Chapter Seventeen

Freshwater vs. Saltwater

New Classical | New Keynesian

A Profession Divided

In the 1970s, economists split into two camps which each pursued their own programs of economic research. In the halls of universities located around the Great Lakes were the freshwater economists who wanted to abandon the idea of Keynes in favor of a macroeconomics rooted in microeconomics. The saltwater economists, housed in the Ivy League schools along the coasts, rejected these new theories and continued to build on the advancements of the Monetarists and New Classical school.

The Efficient Market Hypothesis

People have made fortunes investing in the stock market. What is the reason for their success? Are they just really smart, or do they have a "sixth sense" about these things. The truth is that they are just really lucky. It isn't that knowledge and gut instinct have nothing to do with it, but there are lots of really smart people with good instincts! What economists and financial experts have found is that your guess about the future price of a stock is as good as anyone else's, because the future price changes are essentially random.

Open Video Transcript

You may have wondered, as many do, if there is a way to predict the stock market. Actually, a lot of people think that it is predictable. When we were talking about the stock market crash in 1929, just before the Great Depression, you may have wondered how people didn’t see it coming. But since we have been talking about rational expectations, I want to quote our old friend Dierdre McCloskey, who had this to say: “Muth's notion was that the professors, even if correct in their model of man, could do no better in predicting than could the hog farmer or steelmaker or insurance company. The notion is one of intellectual modesty. The common sense is ‘rationality’: therefore Muth called the argument ‘rational expectations’.”McCloskey is right in saying that to assume that people are rational is an act of modesty. And here modesty goes a long way. There are thousands of people who professionally analyze data and try to predict the movements of the stock market. And so, right off the bat, we shouldn’t assume that we would be any better at it than they would. But the question is, are the professionals even better than a regular person?--First, we need to understand price movements. We tend to think of changes happening along a continuous line. If a stock is currently priced at $100 per share, and then information comes out that convinces everyone that the stock is worth double that value, then people will rush in to buy the stock and they’ll slowly push the price up to $200. Those who act fast might be able to get in early and make a healthy profit, buying close to $100 and seeing the value rise right afterwards. But this is not how it actually happens. Every purchase of stock is also a sale. There is someone who is agreeing to part with their shares for the amount that you are paying. With this news that the company is worth double publicly available, who is going to be willing to sell their shares for less than $200? Everyone holding the stock will also immediately update their valuation, and they won’t part with it for anything less. The price doesn’t slowly rise to $200, it jumps instantly to $200. Now, if your mind is deep into this course, this should remind you of something. The instant jump in the price is a rapid adjustment. The slow climb in the price over time, well after the news is available, shows stickiness. Central to our understanding of the Macroeconomy since Keynes and up to this point is that prices and wages are sticky. But to believe that is to believe that the world is full of people who would sell their stock worth $200 for something way less. --Financial Economists, observing how prices change in financial markets, developed the Efficient Market Hypothesis. It says that stock prices should reflect all available information. That means whether or not a stock price goes up or down in the future depends entirely on information no one has. That means it is impossible to predict how stock prices will change, and any guess will be as good as random chance. Think about it this way: Suppose you had an old baseball card you never really thought twice about until a friend spotted it and said they would give you $500 for it. You didn’t think the card was worth anything before, so shouldn’t you gladly sell it? Well, probably you would want to know why your friend is willing to give you so much money for it. Is it actually worth thousands of dollars and your friend is ripping you off? In that scenario, the price offered is acting like a signal of the information your friend has. Of course, we already know this. Prices are a signal wrapped up in an incentive, as Professor Tabarrok told us many chapters ago. The same is true with financial markets. As soon as someone had information about the future value of a stock, they have a huge financial incentive to take action on that. And the action they take will serve as a signal to the rest of the market that will rapidly adjust the price to fully incorporate that information. For this reason, economists and financial experts say that the changes in the prices of financial assets are a random walk. There is just no way to consistently beat the market, because no person will be able to stay ahead of prices rapidly incorporating information. Essentially, the efficient market hypothesis predicts that even the smartest experts will do no better trading stocks than a monkey throwing darts at the stocks page of the newspaper. So, do you buy it? Do you believe a monkey would do as well as a seasoned Wall Street analyst? Let’s find out. --My darts landed on 30 companies. How would they do compared to the stocks recommended by managed mutual funds? Oops! Better!From the start of the year till now, the stock prices of the companies hit by my darts increased by 31%. The ten biggest managed funds rose only 9.5%. Ok, I admit, I got lucky. Had I thrown the darts a million times to get to an average throw, my dart portfolio would have increased 12% this year. That’s how much the average stock on that table has gone up. But that still beat the professionally managed funds. How can that be? And how can it be that study after study shows that picking stocks randomly, or buying what’s known as an index fund, a funds that owns a little bit of every stock - has brought higher returns than putting money in managed funds?--In microeconomics, people are assumed to be rational. Like Dierdre McCloskey said, this assumption is an act of humility, and it is one of the things I love most about economics. We don’t look down on regular people, we look up to them. We assume that people maximize their utility, another word for their wellbeing, subject to their budget constraint, or the limits of their economic conditions. In other words, people do the best that they can. Finding the implications that these assumptions have for how our economy will make use of the resources and technology we have in order to satisfy human needs and wants was the great project of the classical economists. And it gets pretty far in understanding our actual world. In reality, humans are not perfectly rational, but their economic behavior comes pretty close to what an assumption of rationality suggests. But after Keynes, this assumption of rationality was thrown out of macroeconomics and the next generation of economists came up learning about two contradictory views on how the economy functioned. Some wanted to bridge that divide, but others wondered if it was possible to throw out the Keynesian-inspired macroeconomics all together and form a theory of the business cycle rooted in concepts like rational expectations and the efficient market hypothesis.

