7. Assessment of Economic Impacts

Objectives of the Economic Assessment

Because energy resources are used to produce most goods and services, higher energy prices can affect the economy’s production potential. Since the energy crisis of the 1970s, economic research has led to a better understanding of the potential adverse economic consequences of rising real energy costs, in terms of both long-run equilibrium costs and short-run adjustment costs. Long-run equilibrium costs are associated with reducing reliance on energy in favor of other factors of production—including labor and capital, which become relatively cheaper as energy costs rise. Short-run adjustment costs can arise when price increases disrupt capital or employment markets.

This chapter assesses possible impacts on the economy associated with attaining the emissions target under alternative scenarios presented earlier in the report and comparing them with a reference case. In evaluating these alternative scenarios, five key questions are posed:

• What would be the long-run cost to the economy?
• With rising energy prices and inflation, what adjustment impacts would the economy face?
• How does the allocation of permits affect the economic outcome?
• What is the role of the Climate Change Credit Corporation in mitigating these economic effects?
• How would the Federal Reserve Board react to higher inflation and unemployment?

Treatment of Permits from a Macroeconomic Perspective

Four basic pollution control policies exist: taxes, subsidies, tradable permits, and command-and-control regulation. S.139 focuses on the establishment of a marketable emission allowance trading system; however, the bill is silent on the allocation of allowances—which will have a significant impact on the energy economy—leaving the decision regarding the allocation to the Secretary of Commerce. To assess the economic impacts, key assumptions were made about the implementation of S.139; the most significant relates to the allocation of the allowance permits and the role of the Climate Change Credit Corporation (hereafter referred to as “the Corporation”), which will be granted a portion of the permits.

The bill sets up a system of marketable permits with a split in the allocation of the permits between a nocost allocation of permits to business entities and another portion provided to the Corporation, which can sell the permits through an auction. In principle, under a set of conditions, each of these market mechanisms, if implemented independently, will yield the same solution, i.e., will identify the same marginal cost of reducing a pollutant by a given amount. While the policies may achieve the same economically efficient solution, their distributional impacts are considerably different.¹⁸⁴

In the no-cost allocation to firms, there would be redistribution of income flows among emitters of pollution, in the form of sales and purchases of emission permits. In contrast, with an auction run by the Corporation, there would be a net transfer of income from emitters to the Corporation. The key question at this juncture turns on the use of the funds by the Corporation. If the funds were returned to the emitters through some transfer program, the effect would be the same as in the no-cost allocation scheme, but with the Corporation establishing the distribution mechanism to emitters Another use of the funds would be to return them to consumers in the form of a lump-sum transfer, compensating consumers for the higher prices paid for energy and non-energy goods and services.

The allocation of permits (or redistribution of auctioned revenues) will have differential effects on energy markets and the economy, in terms of both the magnitude and the time profile of the impacts. From a macroeconomic perspective, an auction that transfers funds to consumers in a lump sum would help to maintain their level of overall consumption relative to the no-cost allocation of permits to business. With the transfer, however, total investment would decline relative to the no-cost allocation system. The two effects would tend to counterbalance each other, although not completely. The time profiles of the impacts would differ.

In order to explore the economic implications of different allocation choices for macroeconomic growth, several alternative allocation systems were examined and compared with the reference case,¹⁸⁵ including:

• An allocation that begins with an 80 percent no-cost allocation to firms and a 20 percent allocation to the Corporation in 2010. The share allocated to the Corporation would increase over time to a maximum of 80 percent in 2025. The funds generated from the sale of the permits by the Corporation are recycled back to consumers as a lump-sum transfer after transition assistance and funds for energy-efficient investment are netted out. This methodology is used in the S.139 case.
• A sensitivity case with a fixed 20 percent of the permits granted to the Corporation from 2010 through 2025, with a lump-sum transfer to consumers, with transition assistance and energy efficient investment funds netted out.
• A sensitivity case with a fixed 80 percent of the permits granted to the Corporation from 2010 through 2025, with a lump-sum transfer to consumers with transition assistance and energy efficient investment funds netted out.

In each of these three cases, the Federal Reserve would seek to balance changes in inflation and the unemployment rate through changes in interest rates. Throughout this chapter, all value concepts are presented in real 1996 dollars, unless otherwise specified.

Macroeconomic Cost Measures

A number of economic measures are presented later in this chapter. A few key measures are highlighted: potential gross domestic product (GDP), actual GDP, the value of purchased international permits, and the relationship between inflation, unemployment, and interest rates.

Loss in Potential Output of the Economy

The aggregate supply potential of the economy is embodied in a concept identified as “potential GDP.” The estimate of this concept relies on a production function view of the economy that combines factor input growth and improvements in total factor productivity. Factor inputs equal a weighted average of labor, business fixed capital, public infrastructure, and energy. Based on each factor’s historical share of total input costs, the elasticity of potential output with respect to labor is 0.64 (i.e., a 1 percent increase in the labor supply increases potential GDP by 0.64 percent); the business capital elasticity is 0.26; the infrastructure elasticity is 0.02; and the energy elasticity is 0.07. Factor supplies are defined by estimates of the full employment labor force, the full employment capital stock, end-use energy demand, and the stock of infrastructure. The concept of potential GDP reflects the trajectory of the long-term growth potential of the economy at full employment; actual GDP reflects the trajectory of the actual economy as it adjusts to a long-run path.

Actual GDP and the Adjustment Process

The economy may experience transitional impacts that would result from efforts to reduce U.S. greenhouse gas emissions. The measurement of actual output for the economy, or actual GDP, is the key concept used in the examination of changes in the aggregate economy as it adjusts to its long-run path. In addition to internal frictions caused by wage-price interactions and capital stock obsolescence, losses in domestic income may occur as funds are transferred out of the United States to purchase international greenhouse gas allowances. Resources may be less than fully employed, and the economy will move in a cyclical fashion as the initial cause of the disturbance—the increase in energy prices—plays out over time. Shifts in the sectoral composition of the economy would also accompany the adjustment process. Here, a single fiscal policy is assumed to accompany the greenhouse gas mitigation policy—the revenues collected from the domestic permit auction are returned to consumers through personal income tax rebates.

