Scenario Problem for Workshop #2

SCENE: 10am, Wednesday, November 10th, 1982, White House. The weather outside is grey and bleak. Cold rain is plastering the windows. Gathered for a special discussion of economic policy are: Martin Feldstein, chairman of the Council of Economic Advisors; Treasury Secretary Donald Regan; FED Director Paul Volcker; Labor Secretary Raymond Donovan; Chairman George Schultz; Secretary of Interior, James Watt; Representative Jack Kemp; David Stockman of OMB; Defense Secretary Casper Weinberger; Howard Baker; and Ed Meese presiding.

MEESE: Gentlemen, thank you for coming. The President will be with us momentarily.

(There is general chatter--mainly about the tent city of the unemployed being set up in LaFayette Park across the street from the White House--until Reagan enters.)

REAGAN: (Smiling) Good morning men, glad you could all make it. (He sits down, popping a last jelly bean into his mouth.) Well men, we've got the elections behind us now; it's time to figure out where we go from here with the economy. We've got to keep the ball rolling.

FELDSTEIN: Mr. President, I hate to be a kill-joy, but it doesn't look to me like the ball is rolling much at all at the moment. The latest Commerce Department reports suggest that the outlook is as lousy as the weather.

REAGAN: Now Marty, you're always being pessimistic. Look, thanks to Paul's cooperation, interest rates have come down and the stock market has rebounded a bit.

(Volcker authoritatively snips off the end of another cigar while nodding his agreement.)

FELDSTEIN: That's true, Mr. President, but it doesn't look like investment is responding to these stimuli.

REAGAN: How much response do we need?

FELDSTEIN: Well, assuming a consumption function of C = 104.8 + .6Yd....

REAGAN: A what?!!!

FELDSTEIN: A consumption function, Mr. President, don't worry about it, it's just a technical economic statement about people's spending out of their after-tax income.

REAGAN: (looking bothered) Alright, go ahead.

FELDSTEIN: As I was saying, assuming that particular aggregate consumption function, together with government spending of $657 billion, tax receipts of $599b and private investment of $400b, and net exports of $50billion we predict a deficit of $58 billion and a GNP of about $2131 billion. Now that puts us below the 1981 level of $2922. That's really a severe drop, and obviously unacceptable. If you'll excuse my saying so Mr. President, neither the economy, nor the people, nor your 1984 election prospects can stand that--and the 12 percent unemployment it implies.

DONOVAN: As much as I hate to add fuel to Marty's warning fire, the latest Bureau of Labor Statistics' reports suggest an even greater growth of the labor force than we had anticipated--it seems women are continuing to look for work, instead of taking care of business at home--so 12 percent is probably underestimating unemployment with that scenario.

REAGAN: (looking perturbed) OK, so things aren't rosy. What are your suggestions?

KEMP: Stay-the-course, Mr. President! You just have to give our supply-side package some time to work. For one thing, we must go ahead with the next 10% tax cut as planned! We'll make the yardage!

FELDSTEIN: Jack, a 10% tax cut will mean a drop of $59.9b in net receipts, that will raise the deficit from $58b to $117.9b!! Have you figured out how much the cut will help GNP?

KEMP: No Marty, but...

STOCKMAN: (looking up from his calculator and interrupting) If you use Marty' model, it'll only raise GNP by $89.85, call it $90b, to $2221b--that's not much help!

VOLCKER: Not only is it not much of a direct help, but a deficit of $117.9b is going to scare the money markets silly when the Treasury has to go into them for an extra $59.9b!

REGAN: That's right, I agree with Paul and if we push him to loosen up the money supply to put downward pressure on interest rates, that will fuel inflation--which will further dampen business enthusiasm for investment. Capital expenditure plans are already plunging!

REAGAN: Well damn it, how do we get business investment up? We've already given industry more deregulation, tax cuts and anti-labor action than any other administration in recent times!

WATT: Mr. President, if you'll just give me the go ahead, I'll be more than happy to speed up the leasing of Federal lands--and do it more cheaply to boot. That'll certainly stimulate investment in mining and would help offset the current oil glut. We can certainly speed up drilling on the West Coast and a little more deregulation would push ahead strip mining in the East--say you know we've just had reports there are big coal deposits across the river in Arlington!

BAKER: (urgently) Now wait a minute Jim, we live over there!

WATT: Just a thought...anyway the point was that all that would help productivity in mining where declines have been greatest lately. A few more big shovels would help out a lot.

DONOVAN: (getting caught up in the possibilities) And it would help us further undercut the United Mine Workers and outflank rank and file wildcats!

REAGAN: Howard? Can we get that through over on the Hill?

BAKER: (chewing on his glasses and looking worried) I don't know, Mr. President, the environmental nuts have been blocking us right and left. We certainly won't get far during this session. Did you see that article in this month's Fortune?

REAGAN: Yes, I saw it. I tell you if you've seen one environmentalist, you've seen them all...If there's one species that deserves to be extinct, it's that bunch!

STOCKMAN: Gentlemen, the only thing we can do is slash the budget further, and slash it in a way that stimulates business. We must go after the entitlements, further cuts in food stamps, welfare and...we've got to work out a strategy for security. Right Marty?

FELDSTEIN: David you know I agree with you, I haven't spent the last ten years attacking social security for amusement. Slash social security and you give a big boost to savings--which will put pressure on interest rates--investment in the insurance industry, and you cut the floor out from under waged workers.

