14
CHAPTER
DYNAMIC P OWERP OINT™ S LIDES BY S OLINA L INDAHL
Transmission and
Amplification Mechanisms
CHAPTER OUTLINE
Intertemporal Substitution
Uncertainty and Irreversible Investments
Labor Adjustment Costs
Time Bunching
Collateral Damage
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questions
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Video
Food for Thought….
Some good blogs and other sites to get the juices flowing:
Introduction
Shocks to a part of the economy can be
amplified across the economy and
through time….
Transmission mechanisms are economic
forces that can amplify shocks by
transmitting them across time and
sectors of the economy.
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Transmission Mechanisms
Amplify and Spread Shocks
Five transmission mechanisms:
1.
2.
3.
4.
5.
Intertemporal substitution.
Uncertainty and irreversible investments.
Labor adjustment costs.
Time bunching.
Sticky wages and prices.
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Intertemporal Substitution
1. Intertemporal substitution: the allocation
of consumption, work, and leisure
across time to maximize well-being.
People pay attention to opportunity costs:
A person or business works less hard when working
hard brings the lowest return (and vice versa)
High unemployment? College enrollment is up.
Recession? People retire early.
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Intertemporal Substitution
Farmers work harder when crops are productive
(and work is profitable), less when not.
People truly “make hay while the sun shines”.
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SEE THE INVISIBLE HAND
When do you study?
More as it gets closer to a test or equally each day?
Most people: closer to the test (when the payoff is greater).
8
Try it!
Which of the following cases is an example of
intertemporal substitution?
a) A person decides to stop being a stay-athome mother and enters the workforce to
get extra money for future college expenses.
b) A person decides to stop being a stay at
home mother and enters the workforce
because the economy is booming.
c) A person studies continuously throughout the
semester for her final exams.
d) The United States enters a recession and a
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person loses his job.
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SEE THE INVISIBLE HAND
Rosie the Riveter:
Intertemporal substitution at work during World War II?
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Intertemporal Substitution
Intertemporal Substitution
Effect: Intertemporal substitution magnifies
economic shocks.
When things go a bit bad, the return to work
and investing falls; people work and invest
less.
Also, intertemporal substitution can feed an
economic boom and make it more intense.
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Intertemporal Substitution
When GDP is growing slower than the trend, the employment to
population ratio is also growing slower. The reverse is also true.
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Try it!
Which of the following careers is not an
example of employment that is
characterized by “intertemporal substitution”
(i.e., careers in which someone might
choose to work more during times when the
wage is higher but less when the wage is
lower)?
a)
b)
c)
d)
swimming pool lifeguard in the summer
ski-resort employee
bankruptcy attorney
public worker (ex: government assistant,
U.S. mailman/mailwoman)
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Intertemporal Substitution
Inflation rate (p)
Solow
growth
curve
An initially small shock…..
gets larger with
intertemporal substitution
Conclusion: intertemporal
substitution amplifies the
shocks.
Negative
Average
Shock (2%)
(3%)
Positive
Shock (4%)
Real GDP growth rate
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Uncertainty and Irreversible Investments
2. Uncertainty and Irreversible Investments
Negative shocks increase uncertainty.
When investors are uncertain about the future,
they often prefer to wait and gather more
information before committing.
Many investments are irreversible.
Example: Once construction on an office
building is started, it is hard to tear down
the building and redeploy the steel and
glass to other economic uses.
The more uncertain the world appears, the harder it is for
investors to choose where to invest their resources.
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Labor Adjustment Costs
3. Labor Adjustment Costs: the costs of
shifting workers from declining sectors
of the economy to the growing sectors.
Labor adjustments to shocks are difficult and
costly.
Example: A worker who loses a job
may not be willing or able to
immediately take a pay cut or move
to another state.
Result: ↑unemployment and ↓real
GDP growth.
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Time Bunching
4. Time Bunching: the
tendency of economic
activities to be coordinated
at common points in time.
It pays to coordinate your
economic activities with those of
others.
When do you do garage sales?
Saturday morning!
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Time Bunching
Bunching also causes shocks to spread
through the economy through time.
Example: If a negative economic shock
arrives and the economy slows down…
Many people will be less keen to
work.
Others will cut back on their
work as well.
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Collateral Damage
5. Collateral Damage
Collateral: a valuable asset that is pledged to
a lender to secure a loan. If the borrower
defaults, ownership of the collateral transfers
to the lender.
Collateral shock: a reduction in the value of
collateral. Collateral shocks make borrowing
and lending more difficult.
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Collateral Damage
When the economy is healthy and firms
are profitable, banks are more likely to
make new loans (and create more
growth)
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Collateral Damage
When the economy is strained and firms
are less profitable, banks are less likely to
make new loans (thus slowing down
growth)
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Transmission Mechanisms
Amplify and Spread Shocks
Transmission Mechanisms: Summary
There are five factors that magnify negative
economic shocks.
Core lesson: a medium-sized negative
economic shock is capable of causing
a disproportionately large downturn in
the economy.
Further questions for later chapters:
Could the government help offset some of these
negative supply shocks?
If so, under what conditions?
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Take a look…..
Hayek vs. Keynes rap video, by Russ Roberts and
John Papola: (7:33 minutes)
http://www.youtube.com/watch?v=d0nERTFo-Sk&feature=player_embedded
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Try it!
Why have oil shocks become less
economically important for the United States
in recent years?
a) American producers are now more
energy efficient.
b) Negative oil shocks have been tempered
by positive productivity shocks, such as
improvements in technology.
c) The Federal Reserve has become better
at responding to negative oil shocks.
d) All of the answers are correct.
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