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December 24, 2008

Government Spending and Economic Growth

By Wade Rousse

The following quote is from Gwartney, Stroup, Sobel, and MacPherson’s text book titled Macroeconomics Private &Public Choice:

“In summary, while government activities that focus on the areas where it has a comparative advantage will enhance growth, continued expansion will eventually exert a negative impact on the economy.”

The authors evaluate government spending for 23 OECD countries. They conclude that after a certain point a 10 percent increase in government spending, as a share of GDP, will result in annual economic growth being reduced by approximately one percent.

So the question becomes…at what point will economic growth be hindered? Congressional Budget Office (CBO) consultant Edgar Peden estimates that in the U.S. this will occur when government expenditures are greater than 20 percent of GDP. And Gerald Scully, a University of Texas at Dallas professor, estimates that annual economic growth will slow when government (combined federal, state, and local) spending reaches approximately 22.9 percent of GNP. These numeric thresholds are developed using different methodologies; however, they both indicate that too much government will slow economic growth.

I guess I’m just curious as to your thoughts?? Do you think that cutting government spending once the recession ends will be conducive to economic growth??

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Posted by Wade at 4:43 PM | Comments (5) | TrackBack

December 16, 2008

Limits of Monetary Policy and “Quantitative Easing”

One of the goals of this blog is to decipher some of the not-so-clever and confusing lingo that is economics. I read an article this morning by Ryan Sweet on the Dismal Scientist website that I thought did a good job in just two sentences of describing “Quantitative Easing.” I thought I would share it with you:

“Quantitative easing aims to bring down long-term interest rates and increase liquidity in the financial system. Under a quantitative monetary regime, the Fed would focus directly on the quantity of money in the system rather than on trying to influence the money supply indirectly through the price of credit—in other words, interest rates.”

This will be a popular topic for students of the Fed in 2009 — and a topic debated and most likely misunderstood by the media. We will try to explore it further through this blog.

I will leave you with a couple questions to consider: It may be wise to have a broad-based strategy to ease quantitatively from the beginning, such as buying corporate debt, equities, and long-term Treasuries, but do you see any problems with this strategy from the perspective of the Fed? What would you recommend and is there something in history that you could point to that would help guide policy-makers?

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Posted by Cindy at 3:37 PM | Comments (7) | TrackBack

December 12, 2008

Ricardian Equivalence

By Wade Rousse

Recently, there has been a lot of talk about the economic policies the new administration may quickly implement once in office. I’ve heard utterances of tax cuts for the middle class, and an increase in infrastructure spending, to name just a couple. One thing is for certain. Both will increase the government’s debt.

In this posting, let’s discuss the middle class tax cuts. It’s interesting to think about the different economic theories that lie beneath this policy. The traditional view of this type of government program, which “temporarily” increases the budget deficit, is that consumers will respond to their increase in after-tax income by spending more. As a result, this increase in spending will help the overall economy.

But let’s consider an alternative view. It’s called Ricardian Equivalence. Here, consumers are forward-looking. They consider their current incomes, as well as their future incomes, when making consumption decisions. Realizing that the government seldom reduces spending, consumers know that their increase in current income will be offset by a reduction in future income because the government must eventually raise taxes to re-pay the increased budget deficit. As a result, consumers do not spend more. Therefore, a person who subscribes to Ricardian Equivalence believes a middle-class tax cut would not affect the overall economy.

I’m curious as to which one of these views do you think is correct? In addition, how forward-looking do you think consumers really are?

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Posted by Wade at 6:47 PM | Comments (4) | TrackBack

December 5, 2008

Does GDP tell us how we are doing?

Recently, we held a Fed Challenge orientation here at the Fed. Students were encouraged to memorize “C+I+G+NX” -- even being promised by an instructor that this knowledge will impress on Friday night. We may have oversold, but the point is that GDP is often how we begin a conversation about monetary policy goals. We talk about it as a way to measure how our economy and ostensibly how we are doing.

A student from the orientation, Kevin, asked a great follow-up question: Why do we use GDP instead of something like the Genuine Progress Indicator (GPI)? GPI adjusts GDP downward for things like the cost of crime fighting, pollution costs, changes in leisure time, dependence on foreign assets, etc. Kevin’s underlying point is a good one. Aren’t we after all looking to see how we are doing as a society -- so if crime goes up and we are spending more on police services, we should not see that as progress even though GDP goes up.

A similar welfare indicator that is well known is the Human Development Index (HDI), a composite index published by the United Nations. This index takes into account factors like literacy levels, education levels, GDP per capita, distribution of income, access to clean water, and quality healthcare. The US ranks 12th in HDI and 2nd in GDP per capita. This disparity points to the problem Kevin raised in using GDP as a measure of welfare.

In my opinion, these welfare indices are great assets to policy makers as they give valuable data on thematic areas (literacy, education, empowerment). However, they are composite indices which mean that they collect data from many sources, leading to many accuracy issues. The HDI website strongly suggests that the composite data not be used to create trend analysis. However, these accuracy issues should not render the data worthless. After all, we should be asking ourselves why the US’s income inequality ratio is high (Gini coefficient – included in HDI). A better (more equal income distribution) Gini coefficient is usually correlated to higher per capita GDP, but the US seems to be one of just a handful of exceptions.

With this said, the Fed probably won’t get away from focusing on GDP, although limited, it is something that is easier to accurately measure and responsive to policy changes in a relatively short amount of time (months). Welfare indices, like the ones above, may be good long-term measures, but perhaps difficult to use in the Fed’s capacity as they tend to change very slowly. Just think how long it takes pollution and literacy changes to be reflected.

But the conversation does beg the question – should the Fed/policy makers use them at some level? At the very least, focus more on GDP per capita? What do you think?

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Posted by Cindy at 11:05 PM | Comments (39) | TrackBack