Playing with numbers

f h e British science-fictionwriter.
H. G. Wells. had a touching faith
statisti=. He predicted that
statistical thinking would one day
be as necessary a qualification for
efficient citizenship as the ability
to read and write.
That day seems to have arrived. Statistics. social and economic, abound in the press. But
the world is still full of inefficient

world markcu: 1st year. as world

expons

'fade boomed. Brimin's

grew by 1in

Who is lying? Neither; every figure is correct. The trick is to

choose from the many possible
measures the one which is most
favourable to your argument.

B~~~ drift

Percentages offer a fertile field

for confusion. A percentage is
always a percentage of something; that something is called the
Averaw weekly wag.a
base. The First question to ask is
m
a what is the base of a calculation?
C
It can make a big difference. If it
costs a company $5 to make a
widget that ~ l l for
s S25. its $20
profit margin is either a whopping W96 or a more modest
50.
754
80%. according to whether it is
expressed as a percentage of costs
or sales.
Equal percentage increases imC
25 4
ply bigger absolute increases as
the base itself changes. If prices
rise by 10% a year for ten years
' 04
'
the total increase is not simply
1983
84
85
10070 (10 X lo), but 159% beCaUK each successive 10% rise
citizens. For every statistic which applies to a higher base.
A moving base also means that
is used. another is abused. Few
people are equipped to defend percentage increases and dethemselves against the profes- creases are not symmetricai. If
s i o n a a n o m i s t s as well as prices decline by 10% a ycar,
politicians-who manipulate fig- then after ten years the total fall
ures to suit their own purposes. will be only 65% because the
This brief providEs a guided tour base shrinks every year. Similarthrough the statistical jungle.
ly, if wages fell 50% one year, but
What should the voter make of then rose 50% next. workers
these two contradictory assess- would find their ay packets were
ments of the economic record of 25% smaller t an when they
started: the 50% fall applies to a
Mrs Thatcher's government?
A
fictitious Conservative bigger base than the 50% rise
spokesman boasts;
(see chart I). They need a 100%
lo the four years to l l S . the Brit- pay rise to restore the 50% Cut.
ish economy has grown by an averThe distinction between perof 3% a Yew, compucd with centages and percentage points is
aveWe p W h of less than 2% a murky area. In Britain. the
d u n n ~the Labour~emof1974-79. inflation rate feu from 10% in
G ~ narc
r Nnningat record lev- early 1979 to 6% in 1985. This
ch. I n 1985. Britam's-exporn of
mmrflctud
roK 15%. in. allows the Conservative spokescrcirlng heir share of world m r . man to claim his government has
kco. Tha government has reduced cur the innation rate by 40%.
n t e of ~nflationby 40% since This docs not mcan the inflation
1979
rate has fallen from 46% to 6%.
The Labour spokesman counten: but. as the Labour spokesman
Sraa tbc Coaurvauve government savs. it has fallen bv
- onlv, four
came 10 v
r in 1979.-growth ha% +Gnlagc
points.
a.tng+d
mere 1% iycar4nJy
Another trap to watch out for
haif the avenge rate achieved by
percentage
L h , Yet, &pite thrb denre is wm~acisons
changes in two different numlionrry policim, the n,e of
m n has fa~coby a mere four be". S ~ P F America's expoas
pzanugc pornu. British mmufac- increased by 15%. while imports
8
1-n
arc bean8 rque~rcdout of rose only 10%; thism~ghtsuggest
L

Unequal halves a

:b
rl

a narrowing of the trade deficit.

In fact. the opposite has h a p
pened. America's imports are almost twice as Large as its exports.
so though exports rise faster than
imports in percentage t e n s , in
absolute terms imports increase
by more. Suppose exports were
S200 and imponswere 5400. then
a 15% increase in expons is
equivalent to $30. but a 10% rise
in imports is worth W; ie. the
trade defiqt increases by S10.
Some of the biggest statistical
blunders are made when calculating the percentage appreciation
or depreciation of a cunencv.
sup+ the exchange rate of the
peso to the dollar moves from
Sl=P2 a year ago to a rate of
Sl=P5 today. Then. it is correct
to say that the dollar has risen
1 M 0 / ~ 5 2)
2 x 100against the peso, but it is nonsense to say that the peso has
fallen 150% against the dollar.
This would mean that somebody
who held pesos would have to
pay the bank dollars to persuade
it to take the peso off his hands.
The trick in calculating the site
of the peso's depreciation against
the dollar (a$ opposed to the
dollar's rise against the peso) is
first to express the exchange rate
as the number of dollars per
peso. In this example. the peso
has fallen from Pl=SO.S to
P13SO.2, a 60% depreciatiorw
(0.2 0.5) + 0.5 x 100. But be
warned, though exchange rates
are usually expressed as tht number of D-marks or francs per
dollar. a few currencies. notably
sterling. are quoted upside
down-ie, the number of dollars
per pound.