Real Business Cycle Theory

What we get out of the Efficient Market Hypothesis is a lot of evidence that markets work just as well as we could ever hope they would. The Stock Market seems to rapidly and efficiently incorporate complex information from around the world almost instantaneously! But without any market failures causing price and wage stickiness, the Keynesian view falls apart and we are left needing to explain how something like the Great Depression could happen. Real Business Cycle (RBC) theory is that explanation.

Open Video Transcript

Imagine yourself as an Uber driver. It’s your full-time job, and you spend 40 hours a week driving people around. Some days are slow, and there just aren’t a lot of customers. You spend a lot of time just idling waiting for a ping to go pick someone up. Other days are busy, and a new ride pops up as soon as you drop off the last one. Here’s the question, on which day should you work more? If you’re smart, you’ll work more on the busier day. Your productivity is higher when the demand for Uber rides is high. You produce more rides per hour, and therefore earn more money per hour, than when you would if you weren’t busy and spent a lot of time idling and earning no money at all. You’ll be able to earn enough to pay your bills faster if you work more when its busy. And of course, that is exactly what Uber drivers do. They try to be on road during peak business hours. But in this example lies an important observation, because this behavior doesn’t apply only to Uber drivers. All rational people should be trying to time their hours spent working with their peak productivity. --Microeconomic theory tells us that people will try to maximize their utility subject to their budget constraint. One of the choices people face is the tradeoff between labor and leisure. In this case, the budget constraint is time, and time is scarce. We have to choose how we use it. If we want to maximize our well-being, we will work when the benefits to our labor are high and choose leisure when the benefits to our labor are low. The benefit to our labor is our labor productivity, usually measured as output per hour. If conditions are right and we can get a lot of work done in a little bit of time, then that is the right time to do it. If conditions make working hard, and you can’t get much done even with a lot of time, then that’s when you should take a break and enjoy some time off. That’s what the Uber driver is doing and that is what everyone else should be doing too. Family-owned restaurants are open on the weekends but closed on the slowest couple of weekdays. Companies ask employees to hold off on taking vacations until the big deadline has passed. Airlines run fewer flights at night because the demand is low. --That’s the microeconomic situation, but on the macroeconomic level, labor productivity isn’t smooth. It fluctuates up and down. There are times when the economy overall is seeing rapid growth in labor productivity, times when that growth slows, and other times when labor productivity falls. These fluctuations could be big enough to drive the business cycle. Maybe, just maybe, recessions aren’t the result of animal spirits or monetary shocks causing a shortfall in aggregate demand. Maybe they are just the rational response on the part of workers to time their labor supply with the conditions that yield the biggest return on their effort. --The 1970s provided a clear example of how this might play out. In 1973, oil producing nations conspired to reduce the supply of oil and force its price to skyrocket. The sudden reduction in oil wreaked havoc on the economy. Oil is an important resource, used for many different types of fuel, plastics, and other consumer products. As a result of the shock, gas stations were running out of gas, and many other industries were struggling to maintain their levels of production. Unemployment spiked to 9%, the highest it had been since the Great Depression, and the economy just didn’t seem to be working right. In 1979, the president even got on television and tried to give the nation a pep-talk