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TOPIC 2

TOPIC 2. The Supply Side of the Economy. Goals of Lecture 2. Introduce the supply side of the macro economy. Discuss how countries grow and why some countries grow faster than others. Discuss labor productivity What does it mean? How does it respond coming out of recessions?

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TOPIC 2

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  1. TOPIC 2 The Supply Side of the Economy

  2. Goals of Lecture 2 • Introduce the supply side of the macro economy. • Discuss how countries grow and why some countries grow faster than others. • Discuss labor productivity • What does it mean? • How does it respond coming out of recessions? • Determine how wages are set in an economy. Determine why people work. • Understand where unemployment comes from.

  3. The Production Function • GDP (Y) is produced with capital (K, price-weighted) and labor (N, hours): Y = A F(K,N) • Sometimes, I will modify the production function such that: Y = A F(K,N, other inputs) – where other inputs include energy/oil! • Realistic Example is a Cobb Douglas function for F(.): Y = A K1-α Nα A is Total Factor Productivity (TFP), an index of efficiency (technology) MUST READ: NOTES 3 (my text posted on the teaching page) on the aggregate production function

  4. Measurement • Y is GDP (measured in dollars). As noted above, we want to measure Y in “real” dollars.<<you should know what this means from Notes 1 of the text>>. • For our Cobb Douglas production function (previous slide), N and K are both measured in dollars. • N often is measured in total wage bill • K often is measured as the replacement cost of capital • However, in practice, N can be measured in different ways (hours worked, number of workers). • Wage bill is the preferred method (takes into account “skill” differentials). • However, we will often talk about “standard of living” which is income per capita (Y/N ; where Y is income and N is some population measure).

  5. Features of the Aggregate Production Function Define MPN = Marginal Product of Labor = dY/dN Define MPK = Marginal Product of Capital = dY/dK Math Note: You should be comfortable taking these simple partial derivatives– if you are not, practice this for the quizzes and exams. Diminishing Marginal Products From Cobb-Douglas: MPN = α A (K/N)1-α = α (Y/N) Fixing A and K, MPN falls when N increases MPK = (1-α) A (N/K)α= (1-α) (Y/K) Fixing A and N, MPK falls when K increases Complementarity Across Inputs Increasing A or K, increases MPN Increasing A or N, increases MPK

  6. Labor Share With Cobb-Douglas Labor Share of Income = Income earned by workers divided by GDP = [(W/P)*N/]Y • In equilibrium, real wages of workers will equal MPN (more on this below) • Substituting (W/P) = MPN into above yields: Labor Share of Income = (α) * (Y/N) * (N/Y) (MPN) = α • Cobb-Douglas predicts a constant labor share of α. • Historically, α was stable at a level of about 0.7 (in notes, I often just set α = 0.7).

  7. US Labor Share: 1947Q1 – 2016Q2 Sharp Decline After 2000 Roughly Stable through 2000

  8. Manufacturing “Labor Share”: 1988Q1 – 2014Q2

  9. Sub-Section A Economic Growth

  10. Two Measures of Productivity • Labor Productivity = Y/N = A (K/N)1-α Driven by A and K/N (usually reported in press) • Total Factor Productivity (TFP) = A = Y/F(K,N) • Basically TFP is a ‘catch-all’ for anything that affects output other than K and N. • Work week of labor and capital • Quality of labor and capital • Regulation • Infrastructure • Competition • Specialization • Innovation (including innovation in management practices) • Changes in “discrimination” or “culture” • Some components of TFP tend to be pro-cyclical • (Definition of Pro-cyclical: Variable increases when Y is high, decreases when Y is low)

  11. Growth Accounting Y = A K1-α N α (our production function) %ΔY = %ΔA + (1-α)%ΔK + α%ΔN Output, in a country grows from: Growth in TFP (see entrepreneurial ability, education, roads, technology, etc.) Growth in Capital (machines, equipment, plants) Growth in Hours (workforce, population, labor participation, etc). Perhaps, we care about growth in Y/pop or Y/N (per capita output). %Δ(Y/pop) = %ΔA + (1-α)%Δ(K/pop) + α%Δ(N/pop) or %Δ(Y/N) = %ΔA + (1-α)%Δ(K/N)

  12. How is TFP Measured • The way TFP (A) is usually measured is via a statistical decomposition (referred to as the “Solow Residual”). • Remember our assumed production function: Y = AK1-αNα • Math Note: We are going to transform the production function to make it a little easier to work with (you should get comfortable with this) by taking the logs: • ln(Y) = ln(A) + α0ln(K) + α1ln(N) (where α0 = 1 – α1 ≈ 0.3) (1) • Given that we measure Y, K and N in the data, we can estimate (1) using standard regression techniques. • ln(A) is the constant from the regression. This is our standard TFP measure.

