McGraw Hill's
Economics Web Newsletter
Spring
Issue, Number 7 of 7
Covering Week of April 17, 2000
Note to Instructors
The Economics
Web Newsletter is for use as a tool when teaching the principles of economics. It specifically references the Wall Street
Journal editions of selected McGraw-Hill Principles of Economics texts. Do You Remember presents five or more
quick factual questions and answers covering several articles that have appeared
in the Wall Street Journal in the week preceding the newsletter. They make good in-class quizzes when
reading the Wall Street Journal is required.
Article Analysis reprints one article from the Wall Street Journal
and poses five or more analytical questions and their answers with references
to text chapters.
The Economics
Web Newsletter is written by Jenifer Gamber.
Publication
Date: 4/24/00.
©Published
by McGraw Hill. All Rights Reserved,
2000.
DO
YOU REMEMBER?
If
you have read the Wall Street Journal from April 17th to 21st
you should be able to answer the following questions based upon important
articles relating to economics. The reference at the end of the answer tells
you the date and page number where you can find the article upon which the
question is based.
1.
Did last week's consumer price report confirm that inflation has been licked
or is returning?Click for answer.
2. Fill
in the blanks with the names of two countries and one economic category (Japan,
United States, developing world) to create a sentence that describes the method
by which the global economy recovered since 1998. Here's the sentence: The ________sold,
the ______bought, and _______paid for it.
Click
for answer.
3.
According to economist Ray Fair's model of voter behavior, are movements in the stock
market important to which presidential candidate voters will choose? Click for answer.
4. What
are the two reasons why interest rates facing consumers have risen this year? Click for answer.
5. What
is a significant impediment to trade on the Web on a global scale? Click for answer.
6. Why are
policymakers keeping an eye on the value of the dollar? Click
for answer.
7. On average
how much do Internet only retailers pay on marketing to acquire a new customer?
(a) $11, (b) $31, (c) $82. Click for answer.
8.
Name
one of the three things any new company needs for a successful IPO according
to Mr. Any Kessler? Click
for answer.
9.
Which
two major nonprofits are expected to merge?
Click for answer.
10.
Competitors
to Microsoft are alleging that it is using its monopoly power in the PC market
to gain power
in another market that is currently dominated by other firms. What market
is it?
Click for answer.
11.
What
two sectors are keeping the Chinese economy expanding?
Click for answer.
12.
What
is to blame for much of the recent rise in imports?
Click
for answer.
13.
Which
Presidential candidate has more tax cuts in his budget plan. Gore or Bush?
According
to former CBO chief Robert Reischauer, which candidate correctly forecasts the
budget surplus in coming years?
Click
for answer.
14.
How is Microsoft changing its advertising approach? (It appears to be in
response to the antitrust ruling.)
Click for answer.
ANSWERS TO "DO YOU REMEMBER?"
QUESTIONS
1.
One month's CPI report cannot answer that question definitively, but core
consumer prices (those excluding
food and energy) did rise by 0.4% in March (up 2.4% from 12 months ago). Go to the Bureau
of Labor Statistics. home page at http://stats.bls.gov
for the full report. (See
As Inflation Awakens,
Forces that Muzzle It May Be on the Wane. April 17, page A1.)
2.
The
developing world sold, the U.S. bought and Japan paid for it.
This describes how the
world recovery was based upon purchases by the U.S. goods from the developing world
that were financed by
investment by Japan in the United States. (See World Still Could Use a
Recovery in Japan. April 17,
page A1)
3.
No.
The most important factor is economic growth. Stock market valuations will affect
voter behavior only
if it affects the real economy. (See Stock Market Fall, Taken by
Itself May Not Hurt Gore. April 17,
page A4.)
4.
The
Fed has raised the Federal funds rate by 0.5 percentage point and there is
a larger inflation premium
built into interest rates. (See
Consumers Face Rising Interest Rates on Short-Term Loans and
Credit Cards. April 17, page A15.)
5.
Tariffs,
quotas, and trade laws and regulations. (See Tariffs Impede Trade via Web on Global Scale. April 17, page B1.)
6.
Weakness
in the dollar could indicate that investors are unsure of the U.S. economy.