Oddly enough. either answer

would be correct. The average
level of output in 1981 was 14%
lower than in 1980. but during
1981-ie. from end-1980 to end1981--output grew by 14% bccaux the economic trough was
reached at the start of the year.
The alternative way of calculating an annual rate of change is
to "annualise" it-this is what the
total increase would be if the
monthly rate continued for a full
ycar. This does not mean just
multiplying by 12. Each month's
increase is compounded; eg. a
monthly rise of 2% is equivalent
to an annual rate of 27%. When
hyperinflation takes off this can
make a big difference: prices rose

The time trap

The choice of period aver which a
change is calculated provides
plenty of scope for statistical deception. Mrs Thatcher's ministen
like to base their economic record from 1981. as if a Labour
government had presided over
the recession of 1980-81. The
Conservative spokesman claimed
(correctly) that the economy had
grown by 3% a year in the four
years to 1985; but over the full
seven years s i n u 1979, gowth
has averaged barely 1% a year.
Most economic indicators arc
published monthly or quarterly.
The monthl*. change can be
turned into an annual rate in two
ways. The most common method
is to compare figures with their
level in the same period of the
previous year. But this still leaves
considerable room for manoeuwe. Consider this question: in
1981, did Britain's GDP (a) grow
by 14%. or (b) fall by I)%?

by around SO% a month in Bolivia last year-an annual rate of

13.000%. not 600%.
American economists love to
annualise monthly or quarterly
figures, often with bizarre results. American consumer prices
fell by 0.396 in February. Annwlising this gives an inflation rate
of -3.S0/0. But in the 12 months
to February, prices rose by 3.2%.
Generally. the "inflation rate"
refers to the 12-month rise in
prices, but it is wise to check.
One of the most notorious examples of statistical sleightsf-hand
was Mr Denis Healey's "8.4%"
inflation rate in the British election campaign of October 1974.
This figure was obtained by annualising the rise in prices over a
three-month period; the more
conventional 12-month rate was
twice as high (see chan 2). When.
only a few months later. the annualixd three-month rate leapt
to 58%. Mr Healey soon lost
interest in his favoured measure.
Another trap is whether indicaton such as output or expons
are expressed in nominal terms
(ie. measured in the prices prevailing when thegoods were produced) or real terms (constant
prices). If export receipts inTHE ECONOMIST MAY 31 1W

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minoeoonomic idea: people are and still be rational if they are

