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If You Have Some Cash to Spare ….

you can bid for Paul Samuelson’s Nobel Prize Medal here. Note that at the time of posting the minimum bid required was $495,000.

You can read a brief biography of Samuelson on the Nobel site here. You can read the lecture Samuelson delivered on the occasion of being awarded the price here. (Note that the lecture contains technical material.)

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In the Face of Hyperinflation, Some People in Argentina Don’t Save Currency, They Save … Bricks

Argentina’s Argentina’s Economy Minister Sergio Massa coming from a meeting in Washington, DC with the International Monetary Fund to discuss the country’s hyperinflation. Photo from the Wall Street Journal.

Argentina has been through several periods of hyperinflation during with the price level has increased more than 50 percent per month. The following figure shows the inflation rate as measured by the percentage change in the consumer price index from the previous month for since the beginning of 2018. The inflation rate during these years has been volatile, being greater than 50 percent per month during several periods, including staring in the spring of 2022. High rates of inflation have become so routine in Argentina that an article in the Wall Street Journal quoted on store owner as saying, “Here 40% [inflation] is normal. And when we get past 50%, it doesn’t scare us, it simply bothers us.”

As we discuss in Macroeconomics, Chapter 14, Section 14.5 (Economics, Chapter 24, Section 24.5 ), when an economy experiences hyperinflation, consumers and businesses hold the country’s currency for as brief a time as possible because the purchasing power of the currency is declining rapidly. As we noted in the chapter, in some countries experiencing high rates of inflation, consumers and businesses buy and sell goods using U.S. dollars rather than the domestic currency because the purchasing power of the dollar is more stable. This demand for dollars in countries experiencing high inflation rates is one reason why an estimated 80 percent of all $100 bills circulate outside of the United States. 

The increased demand for U.S. dollars by people in Argentina is reflected in the exchange rate between the Argentine peso and the U.S. dollar. The following figure shows that at the beginning of 2018, one dollar exchanged for about 18 pesos. By November 2022, one dollar exchanged for about 159 pesos. The exchange rate shown in the figure is the official exchange rate at which people in Argentina can legally exchange pesos for dollars. In practice, it is difficult for many individuals and small firms to buy dollars at the official exchange rate. Instead, they have to use private currency traders who will make the exchange at an unofficial—or “blue”—exchange rate that varies with the demand and supply of pesos for dollars. A reporter for the Economist described his experience during a recent trip to Argentina: “Walk down Calle Lavalle or Calle Florida in the centre of Buenos Aires and every 20 metres someone will call out ‘cambio’ (exchange), offering to buy dollars at a rate that is roughly double the official one.” 

People in Argentina are reluctant to deposit their money in banks, partly because the interest rates banks pay typically are lower than the inflation rate, causing the purchasing power of money deposited in banks to decline over time.  People are also afraid that the government might keep them from withdrawing their money, which has happened in the past. As an alternative to depositing their money in banks, many people in Argentina buy more goods than they can immediately use and store them, thereby avoiding future price increases on these goods. The Wall Street Journalquoted a university student as saying: “I came to this market and bought as much toilet paper as I could for the month, more than 20 packs. I try to buy all [the goods] I can because I know that next month it will cost more to buy.”

Devon Zuegel, a U.S. software engineer and economics blogger who travels frequently to Argentina, has observed one unusual way that some people in Argentina save while experiencing hyperinflation:

“Bricks—actual bricks, not stacks of cash—are another common savings mechanism, especially for working-class Argentinians. The value of bricks is fairly stable, and they’re useful to a family building out their house. Argentina doesn’t have a mortgage industry, and thus buying a pallet of bricks each time you get a paycheck is an effective way to pay for your home in installments. (Bricks aren’t fully monetized, in that I don’t think people buy bricks and then sell them later, so people only use this method of saving when they actually have something they want to use the bricks for.)”

Sources: “Sergio Massa Is the Only Thing Standing Between Argentina and Chaos,” economist. com, October 13, 2022;  Devon Zuegel, “Inside Argentina’s Currency Exchange Black Markets,” devonzuegel.com, September 10, 2022; Silvina Frydlewsky and Juan Forero, “Inflation Got You Down? At Least You Don’t Live in Argentina,” Wall Street Journal, April 25, 2022; and Federal Reserve Bank of St. Louis, FRED data set.

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What Caused the Plunge in Sales at Bed Bath & Beyond?

Photo from the Wall Street Journal.

In the Apply the Concept “Trying to Use the Apple Approach to Save J.C. Penney” in Chapter 10, Section 10.4 in both Microeconomics and Economics, we discussed how Ron Johnson had been successful as head of Apple’s retail stores but failed when he was hired as CEO of J. C. Penney.  Insights from behavioral economics indicate that Johnson made a mistake in eliminating Penney’s previous strategy of keeping prices high but running frequent sales. Although Penney’s “every day prices” under Johnson were lower than they had been under the previous management, many consumers failed to recognize that fact and began shopping elsewhere. 

            Johnson’s experience may indicate the dangers of changing a firm’s long-standing business model. Customers at brick-and-mortar retail stores fall into several categories: Some people shop in a number of stores, depending on which store has the lowest price on the particular product they’re looking for; some shop only for products such as televisions or appliances that they hesitate to buy from Amazon or other online sites; while others shop primarily in the store that typically meets their needs with respect to location, selection of products, and pricing. It’s the last category of customer that was most likely to stop shopping at Penney because of Johnson’s new pricing policy because they were accustomed to primarily buying products that were on sale.

            Bed Bath & Beyond was founded in 1971 by Warren Eisenberg and Leonard Feinstein. As the name indicates, it has focused on selling household goods—sometimes called “home goods”—such as small appliances, towels, and sheets. It was perhaps best known for mailing massive numbers of 20 percent off coupons, printed on thin blue cardboard and nicknamed Big Blue, to households nationwide. Although by 2019, the firm was operating more than 1,500 stores in the United States, some investors were concerned that Bed Bath & Beyond could be run more profitably. In March 2019, the firm’s board of directors replaced the current CEO with Mark Tritton who had helped make Target stores very profitable.

            In an approach similar to the one Ron Johnson had used at J.C. Penney, Tritton cut back on the number of coupons sent out, reorganized the stores to reduce the number of different products available for sale, and replaced some name brand goods with so-called private-label brands produced by Bed Bath & Beyond. Unfortunately, Tritton’s strategy was a failure and the firm, which had been profitable in 2018, suffered losses each year between 2019 and 2022. The losses totaled almost $1.5 billion. In June 2022, the firm’s board of directors replaced Tritton with Sue Grove who had been serving on the board.

            Why did Tritton’s strategy fail? Partly because in March 2020, the effects of the Covid-19 pandemic forced the closure of many Bed Bath & Beyond stores. Unlike some other chains, Bed Bath & Beyond’s web site struggled to fulfill online orders. The firm also never developed a system that would have made it easy for customers to order goods online and pick them up at the curb of their retail stores. That approach helped many competitors maintain sales during the pandemic. Covid-19 also disrupted the supply chains that Tritton was depending on to produce the private-label brands he was hoping to sell in large quantities.

            But the larger problems with Tritton’s strategy would likely have hurt Bed Bath & Beyond even if there had been no pandemic. Tritton thought the stores were too cluttered, particularly in comparison with Target stores, so he reduced the number of products for sale. It turned out, though, that many of Bed Bath & Beyond’s most loyal customers liked searching through the piles of goods on the shelves. One customer was quoted as saying, “I used to find so many things that I didn’t need, that I’d end up buying anyway, like July 4th-themed corn holders.” Customers who preferred to shop in less cluttered stores were likely to already be shopping elsewhere. And it turned out that many Bed Bath & Beyond customers preferred national brands and switched to shopping elsewhere when Tritton replaced those brands with private-label brands. Finally, many customers were accustomed to shopping at Bed Bath & Beyond shortly after receiving a Big Blue 20 percent off coupon. Sending out fewer coupons meant fewer trips to Bed Bath & Beyond by those customers.

            In a manner similar to what happened to Johnson in his overhaul of the Penney department stores, Tritton’s changes to Bed Bath & Beyond’s business model caused many existing customer to shop elsewhere while attracting relatively few new customers. An article in the Wall Street Journal quoted an industry analyst as concluding: “Mark Tritton entered the business and ripped up its playbook. But the strategy he replaced it with was not tested and nowhere near sharp enough to compensate for the loss of traditional customers.”

Sources:   Jeanette Neumann, “Bed Bath & Beyond Traced an Erratic Path to Its Current Crisis,” bloomberg.com, September 29, 2022;  Kelly Tyko, “What to expect at Bed Bath & Beyond closing store sales,” axios.com September 22, 2022; Inti Pacheco and Jodi Xu Klein, “Bed Bath & Beyond to Close 150 Stores, Cut Staff, Sell Shares to Raise Cash,” Wall Street Journal, August 31, 2022; Suzanne Kapner and Dean Seal, “Bed Bath & Beyond CEO Mark Tritton Exits as Sales Plunge,” Wall Street Journal, June 29, 2022; Suzanne Kapner, “Bed Bath & Beyond Followed a Winning Playbook—and Lost,” Wall Street Journal, July 23, 2022; and Ron Lieber, “An Oral History of the World’s Biggest Coupon,” New York Times, November 3, 2021. 

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U.S. Carbon Dioxide Emissions in a Global Context

Photo from the New York Times.

As we discuss in Microeconomics and Economics, Chapter 5, Section 5.3, carbon dioxide (CO2) emissions contribute to climate change, including the increases in temperatures that have been experienced worldwide. We’ve found that students are interested in seeing U.S. CO2 emissions in a global context.  

The first of the following figures shows for the years 1960 to 2020, the total amount of CO2 emissions by the United States, China, India, the 28 countries in the European Union, lower-middle-income countries (including India, Nigeria, and Vietnam), and upper-middle-income countries (including China, Brazil, and Argentina). The second of the figures shows the percentage of total world CO2 accounted for by each of the three individual countries and by the indicated groups of countries. in the United States and in the countries of the European Union both total emissions and the percentage of total world emissions have been declining over the past 15 years. Emissions have been increasing in China, India, and in middle-income countries. The figures are from the Our World in Data website (ourworldindata.org). (Note that the reductions in emissions during 2020 largely reflect the effects of the slowdown in economic activity as a result of the Covid-19 pandemic rather than long-term trends in emissions.)

Governments in many countries have attempted to slow the pace of climate change by enacting policies to reduce CO2emissions. (According to estimates by the U.S. Environmental Protection Agency, CO2 accounts for about 76 percent of all emissions worldwide of greenhouse gases that contribute to climate change. Methane and nitrous oxide, mainly from agricultural activity, make up most of the rest of greenhouse gas emissions.) In August 2022, Congress and President Biden enacted additional measures aimed at slowing climate change. Included among these measures were government subsidies to firms and households to use renewable energy such as rooftop solar panels, tax rebates for some buyers of certain electric vehicles, and funds for utilities to develop power sources such as wind and solar that don’t emit CO2. The measures have been estimated to reduce U.S. greenhouse gas emissions by somewhere between 6 percent and 15 percent. Because the United States is responsible for only about 14 percent of annual global greenhouse gas emissions, the measures would likely reduce global emissions by only about 2 percent.

The figures shown above make this result unsurprising. Because the United States is the source of only a relatively small percentage of global greenhouse emissions, reductions in U.S. emissions can result in only small reductions in global emissions. Although many policymakers and economists believe that the marginal benefit from these reductions in U.S. emissions exceed their marginal cost, the reductions can’t by themselves do more than slow the rate of climate change. A key reason that India, China, and other middle income countries have accounted for increasing quantities of greenhouse gases is that they rely much more heavily on burning coal than do the United States, the countries in the European Union, and other high-income countries. Utilities switching to generating electricity by burning coal rather than by burning natural gas has been a key source of reductions in greenhouse gas emissions in the United States.

The two figures above measure a country’s contribution to CO2 emissions by looking at the quantity of emissions generated by production within the country. But suppose instead that we look at the quantity of CO2 emitted during the production of the goods consumed within the country? In that case, we would allocate to the United States CO2 emitted during the product of a good, such as a television or a shirt, that was produced in China or another foreign country but consumed in the United States.

For the United States, as the following figure shows it makes only a small difference whether we measure CO2emissions on the basis of production of goods and services or on the basis of consumption of goods and services.  U.S. emissions of CO2 are about 7 percent higher when measured on a consumption basis rather than on a production basis. By both measures, U.S. emissions of CO2 have been generally declining since about 2007. (1990 is the first year that these two measures are available.)

Sources: Hannah Ritchie, Max Roser and Pablo Rosado, “CO₂ and Greenhouse Gas Emissions,” OurWorldInData.org, https://ourworldindata.org/co2-and-other-greenhouse-gas-emissions; Greg Ip, “Inflation Reduction Act’s Real Climate Impact Is a Decade Away,” Wall Street Journal, August 24, 2022; Lisa Friedman, “Democrats Designed the Climate Law to Be a Game Changer. Here’s How,” New York Times, August 22, 2022; Hannah Ritchie, “How Do CO2 Emissions Compare When We Adjust for Trade?” ourworldindata.org, October 7, 2019; and United States Environmental Protection Agency, “Global Greenhouse Gas Emissions Data,” epa.gov, February 22, 2022.

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Will Changes to the Federal Student Loan Program Unintentionally Give Colleges an Incentive to Increase Tuition?

Drawing from the Wall Street Journal.

In Chapter 1, Section 1.1, one of our three key economic ideas is that people respond to economic incentives.  Government policy can change the economic incentives that people face. Sometimes a government policy can have unintended consequences because it changes economic incentives in a way that policymakers didn’t anticipate. Some economists argue that this was the case with the Biden administration’s decision to change the federal student loan program.

In recent years, college students and their parents have rapidly increased their loan debt. The following figure shows the total value of outstanding student loans beginning in 2000. Student loan debt increased from about $52 billion in 2000 to about $1.6 trillion in 2022. Or, put another way, for every dollar of loan debt students and their parents owed in 2000, they owed more than 27 dollars of debt in 2022. In 2022, the average borrower owed about $37,000.

During the Covid–19 pandemic, the Trump and Biden administrations allowed people with student loans to suspend making payments on them.  The payment moratorium began March 31, 2020 and is scheduled to end on December 31, 2022. Student loan payments are often the largest item in the budgets of recent college graduates. Some economists argue that the need to make student loan payments has made it harder for young adults to accumulate the down payments necessary to buy homes. As a result, young adults are likely to delay forming families, thereby reducing their need to move from an apartment to a house. In 1967, about 83 percent of people aged 25 to 34 lived with a spouse or partner, while in 2021 only about 54 percent did. 

Some economists doubt that student loan debt explains the delay in young adults forming families and buying houses. But many policymakers have seen reducing the burden of student loan debt on young adults as an important issue. In August 2022, President Joe Biden announced a plan under which individuals earning less than $125,000 per year would have up to $10,000 in student loan debt cancelled. Borrowers with Pell grants would have up to another $10,000 cancelled. A second part of the plan involved changes to the federal government’s income-driven repayment (IDR) program. As a result of these changes, lower and middle-income student loan borrowers will be able to more easily have their loan balances canceled. With some exceptions, borrowers who have loans of $12,000 or less will have their loans canceled after making payments for 10 years, rather than the current 20 years. The annual payments for most borrowers using the IDR program will be lowered to 5 percent of their income above about $33,000 per year, rather than the previous 10 percent. 

Some policymakers objected to President Biden’s plan, arguing that it was unconstitutional because it was the result of a presidential executive order rather than the result of Congressional legislation. Many economists focused on a different potential problem with the plan: the economic incentives that might result from the changes to the IDR program. The intention of these changes was to reduce the burden on people who currently have student loans, but the changes also affected the economic incentives facing students applying for loans and colleges in deciding the level of tuition to charge. 

In an article on the Brookings Institution website, Adam Looney, a professor of finance at the University of Utah, argued that because of the changes to the IDR program, the typical college student could expect to pay back only about 50 percent of the amount borrowed. Before the changes, the Congressional Budget Office had estimated that the typical student would end up paying more than 100 percent of the amount borrowed because the student would have to pay interest on the loan amount. Looney argues that students and their parents will have an incentive to borrow more because they will expect to pay back only half of the amount borrowed.  In particular, he notes:

“A large share of student debt is not used to pay tuition, but is given to students in cash for rent, food, and other expenses…. While students certainly need to pay rent and buy food while in school, under the administration proposal a student can borrow significant amounts for ‘living expenses,’ deposit the check in a bank account, and not pay it all back…. Some people will use loans like an ATM, which will be costly for taxpayers and is certainly not the intended use of the loans.”

Sylvain Catherine, a professor of finance at the University of Pennsylvania’s Wharton School, makes a similar argument: “How can we not anticipate the distortionary effects of such a policy? Student will be encouraged to take more debt since they will not have to repay the marginal dollar, and colleges will have an incentive to further increase tuition.” An article in the New York Times noted that taxpayers will be responsible for the value of student loans that aren’t paid back: “By offering more-generous educational subsidies, the government may be creating a perverse incentive for both schools and borrowers, who could begin to pay even less attention to the actual price tag of their education—and taxpayers could be left footing more of the bill.”

It’s too early to judge the extent to which students, their families, and colleges will react to the changed incentives in President Biden’s student debt relief plan. But because the plan changes economic incentives, it may result in consequences not intended by President Biden and his advisers. (Note that the lawsuits challenging the plan’s constitutionality have also not yet been resolved.) 

Sources: Adam Looney, “Biden’s Income-Driven Repayment Plan Would Turn Student Loans into Untargeted Grants,” brookings.edu, September 15, 2022; Gabriel T. Rubin and Amara Omeokwe, “Biden’s Student-Debt-Forgiveness Plan May Cost Up to $1 Trillion, Challenging Deficit Goals,” Wall Street Journal, September 5, 2022; Stacey Cowley, “Student Loan Subsidies Could Have Dangerous, Unintended Side Effects,” New York Times, September 19, 2022; Ron Lieber, “Why Aren’t Student Loans Simple? Because This Is America,” New York Times, September 3, 2022; Congressional Budget Office, “Federal Student Loan Programs, Baseline Projections,” May 2022; U.S. Census Bureau, “Historical Living Arrangements of Adults,” Table AD-3, November 2021; and Federal Reserve Bank of St. Louis FRED data set.

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Ben Bernanke, Douglas Diamond, and Philip Dybvig Win the Nobel Prize in Economics

Ben Bernanke (Photo from the Brookings Institution.)

Douglas Diamond (Photo from Reuters.)

Philip Dybvig (Photo from Washington University.)

Former Federal Reserve Chair Ben Bernanke (now a Distinguished Fellow in Residence at the Brookings Institution in Washington, DC), Douglas Diamond of the University of Chicago, and Philip Dybvig of Washington University in St. Louis shared the 2022 Nobel Prize in Economics (formally called the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel). Card received half of the prize of 10 million Swedish kronor (about 8.85 million U.S. dollars) for “significantly [improving] our understanding of the role of banks in the economy, particularly during financial crises.” (The press release from the Nobel committee can be read here.)

In paper published in the American Economic Review in 1983, Bernanke provided an influential interpretation of the role the bank panics of the early 1930s played in worsening the severity of the Great Depression. As we discuss in Macroeconomics, Chapter 14, Section 14.3 (Economics, Chapter 24, Section 24.3), by taking deposits and making loans banks play an important in the money supply process. Milton Friedman and Anna Schwartz in A Monetary History of the United States, 1867-1960, Chapter 7, argued that the bank panics of the early 1930s caused a decline in real GDP and employment largely through the mechanism of reducing the money supply.

Bernanke demonstrated that the bank failures affected output and employment in another important way. As we discuss in Macroeconomics, Chapter 6, Section 6.2 and Chapter 14, Section 14.4 (Economics, Chapter 8, Section 8.2 and Chapter 24, Section 24.4) banks are financial intermediaries who engage in indirect finance. Banks accept deposits and use the funds to make loans to households and firms. Households and most firms can’t raise funds through direct finance by selling bonds or stocks to individual investors because investors don’t have enough information about households or all but the largest firms to know whether these borrowers will repay the funds. Banks get around this information problemby specializing in gathering information on households and firms that allow them to gauge how likely a borrower is to default, or stop paying, on a loan.

Because of the special role banks have in providing credit to households and firms that have difficulty borrowing elsewhere, Bernanke argued that the bank panics of the early 1930s, during which more than 5,000 banks in the United States went out of business, not only caused a reduction in the money supply but restricted the ability of households and firms to borrow. As a result, households and firms decreased their spending, which increased the severity of the Great Depression.

In a 1983 paper published in the Journal of Political Economy, Diamond and Dybvig presented what came to be known as the Diamond and Dybvig model of the economic role of banks. This model, along with later research by Diamond, provided economists with a better understanding of the potential instability of banking. Diamond and Dybvig note that banking involves transforming long-run, illiquid assets—loans—into short-run, liquid assets—deposits. Recall that liquidity is the ease with which an asset can be sold. Households and firms want the loans they receive from a bank to be illiquid in the sense that they don’t want the bank to be able to demand that the funds borrowed be repaid, except on a set schedule. Someone receiving a mortgage loan to buy a house wouldn’t want the bank to be able to insist on being paid back any time the bank chose. But households and firms also want the assets they hold to be liquid so that they can quickly convert the assets into money if they need the funds. By taking in deposits and using the funds to make loans, banks provide a service to households and firms by providing both a source of long-run credit and a source of short-term assets. 

But Diamond and Dybvig note that because banks hold long-terms assets that can’t easily be sold, if a large number of people attempt simultaneously to withdraw their deposits, the banks lack the funds to meet these withdrawals. The result is a run on a bank as depositors become aware that unless they quickly withdraw their deposits, they may not receive their funds for a considerable time. If the bank is insolvent—the value of its loans and other assets is less than the value of its deposits and other liabilities—the bank may fail and some households and firms will never receive the full value of their deposits. In the Diamond and Dybvig model, if depositors expect that other depositors will not withdraw their funds, the system can be stable because banks won’t experience runs. But because banks know more about the value of their assets and liabilities than depositors do, depositors may have trouble distinguishing solvent banks from insolvent banks. As a result of this information problem, households and firms may decide to withdraw their deposits even from solvent banks. Households and firms may withdraw their deposits from a bank even if they know with certainty that the bank is solvent if they expect that other households and firms—who may lack this knowledge—will withdraw their deposits. The result will be a bank panic, in which many banks simultaneously experience a bank run. 

With many banks closing or refusing to make new loans in order to conserve funds, households and firms that depend on bank loans will be forced to reduce their spending. As a result, production and employment will decline. Falling production and employment may cause more borrowers to stop paying on their loans, which may cause more banks to be insolvent, leading to further runs, and so on. We illustrate this process in Figure 14.3. 

Diamond and Dybvig note that a system of deposit insurance—adopted in the United States when Congress established the Federal Deposit Insurance Corporation (FDIC) in 1934—or a central bank acting as a lender of last resort to banks experiencing runs are necessary to stabilize the banking system. When Congress established the Federal Reserve System in 1914, it gave the Fed the ability to act as a lender of last resort by making discount loans to banks that were solvent but experiencing temporary liquidity problems as a result of deposit withdrawals.

During the Global Financial Crisis that began in 2007 and accelerated following the failure of the Lehman Brothers investment bank in September 2008, it became clear that the financial firms in the shadow banking system could also be subject to runs because, like commercial banks, shadow banks borrow short term to financial long term investments. Included in the shadow banking system are money market mutual funds, investment banks, and insurance companies. By 2008 the size of the shadow banking system had grown substantially relative to the commercial banking system.  The shadow banking system turned out to be more fragile than the commercial banking system because those lending to shadow banks by, for instance, buying money market mutual fund shares, do not receive government insurance like bank depositors receive from the FDIC and because prior to 2008 the Fed did not act as a lender of last resort to shadow banks.

Bernanke believes that his study of financial problems the U.S. experienced during the Great Depression helped him as Fed chair to deal with the Global Financial Crisis.  In particular, Bernanke concluded from his research that in the early 1930s the Fed had committed a major error in failing to act more vigorously as a lender of last resort to commercial banks. The result was severe problems in the U.S. financial system that substantially worsened the length and severity of the Great Depression.  During the financial crisis, under Bernanke’s leadership, the Fed established several lending facilities that allowed the Fed to extend its role as a lender of last resort to parts of the shadow banking system. (In 2020, the Fed under the leadership of Chair Jerome Powell revived and extended these lending facilities.) Bernanke is rare among economists awarded the Nobel Prize in having had the opportunity to implement lessons from his academic research in economic policymaking at the highest level. (Bernanke discusses the relationship between his research and his policymaking in his memoir. A more complete discussion of the financial crises of the 1930s, 2007-2009, and 2020 appears in Chapter 14 of our textbook Money, Banking, and the Financial System, Fourth Edition.)

We should note that Bernanke’s actions at the Fed have been subject to criticism by some economists and policymakers. As a member of the Fed’s Board of Governors beginning in 2002 and then as Fed chair beginning in 2006, Bernanke, like other members of the Fed and most economists, was slow to recognize the problems in the shadow banking system and, particularly, the problems caused by the rapid increase in housing prices and increasing number of mortgages being granted to borrowers who had either poor credit histories or who made small down payments. Some economists and policymakers also argue that Bernanke’s actions during the financial crisis took the Fed beyond the narrow role of stabilizing the commercial banking system spelled out by Congress in the Federal Reserve Act and may have undermined Fed independence. They also argue that by broadening the Fed’s role as a lender of last resort to include shadow banks, Bernanke may have increased the extent of moral hazard in the financial system.

Finally, Laurence Ball of Johns Hopkins University argues that the worst of the financial crisis could have been averted if Bernanke had acted to save the Lehman Brothers investment bank from failing by making loans to Lehman. Bernanke has argued that the Fed couldn’t legally make loans to Lehman because the firm was insolvent but Ball argues that, in fact, the firm was solvent. Decades later, economists continue to debate whether the Fed’s actions in allowing the Bank of United States to fail in 1930 were appropriate and the debate over the Fed’s actions with respect to Lehman may well last as long. (A working paper version of Ball’s argument can be found here. He later extended his argument in a book. Bernanke’s account of his actions during the failure of Lehman Brothers can be found in his memoir cited earlier.)

Sources: Paul Hannon, “Nobel Prize in Economics Winners Include Former Fed Chair Ben Bernanke,” Wall Street Journal, October 10, 2022; David Keyton, Frank Jordans, and Paul Wiseman, “Former Fed Chair Bernanke Shares Nobel for Research on Banks,” apnews.com, October 10, 2022; and Greg Ip, “Most Nobel Laureates Develop Theories; Ben Bernanke Put His Into Practice,” Wall Street Journal, October 10, 2022. 

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A Handy Way to Track Recession Indicators

The Bureau of Labor Statistics is housed in the U.S. Department of Labor. (Photo from don.gov site.)

