Economics for CED

Economics for CED Noémi GiszpencSpring 2004Lecture 7: Macro: Growthof the National Economy May 18, 2004

GNP changes over time • Value of GNP is measured in $, not stuff. • Measured using prices of goods & services. • Therefore GNP can go up in three ways: • More stuff produced • Prices rise with no change in quality • Prices rise with increase in quality Economics for CED: Lecture 7, Noémi Giszpenc

Changes in Price (not Quality) • Example: In 1993, pizza pies cost $10 and hamburgers cost $2.In 1994, pizza costs $9 and burgers $3 • 1993: John Deaux ate 15 pizzas and 20 burgers (cost: $190)1994: 20 pizzas and 16 burgers ($228) • Did consumption increase or decrease?Is he better off or worse off? Economics for CED: Lecture 7, Noémi Giszpenc

Example continued • John is at least as well off (if his tastes haven’t changed). Why? • 1993 consumption of 15 p. & 20 b. at 1994 prices = $195 < $228--means that John could have afforded 1993 consumption but chose different combo (one he presumably likes better) • Follows that consumption increased Economics for CED: Lecture 7, Noémi Giszpenc

In general, if people… • have more than enough income to buy the same goods and services that they bought in an earlier period -- • but they choose to buy a different assortment -- • then we infer that on the whole, they are better off, • and production has increased. Economics for CED: Lecture 7, Noémi Giszpenc

Making price level comparisons • Base Year: the year used as basis for a comparison of output or the price level (arbitrary). • Current Year: the year being compared to the base year (not “this” year). • “fixed weight price index” or Laspeyres’ Index • The cost of the base year assortment of goods at current prices divided by the cost of the base year assortment of goods at base year prices Economics for CED: Lecture 7, Noémi Giszpenc

Another fixed-weight index • Paasche’s Index: • The cost of the current year assortment of goods at current prices divided by the cost of the current year assortment of goods at base year prices • Both indices assume unchanged consumption. • But consumers tend to buy more goodswhose prices have risen less to achieve same levels of well-being. Economics for CED: Lecture 7, Noémi Giszpenc

Correcting for substitution bias • “substitution bias”: difference between a fixed-weight price index and a price index that accounts for substitution • Easiest is Fisher index: geometric mean of Laspeyres and Paasch: Economics for CED: Lecture 7, Noémi Giszpenc

What happens with many years? • Two ways of handling multiple years: • Direct: always use same base year (I87,90) • Chained: multiplies consecutive indices that use consecutive years as base year. ‘87 to ‘90: (I87,87xI87,88xI88,89xI89,90) • Chain indexes are preferable for year-to-year or quarter-to-quarter comparisons. • Direct index preferable for longer term comparisons (1982 to 1987, or 1987 to 1990). • Most reasonable for up to 5 years--after more time, problematic to assume no changes in tastes, goods Economics for CED: Lecture 7, Noémi Giszpenc

Back to John Deaux • Let 1993 be base year. • How much would it cost in 1994 prices to buy the goods and services John bought in 1993? $195. • In the base year, 1993, it had cost $190. • Using Laspeyres’ Index: the price level in 1994 (relative to a 1993 base year) is 195/190 = 1.026 • The inflation from 1993 to 1994 is .026=2.6% Economics for CED: Lecture 7, Noémi Giszpenc

How much did consumption really increase? • 1993: John spent $190; 1994: $228 • This is a nominal (not adjusted) increase in spending of 20% = (228-190)/190 • We know that 2.6% was due to inflation (changes in prices) • Adjusting for inflation, John’s consumption has increased by 20% - 2.6% = 17.4%. • 17.4% is John's increase in "real consumption." • In this context, "real" means the same as "adjusted for inflation." Economics for CED: Lecture 7, Noémi Giszpenc

Applying measures to GNP: ‘92 & ’93 • Measure the outputs of various goods and services with 1992 prices for both years. • Thus, “real GDP” for 1993 is the sum of 1993 production of various goods and services valued at 1992 prices. • Could equally well do it the other way around -- both years in 1993 prices. • The two answers will not come out the same. Each is inaccurate -- biased -- and they are biased in opposite directions. • So theBureau of Economic Analysis (BEA) uses chained real dollars. • And also attempts to adjust for quality--if price went up but quality went up, too, then inflation was less. Economics for CED: Lecture 7, Noémi Giszpenc

