1. M ACROECONOMICS C H A P T E R Economic Growth II: Technology, Empirics, and Policy 8

2. slide 1 CHAPTER 8 Economic Growth II Introduction In the Solow model of Chapter 7,  the production technology is held constant.  income per capita is constant in the steady state. Neither point is true in the real world:  1904-2004: U.S. real GDP per person grew by a factor of 7.6, or 2% per year.  examples of technological progress abound (see next slide).

3. slide 2 CHAPTER 8 Economic Growth II Technological progress in the Solow model  A new variable: E = labor efficiency  Assume: Technological progress is labor-augmenting: it increases labor efficiency at the exogenous rate g:

4. slide 3 CHAPTER 8 Economic Growth II Technological progress in the Solow model  We now write the production function as:  where L  E = the number of effective workers.  Increases in labor efficiency have the same effect on output as increases in the labor force.

5. slide 4 CHAPTER 8 Economic Growth II Technological progress in the Solow model  Notation: y = Y/LE = output per effective worker k = K/LE = capital per effective worker  Production function per effective worker: y = f(k)  Saving and investment per effective worker: s y = s f(k)

6. slide 5 CHAPTER 8 Economic Growth II Technological progress in the Solow model (  + n + g)k = break-even investment: the amount of investment necessary to keep k constant. Consists of:   k to replace depreciating capital  n k to provide capital for new workers  g k to provide capital for the new “effective” workers created by technological progress

7. slide 6 CHAPTER 8 Economic Growth II Technological progress in the Solow model Investment, break-even investment Capital per worker, k sf(k) ( +n +g ) k( +n +g ) k k*k*  k = s f(k)  (  +n +g)k

8. slide 7 CHAPTER 8 Economic Growth II Steady-state growth rates in the Solow model with tech. progress n + gY = y  E  LTotal output g(Y/ L) = y  EOutput per worker 0y = Y/(L  E ) Output per effective worker 0k = K/(L  E ) Capital per effective worker Steady-state growth rate SymbolVariable

9. slide 8 CHAPTER 8 Economic Growth II The Golden Rule To find the Golden Rule capital stock, express c * in terms of k * : c * = y *  i * = f (k * )  (  + n + g) k * c * is maximized when MPK =  + n + g or equivalently, MPK   = n + g In the Golden Rule steady state, the marginal product of capital net of depreciation equals the pop. growth rate plus the rate of tech progress.

10. slide 9 CHAPTER 8 Economic Growth II Growth empirics: Balanced growth  Solow model’s steady state exhibits balanced growth - many variables grow at the same rate.  Solow model predicts Y/L and K/L grow at the same rate (g), so K/Y should be constant.  This is true in the real world.  Solow model predicts real wage grows at same rate as Y/L, while real rental price is constant.  This is also true in the real world.

11. slide 10 CHAPTER 8 Economic Growth II Growth empirics: Convergence  Solow model predicts that, other things equal, “poor” countries (with lower Y/L and K/L) should grow faster than “rich” ones.  If true, then the income gap between rich & poor countries would shrink over time, causing living standards to “converge.”  In real world, many poor countries do NOT grow faster than rich ones. Does this mean the Solow model fails?

12. slide 11 CHAPTER 8 Economic Growth II Growth Empirics: Convergence  Solow model predicts that, other things equal, “poor” countries (with lower Y/L and K/L) should grow faster than “rich” ones.  No, because “other things” aren’t equal.  In samples of countries with similar savings & pop. growth rates, income gaps shrink about 2% per year.  In larger samples, after controlling for differences in saving, pop. growth, and human capital, incomes converge by about 2% per year.

13. slide 12 CHAPTER 8 Economic Growth II Growth empirics: Convergence  What the Solow model really predicts is conditional convergence - countries converge to their own steady states, which are determined by saving, population growth, and education.  This prediction comes true in the real world.

14. slide 13 CHAPTER 8 Economic Growth II Growth empirics: Factor accumulation vs. production efficiency  Differences in income per capita among countries can be due to differences in 1. capital – physical or human – per worker 2. the efficiency of production (the height of the production function)  Studies:  both factors are important.  the two factors are correlated: countries with higher physical or human capital per worker also tend to have higher production efficiency.