A weaker dollar would
contribute to inflation. (See Officials Keep Close Watch on the Dollar.
April 18, page A2.)
7.
(c)
$82. (See New Study Finds Hope for Internet Retailers. April 18,
page A2.)
8.
Any
one: (1) a monster market into which to sell, (2) an unfair business advantage
such as a patent, and
(3) a business model to leverage that unfair advantage. (See Creative Destruction.
Can Be Lucrative. April
18, page A18.)
9.
Second
Harvest and Foodchain. This article discusses how nonprofits.
motivations differ from
for-profit
firms and why many are now considering merging.
(See The Urge to Merge Hits Charities,. April
18, page B1.)
10.
The
market for servers. (See A Tricky Element in the Antitrust Battle: Microsoft.
s Server Tactics,. April
19, page AB1.)
11.
Government
sector and export sector. (See China. s Economy Rallies, But
the Outlook Is Fragile,. April
19, A25)
12.
Higher
oil prices. Go to the Commerce Department. s home page http://www.doc.gov for the full report.
(See Oil Prices Propel U.S. Trade Deficit to a Record. April 20,
A2)
13.
Bush
plans higher tax cuts. Reischauer believes both overestimate the surplus in
coming years. (See Presidential
Candidates Battle over Budget Esoterica,. April 21, A2)
14.
Microsoft
is overhauling its advertising campaign to depict the company. s technology
as a positive force
in society.. (See A Predatory. Monopolist Tries the Old Soft Sell,. April
21, A1)
Inflation
Shows Signs of Stirring
As Forces Restraining It Wane
By
JACOB M. SCHLESINGER and
YOCHI J. DREAZEN
Staff Reporters of
THE WALL STREET JOURNAL
4/17/2000
The Wall Street Journal
Page A1
(Copyright (c) 2000, Dow Jones & Company, Inc.)
WASHINGTON -- For three
years, Federal Reserve Chairman Alan Greenspan has been warning, with ever-increasing
urgency, that there are limits to how fast the New American Economy can grow
without sparking inflation. "We do not know where that point is," he would
say ominously. But "when we reach that point, short of a repeal of the law
of supply and demand," inflation will return.
1. Using
the AS/AD model, demonstrate why there are limits to how fast the New American
Economy can grow without sparking inflation..
What determines that limit?
Friday's consumer-price
report provided the most tangible reminder in a long time that the law of
supply and demand hasn't been repealed. Retail prices, excluding the volatile
food and energy sectors, rose 0.4% in March from the previous month -- and
were up 2.4% from the previous year. That's not much if measured against the
price panics of the 1970s, or even the moderate inflation of the 1980s.
But it's the biggest monthly increase in the core inflation rate in five years.
And even a small speed
bump can have a big effect on a speeding car.
Monthly economic statistics,
of course, are only a misty glimpse of reality. This one, like so many before
it, could turn out to be a fluke.
But it comes at a time
when many of the anti-inflationary forces of the 1990s are waning. Costs for
raw materials, imports, and health care are no longer falling. Overseas economies,
long able to service the demands of the American economy because they were
weak, are picking up steam. Labor markets are growing ever-tighter, and showing
new hints of pushing up labor costs. The great American shopping binge shows
no sign of slowing.
2. What forces are making inflation
more likely? Are they demand
forces, supply forces, or both? Explain
your answer.
'Heightened Alert'
So more than at any time
in recent years, a bad inflation number has to be taken seriously. "We're
in a period of heightened alert," says Edward Boehne, president of the Federal
Reserve Bank of Philadelphia. "We've moved beyond just the risk of accelerating
inflation to some preliminary, fragmentary suggestions that we might be seeing
some accelerating inflation."
The belief that inflation
may have been permanently licked is one of the underlying myths of the millennial
economic boom, and its accompanying bull market. And indeed, much of the conventional
wisdom about what causes inflation has long been shattered. Just half a decade
ago, mainstream economists agreed that an unemployment rate of 6% or lower
would cause prices to accelerate. But unemployment slipped below 6% in 1995,
and below 5% in 1997, while inflation continued to slow.
3. Why do economists believe that
the unemployment rate is important to understanding inflation? The unemployment rate below which prices
accelerate has a specific name. What
is it?