The ultimate impacts of greenhouse gas mitigation policies on the economy will be determined by complex interactions between elements of aggregate supply and demand, in conjunction with monetary and fiscal policy decisions. As such, any discussion of possible transitional impacts on the economy is characterized by uncertainty. The introduction of greenhouse gas emission limits would affect both consumers and businesses. Households would be faced with higher prices for energy and energy-related goods and services, which will have two effects. First, there will be a tendency on the part of households to adjust their spending patterns away from energy-related goods and services. Second, because of lower real disposable income resulting from higher prices for energy, consumers will reduce overall spending and savings. Energy services also represent a key input in the production of goods and services. As energy prices increase, the costs of production rise, placing upward pressure on the nominal prices of all intermediate goods and final goods and services in the economy, with widespread impacts on spending across many markets. The ultimate effect depends on opportunities for substitution away from higher cost energy to other goods and services and the effectiveness of compensatory fiscal and monetary policy.

Purchase of International Permits

The international flow of greenhouse gas permit revenue is considered a change in the purchase of imported services. Funds transferred abroad for purchases of international greenhouse gas emissions permits would, in effect, reduce the amount of potential GDP available for domestic use.

Inflation, Unemployment, and the Role of Monetary Policy

Monetary policy can moderate or intensify the ultimate impacts on the economy; however, trying to predict the response of monetary authorities to large increases in energy prices is a difficult task. The emphasis on controlling inflation relative to concerns about rising unemployment has changed over the past 20 years, and using history as a guide does not remove the large amount of uncertainty about the response of monetary authorities. In addition, the types of financial instruments available have become more numerous and more interdependent, and the task of monitoring the Nation’s money supply has become more complex.

The monetary authorities could concentrate on increased inflation resulting from higher energy prices and choose not to increase the money supply in order to moderate the resulting inflation. In this instance, output and employment losses would be larger than if the money supply were expanded when energy prices increased. Another option would be to allow the money supply to increase in order to remove the unemployment impacts while allowing substantial additional price inflation. This analysis uses neither extreme of these assumptions about the response of the Federal Reserve. The discussion in the following section represents a middle path that the Federal Reserve might follow.

Impacts on the Aggregate Economy

S.139 Case

This section discusses the impacts on the aggregate economy projected in the S.139 case. It focuses on the long-run impact on potential output and the transitional impacts on actual output in the economy. Inflation and unemployment impacts are assessed relative to movements in interest rates in reaction to actions taken by the Federal Reserve Board. The role of international flows of funds to pay for international emissions offsets is also discussed. A single fiscal policy is assumed to accompany the emissions mitigation policy—the revenues collected by the Corporation from the domestic permit auction are returned to consumers, predominantly through a lump-sum transfer to individuals. A provision in the bill also calls for transition assistance, which will be disbursed by the Corporation. The share of the permits allocated to the Corporation changes over time in the S.139 case, rising from a 20 percent allocation in 2010 to 80 percent by 2025. Two sensitivity cases are presented, assuming that the Corporation’s share of permits would be constant throughout the forecast period—at 20 percent and 80 percent, respectively.¹⁸⁷

A. Collection and Distribution of Funds Flowing to the Corporation

Collection of Funds by the Corporation. Because the permits have substantial value under S.139, the establishment of the permit trading system creates a considerable amount of revenue for the Corporation. In the S.139 case, the permit price rises steadily through 2023, then levels off as the amount of banked permits approaches zero and the permit price is determined on a year-by-year basis. Figure 7.1 shows the total amount of revenues in the S.139 case and the growing amount that will flow to the Corporation as the percent allocated to the Corporation grows from 20 percent in 2010 to 80 percent in 2025. In 2010, the aggregate amount of funds totals $116 billion, with $23 billion flowing to the Corporation. By 2025, the aggregate amount of funds has risen to $473 billion, with $378 billion flowing to the Corporation. The large sum of funds, the distribution between grandfathering of the permits and allocating to the Corporation, and the ultimate use of these funds by the Corporation have impacts on the aggregate economy.

Distribution Through Transition Assistance.Under Section 352 of S.139, the Corporation must allocate a percentage of the proceeds it derives from tradable allowances to providing transition assistance to dislocated workers and communities. The percentage specified in S.139 is 20 percent of the Corporation proceeds in 2010, falling by 2 percentage points each year and ending in 2020. The transition assistance may take the form of (1) grants to provide training, adjustment assistance, and employment services to employers and employees, and (2) grants to State and local government to assist communities in attracting new employers or providing other services. The transition assistance portion is removed from the total amount of revenues accruing to the Corporation by the sale of the permits These are interpreted in the model as, first, non-Medicare transfer payments to persons and, second, grants to State and local governments to be spent on consumption of goods and services. Each receives half of the total transition assistance. For the S.139 case, there are three separate trends: the expansion of the revenue base as the percent and going to the Corporation expands from 20 percent to 80 percent; the rise in the permit price, which generates more revenue; and the decreasing share of revenue given to transition assistance. Taking this all into consideration, the nominal amount of transition assistance is about $5 billion in 2010, rising to $8 billion in 2015, and dropping to zero in 2020.

B. Impacts of S.139 on the Aggregate Economy

Impacts on Potential and Actual Output. In the long run, higher energy costs would reduce the use of energy by shifting production toward less energy-intensive sectors, by replacing energy with labor and capital in specific production processes, and by encouraging energy conservation. Although reflecting a more efficient use of higher cost energy, this gradual reduction in energy use would tend to lower the productivity of other factors in the production process. The derivation of the long-run equilibrium path of the economy can be characterized as representing the “potential” output of the economy when all resources—labor, capital, and energy—are fully employed. As such, potential GDP in the Global Insight Model is equivalent to the full employment concept calculated in a number of other models that focus on long-run growth while abstracting from business cycle behavior.

The ultimate impacts of greenhouse mitigation policies on the economy will be determined by complex interactions between elements of aggregate supply and demand, in conjunction with monetary and fiscal policy decisions. As such, cyclical impacts on the economy are bound to be characterized by uncertainty, possibly significant. Raising energy prices and, as a result, downstream prices in the rest of the economy could introduce cyclical behavior in the economy, resulting in employment and output losses in the short run. The measurement of losses in actual output for the economy, or actual GDP, incorporates the transitional cost to the aggregate economy as it adjusts to its long-run path. Resources may be less than fully employed, and the economy may move in a cyclical fashion as the initial cause of the disturbance— the increase in energy prices—plays out over time.

The possible interaction between these impacts is summarized in Figure 7.4, which shows the trends for both loss of potential GDP and loss of actual GDP, reflecting the macroeconomic adjustment cost that may result from the higher prices of the greenhouse gas mitigation policy. It recognizes the possibility that cyclical adjustments may occur in the short run, but that these will play out and converge to potential output as the forecast horizon lengthens.

