Inflationary Expectations – Households v Economists

In recent years more attention has been paid to the psychological effects which rising prices have on people’s behaviour. The various groups which make up the economy, acting in their own self-interest, will actually cause inflation to rise faster than otherwise would be the case if they believe rising prices are set to continue.

Workers, who have tended to get wage rises to ‘catch up’ with previous price increases, will attempt to gain a little extra compensate them for the expected further inflation, especially if they cannot negotiate wage increases for another year. Consumers, in belief that prices will keep rising, buy now to beat the price rises, but this extra buying adds to demand pressures on prices.

At a recent press conference US Fed chair Jerome Powell expressed concern about expectations”
“We can’t allow a wage-price spiral to happen,” he said. “And we can’t allow inflation expectations to become unanchored. It’s just something that we can’t allow to happen.”

A recent IMF blog post by Carlo Pizzinelli looked at the inflationary expectations of consumers against those of policy makers. When monetary or fiscal policy are in the news how do consumer expectations for inflation change? Additionally how do economic events influence expectations? Can we say that consumers form the same expectations as those who deliver policy decisions? The researchers asked consumers to consider four speculative shocks and then make predictions about their impact on inflation and unemployment. The four were as follows:

  • a sharp increase in crude oil prices as a result of falling world supply,
  • a rise in income taxes,
  • an increase in government spending,
  • a rise in the US Federal Reserve’s interest rate.

It is an assumption that these shocks are generally understood by consumers. Researchers provided current figures for the rates of inflation and unemployment and asked them to give their forecasts for the two variables over the following year. They then provided news about one of the four speculative shocks and asked them to make new predictions for inflation and unemployment.

Results show that there are large differences in expectations from consumers and experts. Of note is consumers belief that an increase in income tax and interest rates would increase inflation which is contrary to what experts predict – see Chart 1.

In order to look into why there is a disagreement between two groups consumers were asked as to what they were thinking when they made their predictions – a focus was on demand side v supply side theory. Experts drew on their technical knowledge whilst consumers rely on personal experiences. Consumers believe that higher costs (interest rates up) for firms are then added to the price of the good or service. Experts predict a decline in prices as consumers spend less and save more – see Chart 2

It is important that central banks make their statements in a simple language so that there is clarity for the general public – e.g. when a central bank raises interest rates unexpectedly households are under the assumption that this action will lower inflation and their actions will ultimately lead to a reduction in inflation.

IB/A2 Economics – Macroeconomic policies essay

With the mid-year exams next week here are a couple of mindmaps I produced using OmniGraffle (Apple software). I found it a useful starting point for students to discuss the effectiveness of each policy and the conflicts within macro objectives. This is a very common essay question in CIE Paper 4. My question would be:

What policies has the government in your country implemented since Covid-19 and how successful have they been in meeting macro economic objectives? (25)

BBC Podcast – How do we stop high inflation?

This is a very good podcast on inflation and for anyone new to the subject it explains a lot concepts in very simple language. Concepts like fiscal policy, monetary policy, recession, stagflation etc. Click link below:

BBC – The Real Story – How do we stop high inflation?

The question that the economists try and answer is will the global economy go through a recession in order to get inflation down. Both central banks and governments cushioned the economic shock of the pandemic with low interest rates and spending respectively but this action has been blamed for increased inflation.

Larry Summers suggested that the US Fed had mistakenly seen the inflationary problem as transitory but there is a bit more stubbornness about price increases today. As he put it – some central banks need to go through their ‘full course of antibiotics’ (interest rate hikes) to control inflation as failure to do so means that inflation will return promptly and another course of antibiotics will need to be administered. The longer you leave it the more damaging the downturn/recession will be. He also states that every time the US economy has had an inflation rate greater than 4% and an unemployment rate below 4% the US economy has gone into a recession within two years. Those figures align with US inflation 8.5% and unemployment 3.6%.

Some great discussion and would be useful for a macro policy essay at CIE AS or A2 level. Good for revision of policies and their usefulness today.

Sign up to elearneconomics for multiple choice test questions (many with coloured diagrams and models) and the reasoned answers on Inflation. Immediate feedback and tracked results allow students to identify areas of strength and weakness vital for student-centred learning and understanding.