that ended up being very poorly received. But you’ll notice that the fall in labor productivity pre-dates the recession. The economy just wasn’t great in the 1970s, and the reason had nothing to do with insufficient aggregate demand. It was due to a technological shock, a change in the productive capacity of the economy which reduced the productivity of labor. Since the rewards to labor were depressed by these external conditions, people were wise to choose to work less and leisure more, meaning a drop in GDP. Indeed, people worked about 1 hour less per week on average in 1975 than they did in 1973. --These observations gave birth to a new school of thought called Real Business Cycle Theory. It makes sense that people would work less when the return to their labor is low, but the question was whether or not technological shocks – these economic setbacks that are out of people’s control and reduce labor productivity or slow its growth – were enough to explain the size of the fluctuations in the business cycle. Is it even possible for a technological shock to be significant enough that a downturn as large and long as the Great Depression could even happen? The economists Ed Prescott and Finn Kydland embarked on a research program to find out. Rather than use the macroeconomic models like aggregate supply and aggregate demand to understand the economy, they constructed a mathematical model which represented the entire economy as one person, a single representative consumer whose choices would correspond to the average for the whole economy. Using historical data, they were able to show that fluctuations in labor productivity were just about exactly enough to result in the ups and downs of the overall economy. In fact, the choices of their representative consumer fit the historical data almost perfectly. Many were stunned. It meant this whole problem of business cycles – the central focus of this half of the course – was not the result of some sort of inherent instability in our economic system, or a flaw in markets. This whole time we have been thinking of growth in the economy as something that follows a trend. That an event like the Great Depression represents a deviation from how the economy should have been, a downturn from our potential. But what Prescott and Kydland were saying was that the trend is an illusion. What you see, the ups and the downs, is the trend. Even though the Great Depression was bad, it still represented an economy functioning as well as it possibly could have been. And our frustration with it is a frustration with people choosing to reduce their labor supply in favor of some more leisure because that is what was genuinely best for them. Economists trying to end the recession are basically the guy pounding on the door of the store owner while they spend some quality time with their family demanding they open the shop back up and work instead. In 1986 the economist Larry Summers said, “If these theories are correct, they imply that the macroeconomics developed in the wake of the Keynesian revolution is well confined to the ashbin of history.” But Summers, and many other economists, weren’t buying it. The model couldn’t make forecasts, and therefore couldn’t really be tested. It could only explain events after the fact, and Prescott and Kydland couldn’t offer any other examples of supply shocks to explain any recessions other than the one in 1973. Summers said, “The image of a big loose tent flapping in the wind comes to mind.” Still, the pair Prescott and Kydland were awarded the Nobel prize in economics in 2004.

Supply-Side Economics

The freshwater economists had an ideological agenda that has its roots in the philosophical opposition to Keynes' belief that government interference could benefit the economy. They assembled mountains of evidence that government programs which interfere in markets lead to unintended consequences that leave people worse off. And RBC models were showing that FDR's New Deal slowed the economic recovery, rather than helped it along. This ideology would find its champion in President Ronald Reagan.