Actual GDP, which incorporates adjustment costs associated with moving toward a new long-run equilibrium, shows a sharp decline of 0.7 percentage points in 2011 and 2012. Thereafter, the economy begins to rebound from the initial price effects. However, there is a steady negative impact on the longrun supply potential of the economy as all segments adjust to the new pattern of energy use. While the two measures merge by 2025 at a loss of 0.6 percent of actual GDP and 0.5 percent of potential GDP, clearly, the processes of adjustment for both actual and potential output have not fully played out by the end of the forecast period.

Inflation, Unemployment, and the Role of Monetary Policy

In the setting that has been described, higher prices in the economy would place upward pressure on nominal interest rates. The Federal Reserve Board would then seek to balance the adverse effects of higher energy prices on output and employment by making adjustments to the Federal funds rate. The adjustments would be designed to moderate the possible impacts on both inflation and unemployment, and to return the economy toward its long-run growth path.¹⁸⁹

If the rate of inflation increases, but unemployment does not increase, the Federal Reserve may choose to let the nominal interest rate rise in an attempt to cut the rise in inflation. However, if this is accompanied by an increase in the unemployment rate, the Federal Reserve may consider a cut in the rate to stimulate economic expansion and the demand for labor. In essence, there is a balancing act between the two factors—inflation and unemployment—as the initial originating policy initiative has uneven impacts on the two over time.

Figure 7.5 shows the interrelationship between the projected inflation, unemployment, and Federal funds rates in S.139. The inflation rate in 2010 jumps from 2.2 percent per year to 2.8 percent per year—a difference of 0.6 percentage points—as the provisions of the bill take effect. The price level of the economy continues to rise throughout the forecast period, but the rate of change in the price level—the rate of inflation—decelerates after 2010. After 2017 the inflation rate begins to increase again, but at a slower rate. The rate of inflation always remains above the reference case, keeping continual pressure on the aggregate economy. The unemployment rate increases in response to the rapid increase in inflation. By 2012, the peak impact year, the unemployment rate rises from 4.3 in the reference case to 4.7 percent, a difference of 0.4 percentage points (about 0.6 million jobs). The responses of inflation and unemployment tend not to be symmetric over time. There is a lag between the two effects, with output and employment effects lagging behind price effects. Prices rise in the economy in response to the initial energy price increase and then in response to secondary price effects as the costs of intermediate goods and services rise. Businesses, in response to rising prices and lower aggregate demand, absorb the nearterm output loss but eventually reduce their use of labor. The lag from initial price effects to ultimate output and employment losses can be a year or so.

As a result of the differential effects projected for inflation and unemployment during the years from 2010 to 2012, the Federal Reserve is assumed to allow a modest rise in the Federal funds rate in the short term, when concern over inflation outweighs concern over GDP losses and unemployment. After the initial rise in energy prices, the inflation rate approaches the rate projected in the reference case; however, aggregate output is still depressed, and unemployment in the economy remains above the reference case value. During this period, the Federal Reserve reacts by reducing the Federal funds rate, in order to combat the loss in output and employment in the economy. As unemployment falls and prices continue to rise, the Federal Reserve starts increasing the Federal funds rate after 2013. By 2016 the Federal funds rate is back at baseline, but prices are continuing to rise. With unemployment continuing to fall due to demand pressures, mentioned above, the Federal Reserve Board continues to raise the Federal funds rate, which increases all the interest rates, including the rates on Federal Government debt, above baseline values.

Implicit in this discussion about the ability of the Federal Reserve to influence real activity in the economy is the historically observed relationship between the Federal funds rate and real long-term interest rates. While the Federal Reserve can directly influence the nominal Federal funds rate (which is a short-term rate) by increasing or decreasing unborrowed reserves, it is the real long-term rates that influence decisions to save and invest. Figure 7.6 shows the difference from base for the real yield on AA utility bonds and real average yield on U.S. Treasury bonds. As figures 7.5 and 7.6 show, the real longterm rates (Figure 7.6) track closely the Federal funds rate (Figure 7.5) over the forecast period.

Figure 7.7 shows the impacts on actual GDP as well as gross output (value of production) and employment. Gross output declines by 1.1 percent in 2011, rebounds slightly, then declines again as inflation picks up again just before 2020. Employment reaches a peak loss of 0.6 percent in 2012 and by 2025 is almost back to reference case levels. Gross output and employment impacts of S.139 are discussed in more detail later in this chapter.

Composition of Impacts on Actual GDP. Figure 7.8 highlights the relative impacts on components of actual GDP.¹⁹⁰ In the aggregate, actual GDP falls by approximately $93 billion by 2012 (0.7 percent of reference case). However, the impacts are uneven across the components of GDP.

Consumption of goods and services in the economy contributes the most by far to the overall decline, falling by $79 billion (0.9 percent of reference case) in 2012. This is due to the rapid rise in energy prices and the rapid decline in disposable income. Consumption remains down from the reference case as prices continue to rise, but toward the end of the forecast, consumption begins to recover as inflation begins to stabilize near reference case levels and the amount of disposable income increases. Figure 7.9 shows the rebound in consumption relative to disposable income in percentage terms.

Investment also declines rapidly, reaching a loss of $42 billion (1.6 percent of reference case) in 2011. It recovers early in the period, as the proportion of the funds going to the Corporation remains small. However, as the share remaining in the hands of business declines over time and more funds are shifted to the Corporation, the impact on investment begins to increase again, reaching $49 billion (1.1 percent of reference case) in 2025.

For the S.139 and the other cases it is assumed that the Federal, and State and local governments do not change their spending and revenue policies, relative to the reference case. However, real government spending and revenues will change due to the presence of spending and revenue raising policies that are linked to the state of the economy as well as price changes. As shown in Figure 7.8, real government expenditures (Federal and State and local) decline gradually over the period due to higher prices. Ultimately the real issue is the decline in the nominal surplus for both (Figure 7.10). The Federal and State and local government surpluses worsen as inflation rises, employment and output decline, and interest rates increase. After the initial worsening, both the Federal and State and local surpluses begin to improve, largely due to the sharp decline in the inflation rate and the improvement in the economy. The Federal surplus declines by $34 billion (nominal) in 2012, improves, and then worsens by approximately $104 billion (nominal) by 2025. The State and local government surplus follows much the same pattern, worsening by $13 billion (nominal) in 2011 and by $21 billion in 2024.

