Peter Hurford (ECON 301 – 1)

Inflating our Way to Employment and Investment Confidence: How to Maybe Fix the US Economy

To anyone who has watched the news, listened to the radio, read a newspaper, or

browsed the internet, it is exceedingly clear that the economy is in some sort of trouble.

Many have even experienced the troublesome economy first-hand, experiencing pay cuts

or even outright layoffs and prolonged unemployment. From an analysis of the data

given by the Bureau of Economic Analysis (BEA) in Figure 1, we can see that there was

a major decline in Real GDP growth from the beginning of 2008 until the end of 2009,

with GDP growth now seeming to return to a normal state of roughly 3% growth[1].

However, the Bureau of Labor Statistics (BLS) indicates that another measure of

economic distress, unemployment, has not yet come down with this GDP growth.

Instead, the unemployment rate has remained steady at roughly 9.6%, currently at 9.8%

as of the beginning of November with 15.8 million Americans unemployed[2]. Since

being unemployed typically indicates a separation from a source of income and therefore

an inability to maintain an economically stable lifestyle, unemployment is the most direct

and noticeable psychological manifestation of a struggling economy. Therefore, in order

to “fix” the economy in a directly noticeable way in the short run[3], the US Government

and Federal Reserve (the Fed)’s goal to fix the economy should be to find a way to

increase employment back to full employment, which can be done by returning the Real

GDP (Y) to the desired level of GDP determined to produce full employment (Y*).

[1]: The Bureau of Economic Analysis’s National Economic Accounts (http://bea.gov/national/index.htm) [2]: The Bureau of Labor Statistics’s The Employment Situation News Release (Nov 2010; http://bls.gov/news.release/pdf/empsit.pdf) [3]: According to the LRAS-SRAS model, the economy will automatically return itself to full eployment eventually in the long run. However no one knows how long the long run is.

How unemployment is fixed varies immensely on what kind of unemployment it

is – whether the abnormally high unemployment seen in the recession is cyclical, the

result of insufficient aggregate demand (AD) to provide jobs for everyone who wants to

work, or structural, the result of a mismatch between the skills of the workers and the

skills needed for the job openings. J. Bradford DeLong, a Professor of Economics at the

University of California Berkeley, argues that if unemployment truly was structural we

would see certain industries thriving with a wide variety of job openings and unmet

demand yet no one with the skills to fill those openings[4]. However, DeLong states that a

look at the economy reveals that unemployment has fallen about equally in every single

sector of the economy, except health care, the internet, and logging and mining. The

BLS concurs with DeLong’s assessment, also indicating a drop in employment across all

sectors[5]. Furthermore, if there truly was a structural unemployment, the job openings

would closely match the amount of unemployment, but would just not be filled due to the

mismatch in skills. Yet the BLS indicates that there are only 2.9 million job openings as

of the end of September, hardly enough to match all 15.8 million unemployed[6]. We can

also see from Figure 3 that there was a prolonged drop in the job openings rate

throughout the recession, which is not consistent with structural unemployment.

Therefore we go with DeLong’s assertion that we are currently clearly facing cyclical

unemployment.

Given that we need to solve cyclical unemployment, we turn to the Keynsian

Economic Model to figure out how to solve it. Both DeLong and Paul Krugman, a

[4]: “Is Today’s Unemployment Structual?” by J. Bradford DeLong in The Economists’ Voice [5]: See footnote 2. [6]: The Bureau of Labor Statistics’s Job Openings and Labor Turnover News Release (Sep 2010; http://www.bls.gov/news.release/pdf/jolts.pdf)

professor of Economics at Princeton University, argue that cyclical unemployment can be

alleviated by the Fed setting Monetary Policy to achieve a significantly higher target

inflation rate over the next five years – DeLong wants to aim for 4%[7] and Krugman

wants to aim for 5%[8], both significantly larger than the current aim for roughly 2%.

Both of them also insist that this rate has to be locked-in, publicized, and guaranteed to be

the rate for the next five years – indicating that this rate should be the expected inflation

that all buyers, sellers, and investors should operate under, which would be undermined

with the introduction of doubt or uncertainty into the rate.