Global Economic Outlook

Below is a look at economic conditions in leading global economies. Unemployment is surprising low and with the rise in the cost of living (see inflation figures) this should put pressure on wages. The unemployment rate within the OECD area fell to 5.2% in February, the first time it has fallen below the pre-pandemic unemployment rate (which was recorded in February 2020). The unemployment rate within the OCED had peaked at 8.8% in April 2020.

Inflation, Unemployment and Interest Rates
Annual inflation within the OECD area rose to 8.8% in March 2022, its highest annual increase since 1988. Energy prices have risen by over a third during the past year, while food prices have risen by ten percent within the OECD area. Most central banks have already commenced a tightening programme with the on-going threat of inflation. The Australian Reserve Bank commenced tightening their cash rate in early May, increasing the cash rate by 25 basis points to 0.35%. It is expected that the RBNZ will increase the OCR by 50 basis points next week.

Outlook
If you look at conditions in the major economies you find the following:

  • China – limited growth potential with severe lockdowns
  • USA – higher interest rates could lead to a bust scenario
  • Euro Zone – cost of living crisis
  • Emerging markets – food crisis / famines.

With the indicators looking at recessionary conditions the best news for the global economy would be a withdrawal from Ukraine by Russian troops and an end to a zero-Covid strategy in China. These actions should reduce food and energy prices and therefore save government spending on raising benefits and subsidising food and energy. Economists are fairly optimistic that we will avoid a recession in 2022 as they still have the tools to stimulate if things get worse. However with no end in sight for the Ukraine conflict and interest rates on the rise a recession is on the cards.

Sign up to elearneconomics for multiple choice test questions (many with coloured diagrams and models) and the reasoned answers on Inflation and Unemployment. Immediate feedback and tracked results allow students to identify areas of strength and weakness vital for student-centred learning and understanding.

A2 Revision: Keynes 45˚ line

With the Cambridge A2 exam coming up here is a revision note on Keynes 45˚ line. A popular multi-choice question and usually in one part of an essay. Make sure that you are aware of the following;

Common Errors:
1. C and S are NOT parallel
2. The income level at which Y=C is NOT the equilibrium level of Y which occurs where AMD crosses the 45˚ line.
To Remember:
1. OA is autonomous consumption.
2. Any consumption up to C=Y must be financed.
3. At OX1 all income is spent
4. At OB consumption = BQ and saving= PQ
5. Equilibrium level of Y shown in 2 ways
a) where AMD crosses 45˚ line
b) Planned S = Planned I – point D

Remember the following equilibriums:
2 sector – S=I
With Govt – S+T = I+G
With Govt and Trade – S+T+M = I+G+X

Stephanie Kelton – TED Talk

Recent TED talk by Stephanie Kelton on Modern Monetary Theory – MMT – in which she makes the case to stop looking at government spending as a path towards frightening piles of debt, but rather as a financial contribution to the things that matter — like health care, education, infrastructure and beyond. “We have the resources we need to begin repairing our broken systems,” Kelton says. “But we have to believe it’s possible.” The table below looks at the difference between mainstream monetary policy and modern monetary policy.

The Supercycle and MMT

I listened to a very good interview on the David McWilliams podcast in which he talks with Dario Perkins the super cycle and the end of neoliberalism. A lot of the discussion was around the paper that Dario Perkins had written – A New Supercycle Running on MMT – in which he sees MMT as delivering a superior fiscal-monetary mix.
The fact that fiscal policy must take over from monetary policy has been the apparent with the range of policies that were implemented after the GFC. Since the late-19th century the super cycle can be placed into three phases of Capitalism influenced by macro-financial-political regimes – see chart below. MMT could provide the intellectual rationale for a new form of capitalism – Capitalism 4.0. Over the last century the pendulum has swung between extreme fiscal and extreme monetary policy with the global economy primed for another change.

