A Tale of Marginal Analysis

Casey Mulligan has written a post entitled, “The Laws of Economics Have Been Suspended”. Here is the gist:

Professor Krugman is also saying this week that this recession has nothing to do with bad incentives to earn labor income. (Bless him for citing me! When this is all over, I would love to have a monopoly on teaching the “old fashioned” laws of economics.)

I don’t quite understand this obsession with UI-apologetics, because UI (unemployment insurance) is just one of many policies that collectively (and some by themselves) create terrible incentives:

  • mandating the employers with large payrolls provide health insurance, but that employers with small payrolls do not
  • minimum wage hike
  • means-tested mortgage modification (presenting millions of workers with implicit tax rates in excess of 100% (sic))
  • mean-tested student loan modification
  • unemployment insurance extensions
  • state income tax hikes,
  • IRS means-tested enforcement of prior tax debts
  • marginal federal tax rate hikes on the “rich”!
  • According to Professor Krugman, I am the only one crazy enough to suggest that a list of bad incentives like this might actually show up in the aggregate data!

Not content to let Krugman take all of the credit, one of the anonymous bloggers over at The Economist has written a post entitled, “Lazy workers, enjoying the dole”, in which they argue:

Mr Mulligan seems to be to be using one point, on which he is correct, to make another, on which he is very wrong. Unemployment benefits clearly do provide an incentive to stay out of work longer. Holding other things constant, we would expect an increase in the generosity of unemployment benefits to lead to more joblessness.

But that does not mean that in the absence of unemployment benefits the unemployment rate would be lower, because one cannot hold other things constant while changing benefits.

Of course, this prompted a response from Will Ambrosini: “The Economist doesn’t understand marginal analysis.” Ouch!

Perhaps this is an example why economists have been much maligned recently.

One response to “A Tale of Marginal Analysis

  1. The issue here isn’t marginal vs. inframarginal analysis. It is market clearing vs. effective demand constrained analysis.

    If one believes in market clearing, then real output is always equal to potential output and the unemployment rate is always equal to the natural unemployment rate. Extended unemployment benefits raises the natural unemployment rate, and lowers potential output, so it raises the unemployment rate and lowers potential output.

    If, on the other hand, one believes that prices and wages are sticky, so that a drop in nominal expenditure lowers real expenditure, the real volume of sales, and so real output and employment, then real output can be below potential output and the unemployment rate can be above the natural rate of unemployment.

    And so, extending unemployment benefits can raise the natural unemployment rate without raising the unemployment rate. It can lower potential output without lowering output.

    Because extended unemployment benefits allows the unemployed to spend more, that raises aggregate nominal expenditures. Of course, this spending must be funded. However, the most plausible source of funding under current conditions is money creation. Sure, the Treasury will sell bonds, but with interest rate targetting, the Fed prevents any excess supply of bonds from developing by buying the bonds with nearly created money.

    Now, if markets always clear and the price level and wages are always at the level such that real output equals potential output and the unemployment rate equals the natural unemployment rate, then that money creation just raises the price level and nominal wages.

    But, if prices and wages are sticky, and they have yet to fall enough to clear markets, so that real expenditure and real output remain below their potential levels, then the increase in the money supply raises nominal expenditures, real expenditures, and employment. The unemployment rate falls.

    So, it is possible that extended unemployment benefits result in a higher natural rate of unemployment and a lower unemployment rate and a lower level of potential output and higher output.

    Raising the nominal quantity of money some other way might not have this adverse impact on potential income. Further, the extended unemployment insurance will probably make wages more sticky and so slow a recovery due to an increase in the real quantity of money and an increase in real expenditure.

    It is no accident that Krugman continues to return to the liquidity trap, the zero nominal bound on interest rates, and the supposed ineffectiveness of monetary policy.

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