school's brief

8/10/2019 School's Brief

1/18

Playing with numbers

e British science-fictionwriter.

world markcu:

1st year.

as

world

. G. Wells.

had

a touching faith

'fade

boomed. Brimin's expons

statisti=. He predicted that grewby 1 in

thinking would on e day Wh o is lying? Neither; every fig-

as

necessary a qualification for ure is correct. The trick is to

cient citizensh ip

as

the ability choose from the many possible

read and write. measu res the one which is most

That day seems to have ar- favourable to you r argument.

social

and eco-

omic, abound in the press. But B~~~

drift

he world is still

full

of inefficient

Percentages offer a fertile field

for confusion. A percentage is

always a percentage

of

some-

thing; that something is called the

base. The First question to ask is

what is the base of a calculation?

It can make a big difference. If it

costs a company

5

to make a

widget th at ~ l l sor

S25.

its

20

profit margin is either a whop-

ping

W9

or a more modest

80 . according to whether it is

expressed as a percentag e of costs

o r sales.

Equal percentage increases im-

ply bigger absolute increases as

the base itself changes. If prices

rise by 10% a year for ten years

the total increase is not simply

10070

(10 X lo), but 159% be

CaUK each successive 10%

rise

citizens. For every statistic which applies to a higher base.

is used. another

is

abused. Few

moving base also means that

people are equipped to defend percentage increases and de-

themselves against the p rofes- creases are not symmetricai.

If

s i o n a a n o m i s t s as well as prices decline by

10%

a ycar,

politicians-who manipulate

fig-

then after ten years the total fall

ures to suit their own purposes.

will

be only 65% because the

This brief providEs a guid ed tou r base shrinks every year. Similar-

through the s tatistical jungle. ly, if wages fell 50% on e year, bu t

What should the voter make

o

then rose 50 next. workers

these two contradictory assess- would find their ay packets were

Mrs

Thatcher's government?

r

ents of the economic record of

25%

smaller t an when they

started: the

50%

fall applies to a

A fictitious Conse rvative bigger

base

than the

50%

rise

spokesman boasts;

(see

chart

I).

They need a 100

lo

the four years to

l l S .

the Brit- pay

rise

to restore the

50%

Cut.

ish economy has grown

by

an aver- Th e distinction between per-

of 3% a Yew, compucd

with

centages and percentage poin ts is

aveWe p W h of less than 2% a murky area. In Britain. the

d u n n ~he

L a bour ~e mof974-79.

inflation rate feu from

10%

n

G ~ n r

rc

Nnning

t record lev- early

1979 to

6%

in 1985. This

ch .

In 1985.

Britam's-exporn of

mmrflctud

roK

15%.

in. allows the Conservative spokes-

crc ir lng

heir

share

of

world mr .

man

o claim his governme nt has

kc o .

Tha

government has reduced cur the inna tion rate by 40 .

n t e of ~nflation

y

40 since This docs not mcan the inflation

1979

rate has fallen from

46

to

6 .

The Labour pokesman counten: but. as the Labour spokesman

Sraa

tbc

Coaurvauve government

savs.

it has fallen bv onlv four

Unequal halves

a

A v e r a w w e e k ly w a g . a

ma

C

b

0.

54

C 25

4

04

1983 8 85

-

came 10

v r

n 1979.-growth ha% +Gnlagcoints.

a.tng+d mere

1%

car4nJy

Another trap to watch out for

haif

the avenge

rate

achieved

by

L h et, &pite thr denre is wm~acisons

percentage

lionrry

policim, the n e of

changes in two different num-

m n has

f a ~ c o y a mere four

be . S ~ P F America's expoas

pzanugc pornu. British mm ufac- increased by 15 . while imports

1 n arc bean8

rque~rcd

out

of rose only

10%;

thism ~gh t uggest

a narrowing of the trade deficit.

In fact. the opposite has hap

pened. America's imports are al-

most twice as Large as its exports.

so

though exports

rise

faster than

imports in percentage te n s , in

absolute terms imports increase

by more. Suppose exports were

S200

and

impons

were

5400.

then

a 15 increase in expons is

equivalent to

30.

but a

10% rise

in imports is worth

W

ie. the

trade defiqt increases by S10.

Some of the biggest statistical

blunders are made when calculat-

ing the percentage appreciation

or depreciation of a

cunencv.

su p+ the exchange rate of the

peso to the dollar moves from

Sl=P2

a year ago to a rate of

Sl =P 5 today. Then.

it

is correct

to say that the dollar has risen

1 M 0 / ~ 5

2) 2

x

100-

against the

peso,

but it is non-

sense to say that the peso has

fallen 150% against the dollar.

This would mean that somebody

who held

pesos

would have to

pay the bank dollars to persuade

it to take the

peso

off his hands.

Th e trick in calculating the site

of the peso's depreciation against

the dollar (a opposed to the

dollar's

rise

against the

peso)

is

first to express the exchange rate

as the number of dollars per

peso. In this example. the

peso

has fallen from Pl=SO.S to

P13SO.2, a

60

depreciatiorw

(0.2 0.5) 0.5 x 100. But be

warned, though exchange rates

are usually expressed

as

tht num-

ber of D-marks or francs per

dollar. a few currencies. notably

sterling. are quoted upside

down-ie, the num ber of doll ars

per pound.

The

time

trap

Th e choice of period averwhich

a

change

is

calculated provides

plenty of

scope

for statistical de-

ception.