The rise in the deficit at the Federal level is, in large part, due to the rise in interest rates and payments on Federal debt. As the discussion of Figure 7.5 mentioned, with the inflation rate continually above reference cases rates, interest rates (and therefore interest payments by the Federal Government on its total debt) increase. This increases the nominal size of the Federal deficit. By 2025 the Federal funds rate is 47 basis point above its baseline value, and the yield on 30-year Treasury bonds is approximately 30 basis points above its baseline value. A 30 basis points increase in interest payments on the nominal Federal debt (which is $13,250 billion in 2025 in the baseline case) amounts to approximately $40 billion and is the principal reason for the increasing size of the Federal nominal deficit.

International trade is also affected by these events. Prices for goods and services within the United States compared to foreign prices drive the results. While S.139 is presumed to be offered in conjunction with expected greenhouse gas initiatives outside the United States, trade impacts of a domestic bill such as S.139 should be examined relative to a reference case assuming foreign programs. In this setting, a rise in U.S. energy prices, feeding through to higher domestic prices, makes U.S. exports less competitive overseas. In the S.139 case, exports decline steadily relative to the reference case to a maximum loss of approximately $75 billion in 2025 (Figure 7.11). Imports are also influenced not only by relative prices but also by the loss in output, employment, and income. Imports decline, reaching a maximum loss of $33 billion, but then begin to increase. Imports of industrial materials and supplies plus services decline the most throughout the period, while imports of foods, feeds and beverages; motor vehicles and parts; and non-automotive consumer goods initially decline, but then recover beyond the baseline by 2025. However, the net trade balance actually improves for most of the forecast as imports decline by more than exports through 2020. After 2020, with imports picking back up and exports declining further, the difference in net trade balance turns negative.

The purchase of international emissions permits is represented as an increase in imports of services. In Phase 1 of the implementation, between 2010 and 2015, a covered entity may satisfy 15 percent of its permit requirements by purchasing allowances from non-covered entities, through sequestration, and from other nations. In the S.139 case, annual purchase of international permits is expected to be just under $5 billion (real 1996 dollars) throughout the Phase 1 period, representing 27 to 31 percent of all offset purchases. In 2016, when the offset allowance is reduced to 10 percent, domestic offsets are adequate to satisfy demand, and international purchases drop to zero.

C. Impacts on Output and Employment

This section analyzes the projected impacts of the S.139 case on gross output (or production) and employment. For the manufacturing industries, the value of shipments data collected by the U.S. Bureau of the Census is the basis for measuring the dollar value of output.

Gross Output. In 2001, the service sector accounted for 63 percent of the economy’s total output. The manufacturing sector accounted for 28 percent, and the non-manufacturing industries (agriculture, mining and construction), 9 percent. Of the manufacturing output, 27 percent was from energy-intensive industries.¹⁹¹ In the reference case (Figure 7.12), the service sector is expected to grow at a compound annual growth rate of 3.1 percent for the period 2001-2025, the manufacturing sector at 3.0 percent, and the non-manufacturing sector at 1.4 percent. Energy-intensive industries are projected to grow at a slower pace (1.5 percent) than the non-energy-intensive industries (3.4 percent).

Upon implementation of S.139, the changes in energy prices and the allocation of permit revenue by the Corporation will affect all final demand categories of consumer, investment, and government spending. Demand for domestically produced goods and services will shift, and industries will adjust accordingly.

Figure 7.13 shows the projected changes in output in the S.139 case. All the major sectoral groups decline, but the impacts are uneven. The non-manufacturing sector, which covers mining, is affected the most, followed by the energy-intensive manufacturing industries. In the beginning of the implementation period, the non-energy-intensive industries and the service sector experience a fall in demand because of the surge in prices, but the declines are less than in the other two groups. As a larger portion of the permit revenue is passed to consumers over time, consumer spending improves.

Figure 7.14 shows the average loss in output for the period 2010-2025. The average loss in total output is projected to be about 0.8 percent, slightly higher than the GDP loss of 0.6 percent. Production of the non-manufacturing industries (agriculture, mining, and construction) is projected to be reduced by an average of 1.8 percent, energy-intensive manufacturing by an average of 1.2 percent, and other manufacturing by an average of 0.9 percent. The services sector, which comprises two-thirds of the economy and has relatively lower energy intensity, is expected to be reduced by an average of 0.6 percent.

The impact of the S.139 case on detailed sectors is presented in Figure 7.15. The upper part of the graph shows the projected changes in output at the more aggregate level of detail. Mining is expected to register an 8.6 percent loss relative to the reference case for the period 2010-2025. Agriculture and Business and Personal Services will be least affected. The lower part of the graph shows the projected changes for the manufacturing sectors at the 2-digit Standard Industrial Classification (SIC) level.¹⁹² The impacts vary from a decline of 2.5 percent for furniture to slightly positive for industrial machinery—including computers, the demand for which is expected to increase because their prices are less impacted by increasing energy prices relative to the overall price level.

The differential impacts among industries can be explained by several factors. First, the direct impact of higher energy prices is a reduction in demand for energy products, especially for those with high carbon content. Second, prices for energy-intensive products rise more than prices for non-energy-intensive products and most services, resulting in some substitution effect or change in consumer behavior. Third, demand for some goods and services is not as price-sensitive as others. Fourth, the allocation of permit revenue to consumers increases over time in the S.139 case, which increases the final demand for consumer products and services. Finally, an increase in producer prices changes the relative prices between domestic and foreign goods. Demand for some U.S. goods may fall as they become more expensive, and demand for foreign goods may increase.

Employment. S.139 is projected to have a smaller impact on employment than output. First, there is a portion of employment—managerial and supervisory—that is not engaged in direct production. Second, at least in the short run, the level of direct labor input may be less flexible than the level of production. Also, in the longer run, higher energy prices will induce some substitution from energy to other inputs such as labor and capital. This results in a reduction in labor productivity and a higher labor-to-output ratio. Figure 7.16 shows the average loss in employment for the period 2010-2025 under the S.139 case. The average loss in total employment (including agricultural employment) is projected to be 0.3 percent, or 0.46 million. The loss in non-manufacturing employment is estimated to be 0.9 percent (0.11 million), compared to a 1.8 percent loss in output. Average loss in employment is less in percentage terms for manufacturing (0.5 percent or 0.09 million) and for services (0.2 percent or 0.26 million), corresponding to the smaller impacts on output from these two sectors.