15. slide 14 CHAPTER 8 Economic Growth II Growth empirics: Factor accumulation vs. production efficiency  Possible explanations for the correlation between capital per worker and production efficiency:  Production efficiency encourages capital accumulation.  Capital accumulation has externalities that raise efficiency.  A third, unknown variable causes capital accumulation and efficiency to be higher in some countries than others.

16. slide 15 CHAPTER 8 Economic Growth II Policy issues: Evaluating the rate of saving To estimate (MPK   ), use three facts about the U.S. economy: 1. k = 2.5 y The capital stock is about 2.5 times one year’s GDP. 2.  k = 0.1 y About 10% of GDP is used to replace depreciating capital. 3. MPK  k = 0.3 y Capital income is about 30% of GDP.

17. slide 16 CHAPTER 8 Economic Growth II Policy issues: Evaluating the rate of saving 1. k = 2.5 y 2.  k = 0.1 y 3. MPK  k = 0.3 y To determine , divide 2 by 1:

18. slide 17 CHAPTER 8 Economic Growth II Policy issues: Evaluating the rate of saving To determine MPK, divide 3 by 1: Hence, MPK   = 0.12  0.04 = 0.08 1. k = 2.5 y 2.  k = 0.1 y 3. MPK  k = 0.3 y

19. slide 18 CHAPTER 8 Economic Growth II Policy issues: Evaluating the rate of saving  From the last slide: MPK   = 0.08  U.S. real GDP grows an average of 3% per year, so n + g = 0.03  Thus, MPK   = 0.08 > 0.03 = n + g  Conclusion: The U.S. is below the Golden Rule steady state: Increasing the U.S. saving rate would increase consumption per capita in the long run.

20. slide 19 CHAPTER 8 Economic Growth II Policy issues: How to increase the saving rate  Reduce the government budget deficit (or increase the budget surplus).  Increase incentives for private saving:  reduce capital gains tax, corporate income tax, estate tax as they discourage saving.  replace federal income tax with a consumption tax.  expand tax incentives for IRAs (individual retirement accounts) and other retirement savings accounts.

21. slide 20 CHAPTER 8 Economic Growth II Policy issues: Allocating the economy’s investment  In the Solow model, there’s one type of capital.  In the real world, there are many types, which we can divide into three categories:  private capital stock  public infrastructure  human capital: the knowledge and skills that workers acquire through education.  How should we allocate investment among these types?

22. slide 21 CHAPTER 8 Economic Growth II Policy issues: Allocating the economy’s investment Two viewpoints: 1.Equalize tax treatment of all types of capital in all industries, then let the market allocate investment to the type with the highest marginal product. 2.Industrial policy: Govt should actively encourage investment in capital of certain types or in certain industries, because they may have positive externalities that private investors don’t consider.

23. slide 22 CHAPTER 8 Economic Growth II Policy issues: Establishing the right institutions  Creating the right institutions is important for ensuring that resources are allocated to their best use. Examples:  Legal institutions, to protect property rights.  Capital markets, to help financial capital flow to the best investment projects.  A corruption-free government, to promote competition, enforce contracts, etc.

24. slide 23 CHAPTER 8 Economic Growth II CASE STUDY: The productivity slowdown 1.5 1.8 2.6 2.3 2.0 1.6 1.8 2.2 2.4 8.2 4.9 5.7 4.3 2.9 1972-951948-72 U.S. U.K. Japan Italy Germany France Canada Growth in output per person (percent per year)

25. slide 24 CHAPTER 8 Economic Growth II CASE STUDY: I.T. and the “New Economy” 2.2 2.5 1.2 1.5 1.2 1.7 2.4 1.5 1.8 2.6 2.3 2.0 1.6 1.8 2.2 2.4 8.2 4.9 5.7 4.3 2.9 1995-20041972-951948-72 U.S. U.K. Japan Italy Germany France Canada Growth in output per person (percent per year)

26. slide 25 CHAPTER 8 Economic Growth II CASE STUDY: I.T. and the “New Economy” Apparently, the computer revolution did not affect aggregate productivity until the mid-1990s. Two reasons: 1.Computer industry’s share of GDP much bigger in late 1990s than earlier. 2.Takes time for firms to determine how to utilize new technology most effectively. The big, open question:  How long will I.T. remain an engine of growth?