Mrs

Thatcher's ministen

like to base their economic re-

cord

from

1981. as

if a

Labour

government had presided over

the recession of 1980-81. The

Conse rvative spokesman claimed

(correctly) that the economy had

grown

by

3 a year in the four

years to 1985; but over the full

seven years sinu 1979, gowth

has averaged barely 1% a year.

Most

economic indicators arc

published monthly or quarterly.

The monthl*. change can be

turned into an annual rate in two

ways. The most common metho d

is to compare figures with their

level in the same period of the

previous ye ar. Bu t this still leaves

considerable room for manoeu-

we. Consider this question: in

1981,

did Britain's

GDP

(a ) grow

by 14%.

or

(b) fall by I ) ?

Oddly enough. either answer

would

be correct. The average

level of output in 1981 was

14%

lower than in

1980.

but during

1981-ie. from end-198 0 to end-

1981--output grew by 14% bc-

caux the economic trough

was

reached at the sta rt of the year.

The

alternative way of calcu-

lating an annual rate of change is

to a nnualise it-this is what the

total increase would be if the

monthly rate continued for a full

ycar. This does not mean just

multiplying by

12.

Each month's

increase is compounded; eg. a

monthly rise of

2%

is equivalent

to an annual rate of

27 .

When

hyperinflation takes off this can

make a big difference: prices rose

by around SO a month

in

Boliv-

ia last year-an annual rate of

13.000%.

not 600 .

American economists love to

annualise monthly or quarterly

figures, often with bizarre re-

sults. American consumer prices

fell by

0.396

in February. An nw -

lising this gives an inflation rate

of -3.S0/0.

But

in the 12 months

to February, prices rose by 3.2%.

Generally. the inflation rate

refers to the 12-month rise in

prices, but it is

wise

to check.

On e of the most notorious exam-

ples of statistical sleigh tsf-han d

was

Mr

Denis Healey's 8.4%

inflation rate in the British elec-

tion campaign of October 1974.

This figure was obtained by an-

nualising the

rise

in prices

over

a

three-month

period;

the more

conventional 12-month rate was

twice

as

high (see ch an

2).

When.

only a few months later. the an-

nualixd three-month rate leapt

to 58%. Mr Healey soon lost

interest in his favoured measure.

Another trap is whether indi-

cato n such as output or expons

are expressed in nominal terms

(ie. measured in the prices pre-

vailing when thegoods were pro-

duced) or real terms (constant

prices). If export receipts in-

THE ECONOMIST MAY

31

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11/18

BRIEF

the future

have always agreed

that the

Mum

arfects t h ~

but

have

never

been

sure

In what

wa y s They haw

a lot of t l m

trying

to d e f i n e expectationsabout the

and

then

feeding

t h e m

back

to

c u m t

behavlour.

A

theory suggests that

the

f e e d b a c k k fast and ha8 far-

Impl ica t ions .

Known

the

mUa~laxpectrtloru

t has f o r c e d Keyneriansandmonotarlots

allks

to

h e i r

views.

now a p e hat even

simplest economic theor y has

hing about h ow

pc+

view the future. They haw

to develop

ways

of defining

measuring expectations.

f fons

are

relatively new:

in his General Theory

treated expectation s

u

xog-

because he doubted tho;

cwld be

modelled or

mu-

aaurately.

e sirnplifylng ass umption of

pro-

for example, the

basic

he w ~ n drief: consumption

p u t i c u k period

is influ-

by income in the same

But an y assumption that

ime or "permanent" i m m e

c o n s u m ~t i o n

e

the

so again.

But they

wen much

more influenced by their recent

experience of double-digit infla-

tion and thought that

was

more

likely to continue.

Adaptive expectations. Ex-

trapolation suggests that people

observe the past as a

way

of

predicting the

future.

But the

theory docs not let them learn

from theirom mistakes,

so

some

economists

refined it. They sug-

gested that people do use their

own forecasting enots

to

derive

their next forecasts.

.

That seems quite plausible. If

yqu

have lost money on Knack-

c r s Nag in each of its past

five

races

you will probably avqid it

in the sixtb. Yo u

may

not dKKW

Lucky Lady. who wins by a dir-

tance. but at least YOU

will have

of

bow

h p l e g u g e &void& yourearli&mistake.

lrkely future

income.

Adautive mdextnpolat ive ex-

have provided w pectatibns am not all thn

differ-

amwen.

Lugely based on ent:

it

b

pouible to show mathc-

principle that up cc tn ti on so t matically that an adaptive

future arc fonned by

utpcri

expectations rule is quivllmt t o

f the

past.

;he rwo a r t i e s t a particular kind o f

extrapolative

of thisidea wert: expecrarions.

Both

theories

have

lative e tions. If an obvious

weakness.

They say

n t c r r i w E y a r o t"tLUe f u m p l f a n w c o f a

in the sequmce 4%. 6 . pmkdu variable b aEfectcd

o p l e

will

expect them to only by its

past.

If Lucky

lsdy

DCXI year. Some may simply has never ncod before, neither

in- theory would provide any reason

percentage points for

backing

her. Yet

her put

4% t o 6%. t h re e po in ts f o n .

or

lack of it. i s not the only

m% t o

9

w n d u d e factor ha t will dictate he r hh re.

uext yur's n t e

will be

four

Rm t e n mightk nfluenced

by

hirhcr

at 139 . Others h er ~ e d ie r r e. or c x m ~ l e .

r

tbe

k;bk

a t

the

rate

of

so rise from 4% t o

ad then tran 67' t o

9%-

that next year's jump

k

n

134%. Gtb crw ay. they

b k i q

r t the di rmion of

uewemmrs

md

a y i n g hat i t

m 7 x

oa Lhtaiet of m n p o i a t i v c

pm greater

nore

by

han

the drstont

past.

t r ilfitn. nnny

peopk

in a

Lu Bnuin could re-

LI b ~ ~ o n

ad run at

r

Ifr

3aWt a

year

rn the

I

- they

did not

:he

mk l i t y of it

dong

rucdar

6f other

horrei

from the

urnstock.