In a blog post at the end of August, we noted that real GDP declined during the first two quarters of 2022. On September 29, the Bureau of Economic Analysis (BEA) slightly revised the real GDP data, but after the revisions the BEA’s estimates still showed real GDP declining during those quarters.

A popular definition of a recession is two consecutive quarters of declining real GDP. But, as we noted in the earlier blog post, most economists do not follow this definition. Instead, for most purposes, economists rely on the National Bureau of Economic Research’s business cycle dating, which is based on a number of macroeconomic data series. The NBER defines a recession as “a significant decline in activity spread across the economy, lasting more than a few months, visible in industrial production, employment, real income, and wholesale-retail trade.” The NBER discusses its approach to business cycle dating here.

The Federal Reserve Bank of St. Louis’s invaluable FRED economic data site has collected the data series that the NBER’s Business Cycle Dating Committee relies on when deciding when a recession began. The FRED page collecting these data can be found here

Note that although the Business Cycle Dating Committee analyzes a variety of data series, “In recent decades, the two measures we have put the most weight on are real personal income less transfers and nonfarm payroll employment.” The following figures show movements in those two data series. These data series don’t give a strong indication that the economy was in recession during the first half of 2022. Real personal income minus transfer payments did decline by 0.4 percent between January and June 2022 (before increasing during July and August), but nonfarm payroll employment increased by 1.4 percent during the same period (and increased further in July and August).

As we noted in our earlier blog post, the message from most data series other than real GDP seems to be that the U.S. economy was not in a recession during the first half of 2022.

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Solved Problem: How Does the Value of the U.S. Dollar Affect the U.S. and World Economies?

Supports: Macroeconomics, Chapter 18, Economics, Chapter 28, and Essentials of Economics, Chapter 19.

Between June 2021 and September 2022, the exchange rate between the U.S. dollar and an average of the currencies of the major trading partners of the United States increased by 14 percent. (This movement is shown in the figure above.) An article in the New York Times had the headline “The Dollar Is Strong. That Is Good for the U.S. but Bad for the World.”  

  1. Briefly explain what the headline means by a “strong” dollar. 
  2. Do you agree with the assertion in the headline that a stronger dollar is good for the United States but bad for the economies that the United States trades with? Briefly explain. 
  3. During this period the Federal Reserve was taking actions that raised U.S. interest rates. The article noted that “Those interest rate increases are pumping up the value of the dollar ….” Why would increases in U.S. interest rates relative to interest rates in other countries increase the value of the dollar?

Solving the Problem

Step 1:  Review the chapter material. This problem is about the effect of fluctuations in the exchange rate and the relationship between interest rates and exchange rates, so you may want to review Macroeconomics, Chapter 18, Section 8.2, “The Foreign Exchange Market and Exchange Rates,” or the corresponding sections in Economics, Chapter 28 or Essentials of Economics, Chapter 19.

Step 2: Answer part a. by explaining what a “strong” dollar means. A strong dollar is one that exchanges for more units of foreign currencies, such as British pounds or euros. (A “weak” dollar means the opposite: A dollar that exchanges for fewer units of foreign currencies.)

Step 3: Answer part b. by explaining whether you agree with the assertion that a stronger dollar is good for the United States but bad for the economies of other countries. A stronger U.S. dollar produces winners and losers both in the United States and in other countries. U.S. consumers win because a stronger dollar means that fewer dollars are needed to buy the same quantity of a foreign currency, which reduces the dollar price of imports from that country. For example, a stronger dollar reduces the number of dollars U.S. consumers pay to buy a bottle of French wine that has a 40 euro price.  A strong dollar is bad news for foreign consumers because they must pay more units of their currency to buy goods imported from the United States. For example, Japanese consumers will have to pay more yen to buy an imported Hershey’s candy bar with a $1.25 price. 

The situation is reversed for U.S. and foreign firms exporting goods. Because foreign consumers have to pay higher prices in their own currencies for goods imported from the United States, they are likely to buy less of them, buying more domestically produced goods or goods imported from other countries. U.S. firms will either to have accept lower sales, or cut the prices they charge for their exports. In either case, U.S. exporters’ revenue will decline. Foreign firms that export to the United States will be in the opposite situation: The dollar prices of their exports will decline, increasing their sales.

We can conclude that the article’s headline is somewhat misleading because not all groups in the United States are helped by a strong dollar and not all groups in other countries are hurt by a strong dollar.

Step 4: Answer part c. by explaining why higher interest rates in the United States relative to interest rates in other countries will increase the exchange value of the dollar. If interest rates in the United States rise relative to interest rates in other countries—as was true during the period from the spring of 2021 to the fall of 2022—U.S. financial assets, such as U.S. Treasury bills, will be more desirable, causing investors to increase their demand for the dollars they need to buy U.S. financial assets. The resulting shift to the right in the demand curve for dollars will cause the equilibrium exchange rate between the dollar and other currencies to increase. 

Source:  Patricia Cohen, “The Dollar Is Strong. That Is Good for the U.S. but Bad for the World,” New York Times, September 26, 2022.

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The Federal Open Market Committee’s September 2022 Meeting and the Question of Whether the Fed Should Focus Only on Price Stability

The Federal Reserve building in Washington, DC. (Photo from the Wall Street Journal.)

In the Federal Reserve Act, Congress charged the Federal Reserve with conducting monetary policy so as to achieve both “maximum employment” and “stable prices.”  These two goals are referred to as the Fed’s dual mandate.  (We discuss the dual mandate in Macroeconomics, Chapter 15, Section 15.1, Economics, Chapter 25, Section 25.1, and Money, Banking, and the Financial System, Chapter 15, Section 15.1.) Accordingly, when Fed chairs give their semiannual Monetary Policy Reports to Congress, they reaffirm that they are acting consistently with the dual mandate. For example, when testifying before the U.S. Senate Committee on Banking, Housing, and Urban Affairs in June 2022, Fed Chair Jerome Powell stated that: “The Fed’s monetary policy actions are guided by our mandate to promote maximum employment and stable prices for the American people.”

Despite statements of that kind, some economists argue that in practice during some periods the Fed’s policymaking Federal Open Market Committee (FOMC) acts as if it were more concerned with one of the two mandates. In particular, in the decades following the Great Inflation of the 1970s, FOMC members appear to have put more emphasis on price stability than on maximum employment. These economists argue that during these years, FOMC members were typically reluctant to pursue a monetary policy sufficiently expansionary to lead to maximum employment if the result would be to cause the inflation rate to rise above the Fed’s target of an annual target of 2 percent. (Although the Fed didn’t announce a formal inflation target of 2 percent until 2012, the FOMC agreed to set a 2 percent inflation target in 1996, although they didn’t publicly announce at the time. Implicitly, the FOMC had been acting as if it had a 2 percent target since at least the mid–1980s.)

In July 2019, the FOMC responded to a slowdown in economic growth in late 2018 and early 2019 but cutting its target for the federal funds rate. It made further cuts to the target rate in September and October 2019. These cuts helped push the unemployment rate to low levels even as the inflation rate remained below the Fed’s 2 percent target. The failure of inflation to increase despite the unemployment rate falling to low levels, provides background to the new monetary policy strategy the Fed announced in August 2020. The new monetary policy, in effect, abandoned the Fed’s previous policy of attempting to preempt a rise in the inflation rate by raising the target for the federal funds rate whenever data on unemployment and real GDP growth indicated that inflation was likely to rise. (We discussed aspects of the Fed’s new monetary policy in previous blog posts, including here, here, and here.)

In particular, the FOMC would no longer see the natural rate of unemployment as the maximum level of employment—which Congress has mandated the Fed to achieve—and, therefore, wouldn’t necessarily begin increasing its target for the federal funds rate when the unemployment rate dropped by below the natural rate. As Fed Chair Powell explained at the time, “the maximum level of employment is not directly measurable and [it] changes over time for reasons unrelated to monetary policy. The significant shifts in estimates of the natural rate of unemployment over the past decade reinforce this point.”

Many economists interpreted the Fed’s new monetary strategy and the remarks that FOMC members made concerning the strategy as an indication that the Fed had turned from focusing on the inflation rate to focusing on unemployment. Of course, given that Congress has mandated the Fed to achieve both stable prices and maximum employment, neither the Fed chair nor other members of the FOMC can state directly that they are focusing on one mandate more than the other. 

The sharp acceleration in inflation that began in the spring of 2021 and continued into the fall of 2022 (shown in the following figure) has caused members of the FOMC to speak more forcefully about the need for monetary policy to bring inflation back to the Fed’s target rate of 2 percent. For example, in a speech at the Federal Reserve Bank of Kansas City’s annual monetary policy conference held in Jackson Hole, Wyoming, Fed Chair Powell spoke very directly: “The Federal Open Market Committee’s (FOMC) overarching focus right now is to bring inflation back down to our 2 percent goal.” According to an article in the Wall Street Journal, Powell had originally planned a longer speech discussing broader issues concerning monetary policy and the state of the economy—typical of the speeches that Fed chairs give at this conference—before deciding to deliver a short speech focused directly on inflation.

Members of the FOMC were concerned that a prolonged period of high inflation rates might lead workers, firms, and investors to no longer expect that the inflation rate would return to 2 percent in the near future. If the expected inflation rate were to increase, the U.S. economy might enter a wage–price spiral in which high inflation rates would lead workers to push for higher wages, which, in turn, would increase firms’ labor costs, leading them to raise prices further, in response to which workers would push for even higher wages, and so on. (We discuss the concept of a wage–price spiral in earlier blog posts here and here.)

With Powell noting in his Jackson Hole speech that the Fed would be willing to run the risk of pushing the economy into a recession if that was required to bring down the inflation rate, it seemed clear that the Fed was giving priority to its mandate for price stability over its mandate for maximum employment. An article in the Wall Street Journal quoted Richard Clarida, who served on the Fed’s Board of Governors from September 2018 until January 2022, as arguing that: “Until inflation comes down a lot, the Fed is really a single mandate central bank.”

This view was reinforced by the FOMC’s meeting on September 21, 2022 at which it raised its target for the federal funds rate by 0.75 percentage points to a range of 3 to 3.25 percent. The median projection of FOMC members was that the target rate would increase to 4.4 percent by the end of 2022, up a full percentage point from the median projection at the FOMC’s June 2022 meeting. The negative reaction of the stock market to the announcement of the FOMC’s decision is an indication that the Fed is pursuing a more contractionary monetary policy than many observers had expected. (We discuss the relationship between stock prices and economic news in this blog post.)

Some economists and policymakers have raised a broader issue concerning the Fed’s mandate: Should Congress amend the Federal Reserve Act to give the Fed the single mandate of achieving price stability? As we’ve already noted, one interpretation of the FOMC’s actions from the mid–1980s until 2019 is that it was already implicitly acting as if price stability were a more important goal than maximum employment. Or as Stanford economist John Cochrane has put it, the Fed was following “its main mandate, which is to ensure price stability.”

The main argument for the Fed having price stability as its only mandate is that most economists believe that in the long run, the Fed can affect the inflation rate but not the level of potential real GDP or the level of employment. In the long run, real GDP is equal to potential GDP, which is determined by the quantity of workers, the capital stock—including factories, office buildings, machinery and equipment, and software—and the available technology. (We discuss this point in Macroeconomics, Chapter 13, Section 13.2 and in Economics, Chapter 23, Section 23.2.) Congress and the president can use fiscal policy to affect potential GDP by, for example, changing the tax code to increase the profitability of investment, thereby increasing the capital stock, or by subsidizing apprentice programs or taking other steps to increase the labor supply. But most economists believe that the Fed lacks the tools to achieve those results. 

Economists who support the idea of a single mandate argue that the Fed would be better off focusing on an economic variable they can control in the long run—the inflation rate—rather than on economic variables they can’t control—potential GDP and employment. In addition, these economists point out that some foreign central banks have a single mandate to achieve price stability. These central banks include the European Central Bank, the Bank of Japan, and the Reserve Bank of New Zealand.

Economists and policymakers who oppose having Congress revise the Federal Reserve Act to give the Fed the single mandate to achieve price stability raise several points. First, they note that monetary policy can affect the level of real GDP and employment in the short run. Particularly when the U.S. economy is in a severe recession, the Fed can speed the return to full employment by undertaking an expansionary policy. If maximum employment were no longer part of the Fed’s mandate, the FOMC might be less likely to use policy to increase the pace of economic recovery, thereby avoiding some unemployment.

Second, those opposed to the Fed having single mandate argue that the Fed was overly focused on inflation during some of the period between the mid–1980s and 2019. They argue that the result was unnecessarily low levels of employment during those years. Giving the Fed a single mandate for price stability might make periods of low employment more likely.

Finally, because over the years many members of Congress have stated that the Fed should focus more on maximum employment than price stability, in practical terms it’s unlikely that the Federal Reserve Act will be amended to give the Fed the single mandate of price stability.

In the end, the willingness of Congress to amend the Federal Reserve Act, as it has done many times since initial passage in 1914, depends on the performance of the U.S. economy and the U.S. financial system. It’s possible that if the high inflation rates of 2021–2022 were to persist into 2023 or beyond, Congress might revise the Federal Reserve Act to change the Fed’s approach to fighting inflation either by giving the Fed a single mandate for price stability or in some other way. 

Sources: Board of Governors of the Federal Reserve System, “Federal Reserve Issues FOMC Statement,” federalreserve.gov, September 21, 2022; Board of Governors of the Federal Reserve System, “Summary of Economic Projections,” federalreserve.gov, September 21, 2022; Nick Timiraos, “Jerome Powell’s Inflation Whisperer: Paul Volcker,” Wall Street Journal, September 19, 2022; Matthew Boesler and Craig Torres, “Powell Talks Tough, Warning Rates Are Going to Stay High for Some Time,” bloomberg.com, August 26, 2022; Jerome H. Powell, “Semiannual Monetary Policy Report to the Congress,” June 22, 2022, federalreserve.gov; Jerome H. Powell, “Monetary Policy and Price Stability,” speech delivered at “Reassessing Constraints on the Economy and Policy,” an economic policy symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, federalreserve.gov, August 26, 2022; John H. Cochrane, “Why Isn’t the Fed Doing its Job?” project-syndicate.org, January 19, 2022; Board of Governors of the Federal Reserve System, “Minutes of the Federal Open Market Committee Meeting on July 2–3, 1996,” federalreserve.gov; and Federal Reserve Bank of St. Louis.

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The Return of the FedEx Indicator?

Image from the Wall Street Journal.

On September 16, 2022 an article in the Wall Street Journal had the headline: “Economic Worries, Weak FedEx Results Push Stocks Lower.” Another article in the Wall Street Journal noted that: “The company’s downbeat forecasts, announced Thursday, intensified investors’ macroeconomic worries.”

Why would the news that FedEx had lower revenues than expected during the preceding weeks cause a decline in stock market indexes like the Dow Jones Industrial Average and the S&P 500? As the article explained: “Delivery companies [such as FedEx and its rival UPS) are the proverbial canary in the coal mine for the economy.” In other words, investors were using FedEx’s decline in revenue as a leading indicator of the business cycle.  A leading indicator is an economic data series—in this case FedEx’s revenue—that starts to decline before real GDP and employment in the months before a recession and starts to increase before real GDP and employment in the months before a recession reaches a trough and turns into an expansion. 

So, investors were afraid that FedEx’s falling revenue was a signal that the U.S. economy would soon enter a recession. And, in fact, FedEx CEO Raj Subramaniam was quoted as believing that the global economy would fall into a recession. As firms’ profits decline during a recession so, typically, do the prices of the firms’ stock. (As we discuss in Macroeconomics, Chapter 6, Section 6.2 and in Economics, Chapter 8, Section 8.2, stock prices reflect investors’ expectations of the future profitability of the firms issuing the stock.)

Monitoring fluctuations in FedEx’s revenue for indications of the future course of the economy is nothing new. When Alan Greenspan was chair of the Federal Reserve from 1987 to 2006, he spoke regularly with Fred Smith, the founder of FedEx and at the time CEO of the firm. Greenspan believed that changes in the number of packages FedEx shipped gave a good indication of the overall state of the economy. FedEx plays such a large role in moving packages around the country that most economists agree that there is a close relationship between fluctuations in FedEx’s business and fluctuations in GDP. Some Wall Street analysts refer to this relationship as the “FedEx Indicator” of how the economy is doing.

In September 2022, the FedEx indicator was blinking red. But the U.S. economy is complex and fluctuations in any indicator can sometimes provide an inaccurate forecast of when a recession will begin or end. And, in fact, some investment analysts believed that problems at FedEx may have been due as much to mistakes the firms’ managers had made as to general problems in the economy. As one analyst put it: “We believe a meaningful portion of FedEx’s missteps here are company-specific.” 

At this point, Fed Chair Jerome Powell and the other members of the Federal Open Market Committee are still hoping that they can bring the economy in for a soft landing—bringing inflation down closer to the Fed’s 2 percent target, without bringing on a recession—despite some signals, like those being given by the FedEx indicator, that the probability of the United States entering a recession was increasing. 

Sources: Will Feuer, “FedEx Stock Tumbles More Than 20% After Warning on Economic Trends,” Wall Street Journal, September 16, 2022; Alex Frangos and Hannah Miao, “ FedExt Stock Hit by Profit Warning; Rivals Also Drop Amid Recession Fears,” Wall Street Journal, September 16, 2022; Richard Clough, “FedEx has Biggest Drop in Over 40 Years After Pulling Forecast,” bloomberg.com, September 16, 2022; and David Gaffen, “The FedEx Indicator,” Wall Street Journal, February 20, 2007.

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Should the Fed Be Looking at the Median CPI?

For years, all the products for sale in Dollar Tree stores had a price of $1.00 or less. But as inflation increased, the company had to raise its maxium prices to $1.25. (Thanks to Lena Buonanno for sending us the photo.)

There are multiple ways to measure inflation. Economists and policymakers use different measures of inflation depending on the use they intend to put the measure of inflation to. For example, as we discuss in Macroeconomics, Chapter 9, Section 9.4 (Economics, Chapter 19, Section 19.4), the Bureau of Labor Statistics (BLS) constructs the consumer price index (CPI) as measure of the cost of living of a typical urban household. So the BLS intends the percentage change in the CPI to measure inflation in the cost of living as experienced by the roughly 93 percent of the population that lives in an urban household. (We are referring here to what the BLS labels CPI–U. As we discuss in this blog post, the BLS also compiles a CPI for urban wage earners and clerical workers (or CPI–W).)

As we discuss in an Apply the Concept in Chapter 15, Section 15.5, because the Fed is charged by Congress with ensuring stability in the general price level, the Fed is interested in a broader measure of inflation than the CPI. So its preferred measure of inflation is the personal consumption expenditures (PCE) price index, which the Bureau of Economic Analysis (BEA) issues monthly. The PCE price index is a measure of the price level similar to the GDP deflator, except it includes only the prices of goods and services from the consumption category of GDP. Because the PCE price index includes more goods and services than the CPI, it is suits the Fed’s need for a broader measure of inflation. The Fed uses changes in the PCE to evaluate whether it’s meeting its target of a 2 percent annual inflation rate.

In using either the percentage change in the CPI or the percentage change in the PCE, we are looking at what inflation has been over the previous year. But economists and policymakers are also looking for indications of what inflation may be in the future. Prices of food and energy are particularly volatile, so the BLS issues data on the CPI excluding food and energy prices and the BEA does the same with respect to the PCE. These two measures help avoid the problem that, for example, a period of high gasoline prices might lead the inflation rate to temporarily increase. Note that inflation caclulated by excluding the prices of food and energy is called core inflation.

During the surge in inflation that began in the spring of 2021 and continued into the fall of 2022, some economists noted that supply chain problems and other effects of the pandemic on labor and product markets caused the prices of some goods and services to spike. For example, a shortage of computer chips led to a reduction in the supply of new cars and sharp increases in car prices. As with temporary spikes in prices of energy and food, spikes resulting from supply chain problems and other effects of the pandemic might lead the CPI and PCE—even excluding food and energy prices—to give a misleading measure of the underlying rate of inflation in the economy. 

To correct for this problem, some economists have been more attention to the measure of inflation calculated using the median CPI, which is compiled monthly by economists at the Federal Reserve Bank of Cleveland. The median CPI is calculated by ranking the price changes of every good or service in the index from the largest price change to the smallest price change, and then choosing the price change in the middle. The idea is to eliminate the effect on measured inflation of any short-lived events that cause the prices of some goods and services to be particularly high or particularly low. Economists at the Cleveland Fed have conducted research that shows that, in their words, “the median CPI provides a better signal of the underlying inflation trend than either the all-items CPI or the CPI excluding food and energy. The median CPI is even better at forecasting PCE inflation in the near and longer term than the core PCE price index.”

The following figure shows the three measures of inflation using the CPI for each month since January 2019. The red line shows the unadjusted CPI, the green line shows the CPI excluding food and energy prices, and the blue line shows median CPI. To focus on the inflation rate in a particular month, in this figure we calculate inflation as the percentage change in the index at an annual rate. That is, we calculate the annual inflation rate assuming that the inflation rate in that month continued for a year.

Note that for most of the period since early 2021, during which the inflation rate accelerated, median inflation was well below inflation measured by changes in the unadjusted CPI. That difference reflects some of the distortions in measuring inflation arising from the effects of the pandemic.

But the last two values—for July and August 2022—tell a different story. In those months, inflation measured by changes in the CPI excluding food and energy prices or by changes in median CPI were well above inflation measured by changes in the unadjusted CPI.  In August 2022, the unadjusted CPI shows a low rate of inflation—1.4 percent—whereas the CPI excluding food and energy prices shows an inflation rate of 7.0 percent and the median CPI shows an inflation rate of 9.2 percent. 

We should always be cautious when interpreting any economic data for a period as short as two months. But data for inflation measured by the change in median CPI may be sending a signal that the slowdown in inflation that many economists and policymakers had been predicting would occur in the summer of 2022 isn’t actually occurring. We’ll have to await the release of future data to draw a firmer conclusion.

Sources: Michael S. Derby, “Inflation Data Scrambles Fed Rate Outlook Again,” Wall Street Journal, September 14, 2022; Federal Reserve Bank of Cleveland, “Median CPI,” clevelandfed.org; and Federal Reserve Bank of St. Louis.

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Podcasts Back for Fall 2022! – 9/9/22 Podcast – Authors Glenn Hubbard & Tony O’Brien discuss inflation, the Fed’s Response, cryptocurrency, and also briefly touch on labor markets.

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Solved Problem: How Can Total Employment and the Unemployment Rate Both Increase?

Photo from the New York Times.

Supports: Macroeconomics, Chapter 9, Section 9.1, Economics Chapter 19, Section 19.1, and Essentials of Economics, Chapter 13, Section 13.1.

As it does on the first Friday of each month, on September 2, 2022, the U.S. Bureau of Labor Statistics (BLS) released its “Employment Situation” report for August 2022. According to the household survey data in the report, total employment in the U.S. economy increased in August by 442,000 compared with July. The unemployment rate rose from 3.5 percent in July to 3.7 percent in August. According to the establishment survey, the total number of workers on payrolls increased in August by 315,000 compared with July.

  1. How are the data in the household survey collected? How are the data in the establishment survey collected?
  2. Why are the estimated increases in employment from July to August 2022 in the two surveys different? 
  3. Briefly explain how it is possible for the household survey to report in a given month that both total employment and the unemployment rate increased.

Solving the Problem

Step 1: Review the chapter material. This problem is about how the BLS reports data on employment and unemployment, so you may want to review Chapter 9, Section 9.1, “Measuring the Unemployment Rate, the Labor Force Participation Rate, and the Employment–Population Ratio.” 

Step 2: Answer part a. by explaining how the data from the two surveys are collected. As discussed in Section 9.1, the data in the household survey is from interviews with a sample of 60,000 households, chosen to represent the U.S. population. The data in the establishment survey—sometimes called the payroll survey in media stories—is from a sample of 300,000 establishments (factories, stores, and offices).  

Step 3: Answer part b. by explaining why the estimated increase in employment is different in the two surveys.  First note that the BLS intends the surveys to estimate two different measures of employment. The household survey includes people working at jobs of all types, including people who are self-employed or who are unpaid family workers, whereas the establishment survey includes only people who appear on a non-agricultural firm’s payroll, so the self-employed, farm workers, and unpaid family workers aren’t counted. Second, the data are collected from surveys and so—like all estimates that rely on surveys—will have some measurement error.  That is, the actual increase in employment—either total employment in the household survey or payroll employment in the establishment survey—is likely to be larger or smaller than the reported estimates. The estimates in the establishment survey are revised in later months as the BLS receives additional data on payroll employment. In contrast, the estimates in household survey are ordinarily not revised because they are based only on a survey conducted once per month.  

Step 4: Answer part c. by explaining how in a given month the household survey may report an increase in both employment and the unemployment rate.  The BLS’s estimate of the unemployment is calculated from responses to the household survey. (The establishment survey doesn’t report an estimate of the unemployment rate.) The unemployment rate equals the total number of people unemployed divided by the labor force, multiplied by 100. The labor force equals the sum of the employed and the unemployed. If the number of people employed increases—thereby increasing the denominator in the unemployment rate equation—while the number of people unemployed remains the same or falls, as a matter of arithmetic the unemployment rate will have to fall. 

The BLS reported that the unemployment rate in August 2022 rose even though total employment increased. That outcome is possible only if the number of people who are unemployed also increased, resulting in a proportionally larger increase in the numerator in the unemployment equation relative to the denominator. In fact, the BLS estimated that the number of people unemployed increased by 344,000 from July to August 2022. Employment and unemployment both increasing during a month happens fairly often during an economic expansion as some people who had been out of the labor force—and, therefore, not counted by the BLS as being unemployed—begin to search for work during the month but don’t find jobs.

Source: U.S. Bureau of Labor Statistics, “The Employment Situation—August 2022,” bls.gov, September 2, 2022.  

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Why Might Good News for the Job Market Be Bad News for the Stock Market?

Photo from the New York Times.

On Tuesday, August 30, 2022, the U.S. Bureau of Labor Statistics (BLS) released its Job Openings and Labor Turnover Survey (JOLTS) report for July 2022. The report indicated that the U.S. labor market remained very strong, even though, according to the Bureau of Economic Analysis (BEA), real gross domestic product (GDP) had declined during the first half of 2022. (In this blog post, we discuss the possibility that during this period the real GDP data may have been a misleading indicator of the actual state of the economy.)

As the following figure shows, the rate of job openings remained very high, even in comparison with the strong labor market of 2019 and early 2020 before the Covid-19 pandemic began disrupting the U.S. economy. The BLS defines a job opening as a full-time or part-time job that a firm is advertising and that will start within 30 days. The rate of job openings is the number of job openings divided by the number of job openings plus the number of employed workers, multiplied by 100.

In the following figure, we compare the total number of job openings to the total number of people unemployed. The figure shows that in July 2022 there were almost two jobs available for each person who was unemployed.

