Economic Indicators & Economic Policy

 Rebecca Lindstrom

Introduction

            Fiscal and monetary policy has long been crucial to the stability and growth of the American economy.  These policies impact every person, whether or not he or she realizes the extent of their reach and affect.  Well-known economists have long debated the question of how to effectively encourage positive economic growth.  Some economists support the idea of allowing the economy to stabilize itself, some advocate the use of only monetary or fiscal policy, while others adhere to the idea of using a combination of the policy tools.  Because almost everything that touches one’s life is impacted by economics, a stable economy should be of utmost concern to everyone.  The policies that change the course of economic trends must subsequently be investigated.

Hypothesis

            There are three factors that I think are strong economic policy indicators:  Gross Domestic Product (GDP), inflation rate, and rate of unemployment. 

H:  Both the Federal Reserve Board, via interest rates, and Congress, via tax rates, will work in conjunction to respond to the

     three chosen economic indicators to encourage economic growth or to prevent a recession, depending on the

     circumstances indicated.

A decline in GDP means that fewer goods were produced, meaning that production decreased nationally.  While there may have been growth in some sectors, the overall economy did not grow, but lost productivity.  If inflation rates are rising, then there is too much money in the economy relative to the amount of goods and each dollar one has is worth less than it was a day earlier.  A dollar is a dollar, but its worth can and does fluctuate on a daily basis based on its percentage of the total amount of money in circulation.  As unemployment rates rise, not only are people without income, the economy is losing jobs as well.  Those people without income will turn to the government for help, and the government will historically respond.

While the government may make errors in regards to fiscal and monetary policy, as a whole the Fed and Congress watch for problems and do their best to avert them and to prevent a depression.  The government has developed a responsibility to help those people who are in need and who qualify for assistance.  It is also in their best interest to keep business strong because it is these profits that largely contribute to the government’s income.  These policy changes would bolster the economy in times of recession or slow the economy in times when the growth cannot be sustained.

As the economic tide shifts, the government has historically taken actions to prevent another major depression.  A growth in the national GDP stems from a growing economy.  The actors may increase interest and tax rates in order to prevent an economic bubble from forming and popping, or in an effort to increase governmental and private revenues.  Increasing interest rates is a possible way to remove money from the economy and to decrease inflation, which is detrimental for all people.  A decrease in interest and tax rates would allow more money to be spent by individuals, encouraging business growth and thus increasing the potential for employment.

I would expect interest and tax rates to both influence economic policy decisions for a couple of reasons.  First, increasing the rates removes money from the economy, which is good for slowing an overheating economy or combating inflation.  Secondly, decreasing the rates encourages spending.  Spending leads to economic growth, which is reflected by the GDP.  As the economy grows, unemployment generally decreases, the cause of which is the growth of businesses.  I would expect that Congress and the Federal Reserve Board members are rational actors who would not enact policies that would be detrimental to the economy.  It would only make sense that as the actors who affect the economy, they would work together for the best of the economy.  If the actors do not work in conjunction with one another, one body will undermine the work of the other, and either no net change will take place of the policies may have the opposite of the intended effect.

Implications

There are four main implications that could be results of the data:

I1.  If there is any correlation between the independent and dependent variables, the classical theory of economics would not be supported.

I2.  If there is no correlation between the independent variables and tax rates, Keynesianism is not supported, but if interest rates are correlated instead, monetarism is supported.

I3.  The use of tax rates, but not interest rates, as a result of changes in the independent variables supports Keynesianism, but not monetarism.

I4.  If Keynesianism and monetarism are both supported, the modern consensus will have the greatest level of support.

Literature Review

Classical Economics

            Classical economists base their views on the centuries-old work of Adam Smith, David Ricardo, Thomas Malthus, and John Stuart Mill.  They explained unemployment as a temporary problem that would be resolved once wages fell and employers would then be able to hire more people for the same total wages.  Because of this flexibility of wages, they believe that the government should not directly make changes in the economy.  They adhere to an idea called Say’s Law, which claims that production, or supply, creates exactly the same amount of income that is then used to finance spending.  According to this Law, any income that is not directly reinvested, or spent, in the economy is saved, causing demand to fall below the level of supply.  This saving increases the amount of money available to finance investments, thereby decreasing interest rates because of this excess money available for loans.  Adherents of this theory believe that the quantity of money created by the Federal Reserve Board (Fed) has no influence on the long-run level of output.  They say that this injection of money into the economy only causes price increases.