People hying to prc-

d i a even 8 Jingle variable wi l l

t ake yn w n t of dozens of other

f a n o n

if

they think them mle-

v a t .

That

piece of commonsense

led economists to c on stm a a arid-

heoryof expecutionr.

The n heory is a l k d

n-

tional expmations". It first a p

peared

in

the economic literature

m 1%1. but hrs been a major

theme only since the mid-19%.

Like much else that

is

new i a

nucrotconomia. rational

expec-

tatiom

has

stro ng microeconomic

roots.

It

is

based on a familiar

minoeoonomic idea: people are

rational in the sense that they

do

the bac they an.

As

consumen.

worke n

and

i n v a t o n ,

they

watch d l he market's signals

The theory of nt iona l exp ear-

tions

says

that people form their

views of the future by taking

account of d l availabk mforma-

tion, including their understand-

ing of how th e econom y works. If

they ate trying to predict next

year's inflation rate and

ue

of

m on et aM bent. they will look at

last

year's

g r w h in the money

supply.

Those who think that

prices depend on costs will look

a

wages,

productivity. commod-

ity pries. ctc,.plus (perhaps) the

pronouncements of

Opac

oil

ministers.

Rationalman

Many

economists

initially reject-

ed the r at io n du p ec tP ti on s a p

pmach. mainly becauseitw m e d

to

dnnokb

Keynesian econom-

ics.

More r e n t

work

has

shown

that it

d o e

not. But some eaono-

mists still cb.llmgc th e theo ry oa

its merits r a plausible descrip-

tion of nrlity. They say that

pcopkwithoutdegmr in mathe-

mtid eco~nnMnnot a nd d o

not

riR

through nil the i a f o m w

tion r M i l a b k oa tbe economy,

and out of

th 1 chaos

p r o d u a a

rational foreas

of

my,

inflation.

T b t h b O t ~ e q r p r y , r @ y c h c

S U * ~ of n h o d

arpcct

tions.

The

economic

f o m r s t i n ~

i n d ~ i shriving

and

its results

a re wi ly reported, even in the

popular press. But forecasten

can

never a p e . t he cr it ic s might

reply..

Some

are Keymsians.

some moneta&t+-thcy cannot

d l k ight, and their forecats

a n n o t all be rat ional . This objec-

tion probably cbventatcs th e dis-

agreement between forecasts-

more

than

o

or t wo ye a n

ahead,

they

usually duster

around consensus figures. More

important:

individuals

can differ from

on e another in their expectations

9

and still be rational if they are

using different infonnation. But

when all there individual u p

ta uo m a- added together. errors

tend to

a n a l

out -producing an

aggregate view of the future that

reflects

d l he avai labk informa-

tion. (This is known in th e jargon

as he law of large numben.)

Rational expectations theory

docs not

say

that peop le will not

make mistake; simply that they

will

not

go

on making the

same

kind of mistake year after year,

when the infonnation they need

t o c o m a hat mistake

is

t o hand.

This

defence of rational expec-

tations hns persuaded many

economists.

T h e

heory

has

one

immediate implication. The

more

accurate the information that

peopie dn w on. the less wiH the

future surprisa them. Th ey have

already adjusted their p resent be-

haviour to take account of

it.

From this notion. eaonomim

have developed the

"random-

walk" theory to explain, cg the

ups and

downs

a nd

share

prices.

Stockmukets a re full of inform*

tion,

runs this

argument, and to-

day's share prices embody it.

They ,a rc thm fo re the

best

guide

to tomonotv's

prim;

the only

thing th at ' 'will

cause

them to

move

is

new information, and

that is inbcrtntly unpredictable.

Such analysis

bas

a @oomy

m o d for

people wantlng t o

make

mon y

in stockmarkets

or

cwrrnder:

thy

won't unless

they

have insider infonnatioa

about somtthin g that

wiU

happea

a nd will

move

the market

in

a

e way

once

it b e c o m e

own. For everybody eke. the

opportunities for making a profit

arc s

fketing tha t they d o not

rcalJy exist. This gives rise t o r

rntionrl-tioar joke ab ou t

m

ecomnni~

rofewor walking

with a keen eyed student wrest

the

univndty quad. Look .

~ y s

he

student, pointing at th

ground. a fiw-pound

m e .

"It

can't be , replies the rational

fc uo t. "If it was there. some-

c would have picked it up by

IW)V.*

Hi

reply cmphasises thjt

h e

informat~onwhich moves mar-

kets must k really new. not

something that people could an-

ticipate.

An

apparently unfa-

vau rahl e event-a strike. a rise

in

interest ta ts -o ft en leaves share

prices umhangcd . h i s

is

because

the markets were expecting it to

happen and had already adjusted

prictr.

T h e same

is

m e f o th er e m-

nomic variables. say su porters

of rational expectations. b e y d o

not claim that everybody pew.

s m s

perfect

foresight. Thei r as-

sumption

is more modest - tha t

TClEECOMUlSlOCTC#EAZO.