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The freshwater economists like Ed Prescott at the University of Minnesota and Finn Kydland at Carnegie Mellon were joined by other academic economists working at universities predominantly located around the Great Lakes and constructed a theory of the business cycle which completely abandoned the Keynesian framework in favor of a view that was consistent with the conclusions of microeconomic theory. Markets worked, and government interference – contrary to Keynes – would only hurt the economy, not help it. --It is impossible to separate the economics of these freshwater economists from the free-market ideology that was the cornerstone of the conservative political movement which found its footing in the 1964 presidential campaign of Arizona senator Barry Goldwater and culminated in the election of President Ronald Reagan in 1980. In much the same way that Keynesian economics found itself a perfect marriage with the presidency of Franklin Roosevelt, freshwater economists found in Ronald Reagan an opportunity to influence public policy in their direction. --Real Business Cycle theory claimed that recessions were not the result of shocks to aggregate demand, as Keynes and those who followed him believed, but rather the result of shocks to aggregate supply. The countercyclical policies aimed at managing aggregate demand would be ineffective, and in many cases harmful to economic recovery. The only way to help the economy – these economists said – was to try and boost aggregate supply. From this came the moniker of supply-side economics, which would be the intellectual backing of Reagan’s economic programs. --Legend has it that the economist Arthur Laffer was at a cocktail party with then Governor Ronald Reagan when he presented him a simple theory about taxes on a cocktail napkin. Laffer was explaining the relationship between tax revenue and the tax rate. Tax revenue is the total amount of money the government collects in taxes, but the tax rate is the percentage of people’s income that is paid in taxes. Laffer pointed out the obvious: if the tax rate was 0% - that is if the government took 0% of people’s incomes – then the total revenue collected would also be zero. But then he applied a little economic theory. What if the tax rate was 100%, and the government took 100% of your income in taxes? How much revenue would the government collect then? I don’t know about you, but if the government took 100% of my income, and I got $0 for all my efforts, I wouldn’t work at all. The government would be collecting 100% of nothing. And so total tax revenue would be $0 again, or at least something close to $0. This implies that there is an arc in between. As the government raises the tax rate from 0%, they will collect more and more revenue. But eventually the disincentive effect that taxes have on working would overpower the rise in the tax rate. Higher taxes would actually mean revenue falls, because more and more people choose to reduce the amount of work they do. This is most definitely a real thing. You can imagine a doctor with their own practice who can choose how much they want to work. As they take on more patients and earn more money, their marginal tax rate starts to rise, meaning they pay more and more taxes the more money they make. Eventually, the doctor has the option of taking another patient but paying 40 or 50% of that additional income in taxes or calling it a day and heading home to enjoy some R&R. If the tax rate is very high, they might not feel it’s worth it to take on the additional patient. Actually, prior to Reagan, it was more like 70% of that additional income went to taxes. High marginal tax rates reduce the supply of labor and slow the economy down. What is incredible about the Laffer curve is that it implies that the tax revenue collected here will be the same as the revenue collected here. But this spot corresponds to a relatively low tax rate, while this spot corresponds to a very high tax rate. Over the course of his presidency, Reagan cut the top marginal tax rate from 70% to 28%. Much to the chagrin of the supply-side economists like Laffer though, the cuts were large enough that revenue did fall. --After decades of Keynesian influence, the supply-siders embarked on a program of tax cuts, deregulation, and the promotion of free trade all to promote better economic growth. And the results are mixed. The economy was good under Reagan, recovering from a recession in 1980 nicely, though the economists that still favored the Keynesian view noted that Reagan also increased government spending to its highest levels ever, boosting aggregate demand with record deficits. For better or worse, economists were now caught up in the ideological battles of our national politics, and few were willing to set aside their partisan blinders. But while the governments purse strings were in the hand of the freshwater economists, monetary policy and the Federal Reserve were under the influence of a group of saltwater economists who would come to call themselves the New Keynesians.

The New Keynesians

The debate here is between those who believe markets work and prices adjust freely to changes in the money supply and those who believe there are frictions in the economy which prevent the market from making those changes for a significant period of time. While the freshwater economists were assuming their beliefs to be true, the saltwater economists were finding empirical evidence for those frictions.