1920’s – Monetary policy dominated but ineffective during the Great Depression
1930’s – Fiscal policy dominated as there was a need for government intervention to get the economy moving after the Great Depression
1940’s – 1960’s – Fiscal Policy – with the 2nd World War and the recovery process post-war.
1970’s – Stagflation and fiscal policy is no longer effective and Keynesian economics as government spending just causes higher inflation and higher unemployment.
1980’s – Monetary policy gains traction and inflation is brought under control. Central Banks become independent and fiscal policy and government intervention is seen as a restriction to growth. With Reagan and Thatcher Neoliberalism was the ideology of the day

Source: A New Supercycle Running on MMT

Have we reached a new regime – Capitalism 4.0?
The GFC was a warning that capitalism in its present form was not working and there was potential for a new regime change. However governments adopted austerity and QE which made inequality worse. The issue was that there was no alternative to the neoliberalism Capitalism 3.0 but with the arrival of COVID-19 governments have been forced to spend up large and there is a belief that the old system doesn’t work and that maintaining Capitalism 3.0 will not make the situation any better. Stephanie Kelton, author of The Deficit Myth, argues that we need to rethink our attitudes towards government spending.

Modern Monetary Theory (MMT)
MMT states that a government that can create its own money therefore:Cannot default on debt denominated in its own currency;

  • Can pay for goods, services, and financial assets without a need to collect money in the form of taxes or debt issuance in advance of such purchases;
  • Is limited in its money creation and purchases by inflation, which accelerates once the economic resources (i.e., labor and capital) of the economy are utilised at full employment;
  • Can control inflation by taxation and bond issuance, which remove excess money from circulation, although the political will to do so may not always exist;
  • Does not need to compete with the private sector for scarce savings by issuing bonds.
  • Within this model the only constraint on spending is inflation, which can break out if the public and private sectors spend too much at the same time. As long as there are enough workers and equipment to meet growing demand without igniting inflation, the government can spend what it needs to maintain employment and achieve goals such as halting climate change.

It will be interesting to see if MMT can enjoy the same presence in economic policy that monetarism and Milton Friedman experienced in the post-stagflation time period. Back then there was a political revolution primed to embrace monetarism and neoliberal ideas and an electorate that had experienced a serious economic crisis – stagflation. Subsequently the influence of MMT will come down to politics.

Joe Biden seems to have embarked on a more radical macro-economic policy which has various instruments that are found in MMT. Will there be other political leaders who embrace this paradigm like Reagan and Thatcher in the 1980’s with Friedman and monetarism?

Source: A New Supercycle Running on MMT

David McWilliams podcast – The end of neoliberalism?

Below is a link to a David McWilliams podcast which I recommend – excellent for macro policy.

130 – The end of Neo-Liberalism & economic super-cycles explained with Dario Perkins

There is mention of the collapse of the European Super League and that this could be that defining moment when the irresistible force of a once all-conquering ideology came crashing into the immovable object of a new reality, with devastating consequences.

The interview with Dario Perkins – 20 minutes in – is particularly worth listening to. They talk about Modern Monetary Theory (MMT) and that we shouldn’t worry where the money comes from as the central bank can just print it – spend first and tax later. It’s fiscal policy that will decide whether central banks can meet their inflation targets.

Joe Biden – the world’s most unlikely radical – is a convert to MMT. He is to MMT what Ronald Reagan was to monetarism. Biden’s agenda is to compress inequalities, rip the economy away from Wall Street and give it back to the man on the street by using government spending as an arm not just of economics but democracy underpinned by fairness. Biden wants to reverse the past 30 years and lead us into a new macroeconomic supercycle, which might also last decades.

Keynes v Monetarist – Powerpoint download

Currently covering Keynes vs Monetarist in the A2 course. Here is a powerpoint on the theory that I use for revision purposes. I have found that the graphs are particularly useful in explaining the theory. The powerpoint includes explanations of:

C+I+G+(X-M)

  • 45˚line
  • Circular Flow and the Multiplier
  • Diagrammatic Representation of Multiplier and Accelerator
  • Quantity Theory of Money
  • Demand for Money – Liquidity Preference
  • Defaltionary and Inflationary Gap
  • Extreme Monetarist and Extreme Keynesian
  • Summary Table of “Keynesian and Monetarist”
  • Essay Questions with suggested answers.

Hope it is of use – 45˚line shown. Click the link below to download the file.
Keynes v Monetarist Keynote

Covid-19 stimulus vs GFC stimulus

Below is a useful diagram from McKinsey & Company that compares the money used to assist the economies after the outbreak of Covid-19 and the GFC in 2017. Governments allocated US$10 trillion for economic stimulus in just two months—and for some countries, their response as a percentage of GDP was nearly ten times what it was in the financial crisis of 2008–09.