27. slide 26 CHAPTER 8 Economic Growth II Endogenous growth theory  Solow model:  sustained growth in living standards is due to tech progress.  the rate of tech progress is exogenous.  Endogenous growth theory:  a set of models in which the growth rate of productivity and living standards is endogenous.

28. slide 27 CHAPTER 8 Economic Growth II A basic model  Production function: Y = A K where A is the amount of output for each unit of capital (A is exogenous & constant)  Key difference between this model & Solow: MPK is constant here, diminishes in Solow  Investment: s Y  Depreciation:  K  Equation of motion for total capital:  K = s Y   K

29. slide 28 CHAPTER 8 Economic Growth II A basic model  K = s Y   K  If s A > , then income will grow forever, and investment is the “engine of growth.”  Here, the permanent growth rate depends on s. In Solow model, it does not.  Divide through by K and use Y = A K to get:

30. slide 29 CHAPTER 8 Economic Growth II Does capital have diminishing returns or not?  Depends on definition of “capital.”  If “capital” is narrowly defined (only plant & equipment), then yes.  Advocates of endogenous growth theory argue that knowledge is a type of capital.  If so, then constant returns to capital is more plausible, and this model may be a good description of economic growth.

31. slide 30 CHAPTER 8 Economic Growth II A two-sector model  Two sectors:  manufacturing firms produce goods.  research universities produce knowledge that increases labor efficiency in manufacturing.  u = fraction of labor in research (u is exogenous)  Mfg prod func: Y = F [K, (1-u )E L]  Res prod func:  E = g (u )E  Cap accumulation:  K = s Y   K

32. slide 31 CHAPTER 8 Economic Growth II A two-sector model  In the steady state, mfg output per worker and the standard of living grow at rate  E/E = g (u ).  Key variables: s: affects the level of income, but not its growth rate (same as in Solow model) u: affects level and growth rate of income  Question: Would an increase in u be unambiguously good for the economy?

33. slide 32 CHAPTER 8 Economic Growth II Facts about R&D 1. Much research is done by firms seeking profits. 2. Firms profit from research:  Patents create a stream of monopoly profits.  Extra profit from being first on the market with a new product. 3. Innovation produces externalities that reduce the cost of subsequent innovation. Much of the new endogenous growth theory attempts to incorporate these facts into models to better understand technological progress.

34. Chapter Summary 1. Key results from Solow model with tech progress  steady state growth rate of income per person depends solely on the exogenous rate of tech progress  the U.S. has much less capital than the Golden Rule steady state 2. Ways to increase the saving rate  increase public saving (reduce budget deficit)  tax incentives for private saving CHAPTER 8 Economic Growth II slide 33

35. Chapter Summary 3. Productivity slowdown & “new economy”  Early 1970s: productivity growth fell in the U.S. and other countries.  Mid 1990s: productivity growth increased, probably because of advances in I.T. 4. Empirical studies  Solow model explains balanced growth, conditional convergence  Cross-country variation in living standards is due to differences in cap. accumulation and in production efficiency CHAPTER 8 Economic Growth II slide 34

36. Chapter Summary 5. Endogenous growth theory: Models that  examine the determinants of the rate of tech. progress, which Solow takes as given.  explain decisions that determine the creation of knowledge through R&D. CHAPTER 8 Economic Growth II slide 35

37. M ACROECONOMICS C H A P T E R Introduction to Economic Fluctuations 9

38. slide 37 CHAPTER 8 Economic Growth II In this chapter, you will learn…  facts about the business cycle  how the short run differs from the long run  an introduction to aggregate demand  an introduction to aggregate supply in the short run and long run  how the model of aggregate demand and aggregate supply can be used to analyze the short-run and long-run effects of “shocks.”

39. slide 38 CHAPTER 8 Economic Growth II Facts about the business cycle  GDP growth averages 3–3.5 percent per year over the long run with large fluctuations in the short run.  Consumption and investment fluctuate with GDP, but consumption tends to be less volatile and investment more volatile than GDP.  Unemployment rises during recessions and falls during expansions.  Okun’s Law: the negative relationship between GDP and unemployment.

