1975, and 1982. Unsurprisingly, prior to job polarization, jobless recoveries did not occur. Moreover, jobless recoveries cannot be traced to the business cycle behavior of ‘non-routine’ jobs: employment in these occupations experience only mild contractions, if at all, during recessions, and have experienced essentially no change in the nature of their recoveries over the past half century.

Explaining jobless recovery

A simple counterfactual experiment clarifies the link between job polarization and jobless recoveries. Specifically, we ask what the recoveries in aggregate employment would have looked like if routine employment had rebounded as it did prior to job polarization. Would the US economy still have experienced jobless recoveries? For the 1991, 2001, and 2009 recessions, we replace the per capita employment in routine occupations (following the trough) with the average recoveries following the 1970, 1975, and 1982 recessions. We then sum up the actual employment in non-routine occupations with the counterfactual employment in routine occupations to obtain a counterfactual aggregate employment series.

The behavior of these counterfactual series around the recent NBER recessions is displayed in Figures 2a to 2c. The solid blue line indicates the time path of actual per capita employment. Date 0 indicates the month in which the NBER officially declared the end of the recession. As is clear, aggregate employment continued to fall for many months following the end of each recession. Note that the hatched red line represents the counterfactual series. Had employment in routine occupations recovered as it did prior to job polarization, the US economy would not have experienced jobless recoveries. Hence, we argue that jobless recoveries can be attributed to the lack of recovery in routine jobs.

Figure 2

Conclusions

Structural change in the labor market is clearly manifesting itself in the business cycle. The long-term decline in routine occupations is occurring in spurts - employment in these jobs is lost during recessions. The reach of job polarization is wide. Automation and the adoption of computing technology is leading to the decline of middle-wage jobs of many stripes, both blue-collar jobs in production and maintenance occupations and white-collar jobs in office and administrative support. It is affecting both male- and female-dominated professions and it is happening broadly across industries –manufacturing, wholesale and retail trade, financial services, and even public administration.

The loss of routine jobs in recent recessions has given rise to jobless recoveries. Aggregate employment struggles to rebound following recessions since middle-wage, routine occupations no longer recover. Moreover, employment growth following recent recessions has been unevenly distributed across pay, concentrated in high- and low-wage occupations. A recent report by the National Employment Law Project (2012) indicates that the recovery from the Great Recession has been particularly lopsided, with the majority of jobs added being low-paying jobs.

The pace of job polarization was greatly accelerated in this last recession, and the pace of automation and progress in robotics and computing technology is not slowing down either (Brynjolfsson and McAfee 2011). If the past 30 years is any guide, we should expect future recessions to continue to spur job polarization. Jobless recoveries may be the new norm.

References

Acemoglu, D (1999), “Changes in unemployment and wage inequality: An alternative theory and some evidence”, American Economic Review, 89(5), 1259–1278.

Autor, D H and D Dorn (2012), “The growth of low skill service jobs and the polarization of the U.S. labor market”, American Economic Review, forthcoming.

Autor, D H, L F Katz, and M S Kearney (2006), “The polarization of the U.S. labor market”, American Economic Review: Papers & Proceedings, 96(2), 189–194.

Bernanke, B S (2009), “On the outlook for the economy and policy”, Speech at the Economic Club of New York, 16 November.

Brynjolfsson, E and A McAfee (2011), Race Against The Machine: How the Digital Revolution is Accelerating Innovation, Driving Productivity, and Irreversibly Transforming Employment and the Economy, e-book, Digital Frontier Press.

Goos, M and A Manning (2007), “Lousy and lovely jobs: The rising polarization of work in Britain”, Review of Economics and Statistics, 89(1), 118–133.

Goos, M, A Manning, and A Salomons (2009), “Job polarization in Europe”, American Economic Review: Papers & Proceedings, 99(2), 58–63.

Groshen, E L and S Potter (2003), “Has structural change contributed to a jobless recovery?“, Current Issues in Economics and Finance, Federal Reserve Bank of New York , 9(8), 1–7.

Jaimovich, N and H E Siu (2012), “The trend is the cycle: job polarization and jobless recoveries”. NBER Working Paper, 18334.

National Employment Law Project (2012), “The low-wage recovery and growing inequality”, Data Brief, August.

Schreft, S L and A Singh (2003), “A closer look at jobless recoveries”, Economic Review, Federal Reserve Bank of Kansas City, Second Quarter, 45–72.

