Lecture 1: Macroeconomics Third Year Overview of course – Intermediate level macroeconomic theory course – Basic text is “Macroeconomics – 5 th edition” by Olivier Blanchard – Course outline at – Lecture 1-7 Kenneth Creamer (Thursday 8:00 FNB33) – Lecture 8-14 Chris Malikane Creamer (Thursday 8:00 FNB33) – Evaluation: Tests 18 August and 29 September, plus Exam

Introduction of important concepts in M a c r o e c o n o m i c s Growth Theory – understanding the drivers of long-run economic growth The role of expectations in macroeconomic theory Open economy analysis – including analysis of various exchange rate regimes The conduct of Monetary and Fiscal Policy

Growth Theory – The facts of growth 1.Distinguishing the short-run and the long-run 2.Measuring the standard of living 3.Growth across time and space 4.A formal framework for understanding growth

1.Short run vs. Long-run Important to distinguish the determination of output in the short and medium run—where fluctuations dominate—from the determination of output in the long run—where growth dominates. Cycle vs. trend Traditional demand management through fiscal and monetary policy is concerned with counter- cyclical short- to medium- run stabilisation Growth theory is about growth trends (and the determinants of growth) in the longer run Growth is the steady increase in aggregate output over time.

2. Measuring the Standard of Living Growth is linked to the standard of living. Furthermore, comparisons over time or across countries is output per person (GDP per capita) rather than output itself. The straightforward method of taking a country’s GDP expressed in that country’s currency, and then using the current exchange rate to express it in terms of dollars does not always work for two reasons: – Firstly, the exchange rates varies (as the Rand strengthens from R10/$ to R7/$ it is not correct to simply state that South Africa’s standard of living (reflected in a GDP of R2-trillion) has increased from U2$200-bn to around US$285-bn in a short time period.. – Secondly, the prices of basic goods is much lower in poorer countries than in rich countries, in fact “the lower a country’s GDP per capita the lower the prices of food and basic services” and hence the standard of living is not quite as low as that implied by a direct comparison of the GDP per capita data (e.g. in 2006 USA US$ GDP p.c. vs. India US$790 GDP p.c. would be a 55x higher standard of living)

Measuring the Standard of Living What method do economists use to compare more accurately the standard of living across countries? Economists develop a common set of prices for all countries – known as purchasing power parity (PPP) adjusted GDP and GDP per capita. Example of the effect: For 2006, once a common set of prices is used for food and basic goods in India and the US, the US GDP p.c. is 12x larger than the GDP p.c. in India. This is because the amount of money that Indian’s spend on food and basic goods is re-priced at a common PPP level of US$3666 p.c. (instead of US$790) Process of construction of PPP adjusted GDP. International dollar prices are constructed and outlined in the “Penn World Tables.” (Penn stands for the University of Pennsylvania, where the project is taking place.) Led by three economists—Irving Kravis, Robert Summers, and Alan Heston, who have constructed PPP series not only for consumption (as per the US - India example) but, more generally, for GDP and its components, going back to 1950, for most countries in the world.

Growth and happiness (across countries) See Fig.1 – there is broadly a positive correlation across countries between GDP p.c. (at PPP prices) and % of people surveyed who are happy or very happy (late 1990’s survey), further specific conclusions: Countries with very low happiness – difficult political transitions Amongst rich countries (GDP p.c. > US$20 000) there is little relation between income and happiness Caveat: cross-cultural comparisons of happiness are inherently difficult

Fig.1 – positive correlation between GDP p.c. and happiness

Growth and happiness (within countries) Within the US between 1975 and 1996 GDP p.c. increased by over 60% BUT, there was basically no change in the distribution of happiness (Table 1) YET, rich people self report a higher level of happiness than poor people (Table 2)

Growth and happiness (within countries) Table 1 Distribution of Happiness in the United States Over Time (Percent) Very happy3231 Pretty happy5558 Not too happy1311 Table 2 Distribution of Happiness in the United States Across Income Groups (Percent) Income LevelTop QuarterBottom Quarter Very happy3716 Pretty happy5753 Not too happy631

3.Growth in Rich Countries since 1950  There has been a large increase in output per person (See table 10.1)  There has been evidence of convergence of output per person across countries – emerging economies grow faster and thus the gap in GDP p.c. has been closing between many rich and poor countries.  Real output per capita has increased by a factor of 3.2 since 1950 in the United States, by a factor of 4.4 in France, and by a factor of 11.2 in Japan.  These numbers show what is sometimes called the force of compounding  NOTE: A policy that leads to a 1% increase in growth rate every year for 40 years (e.g. 6% growth instead of 5% growth) leads to a standard of living that is 48% higher than it would have been ( – 1 = 48%) (China vs. Africa – divergence)

Table 10-1 The Evolution of Output per Person in Four Rich Countries since 1950 Annual Growth Rate Output per Person (%) Real Output per Person (2000 dollars) 1950– /1950 France 3.35,92026, Japan 4.62,18724, United Kingdom 2.78,09126, United States 2.611,23336, Average 3.56,87528,4223.9

Note on Logarithmic scale The characteristic of a logarithmic scale is that the same proportional increase in a variable is represented by the same distance on the vertical axis. (whereas linear scale shows units at a constant distance) This is useful in measuring growth to avoid the appearance of highly concave time series, e.g. where 3% growth from a base of R2-trn in the first year = R60-bn, but by year 100 is 2(1,03) 100 = R38,4-trn (see Figs A2.1 and A2.2)

Growth in Rich Countries since 1950 (cont.) Countries with lower levels of output per person in 1950 have typically grown faster (See Fig.10.2) The convergence of levels of output per capita across countries extends to the set of OECD countries.