rational in the sense that they do using different infonnation. But
the bac they an. As consumen. when all there individual u p
worken and invaton, they tauom a- added together. errors
tend t o a n a l out-producing an
watch d l the market's signals.
The theory of ntional expear- aggregate view of the future that
tions says that people form their reflects d l the availabk informaviews of the future by taking tion. (This is known in the jargon
Expecting the
account of d l availabk mforma- as the law of large numben.)
Economfstr have always agreed that the Mum arfects t h ~
tion, including their understandRational expectations theory
present, but have never been sure In what ways They haw ing of how the economy works. If docs not say that people will not
spent a lot of t l m trying to define expectations about the they ate trying to predict next make mistake; simply that they
Mure and then feeding t h e m back to c u m t behavlour. A year's inflation rate and ue of will not go on making the same
ntw theory suggests that the feedback k fast and ha8 far- monetaM bent. they will look at kind of mistake year after year,
Wching Implications. Known 88 the mUa~laxpectrtlorulast year's g r w h in the money when the infonnation they need
approach, It has f o r c e d Keynerians and monotarlotsallks to supply. Those who think that to c o m a that mistake is t o hand.
prices depend on costs will look
rruruss their views.
This defence of rational expeca wages, productivity. commod- tations hns persuaded many
EEonomists now a p e that even so again. But they wen much ity pries. ctc,.plus (perhaps) the economists. The theory has one
the simplest economic theory has more influenced by their recent pronouncements of Opac oil immediate implication. The more
accurate the information that
to say something about how pc+ experience of double-digit infla- ministers.
peopie d n w on. the less wiH the
pk view the future. They h a w tion and thought that was more
future surprisa them. They have
tried t o develop ways of defining likely t o continue.
already adjusted their present beand measuring expectations.
Adaptive expectations. Ex- Rational man
T h e effons are relatively new: trapolation suggests that people Many economists initially reject- haviour t o take account of it.
Keper in his General Theory observe the past as a way of ed the rationdupectPtions a p From this notion. eaonomim
had treated expectations u exog- predicting the future. But the pmach. mainly because it w m e d have developed the "randomm w . because he doubted tho; theory docs not let them learn to dnnokb Keynesian econom- walk" theory to explain, cg. the
tbry cwld be modelled o r m u - from their om mistakes, so some ics. More r e n t work has shown ups and downs and share prices.
rvred aaurately.
economists refined it. They sug- that it d o e not. But some eaono- Stockmukets are full of inform*
Tbe sirnplifylng assumption of gested that people do use their mists still cb.llmgc the theory oa tion, runs this argument, and toexogenous expectations pro- own forecasting enots to derive its merits or a plausible descrip- day's share prices embody it.
tion of nrlity. They say that They ,arc t h m f o r e the best guide
~RCU,
for example, the basic their next forecasts.
t o tomonotv's prim; the only
amsumption function detcribed
That seems quite plausible. If
thing that' 'will cause them to
in Lhe w ~ n brief:
d
consumption yqu have lost money on Knackmove is new information, and
in a p u t i c u k period is influ- c r s Nag in each of its past five
that is inbcrtntly unpredictable.
e n d by income in the same races. you will probably avqid it
Such analysis bas a @oomy
period. But any assumption that in the sixtb. You may not dKKW
Lifaime or "permanent" i m m e Lucky Lady. who wins by a dirm o d for people wantlng t o
make money in stockmarkets or
c h a m i n e s consum~tionbe= the tance. but at least YOU will have
cwrrnder: thy won't! unless
qty@m of bow h p l e g u g e &void& yourearli&mistake.
they have insider infonnatioa
thev lrkely future income. .
Adautive md extnpolative exabout somtthing that wiU happea
h & i m have provided w- pectatibns am not all'thn differand will move the market in a
iour amwen. Lugely based on ent: it b pouible to show mathcMe way once it become
the principle that upcctntionsot matically that an adaptive
own. For everybody eke. the
tbe future arc fonned by utpcri- expectations rule is quivllmt to
opportunities for making a profit
ma of the past. ;he rwo artiest a particular kind of extrapolative
arc so fketing that they d o not
of thisidea wert:
expecrarions. Both theories have
rcalJy exist. This gives rise to r
Extrapolative e
tions. If an obvious weakness. They say
rntionrl-tioar
joke about
*sta n t c r r i w E y a r t o t,"tLUe
fumplfanwcofa
vcu in the sequmce 4%. 6%. pmkdu variable b aEfectcd pcopk without degmr in mathe- m ecomnni~profewor walking
h.p o p l e will expect them to only by its past. If Lucky lsdy mtid eco~nnMannot and d o with a keeneyed student wrest
riw DCXI year. Some may simply has never ncod before, neither not riR through nil the i a f o m w the univndty quad. "Look".
s student, pointing at the
e r m p d P t e the absolute in- theory would provide any reason tion rMilabk oa tbe economy, ~ y the
aesc--two percentage points for backing her. Yet her put and out of th.1 chaos p r o d u a a ground. "a fiw-pound m e " . "It
fnrm 4% to 6%. three points f o n . or lack of it. is not the only rational foreas of. my, can't be", replies the rational
fcuot. "If it was there. somefm6% to 9-d
w n d u d e factorthat will dictate her hh,re. inflation.
y would have picked it up by
R m t e n might k influenced by
I ~ Z Iuext yur's n t e will be four
TbthbOt~eqrpry,r@ychc
of n h o d arpcct* IW)V.*'
mrro hirhcr at 139". Others her ~edierre.for c x m ~ l e or
. tbe S U * ~
i reply cmphasises thjt h e
m$! k;bk at the rate of rucdar 6f other horrei from the tions. The economic f o m r s t i n ~ H
s
and its results informat~onwhich moves marranso% rise from 4% to urnstock. People hying to prc- i n d ~ i thriving
6''' ad then tran 67' t o 9%d i a even 8 Jingle variable will are wi ly reported, even in the kets must k really new. not
4
that next year's jump take y n w n t of dozens of other popular press. But forecasten something that people could anr-L k rn 134%. Gtbcrway. they f a n o n if they think them mle- can never a p e . the critics might ticipate. An apparently unfam b k i q rt the dirmion of v a t . That piece of commonsense reply.. Some are Keymsians. vaurahle event-a strike. a rise in
cannot interest t a t s - o f t e n leaves share
W uewemmrs m d a y i n g that it led economists to constma a arid- some moneta&t+-thcy
m 7 x .
d l k right, and their forecats prices umhangcd. T h i s is because
a theory of expecutionr.
The nm theory is a l k d "n- a n n o t all be rational. This objec- the markets were expecting it t o
Hoa Lhtaiet of m n p o i a t i v c
- e r n
pm greater nore by tional expmations". It first a p tion probably cbventatcs the dis- happen and had already adjusted
'r m than the drstont past. peared in the economic literature agreement between forecastsprictr.
!r t r lilfitn. nnny peopk in a m 1%1. but hrs been a major more than om or two yean
T h e same is m e of other emLu Bnuin could re- theme only since the mid-19%. ahead, they usually duster nomic variables. say su porters
[LIi b ~ ~ had
o nrun at Like much else that is new ia around consensus figures. More of rational expectations. b e y d o
not claim that everybody pew.
cr? r Ifr 3a Wt a year rn the nucrotconomia. rational expec- important:
!;5%
r d I-.
-they did not tatiom has strong microeconomic
individuals can differ from s m c s perfect foresight. Their asa=* :he m k l i t y of it dong roots. It is based on a familiar one another in their expectations sumption is more modest-that