Countries in Europe have allocated around US$4 trillion which is approximately 30 times than that of the Marshall Plan in today’s value – the Marshall Plan was valued at $15bn in 1948. The size of government responses are unprecedented and they, with central banks, are moving into new territory. Global debt is estimated to reach US$300 trillion by the March quarter in 2021 with global GDP taking a huge hit. However unlike the GFC there seems to be an end point once an effective vaccine has been found but many jobs and businesses have gone and it will take time before new ones appear.

Addressing savings glut needs more than monetary policy

Today central banks have a limited toolkit and the powers to deal with the savings glut (see image below), lack of investment, climate change and income inequality. There is a lot of money in the system but the velocity of circulation is slow – MV=PT – and this is one reason why we have little inflation.

Velocity of circulation of money is part of the the Monetarist explanation of inflation operates through the Fisher equation:

M x V = P x T

M = Stock of money
V = Income Velocity of Circulation
P = Average Price level
T = Volume of Transactions or Output

Add to this COVID-19 and the impact it has had on especially developing economies and we have economic stagnation.

Source: Bloomberg Economics

Some economists have suggested the need for more expansionary fiscal policy as well as structural reform to achieve economic growth. The latter being a long-term policy can take the form of price controls, management of public finances, financial sector reforms. labour market reforms etc. Although the US Federal Reserve is adopting a flexible average inflation target to avoid a disinflationary environment it will not be enough to deal with secular stagnation.

Secular stagnation
Since the GFC in 2008 it is evident that low interest rates are the new normal and according to Larry Summers (former Treasury Secretary) we are in an era of secular stagnation. This refers to the fact that on average the ‘natural interest rate’ – the rate consistent with full employment – is very low. There can be periods of full employment but even with 0% interest rates private demand is insufficient to eliminate the output gap. The US was in a liquidity trap for eight of the past 12 years; Europe and Japan are still there, and the market now appears to believe that something like this is another the new normal.

Paul Krugman suggests that there are real doubts about unconventional monetary policy and that the stimulus for an economy should take the form of permanent public investment spending on both physical and human capital – infrastructure and health of the population. This spending would take the form of deficit-financed public investment. There has been the suggestion that deficit-financed public investment might lead to ‘crowding out’ private investment and also how is the debt repaid? Krugman came up with three offsetting factors

  1. When the economy is in a liquidity trap, which now seems likely to be a large fraction of the time, the extra public investment will have a multiplier effect, raising GDP relative to what it would otherwise be. Based on the experience of the past decade, the multiplier would probably be around 1.5, meaning 3% higher GDP in bad times — and considerable additional revenue from that higher level of GDP. Permanent fiscal stimulus wouldn’t pay for itself, but it would pay for part of itself.
  2. If the investment is productive, it will expand the economy’s productive capacity in the long run.This is obviously true for physical infrastructure and R&D, but there is also strong evidence that safety-net programmes for children make them healthier, more productive adults, which also helps offset their direct fiscal cost (Hoynes and Whitmore Schanzenbach 2018).
  3. There’s fairly strong evidence of hysteresis — temporary downturns permanently or semi-permanently depress future output (Fatás and Summers 2015).

Source: “The Case for a permanent stimulus”. Paul Krugman cited in “Mitigating the COVID Economic Crisis: Act Fast and Do Whatever It Takes” Edited by Richard Baldwin and Beatrice Weder di Mauro

Bloomberg Economics – Yellen, Summers Say Central Banks No Match for Savings Glut

Eight body problem in economics

Physicists and mathematicians have puzzled over the three-body problem – the question of how three objects orbit one another according to Newton’s laws. No single equation can predict how three bodies will move in relation to one another and whether their orbits will repeat or devolve into chaos.

John Mauldin of Mauldin Economics wrote about the eight-body problem in economics in which we cannot predict how the economy will react when eight variables change. He lists the following:

What is certain is that as government fiscal intervention starts to lose its effectiveness it will be inevitable that monetary policy will continue to remain very accommodating with bond buybacks and record low interest rates. COVID-19 has turned conventional economic thinking upside down.