            Keynesian economists disagree with Classical Economists for a variety of reasons.  First, they are in support of government interaction in the economy as long as it is done responsibly and with the overall economy being considered.  Keynes argued that because this view of the economy does not provide immediate solutions to economic downturns, recessions and depressions occur, and when they do, are not reversed for many years.  He also rejected Say’s Law on the ground that a decline in the interest rates causes people to want to hold their money, not loan it.  Because of the low rate, people only forego a small amount of interest income, whereas when the interest rates are high, they receive a strong return for little or no work (Kennedy 2000). 

Keynesian Economics

            John Maynard Keynes, the father of economics, developed a thesis directly relating to fiscal policy decisions.  While he wrote in 1936, people still stand by his works today.  Keynesians believe that an expansionary fiscal policy, while creating a budget deficit, is necessary to maintain an economy at full employment (Keynes 1936).  He focused on using fiscal policy instead of monetary policy to stabilize the economy (Blinder 2006).  Keynesians contend that this deficit will reverse itself once the economy is again growing and booming and that the temporary deficit is a small and acceptable price to pay.  They support shrewd governmental involvement for the purpose of maintaining a strong economy in the long run.  Before Keynes, most economists were convinced that using monetary policy to fight recessions was a terrible proposition.  They might have argued that a deficit was acceptable in these times, but that any sort of monetary policy would not have been acceptable.  Prior to Keynes there were governments who used monetary policy in this manner, though it was not widespread or strongly supported.

            Keynes differed from the classical economists for a couple of reasons.  First, he argued that shifts in demand were more important than the same shifts in the long run.  He said that a decline in demand leads to a decrease in the price level as well as Gross Domestic Product.  It is in reference to this point that his most famous quote was issued, “In the long run, we are all dead.”  Without changing the problems in the short term, what might happen in a few years is no longer important.  The second major difference from classical economists is that rather than the money supply dictating changes in demand, Keynes argued that business confidence was the greatest contributor to the business cycle (Krugman and Wells 2006).

Monetarism

According to the Monetarist Rule, the demand for money is directly influenced by the overall price level, the money supply, and the velocity of money, or the annual turnover of a dollar.  Monetarists argue that an increase in the money supply causes an increase in the price level overall (Friedman 1963).  The one assumption of this theory is that the economy is functioning at full employment.  If the economy is as full employment, an increase in the money supply will result in the same percentage increase in inflation.  (If the money supply is increased seven percent per year, a seven percent inflation rate will follow.)  Taking into account levels of employment and growth, the rate of inflation is directly reduced by the amount of increased money demanded by this growth.  During a recession, this relation is not usually seen.  Instead of increasing inflation or the overall price level, economic output is increased.

            Monetarists support the idea of a program that increases the money supply at a low, but constant, rate (Timberlake 1993).  They say that by automating the system they would be able to insulate monetary policy from political influences and prevent the devastating effects that would follow if the Fed made a crucial error.  The concern with this method of policymaking is that the economy does not grow at a stable or constant rate and such automatic adjustments could cause massive economic inflation (Kennedy 2000).  The Fed explicitly followed the rules of monetarism for three years, ending in 1982.  Because of the uncertainty of economic growth and change, the Fed decided that it would no longer set specific growth targets, but would instead focus on maintaining stability overall.

            One of Friedman’s main concerns that is still shared today is that the effects of monetary policy are only felt after a time lag (Bernanke, et al 1999).  These lags are unknown in duration and depth, so the policy that was intended to be helpful is not so when the economy needs it.  These lags are not necessarily disastrous, but only make the control more difficult.  Even if changes in policy are not immediately effective, they still make a positive contribution in the long run.

Modern Consensus

            Much of the controversy among the three schools of macroeconomists took place largely in the 1960s and 1970s.  Today, the controversy still exists, but not to that degree.  Instead, according to Krugman and Wells (2006), a consensus has been reached on a broad level when asking the following questions:

1.      Is expansionary monetary policy helpful in fighting recessions?

2.      Is fiscal policy effective in fighting recessions?

3.      Can monetary and/or fiscal policy reduce unemployment in the long run?

4.      Should fiscal policy be used in a discretionary way?

5.      Should monetary policy be used in a discretionary way?

Classical macroeconomists believed that expansionary monetary policy was at best ineffective and at worst harmful to fighting recessions.  Keynesians did not oppose monetary policy usage, but generally doubted that it was effective.  It was the work of Friedman and those supporters of Monetarism that persuaded the majority of economists that monetary policy is truly effective.  Today, there are very few people who support either the classical or Keynesian views.  Economists today believe that monetary policy, when used effectively, can be used to shift demand and to reduce instability.

