1. C hapter 24 Economic Growth, Business Cycles, and Countercyclical Fiscal Policy © 2002 South-Western

2. 2 Economic Principles Capital-labor and capital- output ratios Technology and labor productivity Labor productivity and economic growth

3. 3 Economic Principles Saving, investment, and economic growth External and internal theories of the business cycle The interaction of the multiplier and accelerator

4. 4 Economic Principles Countercyclical fiscal policy

5. 5 Long-Run Economic Growth Economic growth An increase in real GDP, typically expressed as an annual rate of real GDP growth.

6. 6 Long-Run Economic Growth 1. In The Wealth of Nations, Adam Smith identified four principal factors that contribute to a nation’s economic growth. What are they?

7. 7 Long-Run Economic Growth 1. Principal factors that contribute to a nation’s economic growth: a. The size of its labor force.

8. 8 Long-Run Economic Growth 1. Principal factors that contribute to a nation’s economic growth: a. The size of its labor force. b. The degree of labor specialization.

9. 9 Long-Run Economic Growth 1. Principal factors that contribute to a nation’s economic growth: a. The size of its labor force. b. The degree of labor specialization. c. The size of its capital stock.

10. 10 Long-Run Economic Growth 1. Principal factors that contribute to a nation’s economic growth: a. The size of its labor force. b. The degree of labor specialization. c. The size of its capital stock. d. The level of its technology.

11. 11 EXHIBIT 1U.S. ECONOMIC PERFORMANCE: 1900–2000

12. 12 Exhibit 1: U.S. Economic Performance: 1900-90 In what time period between 1900 and 2000 was there the greatest rate of economic growth in the U.S.? During the first half of the 1940’s when the U.S. was fighting World War II.

13. 13 Long-Run Economic Growth Capital-labor ratio The ratio of capital to labor, reflecting the quantity of capital used by each laborer in production.

14. 14 EXHIBIT 2LONG-RUN ECONOMIC GROWTH

15. 15 Long-Run Economic Growth 2. If capital is $50,000 and labor is 200, what is the capital-labor ratio? The capital-labor ratio is ($50,000/200) = $250.

16. 16 Long-Run Economic Growth Labor productivity The quantity of GDP produced per worker, typically measured in quantity of GDP per hour of labor.

17. 17 Long-Run Economic Growth 3. If real GDP increases from $10,000 to $12,000, and labor rises from 100 to 105, what has happened to labor productivity? Output per laborer rises from ($10,000)/100 = $100 to ($12,000)/105 = $114.29.

18. 18 Long-Run Economic Growth Capital deepening A rise in the ratio of capital to labor.

19. 19 Long-Run Economic Growth 4. Which of the following represents capital deepening? a. Increased worker experience. b. Increased worker training. c. Increased capital-labor ratio.

20. 20 Long-Run Economic Growth 4. Which of the following represents capital deepening? c. Increased capital-labor ratio.

21. 21 EXHIBIT 3THE LABOR PRODUCTIVITY CURVE

22. 22 Exhibit 3: The Labor Productivity Curve How does capital deepening affect labor productivity? The more capital per laborer, the greater the laborer’s productivity. Moreover, new technology can shift upwards the labor productivity curve.

23. 23 Long-Run Economic Growth Capital-output ratio The ratio of capital stock to GDP.

24. 24 Long-Run Economic Growth According to Adam Smith and many economists today, savings automatically convert to investment spending, so that investment-induced growth is dependent on savings.

25. 25 Long-Run Economic Growth Changes in technology can increase labor productivity and GDP without there being any change in the value of the capital stock.

26. 26 EXHIBIT 4THE GROWTH PROCESS

27. 27 Exhibit 4: The Growth Process 1. According to Exhibit 4, what will happen to consumption and investment next year as a consequence of investment this year? Investment this year increases next year’s capital stock, which in turn generates an increase in next year’s consumption and investment spending.

28. 28 Exhibit 4: The Growth Process 2. What will happen to potential future economic growth if more of GDP is consumed and less is invested? Less investment today means less economic growth in the future.

