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This Soft Landing is Getting Harder
Subject Economic Slowdown
Topic Economic Policy
Key Words Soft Landing, Productivity, Unemployment, Interest Rates
News Story

The economy is in its ninth year of continuous expansion and this has caused many to believe that recession has gone the way of the abacus and typewriter. There is continued reference to a "soft landing," a slowdown in economic growth sufficient to prevent inflation without causing unemployment. However, those economists who believe that recession has been banished may change their opinion in the wake of recent market turmoil.

Turmoil in the financial markets has resulted in a substantial increase in interest rates and has reduced access to startup capital via Initial Public Offerings (IPOs). Bonds rated below investment grade carry 13 percent interest rates compared with 9 percent at the beginning of 1998. Stock prices are also down for the year, and combined with increases in interest rates, can produce reductions in capital spending. Investment spending has been a major factor sustaining the expansion both directly and by raising productivity.

Corporate debt is at record levels and firms are defaulting on their interest payments at the highest rate in over a decade. An economic slowdown will exacerbate this problem and cause further reductions in capital spending.

There is still reason to be optimistic. Corporate profits remain strong. One estimate is that pretax profits will increase by 15.2 percent, almost double the 1999 rate. Forecasts for next year call for a 6.8 percent increase. In spite of recent stock price movements, earnings have been growing and, consequently, cash flow is estimated to increase by 11.8 percent this year. Most economists believe that profits and cash flow are the primary determinants of capital spending. Capital spending, they argue, will slow but not plunge.

(Updated November 1, 2000)

Questions
1.

Draw an aggregate demand/aggregate supply diagram and illustrate an economy at equilibrium with an inflationary gap. Carefully identify the inflationary gap?

2. Suppose that interest rates increase. What is the impact of this increase on aggregate demand and macroeconomic equilibrium? How much would aggregate demand have to decrease in order to produce a "soft landing"?
3. Suppose that there is an unexpectedly large decrease in investment, what are the consequences of this change for the economy? Illustrate on your diagram and explain.
Source Jacob M. Schlesinger and Gregory Zuckerman, "Market Turmoil Adds To a Rising Wariness On Capitol Spending," The Wall Street Journal, October 19, 2000.

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