DONOVAN: That's the key! We've put enough heat on to get some concessions, but we need more in order to convince the boys over at the Business Roundtable that we're serious.

STOCKMAN: Moreover, reducing expenditures will lower the deficit and they will love that.

FELDSTEIN: It may stimulate capital expenditures David, but as an economist I have to remind you that the immediate effect will be to reduce aggregate demand and economic activity and worsen the recession. We could, however, cut other kinds of expenditure that buttress labor, say educational expenditure. We could slash grants --that'll teach all those university protestors-- and if their parents have a hard time swallowing it, we could come back next year with loans. For example, if we go with Jack's next round of tax cuts and are able to cut educational expenditures by say $50b--which is optimistic, given the Congress we're now facing--we'll still have a deficit of $67.9 and GNP will be...let's see...only $2095.9 which is worse than our original projection.

REAGAN: oops!

KEMP: Maybe, but suppose investment jumps by say 30%, not impossible coming out of this recession, in reaction to a renewal of our program.

FELDSTEIN: Well, an increase of 30%--which I think is unrealistically high--would translate into some $135b extra investment. The impact would be considerable--GNP would rise to $2433.4, IF it happened.

DONOVAN: That should help reduce unemployment and reduce some of the political heat, maybe those bums across the street would go home. But it might also encourage labor to start making big demands again.

SCHULTZ: Gentlemen, I've kept my peace until now. But I want to say a couple of things. You know I'm from an older school and while we didn't always do everything right, we did generally remember a few things you seem to be forgetting. First, business is simply not going to invest when it's operating at less than 70% capacity! What's the point in adding new plant and equipment when you can't sell what you can already produce? It's true at Bechtel, it's true everywhere. If you want investment, you've got to work on markets and sales...

FELDSTEIN: Yes, George, the old accelerator...

SCHULTZ: Second, if you want to get labor costs down and profit margins up you need to encourage productivity growth. Now if you don't want to do that with government expenditures on R&D --and I gather there is a consensus here against that-- then private industry is going to have to introduce new technology and use it to restructure the labor force to get control of it. And, I repeat, that takes us back to my first point, you're going to have to induce investment by improving markets and I mean aggregate demand!

KEMP: We're doing that with the tax cut...

SCHULTZ: Yes, but its not enough and you're proposing to offset what little gains there will be by reducing transfer payments. Even an increase of disposable income of $59.9 isn't going to produce much of an increase in consumption is it? Especially with Marty's estimate of a MPC of only .6!

REAGAN: (looking annoyed) What?!

FELDSTEIN: Marginal propensity to consume, Mr. President.

REAGAN: Oh...yes...of course...

SCHULTZ: Now one way we could jack up demand would be to increase government spending in ways that would directly stimulate investment -- like defense spending to develop new weapons systems, or energy expenditures to develop new energy would also make my life easier with the Russians and OPEC.

WEINBERGER: Not to mention making my job easier. In fact, I have a little plan here to raise our defense expansion to some $2.2 trillion from our original recommendation of only $1.7...

STOCKMAN: But that will blow the lid off the deficit, we've been through that! And Cap, let's face it, now that you've alienated Ted Stevens over on the Hill, there's precious little chance of getting such proposals through anyway.

SCHULTZ: I hate to sound like a Keynesian, but in a recession what's so wrong with a deficit? Especially when we're taking the money out of the capital markets where business is speculating with it, and giving it to firms who we know are going to invest it?

REAGAN: Are we going round in circles?

MEESE: (straightening his Adam Smith tie) Gentlemen, I think the President means that we've been over this terrain before. We've got to begin to make some judgements about the relative effectiveness of these various proposals.

(At this point the meeting broke for lunch. The discussions are bound to continue...probably about 11 am on Friday.)

Answer the following:

1. Explain how Feldstein came up with a GNP of $2131b?

2. Explain how Stockman came up with $2221.

3. Explain how Feldstein got $2095.9 with a cut in G of $50b.

4. Explain how Feldstein gets $2433.4 as a result of a 30% increase in I.

5. Show how much of an increase in consumption will result from the tax cut of 10% what would happen if the MPC were .75%?

Question #2

Suppose that after this meeting, a consultation between Feldstein and his staff leads him to conclude that the model he has been using is too simple and should be made more realistic. As a result he asks his staff to come up with tax, investment, import and money demand functions. Imagine that you are on his staff and it is your job

First you look up the values of last year's (1981) variables and find that GNP equaled $2922, just as your boss said The average interest rate was 5.6 percent. Total investment was 456, of which 322 was autonomous. Government expenditures were rather high at 790. Moreover, exports were actually much higher at 285 while imports were 95, so X - M = 190 or 140 higher than he seems to expect.

Moreover, past experience suggests that the marginal tax rate is usually about .5, the marginal propensity to invest about .1, the marginal propensity to import .05 and the slope of the money demand function about -.08. Moreover, a call to the Fed tells you that the money supply was about $234 billion, and you are willing to accept your boss' consumption function of C = 104.8 + .6Yd.

From all this work backwards to find parameters and build a new macro model that includes: An import function (of Y), an investment function (of Y, i), a money demand function (of i), a tax function (of Y) all of which are consistent with the known Y = 2922.