Smoothing the Business Cycle versus Fostering Economic Growth: Psychology Meets Normative Macroeconomics: It is sometimes argued that there is a policy trade-off between softening the impact of economic recessions and fostering long-run economic growth. Suppose such a trade-off in macroeconomic policy exists. Those who advocate a growth-focused economic policy point out that even a small increase in the long run growth rate of an economy will generate far greater welfare gains than a substantial softening (or even an elimination) of transitory downturns in the business cycle. Thus, they conclude, to the extent to which there is a trade-off between softening recessions and fostering long run economic growth, the emphasis should be primarily on long run growth. (You are asked to show this in a numerical example in part B which does not presume any Section B material.)
A: There is little debate about the relative magnitude of welfare gains from softening recessions versus increasing long-run growth rates. Still, governments expend substantial resources on fighting recessions, often by taking on debt and introducing incentive distortions into the economy—which in turn will harm long-run growth.
(a) Suppose that, instead of taking the usual form, preferences are reference-based and exhibit a high degree of loss aversion. How does this change how we think about the welfare impact of recessions?
(b) Suppose that the happiness literature is onto something, and that happiness is amore relative rather than absolute notion. How is this consistent with the claimed evidence that happiness within societies does not change much with time even as standards of living increase dramatically?
(c) If you wanted to argue in favor of greater emphasis on softening recessions at the cost of accepting less long-run economic growth, how might you do this in light of your answers to (a) and (b)?
B: The average U.S. growth rate over the past few decades has been in the range of 2.3%, with recessions happening about once every decade. Suppose, then, that we currently have a growth rate of 2.9% during non-recession years and a negative growth rate of −3.3% during recession years (which averages to about 2.3% if recession years happen once every decade.)
(a) Suppose further that, over the next 50 years, we will experience a recession year in years 10, 20, 30, 40 and 50, with the intervening 9 years (beginning in year 1) representing years of economic expansion. If the current average household income is $60,000, what do you project i t will be in 50 years (assuming the growth rates of 2.9%and −3.3%in expansion and recession years? (You can do this by calculating first the increase in average incomes over the first 9 years, then the decrease from the recession in year 10, and so forth. By setting this up in a spreadsheet, you can then easily undertake the policy experiments in parts (b) and (c).)
(b) Now suppose that you have devised a policy that reduces the drop in average income during recessions by nearly 50% from 3.3% to 1.7% at the cost of reducing growth during expansion years by only a little over 10% from 2.9% to 2.6%. What will average household income be in 50 years? What about average income during recession years?
(c) Suppose instead that you have devised a policy that raises the growth rate during expansions by about 10% from2.9% to 3.2% at the cost of also increasing the severity of recessions by 50% from 3.3% to 5%. What will average household income be in 50 years? What about average income during recession years?
(d) True or False: Compared to the status quo as well as the policy experiment in (b), the policy experiment in (c) will result in greater average household income in 50 years and during every recession year.