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While the supply-siders were off rejecting Keynesian economics, the so-called saltwater economists - working at universities mostly along the eastern and western coastline – were working to save the Keynesian view from the devastating critique of Robert Lucas and rational expectations. --Contrary to the assertions of the New Classical economists, the Keynesian framework had an explanation for the energy crisis and stagflation of the 1970s. Where Real Business Cycle theorists were claiming that these recessions amounted to little more than extended and voluntary vacations on the part of workers, the new Keynesians noted that a sharp rise in the price of oil would case a leftward shift in short run aggregate supply, pushing up the price level, and pushing down real GDP. While this did defy the claim of the standard Phillips curve that there is a short run tradeoff between inflation unemployment, because here you had more inflation and more unemployment, it wasn’t in opposition to the overall theory. --But the new Keynesian school of thought was, indeed, new. The rational expectations hypothesis, along with the Lucas critique, needed a response, and it wasn’t going to be found in the orthodox Keynesian framework. But like Keynes, the new Keynesian school rooted their view of the business cycle in empirical reality. The general public, to some degree, did fall for the money illusion, and imperfect competition along with bounded rationality – rather than the assumption of total rationality found in the real business cycle theory – meant that there were price rigidities or sticky prices. The new Keynesian economists embarked on a quest to find rigorous and convincing reasons for wage and price stickiness, because as soon as you have that stickiness, then you have a short run and a long run where changes in aggregate demand will have real effects on the economy. --An explosion of new research was quick to identify rational reasons that prices and wages would be sticky enough that markets would not clear. One was menu costs, named for the example that best illuminated it. When there are changes in the price level, inflation or deflation, then restaurants have to reprint their menus with new prices. That is a real cost, and one which might not be worth it if the price changes are small enough, or if the rate of inflation is changing prices too rapidly. Of course, this applies to more than just restaurants. Adapting to new prices involves costly actions, and avoidance of those costs will be like friction, preventing prices and wages from changing quickly. A second was shoe leather costs, again named for the example given for it. Inflation is like a tax on people who are holding cash. It erodes the purchasing power of your money, and you can afford less than you were able to afford before. To guard themselves against inflation, people will try to store their cash in accounts which pay interest in excess of inflation, and only keep just what cash they need for a short period of time. That means they will need to make more trips to the bank to withdraw small amounts of cash, wearing out their shoes, and forcing them to buy new pairs of shoes more frequently. Ok, I know, this example is a little outdated. Back in the 80s, people used to go to the bank a lot more and pay for things with cash. Today the economy is a bit different, but the problem is still real. Protecting your assets from inflation can involve real costs that prevent people from doing it. The truth is, most people don’t do anything to protect their money from inflation because there are a lot of barriers in the way, and that’s the point. We all face friction which slows us or stops us from behaving perfectly rationally. A third major reason why prices and wages would be sticky are implicit and explicit contracts. I sometimes think about professional athletes for this. When a baseball player signs a 10-year contract with a team, their salary is locked in. No matter what inflation is over those 10 years, their salary won’t be adjusted for it. And of course, lots of people sign contracts like this with their employer. Even if it is just for one year, that’s a year where your wages are locked in. If the economy experiences some unexpected inflation, you won’t be able to adjust your pay until the contract expires and you can renegotiate. And even in circumstances where there isn’t an explicit contract you and your employer are signing, there is a social understanding about how things work. Most employers have HR departments that give each employee an annual review which is followed by a raise that incorporates any cost-of-living adjustments due to inflation. Real business cycle theory is assuming these reviews and adjustments are happening continuously, but that just isn’t the reality we live in. In many ways, this is the whole ballgame. If you can show that there are significant frictions in the economy which slow adjustments to changes in the price level down, then management of that price level through aggregate demand will impact production and employment. --The New Keynesians could just have easily been called the New Monetarists, however. The work of Milton Freidman and Anna Schwartz made clear that it was monetary shocks, not animal spirits and the paradox of thrift, that was causing economic downturns. Monetary policy, and not fiscal policy, was the primary tool for those who wanted to keep the economy stable. And central still were the role of expectations. The hope of a stable Phillips curve that enticed the Neoclassical synthesis was dead, and the New Keynesians recognized that permanent deviations from the natural rate of unemployment would require ever accelerating rates of inflation which would do more harm than good. And while the freshwater economists were whispering in the ears of the President and Congress, the saltwater economists were steering the Federal Reserve.