Equity / Efficiency trade-off

Covered this online with my A2 class this week – Unit 3 of the CIE course. The efficiency losses when the government raises taxes  and pays transfers means that interventions to improve equity have a cost. Income can only be taken away from the rich and given to the poor in a leaky bucket. The ‘leaks’ are efficiency costs represented by the lost incentive to work and produce caused by the taxes taken and the transfers given. The lost output means that there is less to share out.

The size of the leaky bucket effect is one about which there is considerable disagreement. The New Right for instance, argue that the efficiency losses associated with redistributive policies are very large indeed. Government, too, has considered the problem and tax changes made in New Zealand in the eighties have been designed to minimise the efficiency cost of taxes. The marginal rate of tax on income had been brought down from 66 per cent to 33 per cent because it is believed that high rates on high incomes have very bad side-effects. Not only do they discourage work effort, but they also encourage speculative activity and tax evasion.

The equity and efficiency trade-off may be shown in a very abstract way by a frontier such as the above. At a point such as A, the economy is highly efficient but there is a very unequal distribution of income so that equity is low. To improve equity and achieve a point like B. income must be transferred and in the process some efficiency is lost. Equity gains are at the expense of efficiency. As more and more equity is pursued, the steepness of the efficiency/equity frontier increases as the efficiency costs become higher and higher.

As in production possibility analysis, if the economy is not on the equity/efficiency frontier but inside it at a point such as C, then it should be possible to have more of both equity and efficiency. If jobs can be found for the unemployed, the use of the additional scarce resources should improve efficiency and the distribution of income.

The New Right not only argue that the trade-off is a poor one as the efficiency losses from redistribution are very large, but also feel that the goal of more equality is not very desirable in any case.  Those who put the case for equity- i.e., the Social Left take the view that concern about the ‘leaky bucket’ or the efficiency costs is not justified. They argue that people work for a whole host of reasons including pride in doing a good job and are not much affected by high marginal tax rates. For them, the goal of more equality is highly desirable.

Macroeconomic Policy – where we’ve been and where are we going?

The Economist ‘Briefing’ recently looked at what now for macroeconomic policy in the global economy. The GFC of 2008 and outbreak of COVID-19 has got policymakers scratching their head as what can be done to stimulate aggregate demand.

Keynes’ ideas of government involvement in managing the economy in the business cycle – spend in recessions and pay of debt in booms – was flavour of the month in the post-war period. However by the1970’s this policy was in trouble which the spectre of stagflation – high inflation accompanied by high unemployment. According to Keynes the two variables should move in opposite directions. In 1976 the UK Prime Minister James Callaghan in his speech at the Labour Party Conference said:

We used to think that you could spend your way out of a recession, and increase employ­ment by cutting taxes and boosting Government spending. I tell you in all candour that that option no longer exists, and that in so far as it ever did exist, it only worked on each occasion since the war by injecting a bigger dose of infla­tion into the economy, followed by a higher level of unemployment as the next step. Higher inflation followed by higher unemployment.

The 1980’s saw monetarist ideas enter the scene with a focus on the control of inflation though constraining the money supply. University of Chicago economist Milton Friedman and US Federal Reserve Chairman Paul Volcker knew that in order the get inflation down that the economy would have to go through a recession and very higher unemployment in the short-run. However once inflation started to drop the Central Bank could relax monetary policy (interest rates) and then encourage more economic activity in the economy and thereby reducing unemployment. Previously policy had focused on equality of incomes which had a large impact of economic efficiency. Price stability was now the primary focus of a central bank and it was in New Zealand with the 1989 Reserve Bank Act that the first central bank became independent from government. Gone were the days where the Minister of Finance could get on the phone to the Reserve Bank Governor to change interest rates. Central banks had inflationary targets whilst fiscal policy was to keep government debts low and to redistribute income as the government saw fit.

This policy came unstuck after the GFC as central banks dropped interest rates to record levels and implemented a series of quantitative easing (QE) measures to no avail. Growth was stagnant for a long time but eventually demand for labour picked up. This would have normally been accompanied by higher inflation but it wasn’t the case. Just like in the 1970’s inflation and unemployment were not behaving according to the theory but at this time both were favourable – low inflation and low unemployment. However inequality was now gripping the attention of economists and there was concern about the monopoly position of some firms. The rich have a higher tendency to save rather than spend, so if their share of income rises then overall saving goes up and lower interest rates and QE were driving up inequality by increasing house and equity prices.

