Late 1990s and Productivity Review The long run aggregate supply curve (LRAS) curve is a placeholder for potential GDP (GDPP). The aggregate supply curve (AS) curve upward sloping Potential GDP (GDPP) is what GDP equals whenever the actual inflation rate () turns out to equal the expected inflation rate (E).  (%) LRAS AS  The aggregate supply (AS) curve intersects the long run aggregate supply (LRAS) curve at the expected inflation rate (E). E Adaptive expectations: The expected inflation rate (E) depends on the actual inflation rate in the recent past. GDPP G&S Late 1990s   Unemp Real Actual Infl Govt Year Rate (%) GDP Purch 1995 5.6 10,165 2.1 2,260 1996 5.4 10,550 1.8 2,280 1997 4.9 11,025 1.7 2,320 1998 4.5 11,515 1.1 2,370 Average growth rate in the eight decades = 3.3% 3.8% 4.5% 4.4%

Adaptive Expectations Clinton Years Adaptive Expectations LRAS curve is vertical and a placeholder for potential GDP (GDPP). Unemp Real Actual Infl Expected Infl Govt Year Rate (%) GDP Rate (%) Rate (%) Pur 1994 2.1 Potential GDP: GDP whenever actual inflation () equals expected inflation (E). 1995 5.6 10,165 2.1 2,260 2.1 1996 5.4 10,550 1.8 2.1 2,280 What had to happen to the AS curve in 1996? What had to happen to the LRAS curve in 1996? What had to happen to potential GDP in 1996? The AS curve intersects the LRAS curve at the expected inflation rate (E). Shift right. Shift right. Increase.  (%) AS1995 AS1995,1996 First consider 1995 LRAS1995 LRAS1996 AS1996 In 1995, E = 2.1 In 1995,  = 2.1 2.25 In 1995, GDPP = 10,165 E in 1996 = 2.1% Now, consider 1996 2.00 1995 1996 In 1996, E = 2.1 Based on E should the AS curve shift? 1.75 No AD1995 AD1996 1.50 What happened to the AD curve in 1996? Shift right. 10,000 10,250 10,500 10,750 G&S

Question: How could potential GDP increase? Answer: Increase in population. Increase in worker productivity. In 1870, 70-80 percent of all Americans were employed in agriculture. Real GDP Year Population (billions of 2009 $) 1948 144,600,000 2,020 1989 246,000,000 8,475 Today the figure is 2-3 percent. American farmers are far more productive to than in the nineteenth century. Growth rate = 70% Growth rate = 325% Question: Productivity growth fell from an average of 2.75% in the 1950’s to 1.38% in the 1980’s. What difference does it make? 2.75% annual 1.38% annual growth rate growth rate First year $50,000 $50,000 Question: Why the decline? $194,000 $99,000 Fifty years later

Determinants of Productivity Growth Diminishing Marginal Productivity: As capital per worker increases, each additional unit of new capital leads to smaller increases in productivity. Natural Resources Physical Capital Claim: The productivity curve is upward sloping at a diminishing rate Therefore, larger increments of new capital are required to achieve the same amount of productivity growth when capital per worker is initially high than when it is initially low. Productivity Curve Output per Worker Question: What do we call new capital? Answer: Investment Capital per Worker Human Capital Question: Is there no “smoking gun” to explain the decline in productivity growth? Labor Reallocation Technology

U. S Productivity Growth: The Outlook for the 1990’s Question: Based on the trend, what is the outlook for the 1990’s? Question: What does this suggest about the standard of living in the U.S.? Let us see what actually happened.