1/26 – Housing and Financial Markets

Readings
Congressional Support for Subprime Lending
 At the peak of the housing boom, subprime mortgage companies were loaning $600 billion/year, many
homebuyers had poor credit histories
 The Political Economy of the Subprime Mortgage Credit Expansion by Atif Mian, et al:
 Between 2002-2007, a sharp increase in campaign contributions and lobbying activity by the mortgage
industry (rose by 80% between 2002 and 2006). These contributions were targeted to members of
Congress whose districts included a large fraction of subprime borrowers.
 By studying legislators' votes on more than 700 bills that related to housing, find that over time,
campaign contributions and the fraction of a legislator's district that consisted of subprime borrowers
became stronger predictors of representatives' voting.
 The correlation between the concentration of subprime borrowers and voting patterns was greater in
2004, when subprime credit was beginning to flow, than in 1996, when subprime mortgages were still a
small share of the overall mortgage market.
 Conclude that pressure on the U.S. government to expand subprime credit came from both mortgage
lenders and subprime borrowers
Federal Mortgage Modification Programs
 There is a tradeoff between the number of foreclosures prevented in the short term and the durability of
foreclosure prevention efforts.
1/28-1/31 – Keynesian Economics: Retreat and Return
Lecture 1/31

Readings
1. An $800 Billion Mistake by Martin Feldstein (=military spending good; tax rebates saved up & infrastructure
too slow effect)
Problems with the stimulus package - delivers too little extra employment & income for such a large fiscal deficit
(increase in national debt).
 $500/yr tax cut for 2 years for each employed person – 1) not a good way to increase consumer spending:
such temporary, lump-sum tax cuts is largely saved or used to pay down debt. Only 15% of last year's tax
rebates led to additional spending; 2) won’t increase business investment and employment.
 Proposed solution: 1) tax changes should focus on providing incentives to households and businesses to
increase current spending (ex: temporary refundable tax credit to households that purchase cars or other
major consumer durables/home improvements, similar to the investment tax credit for businesses); 2)
postpone the scheduled increase in the tax on dividends and capital gains  raise share prices, leading
to increased consumer spending and, by lowering the cost of capital, more business investment.
 Spending: 1) $100B from increasing the "Medicaid matching rate," (to reduce states' Medicaid costs to free
up state money for spending on anything governors and state legislators want) + $80B for "state fiscal relief"
– most likely end up being state transfer pmts, not increase spending; 2) finance health insurance premiums
for the unemployed  increase unemployment by giving employers an incentive to lay off workers rather
than pay health premiums during a time of weak demand; 3) Large fraction of the package for infrastructure
projects ($50B on energy and water), but will be spent slowly, not fast enough to boost the current economy
(1/5 by end 2010).
 Proposed solution: 1) more $ on defense/military, including replace/repair supplies/equipment (needed
after 5 years of fighting). The military can increase its level of procurement very rapidly.
 Infrastructure spending on domestic military bases can also proceed more rapidly than
infrastructure spending in the civilian economy.
 Military procurement mostly American-made products.
 Temporary increase in military recruiting/training reduce unemployment directly
 All new spending and tax changes should have explicit time limits that prevent ever-increasing additions to
the national debt.
2. By How Much Does GDP Rise if the Government Buys More Output? By RE Hall
 New Keynesian macro models: govt purchases multiplier between 0.7-1.0 (data from WWII, Korean
War), and even higher (1.7) when nominal interest rate is around 0 (year 2009)
 Features for higher multiplier
 The markup ratio of price over cost declines when output increases, i.e., stickiness of the price
level – prices stay constant during a boom that raises input costs (Hall’s one problem with this
model: See below)
 Wage-elastic labor supply to an increase in demand
 consumption linked to current income – employed people consume significantly more goods
and services than the unemployed
 Vs. Neoclassical model: much lower govt purchases multiplier because they predict that consumption
falls when govt purchases rise (consumption multiplier for govt purchases is negative).
 Equations on pg 15-16, can probably be ignored because Hall claims that this model is inconsistent.
 Markup ratios
 The behavior of profit margins seems to suggest that markup ratio rises with output, which
 contradicts with the New Keynesian model. The only plausible explanation is that employers
smooth wage payments to workers rather than paying a wage equal to current marginal revenue of
product.
 See pg 43 for equations
 Hall’s empirical research using BLS data finds that the employment rate and the
markup index move in the same direction – booms are times when the markup index
rises along with employment and recessions are times when the markup index falls
with employment.
 In other words, business owners’ share of income doesn’t fall in booms on account of
lower markups. Rather, their income share rises.