Once COVID-19 hit it was government’s fiscal policy which has been used to try and stabilise the economy and boost growth. Fiscal stimulus – government spending with running up large deficits might be required for a long period of time in order to support the economy. This is more acceptable amongst economists as low interest rates enable the government to service much larger debts and with such low inflation it is unlikely that rates will increase anytime soon. This resembles Modern Monetary Theory (MMT) – the situation where the government can create its own money therefore:

  1. Cannot default on debt denominated in its own currency;
  2. Can pay for goods, services, and financial assets without a need to collect money in the form of taxes or debt issuance in advance of such purchases;
  3. Is limited in its money creation and purchases by inflation, which accelerates once the economic resources (i.e., labor and capital) of the economy are utilised at full employment;
  4. Can control inflation by taxation and bond issuance, which remove excess money from circulation, although the political will to do so may not always exist;
  5. Does not need to compete with the private sector for scarce savings by issuing bonds. Within this model the only constraint on spending is inflation, which can break out if the public and private sectors spend too much at the same time. As long as there are enough workers and equipment to meet growing demand without igniting inflation, the government can spend what it needs to maintain employment and achieve goals such as halting climate change.

Negative interest rates

Some governments have gone the way of negative interest rates (see graphic) to try and stimulate more aggregate demand. This would discourage saving and see a potential withdrawal of cash from the banking system leaving less money to lend out. Avoiding this scenario might involve abolishing high-denomination bank notes and making the holding of large amount of cash expensive and unfeasible. However in order to keep money in the banks might renege on interest rate cuts as customers might move their money to rival banks therefore high negative interest rates would severely dent banks’ profits.

The current economic environment may make negative interest more plausible as:

  • Cash is in decline.
  • Banks are becoming less important to finance.
  • Central bankers are looking at creating their own digital currencies

Final thought

Greater government intervention is what the majority of economists want but it does carry with it risks of significant debt and high inflation. There is an opportunity to rethink the economics discipline and as stated in The Economist:

A level-headed reassessment of public debt could lead to the green public investment necessary to fight climate change. And governments could unleash a new era of finance, involving more innovation, cheaper financial intermediation and, perhaps, a monetary policy that is not constrained by the presence of physical cash. What is clear is that the old economic paradigm is looking tired. One way or another, change is coming

Sources:
The Economist – A new era of economics – July 25th 2020
http://www.britishpoliticalspeech.org/speech-archive.htm?speech=174

Covid-19 and GDP components in New Zealand

New Zealand has been seen by many as a country which has so far done well to restrict the spread of Covid-19 and hopefully limit the longer term impact on the economy. Like many countries the economic consequences have been significant with the contraction of GDP and rising unemployment. New Zealand is now in a deep recession – negative GDP for two consecutive quarters – with GDP set decline by 17% through the six months of the year. By comparison NZ only fell by 2.7% during the GFC in 2008 and part of 2009.

The graph (from Westpac) below shows the importance of government spending in 2020 and continuing into 2021. But the reduction in household spending, residential construction and business investment are a major concern and invariable this will lead to a further loss of job. However the forecast for GDP in 2021 is more promising with household spending and government consumption being the engines of growth. Although some are saying that the recovery will be faster than after the GFC one has to remember that the GDP figures will be a lot higher as they coming from a very low base – even negative. So even a small increase in economic activity will give you a very large percentage change from the previous year. The government have spent approximately $22bn in support measure which is equivalent to around 7% of annual GDP and no doubt there is more to come.

Source: Westpac Economic Overview – Covid-19 Special Edition May 2020

Aggregate demand is crucial here and it is important for both Cambridge and NCEA students to understand its components and how it generates growth – see midmap below.

Adapted from Susan Grant – CIE A Level Revision

Macroeconomic Policies – Mind map

Just covering macro policies / conflicts with my A2 Economics class and produced this mind map in OmniGraffle (Apple software). I found it a useful starting point for students to discuss the effectiveness of each policy and the conflicts within macro objectives. This is a very common essay question in CIE Paper 4.

My question would be what policies has the government in your country implemented since Covid-19 and how successful have they been in meeting macro economic objectives?

Adapted from Susan Grant – CIE AS and A Level Revision