  13. US TFP Growth: 1970Q1 – 2014Q1

  14. Measuring TFP Because A (TFP) is a catch-all term for anything that affects production, the assumed production function does not impose any structure on how to measure the components of TFP. Economists are very good at measuring the extent to which TFP changes over time within a country. It is much harder to measure “why” TFP has changed over time. Economists try to measure this by using detailed firm-level and household-level data to measure production and wages.

  15. How is Labor Productivity Measured • Labor Productivity is easier to measure: Y/N • Y is usually “real GPD” • N is usually total hours worked

  16. Nonfarm Business Labor Productivity Growth: 1988Q1 – 2017Q1 Puzzle?

  17. Manufacturing Labor Productivity Growth: 1988Q1 – 2016Q2 Puzzle?

  18. U.S. Labor Productivity Growth Over Time • 1900-1972: 2.4% per year • 1972-1996: 1.4% per year. • 1996-2004: 2.6% per year. (“Internet boom”) • 2005-2016: 1.1% per year • 2013-2016: ~0% per year Data from Robert Gordon (Professor at Northwestern)

  19. Sub-Section A1 The Causes of Economic Growth

  20. The Role of Investment and Growth Does a one time increase ininvestment today increase Y/N today? YES! Does a one time increase ininvestment today cause a sustained increase in Y/N into the future? No! Back of our mind equations: S = I + NX (From the first lecture). Notice the link between saving and investment. K(t+1) = (1-δ) K(t) + I(t) Definition of Capital Stock Evolution or ΔK(t, t+1) = I(t) - δ K(t) All else equal (i.e. holding N constant), increasing I causes K tomorrow to increase causing K/N tomorrow to increase (i.e. Y/N tomorrow increases).

  21. Time Path of Capital Stock: One Time Increase in I K No investment No investment time t+1 Suppose there is a one time increase in investment at time t (perhaps due to an investment tax credit). Suppose no investment either prior to or after the tax credit.

  22. Can Higher Investment Lead to Infinite Growth? Does a sustained increase ininvestment increase Y/N today? YES! Does a sustained increase ininvestment cause a sustained increase in Y/N? No! Suppose I is fixed at a high level and that K initially is sufficiently small. K grows if I > δ K: But, notice that δK is also growing each period. (Summary: To start, higher I will lead to higher K and Y/N will increase). Eventually, however, I will converge towards δK. More and more of the investment is going to replace outdated capital and the capital stock will grow by smaller and smaller rates. The increase in Y/N will converge back to zero. Summary: High levels of investment will increase the capital stock and output, but both K and Y will eventually converge to a fixed level.

  23. Time Path of K: Permanent Increase in I K The new level of investment has successively less effect due to growing depreciation of the capital stock. No investment time t+1 Suppose there is a permanent increase in investment at time t. Suppose no investment prior to t. In all periods after t, the level of investment remains fixed at the level in t.

  24. Can Higher Investment Growth Cause Infinite Growth? If a one time increase in I gives an increase in Y, why not continuously raise I to higher and higher amounts??? Answer: Diminishing MPK!!! MPK = .3 A (N/K) .7; As K increases, MPK falls. As K goes to infinity, MPK goes to zero (Y stops increasing). Suppose, we keep rising I (each year), K will increase by the amount of I (after controlling for depreciation), but Y will increase by continuously smaller and smaller amounts. Remember Y = C + I + G + NX. I/Y (investment rate) is bounded by 1 (if you invest all your output). This caps the increase in I. I cannot grow forever! Continuously increasing I will NOT lead to sustained economic growth. NOTE: Investment decisions are NOT made in the dark (i.e. something must drive firm investment!)

  25. What Causes Sustained Growth ? Sustained Increases in the growth of A are the only thing that can cause a sustained growth in Y/N. Empirically, when a country exhibits faster Y/N growth ….. 33% typically comes from growth in K/N 67% typically comes from growth in A (where N = employment (not hours) - limited data).

  26. Nonfarm Business Labor Productivity Growth: 1988Q1 – 2017Q1 Puzzle?

  27. Manufacturing Labor Productivity Growth: 1988Q1 – 2016Q2 Puzzle?

  28. Why is US Labor Productivity/TFP Growth Lower • Demographics? • Slower growth in schooling? • Innovations with less spill-overs on productivity (but huge spill-overs on leisure) • What productivity growth we have seen replaces lower skilled workers. Contributing to inequality within the economy. • Have we moved from big innovations in market productivity (electricity, assembly lines, transportation, manufacturing techniques, etc.) to big innovations in leisure technology (facebook, internet, games, etc.)? • Less competition/more regulation?

  29. New Paper of Mine“The Allocation of Talent and Economic Growth” Question 1: How much of the observed TFP growth in the U.S. since 1960 is due to better labor market outcomes (including human capital formation) for blacks and women? o A better allocation of resources leads to higher economic growth. o There have been large changes in the allocation of women and minorities to occupations in the labor market since 1960. Question 2: How much of the convergence of the U.S. south to the U.S. north is due to a decline in discrimination of the south?

