The New Economy Slides: The Goldilocks Economy • We discussed the fact that increases in productivity growth rates resulted in a very happy situation in virtually every aspect of the US economy! • We recall the phrase that increases in productivity growth allows firms to pay higher wages and increase profits without raising prices.
Before looking at the facts, let’s refresh ourselves with the AS, AD and the cruise ship!
Aggregate Supply • AS = f [ Wages (W), Prod Growth (PG), Costs of inputs (COI) , other costs (OC)] • In words, AS is increasing in PG and decreasing in W, COI ,OC. • Most economists believe that 1) policy makers have little if any influence of AS and 2) AS conditions determine output, especially in the long run (think of a vertical AS curve)
Aggregate Demand • AD = C + I + G + X-M • Model each: • C = a0 + a1 (Yd) + a2 (r) + a3 (WSM) + a4 (WRE) + a5 (CC) + a6(EX) • Where the ai ‘s are sensitivity parameters (a0, a1, a3, a4 > 0 ; a2, a6 < 0) • Draw a consumption function and discuss all the shift variables.
AD - continued • Investment • I = b0 (IC) + b1(r) • Where b0 > 0 ; b1 < 0 • Draw an investment demand function • Government Purchases • Net Exports • We will focus on C and I (accounts for about 86% of economy) only and we will only comment about NX.
Now set up our AS – AD model of the economy: Draw the picture beginning in 1995 (use 95 as our subscripts)
From the WSJ • The NavigatorFed Chief's Style: Devour the Data, Beware of Dogma • As Retirement Looms in 2006, Greenspan's Strong Record Will Be Hard to Replicate. Did He Help Create a Bubble? • By GREG IP Staff Reporter of THE WALL STREET JOURNALNovember 18, 2004; Page A1
WASHINGTON – “In September 1996, Alan Greenspan was fixated on a statistic neglected by most economic forecasters. It was service-sector worker productivity, a measure of how much an employee could produce in an hour.Government data suggested it was falling. The chairman of the Federal Reserve was convinced they were wrong. Casting his eye across the American economic landscape, he focused on other signals: rising orders for high-tech equipment and higher profits at the companies that bought the gear.
He knew it had taken decades for the innovation of electricity to boost productivity. Now, he thought, the advent of computers was finally having a similar delayed effect. Mr. Greenspan was so sure of his insight, he was ready to bet the fortunes of the U.S. economy.
That fall, his fellow Fed officials worried that economic growth was so robust it would push up inflation. Eight of the Federal Reserve's 12 regional banks wanted to cool things down by raising interest rates. Two Fed governors took the rare step of warning Mr. Greenspan they might publicly dissent if he didn't recommend such a move.
At a meeting to vote on interest rates, Mr. Greenspan refused and argued that rates should be held flat, according to a transcript. Following his analysis of the productivity data, he believed companies could now make and sell more without having to hire more employees, reducing the threat of inflation.
Today, it's clear Mr. Greenspan was correct. By not raising rates, the Fed allowed the economy to continue growing and unemployment to drop to its lowest level in a generation, even as inflation edged downward. Other central banks "would have clamped down," says Nobel Prize-winning economist Robert Solow of the Massachusetts Institute of Technology. "[Mr. Greenspan] refused to be slave to a doctrine. He kept saying, 'Let's look around us and see what's happening, and act accordingly. "
SO GREENSPAN SAW THE ‘NEW ECONOMY’ BEFORE ANYONE ELSE AND THUS, DID NOT TAKE AWAY THE PUNCH BOWL • NOTE PART OF THE TITLE OF ARTICLE: Did He Help Create a Bubble?
And remember the phrase, higher productivity allows firms to pay higher wages and increase profits without raising prices.
ALSO, RECALL THE OLD (‘TRADITIONAL SPEED LIMITS OF THE ECONOMY’) • PGE 2.5% • NAIRU 5.5%
Interpret the following in terms of the traditional ‘speed limits’ of the economy
Recall the implications of a surge in productivity growth: What are some priors??? • What about Real wages?? • What about profits and thus the value of the stock market? • What about labor market conditions? • What about economic growth? • What about inflation?
So real wages were rising, since the percent change in nominal wages exceeded, for the most part, the percent change in prices
So more people are working and they are making a higher real wage since they are more productive – so what is happening to the size of the economic pie?
What is happening to tax (personal income tax and corporate income tax) revenue ? Why? Government outlays???
So this was the goldilocks economy – people were working, making higher real wages, making gains in wealth in the stock market, had job security and were very confident in things (the future was so bright you had to wear shades!)
Check out this pic – remember, consumption accounts for 70% of our economy (the economic pie)
Discuss two important facts: • One – the impact of capital flows on interest rates. • Two – the implications of all this investment on future productivity growth (thus the phrase, the future was so bright we had to wear shades – or alternatively, the bubble had formed!)
Show what all this looks like in aggregate demand and aggregate supply space
Discuss the value of the US dollar during this time and it’s influence of AS and AD. • AS: The value of the US Dollar and its impacts of commodity prices. • AD: The value of the US Dollar and its impact on NX (a drag on economy)
Introduce the Loss Function with help from the misery index • Go to customized material