Answers for This Time
Introduction to Macro
Part 1:
1. The accompanying graph describes the pattern of sales at Sam's market during much of the 1970's. As you can see, in 1974 Sam's suffered a substantial drop in sales and has never regained the loss. Sam, the owner of this intermediate size super market in Westerly, attributes the loss in sales to a problem with the quality of some of the produce supplied to his market for a brief period in 1974. The error was quickly corrected, but Sam contends that faithful customers were lost during this period and that they never returned. He is therefore suing the supplier for the difference between projected sales and the actual sales over the period 1974-78.
Your job is to prepare a defense for this case. You are to outline your plan and describe the rationale for it. Be sure to indicate what you consider the important factors to be considered and what data you would use, how you would obtain the data, and how you would utilize it. As you prepare your case, remember that time is money and money is a constraint. I am not interested in wish lists. Before you suggest a plan of attack, you had better be sure that it is a feasible plan. If your plan requires unacceptably large data collection costs or requires data that are not available, then your plan is severely flawed.
Before we move on to discuss the significance of scale, let us return to one of our initial problems, SAM's market. You will recall that SAM's had brought suite alleging that their sales had been damaged as a result of a mishap in the store. The benchmark in their case was a projection based on a simple extrapolation of the previous trend. But is this an appropriate benchmark ? In the two graphs below, the pattern of State sales has been used as a benchmark. In the first, the indexes of SAM's sales and supermarket sales in RI are plotted because SAM's sales are in millions and the state sales are in hundred of millions. It seems clear from the graph that SAM's sales decline is in line with the declines in the State, which raises questions regarding the extent to which the mishap was responsible for the sales decline.
A somewhat different view of the situation, but one that brings us to the same conclusion, is the graph of the ratio of SAM's sales to the State's. This measure of relative sales also fails to show the deteriorating position of SAM's. In fact, we see that SAM's share of State sales increased after the mishap as SAM's sales fell less than sales in the State. In fact, when reviewing the two graphs it looks as though SAM's was able to weather the recession of 1982 better than the rest of the supermarkets in the State.
2. Anyone who embarks on a forecasting exercise is very aware of the adage that goes something like this: forecasting is not easy-especially when it is about the future. But let's give it a shot. The graph below contains U.S. sales data for the ITZIBITZI Motorcycle Company. With these data we can attempt to generate forecasts.
This has proven to be an interesting question over the years - one which has given me some insight into the forecasting techniques that students are exposed to. One approach would be to use the historical data to look for trends - some variations on what people would call time-series analysis. The blue line, which captures the trend for the entire period, can be extended through 1977 to generate a forecast of Sales. The problem is that without any adjustment, sales will fall in 1975. This could be taken care of by accepting the slope (growth rate) based on the historical data, but beginning it at the 1994 figure (maroon line). Others may look and see that growth has been faster in recent years and decide to use that growth rate. In this case the forecast line is the green line and we end up with a substantially higher sales forecast.
These are by no means the only ways to forecast sales, and for those interested in alternative techniques, you might want to check out econometrics. One common approach among economists would be to attempt to find some factor(s) that would be responsible for explaining the sales pattern. For example, if you were asked to explain demand you would likely turn to factors such as price and income for the keys to understanding the patterns of movement in demand. The same is true here and over the years students have identified a number of possibilities including price of gas, unemployment rates, and the population.
Too often, however, there has been little effort made to actually consider the nature of the commodity which we are talking about - motorcycles. As it turns out the 'demographics' of motorcycle sales is such that there is a definite age pattern and therefor it is not necessarily the population but the population in a specific age group that matters. In this case a significant wedge appears between the growth in population and the growth in population in prime motorcycle buying age groups and any model based on population growth would overestimate demand.
Part 2:
1. What's happening out there? One of the beauties of the new electronic age is that we can now answer that question. It is now time to test your skills at using data analysis to help you tell a story. You are to construct at least one graph that will allow you to tell me a story about different aspects of the capital market in the US. You may complement this with a simple regression model that you estimate - a chance to show me that you have mastered the powers of regression. More specifically, I am interested in some graphical and / or statistical analysis that will allow you explain the following.
a. The relationship between the maturity effect and inflation. [the maturity effect is the difference between a long-term and a short-term interest rate]
It appears as though there is no evidence of a strong relationship, although when the inflation rate is exceptionally high (right side of diagram) the spread actually turns negative. This suggests that short-term rates adjust to inflation more rapidly than long-term rates, at least when inflation is quite high.
b. The relationship between inflation and the performance of the stock market.