Low inflation -- and
the widespread conviction that it would stay low -- has had myriad benefits.
It has spurred an investment boom by giving executives the confidence to plan
far into the future without uncertainty over prices. It has been used to justify
the sharp rise in the valuation of stocks, with experts arguing that long-term
stability in prices -- and hence interest rates -- lowered the long-term risk
of equities.
The prospect of inflation's
resurgence is especially chilling because all but one recession experienced
since World War II was the direct result of rising prices and the Fed's jacking
up interest rates in response.
The March price number,
and the brutal stock-market sell-off that accompanied it, now put Mr. Greenspan,
the country's top inflation cop, in an uncomfortable bind. His primary mission
is to keep inflation -- and fears of inflation -- under control. To the extent
that Friday's news suggests the Fed is falling behind the curve, it would
seem to make an interest-rate increase imperative when policy makers next
meet May 16.
Balancing Act
The price report will
even give fresh ammunition to those officials who advocate pushing up rates
by a forceful half a percentage point next month -- rather than simply matching
the five quarter-point steps since last June -- to snuff out any possible
shift in inflation sentiment. The "gradualist approach" has been fine as long
as the Fed has been "moving preemptively against the threat of higher inflation,
without any direct corroboration from data on inflation," Fed Governor Laurence
Meyer, one of the central bank's leading hawks, said in a speech delivered
last Wednesday. But, he added, if inflation expectations pick up, "it would
be important to react more aggressively."
4.
Why
is inflation related to Fed. s policy?
What specific action might the Fed take in response to this CPI report?
Why are inflation expectations important to the Fed?
On the other hand, if
the market's precipitous decline continues, the Fed will be loath to make
it worse. And while all evidence is that the economy continues to gallop at
high speed, the instant evaporation of trillions of dollars in stock-market
wealth may well presage some slowing in the excessive consumer spending that
has so worried officials.
After Friday's plunge,
the Wilshire 5000 -- the index of all publicly traded U.S.-based stocks that
the Fed prefers to the narrower Dow Jones Industrial Average and Nasdaq gauges
-- was up just 3% from a year earlier. Fed Chairman Greenspan suggested in
comments earlier this year that the market could grow as fast as a 6% annual
pace without contributing to inflation.
Should market turmoil
continue over the coming weeks, "either the volatility in the market or the
level of prices could stay the Fed's hand," says Daiwa Securities America
chief economist Michael Moran. "The wrenching experience in 1998" -- following
Russia's debt default and the near-collapse of a major hedge fund -- "most
likely will leave officials reluctant to stir a boiling pot," he added.
5. How might a decline in the stock
market affect the economy? Explain why this might happen.
For all the hand-wringing
over the March consumer price report, it's worth keeping the number in perspective.
Though price increases were broad-based, it would be premature to declare
a trend. The 0.4% monthly increase in the so-called core rate -- excluding
food and energy prices -- followed two consecutive months of much tamer 0.2%
increases. Just the day before releasing the consumer price index, the Bureau
of Labor Statistics announced that core prices at the wholesale level -- sometimes
considered a precursor of future inflation patterns -- rose a modest 0.1%,
and had decelerated from February.
Oil Spillover
The March consumer-price
figure reflected the spillover of higher oil costs into other sectors, notably
transportation, which registered the biggest one-month jump of any sector
outside energy. But with the Organization of Petroleum Exporting Countries
agreeing to boost production in late March, energy prices are falling again,
and those other prices are expected to ease as well.
"This number is a reminder
that inflation risks are real in today's economy," Fed Vice Chairman Roger
Ferguson observed after Friday's report. "However, one would hope that one
month's number wouldn't precipitate a major re-evaluation of inflation expectations."
The April price report -- due to be released the morning of the next Fed meeting
-- will help determine whether the March figure was a fluke or a turning point.
In recent public comments,
Mr. Greenspan himself has been upbeat about the prognosis for prices. Asked
at a Senate hearing Thursday if he had seen any fresh evidence of inflation
in recent weeks, he responded that "if you look.. at the underlying cost
structure of American business, I see no evidence of an acceleration in unit
costs."
