Professor Paul Palley's
          Economics Seminars

Suppose that you work in the marketing department for a major automaker. Your goal was originally to evaluate the prospective strength of the demand for three new cars under development; a SUV, a four-door hybrid, and a sports car. You have surveyed a large number of people in a number of demographic groups and various purchasing habits. You have estimated the proportion of people who will consider purchasing one of these new vehicles based on these surveys and found that the proportion exceeds a required benchmark for pursuing development. This was established through hypothesis testing using the process demonstrated in Week 3. For example, suppose that the benchmark is that at least 40% of prospective buyers must indicate an interest in buying one of the specific new vehicles. Then you test to see if this benchmark has net been met based on the results of the survey (H₀: π ≥ 0.40 versus H₁: π < 0.40). You find that you cannot reject the null hypothesis indicating that the benchmark has been met. Now you want to apply what you learned from the surveys to marketing analyses.

A next step is to look for where there are statistically significant relationships between the characteristics of those who filled out the surveys and their responses related to their interest in purchasing one of the new cars. This facilitates marketing efforts because knowing the extent to which there is a relationship between age and interest in one of the vehicles, or income and interest in one of the vehicles, or for example family size and interest in one of the vehicles, helps with targeting you marketing efforts. This is established by setting up contingency or cross tabulation tables as illustrated in the notes, and then using the chi-square distribution as the test statistic for your hypothesis test.

Here is an example that briefly describes this application. Let’s say that you find that the benchmark is met for the four-door hybrid and you want to determine if there is a relationship between interest in this car and family size. You will set-up a contingency table with these variables. Then your null hypothesis will be that there is no relationship between family size and interest in purchasing the four-door hybrid. The alternative hypothesis is that there is a relationship between family size and interest in purchasing the four-door hybrid. If you cannot reject the null hypothesis then you will not market towards family size. Next you might focus on income as this contingency table seems to show a higher probability associated with higher income households indicating interest in the four-door hybrid. Here your null hypothesis will be that there is no relationship between household income and interest in purchasing the four-door hybrid. The alternative hypothesis is that there is a relationship between household income and interest in purchasing the four-door hybrid. If you can reject the null hypothesis then you will focus your marketing efforts on higher income households as that group appears to be your market.

The financial markets provide us with measures of risk that are useful for monitoring the perceptions of investors related to the stability of the economy. The following discussion focuses on historical data related to the 3-Month Treasury bill rate, the three-month Libor rate, the 10-Year Treasury Constant Maturity rate, inflation expectations, Moody’s Seasoned Aaa Corporate Bond Yield, and the value of the dollar. What the discussion below indicates that the markets expect the U.S. and global economy to remain weak, but that there are also signs that the worst of the financial crisis is perceived to be behind us. We see signs that the supply of money has increased and that perceptions of risk have declined some. At the same time, as I point out below, we are some distance away from what we would normally consider to be stable economic growth.

The 3-Month Treasury bill: Secondary Market Rate is an indicator of economic stress because investors look for the safest places to park their money during a crisis, and nothing is perceived to be safer than the 3-Month Treasury Bill. If one looks at longer periods of time it is clear that a 3-month Treasury bill rate in the range of 3.00% and 4.00% is associated with a healthy and stable economy with low levels of inflation. Higher rates reflect higher inflation expectations and a 3-month Treasury bill rate in the range of 2.00% and 3.00% reflects much lower inflation expectations, and slower expected economic growth. We can see in the graph below that first in March 2008, and then in September 2008, October 2008 and November 2008, there were precipitous drops in the 3-month Treasury bill rate. Seeing the 3-month Treasury bill rate approach 0.00% is a sign of extreme financial distress in the financial markets, and the extraordinary lower rates since November indicate persistent weakness. It should be noted that these very low rates are also partly the result of very aggressive Federal Reserve policies. We should expect these rates to remain extraordinary low as long as investors continue to perceive significant risks confronting the economy, and the financial services industry remains in a weakened state and in a risk-averse mood.

The three-month Libor indicates the rate that banks pay each other to borrow for three months. The graph below shows that it rose significantly in the month of October 2008. The significant increase in the three-month Libor in October 2008 reflected risk, the perspective of banks that there was greater risk related to lending to one another. Credit was choked off during this credit crunch, and lending between banks declined significantly contributing to the decline of the economy. Since then the rate has declined precipitously. This decline reflects the exceptional amount of monetary stimulus undertaken by the Bank of England and other actions by the British government. That being said, the significant decline in three-month Libor starting in late October 2008 is not a sign of a healthier economy. What this does indicate is the need for extreme actions by the monetary authorities in England to try to rescue their financial markets and economy. Instead, a healthy economy is one where the three-month Libor fairly reflects the risks associated with a stable economy. In recent years this reflected by the three-month Libor being in the range of 4.00% and 6.00% (see the second graph below).