The Great Moderation

While the ideas of the freshwater and saltwater economists often clashed, they each had significant influence over the course economic policy took in the 80s, 90s, and early 2000s. Since its creation in 1913, the Federal Reserve had often struggled to fulfill its mandate of stable economic growth, full employment, and low inflation. But with the help of the New Keynesians, the Fed finally seemed to find its grove.

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With a robust framework for sticky wages and prices, the New Keynesians had saved the idea of macroeconomic management through sound monetary policy. New Keynesian theory held that monetary shocks were the source of economic instability, which meant that countercyclical monetary policy could iron out those shocks. When money demand is high the Fed can embark on a policy of easy money, meaning increases in the supply of loanable funds and lower interest rates. But when the economy was overheating and inflation was starting to bubble up, the Fed could switch to a policy of tight money, where they slow the growth in the money supply and pushed interest rates up. Since the channel in which monetary policy impact the economy is interest rates, they became the focus of the Federal Reserve. In particular, the Federal Reserve began setting a target for the Federal Funds Rate, or the interest rate banks charge each other for short-term loans. Then the Fed uses open market operations to manipulate the Federal Funds Rate until they hit their target. --Here is a reminder about how open market operations work. Banks hold deposits and use them to make loans. A significant fraction of the loans they make take the form of buying government bonds, which the federal government issues into order to borrow money to cover a budget deficit. Now, the economy is this big, complicated mess of interactions that are almost impossible to decipher, but the goal is to make sure that people’s demand for money is always met and that there is enough cash circulating in the economy to maintain the proper level of aggregate demand. This is the job of the Federal Reserve. When people need more cash, they withdraw from banks. - If a bank finds itself in trouble, it will usually borrow from another bank. But if the demand for cash is large enough, then enough money will leave banks to push interest rates up. To maintain their target interest rate, the Federal Reserve will create new money and use to purchase assets from banks, usually those government bonds. This ensures that the banks will have plenty of cash to lend out, and interest rates stay at their targeted levels. But if too much cash makes its way back into the banks, it will push interest rates down and the economy will begin to overheat and experience inflation. To prevent this from happening, the Fed can sell the assets it bought from the banks in exchange for the cash, and then simply delete the cash. In practice, this usually just means slowing down how much money they create, rather than actually selling off assets. So, the question is, what should their target for the Federal Funds Rate be? How do they know when to raise their target interest rate and when to lower it? Remember that Milton Friedman didn’t trust the Federal Reserve enough to make that call, because his research had shown them prone to error. But the New Keynesians did not think Friedman’s K-Percent rule was sufficient to keep the economy stable. Changes in the money supply needed to be able to adapt to the particulars of the present moment. But acknowledging the potential for human error to wreak havoc on the economy, many agreed that monetary policy should follow a clear rule. --The economist John B. Taylor proposed such a rule. It might look like a lot, but it really is quite simple. ‘r’ is the target for the Federal Funds Rate the Fed should set. It has that little ‘t’ next to it to indicate that it is the value for ‘r’ at time ‘t’, which just is math for the present time. ‘i’ represents the current rate of inflation. Notice that it is in two spots in the equation. This Greek letter rho represent the current real interest rate in the economy. ‘u’ is the current unemployment rate, or in some other versions of the Taylor rule it is the growth rate in real GDP. And lastly, we have ‘i’ with an asterisk and ‘u’ with an asterisk, which each represent the target the Federal Reserve would like to see in the economy for each of those variables. Remember, there is usually a short run tradeoff between inflation and unemployment, but the Federal Reserve has a legal mandate to try to keep both of them low. The 0.5 multiplied by the difference between actual inflation and the targeted level of inflation, and the difference between actual unemployment and the targeted level of unemployment, represents an equal weight on the two goals. --To make things easy, let’s say that the real interest rate in the economy is zero so we can get rid of rho. The target for inflation is 2% and the target for unemployment is 6%. Filling those numbers in, we would have this equation. Now we can just look up the statistics for the actual rate of inflation and the actual unemployment rate. Let’s say that the inflation rate is 3% - higher than our target – and unemployment is 4% - which is lower than our target. Plugging those numbers in, we can solve. The Taylor Rule recommends we use open market operations to push the Federal Funds Rate to 4.5%, which would be a pretty tight monetary policy. That makes sense given that inflation is above our target, and we will want to try to calm inflation down with higher interest rates. --The Federal Reserve does not explicitly follow the Taylor Rule. They conduct monetary policy at their own discretion based on the information they have. However, from around 1987 until 2001, the target for the Federal Funds Rate closely matched the recommendation of the Taylor Rule. Whereas in the 1970s, a decade with high inflation, saw Federal Funds rates much lower than the Taylor Rule would recommend, which had to be balances with high rates in the 80s to bring inflation back down. The freshwater economists may have been enamored with the Real Business Cycle theory, but these saltwater economists had economic models which made actual forecasts that could be checked against reality, and the experience of the 70s, until the turn of the century matched those forecasts. --The 20-year period from 1987 to 2007 saw monetary policy under the guidance of New Keynesian ideas, and it was period of unprecedented economic stability which has been called the Great Moderation. The U.S. experienced only two mild and brief recessions across those 20 years. One in the early 90s, and another following 9/11. Contrast this with the 19th century, which saw fresh recessions every couple years each lasting three times as long as these. People looked forward with optimism, and economists wondered if the divergent paths the different schools of thought had took had, in the end, built a more well-rounded understanding of the economy, and that at long last the problems of the business cycle had finally been solved.