SCHOOLS BRIEF
future

TClEECOMUlSlOCTC#EAZO. I O U

SCHOOLS BRIEF
: q l e make only random foreming e n o n , OM syncmtk ercn that they pon repeating, If
\at is correct. the cumnt W of
<-hinge
rarer, intemc
It-.
w a p . product pncu.
c--is continuously adapting to
carpo orate the future.
To see the impliations of this
leory. apply it briefly to t h m
rmihr areas:
b The "cobw'cb" model of amm e n and produocn. him texto o h on cconomiu indude the
iagrrrm on the previous prp.
.hich shorn bow some markets
an move erntially from one
eriod to the next. If the supply
.f poutir reduced by bligbt
rom Q1 t o @, tbc market will
now away from i u equilibrium
t PIQI to 8 higher price Pa.At
hat price, frrmen ariU plant
nore p o t a m but conrumen will
l c m a d l e u So tbe mn bvwsr
$[ill prub prim down to P
,. db.muraging fvnmr frwn pianting
o much. From yar to year,
mca will jump about. md more
a e v e y year.
Rational expcu8rkmplwider
ur rnmtr to this. It says tbat
mducen arc able to see beyond
'

'

the immediate future. ~ a m ~ployen

n
vill pry tbcm. ktrw
rrrlire that planting mud, more they ue dmultaacourly pmhhg
after Wight will d y dut next up their prices.
year's mrlel. driving dam
In fut.crerybody b acting to
bring r b w t tbc futer i n h d o a "k=if'ttJ=-aywll therefom bead u n ~ g h t that they expea. If they move
back to equilibrium by planting instmmncously, they will pteQI of poutin tbe year after w n t uy of the faster m o m m y
the blight. In other words. the g?ouzh tramlatint into higher
cobweb model ~ t t u m aa time bg spending in nltenns, even for a
in praductioa; but n t i w r i expec- moment. "Refldon" will simply
tations shorn thrt it is really m mean i n f l r h .
Economic forraning. &
information gap. w h i i need not

.G
exist.

Inflation. If ev*rybody believer that faster monetrry

p w t b will produce laster price
Ili88tion. tby Wiu UltkIptc
those c o l l l c q u e ~ ~Wben
~ . tbe
central bank stua spctding up
monetary growth, s a w n will immediately dcmud higher interest
rate$-and borrowen will &lip.
becrw they ue prepared to pry
i n t e r n m t u t b ~ue
t tbe rune in
rul terms u beforetbe monttuy
emaruioa. T h ~ v r r a c y
markets
wih prub down tbc &try's exn t e (provided 0thcountnu us wt rlro bacaing
their moaeur), p w b by the
same d e p c ) . Wortem will bcrmbd hgher wrges-rad an-

-.

tried to answer iu obienions by

lonnly induding e h a a 6
in econometricequations.
These and other implications
of the mtionaI-cxpmrtions ap.
ad^ will often crop up in later
Thc appnolck has klpd
to dcdne new boundaria be
twten different schools of a ~
nomic thought; these uc described in tbe box. It b the
biglat development in economic
theory in the past 10 yeam-and
w n t i a u l foraasting modtb arguably much longer than that.
used to k based on past khav& ~ U K
of its sipificmcc. the
iour-a p.rt w h n amin c w - ~tiorulsrpcctations appn#cb
no* policies wen operating. If a n easily be untmed to soy
these porkies mtinue. the mob more than it docs. At this stage it
eb m y give an aaurate guide to needs musing that the theory
the future. But what happeus if doa not stand or fall simply on
the polides cbmge, whicb h usu- whether people make instant*
ally the q u u t i m that forccuten neaut adjustments. Adjustment
ask of their d l ? The theory hro corm-putting new price on
of rational mpetatioiu says that p O d S kl a shop, sending new
t b e ~ ~ o f t b e m o d e
)
C8tdOgucs
to customers, :"penwill then chage, so attempo to ing wage negotiations. wnhng to
f o ~ t h e f u t u r e w i l l k b u c d ywrt bank to wit& money into a
6n r now-irrckvmt pat. This deposit account, etc. Pcopk may
u y m e n t , k t put f o n u d in corrrctly expect the future but
lW6 by Mr Robert Luar of the still decide to dehy thdr reUnivcnity d atiago. ass Icri- yome. If delay costs less than
our doubt oo the vaJidity d fom unmedirte adjustment, tbcn it b
astiog. Most forccuten have tbentiorul thing to do.

Efs.