 Results from Hall’s regressions & VAR estimates: output multipliers lie in the range from 0.5 to 1.0;
consumption multipliers range from somewhat negative to 0.5 (data from 1948 onward, mainly the
Korean War)
 Application to the 2009 stimulus package (Table 3, pg 48)
 Anticipation effect: announcing future purchases delivers immediate stimulus (announcement in
Feb 2009 raised GDP by 1.1% in 2009, by 1.28% in 2010, and by 0.7% in 2011) – this model
contradicts the common view that the long ramp-up in purchases will delay the effects of the
stimulus until long after they would be most beneficial (lags with fiscal policy).
 Front-loaded stimulus has a smaller effect on GDP in both the first year (2009) and the next two
years, compared to the actual back-loaded policy the much criticized slow ramp-up of the
stimulus is actually more beneficial.
 $62.5 billion govt purchases in the package won’t be able to close the gap of $1.2 trillion shortfall
of GDP from normal levels.
 Conclusion: GDP rises by roughly the same amount of increase in govt purchases (New Keynesian
model) and even more when monetary policy is passive (interest rate ~ 0%). But Hall isn’t convinced
about New Keynesian model’s hypothesis of a countercyclical markup ratio, and therefore believes there
could be another model that explains both the large multiplier and the markup ratio movement better.
3. Defense Spending Would Be Great Stimulus by Martin Feldstein
 Related to reading #1: Dept of Defense budget cuts in response to decline in national income, which is wrong
since we need increase in govt spending to compensate for decrease in consumer consumption and business
investments.
 Obama $300B/yr for fed, state, local govt
 Proposed solution: short term surge in govt spending, esp on DOD, FBI, Dept of Homeland Security, etc, in
2009-2010 and tail off sharply in 2011 when the economy comes back to its prerecession level.
 Avoid wasteful spending by doing things during the period of spending surge that must eventually be
done anyway.
4. Extend the Bush Tax Cuts – For Now by Martin Feldstein (May, 2010)
 Obama proposed to increase tax rate on high-income households while making the existing tax rates
permanent for taxpayers below the top tax bracket.
 Response: 1) a tax increase will kill the current fragile expansion, as it was due to mortgage purchase
program, tax credits for car buyers and first-time home buyers that are now ending. 2) 80% of 1Q10
GDP increase consisted of a rise in consumer spending that was the result of an unrepeatable sharp drop
in the saving rate. 3) High-income households are the main source of taxes and private spending. 4)
Small businesses will also be affected since many are taxed at personal rates.
 But tax cuts shouldn’t be more than 2 years since deficit is a problem.
5. Household Spending Response to the 2008 Tax Rebate
 Related to Reading #1.
 April-Dec 2008, 120M individuals with income <$75,000/yr received one-time stimulus payments totaling
$96B (it was argued that lower-income households were more likely to spend their rebates, so would have
larger stimulative effects).
 But survey finds that this $96B spending only generated $32B consumer spending b/c 3/4 respondents
said they’d save it or use it to pay debt.
 People with income >$75,000 had “mostly-spend” rates ~7% higher than lower-income groups; 40%
higher among those with >$250,000 stock holdings, etc.
 Contradicts conventional assumption that younger, lower-income households are more likely to spend a one-
time tax rebate; is consistent for moderate-stock-wealth households because they haven’t met their savings
goals yet so they’ll save.
6. Macroeconomic Effects from Govt Purchases and Taxes by Robert J. Barro (Nov 09)
 Related to Reading #2.
 Multiplier for defense spending 0.6-0.7 at the median unemployment rate (data from WWII).
 Some evidence that the spending multiplier rises with the extent of economic slack and reaches 1.0
when the unemployment rate is around 12%.
 Since multiplier <1, greater spending crowds out other components of GDP, esp. private investment,
along with non-defense purchases and net exports.
 Increases in average marginal income-tax rates have a significantly negative effect on GDP (tax multiplier ~
-1.1).
7. Rethinking the Role of Fiscal Policy by Martin Feldstein (didn’t finish reading)
 Economists thought fiscal policy not useful to counter cyclical changes, but new stimulus packages around
the world use fiscal stimulus.
 Before, was used to combat Depression but unemployment rate remained high until WWII. After the
war, economists found that Keynesian fiscal policy contributed little to prevent unemployment (due to
crowding out of interest-sensitive spending caused by an induced increase in the demand for money,
effect of larger national debt on long-term interest rates, decreased demand as a result of imports, fiscal
expansion effect on FX). uncertainty about actual effect + long lags btw decision and execution +
simultaneous rise in inflation and unemployment in the 60s  Keynesian not working!
 This time, monetary policy alone not enough to bring back employment. Also, before economy down as
a result of raised r, but this time r already low.
 One-time tax rebate quick effect, no lag.
8. The Evolution of Economic Understanding and Postwar Stabilization Policy
9. The Impact of the 2008 Tax Rebates on Consumer Spending
 Related to Reading #5.