  30. Occupational Sorting Over Time: An Overview Fraction of group (white men, white women, black men, black women) aged 25-55 working in the following occupations: Executives, Mgmt, Architects, Engineers, Math/Computer Science, Natural Scientists, Doctors, and Lawyers. 19602010 White Men 21.2% 23.5% White Women 3.0 (7.3) 17.4 (21.0) Black Men 2.8 14.6 Black Women 1.0 (2.1) 13.0 (15.2) Data: U.S. Census and American Community Survey

  31. Occupational Sorting Over Time: An Overview Where were the other groups working in 1960? 53% of working white women worked in Nursing, Teaching, Sales, Secretarial and Office Assistances, and Food Prep/Service. o The comparable number for white men was 14% (mostly sales) 55% of working black men worked as Freight/Stock Handlers, Motor Vehicle Operators, Machine Operators, Janitorial Services, and Personal Services. o The comparable number for white men was 19% 47% of working black women worked in Household Services, Personal Services, and Food Prep/Services. o The comparable number for white men was 2%

  32. Wage Gaps Over Time: An Overview Log difference in annual earnings of full time workers, conditional on experience, hours and occupation controls (relative to White Men) 196019802010 White Women -0.56 -0.47 -0.26 Black Men -0.37 -0.21 -0.16 Black Women -0.82 -0.47 -0.31

  33. Findings Macro Implications: o 25% − 30% of per capita earnings in the U.S. between 1960 and 2010 was due to declining frictions for white women, black women, and black men. (Shines some light into the black box of TFP growth) o Other interesting results: - Wage growth in the 1970s and the 2000s would have been negative absent the labor market improvements for blacks and women. - About 40% of the convergence of the south to the northeast between 1960 and 1980 is due to declining labor market frictions. - Not much remaining room for growth from this mechanism. Can explain some of the slow down in productivity since 2000.

  34. Another (Potentially Crazy) Idea I have on Productivity Slowdown

  35. Did Early 2000 Finance Boom “Cause” a Fall in STEM Employment?

  36. Is 3 or 4 percent growth possible? • Some politicians promise growth rates of 3 or 4 percent per year? o They do not specify – but, lets suppose they mean real growth. o They do not specify growth in Y or Y/N – the former is possible by increasing N. • Is 3 or 4 percent growth per year possible? o Possible – maybe for short periods of time. o However, given U.S. history, I do not think it is likely. o Also, given current economic conditions, I do not think it is likely at all. • Can Presidents and Congress affect short run growth rates? o No! (unless we are in a recession) o At best, policy makers can affect growth rates in the long run by affecting TPF.

  37. Summary • There is a productivity slowdown – likely a combination of many factors. • Do not believe politicians who tell you they can magically raise growth in Y/N to 3 or 4 percent per year. That is crazy talk. I would be ecstatic if we could increase growth to about 2% per year (i.e., return to our long run average). • Growth in immigration (N) can increase Y but not necessarily Y/N unless it affects A. • Note: Demand side factors do not affect growth conditional on A, K and N. Conditional on A, K and N, demand side factors will only affect prices. (We will prove that later in the course).

  38. Sub-Section A2 Cross-Country Growth

  39. Growth Across Countries Most developed economies grow at the same rate that the “technological frontier” grows. Some helpful definitions: Convergence – countries inside of the technological frontier move towards the technological frontier. Divergence – countries inside of the technological frontier grow at a rate less than the technological frontier.

  40. Distribution of World GDP in 2015 (IMF, $)

  41. World GDP Per Capita in 2016 (IMF, $) Note: Purchasing price parity adjusted

  42. Some Data: Distribution of World GDP in 2000 From Barro, 2003 – includes 147 countries. Horizontal axis is a log scale. All data are in 1995 U.S. dollars.

  43. Some Data: Distribution of World GDP in 1960 From Barro, 2003 – includes 113 countries. Horizontal axis is a log scale. All data are in 1995 U.S. dollars.

  44. Growth Rate of GDP Per Capita: 1960 - 2000 From Barro, 2003 – includes 111 countries.

  45. GDP per Capita in the United States, the United Kingdom, and Japan, 1870–2009 (Weil 2015) Sources: Maddison (1995), Heston, Summers, And Aten (2011).

  46. The Distribution of Growth Rates, 1975–2009 (Weil 2015)

  47. Convergence of Income Across U.S. States: 1940 - 1980

  48. Convergence of Income Across U.S. States: 1980 - 2000

  49. Source of GDP Growth Latin America – Brazil, Chile, Columbia, Mexico, Peru, Uruguay, Bolivia, Ecuador, Paraguay, Venezuela Emerging Asia – Indonesia, Malaysia, Philippines, Thailand, and China Advanced Exporters – Australia, Canada, New Zealand, and Norway. From Sosa et al. (2013), IMF Report

  50. Per Capita GDP vs. Life Expectancy (Acemoglu 2005)

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