Among discussing politics, math, and philosophy, one of my other hobbies is discussing economics. Now that I am studying to be an economics major, I hope to bring my economics musings to this blog. As a starting point, I have posted one of the essays I wrote for class. What follows is a modified, edited, updated, and reformatted version of that essay, split into multiple parts.

Problems in the Economy

To anyone who has watched the news, listened to the radio, read a newspaper, or browsed the internet, or just generally not lived under a rock, 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.

But how would we go about demonstrating this? How can we conclusively show the economy is in trouble without declaring it to be self-evident or pointing to individual cases? The answer is easy — use the data. One of the great things about economics is that we don’t actually have to take people’s word for it — instead we can just look at the data.

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 Real GDP growth now seeming to return to a normal state of roughly 3% growth. (Real GDP is referred to by economists as Y.)

Figure 1 shows a recession followed by a recovery over 2006 - 2010. (Graph source)

The Danger of Unemployment

So yay! The economy is back on track! Or is it? The Bureau of Labor Statistics (BLS) also indicates in their November 2010 “The Employment Situation News Release” (PDF) that another measure of economic distress, unemployment, has not yet come down with this growth in Y. 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. Figure 2, a part of the News Release, shows this trend of unemployment.

Unemployment Level from Nov '08 to Nov '10

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

This Y* is the level of Real GDP that will allow the maximum possible amount of employment. Note that this isn’t an amount where everyone is employed, since people will always be moving from one job to another or moving from college to a job. This just a period of peak efficiency referred to as full employment.

Short Run vs. Long Run

One model economists have at their disposal is the Long Run Aggregate Supply / Short Run Aggregate Supply model, referred to as the LRAS-SRAS model. The details of this model aren’t necessary right now, but the main point is that this model distinguishes between the short-run and the long-run — in the short run, we will almost always have some sort of economic problem to address; in the long run, the economy will eventually recover all by itself.

In the short run, we need to focus everything on reducing unemployment; in the long run, we need to focus everything on reducing the budget deficit. Both have trade offs too — focusing on the short run will hurt in the long run and focusing on the long run will hurt in the short run.

It may seem as if we should focus on the long run in order to be most beneficial. However, doing so will create three problems: what I call the length problem, the piece problem, and the connection problem.

The length problem: This problem is named because no one knows the length of the long run. No one knows (or can know) how long it will take for our economy to recover on its own, as if by market magic. It will happen eventually, but it could be a decade, two decades, five decades, or more… This means we can’t just ignore the short run. While “do nothing” may be a valid economic strategy, it is not a sound one at this time.

The piece problem: This problem is named because the short run is a piece of the long run, as the long run is always built out of multiple short runs. We will never actually physically be in a period of long run — the long run will always be in an unchasable future. The long run will always be the tomorrow compared to the short run’s today. That means that short run problems have to be addressed, since we will always be in the short run at any given time. Failing to fix the problems of the long run will create short run problems down the road, not some sort of different long run problem.

The connection problem: This problem is named because the short run and the long run are intrinsically connected. Due to this link, problems in the short run can actually derail the long run, and helping the short run can indirectly help the long run. If we focus on reducing the deficit, we will increase unemployment both directly (the government hires workers that would be fired) and indirectly (government spending is part of Y, therefore decreasing government spending would decrease Y, and therefore increase unemployment). Furthermore, if we get the economy back on track via jump-start measures, we will have more economic mobility to solve long-run problems, since we won’t have to worry about their solutions leading to more short-run problems.

The Type of Unemployment

Now we need to fix the short run economic problems, and this means we need to fix unemployment. But what is unemployment? One of the biggest lessons of macroeconomics is that unemployment is far more than just people out of work. People can be out of work for a variety of different reasons, creating different types of unemployment, and each of these types require a different economic response in order to alleviate them.

The current debate 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. Cyclical unemployment usually results from recessions and can be fixed via fiscal and monetary economic policies, whereas structural unemployment is very severe and could only be fixed by reforming the labour industry and/or a massive retraining of workers.

J. Bradford DeLong, a Professor of Economics at the University of California Berkeley, argues in his essay “Is Today’s Unemployment Structual?” in The Economist’s Voice and in his blog post on structural unemployment that there is no economic indication that the current unemployment is structural and a lot of economic indication that the current unemployment is cyclical.

The best indication of structural unemployment is that certain industries thrive with many job openings that are simply not being filled because workers don’t have the needed skills, followed by a lot of people seeking employment in specific industries that are already filled and over-employed. This creates a testable hypothesis: If there is structural employment, then (1) there would be enough job openings for a majority of the unemployed, and (2) these job openings would not be filled because of a mismatch of labour skill.

DeLong states in his Economist’s Voice article 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 / mining — there are no massive amounts of job openings in any given sector waiting to be filled. The BLS concurs with DeLong’s assessment (see previous PDF), also indicating a drop in employment across all sectors.

Furthermore, the BLS also gives specific numbers in their September 2010 “Job Openings and Labor Turnover News Release” (PDF), indicating that there are 2.9 million total job openings as of the end of September ’10, hardly enough to match all 15.8 million unemployed workers. These numbers simply indicate that the hypothesis for structural unemployment has failed.

Lastly, not only do none of the indicators for structural unemployment appear, but the chief indicator for cyclical unemployment appears — an economic recession. 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.

Initial Solutions

Given that we need to solve cyclical unemployment, we turn to the Keynesian Economic Model to figure out how to solve it. But why would we do that? Well, the problem with every economic model is that it makes assumptions that might not be true. Every model is just that — a model — that tries to fit as nicely as possible but will never be a perfect match. The economy is simply too complicated to model everything at once.