 Average household increased its weekly expenditures on non-durable goods by 3.5% after receipt of the
rebate. Impact is highest in the week when the rebate is received (weekly spending increased by 6%). No
impact on spending in the few weeks before getting rebate.
 Low-income or low-wealth families spent more than those with higher income or wealth.
 Grocery stores didn’t benefit. Supercenters & non-grocery outlets’ sales increased a lot.
10. The Lack of an Empirical Rationale for a Revival of Discretionary Fiscal Policy by John B. Taylor (Jan 08)
(=anti deliberate fiscal policy)
 Opposite of Reading #9. Agrees with Reading #1 on tax ineffectiveness, but counters #1 on govt purchases.
 Late 90s – early 2000s, economists preferred “to let fiscal policy have its main countercyclical impact
through automatic stabilizers” because “deliberate countercyclical discretionary policy hasn’t contributed to
economic stability and may actually be destabilizing.”
 John B. Taylor against revival of fiscal policy:
 One-time tax rebates in 2008 (most given out in May, with less in June – Aug) didn’t increase private
spending, although disposable personal income rose sharply in May 2008. In fact, consumption started
declining in July 2008 through Oct.
 Regression results conform to the permanent income theory/life cycle theory of consumption in
which temporary increases in income are predicted to lead to proportionately small increases in
consumption; small & insignificant effect.
 Some economists today support temporary tax rebate after seeing success in the 2001 tax rebate
program, but that was part of more permanent multiyear tax cuts that were passed in the same year.
 Increasing govt purchases – will increase GDP in the short run more than temporary tax rebates, but
unsure if it can sustain economic recovery. Expectations of future income and employment growth are
low because this crisis is expected to last for years, so need to directly address these expectation
problems.
 Keynesian model doesn’t take into account of a modern int’l economy & expectations of the future.
 Proposes to focus on 1) automatic stabilizers and 2) long-run reforms (tax, entitlement, infrastructure
spending, keep debt to GDP ratio in line).
 Monetary policy (increase money growth) proved successful for Japan in its 2001 recession. Just don’t let
money growth fall (as in Great Depression).
11. The Retreat from Keynesian Economics by Martin Feldstein.
 Related to Readings 7, 10.
12. The Stimulus Plan We Need Now by Martin Feldstein (Oct 08)
 Related to #1.
 The economy faces 2 separate problems: 1) the downward spiral of home prices (-25% from 06 peak, need to
fall another 10-15% to get back to pre-bubble level) and 2) the decline in aggregate spending (less business
investment due to lower consumer spending, and recession in Europe and Japan reduce our net exports) .
 Congress should reduce defaults by the 12M homeowners who already have negative equity in their
homes, which could drive prices down much further.
 Also need to stop declining prices from pushing a large portion of the other 37M homeowners with
mortgages into negative equity.
 Proposed a mortgage replacement loan.
13. The Tax Rebate Was a Flop. Obama’s Stimulus Plan Won’t Work Either by Martin Feldstein (Aug 08)
 Supports Readings #1, 4, 5, 10; contradicts #7.
 Only 10-20% of rebate spent (added nearly $80B to permanent national debt, while only increasing consumer
spending by $20B).
14. What Would Keynes Have Done? By Gregory Mankiw (Nov 08)
 Overview
 According to Keynes, the root cause of economic downturns is insufficient AD.
 Consumption low due to low consumer confidence; ppl choose to save, but in the short run, this would lead
to lower ADlower GDPlower incomeless $ to save. Bad for both economy and ppl.
 Business investments low.
 Net exports: March 04 – March 08 the dollar fell 19% against an average of other major currencies 
foreign goods more expensiveincrease in net exports. But during the crisis, March – Nov 08 US dollar
appreciated 19% (safe haven for foreigners)  net exports will decrease as US goods become more
expensive.
 Govt purchases: infrastructure, govt spending multiplier, but adds to budget deficit, which will make it
difficult to fulfill SS and Medicare benefits for the baby boomers. But Keynesian economists doesn’t care
 about long run if there are short run problems.
 Normally, the Fed can bolster AD by lowering r (households and companies encouraged to borrow and
spend; equity values up; disincentivize int’l capital to invest in US, thus lowering dollar value in FX  net
exports up)
 But Fed funds rate already at 1%, so current options are 1) set a target for longer-term low r, 2)manage
expectations and assure markets it will avoid prolonged deflation, 3)bought mortgage debt
15. Why America Must Have a Fiscal Stimulus by Lawrence Summers (Jan 08)
 Supports Readings #1
 Fiscal stimulus needs to be 1)timely, 2)targeted at low-income and those whose incomes have recently fallen
for whom spending is most urgent, 3)temporary with no significant adverse impact on the deficit for more
than a year or so after implementation.
 Propose a program of equal payments to all those paying either income or payroll taxes combined with
increases in unemployment insurance benefits for the long-term unemployed and food stamp benefits.