17 of 26 The convergence of levels of output per capita across countries is not specific to the four countries we are looking at, it also extends to the set of OECD countries. Countries with lower levels of output per person in 1950 have typically grown faster. Growth Rate of GDP per Person since 1950 versus GDP per Person in 1950, OECD Countries Figure

Growth trends across many countries – evidence of convergence? There is no clear evidence of convergence across all countries from 1960 to the present (See Fig.10.3) OECD – there is clear evidence of convergence as countries with lower levels of output per person have typically grown faster Asia – countries have generally shown convergence as they have high growth rates for lower initial levels of output per person Africa – no evidence of convergence, that is, countries with initially low levels of output have not shown positive growth (in fact have often shown negative growth in GDP p.c.)

19 of 26 There is no clear relation between per person the growth rate of output since 1960 and the level of output per person in Growth Rate of GDP per Person since 1960 versus GDP per Person in 1960 (2000 dollars) for 70 Countries Figure

Growth over a longer period There is agreement among economic historians about the main economic evolutions over the last 2,000 years: – From the end of the Roman Empire to roughly the year 1500, there was essentially no growth of output per person in Europe. – From about 1500 to 1700, growth of output per person turned positive, about 0.1% per year. It increased to 0.2% per year from 1700 to – This period of stagnation of output per person is often called the Malthusian era. Europe was in a Malthusian trap, unable to increase its output per person. Malthus argued that any increase in output would lead to a decrease in mortality, leading to an increase in population until output per person was back at its initial level. – On the scale of human history, the growth of output per capita is a recent phenomenon – post Industrial Revolution.

Note on Growth Theory vs. Development Economics Growth theory takes many of the institutions of a country e.g. legal system, form of government, etc. as given Development economics seeks to ascertain what institutional reform would assist in creating an environment for sustained growth David Landes Wealth and Poverty of Nations using a close historical analysis of institutions to explain why some countries are rich and some countries are poor. (“Developmental State”)

4. A formal framework for understanding growth To think about the facts presented in the previous sections, we use the framework of analysis developed by Robert Solow, from MIT, in the late 1950s. Particularly: – What determines growth? – What is the role of capital accumulation? – What is the role of technological progress?

Aggregate production function The aggregate production function is a specification of the relation between aggregate output and the inputs in production. Y = F(K,N) Y = aggregate output. K = capital — the sum of all the machines, plants, and office buildings in the economy. N = labor — the number of workers in the economy. The function F, which tells us how much output is produced for given quantities of capital and labor, is the aggregate production function.

State of technology The aggregate production function depends on the state of technology. The higher the state of technology, the higher the output that can be achieved from a given K and a given N. The state of technology can be narrowly understood as a set of blue prints defining the range of products and the techniques available to produce them. A wider definition of the state of technology would include the way in which the economy is organised, the internal organisation of firms and the legal and political systems (or institutions) e.g. the legal protection of intellectual property to reward, protect and encourage invention and innovation.

Returns to Scale Constant returns to scale is a property of the economy in which, if the scale of operation is doubled—that is, if the quantities of capital and labor are doubled—then output will also double. 2Y=F(2K,2N), or xY=F(xK,xN)

Returns to Factors What happens where the quantity of one factor of production is increased and the other factors is held constant? Decreasing returns to capital – where increases in capital (given fixed labour) leads to smaller and smaller increases in output Decreasing returns to labour – where increases in labour (given fixed capital) leads to smaller and smaller increases in output

Output per worker and Capital per worker Constant returns to scale implies that we can rewrite the aggregate production function as (where x = 1/N): The amount of output per worker, Y/N depends on the amount of capital per worker, K/N. –As capital per worker increases, so does output per worker – known as a process of capital accumulation of capital deepening. See Fig.10.4

Output per worker and Capital per worker Increases in output per worker (Y/N) can come from increases in capital per worker (K/N), but at a decreasing rate In Fig 10.4 the increase in capital per worker AB = CD, but the increase in output per worker A’B’>C’D’. This is due to the fact of decreasing returns to capital where the quantity of labour is fixed

29 of 26 Increases in capital per worker lead to smaller and smaller increases in output per worker. Output and Capital per Worker Figure

Sources of Growth – Firstly, increases in output per worker (Y/N) (or output per person - if the ratio of workers to the population remains constant) can come from capital accumulation – i.e. increase in capital per worker (K/N) (move along the production function) Secondly, increases in output per worker (Y/N) can come from technological progress that shifts the production function and leads to more output per worker given capital per worker. – See Fig.10.5 where a n improvement in technology shifts the production function up from F(K/N,1) to F(K/N,1)’, leading to an increase in output per worker for a given level of capital per worker.

31 of 26 An improvement in technology shifts the production function up, leading to an increase in output per worker for a given level of capital per worker. The Effects of an Improvement in the State of Technology Figure

Conclusion These two factors play very different roles in the growth process: – Capital accumulation by itself cannot sustain growth due to the decreasing returns to capital. As a result larger and larger increases in capital per worker would be required and the economy would not be unwilling to save and invest sufficiently to sustain such capital accumulation. Savings play an important role in determining the level of output per person, but do not determine the growth rate or output. (Chapter 11) – Sustained growth requires sustained technological progress. The economy’s rate of growth of output per person is eventually determined by the economy’s rate of technological progress both narrowly defined (in terms of R&D, patents and Education and Training) and broadly defined (in terms of broader social and government institutions (Chapter 12 and 13)