The 10-Year Treasury Constant Maturity Rate is an important indicator in that many other long-term lending rates are tied to it either explicitly or implicitly. Mortgage rates, for example move in the same direction as the 10-Year Treasury rate as they represent an alternative form of long-term investment. The difference between the two rates is reflective of risk. The sizeable decline in as the 10-Year Treasury rate starting in March reflects the rush to quality or risk-free investments that accompanied the decline in the financial markets. Rates increased since then, but they have stabilized at lower levels in the range of 2.60% to 3.00%. This indicates a slight improvement, but a 10-Year Treasury rate at these low levels indicate a very weak economy as this can only be the result of exceptionally low inflation expectations, and this is indicate of an economy that is unable to generate any pricing power on the part of businesses. A healthier economy with inflation expectations in the range of 2.00% to 3.00% would indicate a 10-Year Treasury rate in the range of 5.00% to 6.00%.

The difference between the 10-Year Treasury Constant Maturity rate and the 10-Year Treasury Inflation-Indexed Security is a very good measure of inflation expectations. Inflation is associated with growing economies, and as a result some inflation is desirable. On the other hand, the exceptionally high rates of inflation seen in the 1970s significantly stressed the economy. Very low rates of inflation can also be very problematic as it indicates lower rates of economic growth, and limits the ability of businesses to raise the prices of their products and this reduces the profits they can earn. Deflation is a far more significant risk as declining prices lead to lower profits and potentially losses due to serious declines in all forms of spending as buyers wait for even lower prices. Deflation is associated with severe economic recessions. The sporadic increases in inflation expectations between the middle of 2006 and the middle of 2008 depicted in the graph below reflected higher commodities prices and other inflation pressures. The decline in inflation expectations to nearly 0.00% since then as shown in the graph below indicates severe economic distress and the expectation that the economy will continue to be very weak, and that deflation is a threat. The increase in inflation expectations to just over 1.00% is a moderately positive sign because it indicates that deflation is less of a risk, and that some economic growth is expected in the future. In general, it is believed that inflation rates in the range of 2.00% and 3.00% are associated with a moderately growing and stable economy.

Moody’s Seasoned Aaa Corporate Bond Yield is an indicator that tells us something about the availability of funds for businesses seeking to raise money. Notice in the graph presented below that the real, inflation adjusted, Moody’s Seasoned Aaa Corporate Yield rose sharply between September and November. This is the same period in which, as noted above, the 3-month Treasury Bill rate approached 0%. As I also indicated above, this indicates a flight to risk free assets, and even away from the safest corporate bonds. This is a sign that financial markets perceived significant risks to the real economy, and suggests that if these conditions persisted then the most credit worthy borrowers would face real issues related to their financing efforts. Bond issuers that are associated with higher levels of risk saw even more significant increases in the yield on their bonds. The decline in the real, inflation adjusted, Moody’s Seasoned Aaa Corporate Yield since January is a positive sign because it indicates an increase in the supply of funds for the least risky borrowers and also indicates the perception that economic conditions will improve.

The Trade Weighted Exchange Index for the value of the dollar versus major currencies is another importance indicator related to the perceived risk associated with the global economy. The dollar is generally considered to be a safe haven currency, and as a result in times of global economic stress we will see investors buying dollars that they can use to purchase U.S. Treasury bills and other dollar denominated investments. The long-term trend for the dollar is that it is declining in value. The reason for this the sizeable trade deficit carried by the U.S. What we can see in the graph below is that the dollar increased in value during the last half of 2008, followed by a brief decline, and then once again a sizeable increase between January and March. These increases in value are directly the result of the financial crisis which had become a global financial crisis. What we see though, is that the dollar may be stabilizing in value in a trading range. The positive side of this is that it may indicate that the financial markets see the current period as a bottom for the financial crisis.

Here is an interesting column in the New York Times written by Thomas Friedman related to the problems related to the quality of education in the U.S. The link is: http://www.nytimes.com/2009/04/22/opinion/22friedman.html?ref=opinion

We know that statistics is used to make predictions, apply sample data to arrive at inferences about the populations we are interested in, and assess uncertainty. We see statistics used as a research and decision-making tool in business, economics and finance. We also see statistics applied in the fields of engineering, medicine, sociology, psychology, and communications. What follows is a brief discussion about fun applications of statistics for decision-making purposes.