 Would largely benefit those most likely to be cut off from credit markets and with the most urgent need
to spend.
16. Did the 2008 Tax Rebates Stimulate Spending?
 Agrees with Readings #1, 4, 5, 10, 13.
 Only 1/5 survey respondents said that the 2008 tax rebates would lead them to increase spending; most save
or pay debt.
 The marginal propensity to spend from the rebate was ~1/3 and that there would not be substantially more
spending as a lagged effect of the rebates.
 Nonetheless, the aggregate amounts of the rebates were large enough that they had a noticeable effect on the
timing of GDP and consumption growth in 08Q2-Q3.
 Growth in the second quarter was stronger and growth in the third quarter was weaker than they would have
been absent the rebate.
2/2/2011 – Demand Management – View from the Trenches
Readings
1. Hey, Small Spender by Paul Krugman (Oct 2010)
 Breaks the myth that the Obama govt is expansionary – his fiscal policy never expansionary enough to create
millions of jobs (no new fed programs, infrastructure projects, benefits for low-income workers; health care
reform hasn’t kicked in yet) = not a big govt, didn’t do anything!
 Did spend on unemployment insurance (increased unemployed), Medicaid, financial institutions
 # of govt workers, esp. schoolteachers, in America has been falling under Mr. Obama
 Adjusted for inflation, govt purchases rose only 3% over the past 2 years, slower than the previous two
and economy’s normal rate of growth
 $600 billion cost of the Recovery Act in 09-10: >40% tax cuts, a large chunk to state & local govt aide,
only remainder for govt spending – not much
 State & local govt reduced spending too as their tax revenues (income & property) dropped
2. Estimated Impact of the American Recovery and Reinvestment Act on Employment and Economic Output
from January 2010 through March 2010 by Congressional Budget Office (May 2010)
 (pp. 9) ARRA recipients reported 700k full-time-equivalent jobs in 1Q10, though number not too accurate
 1Q10 ARRA’s policies estimates (pp. 10 for chart)
 Raised real GDP by 1.7-4.2% (inflation adjusted)
 Lowered unemployment by 0.7-1.5 percentage points
 Increased # of ppl employed by 1.2-2.8M
 Increased FTE jobs by 1.8-4.1M
 Expected to increase further during 2010, diminish in 2011, and finally fade away by the end of 2012
3. Options for Responding to Short-Term Economic Weakness by Congressional Budget Office (Jan 08)
 Strong possibility of at least a few quarters of very slow growth; the risk of recession has risen, although may
avoid.
 Fed can keep the economy growing, but no guarantee it will keep it out of recession.
 Automatic stabilizers (unemployment compensation, corporate/personal income tax) will act to stimulate the
economy
 Timing of fiscal stimulus and increase economic activity as much as possible for the budget
 Most effective fiscal stimulus = tax cuts or increased spending on transfer pmts, give to ppl who will spend it
right away
4. Not My Father’s Recession: The Extraordinary Challenges and policy Responses of the First 20 Months of
the Obama Administration by Christina Romer (Sept 2010)
 Opposite #1
 An economic adviser to Obama – pro-govt, did a lot except failed on unemployment (pp. 9)
 1981-82 recession caused by monetary policy that raised the interest rate to bring down post-war inflation
 American Recovery and Reinvestment Act (2009) – bottom of pg 5 has details about the act
 Consisted of hundreds of measures through existing programs, so it was effective in spreading funds
widely and quickly to achieve the most benefit
 Reflected the President’s top priorities for forward-looking investment
 Invested >$90 billion in clean energy, renewable energy
 Aid to state and local govt focused on health and educations
 Tax cuts, unemployment relief, and food & mortgage support; middle class families included this
time
 TARP for financial institutions
 Financial Stability Plan – Jan 09 – continued system-wide support through bond guarantees and joint credit
 provision plans with the Fed, designed to give an honest accounting of the state of our largest financial
institutions
 Set off a wave of private capital-raising
 Credit spreads (an indicator for perceived risk) returned to almost pre-crisis levels
 Automobile industry
 GM, Chrysler emerged from bankruptcy
 All 3 American automakers made profit for the first time in 6 years in 2010
 Employment in motor vehicles and parts increased by 80,000 since its low point in June 2009
 Housing sector
 $50 billion of TARP funds to keep responsible homeowners in their homes
 HAMP program – bring down mortgage rates, encourage refinancing, etc)
 mortgage rates at historic lows, 6 million homeowners refinanced
 lending standards loosened for large firms, although credit remains tight for consumers and small
businesses
 HIRE tax credit to encourage firms to hire unemployed workers
 Real GDP from -6% (end of 2008) to positive starting second half of 2009
 Employment went from -700,000 jobs per month to growing by the beginning of 2010
 But real GDP not growing fast enough to replace all the jobs lost, unemployment still 9.5%
2/4/2011 – National Saving and Growth
Readings
1. Domestic Saving and International Capital Flows by Martin Feldstein (1980)
• Importance of international capital mobility
o Closed economy: national return on additional saving = domestic MPK  the govt just needs to
determine whether this pretax MPK is high enough to jsutify postponing consumption (pretax because
the taxes still stay in the country)
o Open economy: yield to home country on additional saving = net-of-tax return received by investors (not
pre-tax MPK – see bottom of pg 2 for explanation)
 Capital importer  incremental saving will replace foreign source capital that’d otherwise
be invested in the home country
 Capital exporter  incremental saving leave home country
o Taxes
 Closed economy: tax on the income of all capital used in production borne by capital owners
 Open economy: tax burden shifted to labor to the extent that capital is freely mobile across
nations
• Short-term international yield differentials of net-of-tax return quickly arbitraged, but not for long term
(capital not necessarily always move to the higher return country) – why?