40. slide 39 CHAPTER 8 Economic Growth II Growth rates of real GDP, consumption -4 -2 0 2 4 6 8 10 19701975198019851990199520002005 Real GDP growth rate Average growth rate Consumption growth rate Percent change from 4 quarters earlier

41. slide 40 CHAPTER 8 Economic Growth II Growth rates of real GDP, consumption, investment -30 -20 -10 0 10 20 30 40 19701975198019851990199520002005 Percent change from 4 quarters earlier Investment growth rate Real GDP growth rate Consumption growth rate

42. slide 41 CHAPTER 8 Economic Growth II Unemployment 0 2 4 6 8 10 12 19701975198019851990199520002005 Percent of labor force

43. slide 42 CHAPTER 8 Economic Growth II Okun’s Law Percentage change in real GDP Change in unemployment rate -4 -2 0 2 4 6 8 10 -3-201234 1975 1982 1991 2001 1984 1951 1966 2003 1987

44. slide 43 CHAPTER 8 Economic Growth II Index of Leading Economic Indicators  Published monthly by the Conference Board.  Aims to forecast changes in economic activity 6-9 months into the future.  Used in planning by businesses and govt, despite not being a perfect predictor.

45. slide 44 CHAPTER 8 Economic Growth II Components of the LEI index  Average workweek in manufacturing  Initial weekly claims for unemployment insurance  New orders for consumer goods and materials  New orders, nondefense capital goods  Vendor performance  New building permits issued  Index of stock prices  M2  Yield spread (10-year minus 3-month) on Treasuries  Index of consumer expectations

46. slide 45 CHAPTER 8 Economic Growth II Index of Leading Economic Indicators 0 20 40 60 80 100 120 140 160 19701975198019851990199520002005 1996 = 100 Source: Conference Board

47. slide 46 CHAPTER 8 Economic Growth II Time horizons in macroeconomics  Long run: Prices are flexible, respond to changes in supply or demand.  Short run: Many prices are “sticky” at some predetermined level. The economy behaves much differently when prices are sticky.

48. slide 47 CHAPTER 8 Economic Growth II Recap of classical macro theory (Chaps. 3-8)  Output is determined by the supply side:  supplies of capital, labor  technology.  Changes in demand for goods & services ( C, I, G ) only affect prices, not quantities.  Assumes complete price flexibility.  Applies to the long run.

49. slide 48 CHAPTER 8 Economic Growth II When prices are sticky… …output and employment also depend on demand, which is affected by  fiscal policy ( G and T )  monetary policy ( M )  other factors, like exogenous changes in C or I.

50. slide 49 CHAPTER 8 Economic Growth II The Quantity Equation as Aggregate Demand  From Chapter 4, recall the quantity equation M V = P Y  For given values of M and V, this equation implies an inverse relationship between P and Y :

51. slide 50 CHAPTER 8 Economic Growth II The downward-sloping AD curve An increase in the price level causes a fall in real money balances (M/P ), (v is constant) An increase in the price level causes a fall in real money balances (M/P ), (v is constant) Y P AD

52. slide 51 CHAPTER 8 Economic Growth II Shifting the AD curve An increase in the money supply shifts the AD curve to the right. (since MV=PY, and increase in M, increase PY) Every value of P has associated higher Y. An increase in the money supply shifts the AD curve to the right. (since MV=PY, and increase in M, increase PY) Every value of P has associated higher Y. Y P AD 1 AD 2

53. slide 52 CHAPTER 8 Economic Growth II Aggregate supply in the long run  Recall from Chapter 3: In the long run, output is determined by factor supplies and technology is the full-employment or natural level of output, the level of output at which the economy’s resources are fully employed. “Full employment” means that unemployment equals its natural rate (not zero).

54. slide 53 CHAPTER 8 Economic Growth II The long-run aggregate supply curve Y P LRAS does not depend on P, so LRAS is vertical.