Typically, a strong job market with high rates of job openings indicates that firms are expanding and that they expect their profits to be increasing. As we discuss in Macroeconomics, Chapter 6, Section 6.2 (Microeconomics and Economics, Chapter 8, Section 8.2) the price of a stock is determined by investors’ expectations of the future profitability of the firm issuing the stock. So, we might have expected that on the day the BLS released the July JOLTS report containing good news about the labor market, the stock market indexes like the Dow Jones Industrial Average, the S&P 500, and the Nasdaq Composite Index would rise. In fact, though the indexes fell, with the Dow Jones Industrial Average declining a substantial 300 points. As a column in the Wall Street Journal put it: “A surprisingly tight U.S. labor market is rotten news for stock investors.” Why did good news about the labor market could cause stock prices to decline? The answer is found in investors’ expectations of the effect the news would have on monetary policy.

In August 2022, Fed Chair Jerome Powell and the other members of the Federal Reserve Open Market Committee (FOMC) were in the process of tightening monetary policy to reduce the very high inflation rates the U.S. economy was experiencing. In July 2022, inflation as measured by the percentage change in the consumer price index (CPI) was 8.5 percent. Inflation as measured by the percentage change in the personal consumption expenditures (PCE) price index—which is the measure of inflation that the Fed uses when evaluating whether it is hitting its target of 2 percent annual inflation—was 6.3 percent. (For a discussion of the Fed’s choice of inflation measure, see the Apply the Concept “Should the Fed Worry about the Prices of Food and Gasoline,” in Macroeconomics, chapter 15, Section 15.5 and in Economics, Chapter 25, Section 25.5.)

To slow inflation, the FOMC was increasing its target for the federal funds rate—the interest rate that banks charge each other on overnight loans—which in turn was leading to increases in other interest rates, such as the interest rate on residential mortgage loans. Higher interest rates would slow increases in aggregate demand, thereby slowing price increases. How high would the FOMC increase its target for the federal funds rate? Fed Chair Powell had made clear that the FOMC would monitor economic data for indications that economic activity was slowing. Members of the FOMC were concerned that unless the inflation rate was brought down quickly, the U.S. economy might enter a wage-price spiral in which high inflation rates would lead workers to push for higher wages, which, in turn, would increase firms’ labor costs, leading them to raise prices further, in response to which workers would push for even higher wages, and so on. (We discuss the concept of a wage-price spiral in this earlier blog post.)

In this context, investors interpretated data showing unexpected strength in the economy—particularly in the labor market—as making it likely that the FOMC would need to make larger increases in its target for the federal fund rate. The higher interest rates go, the more likely that the U.S. economy will enter an economic recession. During recessions, as production, income, and employment decline, firms typically experience lower profits or even suffer losses. So, a good JOLTS report could send stock prices falling because news that the labor market was stronger than expected increased the likelihood that the FOMC’s actions would push the economy into a recession, reducing profits. Or as the Wall Street Journal column quoted earlier put it:

“So Tuesday’s [JOLTS] report was good news for workers, but not such good news for stock investors. It made another 0.75-percentage-point rate increase [in the target for the federal funds rate] from the Fed when policy makers meet next month seem increasingly likely, while also strengthening the case that the Fed will keep raising rates well into next year. Stocks sold off sharply following the report’s release.”

Sources: U.S. Bureau of Labor Statistics, “Job Openings and Labor Turnover–July 2022,” bls.gov, August 30, 2022; Justin Lahart, “Why Stocks Got Jolted,” Wall Street Journal, August 30, 2022; Jerome H. Powell, “Monetary Policy and Price Stability,” speech at “Reassessing Constraints on the Economy and Policy,” an economic policy symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, August 26, 2022; and Federal Reserve Bank of St. Louis.

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Solved Problem: Evaluating the Disney World Pricing Strategy

Photo from the New York Times.

Supports: Microeconomics, Chapter 6, Section 6.3 and Chapter 10, Section 10.3, Economics Chapter 6, Section 6.3 and Chapter 10, Section 10.3, and Essentials of Economics, Chapter 7, Section 7.4 and Section 7.7. 

In August 2022, an article in the Wall Street Journal discussed the Disney Company increasing the prices it charges for admission to its Disneyland and Walt Disney World theme parks. As a result of the price increases, “For the quarter that ended July 2 [2022], the business unit that includes the theme parks … posted record revenue of $5.42 billion and record operating income of $1.65 billion.” The increase in revenue occurred even though “attendance at Disney’s U.S. parks fell by 17% compared with the previous year….”

The article also contains the following observations about Disney’s ticket price increases: 

  1. “Disney’s theme-park pricing is determined by ‘pure supply and demand,’ said a company spokeswoman.” 
  2. “[T]he changes driving the increases in revenue and profit have drawn the ire of what Disney calls ‘legacy fans,’ or longtime parks loyalists.”
  1. Briefly explain what must be true of the demand for tickets to Disney’s theme parks if its revenue from ticket sales increased even though 17 percent fewer tickets were sold. [For the sake of simplicity, ignore any other sources of revenue Disney earns from its theme parks apart from ticket sales.]
  2. In Chapter 10, Section 10.3 the textbook discusses social influences on decision making, in particular, the business implications of fairness. Briefly discuss whether the analysis in that section is relevant as Disney determines the prices for tickets to its theme parks. 

Solving the Problem

Step 1: Review the chapter material. This problem is about the effects of price increases on firms’ revenues and on whether firms should pay attention the possibility that consumers might be concerned about fairness when making their consumption decisions, so you may want to review Chapter 6, Section 6.3, “The Relationship between Price Elasticity of Demand and Total Revenue” and Chapter 10, Section 10.3, “Social Influences on Decision Making,” particularly the topic “Business Implications of Fairness.” 

Step 2: Answer part a. by explaining what must be true of the demand for tickets to Disney’s theme parks if revenue from ticket sales increased even though Disney sold fewer tickets. Assuming that the demand curve for tickets to Disney’s theme parks is unchanged, a decline in the quantity of tickets sold will result in a move up along the demand curve for tickets, raising the price of tickets.  Only if the demand curve for theme park tickets is price inelastic will the revenue Disney receives from ticket sales increase when the price of tickets increases. Revenue increases in this situation because with an inelastic demand curve, the percentage increase in price is greater than the percentage decrease in quantity demanded. 

Step 3: Answer part b. by explaining whether the textbook’s discussion of the business implications of fairness is relevant as Disney as determines ticket prices.  Section 10.3 may be relevant to Disney’s decisions because the section discusses that firms sometimes take consumer perceptions of fairness into account when deciding what prices to charge. Note that ordinarily economists assume that the utility consumers receive from a good or service depends only on the attributes of the good or service and is not affected by the price of the good or service. Of course, in making decisions on which goods and services to buy with their available income, consumers take price into account. But consumers take price into account by comparing the marginal utilities of products realtive to their prices, with the marginal utilities assumed not to be affected by the prices.

In other words, a consumer considering buying a ticket to Disney World will compare the marginal utility of visiting Disney World relative to the price of the ticket to the marginal utility of other goods and services relative to their prices. The consumer’s marginal utility from spending a day in Disney World will not be affected by whether he or she considers the price of the ticket to be unfairly high.

The textbook gives examples, though, of cases where a business may fail to charge the price that would maximize short-run profit because the business believes consumers would see the price as unfair, which might cause them to be unwilling to buy the product in the future. For instance, restaurants frequently don’t increase their prices during a particularly busy night, even though doing so would increase the profit they earn on that night. They are afraid that if they do so, some customers will consider the restaurants to have acted unfairly and will stop eating in the restaurants. Similarly, the National Football League doesn’t charge a price that would cause the quantity of Super Bowl tickets demanded to be equal to the fixed supply of seats available at the game because it believes that football fans would consider it unfair to do so.

The Wall Street Journal article quotes a Disney spokeswomen as saying that the company sets the price of tickets according to demand and supply. That statement seems to indicate that Disney is charging the price that will maximize the short-run profit the company earns from selling theme park tickets. But the article also indicates that many of Disney’s long-time ticket buyers are apparently upset at the higher prices Disney has been charging. If these buyers consider Disney’s prices to be unfair, they may in the future stop buying tickets. 

In other words, it’s possible that Disney might find itself in a situation in which it has increased its profit in the short run at the expense of its profit in the long run. The managers at Disney might consider sacrificing some profit in the long run to increase profit in the short run an acceptable trade-off, particularly because it’s difficult for the company to know whether in fact many of its customers will in the future stop buying admission tickets because they believe current ticket prices to be unfairly high.  

Sources: Robbie Whelan and Jacob Passy, “Disney’s New Pricing Magic: More Profit From Fewer Park Visitors,” Wall Street Journal, August 27, 2022.

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Is the U.S. Economy in a Recession? Real GDP versus Real GDI

Photo from the Wall Street Journal.

The Bureau of Economic Analysis (BEA) publishes data on gross domestic product (GDP) each quarter. Economists and media reports typically focus on changes in real GDP as the best measure of the overall state of the U.S. economy. But, as we discuss in Macroeconomics, Chapter 8, Section 8.4 (Economics, Chapter 18, Section 18.4), the BEA also publishes quarterly data on gross domestic income (GDI). As we discuss in Chapter 8, Section 8.1 when discussing the circular-flow diagram, the value of every final good and services produced in the economy (GDP) should equal the value of all the income in the economy resulting from that production (GDI). The BEA has designed the two measures to be identical by including in GDI some non-income items, such as sales taxes and depreciation. But as we discuss in the Apply the Concept, “Should We Pay More Attention to Gross Domestic Income?” GDP and GDI are compiled by the BEA from different data sources and can sometimes significantly diverge. 

A large divergence between the two measures occurred in the first half of 2022. During this period real GDP declined—as shown by the blue line in the following figure—after which some stories in the media indicated that the U.S. economy was in a recession.  But real GDI—as shown by the red line in the figure—increased during the same two quarters. So, was the U.S. economy still in the expansion that began in the third quarter of 2020, rather than in a recession?  Or, as an article in the Wall Street Journal put it: “A Different Take on the U.S. Economy: Maybe It Isn’t Really Shrinking.”

In fact, most economists do not follow the popular definition of a recession as being two consecutive quarters of declining real GDP. Instead, as we discuss in Chapter 10, Section 10.3, economists typically follow the definition of a recession used by the National Bureau of Economic Research: “A recession is a significant decline in activity spread across the economy, lasting more than a few months, visible in industrial production, employment, real income, and wholesale-retail trade.” 

During the first half of 2022, most measures of economic activity were expanding, rather than contracting. For example, the first of the following figures shows payroll employment increasing in each month in the first half of 2022. The second figure shows industrial production also increasing during most months in the first half of 2022, apart from a very slight decline from April to May after which it continued to increase. 

Taken together, these data indicate that the U.S. economy was likely not in a recession during the first half of 2022. The BEA revises the data on real GDP and real GDI over time as various government agencies gather more information on the different production and income measures included in the series. Jeremy Nalewaik of the Federal Reserve Board of Governors has analyzed the BEA’s adjustments to its initial estimates of real GDP and real GDI. He has found that when there are significant differences between the two series, the BEA revisions usually result in the GDP values being revised to be closer to the GDI values. Put another way, the initial GDI estimates may be more accurate than the initial GDP estimates.

If that generalization holds true in 2022, then the BEA may eventually revise its estimates of GDP upward, which would show that the U.S. economy was not in a recession in the first of half of 2022 because economic activity was increasing rather than decreasing. 

Sources: Jon Hilsenrath, “A Different Take on the U.S. Economy: Maybe It Isn’t Really Shrinking,” Wall Street Journal, August 28, 2022; Reade Pickert, “Key US Growth Measures Diverge, Complicating Recession Debate,” bloomberg.com, August 25, 2022; Jeremy L. Nalewaik, “The Income- and Expenditure-Side Estimates of U.S. Output Growth,” Brookings Papers on Economic Activity, Spring 2010, pp. 71-127; and Federal Reserve Bank of St. Louis.

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How Should We Measure Inflation?

Image from the Wall Street Journal.

In the textbook, we discuss several measures of inflation. In Macroeconomics, Chapter 8, Section 8.4 (Economics, Chapter 18, Section 18.4) we discuss the GDP deflator as a measure of the price level and the percentage change in the GDP deflator as a measure of inflation. In Chapter 9, Section 9.4, we discuss the consumer price index (CPI) as a measure of the price level and the percentage change in the CPI as the most widely used measure of inflation. 

            In Chapter 15, Section 15.5 we examine the reasons that the Federal Reserve often looks at the core inflation rate—the inflation rate excluding the prices of food and energy—as a better measure of the underlying rate of inflation. Finally, in that section we note that the Fed uses the percentage change in the personal consumption expenditures (PCEprice index to assess  of whether it’s achieving its goal of a 2 percent inflation rate.

            In this blog post, we’ll discuss two other aspects of measuring inflation that we don’t cover in the textbook. First, the Bureau of Labor Statistics (BLS) publishes two versions of the CPI:  (1) The familiar CPI for all urban consumers (or CPI–U), which includes prices of goods and services purchased by households in urban areas, and (2) the less familiar CPI for urban wage earners and clerical workers (or CPI–W), which includes the same prices included in the CPI–U. The two versions of the CPI give slightly different measures of the inflation rate—despite including the same prices—because each version applies different weights to the prices when constructing the index.

            As we explain in Chapter 9, Section 9.4, the weights in the CPI–U (the only version of the CPI we discuss in the chapter) are determined by a survey of 36,000 households nationwide on their spending habits. The more the households surveyed spend on a good or service, the larger the weight the price of the good or service receives in the CPI–U. To calculate the weights in the CPI–W the BLS uses only expenditures by households in which at least half of the household’s income comes from a clerical or wage occupation and in which at least one member of the household has worked 37 or more weeks during the previous year.  The BLS estimates that the sample of households used in calculating the CPI–U includes about 93 percent of the population of the United States, while the households included in the CPI–W include only about 29 percent of the population. 

            Because the percentage of the population covered by the CPI–U is so much larger than the percentage of the population covered by the CPI–W, it’s not surprising that most media coverage of inflation focuses on the CPI–U. As the following figure shows, the measures of inflation from the two versions of the CPI aren’t greatly different, although inflation as measured by the CPI–W—the red line—tends to be higher during economic expansions and lower during economic recessions than inflation measured by the CPI–U—the blue line. 

One important use of the CPI–W is in calculating cost-of-living adjustments (COLAs) applied to Social Security payments retired and disabled people receive. Each year, the federal government’s Social Security Administration (SSA) calculates the average for the CPI–W during June, July, and August in the current year and in the previous year and then measures the inflation rate as the percentage increase between the two averages. The SSA then increases Social Security payments by that inflation rate. Because the increase in CPI–W is often—although not always—larger than the increase in CPI–U, using CPI–W to calculate Social Security COLAs increases the payments recipients of Social Security receive. 

            A second aspect of measuring inflation that we don’t mention in the textbook was the subject of discussion following the release of the July 2022 CPI data. In June 2022, the value for the CPI–U was 295.3. In July 2022, the value for the CPI–U was also 295.3. So, was there no inflation during July—an inflation rate of 0 percent? You can certainly make that argument, but typically, as we note in the textbook (for instance, see our display of the inflation rate in Chapter 10, Figure 10.7) we measure the inflation rate in a particular month as the percentage change in the CPI from the same month in the previous year. Using that approach to measuring inflation, the inflation rate in July 2022 was the percentage change in the CPI from its value in July 2021, or 8.5 percent.  Note that you could calculate an annual inflation rate using the increase in the CPI from one month to the next by compounding that rate over 12 months. In this case, because the CPI was unchanged from June to July 2022, the inflation rate calculated as a compound annual rate would be 0 percent.  

            During periods of moderate inflation rates—which includes most of the decades prior to 2021—the difference between inflation calculated in these two ways was typically much smaller. Focusing on just the change in the CPI for one month has the advantage that you are using only the most recent data. But if the CPI in that month turns out to be untypical of what is happening to inflation over a longer period, then focusing on that month can be misleading. Note also that inflation rate calculated as the compound annual change in the CPI each month results in very large fluctuations in the inflation rate, as shown in the following figure.

Sources: Anne Tergesen, “Social Security Benefits Are Heading for the Biggest Increase in 40 Years,” Wall Street Journal, August 10, 2022; Neil Irwin, “Inflation Drops to Zero in July Due to Falling Gas Prices,” axios.com, August 10, 2022; “Consumer Price Index Frequently Asked Questions,” bls.gov, March 23, 2022; Stephen B. Reed and Kenneth J. Stewart, “Why Does BLS Provide Both the CPI–W and CPI–U?” U.S. Bureau of Labor Statistics, Beyond the Numbers, Vol. 3, No. 5, February 2014; “Latest Cost of Living Adjustment,” ssa.gov; and Federal Reserve Bank of St. Louis.

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Antitrust Policy and Monopsony Power

Photo from the New York Times.

As we discuss in Microeconomics and Economics, Chapter 15, Section 15.6, the U.S. Department of Justice’s Antitrust Division and the Federal Trade Commission have merger guidelines that they typically follow when deciding whether to oppose a merger between two firms in the same industry—these mergers are called horizontal mergers. The guidelines are focused on the effect a potential merger would have on market price of the industry’s output. We know that if the price in a market increases, holding everything else constant, consumer surplus will decline and the deadweight loss in the market will increase. But, as we note in Chapter 15, if a merger increases the efficiency of the merged firms, the result can be a decrease in costs that will lower the price, increase consumer surplus, and reduce the deadweight loss. 

The merger guidelines focus on the effect of two firms combining on the merged firms’ market power in the output market.  For example, if two book publishers merge, what will be the effect on the price of books? But what if the newly merged firm gains increased market power in input markets and uses that power to force its suppliers to accept lower prices? For example, if two book publishers merge will they be able to use their market power to reduce the royalties they pay to writers? The federal antitrust authorities have traditionally considered market power in the output market—sometimes called monopoly power—but rarely considered market power in the input market—sometimes called monopsony power.

In Chapter 16, Section 16.6, we note that a pure monopsony is the sole buyer of an input, a rare situation that might occur in, for example, a small town in which a lumber mill is the sole employer. A monopoly in an output market in which a single firm is the sole seller of a good is also rare, but many firms have some monopoly power because they have the ability to charge a price higher than marginal cost. Similarly, although monopsonies in input markets are rare, some firms may have monopsony power because they have the ability to pay less than the competitive equilibrium price for an input. For example, as we noted in Chapter 14, Section 14.4, Walmart is large enough in the market for some products, such as detergent and toothpaste, that it is able to insist that suppliers give it discounts below what would otherwise be the competitive price.

Monopsony power was the key issue involved in November 2021 when the Justice Department filed an antitrust lawsuit to keep the book publisher Penguin Random House from buying Simon & Schuster, another one of the five largest publishers. The merged firm would account for 31 percent of books published in the U.S. market. The lawsuit alleged that buying Simon & Schuster would allow “Penguin Random House, which is already the largest book publisher in the world, to exert outsized influence over which books are published in the United States and how much authors are paid for their work.”

We’ve seen that when two large firms propose a merger, they often argue that the merger will allow efficiency gains large enough to result in lower prices despite the merged firm having increased monopoly power. In August 2022, during the antitrust trial over the Penguin–Simon & Schuster merger, Markus Dohle, the CEO of Penguin made a similar argument, but this time in respect to an input market—payments to book authors. He argued that because Penguin had a much better distribution network, sales of Simon & Schuster books would increase, which would lead to increased payments to authors. Authors would be made better off by the merger even though the newly merged firm would have greater monopsony power. Penguin’s attorneys also argued that the market for book publishing was larger than the Justice Department believed. They argued that the relevant book market included not just the five largest publishers but also included Amazon and many medium and small publishers “all capable of competing for [the right to publish] future titles from established and emerging authors.”  The CEO of Hachette Book Group, another large book publisher, disagreed, arguing at the trial that the merger between Penguin and Simon & Schuster would result in lower payments to authors. 

The antitrust lawsuit against Penguin and Simon & Schuster was an example of the more aggressive antitrust policy being pursued by the Biden administration. (We discussed the Biden administration’s approach to antitrust policy in this earlier blog post.) An article in the New York Times quoted a lawyer for a legal firm that specializes in antitrust cases as arguing that the lawsuit against Penguin and Simon & Schuster was unusual in that the lawsuit “declines to even allege the historically key antitrust harm—increased prices.” The outcome of the Justice Department’s lawsuit against Penguin and Simon & Schuster may provide insight into whether federal courts will look favorably on the Biden administration’s more aggressive approach to antitrust policy. 

Sources: Jan Wolfe, “Penguin Random House CEO Defends Publishing Merger at Antitrust Trial,” Wall Street Journal, August 4, 2022;  David McCabe, “Justice Dept. and Penguin Random House’s Sparring over Merger Has Begun,” New York Times, August 1, 2022; Eduardo Porter, “A New Legal Tactic to Protect Workers’ Pay,” New York Times, April 14, 2022; Janet H. Cho and Karishma Vanjani, “Justice Department Seeks to Block Penguin Random House Buy of Viacom’s Simon & Schuster,” barrons.com, November 2, 2021; United States Department of Justice, “Justice Department Sues to Block Penguin Random House’s Acquisition of Rival Publisher Simon & Schuster,” justice.gov, November 2, 2021; 

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The Economics of Sneaker Reselling

Photo from the New York Times.

Buying athletic shoes and reselling them for a higher price has become a popular way for some people to make money. The mostly young entrepreneurs involved in this business are often called sneakerheads.  Note that economists call buying a product at a low price and reselling it at a high price arbitrage.  The profits received from engaging in arbitrage are called arbitrage profits.  One estimate puts the total value of sneakers being resold at $2 billion per year.

            Why would anybody buy sneakers from a sneakerhead that they could buy at a lower price online or from a retail store? Most people wouldn’t, which is why most sneakerheads resell only shoes that shoe manufacturers like Nike or Adidas produce in limited quantities—typically fewer than 50,000 pairs. To obtain the shoes, shoe resellers use two main strategies: (1) waiting in line at retail stores on the day that a new limited quantity shoe will be introduced, or (2) buying shoes online using a software application called a bot. A bot speeds up a buyer’s checkout process for an online sale. Typical customers buying at an online shoe site take a few minutes to choose a size, fill in their addresses, and provide their credit card information. But a few minutes is enough time for shoe resellers using bots to buy all of the newly-released shoes available on the site.

            In addition to reselling shoes on their own sites, many sneakerheads use dedicated resale sites like StockX and GOAT. These sites have greatly increased the liquidity of sneakers, or the ease with which sneakers can be resold. In effect, limited-edition sneakers have become an asset like stocks, bonds, or gold because they can be bought and sold in the secondary market that exists on the online resale sites. (We discuss the concepts of primary and secondary markets for assets in Macroeconomics, Chapter 6, Section 6.2 and in Microeconomics and Economics, Chapter 8, Section 8.2.)

            An article in the New York Times gives an example of the problems that bots can cause for retail shoe stores. Bodega, a shoe store in Boston, offered the limited-edition New Balance 997S sneaker on its online site. Ten minutes later, the shoe was sold out. One of the store’s owner was quoted as saying: “We got destroyed by bots. It was making it impossible for our average customers to even have a shot at the shoes.” Although the store had a policy of allowing customers to buy a maximum of three pairs of shoes, shoe resellers were able to get around the policy by having shoes shipped to their friends’ addresses or by having a group of people coordinate their purchases. An article on bloomberg.com described how one reseller along with 15 of his friends used bots to buy 600 pairs of Adidas’s Yeezy sneakers from an online site on the morning the sneakers were released. Adidas has a rule that each customer can buy only one pair of its limited-edition shoes, but the company has trouble enforcing the rule. 

            Shopify and other firms have developed software that retailers can use to make it difficult for resellers to use bots on the retailers’ sites. But the developers of bot software have often been able to modify the bots to get around the defenses used by the anti-bot software. 

            In contrast with owners of retail stores, Nike, Adidas, New Balance, and the other shoe manufacturers have a more mixed reaction to sneakerheads using bots scooping up most pairs of limited-edition shoes shortly after the shoes are released. Like the owners of retail stores, the shoe manufacturers know that they risk upsetting the typical customer if the customer can only buy hot new shoe releases from resellers at prices well above the original retail price. But an active resale market increases the demand for shoes, just as individual investors increased their demand for individual stocks when it became possible to easily buy and sell stocks online using sites like TD Ameritrade, E*Trade, and Fidelity. So manufacturers benefit from knowing that most of their limited-edition shoes will sell out. One industry analyst singled out “The durability of Nike’s … ability to fuel the sneaker resale ecosystem ….” as a particular strength of the company. In addition, manufacturers may believe that the publicity about limited edition shoes rapidly selling out may spill over to increased demand for other shoes the manufacturers sell. (In Microeconomics and Economics, Chapter 10, Section 10.3 we note that some consumers may receive utility from buying goods that are widely seen as popular and fashionable.)

            In the long run, is it possible for sneakerheads to make a profit reselling shoes? It seems unlikely for the reasons we discuss in Microeconomics and Economics, Chapter 12, Section 12.5. The barriers to entry in reselling sneakers are very low. Anyone can list shoes for sale on StockX or one of the other resale sites. Waiting in line in front of a retail store on the day a new shoe is released is something that anyone who is willing to accept the opportunity cost of the time lost can do. Similarly, bots that can be used to scoop up newly released shoes from online sites are widely available for sale. So, we would expect that in the long run entry into sneaker reselling will compete away any economic profit that sneakerheads were earning.

            In fact, by the summer of 2022, prices on reselling sites were falling. In just the month of June, the average price of sneakers listed on StockX declined by 20 percent. Resellers who had stockpiled shoes waiting for prices to increase were instead selling them because they feared that prices would go even lower. And new limited-edition shoes were taking longer to sell out. According to an article in the Wall Street Journal, “A pair of Air Jordans released on July 13 [2022] that might have once vanished in minutes took days to sell out from Nike Inc.’s virtual shelves.” One reseller quoted in the Wall Street Journal article indicated that entry was the reason that prices were falling: “You don’t want prices to go down, but they’re going down anyways, just because of how many people are selling in general.”

            Although a seemingly unusual market, sneaker reselling is subject to the same rules of competition that we see in other markets. 

Sources: Inti Pacheco, “Flipping Air Jordans Is No Longer a Slam Dunk,” Wall Street Journal, July 23, 2022;  Shoshy Ciment, “Sneaker Reselling Side Hustle: Your Guide to Making Thousands Flipping Hyped Pairs of Dunks, Jordans, and Yeezys,” businessinsider.com, May 3, 2022;  Teresa Rivas, “A Strong Sneaker-Resale Market Is Another Boon for Nike,” barrons.com, May 24, 2022; Curtis Bunn, “Sneakers Are So Hot, Resellers Are Making a Living Off of Coveted Models,” nbcnews.com, October 23, 2021; Daisuke Wakabayashi, “The Fight for Sneakers,” New York Times, October 15, 2021; and Joshua Hunt, “Sneakerheads Have Turned Jordans and Yeezys Into a Bona Fide Asset Class,” bloomberg.com, February 15, 2021.