IOU


12/18

SCHOOLSBRIEF

random

fore-

e n o n , OM syncmtk

er-

n that they pon repeating,

If

is correct.

the

c u m n t

W of

rarer in temc

w a p .

product

pncu.

adapting

to

the future.

To s e e the im pliations of this

ory. apply it briefly to t h m

areas:

The

cobw'cb

model

of

am

and produocn. him text-

o n

cconomiu

indude the

on the previous

prp.

shorn

bow some markets

move e rn t i a l ly from one

to the next. If the supply

pout- ir

reduced

by bligbt

Q1 t o @, tbc market will

away from i u equilibrium

PIQI to higher price Pa. t

price f r r me n ariU plant

p o t a m but conrum en will

l e u

So

bemn vwsr

prub pr im down to P,. db-

fvnmr

rwn

pianting

much. From yar t o

year,

will

jump

about md

more

e v e y year.

Rational

expcu8rkm

plwider

rnmtr to

this.

It

says

tbat

arc

ableto see beyond

Pick

a

doctrine

the

immediate

future. ~ a m ~ n

rrrlire that planting

mud, more

after Wight

will

d y

dut

next

year's

mrlel.

driving

dam

k=if'ttJ=-ay-

w ll therefom bead u n ~ g h t

G

back to equilibrium

by

planting

QI of pout- in tbe year after

the blight. In other words. the

cobw eb m odel ~ t t u m a time

b g

in praductioa;but n t i w r i

expec-

tations

shorn

thrt it

is

really

m

information gap. w h i i

need

not

exist.

Inflation. If ev rybody be-

liever that faster monetrry

p w t b will produce laster price

Ili88tion. tby

iu

Ul t k I p t c

those

c o l l l c q u e ~ ~ ~ .ben tbe

central bank

stua spctding

up

monetary growth, s a w n will im-

mediately d c m u d higher interest

ra te$-and borrowenwill lip.

becrw

they ue repared to pry

i n t e r n m t u

t b ~ t

e

be

r u n e

in

rul ermsu eforetbe mont tuy

emaruioa. T h

vrracy

arkets

wih prub down

tbc try's ex-

- n t e (provided 0th

countnu

us

wt rlro bacaing

their moaeur),

p w b by

the

same d e p c ) .

Wortem

will

bc-

rmbd

hgher wrges-rad

an-

ployen vill pry tbcm.

trw

they ue dmultaacourly pmhhg

up their

prices.

In fut rerybody

b

acting to

bring r b w t tbc f u t e r i n h d o a -

that they expea. If they

move

instmmncously, they will

pte-

w n t uy of the faster m o m m y

g?ouzh tramlatint into higher

spending in nl enns, even for

a

moment. Refldon will simply

mean

i n f l r h .

Economic forraning.

wnt iau l fo raas t ing modtb

used to k

based

on

past

k h a v -

iour-a

p.rt w h n min c w

no

policies

wen operating. If

these porkiesm t i n u e . the

mob

eb

m y give an a a u r a t e guide

to

the future. But what

happeus if

the

polides cbmge

whicb

h

usu

ally

the

q u u t i m

that

fo rccu ten

ask

of

their

d l ? he theory

of rationalmpetatioiu says that

t b e ~ ~ o f t b e m o d e )

will then chage, so

attempo

to

f o ~ t h e f u t u r e w i l l k b u c d

6n r

now-irrckvmt

p a t . This

u y m e n t ,

k t put

f o n u d in

lW6 by Mr Robert

Luar of the

Univcnity

d atiago. ass Icri-

our

doubt oo the vaJidityd

om

astiog. Most fo rccu ten have

a a o ( c e a ~ T o r m t c l u a

emnamie

thought:

Neu~' lhekrdmofthkrcf .oolut t*roAwrianr ,

Profcssoas

Robert Luar

Dd

-l%onm* in

B e .

Professor Patrick Minfordof

Liverpool

U m t y

the16

light.

new

druid c a m o m hk i i ~b8t (a) upcct.tionr

re rrtioarl

and (b)

markets

c l r my

quickly.

By

this

they

man that willing b u y m nd willing

rllm

mike br rgmif~

or ic leave them all b a ~ u s e8ges .ad prices

m

flexible. both

up

anddown.

ment. r result, invoiuntuy urwmploymwt

cm

p p ' o n j y

briew and tbca

for

only one

mason: beame

wye, arc

fixed

infrequently. warkm mry temporarily p r h

hm c h s

out d

work by

having wrongly guessed thc

e uilibiium wage

rrte.

AS

UK

tionol-~tio~~ theory

says

L t

yy

x.

.R

pnir

tently make

thb

mistake. m voluatrry unempioyment will

mt

pen&.

So unemployment ten& to be at

h

n m t n l nte .

It

uiso

kawe m e eople

chose

to

be

m c m w .

beclue

they

a n

et a higher

p lo ym at pay and other state

be*Ybie

han

from

a job. ulua

Moacc.rW.

'lh rt-kmmm e u r b t

b R a m

Milton

Friedman, k n g of Chiago Universitymd

DOW

a t the

H m

lnsntutioa in California;

British

m u indude Si

Al8n

Walten, rbo was MR brtdnr 's emaomic rdvberduring het

government s fim tenn. Monetarists

klim

that eoonomia

have a natural tendency to full employment. but that t hb a n

take K\'cILJ WUI 8 achieve

k w oric

r d

wages adjust

ratherMy ome

monetarists

hink &peaations

ntiohd;

o t h m (indudingMr Fticdman) tend

to

ue hem s ennpol8-

t n

or

oth r

mason

why

mmmk

may

k

dw

o

return to fdlcmp loym cot quilibriuhr.