The validity of this theory can be seen with the implementation of the IS curve,

which shows the positive relationship between the real interest rate (r) and Y – achieving

a lower r will indirectly raise Y via an increase in investment (I). However, r is a

complicated mechanic not in the perfect control of the Fed. Instead, it is derived from a

factor that is in the perfect control of the Fed – the federal funds rate (rff) controlled by

open market operations – and two factors that aren’t in perfect control of the Fed – the

term premium (rT), a factor that increases with duration of the loan, and the risk premium

(P), a factor which increases with the perceived risk that the loan will not be repaid.

Essentially, r = rff + rT + P.

Prior to the economic crisis, r was kept at roughly 8% through the Fed

maintaining rff at 5% and the typical value for P in loans to the business sector being 3%.

In November 2008, it became clear that there was a crisis, resulting in a downard shift of

[7]: “Ben Bernanke Could Fix the Economy Pretty Quickly” by J. Bradford DeLong in his journal Grasping Reality With Both Hands (Nov 1, 2010; http://delong.typepad.com/sdj/2010/11/ben-bernanke-could-fix-the-economy-pretty-quickly.html) [8]: “If I Were King Bernanke” by Paul Krugman in his journal The Conscience of a Liberal (Nov 1, 2010; http://krugman.blogs.nytimes.com/2010/11/01/if-i-were-king-bernanke/)

the IS curve, placing the new value of Y far below Y*. The Fed reacted to this by

dramatically reducing rff as far as it can possibly be reduced, to roughly 0%, which

stabilized Y back to Y*. However, a later impact of the economic crisis was a crisis in

consumer confidence, which dramatically increased the fear that loans would no longer

be repayed, thus dramatically increasing P, returning r to 8%, again putting Y far below

Y*. This three-step process can be seen graphically in Figure 4. The solution to this so

far is the current Monetary Policy implemented by the Fed in two instances of

Quantitative Easing has been to increase consumer confidence and drive P back down,

which has resulted in bringing the nominal interest rate down to about 0%.

Now that rff has been lowered as much as possible, there isn’t much more

leverage to be gained by lowering r. It is also possible that r could never match Y* if Y

and IS are positioned as shown in Figure 5, because it is impossible to create a negative r

due to the laws of money demand. We could be in what Krugman refers to as a liquidity

trap, the point where monetary policy becomes useless because of the futility of trying to

lower r below 0[9]. Krugman outlines that indicators of a liquidity trap are AD is

significantly lower than aggregate supply (AS) and monetary policy being pushed to its

limits yet the economy remains in a depression. Arguably, both indicators are true here

since we do have an AD problem as shown by the BLS and DeLong, and current

monetary policy has not yet brought unemployment down.

However, what Krugman and DeLong argue for is a focus on the nominal ex-ante

interest rate (i), which equals the sum of r and the expected level of inflation (πe) and is

the actual interest rate given for a loan. From this, we can re-derive r from the Fisher

[9]: Japan’s Trap by Paul Krugman (1998; http://www.princeton.edu/~pkrugman/japans_trap.pdf)

Equation, where r = i - πe. If i were to be held constant at a known value, r could then be

made negative by increasing inflation. Fortunately we do know values for r, i, πe to some

degree of accuracy – as i is known definitively, πe can be determined via the Consumer

Price Index (CPI), and from these two measures r can be calculated with the Fisher

Equation. The Fed states that i is currently about 0.16% before adjusting for term of loan

and risk[10], and the Cleveland Branch of the Fed states that πe is about 1.6%[11]. This

places r at about -1.5%. Since it is difficult to drop i to 0% (and would result in little

impact on r) and impossible to drop i below 0%, the only way to further decrease r is to

further increase πe, which is done easily by promising a much higher inflation rate on a

term long enough to significantly effect all loans. Krugman’s suggestion of targeting 5%

interest for five years would place r at approximately -4.8%, which may be low enough

to meet an otherwise inaccessible Y* such as in Figure 5. Since the value of Y isn’t

known without further calculations that cannot be done here, we will state that the

targeted interest level is going to be the interest level that produces Y* within the IS-MP

model (r*).