The impact of the S.139 case on employment at the detailed sectoral level is presented in Figure 7.17. The strongest impact is on the mining sector. The mining sector comprises three subsectors: coal, oil, gas extraction, and other metal and non-metal mining. While the output of coal is projected to decrease by an average of 48 percent from the reference case, output of oil and gas (about three times the dollar value of coal production) is projected to increase by 3 percent. Since the latter is more labor-intensive than the former, the positive impact on employment in the oil and gas industry offsets part of the negative impact on employment in the coal industry. Two sectors—agriculture and apparel—are forecast to have a small positive impact on employment under S.139. The impact on employment can be viewed as the combination of the impacts on output, labor productivity, and the relative price of different productive inputs. The output impacts of the two sectors are negative but small, since both sectors are not very sensitive to energy price changes. The reduction in labor cost relative to the producer price of agricultural products and the reduction in labor productivity in the manufacturing sector have, respectively, much stronger impacts on the two sectors.

Economic Impacts of Alternative Cases: Allocations of Permits, No Banking, Increased Offset Limits, and High Technology

The discussion above applies to a case in which the allocation of permits to the Corporation rises from 20 percent in 2010 to 80 percent by 2025, or 4 percentage points per year. How does the economic impact of S.139 change if alternative allocation schemes are used? The section below considers two allocation schemes: keeping the percent allocated to the Corporation steady at 20 percent (corp20) and at 80 percent (corp80) from 2010 through 2025. The second section considers a case with no banking of permits allowed. The third section discusses a case that allows up to 50 percent of a covered entity’s emissions to be met by using offsets, and the fourth section deals with high technology.

A. Holding the Allocation Percent Constant

Magnitude and Distribution of Funds. The six charts included in Figure 7.18 show the allocation of the tradable allowance revenue in nominal terms for the S.139 case and the two fixed allocation cases, plus the distribution of these funds. By presenting them side-by-side using the same scale, the differences between the cases can be seen at a glance. Under the S.139 case, the funds allocated to the Corporation rise from $23 billion in 2010 to $378 billion in 2025. Under the corp20 case, the funds again start at $23 billion, but rise only to $93 billion, $285 billion less than in the S.139 case. For the corp80 case, the amount allocated to the Corporation is much higher in the first year, $94 billion as compared to $23 billion in the S.139 case and the corp20 case. But by the last year, the total has risen to $391 billion, slightly higher than that of the S.139 case. This alteration in the allocation of permits has impacts on both the magnitude and time profile of the economic impacts.

While the impact on actual GDP focuses on the transition impacts, from a long-run perspective the relationship between the impacts on actual and potential GDP is of primary interest. Figure 7.20 focuses on these two concepts over the forecast period. The S.139 case shows the fastest recovery in actual GDP and approaches potential GDP in the last year of the forecast period. The other two cases remain below potential throughout. Note, however, the relative trajectory of potential GDP in the three cases. The corp20 case actually shows the best outcome for potential GDP, declining to approximately 0.3 percent relative to the reference case level in 2025, as compared to 0.5 percent below for the S.139 case and 0.6 for the corp80 case. Stated another way, although the corp20 case has the largest transition cost, the longrun prospects for this case are actually the most favorable. The corp80 case minimizes the near-term loss in actual GDP but has the weakest long-run outcome. The S.139 case recovers faster toward potential GDP by encouraging investment (aggregate demand and supply) in the earlier years and encouraging consumption (aggregate demand) in the later years. The discussion that follows gives more detail about the composition of these changes. Fundamentally, the differences lie in how the various cases affect consumption and investment, both in the short term and in the long term.¹⁹³

Consumer Spending. The initial impact on real consumer spending in the S.139 case is similar to that in the corp20 case whereas the impact in the later years resembles the corp80 case. As a higher percentage of the permit revenues is collected and passed by the Corporation to consumers in the S.139 case, consumer spending starts to improve. By 2021, it exceeds that of the corp80 case and continues to trend upward (Figure 7.21). The question here is, why does real consumption in the S.139 case overshoot real consumption in the corp80 case, from 2020 onward, whereas the respective disposable incomes do not and only approximate each other by 2025? The answer is that while disposable income affects consumer behavior, other factors (wealth, consumer confidence, interest rates, etc.) are also important.

This fact cannot be overemphasized since it is the key to explaining the actual GDP profiles for the three cases. One of the most important factors, besides real disposable income, that can alter consumption behavior significantly is expectations about the future. Households base their expectations to a large extent on their past experiences, that is, their best guide to the future is an extrapolation of recent economic conditions and the changes in those conditions. Consumer sentiment about whether this is a “good time to buy” can therefore be influenced by recent levels and changes in employment, income, interest rates, and inflation.

Consider the following sequence of events. As provisions of the bill take effect and energy prices rise, households experience rising inflation and rising unemployment. Clearly these circumstances would not inspire the confidence necessary to lead to greater consumption spending, especially for bigger ticket items. Now consider the impact on consumer confidence as provisions of the three cases play out. In the S.139 case the household finds that it is receiving an ever-increasing transfer from the Corporation and also notices that the economy is improving. After some time there is therefore a built-in expectation that real disposable income will continue to increase and the economy will continue to improve.

In the corp80 case, while the household receives a greater transfer initially, the fact that it stays constant implies that expected disposable income will not rise by as much, and also the economy is not improving as fast as in the S.139 case. In the corp20 case, the consumer receives a similar transfer as in the S.139 case initially, but over time the transfer does not increase by as much as in the other two cases. The economy is not improving as rapidly either. Thus, the S.139 case differs from the other two cases fundamentally because the consumer is seeing a steady improvement in disposable income and other factors over time, which stimulates consumption spending and in turn leads to a faster recovery in the economy than is projected in the other two cases (Figure 7.21).¹⁹⁴

Investment Spending. Fixed investment consists of residential investment and nonresidential investment. In 2002, residential investment accounted for 29 percent of total investment in nominal terms, and nonresidential investment accounted for 71 percent. Seventy-five percent of the nonresidential investment was in equipment and software.

As shown in Figure 7.22, the change in total investment in the corp80 case is more negative than in the S.139 case, as more emission allowance funds are returned to the consumer. However, the change in the corp20 case tracks closely with that of the S.139 case. To analyze the deviation pattern, two major categories are examined—residential investment and investment in nonresidential equipment.

Impacts on Residential Investment. Although the bill does not cover the residential sector, it is nonetheless affected by income and interest rate changes relative to the reference case. The impact on residential investment in the S.139 case is smaller than those in the corp80 and corp20 cases. In the corp80 case, the nominal mortgage rate is higher (Figure 7.23) than in the S.139 case, dampening the demand for home sales. The rise in the mortgage rate and other interest rates (Figure 7.24) is largely driven by the higher level of prices as reflected by the consumer price index in the corp80 case. In the corp20 case, household disposable income is lower than in the S.139 case, also leading to lower household investment purchases; but interest rates are also lower, helping to support investment purchases. All these factors result in a crossover pattern in the trajectories of residential investment.