o Risk aversion hinders foreign investments  long-term capital not as mobile
o Capital mobility restricted by official restrictions on capital export in both home country and host
country (worried it’ll be hard to get your $ out in ther future)
o Institutional rigidities – US govt requires saving institutions to be invested in mortgages on local real
estate
o Due to int’l differences in tax rules, net return maximization strategy different for each country, requires
specialization
 Much of the direct investment in foreign markets appears to be associated with
implementing marketing strategies, exploiting production knowledge, or overcoming trade
restrictions, NOT pursuit of highest return
• Paper: empirical evidence on the relationship btw domestic savings and int’l capital flows
o Data: 21 OECD industrial countries 1960 – 75, 1) measure the extent to which a higher domestic saving
rate is associated with a higher rate of domestic investment (under perfect world capital mobility, the
two should be UNRELATED as capital always flows to the best rate of return country); 2) if savings
tends to stay in the home country, then differences among countries’ investment rates should correspond
to diff in their savings rate.
o Finding: nearly all of incremental saving remains in the home country (contradicts theoretical
hypothesis).
 Substantial variation in domestic saving rates among the OECD countries: ratio of gross
domestic saving to GDP = 0.25 (average of all countries during the sample period), but
saving rate varied from a high of 0.372 in Japan to a low of 0.184 in UK.
  Beta very close to 1 = most savings stay in the country (pg 9) – Beta = 1: a regression of the
ratio of net foreign investment inflow to GDP on the domestic saving ratio would have a
coefficient of 0.
 Pg 10: exogenous third variable problem addressed (rate of population growth – life-cycle
theory of saving)
 Pg 11 section IV: model that takes into account endogeneity of saving ratio (structural
features that are responsible for intercountry differences in saving rates)
 Pg 13 Section V: regression results on components of saving and investment
 Conclusion: portfolio preferences, institutional rigidities, etc impede the flow of long-term
capital among countries, increases in domestic saving reflected in increase in domestic
investment  govt should try to increase S if want to boost I. Differences in domestic
savings rate correspond to almost equal differences in domestic investment rates. Traditional
hypothesis still works for short-term!
2. Remarks at the European Banking Congress by Alan Greenspan (Nov 2004)
• Mentioned Reading #1 – home bias – residents tend to invest their savings in home country
o True from post-WWII until 1990s due to acceleration in productivity growth in US (increase in
expected real rates of return in US) – home bias Beta fell from 0.95 (1993) to <0.8 (2002)
 Nation’s current account balance: domestic saving – domestic investment = net foreign
investment, so the decrease in Beta means increased dispersion of current account
balances (ex: current account balance deficit in US emerged while surplus in other
countries: US negative current account balance)
• Cumulative deficits = decline in US net int’l investment position in dollar terms decline at an annual pace
equivalent to the % of deficit, so has to eventually be stopped (resist financing) because int’l investors will
adjust their cacumulation of dollar assets or seek higher dollar returns to offset concentration risk
(unacceptably high share of dollar claims in investor portfolio) increase the cost of financing of the US
current account deficit and less tenable  import decrease
o Possible steps US can take: encourage private saving (but can induce recession as C lowers),
decrease federal budget deficit, decrease domestic investment – not good for long-term
3. Savings puzzles and savings policies in the US by Lusardi, Skinner and Venti (April 2001)
• US personal saving rate dropped from 10.6% (1984) to -1% (2001) (but govt & corporate saving still 2.4%) –
why?
o 50% of the drop since 1988 due to households spending increased from stock market boom,
increased valued in retirement assets – wealth effect
o 30% of the drop: accounting transfers from personal saving into govt & corporate saving due to
the way pensions and capital gain taxes are treated
o Low-wealth households just don’t save, anytime – puzzle
• The decline in personal saving hasn’t led to lower rate of investment – offset by flows of resources from
corporate & govt
• Policy intervention: fed govt limited in its ability to target the aggregate personal saving rate, focus on the
very rich as their saving behavior accounts for a large fraction of APS
 o But policies should be quite effective for the low-wealth households – encourage retirement
security rather than higher aggregate personal saving rate.