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Senator Elizabeth Warren vs. Economist Lawrence Summers on Monetary Policy

Senator Elizabeth Warren (Photo from the Associated Press)

Lawrence Summers (Photo from harvardmagazine.com)

As we’ve discussed in several previous blog posts, in early 2021 Lawrence Summers, professor of economics at Harvard and secretary of the treasury in the Clinton administration, argued that the Biden administration’s $1.9 trillion American Rescue Plan, enacted in March, was likely to cause a sharp acceleration in inflation. When inflation began to rapidly increase, Summers urged the Federal Reserve to raise its target for the federal funds rate in order to slow the increase in aggregate demand, but the Fed was slow to do so. Some members of the Federal Open Market Committee (FOMC) argued that much of the inflation during 2021 was transitory in that it had been caused by lingering supply chain problems initially caused by the Covid–19 pandemic. 

At the beginning of 2022, most members of the FOMC became convinced that in fact increases in aggregate demand were playing an important role in causing high inflation rates.  Accordingly, the FOMC began increasing its target for the federal funds rate in March 2022. After two more rate increases, on the eve of the FOMC’s meeting on July 26–27, the federal funds rate target was a range of 1.50 percent to 1.75 percent. The FOMC was expected to raise its target by at least 0.75 percent at the meeting. The following figure shows movements in the effective federal funds rate—which can differ somewhat from the target rate—from January 1, 2015 to July 21, 2022.

In an opinion column in the Wall Street Journal, Massachusetts Senator Elizabeth Warren argued that the FOMC was making a mistake by increasing its target for the federal funds rate. She also criticized Summers for supporting the increases. Warren worried that the rate increases were likely to cause a recession and argued that Congress and President Biden should adopt alternative measures to contain inflation. Warren argued that a better approach to dealing with inflation would be to, among other steps, increase the federal government’s support for child care to enable more parents to work, provide support for strengthening supply chains, and lower prescription drug prices by allowing Medicare to negotiate the prices with pharmaceutical firms. She also urged a “crack down on price gouging by large corporations.” (We discussed the argument that monopoly power is responsible for inflation in this blog post.)

 Summers responded to Warren in a Twitter thread. He noted that: “In the 18 months since the massive stimulus policies & easy money that [Senator Warren] has favored & I have opposed, the inflation rate has risen from below 2 to above 9 percent & workers purchasing power has, as a consequence, declined more rapidly than in any year in the last 50.” And “[Senator Warren] opposes restrictive monetary policy or any other measure to cool off total demand.  Why does she think at a time when there are twice as many vacancies as jobs that inflation will come down without some drop in total demand?”

Clearly, economists and policymakers continue to hotly debate monetary policy.

Source: Elizabeth Warren, “Jerome Powell’s Fed Pursues a Painful and Ineffective Inflation Cure,” Wall Street Journal, July 24, 2022.

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Solved Problem: High Prices and High Revenue in the U.S. Car Industry

Production line for Ford F-series trucks. Photo from the Wall Street Journal.

Supports: Microeconomics, Chapter 6, Section 6.3 and Chapter 15, Section 15.6, Economics Chapter 6, Section 6.3 and Chapter 15, Section 15.6, and Essentials of Economics, Chapter 7, Section 7.7 and Chapter 10, Section 10.5.

In July 2022, an article in the Wall Street Journal noted that “The chip shortage and broader supply constraints have hampered vehicle production … Many major car companies on Friday reported U.S. sales declines of 15% or more for the first half of the year.” But the Wall Street Journal also reported that car makers were experiencing increases in revenues. For example, Ford Motor Company reported an increase in revenue even though it had sold fewer cars than during the same period in 2021.

  1. Briefly explain what must be true of the demand for new cars if car makers can sell 15 percent fewer cars while increasing their revenue.
  2. Eventually, the chip shortage and other supply problems facing car makers will end. At that point, would we expect that car makers will expand production to prepandemic levels or will they continue to produce fewer cars in order to maintain higher levels of profits? Briefly explain. 

Solving the Problem

Step 1: Review the chapter material. This problem is about the effects of price increases on firms’ revenues and on the ability of firms to restrict output in order increase profits, so you may want to review Chapter 6, Section 6.3, “The Relationship between Price Elasticity of Demand and Total Revenue” and Chapter 15, Section 15.6, “Government Policy toward Monopoly.” 

Step 2: Answer part a. by explaining what must be true of the demand for new cars if car makers are increasing their profits while selling fewer cars. Assuming that the demand curve for cars is unchanged, a decline in the quantity of cars sold will result in a move up along the demand curve for cars, raising the price of cars.  Only if the demand curve for new cars is price inelastic will the revenue car markers receive increase when the price increases. Revenue increases in this situation because with an inelastic demand curve, the percentage increase in price is greater than the percentage decrease in quantity demanded. 

Step 3: Answer part b. by explaining whether we should expect that once the car industry’s supply problems are resolved, car makers will continue to produce fewer cars.  Although as a group car makers would be better off if they could continue to reduce the supply of cars, they are unlikely to be able to do so. Any one car maker that decided to keep producing fewer cars would lose sales to other car makers who increased their production to prepandemic levels. Because this increased production would result in a movement down along the demand curve for new cars, the price would fall. So a car maker that reduced output would receive a lower price on its reduced output, causing its profit to decline. (Note that this situation is effectively a prisoner’s dilemma as discussed in Chapter 14, Section 14.2.)

The firms could attempt to keep output of new cars at a low level by explicitly agreeing to do so.  But colluding in this way would violate the antitrust laws, and executives at the firms would risk being fined or even imprisoned. The firms could attempt to implicitly collude by producing lower levels of output without explicitly agreeing to do so. (We discus implicit collusion in Chapter 14, Section 14.2.) But implicit collusion is unlikely to succeed because firms have an incentive to break an implicit agreement by increasing output. 

We can conclude that once the chip and other supply problems facing car makers are resolved, production of cars is likely to increase.

Sources: Mike Colias and Nora Eckert, “GM Says Unfinished Cars to Hurt Quarterly Results,” Wall Street Journal, July 1, 2022; and Nora Eckert, “Ford’s U.S. Sales Increase 32% in June, Outpacing Broader Industry,” Wall Street Journal, July 5, 2022.

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An Index to Measure Supply Chain Problems

Photo of the Port of Los Anglese from the Wall Street Journal.

In economics, index numbers play an important role in gauging the state of the economy. For instance, rather than measure inflation by looking at the price of one or a few goods and services, we use the consumer price index (CPI), which combines the prices of many goods and services into a single number. (In Macroeconomics, Chapter 9, Section 9.4 and Economics, Chapter 19, Section 19.4, we discuss how the Bureau of Labor Statistics constructs the consumer price index.) Similarly, the S&P 500 provides an index of stock prices and the Federal Reserve compiles an index of industrial production that measures the output of factories, mines, and utilities.

            The advantage of indexes is that they provide broader measures of an economic variable. Important as the price of gasoline is in the average family’s budget, the prices of food, clothing, and other goods and services are also important. So, the CPI is a better measure of inflation than is just the price of gasoline.

            But in some cases it can be difficult for economists to construct an index. This problem is particularly likely when an index would not be comprised of similar data, such as prices of goods and services in the case of the CPI. For example, when the Covid–19 pandemic first began to affect the United States in March 2020, the U.S. economy began to experience “supply chain problems.” News articles reported supply chains problems persisting into the summer of 2022. These reports highlighted specific problems, such as shortages of semiconductors that reduced automobile production and ships being backed up at ports leading to delays in U.S. firms receiving imported products. Just as we don’t want to measure inflation by looking only at gasoline prices, we don’t want to measure supply chain problems by looking only at shortages of semiconductors. It would be better to use an index that summarizes what is happening with supply chains in a way that’s analogous to how the CPI summarizes what is happening with the price level. But the very different aspects of supply chain problems make constructing an index that summarizes these problems more difficult than constructing the CPI. 

            Economists at the Federal Reserve Bank of New York have tried to overcome these technical difficulties in devising an index of supply chain problems: the Global Supply Chain Pressure Index (GSCPI). Here’s the New York Fed’s description of the economic data included in the index:

“The GSCPI integrates a number of commonly used metrics with the aim of providing a comprehensive summary of potential supply chain disruptions. Global transportation costs are measured by employing data from the Baltic Dry Index (BDI) and the Harpex index, as well as airfreight cost indices from the U.S. Bureau of Labor Statistics. The GSCPI also uses several supply chain-related components from Purchasing Managers’ Index (PMI) surveys, focusing on manufacturing firms across seven interconnected economies: China, the euro area, Japan, South Korea, Taiwan, the United Kingdom, and the United States.”

Some more detail on components of the index that may be unfamiliar: The Baltic Dry Index (BDI) and the Harpex indexes both measure rates shippers charge firms to move cargo by sea. (Note that the name “Baltic” has historical significance but doesn’t mean that the index covers only the price of shipping in the Baltic Sea.) The Purchasing Managers’ Index (PMI) is derived from surveying purchasing managers at firms around the world about such aspects of their businesses as order backlogs, new orders, delivery time of goods from suppliers, inventories, and costs.  

The following figure shows movements in the GSCPI from January 1998 through June 2022 and is derived from data on the New York Fed site.  Higher values indicate more supply chain problems in the world economy. Movements in the index indicate that supply chain problems reached a peak in April 2020 during the height of the initial disruptions caused by the pandemic. Supply chains then improved through September 2020 before worsening again. The worst reading for the index occurred in December 2021. Supply problems then eased during the first half of 2022, although the index still remained high in June 2022. (Note that the values on the vertical axis are standard deviations from the average values of the index over the whole period. The standard deviation is a statistical measure of how spread out values of a series are relative to the series’ average value. That the value for the index during the first half of 2022 was two to four standards deviations above the average of the index indicates that supply chain problems were much more severe than normal.)

Sources: Liz Young, “Companies Face Rising Supply-Chain Costs Amid Inventory Challenges,” Wall Street Journal, June 21, 2022; Ana Monteiro, “Supply Constrainst a Headache for U.S. Firms as Outlook Dims,” bloomberg.com, June 2, 2022; and Federal Reserve Bank of New York, Global Supply Chain Pressure Index, https://www.newyorkfed.org/research/gscpi.html.

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Be Careful When Interpreting Macroeconomic Data at the Beginning of a Recession

On Friday, July 8, the Bureau of Labor Statistics (BLS) released its monthly “Employment Situation” report for June 2022. The BLS estimated that nonfarm employment had increased by 372,000 during the month. That number was well above what economic forecasters had expected and seemed inconsistent with other macroeconomic data that showed the U.S. economy slowing. (Note that the increase in employment is from the establishment survey, sometimes called the payroll survey, which we discuss in Macroeconomics, Chapter 9, Section 9.1 and Economics, Chapter 19, Section 19.1.)

Data indicating that the economy was slowing during the first half of 2022 include the Bureau of Economic Analysis’s (BEA) estimate that real GDP had declined by 1.6 percent in the first quarter of 2022. The BEA’s advance estimate—the agency’s first estimate for the quarter—for the change in real GDP during the second quarter of 2022 won’t be released until July 28, but there are indications that real GDP will have declined again during the second quarter.  For instance, the Federal Reserve Bank of Atlanta compiles a forecast of real GDP called GDPNow. The GDPNow forecast uses data that are released monthly on 13 components of GDP. This method allows economists at the Atlanta Fed to issue forecasts of real GDP well in advance of the BEA’s estimates. On July 8, the GDPNow forecast was that real GDP in the second quarter of 2022 would decline by 1.2 percent.

Two consecutive quarters of declining real GDP seems inconsistent with employment strongly growing. At a basic level, if firms are producing fewer goods and services—which is what causes a decline in real GDP—we would expect the firms to be reducing, rather than increasing, the number of people they employ. How can we reconcile the seeming contradiction between rising employment and falling output? One possibility is that either the real GDP data or the employment data—or, possibly, both—are inaccurate. Both GDP data and employment data from the establishment survey are subject to potentially substantial future revisions. (Note that because they are constructed from a survey of households, the employment data in the household survey aren’t revised. As we discuss in the text, economists and policymakers typically rely more on the establishment survey than on the household survey in gauging the current state of the labor market.) Substantial revisions are particularly likely for data released during the beginning of a recession. 

In Macroeconomics, Chapter 9, Section 9.1 (Economics, Chapter 19, Section 19.1), we give an example of substantial revisions in the employment data. Figure 9.5 (reproduced below) shows that the declines in employment during the 2007–2009 recession were initially greatly underestimated. For example, the BLS initially reported that employment declined by 159,000 during September 2008. But after additional data became available, the BLS revised its estimate to a much larger decline of 460,000.

Similarly, in Macroeconomics, Chapter 15, Section 15,3, in the Apply the Concept “Trying to Hit a Moving Target: Making Policy with ‘Real-Time Data’,” we show the BEA’s estimates of the change in real GDP during the first quarter of 2008 have been revised substantially over time. The BEA’s advance estimate of the change in real GDP during the first quarter of 2008 was an increase of 0.6 percent at an annual rate. But that estimate of real GDP growth has been revised a number of times over the years, mostly downward. Currently, BEA data indicate that real GDP actually declined by 1.6 percent at an annual rate during the first quarter of 2008. This swing of more than 2 percentage points from the advance estimate is a large difference, which changes the picture of what happened during the first quarter of 2008 from one of an economy experiencing slow growth to one of an economy suffering a sharp downturn as it fell into the worst recession since the Great Depression of the 1930s.

The changes to the estimates of both employment and real GDP during the beginning of the 2007–2009 recession are not surprising. The initial estimates of employment and real GDP rely on incomplete data. The estimates are revised as additional data are collected by government agencies. During the beginning of a recession, these additional data are likely to show lower levels of employment and output than were indicated by the initial estimates. If the U.S. economy is in a recession in the second quarter of 2022, we can expect that the BLS and BEA will revise their initial estimates of employment and real GDP downward, which—depending on the relative magnitudes of the revisions to the two series—may resolve the paradox of rising employment and falling output. 

Or it’s possible that the U.S. economy is not in a recession. In that case, the employment data may be correct in showing an increase in the number of people working, and the real GDP data may be revised upward to show that output has actually been expanding during the first six months of 2022. Economists and policymakers will have to wait to see which of these alternatives turns out to be the case.

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More on Hidden Inflation

This yogurt remained the same price although the container shrank from 5.3 ounces to 4.5 ounces.

Each month, hundreds of employees of the Bureau of Labor Statistics (BLS) gather data on prices of goods and services from stores in 87 cities and from websites. The BLS constructs the consumer price index (CPI) by giving each price a weight equal to the fraction of a typical family’s budget spent on that good or service. (CPI is discussed in Macroeconomics, Chapter 9, Section 9.4 and in Economics, Chapter 19, Section 19.4.) Ideally, the BLS tracks prices of the same product over time. But sometimes a particular brand and style of shirt, for example, is discontinued. In that case, the BLS will instead use the price of a shirt that is a very close substitute.

A more difficult problem arises when the price of a good increases at the same time that the quality of the good improves. For instance, a new model iPhone may have both a higher price and a better battery than the model it replaces, so the higher price partly reflects the improvement in the quality of the phone. The BLS has long been aware of this problem and has developed statistical techniques that attempt to identify which part of the price increases are due to increases in quality. Economists differ in their views on how successfully the BLS has dealt with this quality bias to the measured inflation rate. Because of this bias in constructing the CPI, it’s possible that the published values of inflation may overstate the actual annual rate of inflation by 0.5 percentage point. For instance, the BLS might report an inflation rate of 3.5 percent when the actual inflation rate—if the BLS could determine it—was 4.0 percent.
As the inflation rate increased beginning in the spring of 2021, a number of observers pointed to hidden inflation that was occurring. There were two main types of hidden inflation:

  1. The quality of some services was declining
  2. Some packaged goods contained smaller quantities at the same price

Here’s one example of the deteriorating quality of some services. Because during 2021 and 2022 many restaurants were having difficulty hiring servers, it was often taking longer for customers to have their orders taken and to have their food brought to the table. Because restaurants were also having difficulty hiring enough cooks, they also limited the items available on their menus. In other words, the service these restaurants were offering was not as good as it had been prior to the pandemic. So even if the restaurants kept their prices unchanged, their customers were paying the same price, but receiving less.
Alan Cole, a former senior economist with the Congressional Joint Economic Committee, discussed these other examples on his blog: “hotels clean rooms less frequently on multi-night stays, shipping delays are longer, and phone hold times at airlines are worse.” In a column in the New York Times, economics writer Neil Irwin made similar points: “Complaints have been frequent about the cleanliness of [restaurant] tables, floors and bathrooms.” And: “People trying to buy appliances and other retail goods are waiting longer.”

A column in the Wall Street Journal on business travel by Scott McCartney was headlined “The Incredible Disappearing Hotel Breakfast.” McCartney noted that many hotels continue to advertise free hot breakfasts on their websites and apps but have stopped providing them. He also noted that hotels “have suffered from labor shortages that have made it difficult to supply services such as daily housekeeping or loyalty-group lounges,” in addition to hot breakfasts.
In all of these cases, the actual prices of the services had increased more than had the listed prices because the deterioration in quality meant that people were receiving less for their money.


In addition to deterioration in the quality of services, hidden inflation during this period also took the form of consumers buying some packaged goods in which the quantities had been reduced, although the price was unchanged. For example, in June 2022, an article by the Associated Press noted that:


• “A small box of Kleenex now has 60 tissues; a few months ago, it had 65.”
• “Chobani Flips yogurts have shrunk from 5.3 ounces to 4.5 ounces.”
• “Earth’s Best Organic Sunny Days Snack Bars went from eight bars per box to seven, but the price listed at multiple stores remains $3.69.”


An article in the Wall Street Journal observed that: “Shrinkflation, as economists call it, tends to be easier for companies to pass on to consumers. Despite labels that show price by weight, research shows that most customers look at only the overall price.”


The BLS does try to adjust the measurement of the CPI for shrinkflation, which it can do because the BLS keeps careful track of the quantities included in the packaged goods that are included in its survey.


But the BLS makes no attempt to adjust the CPI for the deterioration in the quality of services because doing so would be very difficult. As Irwin observes: “Customer service preferences—particularly how much good service is worth—varies highly among individuals and is hard to quantify. How much extra would you pay for a fast-food hamburger from a restaurant that cleans its restroom more frequently than the place across the street?” And an economist at the BLS noted that, “We do not capture the decrease in service quality associated with cleaning a [hotel] room every two days rather than one.”


As we noted earlier, most economists believe that the failure of the BLS to fully account for improvements in the quality of goods results in changes in the CPI overstating the true inflation rate. This bias may have been more than offset during 2021–2022 by deterioration in the quality of services resulting in the CPI understating the true inflation rate. As the dislocations caused by the pandemic gradually resolve themselves, it seems likely that the deterioration in services will be reversed. But it’s possible that the deterioration in the provision of some services may persist. Fortunately, unless the deterioration increases over time, it would not continue to distort the measurement of the inflation rate because the same lower level of service would be included in every period’s prices.


Sources: Dee-Ann Durbin, “No, You’re Not Imagining It—Package Sizes Are Shrinking,” apnews.com, June 8, 2022; Annie Gasparro and Gabriel T. Rubin, “The Hidden Ways Companies Raise Prices,” Wall Street Journal, February 12, 2022; Alan Cole, “How I Reluctantly Became an Inflation Crank,” fullstackeconomics.com, September 8, 2021; Scott McCartney, “The Incredible Disappearing Hotel Breakfast—and Other Amenities Travelers Miss,” Wall Street Journal, October 20, 2021; and Neil Irwin, “There Is Shadow Inflation Taking Place All Around Us,” New York Times, October 14, 2021.

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Was the High Inflation of 2021–2022 Due to Shifts in Aggregate Demand or Shifts in Aggregate Supply?

Man surprised by inflation in food prices.

To answer the question in the title:  Negative supply shocks—shifts to the left in the short-run aggregate supply (SRSAS) curve—and positive demand shocks—shifts to the right in the aggregate demand (AD) curve—both contributed to the acceleration in inflation that began in the spring of 2021. But were the aggregate supply shifts, such as the semiconductor shortage that reduced the supply of new automobiles, more or less important than the aggregate demand shifts, such as the expansionary monetary and fiscal policies?

Adam Hale Shapiro of the Federal Reserve Bank of San Francisco used a basic piece of microeconomic analysis to estimate the contribution of shifts in aggregate supply and shifts in aggregate demand to inflation during this period. He looked at the prices of the more than 100 categories of goods and services in the personal consumption expenditures(PCEprice index. The PCE price index is a measure of the price level similar to the GDP deflator, except it includes only the prices of goods and services from the consumption category of GDP. Changes in the PCE price index are the Federal Reserve’s preferred measure of the inflation rate because that index includes the prices of more goods and services than are included in the consumer price index (CPI).

Shapiro explains how he used microeconomic reasoning to determine whether prices in one of the more than 100 categories of goods and services were increasing because of shifts in supply or because of shifts in demand:

“Shifts in demand move both prices and quantities in the same direction along the upward-sloping supply curve, meaning prices rise as demand increases. Shifts in supply move prices and quantities in opposite directions along the downward-sloping demand curve, meaning prices rise when supplies decline.”

 For example, the figure on the left shows the effect on the market for toys of an increase in the demand for toys. (We discuss how shifts in demand and supply curves in a market affect equilibrium price and quantity in Chapter 3, Section 3.4 of Economics, Macroeconomics, and Microeconomics.) The demand curve for toys shifts to the right from D1 to D2, the equilibrium price increases from P1 to P2, and the equilibrium quantity increases from Q1 to Q2. The figure on the right shows the effect on the market for toys if the price increase results from a decrease in the supply of toys rather than from an increase in demand. The supply curve shifts to the left from S1 to S2, the equilibrium price increases from P1 to P2, and the equilibrium quantity decreases from Q1 to Q2

Shapiro used statistical methods to determine the part of a change in price or quantity that was unexpected. He took this approach in order to focus on short-run changes in these markets caused by shifts in demand and supply rather than long-run changes resulting from “factors such as technological improvements, cost-of-living adjustments to wages, or demographic changes like population aging.” In some cases, the quantity or the price in a market were very close to their expected values, so Shapiro labeled the cause of a price increase in this market as “ambiguous.”

Shapiro notes that: “Categories that experience frequent supply-driven price changes include food and household products such as dishes, linens, and household paper items. Categories that experience frequent demand-driven price changes include motor vehicle-related products, used cars, and electricity.”

The following figure shows Shapiro’s results for the period from January 2020 through April 2022. The height of each column gives the inflation rate in the month measured as the percentage change in the PCE price index from the same month in the previous year. For example, in March 2022, the inflation rate was 6.6 percent. The height of the yellow segment is the part of inflation in that month attributable to increases in demand, the height of the green segment is the part of the inflation in that month that is attributable to decreases in supply, and the height of the green segment is the part of the inflation that Shapiro can’t assign to either demand or supply. In March 2022, increased in demand accounted for 2.2 percentage points of the total 6.6 percentage point increase in inflation. Decreases in supply accounted for 3.3 percentage points, and the remaining 1.2 percentage points had an ambiguous cause. 

We can conclude that, measured this way, the increase in inflation from the spring of 2021 through the spring of 2022 was due more to negative supply shocks than to positive demand shocks.

Source: Adam Hale Shapiro, “How Much Do Supply and Demand Drive Inflation?” Federal Reserve Bank of San Francisco Economic Letter, 22-15, June 21, 2022.

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Are the Fed’s Forecasts of Inflation and Unemployment Inconsistent?

The Federal Reserve building in Washington, DC. Photo from the Wall Street Journal.

Four times per year, the members of the Federal Reserve’s Federal Open Market Committee (FOMC) publish their projections, or forecasts, of the values of the inflation rate, the unemployment, and changes in real gross domestic product (GDP) for the current year, each of the following two years, and for the “longer run.”  The following table, released following the FOMC meeting held on March 15 and 16, 2022, shows the forecasts the members made at that time.

  Median Forecast Meidan Forecast Median Forecast 
 202220232024Longer runActual values, March 2022
Change in real GDP2.8%2.2%2.2%1.8%3.5%
Unemployment rate3.5%3.5%3.6%4.0%3.6%
PCE inflation4.3%2.7%2.3%2.0%6.6%
Core PCE inflation4.1%2.6%2.3%No forecast5.2%

Recall that PCE refers to the consumption expenditures price index, which includes the prices of goods and services that are in the consumption category of GDP. Fed policymakers prefer using the PCE to measure inflation rather than the consumer price index (CPI) because the PCE includes the prices of more goods and services. The Fed uses the PCE to measure whether it is hitting its target inflation rate of 2 percent. The core PCE index leaves out the prices of food and energy products, including gasoline. The prices of food and energy products tend to fluctuate for reasons that do not affect the overall long-run inflation rate. So Fed policymakers believe that core PCE gives a better measure of the underlying inflation rate. (We discuss the PCE and the CPI in the Apply the Concept “Should the Fed Worry about the Prices of Food and Gasoline?” in Macroeconomics, Chapter 15, Section 15.5 (Economics, Chapter 25, Section 25.5)).

The values in the table are the median forecasts of the FOMC members, meaning that the forecasts of half the members were higher and half were lower.  The members do not make a longer run forecast for core PCE.  The final column shows the actual values of each variable in March 2022. The values in that column represent the percentage in each variable from the corresponding month (or quarter in the case of real GDP) in the previous year.  Links to the FOMC’s economic projections can be found on this page of the Federal Reserve’s web site.

At its March 2022 meeting, the FOMC began increasing its target for the federal funds rate with the expectation that a less expansionary monetary policy would slow the high rates of inflation the U.S. economy was experiencing. Note that in that month, inflation measured by the PCE was running far above the Fed’s target inflation rate of 2 percent. 

In raising its target for the federal funds rate and by also allowing its holdings of U.S. Treasury securities and mortgage-backed securities to decline, Fed Chair Jerome Powell and the other members of the FOMC were attempting to achieve a soft landing for the economy. A soft landing occurs when the FOMC is able to reduce the inflation rate without causing the economy to experience a recession. The forecast values in the table are consistent with a soft landing because they show inflation declining towards the Fed’s target rate of 2 percent while the unemployment rate remains below 4 percent—historically, a very low unemployment rate—and the growth rate of real GDP remains positive. By forecasting that real GDP would continue growing while the unemployment rate would remain below 4 percent, the FOMC was forecasting that no recession would occur.