Impacts on Nonresidential Investment in Equipment. Investment spending on equipment amounts to 53 percent of total investment in nominal terms. The impact of the S.139 case falls between the corp20 and corp80 cases. Investment in equipment depends very much on the cost of capital. In the S.139 case and corp80 case, the Federal Reserve raises the Federal funds rate throughout most of 2010-2025 to balance the unemployment and inflation impacts (Figure 7.24). This affects all interest rates, and hence the cost of financial capital to businesses, and has a dampening effect on investment.

Impacts on Gross Output. Figure 7.25 compares the average loss in gross output for different allocation schemes for the period 2010-2025. The loss in total output reflects the pattern of loss in actual GDP. The S.139 case shows a smaller impact than the corp20 and corp80 cases because of a faster recovery in consumer spending relative to the corp20 case and a lesser impact on investment relative to the corp80 case.

Manufacturing output can be classified into three broad end-use categories: consumer goods, capital goods, and intermediate goods. Production of consumer goods is affected the least in the corp80 case, in which most permit revenue is distributed to consumers. In the S.139 case, it is expected to improve much faster over time because of improving consumer confidence. On the other hand, production of capital goods in the corp80 case has the worst impact because of the weaker investment response, compared with the S.139 case and corp20 case, which have similar impacts. Production of intermediate goods has mixed impacts, depending on the nature of the final goods produced. In the short run, the impact is least in the corp80 case because of the smaller consumption impact. In the longer run, the S.139 case has a faster recovery. The corp20 case is expected to have the worst average impact.

When analyzed by the four categories of output (Figure 7.25), energy-intensive manufacturing output is mostly intermediate goods and therefore has the worst impact in the corp20 case. Non-energy-intensive manufacturing is a mix of capital goods, intermediate goods, and consumer goods. In value terms, this category is dominated by machinery and equipment, which is worse off in the corp80 case. Nonmanufacturing industries have the worst impacts over all other categories. The impacts in the S.139 case are slightly better than in the other two cases because of a faster recovery in the construction sector. The service sector serves both consumers and businesses. Consumer services are worse off in the corp20 case, while business services suffer more in the corp80 case. Since the former is more dominant, the corp20 case shows the worst impact on services.

Impact on Employment. The relative impacts on employment do not necessarily follow the relative impacts on output because of changes in other factors like productivity, capacity utilization and relative costs. As shown in Figure 7.26, the impact on employment is less in the corp80 case and more in the corp20 case. Compared with the other allocation schemes, corp80 has less negative impact on consumption but more negative impact on investment. In the long run, this tradeoff is reflected in the potential GDP. The corp80 case has a slower substitution of capital and technology for labor, resulting in a smaller impact on employment. The opposite is true for the corp20 case.

Given the different profiles of impacts in the three cases investigated so far—S.139, corp20, and corp80—which one is judged to have the least impact? Figure 7.27 shows two measures of impact covering the entire period from 2004 through 2025. The first shows the undiscounted sum of the impacts on actual GDP and the second calculates a discounted sum of the same stream of actual GDP impacts using a discount rate of 7 percent. Under S.139 the undiscounted sum of the actual GDP loss is $1,354 billion, and the discounted loss is $507 billion (or $1,626 per capita in 1996 prices). Both corp20 and corp80 have undiscounted and discounted actual GDP losses that are higher than in the S.139 case. Also, the corp80 case has slightly smaller aggregate impact than the corp20 case. Given the discussion of these respective cases earlier in this chapter, this result is expected.

B. Economic Impacts of a No Banking Case

In the scenarios discussed up to this point, banking of allowances was permitted in the post-2010 period. The no banking case removes the banking provisions while still maintaining the greenhouse gas targets of S.139. The difference between the no banking case and the S.139 case (with banking) indicates the effectiveness of banking in smoothing the transition effects on the energy system and the aggregate economy. Figure 7.28 shows the computed tradable allowance revenue in nominal terms under the no banking case. The period from 2010 to 2015 shows the small amount of allowance revenues under this case, but they expand dramatically in 2016. (Figure 7.1 shows the smooth profile in the S.139 case.) In the S.139 case, nominal tradable allowance revenue rises steadily from just over $100 billion in 2010 to approximately $200 billion in 2015, and then to just under $500 billion by 2025. However, in the no banking case, nominal allowance revenue remains well under $110 billion from 2010 through 2015, and then jumps dramatically to $451 billion in 2016. After the initial surge, the price of the tradable allowance eases a little but begins to rise again in 2019 when energy demand continues to increase. The allowance revenue varies between $330 billion and $440 billion for the remainder of the forecast period.

Under these conditions, the profile of the distribution of funds to transition assistance, energy-efficient rebates, plus the lump-sum transfer to consumers takes on a very different look. Instead of starting small and rising smoothly over the period, the distribution of funds remains small through 2015, then increases dramatically in 2016 to $200 billion. This sharp difference in the profile of energy prices and the subsequent collection and redistribution of funds is reflected most directly in comparing the impacts on the consumer price index, disposable income, and actual GDP relative to the impacts in the S.139 case (Figure 7.29). Through 2015, disposable income and actual GDP both decline by much less than in the S.139 case. In 2015, the loss in disposable income in the no banking case is 0.2 percent, while in the S.139 case the impact is larger, at 0.7 percent. The impact on actual GDP in the no banking case shows a similar profile, and by 2015 it is almost at reference case levels. However, in 2016 energy prices rise sharply in response to the rise in the allowance price. Actual GDP and disposable income both decline sharply. Both measures reach a peak loss in 2017, with actual GDP 1.9 percent below the reference case level and disposable income 1.8 percent below. Thereafter, both recover sharply. The recovery in both is due to a sharp falloff in energy prices as the allowance price declines, plus the large increases in funds distributed back to consumers and in transition assistance in the post-2015 period.