4. The Importance of Raising National Saving by Gov. Edward Gramlich (March 2005)
• Low national savings rate  many our investment done by foreigners rather than our own saving, which will
be bad in the long-run: high intl liability, has to pay back interest or dividends
o NS = private saving (S) – budget deficits (BD) = I – funds borrowed from abroad (B)
 High NS will raise future living standards whether used to finance investments or reduce
intl debt
 Twin deficit – budget deficits lead to current account deficit of the same size, in which
case I and private saving move together
• Congressional Budget Office projection for the next decade (following 2001): primary deficit averages ~ 2%
of GDP for the next few years before gradually shrinking, and the debt-GDP ratio climbs to ~45% by 2015.
5. The Return of US Saving by Martin Feldstein
6. U.S. Economic Growth in the Decade Ahead by Martin Feldstein (Jan 2010)
• Examines likely growth of US GDP in the coming decade (estimates to be ~2.6/yr)
o Recovery from current recession
 unemployment falls from current 10% to ~5% coupled with reduced cyclical fall in
labor force participation  Okun’s Law: 1% fall in unemp = 2% rise in GDP; cyclical
rise of real GDP of 13% over the next decade = 1.2% per year
o Rise in potential GDP as a result of the expansion of labor force, growth of capital stock and
increase of multifactor productivity, but hindered by:
 Not all of the increased output will remain in US  if trade deficit decreases by 3% of
GDP  the rise in exports and decline in imports will reduce output available for US
consumption and investment by ~0.3% per year
 Decline of the dollar: if the real trade-weighted value of the dollar declines by 25% over
the next decade  cost of imports increases  reduce growth of our real incomes by
~0.4% per year
  the two int’l effects would leave the net growth of real goods and services available
for US consumption and investment (both domestic & import) at 1.9% per year = same
as the average growth during the past decade
 BUT if the slower growth of the labor force reduces annual GDP growth by 0.26%,
AND there’s no rise in productivity (due to capital accumulation), AND multifactor
productivity decliens to pre-2000 average  annual GDP growth rate will decline about
0.9% to 1.4% per year, PLUS 1.2% per year cyclical rise in real GDP (calculated above
from Okun’s Law as a result of higher employment) = real GDP growth rate of 2.6% per
year – but these are very conservative assumptions
Near-term risks: depressed resi and commercial real estate markets, local banks restrict lending due to concern
about defaults, high fiscal deficits leads to higher long-term real interest rates

Lecture – National Saving

1. National saving in Econ1420
 Budget deficits
 Consumption taxes
 Social security reform
 Trade deficits
2. What’s saving?
 saving = income – consumption = sacrifice today so we can have more consumption later
 saving in the two-period market graph (See slide)
 transfer consumption from period 1 to period 2 (income becomes Y*(1+r) from interest rate)
 utility curve U(C1, C2) comes from consumption, not saving
 components of US net national saving as Share of GDP (net = +/- replace existing facilities)
 4 sectors: household, business, S&L govt, federal govt
 Household: saving = disposable income – consumption
 7.2 in 1980, 5.2 1990, 1.7 in 2000, 0.3 in 2006, 4.7 in 2009
 Why did household saving fall (1990-2000)?
 Population structure change – younger population > older retired population
 Portfolio wealth and housing wealth increased  consumption went up, but income didn’t
change
 Productivity up – people thought their wages will increase
 Americans became impatient
 Old – income from social security; young – easier access to credit card (debt easier)  saving
decreases, consumption increases
 People’s savings decrease when their children grow up (no more tuition, shelter, etc)
 Healthcare:
 Business: saving = net profit (after taxes) – dividend


 S&L govt: saving = taxes – spending

 0,3, 0,1, 0,5, 0,2 (2006)
 Federal govt: saving = taxes – spending
 -1.9, -3.0, 1.9, -1.7 (2006)