It turns out that the Keynesian Model works very well in modeling a recession economy. In a recession economy, employment is not at full employment — the labour force is underemployed, and employment can be increased. Furthermore, price inflation is much more difficult to achieve and attempts to increase the money supply will be more likely to increase Y. These are also the assumptions held by the Keynesian model.

Inflating Our Way to a Better Economy

Now that we have the background knowledge necessary to know what is going on, here is my main theory for how to (maybe) save the economy: increase the inflation rate. This theory is also advocated by DeLong and Paul Krugman, a professor of Economics at Princeton University, who both 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% and Krugman wants to aim for 5%, both significantly larger than inflation targeting? It’s an easy policy to describe, though not as easy to implement. It works on three principles:

1. The Fed picks a desired inflation rate per year. This is the targeted rate.
2. If the inflation rate appears to be above the targeted rate, preform operations to lower inflation.
3. If the inflation rate appears to be below the targeted rate, preform operations to raise inflation.

The Hows of Inflation Targeting

While inflation targeting is an easy mechanism, it leaves three complex questions unanswered: (1) “What operations lower and raise the inflation rate?”, (2) “How are these operations initiated?”, and (3) “Why would we even want to inflation target in the first place?”.

Question 3 is a very big and critical question, so I’ll have to leave it for a later installment. Keep in mind, however, that any inflation targeting plan is incomplete without an answer to this question. Since I handwaved away Question 3 for the time being, that leaves Question 1 and Question 2 — the basic hows of inflation targeting. Generally, inflation is caused by adding more money to the money supply. However, this doesn’t answer how the money is added, since certainly the Federal Reserve doesn’t just print money and hand it out to random people.

Instead, the Federal Reserve does two things: buy and sell bonds and loan to banks. First on bonds: in order to create inflation, the Fed will simply buy a ton of bonds that are being held, trading the bonds for physical money, increasing the money supply. In order to lower inflation, the reverse will happen — bonds will be sold, and money will be sucked out, reducing the money supply.

Second on loans: the Fed is a bank itself that loans to other banks. When a bank borrows from the Fed, the Fed simply creates the money by printing it, and the bank then gets this money in its reserve, creating money and therefore increasing the money supply. While loaning is always permissible, the Fed can control how much loaning goes on by raising and lowering the interest rate at which loans are made — the federal funds rate. A higher funds rate means less loans, and therefore less money being added to the money supply, and therefore less inflation. A lower funds rate means more loans, and therefore more inflation.

Together, these two operations allow the Federal Reserve a surprisingly large amount of control over the inflation rate. We’ll see more on this in Part II.

Confidence is More Than a Number

Both DeLong and Krugman in their assessments on increasing the inflation rate argue that there is more to inflation than merely making it a higher number, however — for example, if it was done in secret like current inflation targeting is, it wouldn’t work. Both of them also insist that this rate has to be locked-in, widely publicized, shouted from the rooftops, 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 increase itself has a direct economic benefit that I will seek to show in Part II. However, simply guaranteeing a rate — any reasonable rate — is something the Fed has not yet done, and is something that can be done quickly to benefit the economy. This is because a portion of the economy is not directly rational, but emotional.

Unemployment can be decreased by increasing Y (see Okun’s Law), increasing investment can increase Y (by definition), and investment can be increased by increasing the confidence needed to invest. This confidence is increased by guaranteeing a rate, taking away the worry of inflationary changes over the next years.

Other Sources of Confidence

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 (to be unveiled further in Part II), Ayse Imrohoroglu, a professor of business and finance economics at the University of South Carolina’s Marshall School of Business argues that fiscal policy also needs to be structured and promised in order to insure investment confidence — monetary policy can’t create confidence alone.

First, what is the difference between fiscal and monetary policy? Quite simply, fiscal policy is what Congress does with money, such as raising / lowering taxes, change business regulations, or increasing / decreasing government spending on different things. Monetary policy is what the Federal reserve does with money, such as print more money, buy / sell bonds, change the federal funds rate, and change the rules for bank lending. Both are different methods to control the same economy.

We saw that it is quite easy to achieve stability and confidence in monetary policy — simply tell people what you plan on doing and stick to it. Stability in fiscal policy will be the same strategy, however, is going to be a bit more difficult to achieve.

Fiscal Confidence

Now, how do we achieve stability and confidence within fiscal policy? This has to be done by clear promises enumerated by Obama, the House, and the Senate. Business taxes and regulations should be frozen — declared by a clear promise that they won’t be changed — in order to let businesses and investors know exactly what they will be dealing with. (Prior to this, we also could deal with some key fiscal policy reforms, that I hope to further discuss in Part II.)

I imagine that freezing regulations and taxes would be politically difficult, if not outright impossible. In order to be more practical, perhaps it can be agreed that taxes and regulations can be changed, but no changes will take place for five years. This would give businesses more than enough time to see the changes and react to them, creating the same stability.

If this is also politically unfeasible, could the plan still survive without it? Yes. The gain in monetary policy stability alone would be enough to increase consumer confidence by some amount, though it would greatly help to also have fiscal policy support.

Part II Coming Soon

This Part I was purely introductory — nothing substantial was truly introduced. However, due to length, I again feel compelled to cut something I wish could be a single essay into multiple separate parts. The second forthcoming part will seek to use economic graphs and models to specifically analyze the impact of increasing inflation and demonstrate how it will affect the economy. I also hope to discuss what is currently being done by the Fed, possible fiscal policy reforms that could be done by Congress, and discuss why inflation isn’t evil over the next part, though I expect I might need a third part to get it all in.

Part II will address some of this, and I’ll edit this space when it is released. I imagine it will come in sometime next week, so stay tuned.

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