29. 29 EXHIBIT 5GROSS NATIONAL SAVING IN THE UNITED STATES: 1960–99 Source: Council of Economic Advisers, Economic Report of the President (Washington, D.C.: U.S. Government Printing Office, 2000), p. 73.

30. 30 Exhibit 5: Gross National Savings in the United States: 1960-99 According to Exhibit 5, what is the relationship between personal savings and government savings? It appears that they may be inversely proportional.

31. 31 EXHIBIT 6SOURCES OF US. GROWTH: 1947–2000 Source: Council of Economic Advisers, Economic Report of the President (Washington, D.C.: U.S. Government Printing Office, 1994), p. 44, and author’s estimates.

32. 32 Exhibit 6: Sources of U.S. Growth: 1947-2000 1. According to Exhibit 6, which of the following made the largest contribution to economic growth from 1947 to 1973: a. Labor inputs. b. Capital inputs. c. Technological change.

33. 33 Exhibit 6: Sources of U.S. Growth: 1947-2000 1. According to Exhibit 6, which of the following made the largest contribution to economic growth from 1947 to 1973: c. Technological change.

34. 34 Exhibit 5: Sources of U.S. Growth: 1947-2000 2. According to Exhibit 6, which of the following made the largest contribution to economic growth from 1973 to 1992: a. Labor inputs. b. Capital inputs. c. Technological change.

35. 35 Exhibit 6: Sources of U.S. Growth: 1947-92 2. According to Exhibit 6, which of the following made the largest contribution to economic growth from 1973 to 1992: b. Capital inputs.

36. 36 Exhibit 6: Sources of U.S. Growth: 1947-2000 3. According to Exhibit 6, what happened to the role of technological change as a source of U.S. economic growth across the two time periods? While technological change was the most important source of economic growth from 1947 to 1973, it was one of the smallest and least important sources of economic growth between 1973 and 1992.

37. 37 The Business Cycle The business cycle represents year to year deviations from the dominant, long-run path of U.S. economic growth. These deviations seem to map out a picture of recurring cycles.

38. 38 EXHIBIT 7THE U.S. BUSINESS CYCLE RECORD: 1860–1990 Source: Ameritrust Company, Cleveland, Ohio.

39. 39 Exhibit 7: The U.S. Business Cycle Record: 1860-1990 1. According to Exhibit 7, were recessions more frequent before World War II or after World War II? Recessions were more frequent before World War II.

40. 40 Exhibit 7: The U.S. Business Cycle Record: 1860-1990 2. In which of the following decades was there the greatest period of rapid and prolonged economic growth in Exhibit 6? a. 1870 – 1880. b. 1930 – 1940. c. 1960 – 1970.

41. 41 Exhibit 7: The U.S. Business Cycle Record: 1860-1990 2. In which of the following decades was there the greatest period of rapid and prolonged economic growth in Exhibit 6? c. 1960 – 1970.

42. 42 Traditional Theories of the Business Cycle 1. What factors contribute to externally-induced cycles? Wars, changes in climate, population booms, clustering of innovations, changes in consumer confidence, changes in government spending, or changes in international exchange rates.

43. 43 Traditional Theories of the Business Cycle 2. What is the sunspot theory of the business cycle? According to William Stanley Jevons, years of good harvest, low food prices, and higher real income and employment, are inversely related to the number of sunspots.

44. 44 Traditional Theories of the Business Cycle 2. What is the sunspot theory of the business cycle? The sunspot theory mostly applies to agricultural economies, and is less relevant to modern industrialized countries.

45. 45 Traditional Theories of the Business Cycle 3. What is the war-induced theory of the business cycle? Wars require massive increases in government spending, which tends to increase economic growth. Marxists and others have argued that wars are sometimes engineered to get us out of economic crises.

46. 46 Traditional Theories of the Business Cycle 3. What is the war-induced theory of the business cycle? The decline in spending at the end of wars can contribute to economic downturns.

47. 47 You Got the Dates? We Got The Growth Rates According to the chart on page 541 of the textbook, what was the average annual rate of economic growth between 1970 and 1996? Reading down from 1970 and across from 1996 we find that the average rate of economic growth was 2.8 percent.