Some economists see an inconsistency in the FOMC’s forecasts of unemployment and inflation as shown in the table. They argued that to bring down the inflation rate as rapidly as the forecasts indicated, the FOMC would have to cause a significant decline in aggregate demand. But if aggregate demand declined significantly, real GDP would either decline or grow very slowly, resulting in the unemployment rising above 4 percent, possibly well above that rate.  For instance, writing in the Economist magazine, Jón Steinsson of the University of California, Berkeley, noted that the FOMC’s “combination of forecasts [of inflation and unemployment] has been dubbed the ‘immaculate disinflation’ because inflation is seen as falling rapidly despite a very tight labor market and a [federal funds] rate that is for the most part negative in real terms (i.e., adjusted for inflation).”

Similarly, writing in the Washington Post, Harvard economist and former Treasury secretary Lawrence Summers noted that “over the past 75 years, every time inflation has exceeded 4 percent and unemployment has been below 5 percent, the U.S. economy has gone into recession within two years.”

In an interview in the Financial Times, Olivier Blanchard, senior fellow at the Peterson Institute for International Economics and former chief economist at the International Monetary Fund, agreed. In their forecasts, the FOMC “had unemployment staying at 3.5 percent throughout the next two years, and they also had inflation coming down nicely to two point something. That just will not happen. …. [E]ither we’ll have a lot more inflation if unemployment remains at 3.5 per cent, or we will have higher unemployment for a while if we are actually to inflation down to two point something.”

While all three of these economists believed that unemployment would have to increase if inflation was to be brought down close to the Fed’s 2 percent target, none were certain that a recession would occur.

What might explain the apparent inconsistency in the FOMC’s forecasts of inflation and unemployment? Here are three possibilities:

  1. Fed policymakers are relatively optimistic that the factors causing the surge in inflation—including the economic dislocations due to the Covid-19 pandemic and the Russian invasion of Ukraine and the surge in federal spending in early 2021—are likely to resolve themselves without the unemployment rate having to increase significantly. As Steinsson puts it in discussing this possibility (which he believes to be unlikely) “it is entirely possible that inflation will simply return to target as the disturbances associated with Covid-19 and the war in Ukraine dissipate.”
  2. Fed Chair Powell and other members of the FOMC were convinced that business managers, workers, and investors still expected that the inflation rate would return to 2 percent in the long run. As a result, none of these groups were taking actions that might lead to a wage-price spiral. (We discussed the possibility of a wage-price spiral in earlier blog post.) For instance, at a press conference following the FOMC meeting held on May 3 and 4, 2022, Powell argued that, “And, in fact, inflation expectations [at longer time horizons] come down fairly sharply. Longer-term inflation expectations have been reasonably stable but have moved up to—but only to levels where they were in 2014, by some measures.” If Powell’s assessment was correct that expectations of future inflation remained at about 2 percent, the probability of a soft landing was increased.
  3. We should mention the possibility that at least some members of the FOMC may have expected that the unemployment rate would increase above 4 percent—possibly well above 4 percent—and that the U.S. economy was likely to enter a recession during the coming months. They may, however, have been unwilling to include this expectation in their published forecasts. If members of the FOMC state that a recession is likely, businesses and households may reduce their spending, which by itself could cause a recession to begin. 

Sources: Martin Wolf, “Olivier Blanchard: There’s a for Markets to Focus on the Present and Extrapolate It Forever,” ft.com, May 26, 2022; Lawrence Summers, “My Inflation Warnings Have Spurred Questions. Here Are My Answers,” Washington Post, April 5, 2022; Jón Steinsson, “Jón Steinsson Believes That a Painless Disinflation Is No Longer Plausible,” economist.com, May 13, 2022; Federal Open Market Committee, “Summary of Economic Projections,” federalreserve.gov, March 16, 2022; and Federal Open Market Committee, “Transcript of Chair Powell’s Press Conference May 4, 2022,” federalreserve.gov, May 4, 2022. 

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Does Majoring in Economics Increase Your Income?

Image by Andrea D’Aquino in the Wall Street Journal.

Studying economics provides students in any major with useful tools for understanding business decision making and for evaluating government policies. As we discuss in Chapter 1, Section 1.5 of Microeconomics, Macroeconomics, and Economics, majoring in economics can lead to a career in business, government, or at nonprofit organizations. Many students considering majoring in economics are interested in how the incomes of economics majors compare with the incomes of students who pursue other majors.

            The Federal Reserve Bank of New York maintains a web page that uses data collected by the U.S. Census to show the incomes of people with different college majors. The following table shows for economics majors and for all majors the median annual wage received by people early in their careers and in the middle of their careers. The median is a measure of the average calculated as the annual wage at which half of people in the group have a higher annual wage and half have a lower annual wage. “Early career” refers to people aged 22 to 27, and “mid-career” refers to people aged 35 to 45.  The data are for people with a bachelor’s degree only, so people with a masters or doctoral degree are not included.  

 Median Wage Early CareerMedian Wage Mid-Career
Economics majors$55,000$93,000
All majors$42,000$70,000

The table shows that early in their careers, on average, economics majors earn an annual wage about 31 percent higher than annual wage earned by all majors. At mid-career, in percentage terms, the gap increases slightly to 33 percent.

            How should we interpret these data? In Chapter 1, Section 1.3, in discussing how to evaluate economic models, we made the important distinction between correlation and causality. Just because two things are correlated, or happen at the same time, doesn’t mean that one caused the other. In this case, are the higher than average incomes of economics majors caused by majoring in economics or is majoring in economics correlated with higher incomes, but not actually causing the higher incomes. It might be true, for instance, that on average economics majors have certain characteristics—such as being more intelligent or harder workers—than are students who choose other majors. Because being intelligent and working hard can lead to successful careers, students majoring in economics might have earned higher incomes on average even if they had chosen a different major.

(Here’s a  more advanced point about identifying causal relationships in data: The problem with determining causality described in the previous paragraph is called selection bias. Students aren’t randomly assigned majors; they choose, or self-select, them. If students with characteristics that make it more likely that they will earn high incomes are also more likely to choose to major in economics, then the higher incomes earned by economics majors weren’t caused by (or weren’t entirely caused by) majoring in economics.)

            Economists Zachary Bleemer of the University of California, Berkeley and Aashish Mehta of the University of California, Santa Barbara have found a way to evaluate whether majoring in economics causes students to earn higher incomes. The authors gathered data on all the students admitted to the University of California, Santa Cruz (UCSC) between 2008 and 2012 and on their incomes in 2017 and 2018. To major in economics, students at UCSC needed a grade point average (GPA) of 2.8 or higher in the two principles of economics courses. The authors compared the choices of majors and the average early career earnings of students who just met or just failed to meet the 2.8 GPA threshold for majoring in economics. The authors use advanced statistical analysis to reach the conclusion that: “Comparing the major choices and average wages of above-and-below-threshold students shows that majoring in economics caused a $22,000 (46 percent) increase in annual early-career wages of barely above-threshold students.” 

            The authors attribute half of the higher wages earned by economics majors to their being more likely to pursue careers in finance, insurance, real estate, and accounting, which tend to pay above average wages.  The authors note that their findings from this study “imply that students’ major choices could have financial implications roughly as large as their decision to enroll in college ….”

Sources: Federal Reserve Bank of New York, The Labor Market for Recent College Graduates, https://www.newyorkfed.org/research/college-labor-market/index.html; and Zachary Bleemer and Aashish Meta, “Will Studying Economics Make You Rich? A Regression Discontinuity Analysis of the Returns to College Major,” American Economic Journal: Applied Economics, Vol. 14, No. 2, April 2022, pp. 1-22.

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Harvard Professor Edward Glaeser on the Importance of Working on Site

Recently Tunku Varadarajan of the Wall Street Journal interviewed Edward Glaeser on whether the increases in working remotely due to the pandemic are likely to persist.

Glaeser notes that compared with the period before the pandemic, office attendance is still down 19% nationwide. In some large cities, it’s down considerably more, including being down more than 50% in San Francisco and 32% in New York and Boston.

Glaeser believes that a decline in working on site can be a particular problem for young workers:

“Cities—and face-to-face contact at work—have ‘this essential learning component that is valuable and crucial for workers who are young,’ [Glaeser] says. The acquisition of experience and improvement in productivity, ‘month by month, year by year,’ ensures that individual earnings are higher in cities than elsewhere.”

According to Glaeser, people who work remotely face a 50% reduction in the probably of being promoted.

Glaeser is not a fan of remote teaching:

“Delivering a lecture to 100 students on Zoom, he says, is ‘just a bad movie, a really bad movie. None of the magic that comes from live lecturing and live interaction with students is there when you’re doing it via Zoom.'”

There is much more in the article, which is well worth reading. It can be found here (a subscription may be required).

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A Day in the Life of a Price Checker for the Bureau of Labor Statistics

Emily Mascitis checks prices at an auto-repair shop in Philadelphia. (Photo from the Wall Street Journal.)

As we discuss in Macroeconomics, Chapter 9, Section 9.4, (Economics, Chapter 19, Section 19.4) in calculating the consumer price index (CPI) each month, the Bureau of Labor Statistics sends hundreds of employees to gather price data from stores and offices. A reporter for the Wall Street Journal followed a price checker as she visited an auto-repair shop, a grocery store, and other businesses.

The article provides an excellent discussion of the care with which prices are collected, particularly with respect to making sure that the prices are for the same good or service each month. For instance, while in a grocery, the price checker almost made the mistake of recording the price of a can of low sodium chicken noodle soup, rather than the price of regular chicken noodle soup as in previous months.

At one point, the price checker noted that the price of clementines had been increasing rapidly and remarked that when buying fruit for her own family “We need to pick a less expensive fruit.” Switching from buying a fruit, in this case clementines, with a price that is increasing rapidly to a fruit with a price that is increasing more slowly, say regular oranges, is an example of the substitution bias. That’s one of the four biases discussed in Section 9.4 that can cause the measured increase in the CPI to overstate the true rate of inflation.

The article can be found here. (A subscription may be required.)

Source: Rachel Wolfe, “How the Inflation Rate Is Measured: 477 Government Workers at Grocery Stores,” Wall Street Journal, May 10, 2022.

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Interest Rates, the Yen, the Dollar, and the International Financial System 

Photo from the Wall Street Journal.

From early March to early May 2022, the Japanese yen persistently lost value versus the U.S. dollar. Between March 1 and May 9, the yen declined by 14% against the dollar, which is a substantial loss in value during such a short time period.  What explains the decline in the exchange rate between the yen and the dollar during that time? In Macroeconomics, Chapter 18, Section 18.2 (Economics, Chapter 28, Section 28.2), we saw that the exchange rate between most pairs of currencies fluctuates in response to these factors:

  • The foreign demand for U.S. goods
  • U.S. interest rates relative to foreign interest rates
  • Foreign demand for making direct investments or portfolio investments in the United States
  • The U.S. demand for foreign goods
  • Foreign interest rates relative to U.S interest rates
  • U.S. demand for making direct investments or portfolio investments in other countries

The following figure shows movements in the exchange rate between the yen and the U.S. dollar since 2010.  During different periods, the factor that is most important in explaining fluctuations in an exchange rate varies.  (Important note: The figure follows the convention of expressing the exchange between the yen and dollar in terms of yen per dollar. Therefore, in the figure, an increase in the exchange rate corresponds to a decrease in the value of the yen versus the dollar because it takes more yen to buy one dollar.)

From early March to early May 2022, the decline in value of the yen versus the dollar was mainly the result of U.S. interest rates increasing relative to Japanese interest rates. As the inflation rate increased rapidly in the spring of 2022, both short-term and long-term interest rates in the United States increased, partly in response to policy actions taken by the Federal Reserve. The Federal Reserve was attempting to increase interest rates in order to raise borrowing costs for households and firms, thereby slowing spending and inflation.  Japan was experiencing much lower rates of inflation—well below the Bank of Japan’s 2% annual inflation target—so the BOJ was reluctant to increase interest rates. As a consequence, the gap between the interest rate on 10-year U.S. Treasury notes and the interest rate on 10-year Japanese government bonds had risen to 2.9 percentage points.

Higher U.S. interest rates caused a shift to the right in the demand for dollars in exchange for yen as foreign investors exchanged their yen for dollars in order to buy U.S. Treasury securities and other U.S. financial assets.  As we show in Chapter 18, Figure 18.13, an increase in the demand for dollars (holding all other factors constant) increases the equilibrium exchange rate between the yen and the dollar.  

What effect does a stronger dollar and a weaker yen have on the two countries’ economies?  A weaker yen means that the yen price of imports from the United States will be higher. The higher prices will increase the Japanese inflation rate, but with inflation being low in in the spring of 2022, Japanese policymakers weren’t concerned by this effect. And because the value of U.S. imports is small relative to the size of the Japanese economy, the effect on the inflation rate wouldn’t be large in any case. The dollar price of Japanese exports to the United States will be lower, which should help Japanese firms exporting to the United States.

The effect on the U.S. economy will be the mirror image of the effect on the Japanese economy. The dollar price of Japanese imports being lower will help reduce the U.S. inflation rate, but not to a great extent because the value of Japanese imports is small relative to the size of the U.S. economy. The yen price of U.S. exports to Japan will be higher, which will be bad news for U.S. firms exporting to Japan.

Finally, many banks, other financial firms, and non-financial firms borrow money in dollars. They do so because over time the advantages of borrowing dollars has increased, even for foreign firms that receive most of their revenue in their domestic currency rather than dollars. In particular, the value of the dollar is relatively stable compared with the value of many other currencies. In addition, the Federal Reserve has made available short-term dollar loans to foreign central banks that allow those banks to provide short-term loans to local firms that are having temporary difficulty making dollar payments on their loans. By late 2021, the total amount of dollar loans made outside of the United States had risen to more than $13 trillion. In the spring of 2022, the value of the dollar was rising not just against the Japanese yen but also against many other currencies. The increase was bad news for foreign firms borrowing in U.S. dollars because it would take more of their domestic currency to buy the dollars necessary to make their loans payments. A large and prolonged increase in the value of the U.S. dollar could possibly upset the stability of the international financial system. 

Sources:  Yuko Takeo and Komaki Ito, “Japan’s Stepped-Up Warnings Fail to Stem Yen’s Slide Past 128,” bloomberg.com, April 19, 2022; Jacky Wong, “Japan Gets a Taste of the Wrong Type of Inflation,” Wall Street Journal, April 1, 2022; Megumi Fujikawa, “Yen Hits Lowest Level Since 2015, and Japan, U.S. Are OK With That,” Wall Street Journal, March 28, 2022; Bank for International Settlements, “BIS International Banking Statistics and Global Liquidity Indicators at End-September 2021,” January 28, 2022; and Federal Reserve Bank of St. Louis.

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Are We at the Start of a Recession?

On Thursday morning, April 28, the Bureau of Economic Analysis (BEA) released its “advance” estimate for the change in real GDP during the first quarter of 2022. As shown in the first line of the following table, somewhat surprisingly, the estimate showed that real GDP had declined by 1.4 percent during the first quarter. The Federal Reserve Bank of Atlanta’s “GDP Now” forecast had indicated that real GDP would increase by 0.4 percent in the first quarter. Earlier in April, the Wall Street Journal’s panel of academic, business, and financial economists had forecast an increase of 1.2 percent. (A subscription may be required to access the forecast data from the Wall Street Journal’s panel.)

Do the data on real GDP from the first quarter of 2022 mean that U.S. economy may already be in recession? Not necessarily, for several reasons:

First, as we note in the Apply the Concept, “Trying to Hit a Moving Target: Making Policy with ‘Real-Time’ Data,” in Macroeconomics, Chapter 15, Section 15.3 (Economics, Chapter 25, Section 25.3): “The GDP data the BEA provides are frequently revised, and the revisions can be large enough that the actual state of the economy can be different for what it at first appears to be.”

Second, even though business writers often define a recession as being at least two consecutive quarters of declining real GDP, the National Bureau of Economic Research has a broader definition: “A recession is a significant decline in activity across the economy, lasting more than a few months, visible in industrial production, employment, real income, and wholesale-retail trade.” Particularly given the volatile movements in real GDP during and after the pandemic, it’s possible that even if real GDP declines during the second quarter of 2022, the NBER might not decide to label the period as being a recession.

Third, and most importantly, there are indications in the underlying data that the U.S. economy performed better during the first quarter of 2022 than the estimate of declining real GDP would indicate. In a blog post in January discussing the BEA’s advance estimate of real GDP during the fourth quarter of 2021, we noted that the majority of the 6.9 percent increase in real GDP that quarter was attributable to inventory accumulation. The earlier table indicates that the same was true during the first quarter of 2022: 60 percent of the decline in real GDP during the quarter was the result of a 0.84 decline in inventory investment.

We don’t know whether the decline in inventories indicates that firms had trouble meeting demand for goods from current inventories or whether they decided to reverse some of the increases in inventories from the previous quarter. With supply chain disruptions continuing as China grapples with another wave of Covid-19, firms may be having difficulty gauging how easily they can replace goods sold from their current inventories. Note the corresponding point that the decline in sales of domestic product (line 2 in the table) was smaller than the decline in real GDP.

The table below shows changes in the components of real GDP. Note the very large decline exports and in purchases of goods and services by the federal government. (Recall from Macroeconomics, Chapter 16, Section 16.1, the distinction between government purchases of goods and services and total government expenditures, which include transfer payments.) The decline in federal defense spending was particularly large. It seems likely from media reports that the escalation of Russia’s invasion of Ukraine will lead Congress and President Biden to increase defense spending.

Notice also that increases in the non-government components of aggregate demand remained fairly strong: personal consumption expenditures increased 2.7 percent, gross private domestic investment increased 2.3 percent, and imports surged by 17.7 percent. These data indicate that private demand in the U.S. economy remains strong.

So, should we conclude that the economy will shrug off the decline in real GDP during the first quarter and expand during the remainder of the year? Unfortunately, there are still clouds on the horizon. First, there are the difficult to predict effects of continuing supply chain problems and of the war in Ukraine. Second, the Federal Reserve has begun tightening monetary policy. Whether Fed Chair Jerome Powell will be able to bring about a soft landing, slowing inflation significantly while not causing a large jump in unemployment, remains the great unknown of economic policy. Finally, if high inflation rates persist, households and firms may respond in ways that are difficult to predict and, may, in particular decide to reduce their spending from the current strong levels.

In short, the macroeconomic forecast is cloudy!

Source: The BEA’s web site can be found here.

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You’ve Decided to Buy Twitter, So Who Are You Going to Call?  Investment Banks, of Course

Elon Musk. (Photo from the Associated Press.)

That’s what Elon Musk did in April 2022.  In early April, Musk purchased about 9% of Twitter’s shares.  On April 25, he became the owner of Twitter by buying the roughly 90% remaining shares for $54.20 per share. The total he paid for these remaining shares came to $44 billion. Following his often unorthodox style, Musk announced his plans in a tweet on Twitter. Where did he get the money to fund such a large purchase? 

According to Forbes magazine, in March 2022, Musk was by far the richest person in the world with total wealth of about $270 billion—nearly $100 billion more than Amazon founder Jeff Bezos, who is the second-richest person.  While it appears that Musk could afford to buy Twitter without having to borrow any money,  Bloomberg estimated that in April 2022 Musk had only $3 billion in cash. Much of his wealth was in Tesla stock or his ownership shares in SpaceX and the Boring Company, both of which are private companies that, therefore, don’t have publicly traded stock. Musk was reluctant to fund all of his offer for Twitter by selling Tesla stock or finding investors willing to buy into SpaceX and Boring.

Musk turned to investment banks to help him raise the necessary funds. Investment banks, such as Goldman Sachs, differ from commercial banks in that they don’t accept deposits, and they rarely lend directly to households. Instead, investment banks have traditionally concentrated on providing advice to firms issuing stocks and bonds or to firms (and billionaires!) who are looking for ways to finance mergers or acquisitions.  A syndicate of investment banks, including Morgan Stanley (which served as Musk’s lead adviser), Bank of America, Barclays, and what an article in the Wall Street Journal described as “nearly every global blue-chip investment bank aside from the two [Goldman Sachs and JP Morgan Chase] advising Twitter,” put together the following financing package. Initially, Musk wanted to raise $46.5 billion in financing—more than in the end he needed. Of that amount, Musk would provide $21 billion and the investment banks would provide loans for the remaining $25.5 billion. As collateral for the loans, Musk pledged $60 billion of his Tesla stock. 

Musk’s financing was a combination of equity—the $21 billion in cash—and debt—the $25.5 billion in loans from investment banks. To fund his equity investment, he was considering selling some of his stock in Tesla but hoped to attract other equity investors who would put up cash in exchange for part ownership of Twitter. According to press reports, Apollo Global Management, a private equity firm was considering becoming an equity investor. (As we saw in Chapter 9, Section 9.2, private equity firms raise equity capital to invest in other firms.)  Musk’s purchase is called a leveraged buyout (LBO) because (1) he relied  on borrowing for a substantial part of his purchase of Twitter and  (2) he intended to take the company private—the company would no longer have publicly traded stock.

Why would Musk want to buy Twitter? He shared the view of some industry analysts that Twitter’s management had failed to take advantage of opportunities to increase the firm’s profit. The actions of Musk and the investment banks were part of the market for corporate control. As we discuss in Microeconomics, Chapter 8, Section 8.1 (Macroeconomics, Chapter 6, Section 6.1), in large corporations there is often a separation of ownership from control. Although the shareholders legally own the firm, the firm’s top management controls the firm’s day-to-day operations. The result can be a principal-agent problem with the management of a large firm failing to act in the best interests of the firm’s shareholders. The existence of a market for corporate control in which outsiders buy stakes in firms that appear to be poorly managed can make firms more efficient by overcoming these moral hazard problems.

             But Musk had another reason for buying Twitter. As he stated in an interview, “Having a public platform that is maximally trusted and broadly inclusive is extremely important to the future of civilization.”  It was unclear whether this and similar statements meant that  after gaining control of Twitter he might take actions that won’t necessarily increase the firm’s profitability. 

            Elon Musk’s purchase of Twitter is a high profile example of the role that investment banks can play in determining control of large corporations. 

Sources: Kurt Wagner, “Elon Musk Lands Deal to Take Twitter Private for $44 Billion,” bloomberg.com, April 25, 2022; Cara Lombardo and Liz Hoffman, “How Elon Musk Won Twitter,” Wall Street Journal, April 25, 2022; Michele F. Davis, “Elon Musk Vets Potential Equity Partners for Twitter Bid,” bloomberg.com, April 21, 2022; Sabrina Escobar, “Elon Musk Isn’t Twitter’s Only Problem. It Faces a Number of Short-Term Headwinds,” barrons.com, April 21, 2022; Cara Lombardo and Liz Hoffman, “Elon Musk Says He Has $46.5 Billion in Funding for Twitter Bid,” Wall Street Journal, April 21, 2022; Andrew Ross Sorkin, Jason Karaian, Vivian Giang, Stephen Gandel, Lauren Hirsch, Ephrat Livni, and Anna Schaverien, “Elon Musk Wants All of Twitter,” New York Times, April 14, 2022; Rob Copeland, Rebecca Elliott, and Cara Lombardo, “Elon Musk Makes $43 Billion Bid for Twitter, Says ‘Civilization’ At Stake,” Wall Street Journal, April 14, 2022; “The World’s Real-Time Billionaires,” forbes.com, April 24, 2022; Musk’s tweet announcing his offer to buy Twitter can be found here.

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Glenn on Economic Growth and Its Social Consequences

Adam Smith bronze statue on Royal Mile Market square in front of Saint Gilles Cathedral in Edinburgh, Scotland.

Growth matters. A lot. A slightly higher rate of economic growth, sustained over time, can make the difference between a big increase in living standards and relative stagnation. Whether we can still generate strong and steady growth is a “$64,000 question” for the economy — the question. Nobel Prize–winning economist Robert Lucas famously observed that once economists think of long-term growth, it is hard to think of anything else. A pro-growth policy agenda is a good idea because growth is a good idea.

But a deeper question remains: Is public support for growth guaranteed? Oren Cass of American Compass refers to growth and economists’ fealty to economic participation for all as “economic piety.” This critique resonates for a simple reason: Forces that propel growth invariably leave a wake of economic disruption for people in many places and political disruption for the nation. A serious discussion of pro-growth policy must account for that disruption.

A conventional pro-growth policy agenda can be enhanced by support for openness to markets, ideas, and new ways of doing things, and for the ability of firms to adapt to change. Such an enhanced agenda would center on infrastructure broadly defined, development and dissemination of better management practices, and reduced barriers to competition.

Yet the political process, and even many a conservative, is openly skeptical of such an agenda. This skepticism is rooted not in disagreement over the future of scientific advances or of organizational adaptation — but in a concern that growth’s benefits be shared broadly. Addressing this skepticism head-on is essential for rebuilding social support for growth and for countering well-meaning but potentially harmful policies.

The system that needs defending is a mature and successful one. Adam Smith, the great proponent of the “invisible hand” (not the visible hand of a state-directed economy), saw openness and competition as worth the candle. His 1776 publication of The Wealth of Nations came before what we would recognize today as industrial capitalism, though technological change and globalization were features of economic debates in the aftermath of Smith’s ideas.

Smith’s radical insight is central to economic policy today: National prosperity (the “wealth of a nation”) is represented by consumption of goods and services by its people — i.e., their living standards. The goal of the economy in Smith’s telling was to make the economic pie as large as possible. His advocacy of free markets and competition rested on their ability to boost consumption possibilities.

Two centuries later, Nobel laureates Kenneth Arrow and Gérard Debreu added the jargon and mathematics of contemporary economics to formalize Smith’s intuition. While individuals and firms act independently, competitive markets lead to an efficient allocation of resources and a maximized economic pie. Friedrich Hayek, another Nobel laureate, hailed the virtue of a decentralized competitive price system in maximizing economic activity.

Smith’s radicalism draws from his attack on mercantilism—the economic orthodoxy of the day—which stressed a zero-sum view of trade and state intervention to promote and protect certain firms and industries. (Sound familiar?) His second radical insight was that the “nation” did not mean the sovereign and the well-connected. In Smith’s view, individuals as consumers—all people—were kings. Finally, channeling the sympathetic concern espoused in his earlier classic, The Theory of Moral Sentiments, Smith championed mass participation in the productive economy as a precondition for human flourishing.

It is fair to say that Smith lacked a theory of per capita growth in the economy over time; indeed, he wrote before the massive increase in living standards attendant upon the Industrial Revolution. After 1800, per capita income in the United Kingdom — and the United States — witnessed a 30-fold increase. There have also been major improvements in the quality of goods and services that such a statistic doesn’t quite capture. And, of course, many of today’s offerings — from smartphones to computers to air-conditioning — were not available even in 1900, let alone 1800.

That lacuna in Smith’s theory partly reflects technical difficulties in modeling growth. Higher output can come from growth in inputs such as labor and capital, but what determines their growth? Today’s economists highlight population growth and society’s willingness to work, save, and invest. Still more important is growth in productivity, or the efficiency with which inputs are used to produce goods and services.