Some

db fa sh ~o ne d onetarists sti ll

unue

hat rehtioavia a

salboost

will

ntcm t rat- but aoidem md, kcruse the

tried to answer

iu

obienions

by

lonnly induding e h a a 6

in econometricequations.

These and other implication

of the mtionaI-cxpmrtions

ap

ad

will often

crop

up in later

Efs.

Thc

appnolck has

klpd

to dcdne new boundaria be

twten different schools of a ~

nomic thought; these u de-

scribed

in

tbe box.

It

b

the

biglat

development in

economic

theory in the past

10

yeam-and

arguably much longer than that.

~ U K

f its sipificmcc. the

~ t io ru l s rp cc ta t ions appn#cb

a n easily

be

untmed to soy

more than it

docs.

At this st ge i

needs

m u s i n g

that the theory

doa not stand or fall simply

on

whether people make instant*

neaut adjustments. Adjustment

hro corm-putting new price

on

p Od S kl a shop, sending

new

C8tdOgucs t o customers, : pen-

ing

wage

negotiations.

wnhng

to

ywrt

bank

to

w it & money into a

deposit account, etc. Pcopk

may

corrrctly expect

the

future but

st ll

decide

t o d e h y t h d r

re-

yome.

f

delay costs

less

than

unmedirte

adjustment, tbcn it

b

tben tioru l thing to do.

LMnvvc illtbeb8sic~LMdiypMiobriettwo)b~ncnid.

But

monctuirtr

of

dl

vintages kli that the only lasting

e f f e c t o f ~ m d c m r n d( W h e t h e T w m e ~ 0r ~ ) w i l l b

on

prictr,

k aw

tbc

lonpnan

8ggrcptMupply

nvve

is

va\ial.

Thus

cbcy

see

no t m ty ing to fine-tune mad,

and advocatettublamdEnteof m-growth.

New Kepdm.

Thb

term

Q I V ~ ~everal N o k l priEc

winaar: in Ansub . Profcuon I l l t ~ ~ tlein

and

James

Tobin; inBritain,

Sir

John H i c b rod

Professor J u n a

M u d c .

'Ibey

a h btlim

tbrt

economicr tend to a full-employmeat

equiliium,

but

tbat tbey m y

ke

many yean to reach it

unkrspvcrnwatsboost

demand

duriag

a

recession fhir will

beeffeetivtiabooaingoutput.theyoy,kcuaetbcsbort-tum

aggr rp tempply

cunt

lopcr

up from

eft to right. In the long-

term.

however. thy

p e with

new d d a l s andmonctuiru

tbat

tbt

suppty c r t ~

s

vertical. sooutput a n

k

ncrrued oely

by rriring

prod-.

New Ktyncs8ns

argue

t h t ccowmia uke

so ong

to

mum

to

full

employmeat boouse

thc

stickiness

of wager

urd

(to a

lesxr

ment)

prices

prrvcaa

~ e t srom clearing. S m t ew

Keyrmiua

see

thisstickinessaspmof thr t expectations rc

not

rational; cornpanics .ndworktn do not l u m from their erron

in fom rr t in g what md

wqa

uc needed to

dear

think

that

expectations ur

ntioarl; the mag b

warn.

vhjch

are

so rigid-bcausc d

amtriar. minimum-mp Lwr.

trdcunio

power.

e t u h r t

tbcy prcvent rome pcopk from gating

job

even tbougb they

want one.

Whrt do hese

dWndom

mean lor

puzzled

finrncem i n b t m

trying

to

stm

their

ccoaomicr to

wainf la t ionuy pavth?

P o p l a r dircuaio4 of ecoaomic

poliy

.dl1 revolver around

Keynerirnivn (oldayle) vcnus moncurum (ditto). But most

academic ~oaomin,hink thrt distinction

i s

at best imlcvant ,

r t wo nt misJeding.

Thty

have #rcpted the rational up cc ta -

tiom a p p r d . m d inm red

it

in both new

ctusicol

md

m

Keynesian theories.

??E

as helped to highlight the

red

diugrecment between the two schools:whether markets clear.


13/18


14/18


15/18

OLS BRIEF-

deficitsdo

b m o d e l sof

the

economyhave slgnlfkmt

p

They

ttw

way

thlt

UI.

gwemnnnter

budgat

* maws

f i ~ n c i r l

aaets for

thuprivate ctw to

hoid.

briefs

have

dinuKd

rded

government

pdky

in

ocomrmy. They

PssumLd

that

an f rreiy nite

sptnding

or

cu t

mu. e-

of what

hap-

t o th e

A finance

is

not t h u simple.

Take

he

case

of

an

ncrease

in

spending.

Provided

tbat

prrvioutly

its

income and urpendi-

its b u d g d e

in spending

will

create

defiat.

That deticit

h q

o

imnnd,

either by

W i n g

to

me

g w e r n m e n t * ~

c;d

t o [i.

ts

d e r i t

doer not

d i d y

d c r r ~ D p B

nearlierbxkb. ~ u t

the defi t

i n t o w w u o t

the demand

side

of th

in

important w8ys'Rccent

have

u r c n d c d

the IS=

framework t o

s b w

bow.

in figure 1

the

demrad side of

economyis

initially

in

P witb

i n t e r n ratesat?$

manded a t Y,. Aoume

the

budget &fitit

is zero

a t

the

g o v a n m e a t

now

Mic spending, tbe IS

we&

rom

IS,

o

1 . and

risa

toY2.