Practice Questions

1. The Taylor Rule is given by:

r_t = i_t + p_t + 0.5(i_t - i_t*) + 0.5(u_t* - u_t)

Suppose that in 2035, inflation stands at 4%, real interest rates stand at 2%, and the unemployment rate is 9%. The Federal Reserve is targeting 2% inflation, and the natural rate of unemployment is 5%.

What target should the Federal Reserve set for the Federal Funds rate?

Reveal the Answer

According to the information in the question:

i_t = 4
p_t = 2
u_t = 9

i_t* = 2
u_t* = 5

Plugging that information to the equation gives the answer:

r_t = 4 + 2 + 0.5(4 - 2) + 0.5(5 - 9)

r_t = 5

So, the Federal Reserve should target a Federal Funds rate of 5%.

2. The Federal Funds Rate currently stands at 3%. Based on the answer to the previous question, what should the Federal Reserve do in order to reach its target for the Federal Funds Rate?

Reveal the Answer

The Federal Reserve is targeting a rate of 5%, but currently sees a rate of 3%. It needs to push interest rates up.

To increase interest rates, the Fed will need to implement tight monetary policy, where they slow or reverse their purchases on government bonds to slow or reduce the money supply.

Quick Quiz

Now is the time to test yourself on these concepts! This quick quiz is a great way to see what has clicked and what needs more attention. It is also a good time to reach out to your instructor with questions.

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Deeper Thoughts and Extra Practice

Dr. Goegan Explains...

Example Question
The Taylor Rule is given by r_t = i_t + p_t + 0.5(i_t - i*_t) + 0.5(u*_t - u_t)

The Federal Reserve is targeting 2.2% inflation and the natural rate of unemployment is believed to be 4.2%.

Economic data suggests that the inflation rate is currently -1.2% while the unemployment rate is 8.8%. The real rate of interest is believed to be 0.9%.

According to the Taylor Rule, what target should the Federal Reserve set for the Federal Funds Rate?

Put your final answer in percentage form (e.g. 30.57 not 0.3057), but be careful about this. If you just use the numbers as is, you don't need to adjust anything. Round your final answer to two decimal places. Both positive and negative answers are possible.

Video Solution

Dr. Goegan Explains...

Example Question
Suppose that a person's life is divided into two periods. A period of poor economic times, when this person earns $27 per hour of work, and a period of good economic times when they earn $37 per hour. The person cannot work more than 2000 hours in a single period, but they want to earn $100,000 total across both periods.

What is the minimum number of hours this person needs to work total?

Round your answer to two decimal places. Then take a second and think about what is happening to GDP in each time period and connect the dots to Real Business Cycle Theory.

Video Solution

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