Smith’s pin-factory example — in which output rose with the specialization of tasks — links how things are done with the level of productivity. But what factors determine productivity growth over time? Today’s economic analysis focuses on technology and the process of generating ideas. Since economic growth is still crucial for people seemingly marginalized by capitalism, it’s worth asking whether the economic foundations expressed in The Wealth of Nations are still relevant today. Where does growth come from now? And do those sources still require openness and competition?

The short answer is that they do, but to see why, we need to focus on the ideas of two prominent economists after 1800: Edmund Phelps and Deirdre Nansen McCloskey.

Phelps, a Nobel laureate, has done much to connect growth to Smith’s foundational ideas. He starts with Smith’s emphasis on a great many individuals (not the state or privileged firms) searching for new and better ways of doing things. This relentless search produces innovative ideas, processes, and goods that drive growth — but only if the political economy allows openness. Smith’s messy, “bottom up” version of the market therefore puts mass innovation at the heart of economic growth. Phelps’s argument reflects how Smithian societies committed to openness are best able to prosper and promote growth.

This argument has two important applications. The first is to debunk the sometimes fashionable view of secular productivity decline — that we have run short of new things to discover and exploit. The second is to give an answer to economies struggling with growth in a period of structural changes from technology and globalization. Slowdowns in innovation are likely not due to scientific barrenness but to walls against openness and change — that is, fears of disruption.

Phelps’s concern with economic dynamism draws him to Smith’s arguments against mercantilist tinkering in the economy. Like Smith, he worries about the hidden costs of tinkering with competition by blocking change from the outside and by enabling rent-seeking on the inside. These “corporatist” policies — fashionable among some conservatives at present — inevitably embolden vested interests and cronyism, slowing change and growth. Even seemingly small interventions can subtly diminish innovation, a point to which I’ll return.

Yet such a critique must acknowledge the political consequences of disruption. Dynamism is messy. It creates growth in the aggregate, but with many individual losers as well as individual gainers.

McCloskey, an economic historian, has similarly identified the continuous, large-scale, voluntary, and unfocused search for betterment as the source of new ideas that can produce economic growth. She sees this “innovism” as primarily a cultural force, preferring the term to the more familiar “capitalism,” and connects innovism to economic liberalism. Echoing Smith, she emphasizes how an open economy allows individuals—from the moderately to the spectacularly talented—to “have a go.” This economic liberalism allows competition to enshrine liberty and mass flourishing.

In McCloskey’s telling, growth depends on a liberal tolerance and openness to change, which encourage many people to be alert to opportunity. Sustaining that tolerance as structural shifts bring economic misfortune to many individuals, however, requires more than devotion to Smith.

Therein lies the current economic-policy rub. Economists’ theories of growth bring to mind a coin: Sunny descriptions of growth and dynamism are “heads,” and hand-wringing over disruption is “tails.” As I observed earlier, growth is messy. It can push some individuals, firms, and even industries off well-worn and comfortable paths.

But Smith offers more in defense of growth than paeans to laissez-faire. Though he is sometimes caricatured as being anti-government in all cases, Smith was principally opposed to mercantilist privileges for specific businesses and industries and to the governmentalization of social affairs. He wanted government to provide what economists today call “public goods,” such as national defense, the criminal-justice system, and enforcement of property rights and contracts the institutional underpinnings of commerce and trade. He also favored support for infrastructure to keep commerce flowing freely.

But Smith went further: To prepare workers and enrich their lives, he called for government to provide universal education, and he drew a connection between education and liberty as well as work in a free society. But boosting participation in today’s economy—participation that provides support for growth—will require a bit more.

Not surprisingly, political reaction to economic disruption brings about — pardon the econ-speak—a “demand” for and “supply” of policy actions. Job losses, firm failures, and diminished industry fortunes bring about a demand for help, for adaptation. The political process responds with a supply of ideas in one of two forms: walls or bridges. Walls are protections against disruption or change. Bridges, ways to get somewhere or back, prepare individuals for the changed economy and help those whose economic participation has been disrupted reenter the workforce.

Proposals for walls are familiar. They can be physical, of course, but they needn’t be. Conservative populists advocate limits on trade and technology, in order to advance industrial policy. Some progressives advocate universal basic income. All these policies would diminish the prospects for economic advances.

The most prominent sort of wall today is what I call “modern corporatism.” It assumes that Smith was wrong: The “wealth of a nation” lies not in consumption or living standards (and so ultimately in growth) but in jobs, good jobs, even particular good jobs, with good manufacturing jobs the very paradigm. The sort of tinkering with the market that drew Smith’s ire may actually be a necessary way of recentering economic policy on jobs, so the theory goes. Opportunities for work, and for the dignity it can bring, are surely important.

A gentle industrial policy devised by social scientists who are worried about jobs is not the answer. It results in state tinkering for special interests, precisely the kind of thing that prompted Smith’s criticism of mercantilism. Moreover, as University of Chicago economist Luigi Zingales argues in A Capitalism for the People, it risks a vicious cycle: A little bit of tinkering becomes a lot of tinkering—and anyone who cannot justify special privileges is left out, calling into question social support for growth. Nevertheless, industrial policy has caught the attention of elected officials on the right, from Donald Trump to Josh Hawley to Marco Rubio. While national security and the border can be exceptions as concerns, advice from Milton Friedman to the party of Ronald Reagan this is not.

That said, economists’ invocation of Smith as a proponent of let-’er-rip laissez-faire is neither faithful to Smith nor particularly helpful to individuals and communities buffeted by disruption. With today’s rapid and long-lasting technological change and globalization, “having a go” requires support for acquiring new skills when they are needed.

That is why we need more bridges. Bridges take us somewhere and bring us back. The journey to somewhere is about preparation for new opportunities. The journey back is about reconnecting to the productive economy when economic forces beyond our control have knocked us away.

Economic bridges have three features. The first is that they help people overcome a specific challenge on their way to economic flourishing — they don’t provide that outcome directly. The second is that wider society builds the bridge, through private organizations, governments, or public–private partnerships, as globalization and technological change have introduced significant risks that individuals by themselves cannot avoid. The third feature is that they avoid restraints on openness to changes in markets and ideas.

We once did better, much better. During the Civil War, President Abraham Lincoln worked with Congress to pass the Morrill Act, directing resources to the development of land-grant colleges around the country, extending higher education to citizens of modest means, and enabling workers to develop skills for new industries, particularly in manufacturing. As World War II drew to a close, President Franklin D. Roosevelt and Congress came together to enact the G.I. Bill, helping to educate returning troops for a changing economy.

Supporting economic growth and undergirding broad participation in the economy require similarly bold ideas. To begin, community colleges are the logical workhorses of skill development and retraining, and their presence in regional economies makes them attractive partners for employers. Yet community colleges have seen their state-level public support wither. The Biden administration calls for free tuition, which would boost demand but provide no support for community college to offer a practical education and an emphasis on completion. Amy Ganz, Austan Goolsbee, Melissa Kearney, and I proposed an alternative approach based on the land-grant-college model. We proposed a supply-side program of federal grants to strengthen community colleges — contingent on improved degree-completion rates and labor-market outcomes. To further encourage training, the federal government could offer a tax credit to compensate firms for the risk of losing trained workers. It could also increase the earned-income tax credit for workers with or without children.

New ideas are also needed to promote workers’ reentry into the workforce. Personal reemployment accounts, for example, would support dislocated workers and offer them a reemployment bonus if they found a new job within a certain period of time. The “personal” refers to individuals’ choosing from a range of training and support services. Another idea is to beef up support for place-based assistance to areas with stubbornly high rates of long-term nonemployment. Such support could be integrated with an increase in the earned-income tax credit and the supply-side investment in community colleges. Building on the decentralized approach in the land-grant colleges and grants to community colleges, expanded place-based aid would be delivered via flexible block grants encouraging business and employment.

Broad public support required for growth and dynamism requires both bridge-building and a political language that frames it. Growth, opportunity, and participation are good, and we do not need a new economics. But phrases like “transition cost” and “inevitable economic forces” must give way to bridges of preparation and reconnection.

‘Why did nobody see it coming?” a quizzical Queen of England questioned a quorum of economists at the London School of Economics about the global financial crisis as it emerged in late 2008. How could major disruptive forces build up over time and yet escape the attention of experts and leaders?

Of the disruptive structural changes accompanying economic dynamism, one might ask a similar question. Growth matters. But that growth is one side of a coin whose flip side is disruption is known, certainly to economists. Why has our political discourse not emphasized this basic point?

Why did we not see fatigue with change coming among the people who most had to bear its ill effects?

However foolishly, we did not. Some so-called conservatives today have responded by saying that we should limit change. Surely a better response is that we should seek ever more growth by allowing unfettered change, but also facilitate the establishing of ever more connections in a growing economy. That classical-liberal answer has the better place in American conservatism — and in American economic life.

— This essay is sponsored by National Review Institute. Originally published here.

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Hoover Institution Podcast with Lawrence Summers and John Cochrane

Lawrence Summers (Photo from harvardmagazine.com.)
John Cochrane (Photo from hoover.org.)

In several of our blog posts and podcasts, we’ve discussed Lawrence Summers’s forecasts of inflation. Beginning in February 2021, Summers, an economist at Harvard who served as Treasury secretary in the Clinton administration, argued that the United States was likely to experience rates of inflation that would be higher and persist longer than Federal Reserve policymakers were forecasting. In March 2021, the members of the Fed’s Federal Open Market Committee had an average forecast of inflation of 2.4 percent in 2021, falling to 2.0 percent in 2022. (The FOMC projections can be found here.)

In fact, inflation measured by the CPI has been above 5 percent every month since June 2021; the Fed’s preferred measure of inflation—the percentage change in the price index for personal consumption expenditures—has been above 5 percent every month since October 2021. Summers’s forecasts of inflation have turned out to be more accurate than those of the members of the Federal Open Committee. 

In this podcast, Summers discusses his analysis of inflation with four scholars from the Hoover Institution, including economist John Cochrane. Summers explains why he came to believe in early 2021 that inflation was likely to be much higher than generally expected, how long he believes high rates of inflation will persist, and whether the Fed is likely to be able to achieve a soft landing by bringing inflation back to its 2 percent target without causing a recession. The first half of the podcast, in particular, should be understandable to students who have completed the monetary and fiscal policy chapters (Macroeconomics, Chapters 15 and 16; Economics, Chapters 25 and 26).  Background useful for understanding the podcast discussion of monetary policy during the 1970s can be found in Chapter 17, Sections 17.2 and 17.3.

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Is the Fed Becoming Too Political to Remain Independent?

Neel Kashkari, president of the Federal Reserve Bank of Minneapolis. Photo from the Wall Street Journal.
Pat Toomey, U.S. Senator from Pennsylvania. Photo from http://www.toomey.senate.gov.

As we discuss in Macroeconomics, Chapter 17, Section 17.4 (Economics, Chapter 27, Section 27.4), the Federal Reserve is unusual among federal government agencies in being able to operate largely independently of Congress and the president.  Congress passed the Federal Reserve Act, which established the Federal Reserve System, in 1913, and has amended it several times in the years since. (Note that, as we discuss in the Apply the Concept, “End the Fed?” in this chapter, the U.S. Constitution does not explicitly authorized the federal government to establish a central bank.) Section 2A of the act gives the Federal Reserve System the following charge:

“The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”

Elsewhere in the act, the Fed was given other specified responsibilities, such as supervising commercial banks that are members of the Federal Reserve System and serving on the Financial Stability Oversight Council (FSOC), which is charged with assessing risks to the financial system. 

Because Congress can change the structure and operations of the Fed at any time and because Congress has given the Fed only certain specific responsibilities, traditionally the Fed has avoided becoming involved in policy debates that are not directly concerned with its responsibilities. Over the years, most members of the Board of Governors have believed that if the Fed were to become involved in issues beyond monetary policy and the working of the financial system, Congress might decide to revise the Federal Reserve Act to reduce, or even eliminate, Fed independence.

In the spring of 2022, though, there were two instances where some members of Congress argued that the Fed had become involved in policy issues that went beyond the Fed’s responsibilities under the Federal Reserve Act. The first instance involved President Joe Biden’s nomination in January 2022 of Sarah Bloom Raskin to serve on the Fed’s Board of Governors. In 2010, Raskin was nominated to the Board of Governors by President Barack Obama and confirmed by the Senate in a voice vote without significant opposition. (In 2014, she resigned from the Board to accept a position in the Treasury Department.)

Her nomination by President Biden encountered significant opposition, however, largely because in July 2020 she had suggested that when the Fed expanded its lending programs during the Covid-19 pandemic it should have excluded firms in the oil, natural gas, and coal industries: “The Fed is ignoring clear warning signs about the economic repercussions of the impending climate crisis by taking action that will lead to increases in greenhouse gas emissions at a time when even in the short term, fossil fuels are a terrible investment.” Although her supporters argued that in formulating policy the Fed should take into account the threats to financial stability caused by climate change, when it became clear that a majority of the Senate disagreed, Raskin withdrew her nomination. 

In April 2022, some members of Congress, including Senator Pat Toomey of Pennsylvania, questioned whether it was appropriate for President Neel Kashkari of the Federal Reserve Bank of Minneapolis to formally support the campaign to amend the Minnesota state constitution to include a provision stating that, “All children have a fundamental right to a quality public education …. It is a paramount duty of the state to ensure quality public schools that fulfill this fundamental right.”

The Bank defended its support for the amendment in a statement on its website: “The Federal Reserve Bank of Minneapolis’ support of the Page amendment is closely linked to the mission of the Federal Reserve. Congress assigned the Federal Reserve the dual goals of achieving (1) stable prices and (2) maximum employment, and one of the greatest determinants of success in the job market is education.”

Senator Toomey strongly disagreed, arguing in a letter of Bank President Kashkari that: “This amendment is highly political, as it wades into an ongoing debate about whether government-run school systems are preferable to parental choice in education.” Toomey asserted that: “These political lobbying efforts by you and other Minneapolis Fed officials … are well beyond the Federal Reserve’s mandate, violate Federal Reserve Bank policies, constitute a misuse of Minneapolis Fed resources, and ultimately undermine the Federal Reserve’s independence and credibility.”

It remains to be seen whether Congress will ultimately accept the arguments of Federal Reserve policymakers such as Kashkari and Raskin that the Fed needs to interpret its mandate from Congress more broadly, or whether Congress will decide to amend the Federal Reserve Act to more explicitly limit the boundaries of Fed action—or to reduce Fed independence in some other ways. 

Sources: Sarah Bloom Raskin, “Why Is the Fed Spending So Much Money on a Dying Industry?” New York Times, May 28, 2020; Andrew Ackerman and Ken Thomas, “Sarah Bloom Raskin Withdraws as Biden’s Pick for Top Fed Banking Regulator,” Wall Street Journal, March 15, 2022; Michael S. Derby, “GOP Senator Criticizes Minneapolis Fed Over Education Issue,” Wall Street Journal, April 12, 2022; Federal Reserve Bank of Minneapolis, “Page Amendment: Every Child Deserves a Quality Public Education,” minneapolisfed.org; and Pat Toomey, “Letter to Neel Kashkari,” banking.senate. gov, April 11, 2022.

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New! – 4/07/22 Podcast – Authors Glenn Hubbard & Tony O’Brien revisit the role of inflation in today’s economy & likely Fed responses in trying to manage it.

Authors Glenn Hubbard and Tony O’Brien reconsider the role of inflation in today’s economy. They discuss the Fed’s possible responses by considering responses to similar inflation threats in previous generations – notably the Fed’s response led by Paul Volcker that directly led to the early 1980’s recession. The markets are reflecting stark differences in our collective expectations about what will happen next. Listen to find out more about the Fed’s likely next steps.

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Did the Fed Make a Mistake by Not Preempting Inflation?

Warning: Long post!

It now seems clear that the new monetary policy strategy the Fed announced in August 2020 was a decisive break with the past in one respect: With the new strategy, the Fed abandoned the approach dating to the 1980s of preempting inflation. That is, the Fed would no longer begin raising its target for the federal funds rate when data on unemployment and real GDP growth indicated that inflation was likely to rise. Instead, the Fed would wait until inflation had already risen above its target inflation rate. 

Since 2012, the Fed has had an explicit inflation target of 2 percent. As we discussed in a previous blog post, with the new monetary policy the Fed announced in August 2020, the Fed modified how it interpreted its inflation target: “[T]he Committee seeks to achieve inflation that averages 2 percent over time, and therefore judges that, following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.”

The Fed’s new approach is sometimes referred to as average inflation targeting (AIT) because the Fed attempts to achieve its 2 percent target on average over a period of time. But as former Fed Vice Chair Richard Clarida discussed in a speech in November 2020, the Fed’s monetary policy strategy might be better called a flexible average inflation target (FAIT) approach rather than a strictly AIT approach. Clarida noted that the framework was asymmetric, meaning that inflation rates higher than 2 percent need not be offset with inflation rates lower than 2 percent: “The new framework is asymmetric. …[T]he  goal of monetary policy … is to return inflation to its 2 percent longer-run goal, but not to push inflation below 2 percent.” And: “Our framework aims … for inflation to average 2 percent over time, but it does not make a … commitment to achieve … inflation outcomes that average 2 percent under any and all circumstances ….”

Inflation began to increase rapidly in mid-2021. The following figure shows three measure of inflation, each calculated as the percentage change in the series from the same month in the previous year: the consumer price index (CPI), the personal consumption expenditure (PCE) price index, and the core PCE—which excludes the prices of food and energy. Inflation as measured by the CPI is sometimes called headline inflation because it’s the measure of inflation that most often appears in media stories about the economy. The PCE is a broader measure of the price level in that it includes the prices of more consumer goods and services than does the CPI. The Fed’s target for the inflation rate is stated in terms of the PCE. Because prices of food and inflation fluctuate more than do the prices of other goods and services, members of the Fed’s Federal Open Market Committee (FOMC) generally consider changes in the core PCE to be the best measure of the underlying rate of inflation. 

The figure shows that for most of the period from 2002 through early 2021, inflation as measured by the PCE was below the Fed’s 2 percent target. Since that time, inflation has been running well above the Fed’s target. In February 2022, PCE inflation was 6.4 percent. (Core PCE inflation was 5.4 percent and CPI inflation was 7.9 percent.) At its March 2022 meeting the FOMC begin raising its target for the federal funds rate—well after the increase in inflation had begun. The Fed increased its target for the federal funds rate by 0.25 percent, which raised the target from 0 to 0.25 percent to 0.25 to 0.50 percent.

Should the Fed have taken action to reduce inflation earlier? To answer that question, it’s first worth briefly reviewing Fed policy during the Great Inflation of 1968 to 1982. In the late 1960s, total federal spending grew rapidly as a result of the Great Society social programs and the war in Vietnam. At the same time,  the Fed increased the rate of growth of the money supply. The result was an end to the price stability of the 1952-1967 period during which the annual inflation rate had averaged only 1.6 percent. 

The 1973 and 1979 oil price shocks also contributed to accelerating inflation. Between January 1974 and June 1982, the annual inflation rate averaged 9.3 percent. This was the first episode of sustained inflation outside of wartime in U.S. history—until now. Although the oil price shocks and expansionary fiscal policy contributed to the Great Inflation, most economists, inside and outside of the Fed, eventually concluded that Fed policy failures were primarily responsible for inflation becoming so severe.

The key errors are usually attributed to Arthur Burns, who was Fed Chair from January 1970 to March 1978. Burns, who was 66 at the time of his appointment, had made his reputation for his work on business cycles, mostly conducted prior to World War II at the National Bureau of Economic Research. Burns was skeptical that monetary policy could have much effect on inflation. He was convinced that inflation was mainly the result of structural factors such as the power of unions to push up wages or the pricing power of large firms in concentrated industries.

Accordingly, Burns was reluctant to raise interest rates, believing that doing so hurt the housing industry without reducing inflation. Burns testified to Congress that inflation “poses a problem that traditional monetary and fiscal remedies cannot solve as quickly as the national interest demands.” Instead of fighting inflation with monetary policy he recommended “effective controls over many, but by no means all, wage bargains and prices.” (A collection Burns’s speeches can be found here.)

Few economists shared Burns’s enthusiasm for wage and price controls, believing that controls can’t end inflation, they can only temporarily reduce it while causing distortions in the economy. (A recent overview of the economics of price controls can be found here.) In analyzing this period, economists inside and outside the Fed concluded that to bring the inflation rate down, Burns should have increased the Fed’s target for the federal funds rate until it was higher than the inflation rate. In other words, the real interest rate, which equals the nominal—or stated—interest rate minus the inflation rate, needed to be positive. When the real interest rate is negative, a business may, for example, pay 6% on a bond when the inflation rate is 10%, so they’re borrowing funds at a real rate of −4%. In that situation, we would expect  borrowing to increase, which can lead to a boom in spending. The higher spending worsens inflation.

Because Burns and the FOMC responded only slowly to rising inflation, workers, firms, and investors gradually increased their expectations of inflation. Once higher expectation inflation became embedded, or entrenched, in the U.S. economy it was difficult to reduce the actual inflation rate without increasing the target for the federal funds rate enough to cause a significant slowdown in the growth of real GDP and a rise in the unemployment rate. As we discuss in Macroeconomics, Chapter 17, Sections 17.2 and 17.3 (Economics, Chapter 27, Sections 27.2 and 27.3), the process of the expected inflation rate rising over time to equal the actual inflation rate was first described in research conducted separately by Nobel Laureates Milton Friedman and Edmund Phelps during the 1960s. 

An implication of Friedman and Phelps’s work is that because a change in monetary policy takes more than a year to have its full effect on the economy, if the Fed waits until inflation has already increased, it will be too late to keep the higher inflation rate from becoming embedded in interest rates and long-term labor and raw material contracts.  

Paul Volcker, appointed Fed chair by Jimmy Carter in 1979, showed that, contrary to Burns’s contention, monetary policy could, in fact, deal with inflation. By the time Volcker became chair, inflation was above 11%. By raising the target for the federal funds rate to 22%—it was 7% when Burns left office—Volcker brought the inflation rate down to below 4%, but only at the cost of a severe recession during 1981–1982, during which the unemployment rate rose above 10 percent for the first time since the Great Depression of the 1930s. Note that whereas Burns had largely failed to increase the target for the federal funds as rapidly as inflation had increased—resulting in a negative real federal funds rate—Volcker had raised the target for the federal funds rate above the inflation rate—resulting in a positive real federal funds rate. 

Because the 1981–1982 recession was so severe, the inflation rate declined from above 11 percent to below 4 percent. In Chapter 17, Figure 17.10 (reproduced below), we plot the course of the inflation and unemployment rates from 1979 to 1989.

Caption: Under Chair Paul Volcker, the Fed began fighting inflation in 1979 by reducing the growth of the money supply, thereby raising interest rates. By 1982, the unemployment rate had risen to 10 percent, and the inflation rate had fallen to 6 percent. As workers and firms lowered their expectations of future inflation, the short-run Phillips curve shifted down. The adjustment in expectations allowed the Fed to switch to an expansionary monetary policy, which by 1987 brought unemployment back to the natural rate of unemployment, with an inflation rate of about 4 percent. The orange line shows the actual combinations of unemployment and inflation for each year from 1979 to 1989.

The Fed chairs who followed Volcker accepted the lesson of the 1970s that it was important to head off potential increases in inflation before the increases became embedded in the economy. For instance, in 2015, then Fed Chair Janet Yellen in explaining why the FOMC was likely to raise to soon its target for the federal funds rate noted that: “A substantial body of theory, informed by considerable historical evidence, suggests that inflation will eventually begin to rise as resource utilization continues to tighten. It is largely for this reason that a significant pickup in incoming readings on core inflation will not be a precondition for me to judge that an initial increase in the federal funds rate would be warranted.”

Between 2015 and 2018, the FOMC increased its target for the federal funds rate nine times, raising the target from a range of 0 to 0.25 percent to a range of 2.25 to 2.50 percent. In 2018, Raphael Bostic, president of the Federal Reserve Bank of Atlanta justified these rate increases by noting that “… we shouldn’t forget that [the Fed’s] credibility [with respect to keeping inflation low] was hard won. Inflation expectations are reasonably stable for now, but we know little about how far the scales can tip before it is no longer so.”

He used the following figure to illustrate his point.

Bostic interpreted the figure as follows:

“[The red areas in the figure are] periods of time when the actual unemployment rate fell below what the U.S. Congressional Budget Office now estimates as the so-called natural rate of unemployment. I refer to these episodes as “high-pressure” periods. Here is the punchline. Dating back to 1960, every high-pressure period ended in a recession. And all but one recession was preceded by a high-pressure period….

I think a risk management approach requires that we at least consider the possibility that unemployment rates that are lower than normal for an extended period are symptoms of an overheated economy. One potential consequence of overheating is that inflationary pressures inevitably build up, leading the central bank to take a much more “muscular” stance of policy at the end of these high-pressure periods to combat rising nominal pressures. Economic weakness follows [resulting typically, as indicated in the figure by the gray band, in a recession].”

By July 2019, a majority of the members of the FOMC, including Chair Powell, had come to believe that with no sign of inflation accelerating, they could safely cut the federal funds rate. But they had not yet explicitly abandoned the view that the FOMC should act to preempt increases in inflation. The formal change came in August 2020 when, as discussed earlier, the FOMC announced the new FAIT. 

At the time the FOMC adopted its new monetary policy strategy, most members expected that any increase in inflation owing to problems caused by the Covid-19 pandemic—particularly the disruptions in supply chains—would be transitory. Because inflation has proven to be more persistent than Fed policymakers and many economists expected, two aspects of the FAIT approach to monetary policy have been widely discussed: First, the FOMC did not explicitly state by how much inflation can exceed the 2 percent target or for how long it needs to stay there before the Fed will react. The failure to elaborate on this aspect of the policy has made it more difficult for workers, firms, and investors to gauge the Fed’s likely reaction to the acceleration in inflation that began in the spring of 2021. Second, the FOMC’s decision to abandon the decades-long policy of preempting inflation may have made it more difficult to bring inflation down to the 2 percent target without causing a recession. 

Federal Reserve Governor Lael Brainard recently remarked that “it is of paramount importance to get inflation down” and some Fed policymakers believe that the FOMC will have to begin increasing its target for the federal funds rate more aggressively. (The speech in which Governor Brainard discusses her current thinking on monetary policy can be found here.) For instance James Bullard, president of the Federal Reserve Bank of St. Louis, has argued in favor of raising the target to above 3 percent this year. With the Fed’s preferred measure of inflation running above 5 percent, it would take substantial increases int the target to achieve a positive real federal funds rate.

It is an open question whether Jerome Powell finds himself in a position similar to that of Paul Volcker in 1979:  Rapid increases in interest rates may be necessary to keep inflation from accelerating, but doing so risks causing a recession. In a recent speech (found here), Powell pledged that: “We will take the necessary steps to ensure a return to price stability. In particular, if we conclude that it is appropriate to move more aggressively by raising the federal funds rate by more than 25 basis points at a meeting or meetings, we will do so.”

