Friday, December 13, 2002

What Did You Learn In School This Year, Uncle Mark?-I just had the last Macroeconomics class of the semester Thursday morning; the final’s next Tuesday. You learn almost as much teaching a class as you do taking it; having to present material to students makes you have a deeper understanding of the concepts. Here are some things that struck me over the last four months while teaching Macro: Unemployment-First of all, the Phillips Curve (inflation inversely related to unemployment) is dead and cremated, but someone forgot to tell the next of kin. It only works when the inflation is demand-driven. The oil-shock stagflation of the 70s put it in the ICU and the technology and tax-cut boosts to aggregate supply of the 80s and 90s created a low-inflation, low-unemployment economy that delivered the coup-de-grace to the Curve, leaving traditional economists scratching their heads. The other thing that struck me was the increase in the labor force over the last quarter-century. Not only do we have fewer stay-at-home moms, we have more older workers still working and a greater use of the handicapped. Also, better utilization of minorities has helped. Exchange Rates- Exchange rates are simpler than people think; the demand for a currency is the demand for the stuff (goods, services, investments) that the currency can buy and the supply of the currency is the demand of your citizens for the stuff in the other country. If people don’t want to buy a country’s stuff (are you listening in Ottawa?), the currency will go down in value. Monetary Policy Throw the IS-LM graph set in the Dumpster with the Phillips Curve. The standard Keynesian monetary theory assumes that cash doesn’t earn interest; by raising interest rates, you could cause speculative demand for cash to drop (since the opportunity cost of holding cash as an investment just went up), thus decreasing the demand for money. However, the growth of money-market mutual funds and interest-bearing checking accounts means that cash does earn interest, and that interest rate will tend to go up and down with longer-term interest rates. If the slope of the yield curve (difference between long-term and short-term interest rates) stays the same as interest rates change, then the opportunity costs of holding cash remains stable. Thus, the speculative demand for money is rather insensitive to interest rates. Once we’ve razed Keynes, That leaves you with the classic monetarist equation of Price Level * Real GDP = Money Supply * Velocity of Money [number of times money changes hands in a year]. If you want to keep prices stable, change the money supply at the rate that GDP changes, assuming that velocity stays the same. That’s much less fun for the Fed, but seems to explain things better than the Keynesian model. Aggregate Supply The more I think about this, the more out-of-the-loop most liberal economists seem. Keynesian economics was developed to explain the Great Depression and came up with an honorable hypothesis for the situation. The economy had excess capacity. Consumers weren’t spending and business didn’t want to be investing in new plant and equipment when the stuff they had was sitting idle. So, let’s have government pick up the slack and start spending to boost aggregate demand (AD). Do we want to raise taxes to pay for the spending? Nah, we’ll borrow it. With interest rates low and business not doing any investing anyway, the deficits will suck up money that was lying fallow. Is all this extra spending inflationary? Nah, we’ve got excess capacity in the economy to use, since the aggregate supply (AS) curve is flat for now. The problem with Keynesian economics is a lot like the Maginot Line; it was designed to fight the previous war. It works in a recession, when goosing demand by deficit government spending can be done without creating inflation and depressing aggregate supply. However, if you’re not in a recession, such policies will be counter-productive, as the extra spending will be inflationary and cause AS to shrink due to higher interest rates from the big deficits causing the cost of capital to rise (a.k.a. the Crowding Out Effect). In relatively good times, policy needs to shift from goosing demand to goosing supply. That means cutting taxes (which helps AD, too, but Keynesians prefer spending to tax cuts), reducing regulations and encouraging productivity and new technology to encourage people to invest in new plant and equipment and new businesses. Keynesians largely ignored the supply curve, assuming that it was a given, flat in recessionary times and near vertical (maxed out, extra demand only creates inflation) in “full-employment” times. However, not every ignored the AS curve. Now, we have economists who recognize that boosting the supply of goods is important; their emphasis on supply got them dubbed “supply-siders.” Liberals didn’t like it, for it challenged their Keynesian assumptions and implied that smaller government was better for the economy. I knew this before, but I’ve become more assured in the usefulness of the supply-side critique this semester. I’m tempted to write my own textbook in the next few months to use in my class; however I’d try and not quite do it as a stuffy a manner as the standard-issue textbook. If I get the project completed, it might also serve as a good examination of the intersections of politics, finance and economics, which would be a good read for the concerned citizen as well as the econ crowd. I'd think about posting a few pages at a time, letting my loyal readers give feedback as it goes along, adding and expounding on the text as we go, with the goal of having a serviceable book (or a good supplement to a standard text) by next fall.

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