Pick a doctrine
a a o ( c e a ~ T o r m t c l u a LMnvvc(illtbeb8sic~LMdiypMiobriettwo)b~ncnid.
But monctuirtr of dl vintages kli& that the only lasting
emnamie thought:
Neu~'lhekrdmofthkrcf.oolutt*roAwrianr,
Profcssoas Robert Luar 8Dd -l%onm*t;
in B e .
Professor Patrick Minford of Liverpool U m t y b the 16light.
new druidc a m o m h k i itb8t
~ (a) upcct.tionr
are rrtioarl and (b) markets c l a r my quickly. By this they
man that willing buym 8nd willing rllm mike brrgmif~
orbicb leave them all b a ~ u s w8ges
e
.ad prices m
flexible. both up and down.
ment. k r result, invoiuntuy urwmploymwt 'cmb p p ' o n j y
briew and tbca for only one mason: beame wye, arc fixed
infrequently. warkm mry temporarily p r h t h m c h s out d
work by having wrongly guessed thc e uilibiium wage rrte. AS
UK "tionol-~tio~~
theory says L t uyy x. .R pnir
tently make thb mistake. mvoluatrry unempioyment will mt
pen&. So unemployment ten& t o be at h " n m t n l nte". It
uiso kawe m e people chose to be m c m w .
beclue they a n get a higher
ploymat pay and other state be* u than from a job. ulua
Moacc.rW. 'lhkrt-kmmm e u r b t b R a m Milton
Friedman, k n g of Chiago University md DOW at the H m
lnsntutioa in California; British & m u indude Si Al8n
Walten, rbo was MR Tbrtdnr's emaomic rdvber during het
government's fim tenn. Monetarists klim .that eoonomia
have a natural tendency to full employment. but that thb a n
take K\'cILJ WUI 80 achieve kaw orica rad wages adjust
ntiohd;
rather My:
Some monetariststhink &peaations
o t h m (induding Mr Fticdman) tend to ue them 8s ennpol8tin or other masonwhy e m m m k may k d w to
return to fdlcmploymcot quilibriuhr.
Some dbfash~onedmonetarists still unue that rehtioa via a
6 s a l boost will & intcmt rat- but aoidemmd, kcruse the

Ybie

effectof~mdcmrnd(WhetheTwme~0r~)willbe
on prictr, kaw tbc lonpnan 8ggrcptMupply nvve is
va\ial. Thus cbcy see no
t m tying to fine-tune &mad,

and advocate ttublamdEnteof m-growth.

New Kepdm. Thb term Q I V ~several
~
N o k l priEc
winaar: in A n s u b . Profcuon I . l l t ~ Klein
~ t and James
Tobin; in Britain, Sir John Hicb rod Professor J u n a Mudc.
'Ibey a h btlim tbrt economicr tend to a full-employmeat
equiliium, but tbat tbey m y take many yean to reach it
unkrs pvcrnwats boost demand duriag a recession. 'fhir will
beeffeetivtiabooaingoutput.theyoy,kcuaetbcsbort-tum
aggrrptempply cunt rlopcr up fromleft to right. In the longterm. however. thy a p e with new d d a l s and monctuiru
tbat tbt suppty c r t i~s vertical. so output a n k incrrued oely
by rriring prod-.
New Ktyncs8ns argue t h t ccowmia uke so long to mum
to full employmeat boouse thc stickiness of wager urd (to a
lesxr ment) prices prrvcaa ~ e t from
s clearing. S m t hew
Keyrmiua see this stickiness as pmof thrt expectations arc not
rational; cornpanics .ndworktn do not l u m from their erron
in fomrrting what
md wqa uc needed to dear
think that expectations ur
ntioarl; the mag b warn. vhjch are so rigid-bcausc d
amtriar. minimum-mp Lwr. trdcunioa power. e t u h r t
tbcy prcvent rome pcopk from gating 8 job even tbougb they
want one.
Whrt do these dWndom mean lor puzzled finrnce minbtm
trying to stm their ccoaomicr to wainflationuy pavth?
Poplar dircuaio4 of ecoaomic poliy .dl1 revolver around
Keynerirnivn (oldayle) vcnus moncurum (ditto). But most
academic ~oaomin,think thrt distinction is at best imlcvant,
rt wont misJeding. Thty have #rcpted the rational upcctatiom a p p r d . m d inm
red it in both new ctusicol md
m Keynesian theories.
has helped to highlight the red
diugrecment between the two schools: whether markets clear.