But Powell argued that the FOMC could achieve “a soft landing, with inflation coming down and unemployment holding steady” even if it is forced to rapidly increase its target for the federal funds rate:

“Some have argued that history stacks the odds against achieving a soft landing, and point to the 1994 episode as the only successful soft landing in the postwar period. I believe that the historical record provides some grounds for optimism: Soft, or at least softish, landings have been relatively common in U.S. monetary history. In three episodes—in 1965, 1984, and 1994—the Fed raised the federal funds rate significantly in response to perceived overheating without precipitating a recession.”

Some economists have been skeptical that a soft landing is likely. Harvard economist and former Treasury Secretary Lawrence Summers has been particularly critical of Fed policy, as in this Twitter thread. Summers concludes that: “I am apprehensive that we will be disappointed in the years ahead by unemployment levels, inflation levels, or both.” (Summers and Harvard economist Alex Domash provide an extended discussion in a National Bureau of Economic Research Working Paper found here.)

Clearly, we are in a period of great macroeconomic uncertainty. 

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Is Vladimir Putin Acting Rationally?

Photo of Russian President Vladimir Putin from the Wall Street Journal.

On February 24, when Russian President Vladimir Putin launched an assault on Ukraine he apparently expected within a few days to achieve his main objectives, including occupying the Ukrainian capital of Kyiv and replacing the Ukrainian government. After three weeks, the fierce resistance of the Ukrainian armed forces have resulted in his failing to achieve these objectives. Although the Russian military had expected to experience few casualties or losses of equipment, in fact Russia has already lost more military personnel killed than the United States has since 2001 in Afghanistan and Iraq combined, as well as experiencing the destruction of many tanks, planes, and other equipment. 

The United States, the European Union, and other countries have imposed economic sanctions on Russia that have reduced the country’s ability to import or export most goods, other than oil and natural gas. The sanctions have the potential to reduce the standard of living of the average Russian citizen.

Most importantly, the war has killed thousands of Ukrainians and inflicted horrendous damage on many Ukrainian cities.

Despite all this, is Putin’s persistence in the invasion rational or if he were acting rationally would he instead withdraw his troops or accept a political comprise (at this writing, negotiations between representatives of Russia and Ukraine are continuing)?  First, recall the economic definition of rationality: People are rational when they take actions that are appropriate to achieve their goals given the information available to them. (We discuss rationality in Microeconomics, Chapter 10, Section 10.4, and in Economics, Chapter 10, Section 10.4.) Note that rationality does not deal with whether a person’s goals are good or bad. In this discussion, we are considering whether Putin is acting rationally in attempting to achieve the—immoral—goal of subjugating a foreign country.

Peter Coy, a columnist for the New York Times, discusses three reasons Putin may continue his attack on Ukraine even though, “The bloody invasion of Ukraine has been a disaster” for Putin. The first reason, Coy recognizes, involves an economic concept. His other two reasons can also be understood within the economic framework we employ in Microeconomics.

First, Coy argues that Putin may have fallen into one of the pitfalls to decision making we discuss in Chapter 10: A failure to ignore sunk costs. Coy notes that Putin may want to continue the attack to justify the death and destruction that has already occurred. However, those costs are sunk because no subsequent action Putin takes can reduce them. If Putin is continuing the attack for this reason, then Coy is correct that Putin is not acting rationally because he is failing to ignore sunk costs in making his decision. 

There is a subtle point, though, that Coy may be overlooking: Putin is effectively a dictator, but he may still believe he needs to avoid Russian public opinion turning too sharply against him. In that case, even if recognizes that he should ignore sunk costs he may believe that the Russian public may not be willing to ignore the costs of the death and destruction that has already occurred. In that case, his refusal to ignore this sunk cost be rational.

Coy’s second reason why Putin may continue the attack is that he may believe “just another few weeks of fighting will be enough to subdue Ukraine.”  Although Coy doesn’t discuss the point in these terms, it would be rational for Putin to continue the attack if he believes that the marginal benefit of doing so exceeds the marginal cost. (We discuss this point directly in Chapter 1, Section 1.1 “Optimal Decisions Are Made at the Margin,” and provided many examples throughout the text.)  The marginal cost includes the additional Russian military casualties and losses of equipment from prolonging the war and the cost of economic sanctions to the Russian economy. (It seems unlikely that Putin is taking into account the additional loss of life among Ukrainians and the additional devastation to Ukrainian cities from prolonging the war.)

The marginal benefit from continuing the attack would be either winning the war or obtaining a more favorable peace settlement in negotiations with the Ukrainian government. If Putin believes that the marginal benefit is greater than the marginal cost, he is acting rationally in continuing to attack. 

Coy’s final reason why Putin may continue the attack is that “he has little to lose by fighting on.” Although Coy doesn’t discuss the point in these terms, Russia may be suffering from a principal-agent problem. As we discuss in Microeconomics, Chapter 8, Section 8.1 (also Economics, Chapter 8, Section 8.1 and Macroeconomics, Chapter 6, Section 6.1) the principal-agent problem arises when an agent pursues the agent’s interst rather than the interests of the principal in whose behalf the agent is supposed to act. In this case, Putin is the agent and the Russian people are the principal. Putin’s own interest may be in prolonging the war indefinitely in the hopes of ultimately winning, despite the additional Russian soldiers who will be wounded or killed and despite the economic suffering of the Russian people resulting from the sanctions.

Although as president of Russia, Putin should be acting in the best interests of the Russian people, as a dictator, he can largely disregard their interests. Unlike his soldiers, Putin isn’t exposed to the personal dangers of being in battle. And unlike the average Russian, Putin will not suffer a decline in his standard of living because of economic sanctions.

Appalling as the consequences will be, Putin’s continuing his attack on Ukraine may be rational.

Sources: Peter Coy, “Here Are Three Reasons Putin Might Fight On,” New York Times, March 14, 2022; Alan Cullison, “Talks to End Ukraine War Pause as Russia’s Offensive Intensifies,” Wall Street Journal, March 14, 2022; and Thomas Grove, “Russia’s Military Chief Promised Quick Victory in Ukraine, but Now Faces a Potential Quagmire,” Wall Street Journal, March 6, 2022.

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Macro Solved Problems on Treasury Bonds and Defining Inflation

Ernie Banks of the Chicago Cubs poses for a portrait circa 1963. (Photo by Louis Requena/MLB Photos)

With the owners of the Major Labor Baseball teams and the Major League Players Association having finally settled on a new collective bargaining agreement, the baseball season will soon begin. Ernie Banks, the late Hall of Fame shortstop for the Chicago Cubs, was known for his upbeat personality. However bad the weather might be at Chicago’s Wrigley Field, Banks would run on the field and say, “What a great day for baseball! Let’s play two.”

In honor of Ernie Banks, today let’s do two Solved Problems in macro. They both involve errors that students in principles courses often make. So, in that sense they would also work as Don’t Let This Happen to You features. 

Solved Problem 1.: Bond Yields and Bond Prices

An article in the Financial Times had the following headline:  “U.S. Government Bond Prices Drop Ahead of Federal Reserve Meeting.” The first sentence of the article reads: “U.S. government bond yields rose to multiyear highs on Monday ahead of this week’s Federal Reserve meeting ….”

a. When a media article mentions “U.S. government bonds,” what type of bonds are they referring to?

b. Is there a contradiction between the headline and the first sentence of the article? Is the article telling us that U.S. government bonds went up or down? Briefly explain.

Solving the Problem

Step 1:  Review the chapter material. This problem is about the inverse relationship between bond yields and bond prices, so you may want to review Macroeconomics, Chapter 6, Appendix, “Using Present Value” (Economics, Chapter 8, Appendix, “Using Present Value”). You may also want to review the discussion of U.S. Treasury bonds in Macroeconomics, Chapter 16, Section 16.6, “Deficits, Surpluses, and Federal Government Debt” (Economics, Chapter 26, Section 26.6, “Deficits, Surpluses, and Federal Government Debt”).

Step 2: Answer part a. by explaining what media articles are referring to when they use the phrase “U.S. government bonds.” As discussed in Chapter 16, Section 16.6, most of the bonds issued by the federal government of the United States are U.S. Treasury bonds. The Treasury sells these bonds to investors when the federal government doesn’t collect enough in tax revenues to pay for all of its spending. So, when the media refers to U.S. government bonds, without further explanation, the reference is always to U.S. Treasury bonds. 

Step 3: Answer part b. by explaining that there is no contradiction between the headline and the first sentence of the article. An important fact about bond markets is that when the price of a bond falls, the yield—or interest rate—on the bond rises. The reverse is also true: When the price of a bond rises, the yield on the bond falls.  The reason why this relationship holds is explained in the Appendix to Chapter 6: The price of a bond (or other financial asset) should be equal to the present value of the payments an investor receives from owning that asset. If you buy a U.S. Treasury bond, the price will equal the present value of the coupon payments the Treasury sends you during the life of the bond and the final payment to you by the Treasury of the principal, or face value of the bond. Remember that present value is the value in today’s dollars of funds to be received in the future. The higher the interest rate, the lower the present value of a payment to be received in the future. So a higher yield, or interest rate, on a bond results in a lower price of the bond because the higher yield reduces the present value of the payments to be received from the bond.

Therefore, whenever the yield on a bond rises, the price of the bond must fall (and whenever the yield on a bond falls, the price of the bond must rise. So, we can conclude that the headline of the Financial Times article and the first sentence of the article are consistent, not contradictory:  Because the prices of Treasury bonds fell, the yields on the bonds must have risen.

Source: Nicholas Megaw, Naomi Rovnick, George Steer, and Hudson Lockett, “U.S. Government Bond Prices Drop Ahead of Federal Reserve Meeting,” ft.com, March 14, 2022.

Solved Problem 2: Being Careful about the Definition of Inflation

An article in the New York Times contrasted inflation during the 1970s with inflation today:

“Price increases had run high for more than a decade by the time Mr. Volcker became chair [of the Federal Reserve Board of Governors] in 1979 …. Shopper expected prices to go up, businesses knew that, and both acted accordingly. This time, inflation has been anemic for years (until recently), and most consumers and investors expect costs to return to lower levels before long, survey and market data show.”

a. What does the article mean by “inflation has been anemic for years”?

b. In the last sentence what “costs” is the article referring to?

c. Is the article correctly using the definition of inflation in the last sentence? Briefly explain.

Solving the Problem

Step 1:  Review the chapter material. This problem is about the definition of inflation, so you may want to review Macroeconomics, Chapter 9, Section 9.4, “Measuring Inflation” (Economics, Chapter 20, Section 20.4, “Measuring Inflation”).

Step 2: Answer part a. by explaining what the phrase “inflation has been anemic for years” means. Anemia is a medical disorder that usually has the symptom of fatigue. So, the word “anemic” is often used to mean weak. The article is arguing that until recently, the inflation rate had been weak, or slow.  

Step 3: Answer part b. by explaining what the article is referring to by “costs.” Economists typically use the word costs for the amount that firm pays to produce a good—labor costs, raw material costs, and so on. Here, though, the article is using “costs” to mean “prices.”  Costs is often used this way in everyday conversation: “I didn’t buy a new car because they cost too much.” Or: “Has the cost of a movie ticket increased?” 

Step 4: Answer part c. by explaining whether the article is correctly using the definition of inflation. In writing “consumers and investors expect costs to return to lower levels” the article is making a common mistake. The article seems to mean that consumers and investors expect that the rate of inflation will be lower in the future. But even if the rate of inflation declines from nearly 8 percent in early 2022 to, say, 3 percent in 2023, prices will still be increasing. So, prices (“costs” in the sentence) will still be higher next year even if the rate of inflation is lower. In other words, even if the rate of increase in prices—inflation—declines, the price level will still be higher. 

It’s a common mistake to think that a decline in the inflation rate means that prices will be lower, when actually prices will still be increasing, just more slowly.

Source: Jeanna Smialek, “Powell Admires Volcker. He May Have to Act Like Him,” New York Times, March 14, 2022.

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Inflation, Supply Chain Disruptions, and the Peculiar Process of Purchasing a Car

Photo from the Wall Street Journal.

Inflation as measured by the percentage change in the consumer price index (CPI) from the same month in the previous year was 7.9 percent in February 2022, the highest rate since January 1982—near the end of the Great Inflation that began in the late 1960s. The following figure shows inflation in the new motor vehicle component of the CPI.  The 12.4 percent increase in new car prices was the largest since April 1975.

The increase in new car prices was being driven partly by increases in aggregate demand resulting from the highly expansionary monetary and fiscal policies enacted in response to the economic disruptions caused by the Covid-19 pandemic, and partly from shortages of semiconductors and some other car components, which reduced the supply of new cars.

As the following figure shows, inflation in used car prices was even greater. With the exception of June and July of 2021, the 41.2 percent increase in used car prices in February 2022 was the largest since the Bureau of Labor Statistics began publishing these data in 1954. 

Because used cars are a substitute of new cars, rising prices of new cars caused an increase in demand for used cars. In addition, the supply of used cars was reduced because car rental firms, such as Enterprise and Hertz, had purchased fewer new cars during the worst of the pandemic and so had fewer used cars to sell to used car dealers. Increased demand and reduced supply resulted in the sharp increase in the price of used cars.

Another factor increasing the prices consumers were paying for cars was a reduction in bargaining—or haggling—over car prices.  Traditionally, most goods and services are sold at a fixed price. For example, some buying a refrigerator usually pays the posted price charged by Best Buy, Lowes, or another retailer. But houses and cars have been an exception, with buyers often negotiating prices that are lower than the seller was asking.

In the case of automobiles, by federal law, the price of a new car has to be posted on the car’s window. The posted price is called the Manufacturer’s Suggested Retail Price (MSRP), often referred to as the sticker price.  Typically, the sticker price represents a ceiling on what a consumer is likely to pay, with many—but not all—buyers negotiating for a lower price. Some people dislike the idea of bargaining over the price of a car, particularly if they get drawn into long negotiations at a car dealership. These buyers are likely to pay the sticker price or something very close to it.

As a result, car dealers have an opportunity to practice price discrimination:  They charge buyers whose demand for cars is more price elastic lower prices and buyers whose demand is less price elastic higher prices. The car dealers are able to separate the two groups on the basis of the buyers willingness to haggle over the price of a car. (We discuss price discrimination in Microeconomics and Economics, Chapter 15, Section 15.5.)  Prior to the Covid-19 pandemic, the ability of car dealers to practice this form of price discrimination had been eroded by the availability of online car buying services, such as Consumer Reports’ “Build & Buy Service,” which allow buyers to compare competing price offers from local car dealers. There aren’t sufficient data to determine whether using an online buying service results in prices as low as those obtained by buyers willing to haggle over price face-to-face with salespeople in dealerships.

In any event, in 2022 most car buyers were faced with a different situation: Rather than serving as a ceiling on the price, the MSRP, had become a floor. That is, many buyers found that given the reduced supply of new cars, they had to pay more than the MSRP. As one buyer quoted in a Wall Street Journal article put it: “The rules have changed so dramatically…. [T]he dealer’s position is ‘This is kind of a take-it-or-leave-it proposition.’” According to the website Edmunds.com, in January 2021, only about 3 percent of cars were sold in the United States for prices above MSRP, but in January 2022, 82 percent were.

Car manufacturers are opposed to dealers charging prices higher than the MSRP, fearing that doing so will damage the car’s brand. But car manufacturers don’t own the dealerships that sell their cars. The dealerships are independently owned businesses, a situation that dates back to the beginning of the car industry in the early 1900s. Early automobile manufacturers, such as Henry Ford, couldn’t raise sufficient funds to buy and operate a nationwide network of car dealerships. The manufacturers often even had trouble financing the working capital—or the funds used to finance the daily operations of the firm—to buy components from suppliers, pay workers, and cover the other costs of manufacturing automobiles.

The manufacturers solved both problems by relying on a network of independent dealerships that would be given franchises to be the exclusive sellers of a manufacturer’s brand of cars in a given area. The local businesspeople who owned the dealerships raised funds locally, often from commercial banks. Manufacturers generally paid their suppliers 30 to 90 days after receiving shipments of components, while requiring their dealers to pay a deposit on the cars they ordered and to pay the balance due at the time the cars were delivered to the dealers. One historian of the automobile industry described the process:

The great demand for automobiles and the large profits available for [dealers], in the early days of the industry … enabled the producers to exact substantial advance deposits of cash for all orders and to require cash payment upon delivery of the vehicles ….  The suppliers of parts and materials, on the other hand, extended book-account credit of thirty to ninety days. Thus the automobile producer had a month or more in which to assemble and sell his vehicles before the bills from suppliers became due; and much of his labor costs could be paid from dealers’ deposits.

The franchise system had some drawbacks for car manufacturers, however. A car dealership benefits from the reputation of the manufacturer whose cars it sells, but it has an incentive to free ride on that reputation. That is, if a local dealer can take an action—such as selling cars above the MSRP—that raises its profit, it has an incentive to do so even if the action damages the reputation of Ford, General Motors, or whichever firm’s cars the dealer is selling.  Car manufacturers have long been aware of the problem of car dealers free riding on the manufacturer’s reputation. For instance, in the 1920s, Ford sent so-called road men to inspect Ford dealers to check that they had clean, well-lighted showrooms and competent repair shops in order to make sure the dealerships weren’t damaging Ford’s brand.

As we discuss in Microeconomics and Economics, Chapter 10, Section 10.3, consumers often believe it’s unfair of a firm to raise prices—such as a hardware store raising the prices of shovels after a snowstorm—when the increases aren’t the result of increases in the firm’s costs. Knowing that many consumers have this view, car manufacturers in 2022 wanted their dealers not to sell cars for prices above the MSRP. As an article in the Wall Street Journal put it: “Historically, car companies have said they disapprove of their dealers charging above MSRP, saying it can reflect poorly on the brand and alienate customers.”

But the car manufacturers ran into another consequence of the franchise system. Using a franchise system rather than selling cars through manufacturer owned dealerships means that there are thousands of independent car dealers in the United States. The number of dealers makes them an effective lobbying force with state governments. As a result, most states have passed state franchise laws that limit the ability of car manufacturers to control the actions of their dealers and sometimes prohibit car manufacturers from selling cars directly to consumers. Although Tesla has attained the right in some states to sell directly to consumers without using franchised dealers, Ford, General Motors, and other manufacturers still rely exclusively on dealers. The result is that car manufacturers can’t legally set the prices that their dealerships charge. 

Will the situation of most people paying the sticker price—or more—for cars persist after the current supply chain problems are resolved? AutoNation is the largest chain of car dealerships in the United States. Recently, Mike Manley, the firm’s CEO, argued that the substantial discounts from the sticker price that were common before the pandemic are a thing of the past. He argued that car manufacturers were likely to keep production of new cars more closely in balance with consumer demand, reducing the number of cars dealers keep in inventory on their lots: “We will not return to excessively high inventory levels that depress new-vehicle margins.” 

Only time will tell whether the situation facing car buyers in 2022 of having to pay prices above the MSRP will persist. 

Sources: Mike Colias  and Nora Eckert, “A New Brand of Sticker Shock Hits the Car Market,” Wall Street Journal, February 26, 2022; Nora Eckert and Mike Colias, “Ford and GM Warn Dealers to Stop Charging So Much for New Cars,” Wall Street Journal, February 9, 2022; Gabrielle Coppola, “Car Discounts Aren’t Coming Back After Pandemic, AutoNation Says,” bloomberg.com, February 9, 2022; cr.org/buildandbuy; Lawrence H. Seltzer, A Financial History of the American Automobile Industry, Boston: Houghton-Mifflin, 1928; and Federal Reserve Bank of St. Louis.

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Will the U.S. Ban on Russian Oil Imports Reduce Russian Oil Revenue?

Photo of Russian oil refinery from the New York Times.

On March 8, 2022, President Joe Biden announced that the United States would no longer allow new shipments of oil from Russia to the United States. Russian oil made up about 8 percent of total U.S. oil imports and about 2 percent of U.S. oil consumption.  European countries, which are much more heavily dependent on oil imports from Russia, announced plans to gradually reduce Russian oil imports.

The point of these policy actions was to reduce the revenues Russia would receive from oil exports as retaliation for Russia’s invasion of Ukraine. Beyond the effect of direct action against Russian oil imports, Russian oil exports were reduced further as a result of other sanctions imposed on the Russian economy by the United States and other countries. These sanctions made it difficult for Russia to access shipping services and the international payments system.

The decline in Russian oil exports reduced the total supply of oil on the international oil market, pushing up the price of the oil. The following figure shows the daily price in dollars per barrel of Brent crude oil, which is the most commonly used benchmark price of oil.

Will the actions taken by the United States and other countries reduce Russian oil revenues? As we discuss in Microeconomics, Chapter 6, Section 6.3, whether a seller’s total revenue will decrease as a result of a decrease in the quantity sold depends on the price elasticity of demand for the seller’s product. If demand is price elastic, the revenue the seller receives will fall. If demand is price inelastic, the revenue the seller receives will rise. 

In this case, Russia’s oil revenue will decline if the percentage increase in the price of oil is less than the percentage decrease in the quantity of oil Russia is selling. The energy information firm Energy Intelligence has estimated that Russian oil exports have declined by about one-third. On the day before the Russian invasion of Ukraine, the price of Brent crude oil was about $99 per barrel. It then rose to $129 per barrel on March 7 before falling to $109 per barrel on March 10.  Based on these values, the price Russia received per barrel of oil increased between 9 and 29 percent or by less than the 33 percent decline in the quantity of oil Russia sold.

Because the percentage decline in quantity was greater than the percentage increase in price, we can conclude that the actions taken by the United States and other countries reduced Russian oil revenue. In fact, the reduction in revenue is probably larger than indicated by the change in the price of Brent crude oil. Media reports indicate that to find buyers Russia is having to discount its oil by more than $10 per barrel from the Brent price.  In addition, the countries of the European Union have pledged to reduce Russian oil imports by two-thirds by the end of 2022 and the United Kingdom has pledged to end them entirely. Although Russia might be able to redirect to other countries some oil it had been exporting to Europe and the United States, it seems likely that Russia’s total oil exports will eventually decline by more than the initial one-third.

Sources: Andrew Restuccia and Josh Mitchell, “Biden Bans Imports of Russian Oil, Natural Gas, Wall Street Journal, March 8, 2022; Stanley Reed, “The Future Turns Dark for Russia’s Oil Industry,” New York Times, March 8, 2022; Collin Eaton, “How Much Oil Does the U.S. Import From Russia and Why Is Biden Banning It?” Wall Street Journal, March 9, 2022; “Russian Oil Exports Fall by One-Third,” energyintel.com, March 2, 2022; and Tsuyoshi Inajima and Serene Cheong, “More Russian Oil Deeply Discounted as Ban Risk Alarms Buyers,” bloomberg.com, March 7, 2022. Brent crude oil price data from the Federal Reserve Bank of St. Louis and the Wall Street Journal.

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Glenn’s Opinion Column on the Economics of an Increase in Defense Spending

Graphic from the Wall Street Journal.

Glenn published the following opinion column in the Wall Street Journal. Link here and full text below.

NATO Needs More Guns and Less Butter

Russia’s unprovoked invasion of Ukraine has challenged Western assumptions about security, economics and the postwar world order. In Europe and the U.S., public finances have long favored social spending over public goods such as defense. While President Biden doubled down on his proposal to increase social spending during his State of the Union address, Russia’s aggression highlights the shortcomings of this model. Western democracies now face a more uncertain and dangerous world than they did two weeks ago. Navigating it will require significantly higher levels of defense and security spending.

But change will be difficult, and the magnitude of what needs to be done is sobering. The U.S. currently spends 3.2% of gross domestic product on defense—roughly half of Cold War spending levels relative to GDP. An increase in spending of even 1% of GDP would amount to about $210 billion. That’s about 5% of the total federal spending level using a 2019 pre-Covid baseline. While Covid spending was large, it was transitory. Defense outlays would be much longer-lasting, an insurance premium or transaction cost for dealing with a more dangerous world.

The U.S. is not alone. Germany’s announcement of €100 billion in additional defense spending this year represents an increase of just over 0.25% of GDP, leaving Berlin still under the 2% commitment agreed to by North Atlantic Treaty Organization allies. Increasing Europe’s defense spending merely to the agreed-on level would require significant outlays. Such spending increases would occur against the backdrop of elevated public debt relative to GDP, brought on in part by heightened borrowing during the Covid pandemic and the earlier global financial crisis. High levels of public debt make it unlikely that countries will want to pay to increase their defense spending with new borrowing.

Paying for higher levels of defense spending will force most governments either to raise taxes or cut spending. Tax increases raise risks to growth. The larger non-U.S. NATO economies are already taxed to the hilt. Tax revenue relative to the size of the economy in France (45%), Germany (38%), Canada (34%) and the U.K. (32%) doesn’t leave much room to tax more without depressing economic activity. The U.S. has a lower tax share of GDP—about 17.5% at the federal level and 25.5% in total—but its patchwork quilt of income and payroll taxes makes tax increases more costly by distorting household and business decisions about consumption and investment.

A significant tax increase in the U.S. would need to be accompanied by fundamental tax reform, dialing back income taxes (as with the 2017 reduction in corporate tax rates) and increasing reliance on consumption taxes. A broad-based consumption tax could be implemented by imposing a tax at the business level on revenue minus purchases from other firms (a “subtraction method” value-added tax). Alternatively, the tax system could impose a broad-based wage and business cash-flow tax, with a progressive wage surtax on high earners. These consumption-tax alternatives would be efficient and equitable in a revenue-neutral tax reform. And they are crucial in avoiding decreases in savings, investment and entrepreneurship that accompany a tax increase.

Since the 1960s, spending on Social Security, Medicare and Medicaid has come to dominate the federal budget. Outlays for these programs have almost doubled since then as a share of GDP to 10.2% today, and the Congressional Budget Office projects they will consume about another 5% of GDP annually by 2040. Spending offsets to accommodate higher defense spending would surely require slowing the growth in social-insurance spending. As with tax increases, there are trade-offs. It is possible to slow the growth of this spending while preserving access to such support for lower-income Americans. Accomplishing that will require focusing net taxpayer subsidies on lower-income Americans, along with undertaking market-oriented health reforms. Such changes require serious attention.

The U.S. and its NATO allies will face a challenging set of economic trade-offs and political realities in achieving higher defense spending. The challenge will be exacerbated by additional private investment needs in a more dangerous world of investment risks, skepticism about globalization, and cybersecurity threats. 

In the U.S., the failure of the 2010 Simpson-Bowles Commission’s proposed spending and tax reforms to spark a serious discussion is a warning sign. So, too, is the antipathy of Democratic and Republican officials alike toward creating the fiscal space necessary to accommodate greater defense spending. Such challenges don’t cause threats to vanish. They require leadership—now.