Again, given the very different impact profiles in the two cases—S.139 and no banking—which one is judged to have the least impact? Clearly, the peak impact is smaller in the S.139 case with banking, but the S.139 case shows a larger impact in the 2010-2015 period. The no banking case has smaller impacts early, but has much larger impacts in subsequent years. Figure 7.30 shows two summary measures of impact covering the entire period from 2004 through 2025. The first shows the undiscounted sum of the impacts on actual GDP and the second calculates a discounted sum of the same stream of actual GDP impacts using a discount rate of 7 percent. Under S.139 the undiscounted sum of the actual GDP loss is $1,354 billion and the discounted loss is $507 billion ($1,626 per capita in 1996 prices). In the no banking case, the undiscounted sum of the actual GDP loss is $1,752 billion, or $398 billion greater than in the S.139 case. The discounted loss in the no banking case is $609 billion ($1,955 per capita in 1996 prices), or $102 billion higher than in the S.139 case. Using these summary measures, plus the time profile of the impacts, the banking provisions of S.139 lessen the aggregate impact on the economy and result in a significantly smoother trajectory of impacts through 2025.

C. Economic Impacts of 50% Offset Case

S.139 specifically allows a covered entity to satisfy 15 percent of its total allowance requirement in 2010-2015 by purchasing allowances from non-covered entities, through sequestration, or from the international allowance market. After 2015, the “offset allowance” is reduced to 10 percent. This section discusses the macroeconomic impacts of the sensitivity case that allows a maximum of 50 percent of the allowance to be offset for the years 2010 through 2025. In this case, the offset clearing price equates to the emissions price, resulting in a lower allowance price and lower revenue from allowance trading.

Figure 7.31 shows the computed tradable allowance revenue under the offset50 case. In the period 2010 to 2015, total tradable allowance revenue in nominal terms in the offset50 case is about 23 percent lower than in the S.139 case. However, in the second phase of implementation, when the more stringent emissions requirement results in more offset purchases, nominal tradable allowance revenue grows more slowly than in the S.139 case, reaching $382 billion in 2025. As a result, the distribution of funds to transition assistance, energy-efficient rebates, and the lump-sum transfer to consumers is lower than in the S.139 case.

With a lower emissions price trajectory, the price effect of the offset50 case to the economy is smaller. The first chart in Figure 7.32 compares the changes in consumer price index under the two scenarios. The price impact of the offset50 case is about the same as that of the S.139 case in 2010, and is gradually reduced to half by 2025. This implies that the negative impacts on output and employment are less than in the S.139 case. Figure 7.32 also compares the impacts on actual GDP under the two scenarios. Because the effects on energy prices and demand are smaller in the offset50 case, the impact on economy is expected to be smaller.

As the demand for offset allowance increases significantly in the offset50 case, the purchase of international permits is projected to increase. Figure 7.33 compares the demand for international offsets in the S.139 and offset50 cases. Unlike the S.139 case, demand for international offsets in the offset50 case continues to grow after 2015, reaching $26 billion (in 1996 dollars) by 2025.

Figure 7.34 provides the undiscounted and discounted (using a 7 percent discount rate) sum of the impacts on actual GDP over the period 2004 through 2025. Under the offset50 case, the undiscounted sum of the actual GDP loss is $1,049 billion, or $305 billion lower than in the S.139 case. The discounted loss for the offset50 case is $399 billion ($1,279 per capita in 1996 dollars), or $108 billion lower than in the S.139 case.

D. Economic Impacts of High Technology Case

The cost and performance of emerging technologies useful in reducing energy use or its greenhouse gas intensity are among the most important factors affecting the evaluation of S.139 impacts. Using the assumptions of the AEO2003 high technology case for the four end-use sectors and the electric power sector, a high technology reference case and a high technology variation of the S.139 case were prepared. Assumptions in the high technology cases vary by sector but generally include earlier availability, lower costs, and higher efficiencies for advanced technologies than in the reference case.

Table 7.1 provides key results that can be used to show how assumptions about the state of energy-related technology affect the impacts of S.139. Energy-related carbon dioxide emissions in the high technology reference case are 8 percent lower in 2025 than in the standard reference case. The smaller reduction in carbon dioxide emissions needed to comply with S.139 reduces the estimated allowance price in the S.139 high technology case in 2025 by 28 percent relative to its level in the S.139 case. Three sets of comparisons can be used to gauge the economic effects of S.139 under high technology assumptions: (1) the S.139 case relative to the reference case, (2) the S.139 high technology case relative to the high technology reference case, and (3) the S.139 high technology case relative to the reference case.

The change in economic performance between the high technology reference case and the S.139 high technology case (row 2 in Table 7.1), implicitly assumes that the enactment of S.139 does not affect the set of available technologies, only what and how much is chosen from that set. Using this comparison, S.139 reduces accumulated actual GDP over the modeled 2004-2025 time frame by $1.035 trillion (0.33 percent). By 2025, when the transition to the S.139 regime is largely complete, the overall size of the economy is reduced by $95 billion (0.50 percent). In contrast, between the S.139 case and the reference case (row 1), the change in cumulative economic impact is $1.354 trillion (0.43 percent). Thus, a high technology economy would lower the economic cost of achieving S.139 by $319 billion and would cut the percentage loss to the economy to 0.1 percent over the 2004-2025 horizon.

Alternatively, economic performance in the S.139 high technology case and the standard reference case can be compared (row 3 in Table 7.1). This comparison implicitly assumes that S.139 is directly responsible for creating technologies with the cost and performance characteristics of EIA’s high technology case, which would not be available in its absence. Using this approach, S.139 reduces accumulated actual GDP over the modeled 2004-2025 time frame by $971 billion (0.31 percent). By 2025, when the transition to the S.139 regime is largely complete, the overall size of the economy is reduced by $94 billion (0.50 percent).

Analytical judgment and a recognition of inherent modeling limitations are needed to assess which approach is most likely to reflect the actual impact of “high technology” on the economic assessment of S.139. The major effect that S.139 has on delivered energy prices suggests that it should provide some incentive to research and develop new technologies to increase energy efficiency or reduce greenhouse gas intensity. If so, the first approach (comparison of two high technology cases) could overstate adverse economic impacts.

On the other hand, the third approach (comparison of the S.139 high technology case to the standard reference case) does not consider the cost of researching and developing new technologies. Moreover, NEMS does not explicitly represent the role of non-energy-related research and development (R&D) activities in supporting the baseline scenario of economic growth in its macroeconomic component. Therefore, NEMS cannot represent the macroeconomic impact of diverting R&D effort away from other sectors toward energy-related technologies. Such shifts in R&D effort would erode baseline growth to the extent that scarce R&D resources and technological progress in other areas of the economy were reduced.¹⁹⁵

The analysis of these effects continues to be an active area of academic research. Based on its reading of the available literature, EIA’s view is that the first approach is most likely to provide estimates of economic impacts that are closest to the actual economic effects under a high technology scenario. A separate issue related to technology is the possibility that one or more technologies superior to those identified in the “high technology” case could become available within the time frame of this analysis. While the high technology case assumptions are optimistic by design, there is always a potential for undiscovered or unanticipated technological developments to occur. The contribution of such technologies within the time frame of this analysis is likely to be limited by delays that often arise in the market penetration of new energy technologies, particularly when the new technologies are not readily compatible with the existing infrastructure.