But

me ns hat

gokmment

now &a budget

If

i t finances that & k i t bv

utingmoncy. t h e ~ ~ n r m d

from

LM,

o LMh ' n g

ThetMcurveriUcarryoa

to th e right

8s longu

he

dget defiat persists and the

~JOOSCS o firunoe

it

money.

But

two

will

g n d u d l y

rlw

thh

xrs

and

brine

Ibe emaomv

the

d uid

ace,

nlypriar will

r k .

f

urn

daarnd doa

bring

fonh extra

output

t h b

will re-

d u e th e budget & k i t by in-

a c u i n g

t u

rvtnua & I & LM

cum

shifts,

t e budget

d e5 6 t b

hlling; eventually.

men

if

prices

did not rise, the

economy

would

reach new

lm l of output at

which tbe budge

defidt was

at

to

zero.

The

money

supply

would

no

longer netd to

inawse;

the

economy

would be

back i a

equilibrium.

O n

one

ntrrpma.th,

tp d m

pie

IS-LM

model

unplitly

as-

sumes hat

th e government

cw

en its

deficit not

by

printing

money, but

y

selling

boa .

b

9

n n n

'Ibrt is why

interest

rates rise

when

tbe IS NNC

*fa to

the

rigbtg higher interest

nus ue

the

iaccatk for

ptopte

to bold

more bonds.

But t ha t a n n o t

be

tbe

end of the

story.

becaw if

p""=bp ~"~*,

- n L

aodr of

rwerngrow=

ing.

zo

the

ecoaomy

cannotk

n

tquitibrium.

What

will

k

bc effectof

this

growing stock d

p v c m m c a t

bods?

If

the

printe

rector fecb

wultbier.

it n u v mend more on

-

ma

; t i

w

eqkibr ium.

' @. A bond:hu~ed budget

Tmc ncrrrrc in

diter k i t

wi l l themfore

Ii f t tbc

IS

reduces

the

rul value of

m m q

supply, .ad so

brakes

LM

cum's movc

to the right.

inflationary

p

tbe

curveshifts

u p

aggregate-supply

curve-was

in detail

in

the fourth

of this

series. R e d l

t h t

Keynesian a m g a t e - s u p -

c u m the demand

boost

wiM

both

output

and price.

In

'curve

fwth e r to

the

ight than

the

simple

model

supposed.

giving

r

bigger

i m u c n

demand.

A t

firs

J&t. it seems l i b

doubiecoontmg

to drim rntxrrr

boort

from f i olicy on t h e

p u n thu bond-Gnutdng

mka

people

wealthier.

If

pco

ple how

k m

their money t o

t h e

government

to pay

for public

spending.

how can

they

spend

it

t h e m u t v s

ss

well?

Imagine

m

economy

( ill

with

no

intern#ioml

tndt)

where the

government

has no

income and

no demand for goods

a d set-

vices;

t h e p r in r e renot hts

m

income

of

f

100.

It

spends

flO

of

thb on

its

own output

a d

u v r r i e . spends on mveffrncnt

00. The

government

then

decides

t o spend

flO.

md

born rom

the private

vcror

to finance it

Government

spending

lccds

s tn ight througb t o t k private

-or.

so ts income rim o

f 110.

It

will probably

save

the same

proportion

of

its income

as k

r o d .

f

wtricb

f10 will

be

rpent on thc

new

government

bonds.

fbr rut.

Q3.

v i U be

spent o n invts tmcat

his

is

l s r than before ,

because the

pwfdtnent hu

b ad t o k t i n t u -

at n t a

rise

to make its bonds

8mrctive

t o tb e

public*

squccz-

ingout

some

privrte investment.

In the next

pciiod suppore

government spending

falls back

to

m

l u t

will

happen to

conrumption? It

will bt

higher.

up the

rmltb-eff- theory,

because tbc privrtc seaor now

h a wrw finrncirl ruer,

in tbe

shape of

its

f

0

of govcmtnent

bonds.

Consurnen

feel

richer. so

hra

now

on they

will

spend,my.

71 of

their

income

on c o o s u m p

tion.

and

onty29 on

investment

goods.

Tbot

increase in

tbe

p m

pruity t o coruumeshifts their 1S

CUM to the

rigbt.

The

t h m y

thrt

bond-fi-

rn d

d e f d t

mker

the *te

sector

richer

may be

admet ia l -

ly

sound.

But

Professor

R o k n

Barn

of

Chiago

University

ar-

R

r that it h emwmicr l ly frlre.

c

htc

led the

m h l

of

an

dea

.firs moored by

the nineteenth

centwy Englbb economist. Da-

vid

Ricudo. hence his

ideuh v e

k e n a kl lc d "nto-Rbdh".

~ B u c o i ~ r n ~ i a

ketping

witb t

new

classad

ippnrrcb to eoonomia.

goa

u

followr

Whca tbc p v crn mcn t

~Llrbondstotrnurctiospcnd-

ing.

people rcdu that

it

will

haw

to

rc?vicc (and

~ n n u l l y

repay) its

bomrwing.

7he

only

ctnrin some

of government

revenue s taxes. so

e n n

bonow-

ing

will

in time

mean h igher t u -

er. Thc

private

seaor

ot

tmt

its bond purchase as in-

crencd

wealth. but

u

portent

of increased

turn

T o

prepare

for

that

day. peopk

reduce their con-

sumption

and i m w

their wv-

ingr by the whok amount of the

increase in govenuntnt rpendulg.

As a r l t . not only s there

no

n d t h ef fect in consumption;

the=

b also

no cxpanskm of

demand rhrmgh the familiar

muttiplicr procto.

