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News Summaries
STOCK MARKET AND THE WEALTH EFFECT
(08/97)
Do U.S. households today tend to spend a larger
percentage of their income as their wealth increases or do savings
rates increase? Until recently, it appeared that this Americans
were saving more for the future and generally avoiding malls,
except during sales and holidays. Refuting this line of thought
is economic data recently released by the Commerce Department.
It indicates that consumers are shopping and spending in accord
with the growth of the stock market, which has doubled since the
end of 1994.
As the stock market grows, households accumulate
new wealth (in excess of $2 trillion since the end of 1994).
Households may choose to increase their savings or spending patterns
in response. For many years economists have argued that the wealth
effect--which states that households will spend a larger portion
of their income (and save smaller portions) as wealth increases--prevailed.
Commerce data shows that during the first 5 months of 1997 the
savings rate fell to 4% from 4.8% , which was the average for
1995. As savings decreased, consumption rose.
One problem of a strong wealth effect is that
it widens the business cycle: thus, the goods times are really
good, but the bad times are awful. The explanation for this
is that as the economy grows, corporate profits increase, stock
prices increase, consumer wealth grows, spending increases, and
the economy grows even stronger. However, when the economy slows,
the stock market declines, consumer wealth falls, spending falls,
and the economy slumps even further. So the wealth effect amplifies
the swings in the economy. Therefore, a slight decline in real
GDP could precipitate a major recession.
One cause for optimism is that the wealth effect
has weakened from where it was 10 years ago. Today a typical
consumer spends an extra 3.5 cents for every new dollar of wealth,
compared with 5 cents a decade ago. Another cause for hope is
the ever-watchful Federal Reserve, who follow the stock market
and the wealth effect closely. In fact, in 1987 when the stock
market tumbled, the Fed responded quickly to spur the economy,
in a move so successful that it calmed investor fears and laid
the foundation for strong growth in 1988.
Questions
1. Explain why a growing stock market tends
to increase the percentage of income that households spend.
2. Define wealth effect.
3. What are some problems associated with
a falling savings rate?
4. What part of the business cycle are we
in now?
5. Suppose corporate profits begin slumping.
What will probably happen to household wealth? spending?
6. Discuss why the wealth effect may have
weakened. Could the belief that social security will fail impact
this?
7. What steps can the Fed take to spur the
economy?
- What effect does the wealth effect have
on aggregate demand?
Keywords:
wealth, savings rates, stock market, wealth effect, household
consumption, business cycle, recession, profits, real GDP, Federal
Reserve
Source: Ip,
Greg. "The Outlook: The Wealth Effect Is Back in Play,"
Wall Street Journal, August 25, 1997, page A1.
GAINS IN U.S. WORKER PRODUCTIVITY
(06/97)
The productivity of U.S. workers
jumped 2.6% on an annual basis in the first quarter of 1997, the
highest rate since 1993. Productivity measures the output of
goods and services per hours worked. As productivity rises, workers
produce more per hour. This allows companies to pay higher wages
without raising the prices of their products-which would lead
to inflation. Many companies are crediting the gains to their
decisions to invest in technology.
For example, New Jersey Steel spent
$50 million in 1994 on a new steelmaking system which is the latest
in heavy-manufacturing technology. This year productivity is
up 25% over last year, while costs are down 20%. HomeSide, a
mortgage bank in Florida installed a new software program that
allows a loan application to be processed in less than 10 days,
a drop from 17 days the previous year. In the agriculture industry,
Monsanto's genetically engineered seeds for soybeans and canola
are increasing yields while lowering pesticide costs.
Although new technology has been
implemented in many companies over the past few years, it has
been only recently that it has been used effectively by a wide
array of people. People must be trained to use it and we are
only now on the point of the learning curve whereby the benefits
are being seen.
As the Federal Reserve meets to
decide on the appropriate monetary policy, the members will certainly
consider the gain in productivity. Although it is just one statistic,
it is important in determining whether businesses will raise prices
to cover their additional wage costs. As long as wage increases
are balanced by an increase in productivity, businesses have no
need to raise prices, inflation should remain tame, and the Fed
would have no need to raise interest rates.
Questions
1. What is the effect on aggregate
supply when worker productivity increases ?
2. Suppose that Susie's grade is
72 on test 1 and she studied 10 hours. On test 2, her grade is
86 but she studied only 7 hours. Did Susie's productivity rise
or fall? Explain how the learning curve might have something
to do with this improvement.
3. Explain why an increase in worker
productivity tends to hold down inflation.
4. Explain why there is usually
a lag (delayed) effect on productivity when new technology is
purchased by a business.
5. Discuss why the Federal Reserve
studies labor productivity as it is determining monetary policy.
Keywords: productivity,
inflation, learning curve, technology, investment, Federal Reserve,
monetary policy, interest rates
Sources:
Neuborne, Ellen. "Productivity Jumps; Technology Gets Credit,"
USA Today, June 19, 1997, p.B1.
Lenzner, Robert and Bruce Upbin.
"Monsanto v. Malthus," Forbes, Mar1997,
pages 58-64.
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