This is not a very strong relationship, but there does appear to be a weak negative relationship between the growth in stock prices and the inflation rate.
c. The relationship between the federal budget deficit and the trade deficit.
The scatter diagram suggests that there is a positive relationship between the two deficit - budget deficits tend to be associated with trade deficits. There is a reason why we would expect a relationship and we will discuss it when we move to our discussion of public finances.
d. The relationship between real interest rates and inflation.
Although once again there is not a perfect fit, it appears as though there is an inverse relationship - when the inflation rate rises real interest rates fall. This suggests that in the short-term interest rates adjust slowly to inflation. This relationship can be seen in both the time-series graph and the scatter diagram.
2. The AS-AD model plays much the same role in macroeconomics that the S-D model plays in microeconomics. It provides a way of structuring your thinking as you read the business news and try to make sense of the movements in the economy. You are to demonstrate with the aid of the AS-AD model the impact of the following events:
The AS-AD graph that is at the center of this questions appears below. The approach is similar to the cookbook approach with the S-D model. In each question we need to identify which curve it shifts and what is the nature of the shift. The answers that are sketched out below should not be viewed as the complete answer in that there are certainly additional linkages that could be identified, but these are major links that will provide you with a sense of how you can utilize the diagram to sort through the impact of events on the US economy.
a. A recession in Asia. On the demand side, a recession outside of the US will likely reduce demand for US exports which are a component of AD. This would shift the AD curve inward moving the intersection down and to the left. The recession in Asia would put downward pressure on income and prices in the US. This was widely accepted as one of the reasons that the Fed did not take action to slow down the economy in the summer of 1998. The belief was that the Asian crisis would slow it down and thus the Fed would not need to step in.
b. A substantial slide in the value of the yen. The decline in the yen is the flip side of an increase in the value of the dollar. A declining yen will reduce US exports and increase US imports since US goods are now more expensive in Japan and Japanese goods are now cheaper in the US. This will reduce AD and the AD curve will shift inward putting downward pressure on output and prices. The decrease in the price of Japanese imports will be reflected in a lower level of prices in the US which is comparable to a reduction in the cost of production. This will shift the AS curve outward which will put upward pressure on output and downward pressure on prices. The combined effect is a clear lowering of prices (inflation) with a less certain change in output
c. A decrease in the price of oil as Iraq's oil production returns to the market. The decrease in the price of oil will lower the cost of production. This will shift the AS curve outward which will put upward pressure on output and downward pressure on prices. This is the opposite effect from what we saw in 1973 when the OPEC nations dramatically raised the price of oil and sent the US economy into stagflation. The increase in the price of oil shifted the AS curve in putting downward pressure on output (Stagnation) and upward pressure on prices (inflation).
3. What is the relationship between the budget deficit and the trade deficit?
There is no simple relationship between them, but the national income identity does provide a framework for looking at that question. The AS = AD version of the identity appears below.
(1) Q = C + I + G + X - M
As we saw in the section on the national income identity, this equation can be transformed into one which explicitly contains the trade and budget deficits. The trade deficit is defined to be the value of imports minus the value of exports (M-X). The budget deficit is defined to be the value of outlays minus the value of receipts (G-T). The resulting equation is:
(3) (S - I) = (NFP - TDEF) + BDEF
With a little reworking of the algebra we get the following:
TDEF = BDEF + [NFP + (I - S)]
Based on this equation we should expect a positive relationship between the budget and trade deficits, although the relationship may not be a very good one since there are other factors to consider - the balance between savings and investment (S-I) and the level of net foreign payments (NFP). For example, we could have a trade surplus [TDEF < 0] and a budget deficit [BDEF > 0] if (I - S) < 0 which would be the case if the country had a high savings rate and/or a low rate of investment.