The effect of

rn

increase in public spending

financed by bond

sales

is

eu c r ly

the

same as

if

the

government

had financed

iu

extra spendin8

by miring t u e s im med ia tel y a d

keeping

iu

budget

balanced.

What

if

the

defiit is

f i n a d

by

printing money?

A

similar

argument applies. a a o r d i n g t o

Profeuor

Barro. The rational

m

n

the

m e e t

will

r c a k h u

printing

money will

in time

in-

creme

inflation. That. in turn.

will reduce

the

real

value

of

bir

money holdihg.

He

therefore

decides

to

save more tomaintain

hi,

red cub

balances.

so his

consumption immediately falh

klow what it

would otherwLe

have

been.

Until Professor Barn 's

contri-

bution, the o bv io us co u n t e r a -

gumcat to thcx' nco-Ri i rd ian

v i m

was

to. .ugue t tu t a

c u

d efe rml

is

the

ma best

th ing to

a

tax

not

levied.

If today's

con

s u m u nr

hat

$

budget dcfKit

will

raise

m u aid by

futurt

gcncntiom. they have no-

t o i n m w

heir

own

w i n g .

So

a

budget deficit

will

have multiplier

tffem

in.

rhc

shon-run. and

Keynesian demand mampnm

an

k

ffective.

Not so.

aqued

Rdesoc

Buro. f houvholQ cnrr lbout

succeedin8

generatiom. tbq

hove

eflmiwly infinite t m e

monr.

Pamlts

wtw Lnor Ihn

t k i r

children

wll hawe

ro

re

higher

taxes

in

thc f u ~ m

errvv

of an ncrc;r*c

In thc

huJCclMI

a t oday

uort

u v l n F

mrrc mmc-

dbte ly . u p n

o k~*c

h r r

chrC

dren

v

higgcr

h1 61 . They

n U

cut thew

olmumpm awl

lrrrl

out t k rrrp;mu*luly cna35 of

I ~ C

c r i .

l h r s rk-llry. ) k c m s h ofthe

debate

ah- mu

da= .d

o m k

vcaa

lr, b u k c a ~ ~ -

m m

nno thrae vho t h k

fl

o t n k d y

Ilu

h w who

th~nk rt too prrportmus

f

YO One cnt~. Ruicwr

m

obm

of

Y a k

Un~v ers l iy .

managedto u k c

he

J urnus-

4y

jw h g m u g h tom t e down

m e bjccuom.

Here

arc two d

the

most


16/18

.

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17/18

BRIEF

supply

isw

&&dent

t h t etoaonrbo

Lm attention to tbe

t b a q

emrn and more to

tbe tbe-

d

supply during

tbc 191(k.

urm

kreascs in

the

of

oil confrontedtbem with

m e . Tbe

oil shocks

urn

to h v e big effects. but the

with aggmpte

de-

m d e

it

bud to

see

wbat

rrdght

be.

Ecoaomia

aeeb

qpty-ridt

tbeoria to sbow

ation"--high

uncmpky.

combbed with high

Farimplidty trkethetucd

lo induma m n q

m

the horl

rum*

at leas) a

rmopnt o f botP vil

be

tDP en-araa.b e r r a e q u i v r t e n t c o a

of figure

1.

kamd,

beamc

ail b mole

iirmr win be redud. So

tbe

cowt

to rrrr

sunmhac be-

m a , and

Y,.

But

if

it

out to

be

a h 2,

t h t w a ~ M

imply

r

kwl

d

e m p m t

yutu th.a N1, open* po-

sition.

Baause

the poducbon

fweiofl hu

shifted

down, em-

ploymmt rnigbt

be

b i w even

though

outputhr

allen.

Tbe &tion to this pudax

lin in

figure

2.

As

t e fourtb

-brief

ia

this =ria arpl.ibed tbc

labour

h a djusts

to 8

om

cquilibriuxuat r higber

prias level

through

shifts

in

tbe

danrad

supply

wu

for

labour.

Hi*

pnccr mrke firm, \nnt to hire

more

workem

at

the going wage

rate

kcrust tbe

mrrIparl

P-

m w )

w d c m

wurt

to reduce

tbeit rupply

of

Irboor, k a w a he red wlge

is

k m r f o r m r y k v e l o f t b c ~

nr lar~ntc.Sotogcr [r rwY~

3,tbcISadLD

t b ~ I m l o f em p k ymm t i r

~omewbat

twcm

N, rod Nl.

ButiftheLDcrrsvcrhiirrupa

kmg~y , i ad t J IeLScr~veJh i l t s

in 6 2

T'ogctbcr;

t hmp cut output

fim

o Y x a a d t b e o t o Y,

Tha 8sstmu

that tbe ovrrg

Y38nd.

s

to

.

Thenatst isf8miK8rtrom

t

PI.

-.

demd

in Flclorirs

u P,Y&

So

tbe oil-

mhad

outpm--rpe combi-

UY

Whabuttbevorten Tbe

qmraMdf ipu r r r 1

to tht whetbe?

of rr,

o ~ l p n c e

ike. To

see

look

at

figure

1.

Output

rigbtdN;infigure%implyhga

& i * l e v t l o f e m ~ t b r v r

b e f o n t b c o i i ~ T h t d

hppn --caa~y

h t r ~ F ~ s ~ a ~ i n -

ceahvc

to SUbrdWe L.krrp

fa

-p.