A major reason for the
stellar inflation performance of the 1990s has been a sharp rise in productivity,
or output per worker hour, which allows companies to absorb higher costs without
raising prices. As a result, Fed officials and many other economists believe
the U.S. can now grow much faster than was possible just four years ago without
overheating. The Fed has raised its estimate of potential annual gross domestic
product growth, adjusted for inflation, from just over 2% to possibly as high
as 4%.
6. What
important factor is keeping prices low?
How does this relate to the unemployment rate mentioned in your answer
to question #3?
But only the most starry-eyed
New Economy believers think that the 7% annualized pace set in last year's
fourth quarter is sustainable. Analysts at the time dismissed that figure
as artificially bloated by preparations for the year-2000 computer bug by
companies and households. But growth through the first part of this year has
continued to streak at similar warp speed. With strong retail sales figures
reported last week, Goldman, Sachs & Co. raised its estimate of first-quarter
growth from an already high 5% to a whopping 6%. The Commerce Department will
report the official figure next week.
Rapid growth hasn't sparked
inflation in part because wage gains have been surprisingly muted despite
tight labor markets. But the current pace of growth could push the jobless
rate down even further -- Goldman Sachs economists expect a rate of 3.75%
by year's end vs. 4.1% today. "There are signs that both sides of the pay-bargaining
process recognize enhanced leverage for employees these conditions should
promote continued strong increases in wages and benefits," they wrote in a
report issued Friday.
Recoveries Abroad
Noninflationary growth
also has been possible because much of the rest of the world was floundering,
meaning that global demand for key commodities and goods was still moderate.
But this latest acceleration in American growth comes at a time when the rest
of the world is recovering from the various financial panics of the late 1990s.
That's one reason import prices have risen 1% over the past year, compared
with a 2.4% decline during the prior 12 months, the Labor Department reported
last week.
Economic policy makers
worry that the weakening stock market could further boost import prices. That
would happen if foreigners start pulling investments out of the U.S., a move
that would drive down the value of the dollar, raising the dollar-denominated
cost for goods priced in yen or euros.
There have been fresh
signs that cost pressures for U.S. companies have been rising, and not just
from oil. In the National Association of Purchasing Management's monthly survey
of manufacturers, the index measuring prices paid for supplies jumped in March
to its highest level since February 1995 -- a period when inflation worries
were mounting and the Fed was completing its last round of interest-rate increases.
Fifty-eight percent of the companies contacted last month said they were paying
higher prices for commodities, up from just 35% in December.
Rising prices for supplies
isn't an automatic recipe for consumer inflation. A major reason prices have
remained so tame in recent years is that the pricing power of U.S. companies
-- the ability to pass on costs to consumers -- collapsed in the 1990s. Strong
forces in the New Economy continue to counter inflation, from more global
trade to e-commerce. As a result, many companies faced with newly rising costs
are still forced to eat them or offset them with higher productivity.
7. What
temporary factors have kept inflation down in recent years?
A key question now is
whether consumer demand has gotten so strong that pricing power may be beginning
to return, eroding another important dam that has helped hold back inflation.
'A Little Evidence'
Mr. Boehne, the Philadelphia
Fed President, says he is seeing for the first time in a long time "a little
evidence, though I wouldn't call it conclusive" that firms in his region are
saying, " 'Let's see if we can raise some prices, see if they can stick.' "
Similarly, Jack Beebe, research director of the San Francisco Fed says that
out West, "there seems to be an environment where there isn't quite so much
difficulty in adjusting prices a bit."
For years, Tenet
Healthcare Corp. saw its margins shrink because of an inability to pass
higher costs on to the managed-care companies that are its primary customers.
In recent months, Tenet, which runs a chain of 112 hospitals in 17 states,
has pushed through price increases of as much as 6%. "We've served notice
that we won't continue to provide services at prices that are uneconomical,"
says spokesman Harry Anderson.
The trickiest part of
the inflation picture is how the stock market may affect it. Mr. Greenspan
has estimated that a full percentage point of growth over each of the past
four years has come directly from consumer spending inspired by soaring stock
portfolios. And because the market had been rising for months despite the
Fed's rate increases, officials have felt that their moves so far have "had
a smaller effect than usual -- nearly zero -- on overall financial conditions
and hence on aggregate demand," Fed Governor Meyer said last week.