48. 48 Traditional Theories of the Business Cycle 4. What is the housing theory of the business cycle? Disasters or low interest rates spur large investments in new housing, which in turn promotes increased economic growth. As housing investment slows, so too does economic growth.

49. 49 Traditional Theories of the Business Cycle 5. What is the innovation theory of the business cycle? Pioneering innovations promote a host of supporting innovations in clusters, and thus produce their own variety of business cycle. Steam engines, railroads, electricity, cars, and computers offer some examples.

50. 50 Traditional Theories of the Business Cycle 5. What is the innovation theory of the business cycle? Yet even pioneering innovations eventually exhaust their potential, creating the potential for reduced investment, demand, and employment.

51. 51 Traditional Theories of the Business Cycle Many economists believe that business cycles do not just develop from external factors. According to this view, the economy’s continuous motion is inherently cyclical due to internal factors.

52. 52 Traditional Theories of the Business Cycle 6. What factors contribute to internally induced business cycles? Changes in investment spending and changes in national income are mutually reinforcing due to the role of expectations.

53. 53 Traditional Theories of the Business Cycle Accelerator The relationship between the level of investment and the change in the level of national income.

54. 54 Traditional Theories of the Business Cycle 7. How does the accelerator contribute to the business cycle? An initial injection of new investment spending into the economy triggers the income multiplier into action, and as a result people’s income and consumption spending grow.

55. 55 Traditional Theories of the Business Cycle 7. How does the accelerator contribute to the business cycle? Buoyed by this growth in sales, firms expect growth to continue and increase investment spending accordingly. This creates the upward phase of the business cycle.

56. 56 Traditional Theories of the Business Cycle 7. How does the accelerator contribute to the business cycle? Having acquired additional capital stock through investment, firms must experience even higher sales. But if consumers simply maintain their level of consumption, inventories build up and investment declines, initiating the downward phase of the cycle.

57. 57 Real Business Cycle Theory Economists who subscribe to real business cycle theory challenge the idea that internal or external cycles exist.

58. 58 Real Business Cycle Theory They argue that the economy is dynamic and operates near full employment. The principal factor shaping the unevenness (not cycles) in the economy’s growth path is the random occurrence of many small productivity- enhancing innovations.

59. 59 Real Business Cycle Theory How is real business cycle theory different from the innovation cycle theory developed by Schumpeter? The Schumpeterian innovation cycle is based on the notion that innovations are clustered and connected, leading to cycles.

60. 60 Real Business Cycle Theory How is real business cycle theory different from the innovation cycle theory developed by Schumpeter? In contrast, real business cycle theory assumes many small random innovations that lead to an uneven path of economic growth but no cycles.

61. 61 Countercyclical Fiscal Policy Countercyclical fiscal policy Fiscal policy designed to moderate the severity of the business cycle.

62. 62 Countercyclical Fiscal Policy 1. Which of the following is an example of countercyclical fiscal policy? a. More gov’t. spending when the economy is growing rapidly. b. Higher taxes when the economy is growing rapidly.

63. 63 Countercyclical Fiscal Policy 1. Which of the following is an example of countercyclical fiscal policy? b. Higher taxes when the economy is growing rapidly.

64. 64 Countercyclical Fiscal Policy 2. Why is timing such a difficult problem with effective countercyclical fiscal policy? Long lags between the identification of the economic problem and the execution of the policy can unintentionally lead to procyclical rather than countercyclical policy.

65. 65 Countercyclical Fiscal Policy 2. Why is timing such a difficult problem with effective countercyclical fiscal policy? Thus countercyclical fiscal policy must be based on forecasts of future economic conditions, and these forecasts can be wrong.

66. 66 Countercyclical Fiscal Policy Administrative lag The time interval between deciding on an appropriate policy and the execution of that policy.

67. 67 EXHIBIT 8DESIGNING COUNTERCYCLICAL POLICY

68. 68 Exhibit 8: Designing Countercyclical Policy If the economy follows path ac instead of path ab, but countercyclical fiscal policy is designed for path ab, what is might occur? The dynamics of the accelerator- multiplier interaction will drive the economy into inflation.

69. 69 Countercyclical Fiscal Policy There are many economic theories of cycles and growth, some making good sense, some less so, but all of them struggling to understand the real world.