Lecture 11 on Tuesday 11/6/2012

Brief Outline of Topics Covered in Lecture 11

Chapter 21 The Monetary Policy and Aggregate Demand Curves

Policy effectiveness in the short-run

Chapter 22 Aggregate Demand and Supply Analysis

The Aggregate Supply Curve 

• LRAS curve
• SRAS curve
• Shifts in the LRAS curve
• Shifts in the SRAS curve
• Equilibrium of AS and AD
• SR and LR response to AD shocks
• SR and LR response to AS shocks

Video

Extra Reading:

How will the election change the Fed?, by Mark Thoma, CBS MoneyWatch: There is a lot of uncertainty about who will lead the Federal Reserve after current Chairman Ben Bernanke's term ends on Jan. 31, 2014. Although Bernanke is eligible to serve another four years, he has hinted that he may not seek another term. In addition, Republican presidential candidate Mitt Romney has made it clear that if he wins the election, he will appoint a new chairman whether or not Bernanke seeks another term.

If Bernanke is replaced, who is likely be the next Fed chief, and what impact will the change in leadership have on U.S. monetary policy?

If President Barack Obama is re-elected and chooses to replace Bernanke, I believe -- as do others -- that Fed Board of Governors Vice Chairman Janet Yellen is the most likely nominee. Her views are close to those of Bernanke, so she would provide the continuity that financial markets seek. She is also highly experienced, having served as president of the San Francisco Fed, and her academic credentials are very strong. She'll be able to handle the academic heavyweights on the bank's monetary policy committee. There are also political advantages for Obama if he appoints what would be the first female Fed chief.

If Romney is elected, it's a different story. Economists in the Romney camp, such as Stanford University's John Taylor, would be much more hawkish in trying to control inflation and much more devoted to following rule-based, rather than discretionary, policy.

Taylor, a favorite among many if Romney is elected, is responsible for the "Taylor Rule" as a guide to monetary policy. The Taylor rule links the interest rate set by the Fed to inflation and economic output so that interest rates rise when inflation goes up or the economy is booming, and fall when inflation is below target or the economy falls into a recession. He has been quite vocal in his opposition to any policy that deviates from this rule.

However, I don't think that Taylor is likely be the next Fed chair even if Romney wins, because the economist's hawkish views on monetary policy make him unlikely to survive Senate confirmation. I also don't think there's a strong favorite to point to if Taylor is out of the picture, though two other Romney economic advisers -- Columbia University's Glenn Hubbard and Greg Mankiw of Harvard University -- are often mentioned.

And in some ways, whomever is likely to get the nod in a Romney administration isn't that important, since that person is sure to have views that move policy in the direction that Taylor would favor.

But no matter who is in control of the Fed, in normal times policy is likely to be conducted much as the Taylor rule describes -- that was certainly true before the Great Recession. It's during abnormal times, as we've just experienced, when there is reason to abandon Taylor's approach and the differences in policy would emerge.

What would that mean for monetary policy? A Fed led by Taylor or someone with his views would be much less likely to react aggressively during a downturn or to implement bank bailouts, and much more likely to pursue a fast exit from any stimulative policies. For example, if Taylor had his way, the Fed already would have raised interest rates by now and would be backing off quantitative easing rather than implementing another round (if it ever pursued such a policy in the first place).

However, I don't want to overemphasize the differences even during unusual economic times. It's easy to criticize the Fed from the outside, and to proclaim that central bankers should stand up to the pressure not to bailout a troubled financial system. But when you are the Fed chair and it's your reputation on the line -- when people's livelihoods depend on your decisions, when the choice is between letting big banks fail and risking a complete blowout of the financial system -- or taking action known to stabilize the financial system, even hawkish chairs are likely to act.

After all, the bank bailout, though widely attributed to Obama, actually came under George W. Bush's presidency and was enacted with Republican support. If another financial meltdown happens, Fed action is likely no matter how much tough talk there's been in the past.

There's another reason to expect current policy to continue, at least initially, even if Fed leadership changes. The Fed chair, though very powerful, must still command a majority of votes on the bank's monetary policy committee in order to control policy. If the Fed chair proposes a radical departure from present policy, it is unlikely to be approved. Over time, as current Fed members' terms expire or they voluntarily step down, a president can shape the committee and policy through new appointment. But a new Fed chief would have a lot of trouble completely altering the course of policy on day one.

Of course, who wins the presidential election still matters. It shapes how aggressive and persistent monetary policy will be in combating unemployment, particularly during a severe recession. It also matters for another critical aspect of policy -- bank regulation. A Fed chair appointed by Obama would be much more likely to pursue strict regulation of banks than a Fed led by a Romney appointee. For those who believe that our current troubles are due, at least in part, to the failure to regulate the banking system, this is no small difference.

Homework 5

Economics 470/570
Fall 2012
Homework 5
Answers posted late Friday (11/9)

Chapter 20, pgs. 512-514

Problems 9, 11, 14, 24, and 25

Chapter 21, pgs. 525-527

Problems 11, 13, 22, and 24

Midterm Solution

Here's the midterm and the solution.