55. slide 54 CHAPTER 8 Economic Growth II Long-run effects of an increase in M Y P AD 1 LRAS An increase in M shifts AD to the right. P1P1 P2P2 In the long run, this raises the price level… …but leaves output the same. (money neutrality) AD 2

56. slide 55 CHAPTER 8 Economic Growth II Aggregate supply in the short run  Many prices are sticky in the short run.  For now (and through Chap. 12), we assume  all prices are stuck at a predetermined level in the short run.  firms are willing to sell as much at that price level as their customers are willing to buy.  Therefore, the short-run aggregate supply (SRAS) curve is horizontal:

57. slide 56 CHAPTER 8 Economic Growth II EXTREME SHORT RUN: The short-run aggregate supply curve Y P SRAS The SRAS curve is horizontal: The price level is fixed at a predetermined level, and firms sell as much as buyers demand. The SRAS curve is horizontal: The price level is fixed at a predetermined level, and firms sell as much as buyers demand.

58. slide 57 CHAPTER 8 Economic Growth II Short-run effects of an increase in M Y P AD 1 In the short run when prices are sticky,… …causes output to rise. What about Unemployment? SRAS Y2Y2 Y1Y1 AD 2 …an increase in aggregate demand…

59. slide 58 CHAPTER 8 Economic Growth II From the short run to the long run Over time, prices gradually become “unstuck.” When they do, will they rise or fall? rise fall remain constant In the short-run equilibrium, if then over time, P will… The adjustment of prices is what moves the economy to its long-run equilibrium.

60. slide 59 CHAPTER 8 Economic Growth II The SR & LR effects of  M > 0 Y P AD 1 LRAS SRAS P2P2 Y2Y2 A = initial equilibrium A B C B = new short- run eq’m after Fed increases M C = long-run equilibrium AD 2

61. slide 60 CHAPTER 8 Economic Growth II How shocking!!!  shocks: exogenous changes in agg. supply or demand  Shocks temporarily push the economy away from full employment.  Example: exogenous decrease in velocity If the money supply is held constant, a decrease in V means people will be using their money in fewer transactions, causing a decrease in demand for goods and services.

62. slide 61 CHAPTER 8 Economic Growth II SRAS LRAS AD 2 The effects of a negative demand shock Y P AD 1 P2P2 Y2Y2 AD shifts left, depressing output and employment in the short run. A B C Over time, prices fall and the economy moves down its demand curve toward full- employment.

63. slide 62 CHAPTER 8 Economic Growth II Supply shocks  A supply shock alters production costs, affects the prices that firms charge. (also called price shocks)  Examples of adverse supply shocks:  Bad weather reduces crop yields, pushing up food prices.  Workers unionize, negotiate wage increases.  New environmental regulations require firms to reduce emissions. Firms charge higher prices to help cover the costs of compliance.  Favorable supply shocks lower costs and prices.

64. slide 63 CHAPTER 8 Economic Growth II CASE STUDY: The 1970s oil shocks  Early 1970s: OPEC coordinates a reduction in the supply of oil.  Oil prices rose 11% in 1973 68% in 1974 16% in 1975  Such sharp oil price increases are supply shocks because they significantly impact production costs and prices.

65. slide 64 CHAPTER 8 Economic Growth II SRAS 1 Y P AD LRAS Y2Y2 CASE STUDY: The 1970s oil shocks The oil price shock shifts SRAS up, causing output and employment to fall. A B In absence of further price shocks, prices will fall over time and economy moves back toward full employment. SRAS 2 A

66. slide 65 CHAPTER 8 Economic Growth II Stabilization policy  def: policy actions aimed at reducing the severity of short-run economic fluctuations.  Example: Using monetary policy to combat the effects of adverse supply shocks:

67. slide 66 CHAPTER 8 Economic Growth II Stabilizing output with monetary policy SRAS 1 Y P AD 1 B A Y2Y2 LRAS The adverse supply shock moves the economy to point B. SRAS 2

68. slide 67 CHAPTER 8 Economic Growth II Stabilizing output with monetary policy Y P AD 1 B A C Y2Y2 LRAS But the Fed accommodates the shock by raising agg. demand. results: P is permanently higher, but Y remains at its full- employment level. SRAS 2 AD 2