,

' I b r r , d ~ . i r t b t c r s e o f

arvc. Tbo

a l c r s s , w i t h a v a f i c l l ~

g t ~ ~ p p t yrrm.

the

f d

br id inthr~SbOwd, i f tbt

Lbaumutetdjurtrmrtrrm-

~ o o ~ p r i m , e m -

=

i nm t l iUabov cN ,

2.tbekvclto*it

d r o p r o o o t h n t b c o i l ~

F h n n r b u p o i a t , L S . a d w

curvrrrir t g e t h e t , bdcplg

ral

~ a r o r u m r r p n o c r n r e b a n

PI o6~ 3.

M a C O & 8- t h t

h

du r i a lm od c b g i ~ e r ~ t r u c r p i U

m e han the Kcyncsi8a

model of

tbc

long-term state of the

caxm

my.

Thb

i s

depraring:

an

it

r a U y k ~ t h r t . n ~ i n

tbe

*the

piee

of ra

ervatirl

import

like d

will pmumdy

nhc tbeknldooempbymem.

Y a .

unksr vorlren

ut

willing

to

w r k as hrd rr

they didkfm

8 n d f o r l o m r r u l w a ~

Sucb

8

dMp

Of

UtiNdtr

would

rhift the

8gpegat.e urpply

C L L m ( i n b 0 t h " ~ " d

''dusical"

modtlt) but

ta

the

right*

restoring

emplaymmt.

But

r-tbeor)rdkbourmpply,

which thinb of iadividub

prd-

ing off income

apinsa

kiurt

a n ~ u p w i t b m r r u o n w h y

rnituda should

c luy. When

hll.u,wiUIhcurpp

oorrra

it bclp a, q h i n

tk

r t r * ~ o f t b c

1m.

Sonof Philllpscurve

~ t b e b r i & i a & v l i c r b r v e

u s e d 8 r y p ~ O f ~ U l 8 f ~

called

amlpuativt

ShIiCs.

Thir

metbod rrspma that economic

(8

in

sy-l-t

POW.

ehnp in

oil

pnca. ctc)

m0vctbeaconomyfmrmoaest..

blepositiontoanotbcr.~pru-

ticc

lm-mcvm* oappomn,

are

amr~rra.Intbe)upa,tby

u dynamic . Mucb.of the

most

m c u l t m o d a n t k a y ~

t ir dyarmirm. A

hrnfurbrrbsd

rthtionrhip-tb.

PhiUip-

- - i n a n y t b r t W f u r t b t r l i g h t

onthc

onomy'stu y&e.

Tbe ari#inrl rad

P

i hil-

bpawewadnvainmutick

ia

1958.

It

pkned

inflation

(m,

hanges

in

wage

rates)

against

u em loymentmd found

t

hat

w b m

i n

tionwas hi*,

un-

employment w u ow

and

vice

veru. The rclatioruhip

seemed

to

hold good for

many yem

and

in

different

awntria. I t

waned

u, suggest

that

r

govenunent

b m

to

cut une

Joy-

a n t

u

toleratings 1 & 1 1 3 *

ttn t e of inflation.

By the h t e

194

that

happy

rclatiorahip

a.u

breaking dom.

Tbe

Phillips

curveseemed to shift

upwads

over time, u, t&t a

pu\iarlu level of

wumployment

comrpanded

to ever-higher in-

flationnta How economic

thaniwaammt

for thh?

la a

d y d c

ummy , w r g a

.adpricesa n oth be ncreasing

at

anwtDt

Icwls

of

mp t .

em-

oymmt rod ager. In d-

ea be

mggrrg8te

&mad

.ad

l y ~ u t

G :=

time.

If

tihe

camooly

is g m i n g , output

M d

r e d v r g e s cmrb ob e r k n t am -

tia#nuly.

S

the

growth

rate of

a p t 3%

r

yur

m i ~ t l i K a t S r y t u d w ? g a

u 8 % r y e u , r t l a t a a m ~ u a t

kvclof

calploymeot.

Ibc cluckl idea khhd tbs

tbaoretialPhillipcplr.ebth.t

tba rate

of oaeue inmgu ( a d

~ ) ~ d e p c o d ~ ~ ~ ~ d c

0 f J r L . h t h c Lbau~ e t . K

tbc eran

rupply of

I.bout is

hi@,itdlhrveamaagbLmp

dlea

on

tbe

~g

pia spinl .Thhisrnerdemmt

m rbecumomicmodelducxii

intbercbriefr: t b c v d d ~

p l a y m e n t ( t a k e a m a w r r m b o (

a r r r r L b ou r r t l p p t y } i s ~

t o b r v e r o e d [ t u o a d t e r ~ 1 ~ 8 t

*wycr(=dpriqr)*%.

H c pruaoaud hr

tnrcprjcelDue8laIbo&cr~

r r r e U ~ ~ c h a @ . U r t

some

given h l

f

unenlpltq*

Mm.-c rpoapn 'o~

rise by 10%,

they vin

raise

theit

vagt

demand to

10%

a k m hat

it wa

before. 'lhir chnges

the

W i l l i p a a r e

F 4m Pld

crnve (SRPC)

ndr

Longmn

RLNC

0 uppae

tbc saraomy s

at

point

A on tbc

sht-mn nrv

o d

the g o v m

rntDtdtddatOrrpurddtrmndt0

redlbce Lbc

tumqqlneat rue

from

U,

o

U*,

p m t 5.Lnwa

mnaployment

mans

leaslackin

the abour mukct a d en=

the

n t e of wage idlation riw

from

WI, to

WI,.

But

in

due

caunc.

the

cast


18/18

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school's brief

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