3. What explains the pre-recession decline in household saving?
4. Why does national saving matter?

1970-1995 GDP growth 3%, pop growth 1%, GDP/pop growth 2%  after 30 years 81%
1995-2000 GDP growth 4%, pop growth 1%, GDP/pop growth 3%  after 30 years 143% - try to keep at this
level

SIKYC
Financing domestic investment
Closed economy: I = S
Open economy: I = S-NFI (net foreign investment)
 Portfolio investment: you buy stocks in a Mexican company
 Direct investment: GE builds a plant in Mexico
 Feldstein estimates for 23 OECD countries (1960-1986) beta=0.83 (how much we invest very closely related
to how much we save), in a closed economy: Beta=1, integrated world capital markets: Beta=0
Japan had a lot of capital deepening (technological advancement)  faster growth rate of per capita
People save less than optimal
Economy gets 2/3 benefit, but people only get 1/3 benefit (after tax real return 3%) less incentive for saving for
people
9% real return and 3% inflation rate
2/7 – 2/9: Business Cycles Inflation and Monetary Policy
Readings
1. What Ends Recessions? By Romer (1994)
 Review of 8 recessions in the U.S. since 1950 – whether monetary and fiscal policies have helped or
hindered them
 Monetary policy
 Indicators: quarterly change in nominal fed funds rate, estimated change in real funds rate
 Fed lower nominal funds rate after the trough, and it also leads to decline in real funds rate
 Moderate tendency for both nominal and real funds rates to rise, 2nd to 5th quarters after troughs
 source of most postwar recoveries – moved toward expansion shortly after the star of most recessions
 on average contributed to 2% points to real GDP growth in the four quarters following the trough
 fiscal policies
 indicator: ratio of high-employment surplus to trend or potential GDP (can also be changed by
temporary tax changes, investment tax credits, etc)
 limited amount occurred around troughs and effect too small
2. Enough With the Interest Rate Cuts by Martin Feldstein (April 2008)
 If keep on lowering fed funds rate, damage > benefit
 Lower interest rates  raise energy & food prices (increased demand from China, India, etc + lower r
makes it less costly for commodity investors and speculators to hold larger inventories, bid up the prices
to levels at which the expected future returns are in line with the lower rates, thus adding upward
pressure on commodity prices + rise in oil price induces farmers use more land to grow corn for ethanol
so less land for food)  central banks in developing countries will need to raise interest rates to offset
the inflationary impact of higher imported commodity prices  political instability, reduce real incomes
in those countries
 25% weight in US CPI: 10% rise in prices of food and energy = 2.5% rise in overall price level
(inflation)  depress real income
 worse effect in emerging-market, lower-income countries since food and energy even a larger part
of their CPI basket
 Usually, the concern is that lower r  stimulates economy  rise in wages and product prices
 But right now we have such high unemployment and low capacity utilization, so this won’t happen
 Current housing industry and credit market not going to be stimulated by lower interest rate (will not
stimulate AD by inducing home building b/c high inventory of unsold homes, also didn’t bring down
mortgage interest rates much)
 Current economic recovery needs: fix credit markets, prevent home prices to drop even lower so
people won’t default on mortgages
3. The Rationale for Inflation Targeting by Mishkin and Posen (1997)
 Consensus emerged that activist monetary policy to stimulate Y, reduce unemployment beyond their
sustainable levels  higher inflation, but NOT persistently lower unemployment or higher Y  monetary
policy should target price stability
 Milton Friedman: monetary policy have long and variable lags, not always desired results
 No long-run trade-off btw inflation and unemployment – Phillips curve only works in the short-run
 Expansionary policy can lead to higher inflation that persists b/c it becomes embedded in price
expectations, whereas rise in Y or decline in unemployment cannot persist b/c of capacity
constraints in the economy
 Time-inconsistency problem of monetary policy: wage and price setting behavior is influenced by
expectations of future monetary policy – workers and firms know policymakers trying to stimulate the
 economy, so they raise their expectations of inflation  wages and prices rise, but average Y doesn’t
 Price stability promotes efficient economic system and thus higher living standards, so costs of inflation
 Shoe leather cost – cost of economizing on the use of non-interest-bearing money
 Overinvestment in the financial sector
 Distorts decisions about future expenditures, uncertainties make it harder to arrive at optimal
production level
 Alters the relative attractiveness of real vs nominal assets for investment and short-term vs long-
term contracting
 Tax systems not indexed for inflation, so inflation raises the cost of K  I drops; also
misallocation of K to different sectors  distorts L supply and wrong corporate financing decision
 Advantages and disadvantages of inflation targeting (pg 4)
 Advantages and disadvantages of nominal GDP targeting (pg 5)
4. QE2 is Risky and Should Be Limited by Martin Feldstein (Nov 2010)
 Quantitative easing – Fed will buy long-term govt bonds to add cash to the economy and banks 
expectation of this has lowered long-term interest rate, depressed the dollar, bid up the price of commodities
and farm land
 When r returns to normal levels  negative equity problem will occur again (although not with houses
this time)
 Lower r in US  capital flow to emerging markets  currency volatility (those currencies appreciate)
 hurts their exports  they limit imports  possible trade conflict
 There isn’t much left for the Fed to do; the president & Congress need to help homeowners with negative
equity and businesses that can’t get credit, remove the threat of higher tax rates, reduce the out-year fiscal
deficits
5. The Fed and the Crisis: A Reply to Ben Bernanke by John B. Taylor
 Taylor rule: central banks should increase r when price inflation rises, and decrease r when the economy goes
into a recession
 Critique of the Fed 2002 – 2005: fed funds rate below what the Taylor rule would call for  easy monetary
policy contributed to the housing boom, excessive risk taking, and the financial crisis
 Bernanke’s alternative responses to the Fed’s policy in 2002-2005
 He uses the Fed’s forecasts of future inflation into the Taylor rule, rather than the actual measured
inflation
 Taylor’s response: Fed’s forecasts too low, no empirical evidence that this alternative improves
central bank performance
2/9/ Lecture – Instruments & Targets
Federal fund interest rate – the rate at which banks lend to each other overnight
Cost of bringing down inflation
 Short run Philips curve – temporarily increase unemployment to bring down inflation
 Contracted economy, lowered GDP?