My first exposure to statistics as an interesting topic to focus on was through my love of baseball when I was a kid. I loved baseball cards not for the picture on the front of the card. The attraction for me was the statistics on the back. For example, I learned how to calculate each player’s batting average (hits/official at bats) and on base average (hits+walks/at bats+walks) and other statistics. In time I learned how the team’s manager can use these statistics as an example of statistics probability. By knowing a player’s batting average when facing a left-handed pitcher versus a right-handed pitcher, and when another teammate is already on second or third base (in scoring position) the manager can make a strategic decision related to whether or not to use a different or pinch hitter. Other more detailed data is available for batters, and also pitchers. The manager can use these statistics as subjective probability tools to select the player best suited to succeed in the particular situation confronted by the team. There are great sources for this sort of baseball related data. See The Baseball Encyclopedia and books written by Bill James. An interesting book about Billy Beane, the General Manager of the Oakland A’s who has managed to be successful despite the team playing in a small market, is Moneyball: The Art of Winning an Unfair Game by Michael Lewis. This book is about how Billy Beane used statistics to put together a team of affordable players that could succeed, if not win the World Series, despite working with a small budget.

There are other fun and interesting books about applications of statistics, and examples, and examples of the poor use or interpretation of statistics. Here is a link through the BBC illustrating this (http://www.bbc.co.uk/dna/h2g2/A1091350). Here is another interesting Blog about the misuse of statistics and data you might want to read (http://blogs.wsj.com/numbersguy/). Here is a Blog that addresses interesting application of economics and statistics in unconventional situations that is fun and interesting to read (http://freakonomics.blogs.nytimes.com/).

Have fun with these resources and search for other fun applications of statistics, and practical ones as well.

Agreements and disagreements from the Group of 20 countries or G-20 (http://www.g20.org/) meeting of the leaders of the twenty countries with the most important economies illustrated the challenges associated with coordinating economic policies even in the face of a severe recession. Their goal was to address issues related to the financial crisis of 2008-09, the recession, and to fight against protectionism in order to bolster trade and help pull the global economy out of the recession.

What was announced by the leaders on Thursday, April 2, 2009 included $1.1 trillion in additional loans and guarantees to finance trade and assist developing economies. What was also agreed to include stringent new regulations on hedge funds bond rating agencies, and additional efforts to crackdown on tax havens. Other areas of agreement included new global rules related to capping the pay and bonuses earned by bankers, and a unified approach in dealing with the toxic assets on the balance sheets of world’s banks. The G-20 restated their commitment to free trade and to fight against protectionism, and pledged $250 billion in financing for trade. Furthermore, it was noted that in the long-run exit strategies from stimulus policies are needed to ensure price stability or avoid inflation.

The most important take-away from the meeting was additional support for the International Monetary Fund or IMF (http://www.imf.org/external/index.htm) which is a different entity to the World Bank (http://www.worldbank.org/). The IMF is an important organization in the fight against the global economic crisis and extends emergency loans to many countries. The G-20 pledged to increase the resources of the IMF to $750 billion from $250 billion through $500 billion in loans and a one-time issue of $250 billion in a synthetic currency of the Fund called Special Drawing Rights.

The problems or disagreements included a lack of additional funds to stimulate the global economy. The source of this disagreement is the desire by the U.S., China, Japan, and England for greater stimulus, but most of continental Europe was opposed. They argued that it would be more prudent to analyze the impact of efforts to stimulate the economy that had already been impact first. The U.S. and other countries opposed European efforts to develop regulatory authorities with authority in all countries, but did agree on policies to increase transparency and to create an ability to issue warnings for banks. This differs from the proposal for a Financial Stability Forum or a single regulatory authority, and instead we ended up with a system where each country primarily engages in its own regulatory efforts.

It is important to note that we have a global economy with a multitude of counter-party financial relationships, international trade is a growing part of the global economy, and that debtor nations like the U.S. and creditor nations like China must cooperate in order for economic stability to prevail. Furthermore, efforts by developing economies to grow should be encouraged facilitating greater global economic growth. Finally, trade encourages political stability. That being said, we must remember that disagreements are a natural by-product of these conferences because each nation has its own internal politics. It is natural for the U.S. and other countries to work hard to ward off a deeper recession as the Great Depression still resonates in our history. It is natural for Germany and other countries to be wary of inflation as the hyper-inflation in Germany in the 1920s helped lead to Hitler’s takeover of Germany and this still resonates in their history.