69. slide 68 CHAPTER 8 Economic Growth II Chapter Summary 1. Long run: prices are flexible, output and employment are always at their natural rates, and the classical theory applies. Short run: prices are sticky, shocks can push output and employment away from their natural rates. 2. Aggregate demand and supply: a framework to analyze economic fluctuations CHAPTER 9 Introduction to Economic Fluctuations slide 68

70. slide 69 CHAPTER 8 Economic Growth II Chapter Summary 3. The aggregate demand curve slopes downward. 4. The long-run aggregate supply curve is vertical, because output depends on technology and factor supplies, but not prices. 5. The short-run aggregate supply curve is horizontal, because prices are sticky at predetermined levels. CHAPTER 9 Introduction to Economic Fluctuations slide 69

71. slide 70 CHAPTER 8 Economic Growth II Chapter Summary 6. Shocks to aggregate demand and supply cause fluctuations in GDP and employment in the short run. 7. The Fed can attempt to stabilize the economy with monetary policy. CHAPTER 9 Introduction to Economic Fluctuations slide 70

72. M ACROECONOMICS C H A P T E R Aggregate Demand I: Building the IS -LM Model 10

73. slide 72 CHAPTER 8 Economic Growth II In this chapter, you will learn…  the IS curve, and its relation to  the Keynesian cross  the loanable funds model  the LM curve, and its relation to  the theory of liquidity preference  how the IS-LM model determines income and the interest rate in the short run when P is fixed

74. slide 73 CHAPTER 8 Economic Growth II Context  Chapter 9 introduced the model of aggregate demand and aggregate supply.  Long run  prices flexible  output determined by factors of production & technology  unemployment equals its natural rate  Short run  prices fixed  output determined by aggregate demand  unemployment negatively related to output

75. slide 74 CHAPTER 8 Economic Growth II Context  This chapter develops the IS-LM model, the basis of the aggregate demand curve.  We focus on the short run and assume the price level is fixed (so, SRAS curve is horizontal).  This chapter (and chapter 11) focus on the closed-economy case. Chapter 12 presents the open-economy case.

76. slide 75 CHAPTER 8 Economic Growth II The Keynesian Cross  A simple closed economy model in which income is determined by expenditure. (due to J.M. Keynes)  Notation: I = planned investment E = C + I + G = planned expenditure Y = real GDP = actual expenditure  Difference between actual & planned expenditure = unplanned inventory investment

77. slide 76 CHAPTER 8 Economic Growth II Elements of the Keynesian Cross consumption function: for now, planned investment is exogenous: planned expenditure: equilibrium condition: govt policy variables: actual expenditure = planned expenditure

78. slide 77 CHAPTER 8 Economic Growth II Graphing planned expenditure income, output, Y E planned expenditure E =C +I +G MPC 1

79. slide 78 CHAPTER 8 Economic Growth II Graphing the equilibrium condition income, output, Y E planned expenditure E =Y 45 º

80. slide 79 CHAPTER 8 Economic Growth II The equilibrium value of income income, output, Y E planned expenditure E =Y E =C +I +G Equilibrium income

81. slide 80 CHAPTER 8 Economic Growth II An increase in government purchases Y E E =Y E =C +I +G 1 E 1 = Y 1 E =C +I +G 2 E 2 = Y 2 YY At Y 1, there is now an unplanned drop in inventory… …so firms increase output, and income rises toward a new equilibrium. GG

82. slide 81 CHAPTER 8 Economic Growth II Solving for  Y equilibrium condition in changes because I exogenous because  C = MPC  Y Collect terms with  Y on the left side of the equals sign: Solve for  Y :

83. slide 82 CHAPTER 8 Economic Growth II The government purchases multiplier Example: If MPC = 0.8, then Definition: the increase in income resulting from a $1 increase in G. In this model, the govt purchases multiplier equals An increase in G causes income to increase 5 times as much!

84. slide 83 CHAPTER 8 Economic Growth II Why the multiplier is greater than 1  Initially, the increase in G causes an equal increase in Y:  Y =  G.  But  Y   C  further  Y  further  C  further  Y  So the final impact on income is much bigger than the initial  G.