If the stock market remains
depressed, that will certainly damp demand and reduce the risk of inflation
-- although the effect might be less than the magnitude Friday's carnage would
suggest.
Lagging Expenditure
Research shows consumers
only spend their stock market wealth with long lags. The recent surge in spending
has likely been, and continues to be, fueled by the double-digit market gains
of 1995 through 1998. The drop has yet to eat into those gains.
Besides, even with the
stock-market drop, prospects for job growth and income growth remain strong-factors
that affect the spending habits of far more households than the Dow Jones
industrials or Nasdaq. The University of Michigan reported Friday that its
consumer sentiment index -- often a gauge of future consumer spending -- rose
over the past two weeks despite the market turmoil.
Bottom line: "It's an
oversimplification to say the stock market goes up or the stock market goes
down, and therefore the implication for monetary policy is the following,"
says Mr. Boehne. "We have to look at the overall economy and the influences
on it."
ANSWERS
TO ARTICLE ANALYSIS QUESTIONS
Chapter
references appear after the answer to each question.
Refer to the following chapters in McConnell and Brue. s Economics
and Macroeconomics for help when answering these questions:
Chapter 8, 11, and 16.
Refer
to the following chapters in Colander. s Economics and Macroeconomics
for help when answering these questions: Chapters 8, 10, 14.
1.
Because
the economy has only so many resources to devote to production, there is a
real limit to the amount of goods and services an economy can produce.
This is known as potential output.
When the economy is far below potential output, the price level is
relatively fixed and output can rise without a rise in the price level. As the economy expands closer to potential
output, increases in aggregate demand are split between increases in the price
level and real output. An economy
can operate beyond its potential for only short periods of time. Eventually the price level will rise
and real output will fall to its potential. The AS/AD captures this with an
AS curve (also called an AS path) that has three parts. a flat part, an upward
sloping part and a vertical part shown in the graph below.
2.
Strong
aggregate demand (from both domestic and foreign sources) and growing shortages
(tight labor markets) are making inflation more likely.
These are both demand and supply forces. Return
to article.
3.
During
periods in U.S. economic history low unemployment has been associated with
high inflation and high unemployment has been associated with low inflation.
This empirical tradeoff is known as the Phillips curve. In addition to this empirical history,
the unemployment rate indicates the slack in the labor market. The argument is that when there is excess
supply in the labor market (high unemployment) wages will not rise by as much
and therefore product prices will not rise as much either. The rate below which prices accelerate
is known as the natural rate of unemployment.
Return to the article.
4.
The
two goals of the Fed are price stability (low inflation) and full employment
(low unemployment). When inflation is high, the Fed can execute
open market operations (sell bonds) to raise interest rates and slow the economy.
By slowing the economy inflationary forces can be lessened.
In the long run, the quantity theory says that there is a direct relationship
between money growth and inflation. According to that theory, in the long
run, the Fed controls the inflation rate.
The Fed might raise interest rates by selling bonds in response to
this report. Inflation expectations
are important to the Fed because inflation expectations that become built
into people. s pricing behavior are more difficult to eliminate. Such expectations can lead to higher
inflation rates without any rises in output. Return to
article.
5.
Fifty
percent of all Americans own stock, which is counted as wealth.
On average, the marginal propensity to consume out of one. s wealth
is 3 percent. Thus, if wealth declines, consumption
will decline. Consumption is a component of aggregate demand and lower aggregate
demand will lead to a slower or possibly contracting economy. Return to article.
6.
Growth
in potential output (increases in labor productivity) is keeping inflation
low. When potential output rises,
that means the economy can produce more goods and services.
This is shown as a shift in the AS curve to the right.
When potential output rises, the unemployment rate falls. Return to article.
7. Temporary
factors that have kept inflation low in recent years are low demand for U.S.
exports (weak foreign economies), global competition that keeps U.S. firms
from passing on cost increases to consumers, increased competition from e-commerce,
slower health care cost inflation, and a strong dollar that has lowered import
prices of raw materials. Return
to article.