Summary Tables of Economic Impacts

Tables 7.2, 7.3, 7.4, and 7.5 provide a summary view of the economic impacts associated with the cases presented in this chapter. The economic impacts are presented using a number of different metrics: growth rates, percentage change from the reference case, undiscounted and discounted sum of the change in GDP and disposable income, plus per capita GDP and disposable income changes. These are meant to summarize the rather complex nonlinear relationship between the energy market effects of these policies and the interaction with the overall economy. The tables highlight the key findings of this chapter:

• There is little or no significant impact on the growth rate of the economy for the long-run horizon of 2001-2025. Between 2001 and 2025, the growth rates for actual GDP and potential GDP are virtually identical. The consumer price index is slightly elevated, and the growth rate for disposable income declines in only one case (corp80).
• Although the growth rate effects are small, the percent change from the reference case in any given year can be larger. Most of the largest impacts occur near 2012 as the economy is adjusting to the more stringent provisions of the bill. Actual GDP declines between 0.3 and 0.8 percent relative to the reference case in 2012. However, by 2025, the picture has changed. In some of the cases, notably the S.139 case, the economy is recovering and returning toward the reference case. Here, it is helpful to keep the time profile in mind (see Figure 7.20).
• Actual GDP and potential GDP tend to converge over time. Actual GDP measures the transition costs associated with the bill, while potential GDP shows the long-run path of the economy. The two begin to merge as the transition costs diminish.
• While the undiscounted sum of the GDP loss ranges between $1.0 and $1.8 trillion (1996 dollars) and the discounted sum of the GDP loss ranges between $0.4 and $0.6 trillion, these losses represent between 0.3 and 0.6 percent of the total stream of GDP over the 2004-2025 period.
• The relative impacts between the S.139 cases and the corp20 and corp80 cases are caused by the alternative methods of passing funds first to the Corporation and then to the consumer. The S.139 case looks much like the corp20 case early on in the forecast period because the S.139 starts with the same share of revenues going to the Corporation (20 percent). However, as this share shifts toward a maximum of 80 percent in 2025, the S.139 case recovers more rapidly as the amount of funds returned to consumers increases, increasing disposable income and consumption expenditures.
• The loss in disposable income per capita (discounted) ranges from $100 (corp80) to $2,168 corp20), with the S.139 case showing a loss of $1,037. Actual GDP measures the transition costs associated with the bill, while potential GDP shows the long-run path of the economy. The two begin to merge as the transition costs diminish.
• The S.139 case, with its banking provisions, smoothes the impact on the economy and yields a smaller aggregate loss relative to a case with no banking. Without the banking provisions, there is a sharp difference in the profile of energy prices and the subsequent collection and redistribution of funds, with the impact on the economy much more uneven over time.
• If the allowable offset allowance limit is raised, the clearing price for allowances falls and the impact on the economy is reduced. The undiscounted sum of the actual GDP loss is $305 billion lower in the offset50 case than in the S.139 case.
• The major effect of S.139 on delivered energy prices suggests that it should provide some incentive to research and develop new technologies to increase energy efficiency or reduce greenhouse gas intensity. If achieved, a high technology energy economy would lower the cost of achieving S.139.

Uncertainties Associated with Projected Economic Impacts

As is inherent in any medium- to long-term forecast, the projected economic impacts of the S.139 and alternative cases are subject to considerable uncertainty. As will become obvious as the discussion proceeds, providing a quantitative estimate of the level of uncertainty is extremely difficult and would be arbitrary. The standard way in which uncertainty is quantified is by providing summary measures of how well the macroeconomic framework, which is used for the projections, tracks historical data. Based on these summary measures, a prediction error is computed, which gives an indication of the error to expect in predictions. While the Global Insight suite of models tracks historical data closely, there are four additional sources of uncertainty associated with the economic projections discussed in this chapter.

Statistical Uncertainty. This type of uncertainty arises because of the behavioral nature of the models used. For the reference and alternative cases, the economic projections are based on Global Insight’s suite of econometric models. These models are a representation of the U.S. economy, as it has evolved historically, with detailed output, employment, price, and financial sectors. These models, taken together, explain the relationships among more than 1,500 macroeconomic concepts. The behavioral relationships in these models have been estimated statistically employing historical time series data. As is well known in statistics theory, while the parameter estimates of these relationships are unbiased they are subject to statistical error because they are drawn from a sample. In other words, while the parameter estimates provide the best linear unbiased point estimates of the causal effects of explanatory variables, the true effects could be larger or smaller than the ones estimated. Since the macroeconomic cost measures (actual GDP, potential GDP, real disposable income, inflation, unemployment, etc.) are composites of other macroeconomic behavioral variables, the statistical errors associated with these aggregates are also a composite of statistical errors of those behavioral variables. Therefore, the composite statistical errors are hard to quantify and can conceivably build up, resulting in large errors in the projections of composite variables (GDP, etc.). While the statistical errors can be minimized, as has been done in Global Insight’s models, they cannot be eliminated. Moreover, because these parameter estimates are invariant across the different cases, this type of uncertainty is not expected to change across them.

Uncertainty of Future Economic Relationships. In contrast to the first type of uncertainty, a more significant source of uncertainty is associated with macroeconomic relationships that have been estimated statistically based on past information but may change in the future because of, or in spite of, the different cases. The U.S. economy is dynamic and continues to evolve over time in response to changes in demographics, tastes and preferences, technologies, economic institutions, and world developments. Assuming that the macroeconomic relationships of the past will continue to hold in the future is more problematic, and the level of uncertainty in projections increases for longer the projection periods.

Uncertainty in the Future Evolution of Exogenous Variables. Another source of uncertainty arises because of the assumed evolution of variables not explained within the Global Insight models. Major variables include expected U.S. population growth, foreign economic growth, exchange rates, foreign interest rates, and foreign prices. While it is assumed that the projected values for these variables are the same across all cases, they may not be the same. For example, it is conceivable that exchange rates may change, with implications for U.S. exports and imports, as the Federal Reserve changes the Federal funds rate.

Special Topics

7. Assessment of Economic Impacts - Tables

Notes