Raising inflation can be seen to solve the economy in a different model – the

SRAS-LRAS curve. In this curve, Y in the short run is determined by an intersection

from short-run AS (SRAS) and AD, which is stated to also equal the quantity of money

(M) times the velocity of money (V). The raising of inflation will make the demand to

hold money (MD) decrease due to a fear that money will not have the same purchasing

power, and thus will increase the rate at which money is spent, increasing V. Combined

[10]: Calculated from the Federal Reserve’s Selected Interest Rates (Dec 3, 2010; http://www.federalreserve.gov/releases/h15/update/), with the assumption that the one-month nominal interest rate stated is representative of a base nominal interest rate that has undergone no adjustment for term or risk of loan. [11]: Cleveland Fed Estimates of Inflation Expectations News Release by the Cleveland Federal Reserve Branch (Nov 17, 2010; http://www.clevelandfed.org/research/data/inflation_expectations/index.cfm)

with the fact that the way of raising inflation will increase M itself, since M increases and

V increases, the quantity MV increases, and therefore AD also increases. If the amount

of inflation is sufficient, AD will equal (or exceed) SRAS and therefore return the

economy to Y*. The slide of the economy and the response by increasing inflation

within the SRAS-LRAS model can be seen in Figure 6.

However, targeting an inflation rate is just that – targeting. If it isn’t exact, how

can we ensure that we can reach r* in a controlled manner? First, to what degree is

inflation uncontrolled? Inflation is increased by increasing M, however the fractional

reserve banking system will create a reserve effect that will greatly amplify the increase

in the money supply and is outside of the Fed’s control. The reserve effect is controlled

by the reserve-deposit ratio (Rrd) determined by the banks’ desire to exceed the federal

funds rate and the currency-deposit ratio (Rcd) determined by the people’s desire to

deposit money in the bank – specifically if the Fed increases M by J, the reserve effect

will result in a total increase of M equal to J[(1+Rcd)/(Rrd+Rcd)]. If either of these two

ratios were to fall, the reserve effect would also fall, decreasing M and therefore AD,

making it harder to heal the economy. If either of these two ratios were to raise, the

reserve effect would increase, increasing M and therefore AD, potentially surpassing

SRAS and therefore opening up the economy to a permanently higher price level (P), as

seen in Figure 7. Instead, if we manage to get M just right, the price level will be higher

only in the short run, and in the long-run the economy will return to an optimal state of a

normal, acceptable P (P*) with Y*. This is the fear of the Fed – they may not want to try

a Krugman inflationary policy for fear of overshooting r* and therefore creating P > P*.

Now on how to control the increase in M to target r* without overshooting and

therefore causing P > P* or undershooting and therefore causing Y < Y*, both of which

are undesirable. This can be done by taking an opposite policy than the current Fed is

doing – instead of subsidizing reserves to keep Rrd artificially high and far above the

reserve requirement (Rrd*), we can return Rrd to an ideal level by changing Rrd* to that

ideal level and taxing reserves sufficiently that banks would be motivated to return Rrd to

match Rrd*, a position taken in Sweden and advocated for in America by Bruce Bartlett,

an economist who served in the Reagan and Bush Sr. Administrations[12]. Such a

reduction is likely to increase M all on its own without needing an increase in M, since it

will encourage additional lending and therefore amplify already existing M via the

reserve effect with about $1 trillion in excess reserves[13]. Robert Pollin, a professor of

economics at University of Massachusetts-Amherst, suggests that if this was carried out

with a tax of about 1% to 2% and with an additional $300 billion in loan guarantees, the

measure could create 3 million new jobs from the increase in I at little cost to the

deficit[14]. As this is not enough to cover all of the unemployed, it could be magnified

with additional increases in M by the Fed.

One last additional benefit to this monetary policy isn’t directly economic, but

emotional. Since I directly rises and falls based on confidence in the market and only

indirectly on actual values and indicators, this plan further recovers the economy by

[12]: “Don’t Subsidize Reserves, Tax Them” by Bruce Bartlett in “Experts Weigh In: Can the Economy Be Saved?” in The Los Angeles Times (Nov 14, 2010; http://www.latimes.com/news/opinion/la-oe-economists-20101114-web,0,4478455,full.story) [13]: The St. Louis Federal Reserve’s Excess Reserves of Depository Institutions (Dec 3, 2010; http://research.stlouisfed.org/fred2/series/EXCRESNS) [14]: “Large deficits remain essential” by Robert Pollin in “Experts Weigh In: Can the Economy Be Saved?” in The Los Angeles Times (Nov 14, 2010; http://www.latimes.com/news/opinion/la-oe-economists-20101114-web,0,4478455,full.story)

raising I via raising confidence. Ayse Imrohoroglu, a professor of business and finance

economics at the University of South Carolina’s Marshall School of Business, argues that

the economy is at an impasse because investors hold onto their money rather than use

them to invest – while increasing interest rates will decrease their desire to hold onto

money and thus increase their desire to invest, a clear policy of targeted inflation and

therefore a clear and promised policy of exactly what will happen with interest rates will

increase confidence in the market and thus further increase I and therefore Y[15].