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Fanatics: The Unlikely Unicorn

Image from fanatics.com website.

unicorn is a startup, or newly formed firm, that has yet to begin selling stock publicly and has a value of $1 billion or more. (We discuss the difference between private firms and public firms in Economics and Microeconomics, Chapter 8, chapter opener and Section 8.2, and in Macroeconomics, Chapter 6, chapter opener and Section 6.2.) Usually, when we think of unicorns, we think of tech firms. That assumption is largely borne out by the following list of the 10 highest-valued U.S.-based startups, as compiled by cbinsights.com.

FirmValue
SpaceX$100.3 B
Stripe$95 B
Epic Games$42 B
Instacart$39 B
Databricks$38 B
Fanatics$27 B
Chime$25 B
Miro$17.5 B
Ripple$15 B
Plaid$13.4 B

Nine of the ten firms are technology firms, with six being financial technology—fintech—firms. (We discuss fintech firms in the Apply the Concept, “Help for Young Borrowers: Fintech or Ceilings on Interest Rates,” which appears in Macroeconomics, Chapter 14, Section 14.3, and Economics, Chapter 24, Section 24.3.) The one non-tech firm on the list is Fanatics, whose main products are sports merchandise and sports trading cards.  Because a unicorn doesn’t issue publicly traded stock, the firm’s valuation is determined by how much an investor pays for a percentage of the firm. In Fanatics’s case, the valuation was based on a $1.5 billion investment in the firm made in early March 2022 by a group of investors, including Fidelity, the large mutual find firm; Blackrock, the largest hedge fund in the world; and Michael Dell, the founder of the computer company.

These investors were expecting that Fanatics would earn an economic profit. But, as we discuss in Chapter 14, Section 14.1 and Chapter 15, Section 15.2, a firm will find its economic profit competed away unless other firms that might compete against it face barriers to entry. Although Fanatics CEO Michael Rubin has plans for the firm to expand into other areas, including sports betting, the firm’s core businesses of sports merchandise and trading cards would appear to have low barriers to entry. There are already many firms selling sportswear and there are many firms selling trading cards. The investment required to establish another firm to sell those products is low. So, we would expect competition in the sports merchandise and trading card markets to eliminate economic profit.

The key to Fanatics success is that it is selling differentiated products in those markets. Its differentiation is based on a key resource that competitors lack access to: The right to produce sportswear with the emblems of professional sports teams and the right to produce trading cards that show images of professional athletes. Fanatics has contracts with the National Football League (NFL), Major League Baseball (MLB), the National Hockey League (NHL), the National Basketball Association (NBA), and Major League Soccer (MLS)—the five most important professional sports leagues in North America—to produce jerseys, caps, and other sportswear that uses the copyrighted brands of the leagues’ teams. (In some cases, as with the NBA, Fanatics shares the right with another firm.)

Similarly, Fanatics has the exclusive right to produce trading cards bearing the images of NFL, NBA, and MLB players. In January 2022, Fanatics bought Topps, the firm that for decades had held the right to produce MLB trading cards. 

Fanatics has paid high prices to these sports leagues and their players to gain the rights to sell branded merchandise and cards. Some business analysts questioned whether Fanatics will be able to sell the merchandise and cards for prices high enough to earn an economic profit on its investments. Fanatics CEO Rubin is counting on an increase in the popularity of trading cards and the increased interest in sports caused by more states legalizing sports gambling. 

That Fanatics has found a place on the list of the most valuable startups that is otherwise dominated by tech firms indicates that many investors agree with Rubin’s business strategy.

Sources:  “The Complete List of Unicorn Companies,” cbinsights.com; Miriam Gottfried and Andrew Beaton, “Fanatics Raises $1.5 Billion at $27 Billion Valuation,” Wall Street Journal, March 2, 2022; Tom Baysinger, “Fanatics Scores $27 Billion Valuation,” axios.com March 2, 2022; Lauren Hirsch, “Fanatics Is Buying Mitchell & Ness, a Fellow Sports Merchandiser,” New York Times, February 18, 2022; and Kendall Baker, “Fanatics Bets Big on Trading Card Boom,” axios.com, January 5, 2022.

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Solved Problem: U.S. Treasury Bonds and the Russian Invasion of Ukraine

Supports: Macroeconomics, Chapter 10, Section 10.5, Economics Chapter 20, Section 20.5, and Essentials of Economics, Chapter 14, Section 14.2.

On March 2, 2022, as the conflict between Russia and Ukraine intensified, an article in the Wall Street Journal had the headline “Investors Pile Into Treasurys as Growth Concerns Flare.” The article noted that: “The 10-year Treasury yield just recorded its largest two-day decline since March 2020, while two-year Treasury yields plunged the most since 2008.”

a. What does it mean for investors to “pile into” Treasury bonds?

b. Why would investors piling into Treasury bonds cause their yields to fall?

c. What are “growth concerns”? What kind of growth are investors concerned about?

d. Why might growth concerns cause investors to buy Treasury bonds?

Solving the Problem

Step 1: Review the chapter material. This problem is about the effects of slowing economic growth on interest rates, so you may want to review Chapter 10, Section 10.5, “Saving, Investment and the Financial System.” You may also want to review Chapter 6, Appendix A (in Economics, Chapter 8, Appendix A), which explains the inverse relationship between bond prices and interest rates. 

Step 2: Answer part a. by explaining what the article meant by the phrase “pile into” Treasury bonds. The article is using a slang phrase that means that investors are buying a lot of Treasury bonds.

Step 3: Answer part b. by explaining why investors piling into Treasury bonds will cause the yields on the bonds to fall. As the Appendix to Chapter 6 explains, the price of a bond represents the present value of the payments that an investor will receive over the life of the bond. Lower interest rates result in a higher present value of the payments received and, therefore, higher bond prices or—which is restating the same point—higher bond prices result in lower interest rates. If investors are increasing their demand for Treasury bonds, the increased demand will cause the prices of the bonds to increase and cause the yields—or the interest rates—on the bonds to fall.

Step 4: Answer part c. by explaining the phrase “growth concerns.” In this context, the growth being discussed is economic growth—changes in real GDP.  The headline indicates that investors were concerned that the Russian invasion of Ukraine might lead to slower economic growth in the United States.

Step 5: Answer part d. by explaining why investors might purchase Treasury bonds if they were concerned about economic growth slowing. Using the model of the loanable funds markets discussed in Chapter 10, Section 10.5, we know that if economic growth slows, firms are likely to engage in fewer new investment projects, which would shift the demand curve for loanable funds to the left and result in a lower equilibrium interest rate. Investors who have purchased Treasury bonds will gain from a lower interest rate because the price of the Treasury bonds they own will increase. In addition, stock prices depend on investors’ expectations of the future profitability of firms issuing the stock. Typically, if investors believe that economic growth is likely to be slower in the future than they had previously expected, stock prices will fall, which would make Treasury bonds a more attractive investment. Finally, investors believe there is no chance that the U.S. Treasury will default on its bonds by not making the interest payments on the bonds. During an economic slowdown, investors may come to believe that the default risk on corporate bonds has increased because some corporations may run into financial problems. An increase in the default risk on corporate bonds increases the relative attractiveness of Treasury bonds as an investment.

Source: Gunjan Banerji, “Investors Pile Into Treasurys as Growth Concerns Flare,” Wall Street Journal, March 2, 2022.

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New 3/01/22 Podcast – Authors Glenn Hubbard & Tony O’Brien discuss Russia’s Invasion of Ukraine.

Authors Glenn Hubbard & Tony O’Brien reflect on the global economic effects of Russia’s invasion of Ukraine last week. They consider the impact on the global commodity market, US monetary policy, and the impact on the financial markets in the US. Impact touches Introductory Economics, Money & Banking, International Economics, and Intermediate Macroeconomics as the effects of Russia’s aggression moves into its second week.

A map of Europe with Ukraine in the middle right below Belarus and to the east of Poland.

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Ukraine

On Tuesday, March 1, Glenn and Tony will record a podcast on the economic consequences of the Russian invasion of Ukraine. The recording will be posted to this blog and also available through iTunes.

Some useful links

General information on developments (political and military, as well as economic):

Updates on the website of the Financial Times (note that the FT has dropped its paywall to allow non-subscribers to read this content). This article on the possible effects on the global economy is particularly worth reading.

The Twitter feed of Max Seddon, the FT’s Moscow bureau chief, is here.

The website of the New York Times has an extensive series of updates focused on military and political developments (subscription may be required).

Streaming updates on the website of the Wall Street Journal (subscription may be required).

A Twitter feed that provides timely updates on the military situation.

An article in the New Yorker discussing Russian President Vladimir Putin’s claims about the historical relationship between Russia and Ukraine.

A pessimistic blog post by a retired U.S. Army Colonel on whether the U.S. military is equipped to fight a war in Europe.

Discussions focused on economics:

As background, the following figure from the Our World in Data site shows the growth in real GDP per capita for several countries. The underlying data were compiled by the World Bank and are measured in constant international dollars, which means that they are corrected for inflation and for variations across countries in the purchasing power of the domestic currency.

In 2020, Russian GDP per capita was less than half that of U.S. GDP per capita although about 50 percent greater than GDP per capita in China. GDP per capita in Lithuania, part of the Soviet Union until 1991, and Poland, part of the Soviet bloc until 1989, are significantly higher than in Russia. These two countries have become integrated into the European economy and have grown more rapidly than has Russia, which continues to rely heavy on exports of oil, natural gas, and other commodities. Ukraine is not as well integrated into the European economy as are Poland and Lithuania and Ukraine experienced little economic growth since attaining independence in 1991. In fact, Ukraine’s real GDP per capita was lower in 2020 than it had been in 1991.

Here is a transcript of President Joe Biden’s speech imposing sanctions on Russia.

Informative Full Stack Economics blog post by Alan Cole explaining the likely reasons why U.S. and European sanctions on Russia excluded energy. Useful explanation of the role of correspondent banking in international trade.

An article in the Economist discussing sanctions (subscription may be required).

An article in the New York Times discussing the SWIFT (Society for Worldwide Interbank Financial Telecommunications) service, which is based in Belgium, and is a key component of the international financial system. Some policymakers have proposed cutting Russia off from SWIFT. The article discusses why some countries have been opposed to taking that step (subscription may be required).

An opinion column by Justin Fox on bloomberg.com examines in what sense the United States is energy independent and the economic reasons that the U.S. still imports some oil from Russia (subscription may be required).

Blog post by economic writer Noah Smith on the possible effects of the invasion on the post-World War II international economic system.

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Would Cutting the Federal Excise Tax on Gasoline Lower the Price that Consumers Pay?

Photo from bloomberg.com.

The federal government levies an excise tax of 18.4 cents per gallon of gasoline. (An excise tax is a tax that a government imposes on a particular product. In addition to the tax on gasoline, the federal government imposes excise taxes on tobacco, alcohol, airline tickets, and a few other products.) In February 2022, inflation was running at the highest level in several decades. The average retail price of gasoline across the country had risen to $3.50 per gallon from $2.60 per gallon a year earlier. The following figure shows fluctuations in the retail price of gasoline since January 2000. 

Policymakers were looking for ways to lessen the effects of inflation on consumers. An article in the Wall Street Journalreported that several Democratic members of the U.S. Senate, including Mark Kelly of Arizona, Maggie Hassan of New Hampshire, and Raphael Warnock of Georgia proposed that the federal excise tax on gasoline be suspended for the remainder of 2022. The sponsors of the proposal believed that cutting the tax would reduce the price of gasoline that consumers pay at the pump. Other members of the Senate weren’t so sure, with one quoted as saying that cutting the tax was “not going to change anything” and another arguing that oil companies would receive most of the benefit of the tax cut.

Some members of Congress were opposed to suspending the gasoline tax because the revenue raised from the tax is placed in the highway trust fund, which helps to pay for federal contributions to highway building and repair and for mass transit. In that sense, the gasoline tax follows the benefits-received principle, under which people who receive benefits from a government program—in this case, highway maintenance—should help pay for the program. (We discuss the principles for evaluating taxes in Microeconomics, Chapter 17, Section 17.2 and in Economics, Chapter 17, Section 17.2) Other members of Congress were opposed to suspending the tax because they believe that the tax helps to reduce the quantity of gasoline consumed, thereby helping to slow climate change. 

Focusing just on the question of the effect of suspending the tax on the retail price of gasoline, what can we conclude? The question is one of tax incidence, which looks at the actual division of the burden of a tax between buyers and sellers in a market. In other words, tax incidence looks beyond the fact that gasoline stations collect the tax and send the revenue to federal government to the issue of who actually pays the tax. As we note in Chapter 17, Section 17.3:

When the demand for a product is less elastic than supply, consumers pay the majority of the tax on the product. When the demand for a product is more elastic than supply, firms pay the majority of the tax on the product. 

Consumers would receive all of the tax cut—that is, the retail price of gasoline would fall by 18.4 cents—only in the polar case where the demand for gasoline were perfectly price inelastic. Similarly, consumers would receive none of the tax cut and the price of gasoline would remain unchanged—so oil companies would receive all of the tax cut—only in the polar case where the demand for gasoline is perfectly price inelastic. (It’s a worthwhile exercise to show these two cases using demand and supply graphs.)

In the real world, we would expect to be somewhere in between these two cases, with consumers receiving some of the benefit of suspending the tax and producers receiving the remainder of the benefit. The short-run price elasticity of demand for gasoline is quite small; according to one estimate it is only −.06.  The short-run price elasticity of supply of gasoline is likely to be somewhat larger than that in absolute value, which means that we would expect that consumers would receive the majority of the tax cut. (Note that we would expect the long-run price elasticities of demand and supply to both be larger for reasons we discuss in Chapter 6, Section 6.2 and 6.6.) In other words, the retail price of gasoline would fall, holding all other factors constant, but not by the full tax cut of 18.4 cents.

Joseph Doyle of MIT and Krislert Samphantharak of the University of California, San Diego studied the effect of suspension in the state excise tax on gasoline in Indiana and Illinois in 2000. In that year, Indiana suspended collecting its gasoline excise tax for 120 days and Illinois suspended its tax for 184 days. The authors estimate that consumers received about 70 percent of the tax cut in the form of lower gasoline prices. If we apply that estimate to the federal gasoline tax, then suspending the tax would lower the price of gasoline by about 12.9 cents per gallon, holding all other factors that affect the price of gasoline constant. As the above figure shows, the retail price of gasoline frequently fluctuates up and down by more than 12.9 cents, even over fairly brief periods of time. In that sense, the effect on the gasoline market of suspending the federal excise tax on gasoline would be relatively small.  

Sources: Andrew Duehren and Richard Rubin, “Some Lawmakers Want to Halt Gas Tax Amid High Inflation. Others See a Gimmick,” Wall Street Journal, February 16, 2022; Tony Romm and Jeff Stein, “White House, Congressional Democrats Eye Pause of Federal Gas Tax as Prices Remain High, Election Looms,” Washington Post, February 15, 2022; Joseph J. Doyle, Jr., Krislert Samphantharak, “$2.00 Gas! Studying the Effects of a Gas Tax Moratorium,” Journal of Public Economics, Vol. 92, No.s 3-4, April 2008, pp. 869-884; and Federal Reserve Bank of St. Louis.

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Are Economic Profits a Sign of Market Power?

Cecilia Rouse, chair of the Council of Economic Advisers. Photo from the Washington Post.

An article in the Washington Post discussed a debate among President Biden’s economic advisers. The debate was over “over whether the White House should blame corporate consolidation and monopoly power for price hikes.” Some members of the National Economic Council supported the view that the increase in inflation that began in the spring of 2021 was the result of a decline in competition in the U.S. economy.

Some Democratic members of Congress have also supported this view. For instance, Massachusetts Senator Elizabeth Warren argued on Twitter that: “One clear explanation for higher inflation? Giant corporations are exploiting their market power to further raise prices. And corporate executives are bragging about their higher profits.” Or, as Vermont Senator Bernie Sanders put it: “The problem is not inflation. The problem is corporate greed, collusion & profiteering.”

But according to the article, Cecilia Rouse, chair of the President’s Council of Economic Advisers (CEA), and other members of the CEA are skeptical that a lack of competition are the main reason for the increase in inflation, arguing that very expansionary monetary and fiscal policies, along with disruptions to supply chains, have been more important.

In an earlier blog post (found here), we noted that a large majority of more than 40 well-known academic economists surveyed by the Booth School of Business at the University of Chicago disagreed with the statement: “A significant factor behind today’s higher US inflation is dominant corporations in uncompetitive markets taking advantage of their market power to raise prices in order to increase their profit margins.”

One difficulty with the argument that the sharp increase in inflation since mid-2021 was due to corporate greed is that there is no particular reason to believe that corporations suddenly became more greedy than they had been when inflation was much lower. If inflation were mainly due to corporate greed, then greed must fluctuate over time, just as inflation does. Economic writer and blogger Noah Smith poked fun at this idea in the following graph

It’s worth noting that “greed” is one way of characterizing the self-interested behavior that underlies the assumption that firms maximize profits and individual maximize utility. (We discuss profit maximization in Microeconomics, Chapter 12, Section 12.2, and utility maximization in Chapter 10, Section 10.1.) When economists discuss self-interested behavior, they are not making a normative statement that it’s good for people to be self-interested. Instead, they are making a positive statement that economic models that assume that businesses maximize profit and consumers maximize utility have been successful in analyzing and predicting the behavior of businesses and households. 

Corporate profits increased from $1.95 trillion in the first quarter of 2021 to $2.40 trillion in third quarter of 2021 (the most recent quarter for which data are available). Using another measure of profit, during the same period, corporate profits increased from about 16 percent of value added by nonfinancial corporate businesses to about 18 percent. (Value added measures the market value a firm adds to a product. We discuss calculating value added in Macroeconomics, Chapter 8, Section 8.1.)

There have been mergers in some industries that may have contributed to an increase in profits—the Biden Administration has singled out mergers in the meatpacking industry as having led to higher beef and chicken prices. At this point, though, it’s not possible to gauge the extent to which mergers have been responsible for higher prices, even in the meatpacking industry.   

An increase in profit is not by itself an indication that firms have increased their market power. We would expect that even in a perfectly competitive industry, an increase in demand will lead in the short run to an increase in the economic profit earned by firms in the industry. But in the long run we expect economic profit to be competed away either by existing firms expanding their production or by new firms entering the industry.

In Chapter 12, we use Figure 12.8 to illustrate the effects of entry in the market for cage-free eggs. Panel (a) shows the market for cage-free eggs, made up of all the egg sellers and egg buyers. Panel (b) shows the situation facing one farmer producing cage-free eggs. (Note the very different scales of the horizontal axes in the two panels.) At $3 per dozen eggs, the typical egg farmer is earning an economic profit, shown by the green rectangle in panel (b). That economic profit attracts new entrants to the market—perhaps, in this case, egg farmers who convert to using cage-free methods. The result of entry is a movement down the demand curve to a new equilibrium price of $2 per dozen. At that price, the typical egg farmer is no longer earning an economic profit.

A few last observations:

  1. The recent increase in profits may also be short-lived if it reflects a temporary increase in demand for some durable goods, such as furniture and appliances, raising their prices and increasing the profits of firms that produce them. The increase in spending on goods, and reduced spending on services, appears to have resulted from:  (1) Households having additional funds to spend as a result of the payments they received from fiscal policy actions in 2020 and early 2021, and (2) a reluctance of households to spend on some services, such as restaurant meals and movie theater tickets, due to the effects of the Covid-19 pandemic.
  2. The increase in profits in some industries may also be due to a reduction in supply in those industries having forced up prices. For instance, a shortage of semiconductors has reduced the supply of automobiles, raising car prices and the profits of automobile manufacturers. Over time, supply in these industries should increase, bringing down both prices and profits.
  3. If some changes in consumer demand persist over time, we would expect that the  economic profits firms are earning in the affected industries will attract the entry of new firms—a process we illustrated above. In early 2022, this process is far from complete because it takes time for new firms to enter an industry.

Source:  Jeff Stein, “White House economists push back against pressure to blame corporations for inflation,” Washington Post, February 17, 2022; Mike Dorning, “Biden Launches Plan to Fight Meatpacker Giants on Inflation,” bloomberg.com, January 3, 2022; and U.S. Bureau of Economic Analysis.ec

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Does Inflation Affect Lower-Income People More than Higher-Income People?

There’s a consensus among economists that increases in unemployment during a recession typically are larger for lower-income people than for higher-income people. Lower-income people are more likely to hold jobs requiring fewer skills and firms typically expect that when they lay off less-skilled workers during a recession they will be able to higher them—or other workers with similar skills—back after the recession ends. Because higher income have skills that may be difficult to replace, firms are more reluctant to lay them off. 

For instance, in an earlier blog post (found here) we noted that during the period in 2020 when many restaurants were closed, the Cheesecake Factory continued to pay its 3,000 managers while it laid off most of its servers. That strategy made it easier for the restaurant chain to more easily expand its operations when the worst of government-ordered closures were over. More generally, Serdar Birinci and YiLi Chien of the Federal Reserve Bank of St. Louis found that workers in the lowest 20 percent (or quintile) of earnings experienced an increased unemployment rate from 4.4 percent in January 2020 to 23.4 percent in April 2020, whereas workers in the highest quintile of earnings experienced an increase only from 1.1 percent in January to 4.8 percent in April.

If lower-income people are hit harder by unemployment, are they also hit harder by inflation? Answering that question is difficult because the U.S. Bureau of Labor Statistics (BLS) doesn’t routinely release data on inflation in the prices of goods and services purchased by households at different income levels.  The main measure of consumer price inflation compiled by the BLS represents changes in the consumer price index (CPI). The CPI is an index of the prices in a market basket of goods and services purchased by households living in urban areas. The information on consumer purchases comes from interviews the BLS conducts every three months with a sample of consumers and from weekly diaries in which a sample of consumers report their purchases. (We discuss the CPI in Macroeconomics, Chapter 9,  Section 9.4 and in Economics, Chapter 19, Section 19.4.)

The BLS releases three measures of the CPI, the two most widely used of which are the CPI-U for all urban consumers and CPI-W for urban wage earners. CPI-W covers the subset of households that receive at least half their household income from clerical or wage occupations and who have at least one wage earner who worked for 37 weeks or more during the previous year. CPI-U represents about 93 percent of the U.S. population and CPI-W represents about 29 percent of the U.S. population. Finally, in 1988 Congress instructed the BLS to compile a consumer price index reflecting the purchases of people aged 62 and older. This version of the CPI is labeled R-CPI-E; the R indicates that it is a research series and the E indicates that it is intended to measure the prices of goods and services purchased by elderly people. Because the sample used to calculate the R-CPI-E is relatively small and because of some other difficulties that may reduce the accuracy of the index, the BLS considers it a series best suited for research and does not include the data in its monthly “Consumer Price Index” publication. In any event, as the following figure shows, inflation, measured as the percentage change in the CPI from the same month in the previous year, has been very similar for all three measures of the CPI.

Because the market baskets of goods and services consumed by a mix of high and low-income households is included in all three versions of the CPI, none of the versions provides a way to measure the possibly different effects of inflation on low-income and on high-income households. A study by Josh Klick and Anya Stockburger of the BLS attempts to fill this gap by constructing measures of the CPI for low-income and for high-income households. They define low-income households as those in the bottom 25 percent (quartile) of the income distribution and high-income households as those in the top quartile of the income distribution. During the time period of their analysis—December 2003 to December 2018—the bottom quartile had average annual incomes of $12,705 and the top quartile had average annual incomes of $155,045.

The BLS researchers constructed market baskets for the two groups. The expenditure weights—representing the mix of products purchased—don’t differ too strikingly between lower-income and higher-income households, as the figure below shows. The largest differences are housing, with low-income households having a market basket weight of 45.2 percent and high-income households having a market basket weight of 39.5 percent, and transportation, with low-income households having a market basket weight of 13.0 percent and high-income households having a market basket weight of 17.2 percent.

The following table shows the inflation rate as measured by changes in different versions of the CPI over the period from December 2003 to December 2018. During this period, the CPI-U (the version of the CPI that is most frequently quoted in news stories) increased at an annual rate of 2.1 percent, which was the same rate as the CPI-W. The R-CPI-E increased at a slightly faster rate of 2.2 percent. Lower-income households experienced the highest inflation rate at 2.3 percent and higher-income households experienced the lowest inflation rate of 2.0 percent.  

CPI-UCPI-WR-CPI-ECPI for lowest income quartileCPI for highest income quartile
2.1%2.2%2.1%2.3%2.0%

The differences in inflation rates across groups were fairly small. Can we conclude that the same was true during the recent period of much higher inflation rates? We won’t know with certainty until the BLS extends its analysis to cover at least the years 2021 and 2022. But we can make a couple of relevant observations. First, for many people the most important aspect of inflation is whether prices are increasing faster of slower than their wages. In other words, people are interested in what is happening to their real wage. (We discuss calculating real wage rates in Macroeconomics, Chapter 9, Section 9.5 and in Economics, Chapter 19, Section 19.5.)

The Federal Reserve Bank of Atlanta compiles data on wage growth, including wage growth by workers in different income quartiles. The following figure shows that workers in the top quartile have experienced more rapid wage growth in the months since the beginning of the Covid-19 pandemic than have workers in the other quartiles. This gap continues a trend that began in 2015. The bottom quartile has experienced the slowest rate of income growth. (Note that the researchers at the Atlanta Fed compute wage growth as a 12-month moving average rather than as the percentage from the same month in the previous year, as we have been doing when calculating inflation using the CPI.) For example, in January 2022, calculated this way, average wage growth in the top quartile was 5.8 percent as opposed to 2.9 percent in the bottom quartile.

As with any average, there is some variation in the experiences of different individuals. Although, as a group, lower-income workers have seen wage growth that lags behind other workers, in some industries that employ many lower-income people, wage growth has been strong. For instance, as measured by average hourly earnings, wages for all workers in the private sector increased by 5.7 percent between January 2021 and 2022. But average hourly earnings in the leisure and hospitality industry—which employs many lower-income workers—increased by 13.0 percent.

Overall, it seems likely that the real wages of higher-income workers have been increasing while the real wages of lower-income workers have been decreasing, although the experience of individual workers in both groups may be very different than the average experience. 

Sources: Josh Klick and Anya Stockburger, “Experimental CPI for Lower and Higher Income Households Serdar,” U.S. Bureau of Labor Statistics, Working Paper 537, March 8, 2021; Birinci and YiLi Chien, “An Uneven Crisis for Lower-Income Households,” Federal Reserve Bank of St. Louis, Annual Report 2020, April 7, 2021; and Federal Reserve Bank of Atlanta, “Wage Growth Tracker,” https://www.atlantafed.org/chcs/wage-growth-tracker.

NEW! 11/17/22 Podcast – Authors Glenn Hubbard & Tony O’Brien discuss inflation, the Fed’s Response, FTX collapse, and also share thoughts on economics themes in holiday movies!