??E

t h e m u t v s ss well?
muttiplicr procto. The effect of
Imagine m economy (#illwith rn increase in public spending
no intern#ioml tndt)where the financed by bond sales is eucrly
government has no income and the same as if the government
no demand for goods a d set- had financed iu extra spendin8
vices; the prinre renot hts m by miring t u e s immediately a d
income of f 100. It spends flO of keeping iubudget balanced.
thb on its own output. a d
What if the defiit is f i n a d
What deficits
u v r r i e . spends on mveffrncnt by printing money? A similar
S l m p b m o d e l s of the economy have slgnlfkmt p They -00.
The government argument applies. aaording t o
ipttw way thlt UI.gwemnnnterbudgat*&maws
then decides to spend flO. md Profeuor Barro. The rational
new f i ~ n c i raaaets
l
for thu private #ctw to hoid.
born from the private vcror min the m e e t will r c a k t h u
to finance it.
printing money will in time inGovernment spending lccds creme inflation. That. in turn.
Revioto briefs have dinuKd the d.uid ace,only priar will
the rde d government pdky in r k .
stnight througb to t k private will reduce the real value of bir
the ocomrmy. They PssumLd that
If urn daarnd doa bring -or. so its income rimto f 110. money holdihg. He therefore
policy-maken an frreiy nite fonh extra output, t h b will re- It will probably save the same decides to save more to maintain
public sptnding or cut mu. re- d u e the budget & k i t by in- proportion of its income as k- hi, red cub balances. so his
p r d b of what hapto the acuing t u rrvtnua. &I& LM r o d . of wtricb f10 will be consumption immediately falh
gowmmcnt's budget. A finance c u m shifts, tbe budget de56t b rpent on thc new government klow what it would otherwLe
minister's task is not t h u simple. hlling; eventually. men if prices bonds. fbr rut. Q3. v i U be have been.
Take the case of an increase in did not rise, the economy would spent o n invtstmcat & This Until Professor Barn's contripublic spending. Provided tbat reach 8 new l m l of output a t is l s r than before, because the bution, the obvious c o u n t e r a the government had prrvioutly which tbe budge! defidt was at$ pwfdtnent hu bad to k t intu- gumcat t o thcx' nco-Riirdian
matched its income and urpendi- to zero. The money supply would at n t a rise to make its bonds v i m was to..ugue ttut a c u
turrcbairndng its b u d g d e no longer netd t o inawse; the 8mrctive t o tbe public* squccz- deferml is the ma best thing t o
ibantc in spending will create 8 economy would be back ia ing out some privrte investment. a tax not levied. If today's conIn the next pciiod suppore s u m luKnr that $ budget dcfKit
budget defiat. That deticit h q to equilibrium.
On one intrrpma.th, tpc d m government spending falls back will raise m u paid by futurt
k fimnnd, either by W i n g to
pie IS-LM model unplitly as- to m.Wlut will happen t o gcncntiom. they have no'sumes that the government cw- conrumption? It will bt higher. t o i n m w their own w i n g . So a
theory, budget deficit will have multiplier
en its deficit not by printing up the rmltb-effme gwernment*~ac;d to [i. money, but by selling boa&. because tbc privrtc seaor now tffem in. rhc shon-run. and
h a wrw finrncirl ruer, in tbe
~ n itsad e r i t doer not d i d y b
shape of its f10 of govcmtnent
affecttksu plysideofthemod-9
bonds. Consurnen feel richer. so
4 d c r r ~ D p~n
B earlier bxkb. ~ u t
h r a now o n they will spend, my.
taking the defit into w w u o t
71% of their incomeon coosump
cbonga the demand side of the
tion. and onty 29% on investment
model in important w8ys'Rccent
goods. Tbot increase in tbe p m
theories have u r c n d c d the IS=
pruity to coruume shifts their 1S
Lhl framework t o s b w bow.
CUM to the rigbt.
in figure 1 the demrad side of
The t h m y thrt 8 bond-fithe economy is initially in
arnad d e f d t mker the *te
.uP. witb i n t e r n ratesat?$
sector richer may be a d m e t i a l output &manded at Y,. Aoume
ly sound. But Professor R o k n
tbat the budget &fitit is zero at
nnn
Barn of Chiago University artbat point. If the govanmeat now
er that it h emwmicrlly frlre.
rakes
Mic spending, tbe IS
cwe
from IS, to 1%. and 'Ibrt is why interest rates rise c htc led the m h l of an idea Keynesian demand m a m p n m
output demanded risato Y2. But when tbe IS NNC *fa to the .firs moored by the nineteenth an k effective.
Not so. aqued Rdesoc
highcrpubiicspending meansthat rigbtg-higher interest nus ue centwy Englbb economist. Dat h i gokmment now &a budget the iaccatk for ptopte to bold vid Ricudo. hence his ideuh v e Buro. If houvholQ cnrr lbout
deficit. If it finances that & k i t bv more bonds. But that a n n o t be k e n lakllcd "nto-Rbdh". succeedin8 generatiom. t b q
infinite t m e b
~ B u c o i ~ r n hove
~ ieflmiwly
a
crutingmoncy. t h e ~ ~ n r mtbed end of the story. becaw if
ketping witb t new classad monr. Pamlts wtw Lnor Ihn
shift from LM,t o LMh b ' n g p""=bp!~"~*,
ippnrrcb to eoonomia. goa u t k i r children wll hawe ro Ire
dcm8ndrrillfurtber.
- n L
herrvv
rwerngrow= followr Whca tbc pvcrnmcnt higher taxes in thc f u ~ m
ThetMcurveriUcarryoa aodr of
shiftulg to the right 8s longu the ing. zo the ecoaomy cannot k in ~Llrbondstotrnurctiospcnd-of an incrc;r*c In thc huJCcl MIing. people rcdu that it will a t today uort uvlnF mrrc mmcbudget defiat persists and the tquitibrium.
thcrr chrC
What will k rbc effect of this haw to rc?vicc (and ~ n n u l l ydbtely .up n to k~*c
gowmmcnt ~JOOSCSto firunoe it
through printing money. But two growing stock d pvcmmcat repay) its bomrwing. 7he only dren v higgcr h 1 + 6 1 . They n U
fMon will g n d u d l y rlw thh bods? If the printe rector fecb ctnrin some of government cut thew olmumpm awl clrrrl
mxrs and brine Ibe emaomv wultbier. it n u v mend more on revenue is taxes. so e n n bonow- out t k rrrp;mu*luly cna35 of
io m
a ;ti &w eqkibrium.
'
A bond:hu~ed budget ing will in time mean higher t u - I ~ dCc r i .
l h r s rk-llry. ) k c m s h of the
Tmc incrrrrc in &d
niter & k i t will themfore I i f t tbc IS er. Thc private seaor h not
mu d a = . d
prim. reduces the rul value of 'curvefwther t o the right than the tmt its bond purchase as in- debate ahthe m m q supply, .ad so brakes simple model supposed. giving r crencd wealth. but u a portent n o m k vcaa lr, b u k ! c a % ~ ~ of increased turn T o prepare for m m nno thrae vho t h k fl
the LM cum's movc to the right. bigger i m u c in demand.
At firs! J&t. it seems l i b that day. peopk reduce their con- o t n k d y Ilu d l h w who
Thb inflationary- p
tbe
aggngate-dcmand curve shiftsup doubiecoontmg to drim rntxrrr sumption and i m w their wv- th~nk rt too prrportmus fa
One cnt~. Ruicwr
boort from f i policy on the ingr by the whok amount of the YO&
the aggregate-supply curve-was
m Tobm of Y a k Un~versliy.
dcsuibtd in detail in the fourth p u n & t h u bond-Gnutdng increase in govenuntnt rpendulg. J
As a r l t . not only is there no managed to u k c the &J urnusbrief of this series. R e d l t h t mka people wealthier. If pco
with a Keynesian amgate-sup- ple how k m their money to the n d t h effect in consumption; 4y jw h g e m u g h to m t e down
ply c u m , the demand boost wiM government to pay for public the= b also no cxpanskm of m e objccuom.
Here arc two d the most
66 nix both output and price. In spending. how can they spend it demand rhrmgh the familiar