This plan can be further solidified if the government were also to clearly promise

expectations for future taxes and business regulations over the next five years as well.

While the fiscal policy side of saving the economy takes a back seat to the monetary

policy in this plan, Imrohoroglu argues that fiscal policy also needs to be structured and

promised in order to insure investment confidence. This could be done by a promise to

allow the Bush tax cuts to expire for the wealthy but stay for the middle class and then

freeze both business taxes and business regulations over the next five years so that

investors know what they’re getting into. Imrohoroglu also argues that Unemployment

insurance benefits also need to be extended and Krugman concurs, stating that

maintaining unemployment insurance benefits by perpetually extending them as long as

employment remains low (as long as Y < Y*) is the best stimulus possible, since nearly

all of that money goes right back into the economy in the form of consumption[16]. Since,

however, the monetary policy is based upon increasing investment, government spending

(G) should not be increased by directly spending on goods and services since that would

[15]: “Uncertainty is killing confidence” by Ayse Imrohoroglu in “Experts Weigh In: Can the Economy Be Saved?” in The Los Angeles Times (Nov 14, 2010; http://www.latimes.com/news/opinion/la-oe-economists-20101114-web,0,4478455,full.story) [16]: “Punishing the Jobless” by Paul Krugman in The New York Times (July 4, 2010; http://www.nytimes.com/2010/07/05/opinion/05krugman.html)

crowd out investment and it shouldn’t be decreased since this would negatively affect the

economy. Furthermore, as Krugman argues, the government needs to move away from

attempting large-scale deficit reduction (raising taxes, lowering spending) until the

economy recovers[17]. While fixing the budget deficit is certainly important, fixing it now

is perhaps the worst possible time, as the involved increases to taxes and decreases to

spending necessary would negatively impact investment and consumption, and therefore

slide the economy back down. Perhaps budget deficit reduction plans could be

considered and then put into place after a five-year period has passed, to make sure the

economy has time to recover first.

In conclusion, under this plan government spending should be held constant

(except on transfer payments to the unemployed), taxes should be raised on the wealthy

and then kept constant for five years, business regulations should be held constant for

five years, and Y should be increased by raising investment via dramatically lowering r

via dramatically increasing the targeted inflation rate via dramatically raising the money

supply in a controlled manner via taxing excess reserves and increasing the money

supply.

[17]:“Now and Later” by Paul Krugman in The New York Times (July 20, 2010; http://www.nytimes.com/2010/06/21/opinion/21krugman.html)

Figure 1: Quarter-to-Quarter Growth in Real GDP

Source: Bureau of Economic Analysis, http://bea.gov/newsreleases/national/gdp/gdp_glance.htm Figure 2: Unemployment Rate, Seasonally Adjusted, Nov ’08 – Nov ’10

Source: Bureau of Labor Statistics November The Employment Situation, http://bls.gov/news.release/pdf/empsit.pdf

Figure 3: Job Openings Rate, Seasonally Adjusted, Oct ’07 – Sep ’10

Source: The Bureau of Labor Statistics’s September Job Openings and Labor Turnover, http://www.bls.gov/news.release/pdf/jolts.pdf Figure 4: The Three Steps to the Current Economic Situation as seen in the IS-MP Curve

Lowering r by lowering rff to re-meet Y*

The crisis occurs An increase in P dramatically re-increases r

Figure 5: Example of an IS-MP Curve Where Y* Cannot Be Reached Without Negative r

If IS falls low enough, no non-negative r will be able to restore the economy back to Y*. Figure 6: The Sliding Economy and the Recovery via Inflation in the SRAS-LRAS Model

When MV = AD falls, Y dramatically decreases in the short run. The recovery involves increasing MV back to where it was via inflation. P is currently at P*.

Figure 7: Overshooting Causes a Permanently Higher Price Level in the SRAS-LRAS Model

If AD is raised too much, it will enter into a state where Y* is reached, but at the cost of permanently raising P above P*.