The views on fiscal policy and demand are relatively similar to the above question.  Classical macroeconomists were even more vehemently opposed to the use of fiscal policy than to the use of monetary policy.  Keynesians were largely in support of the use of fiscal policy when fighting recessions.  Monetarists argued that as long as there was no change in the money supply (monetary policy), fiscal policy would accomplish nothing.  Today, most economists take the view that the government does not need to pass a balanced budget, but that it should be used as an automatic economic stabilizer.

Today’s view on long run unemployment is that there is a natural rate of unemployment, which limits the effectiveness of policies.  Effective policy can control swings in unemployment, but can never solve the problem.  Monetarists were the ones who first proposed this explanation that is now widely accepted.  Classical macroeconomists thought that the government could do nothing about unemployment while Keynesians felt that in exchange for inflation, expansionary fiscal policy could achieve a permanently low unemployment rate.

The final two questions in the chart below ask if the respective policies should be used in a discretionary manner.  Many people believe that these policies should be automatic responses to changes in the economy, while others believe that there should be substantial deliberation before any changes in interest or tax rates are made.  Keynesians believe that these policies should be used in a discretionary manner while the modern consensus adherents do not hold a strong position either way.  Classical economist and monetarist advocates hold the stance that any fiscal or monetary policy should be automatic, which removes the potential for political influence.

Fiscal policy is criticized for its lags in effectiveness because of the time required to pass a bill in Congress.  As a result, most present economists emphasize the effectiveness and importance of monetary policy over fiscal policy.  There is not a consensus as to how the Fed should set its policy, but there is consensus that the group needs to be independent of Congress, and that Congress should use its fiscal policy ability sparingly because of political influence.  There is some disagreement among the arguments presented by all three other groups on the effectiveness of these policies, but the chasm is much shallower than it was fifty years ago.

Table taken from Krugman and Wells, 2006.

Research Design

          I will conduct a time series study of several variables.  I have collected data from 1940 through 2006 for each of my variables.  The independent variables to be analyzed are Gross Domestic Product, the rate of inflation, and the rate of unemployment.  The unemployment information comes from the Bureau of Labor Statistics;  the GDP rates from Economic History Services;  and inflation data from www.inflationdata.com.  The dependent variables that the Fed and Congress may manipulate are interest rates and the lowest and highest tax rates respectively.  I use both the highest and lowest tax rates to examine the possibility that one level of taxpayers may be more affected by changes in the policy.  Also, with the variances in rates over the years, the average tax rates could not be accurately compared.  The tax rate data was obtained from the Internal Revenue Service;  the interest rate data is taken from William Hummel’s article “Money:  What it Is;  How it Works.”

Results & Discussion

T-Tests

Unemployment & Interest/Tax Rates

Economists generally agree that the natural rate of unemployment is somewhere between 4% and 6%, and that no matter what action the government takes, the rate will never be below this number.  I chose to use all of these possible points (4%, 5%. and 6%) as the cut points for the t-tests to see if one point really was significant.  What I found was that the results of this test were similar regardless of the cut point chosen.

            Using any cut point, we find significant relationships between the independent and dependent variables.  What is especially of note is that the relationship between the unemployment rate and the prime loan rate is that the correlation is positive.  This means that as the rate of unemployment increased, so did interest rates. 

            What can be seen as a result of these tests is that both fiscal and monetary policy were affected by changes in the independent variables.  Because fiscal policy was used, there is support for the Keynesian view of economics (I3).  The use of monetary policy is supportive of the monetarist ideas (I2).  Given that both types of policies were statistically significant, there is the most support for the modern consensus (I4), which supports the use of both types of policies to stabilize and/or direct the economy.  Thus, the results of this test support my hypothesis and the fourth implication.

Inflation & Interest/Tax Rates

I chose to look at the significance of inflation rates at two different points:  2% and 3%.  My rationale for this choice is that economists generally like to see inflation rates at less than 2%, but between 2% and 3% is not disastrous to the economy as long as it is not a sustained rate.  I chose two points to see whether or not an increased rate of inflation led to increasingly significant changes or not.  The statistical tests indicate that inflation is a significant influence on interest and tax rates across almost all the tested variables, though more so at 2%.

At a cut point of 2% all of the dependent variables are significant.  These results are supportive of I2 and I3, meaning that both the theories of Keynesianism and monetarism are factors.  This combination also supports I4, and my hypothesis with great certainty.