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r a U y k ~ t h r t . n ~
piee of ra ervatirl
import like d will pmumdy
nhc tbeknldooempbymem.
Ya. unksr rvorlrenut willing to
w r k as hrd rr they did kfm,
tbe *the

ionthc
n #onomy'stu
y&e.
Tbe ari#inrl rad diPhil-

bpawewadnvainmutick
ia 1958. It pkned inflation
changes in wage rates)
against uaem loyment md found
8ndforlomrrulwa~
that w b m i n tion was hi*, unSucb 8 dlMp Of UtiNdtr employment w u low and vice
Extending
would rhift the 8gpegat.e urpply veru. The rclatioruhip seemed
C L L m ( i n b 0 t h " ~ " d to hold good for many yem and
''dusical" modtlt) but ta the in different awntria. I t waned
right*restoringemplaymmt. But u, suggest that r govenunent
d c b m to cut une Joyr-tbeor)rdkbourmpply,
11 is w &&dent t h t etoaonrbo cowt to rrrr sunmhac be- which thinb of iadividub prd- a n t bu toleratings 1 & 1 1 3 *
prid Lm attention to tbe t b a q m a Y, and Y,. But if it d ing off income apinsa kiurt. tt n t e of inflation.
of demrnd and more to tbe tbe- out to be a h Y2, t h t w a ~ Ma n ~ u p w i t b m r r u o n w h y By the h t e 194% that happy
F d supply during tbc 191(k. imply r kwl d e m p m t rnituda should c)luy. When rclatiorahip a.u breaking dom.
T ~ Qmurm kreascs in the yutu th.a N1,
hll.u,wiUIhcurpp Tbe Phillips curve seemed to shift
open* poprim of oil confrontedtbem with sition. Baause the poducbon
upwads over time, u, t&t a
r m e . Tbe oil shocks urn fweiofl hu shifted down, em- oorrra! it bclp a, q h i n tk pu\iarlu level of wumployment
comrpanded to ever-higher inm
.
mrt to h v e big effects. but the ploymmt rnigbt be b i w even r t r * ~ o f t b c 1
flation nta. How & economic
-pation
with aggmpte de- though output hr fallen.
for thh?
Tbe &tion to this pudax
mand m d e it bud to see wbat
of Philllps curve thaniwaammt
la a d y d c c u m m y , w r g a
r b q rrdght be. Ecoaomia aeeb lin in figure 2. As tbe fourtb
ed qpty-ridt tbeoria to sbow -brief ia this =ria arpl.ibed, tbc ~ t b e b r i & i a & v l i c r b r v e .adprices a n both be increasing
haodrtikethircouldcrpliin labour h a adjusts to 8 om u s e d 8 r y p ~ O f ~ U l 8at fa n~w t D t Icwls ofmpt. emoymmt rod d vager. In d"stagl!Lation"--high uncmpky. cquilibriuxuat r higber prias level called amlpuativt ShIiCs. Thir
me*
combbed with high through shifts in tbe danrad d metbod rrspma that economic ea, cbe mggrrg8te & m a d .ad
l
y
~
u
t
supply nwu for labour. Hi*
idation.
(8
in sy-l-t
Farimplidty,trkethetucd pnccr mrke firm, \nnt to hire POW.ehnp in oil pnca. ctc)
time. If tihe
Fuwri., lo induma a m n q more workem at the going wage m0vctbeaconomyfmrmoaest.. camooly is g m i n g , output M d
blepositiontoanotbcr.~pru- redvrgescmrboberkntam~itbb0oilatiaown.De8rcral rate kcrust tbe mrrIparl
ticc, lm-mcvm* oappomn, are tia#nuly. Sf the growth rate of
affeusitiatwo~ways.
F ~ F ~ w i l l u ~ h o i l .P-S o
w d c m amr~rra.Intbe)upa,tby a p t
3% r yur,
l b l t (m the horl rum*at leas) a wurt to reduce tbeit rupply of ut "dynamic". Mucb.of the most m i ~ t l i K a t S % r y t u d w ? g a
gh'o rmopnt of &botP vil) be Irboor, k a w a the red wlge is m c u l t m o d a n t k a y ~u 8 % r y e u , r t l a t a a m ~ u a t
kvcl of calploymeot.
k m r f o r m r y k v e l o f t b c ~ thir dyarmirm. A
Thb e r r a e q u i v r t e n t c o a n r l a r ~ n t c . S o t o g c r [ r r w Y ~hrnfurbrrbsd
Ibc cluckl idea khhd tbs
3,tbcISadLD rthtionrhip-tb. PhiUiptbaoretialPhillipcplr.ebth.t
Qomnrdsbi!linthcprod~
- - i n a n y t b r t W f u r t b t r l i g h t tba rate of ioaeue in mgu( a d
hroccionof figure 1.
kamd, beamc ail b mole
~ ) ~ d e p c o d ~ ~ ~ ~ d c O
0fJrL.hthcLbau~et.K
#pemivt*tk~utpmductdt b ~ I m l o f e m p k y m m t i r
tbc eran rupply of I.bout is
byachamwarkamFaclor- ~omewbatktwcm N, rod Nl.
hi@,itdlhrveamaagbLmp
is's iirmr win be redud. So tbe ButiftheLDcrrsvcrhiirrupa
dlea on tbe ~g
~ ~ o f l i b m l r h kmg~y,iadtJIeLScr~veJhilts
l k