 If inflation=4% and want to bring down to 2% (global consensus of reasonable inflation – measurement
problems in inflation rate due to quality change, new product  leads to overestimated inflation because
quality change and improvement not fully taken into account so 2% inflation really corresponds to 0% -
maintain the same utility table for the same expenditure)
 If bring down to 0%, can lead to deflation  r=i-pi, makes real interest rate even higher
 Pi=0.4 to 0.2: 1 yr increase real unemployment by 3% or 2 yrs increase real unemployment by 1.5%
each (both temporary) – cost, permanent increase in GDP of 1% (per year?) (reduce deadweight loss,
inefficiency in economy) – benefit
  Okun’s law: real unemployment increase 1%  temporary loss in gdp by 2.25%, so 3% increase in
unemployment would lead to gdp loss of 6.75%  so it pays for itself in 7 years
 Taylor Rule (related to Tinberger handout) – modeled Greenspan’s behavior between 1987 – 1997
 When inflation goes up, Fed not only has to raise nominal rates, but also has to raise real rates –
whenever we deviate from AD, we will move there, whenever pi high, interest rate will decrease(?) to
bring pi down, vice versa
 Problem: by keeping interest rate really low  real assets become overpriced (financial crisis in 2007)
2/11 – 2/14: Budget Deficits and Surpluses
Readings
1. What Do Budget Deficits Do? by Mankiw & Ball (1995)
 Immediate effects of budget deficits: I, NX
 public saving negative, national saving↓(by less than fall in public saving)
 S = Y - C – G; Y = C + I + G + NX  S = I + NX  I and/or NX ↓
 S↓= supply of loanable funds↓ r↑ I↓
 r↑= demand for domestic investment↑b/c higher return for both investors at
home and abroad  foreigner demand domestic currency in order to invest 
domestic currency appreciate  domestic goods more expensive  NX↓
 NX↓= assets flow abroad (pay assets for imports)
 Long-run effects: GDP, wealth, future taxes
 I↓ K growth↓ production capacity↓
 NX↓ assets flow abroad  income from production flows abroad to pay interest,
rent, profit (foreigners hold our bonds, real estate, equity)  national income for
residents↓
 K↓ MPL↓= real wage↓(less capital to work with) MPK↑(rate of profit↑)
 Govt may raise taxes when debt comes due  household income↓(tax pmt +
deadweight loss from taxes distorting incentives)
 If doesn’t raise taxes: cut transfer pmts or other spending
 BUT doesn’t always have to raise taxes, can ROLL OVER DEBT, as long as GDP
growth rate > interest rate growth rate  ratio of debt to GDP↓
 Risk: some slight chance that domestic economy becomes bad, then debt will
rise faster than GDP  debt too large, can’t sell it anymore  forced to raise
taxes or cut spending
 Recent US deficits quantified (calculations pg 9 – 11)
 Cobb-Douglas production function: MPK proportional to Y/K ratio
 Deficits cause redistributions
 Current taxpayers & future capital owners gain; future taxpayers & future workers lose
 K↓ MPL↓= real wage↓
 MPK↑= rate of profit↑
 Desirable or not? Ability-to-pay principle: good if they go from better-off people to
worse-off people  thus in this case, UNDESIRABLE
 Future effects
 Hard landing where demand for domestic assets collapses
2. The Budget and Economic Outlook: 2011-2021 by Congressional Budget Office (2011)
 Summary
 Chapter 1: The Budget Outlook
3. Long Term Budget Outlook by Office of Management and Budget (2011)
 Pp 45-54 chapter 5
4. Fiscal Policy and Social Security Policy During the 1990s by Elmendorf, Liebman and Wilcox (2002)
 Pg 1-24, 63-80
5. The Deficit Dilemma and obama’s Budget by Martin Feldstein (2010)
6. Preventing a National Debt Explosion by Martin Feldstein (2011)
7. 2/16 – 2/18: The Dollar and the Trade Balance
Readings