(m,

tL

supply

Son

?
G$:=

mw)

.
*ktDP'en-araa.

to
in 62 T'ogctbcr; rigbtdN;infigure%implyhga
tbeaE thmp cut output fim & i * l e v t l o f e m ~ t b r v r
h Y , toYxaadtbeoto Y, b e f o n t b c o i i ~ T h t d
a d t b t a ~ m k d w a k a rhppn*--caa~y
~

h t r ~ F ~ s ~ a ~ i n proyeP-Nlto&
Tha 8sstmu that tbe ovrrg ceahvc to SUbrdWe L.krrp fa
krrfofpricahrswtcbrPgcd.

-p.

F~3SbOVlrhutheeombiDI, ' I b r r , d ~ . i r t b t c r s e o f
cKm4fkY#OU
(Y38nd.
arvc. Tbo
-pricer(Ptw-

-.

corMintbe.ggrrg.rs-rup@y
-from
s, to $.
Thenatst isf8miK8rtrom a l " c r s s , w i t h a v a f i c l l ~
g t ~ ~ p pcrrm.
t y k the f
d
m&
At PI.
apn, d e m d in Flclorirs b r i d i n t h r ~ S b O w d , i f t b t

Lbaumutetdjurtrmrtrrmr
k
.
~ o o ~ p r i m , e m WinmtliUabovcN,
u P,Y& So tbe oil)

Tbcea~aomyrrcprrrru,&b

2.tbekvclto*it
prrrLbakbaIww#adpriecr
rrrd m h a d outpm--rpe combi- d r o p r o o o t h n t b c o i l ~

anxrarbicbd+nund-Pdc UYFhnnrbupoiat,LS.adw
ramuabotoexplrin.
curvrr rir tgethet, bdcplg ral

Whabuttbevorten?Tbe ~arorumrrpnocrnreban
PIio 6~ 3.
8thth
W 3 h ~ f i v t 8 d u r - C U C M a ~CO&
msrrr to tht
whetbe? durialmodcbgi~er~trucrpiU
m e than the Kcyncsi8a model of
m u l t of rr, o ~ l p n c ehike. To see tbc long-term state of the caxm
58 thrr. look at figure 1. Output my. Thb is depraring: an it
tbcorrticrl qmraMdfipurrr1

pia!spinl.Thhisrnerdemmt
rbecumomicmodelducxii
intberc briefr: t b c & v d d ~
playment(takeamawrrmbo(
arrrrLbourrtlppty}is~
tobrveroed[tuoadter~1~8t

*wycr(=dpriqr)*%.

H
,
c%pruaoaud hr
tnrcprjcelDue8laIbo&cr~

r r r e U ~ ~ c h a @ . U , r t
some given h l of unenlpltq*
Mm.-crpoapn'o~
rise by 10%, they vin raise theit
vagt demand to 10% a k m *hat
it wa before. 'lhir chnges the
Willipaare

F-4m-Pld-

crnve (SRPC)and r Longmn

RLNC

0suppae
.

tbc saraomy is at point A on tbc

sht-mn cnrvc o d the g o v m
rntDtdtddatOrrpurddtrmndt0
redlbce Lbc tumqqlneat rue
from U,to U*,8! p m t 5 . Lnwa
mnaployment mans leaslackin
the labour mukct a d hen= the

n t e of wage idlation riw from

WI, to WI,.
But in due caunc. the cast-

+aa

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