Comparing nominal to real GDP • - Which is nominal? • - Which is real? • What is the base year? • What caused most of growth in nominal GDP in the 1970’s? Economics for CED: Lecture 7, Noémi Giszpenc

Problems with GDP as measure of national well-being • Population (see last lecture) • Undocumented transactions • An important component in production, especially in less developed countries. Official GDP figures might understate production growth to some extent. • Nonmarket gains and losses • Social changes; Environmental changes; Household production; Leisure time… Economics for CED: Lecture 7, Noémi Giszpenc

What is economic growth? • Economic growth is a sustained increase in real GDP per capita. • Usually measured as a rate: ∆RGDP/RGDP • Compounds: assume 2% annual growth: Economics for CED: Lecture 7, Noémi Giszpenc

Some adjustments • Need to subtract population growth rate to get growth rate of real GDP per capita. • Labor productivity is the output per person employed in the work force • Growth of labor productivity = growth of real GDP - growth of employed labor force Economics for CED: Lecture 7, Noémi Giszpenc

Visualizing economic growth • Real GDP growth issupposed to measurean increase in the ability to producemany differentthings (a shift outward in theproduction possibilities frontier) Economics for CED: Lecture 7, Noémi Giszpenc

What is the opposite of growth? • Brief decline of economy = Recession • Two consecutive quarters (3-month periods) of declining GDP • A period when business production, employment and earnings fall below levels that the economy is capable of achieving • Longer-term decline = Depression • Ordinarily occurring over several fiscal years • A long-term economic state characterized by high unemployment, low prices, low levels of trade and investment, restriction of credit, many bankruptcies Economics for CED: Lecture 7, Noémi Giszpenc

Now we know what it is & how to measure it--but what causes it? • The Mercantilists (16th to 18th C. Europe): • Economic power necessary for political power--and reverse is also true: power can increase wealth. • Nations can conquer, colonize & regulate industry & trade • Exports add more to national economy than imports--balance of trade & export support important. • James Steuart: Free trade between unequal parties tends to increase inequalities • Because of different bargaining power • Thus free trade is rational for winners but not for everybody. Economics for CED: Lecture 7, Noémi Giszpenc

Problems with Mercantilism • Principles badly applied in practice • Gov’ts quick to introduce new trade restrictions and taxes but slow to dismantle outdated ones. • Conflict between national interest & particular business interests • Nation as whole paid for protection w/out receiving benefits of full employment or nat’l self-reliance • Chronic trade surpluses as bad as chronic deficits--beggars trading partners • In general too much emphasis on int’l trade. Economics for CED: Lecture 7, Noémi Giszpenc

Classical Economists • Adam Smith (1723-1790): • Increasing division of labor increases the productivity of labor. • “The Division of Labour is limited by the Extent of the Market” • As productivity increases, incomes rise, increasing demand (the size of the market) and allowing greater division of labor. • Technical invention also raises productivity Economics for CED: Lecture 7, Noémi Giszpenc

Adam Smith’s take continued • “Virtuous circle” not guaranteed. • Grinds to halt if market limited by gov’t • Ex: if gov’t creates monopolies, they would limit output to keep profits and prices up • Ex: if gov’t limits trade • Thus, role of gov’t is to maintain order and protect property and contracts, & otherwise stay out of market • Rising wages a sign of a healthy economy; more so than high profits. • But capitalists do turn profit into new investment (capital formation), increasing productivity & growth. Economics for CED: Lecture 7, Noémi Giszpenc

A pessimistic response • Thomas Malthus (1766-1834),country priest and political economist, pointed out that one of the two inputs to production (land) is fixed, but the other (labor) is variable. • The law of diminishing marginal productivity predicts that labor will become less productive as it increases (and land remains fixed). • Since MPL determines wage, wages will be pushed down to subsistence levels. Economics for CED: Lecture 7, Noémi Giszpenc

The Malthus story • As population (labor force) increases, marginal productivity (& wages) fall. • Without use of contraception or abstention, families will grow to the limit. • Population growth will come to a halt at L. • Growth of national income will halt as well. Economics for CED: Lecture 7, Noémi Giszpenc

The controversy • Since Malthus wrote 200 years ago, population has continued to increase, as has agricultural and manufacturing productivity. • However, that could be a series of lucky accidents. There is no scientific reason to believe we will continue to be lucky. Economics for CED: Lecture 7, Noémi Giszpenc

Enter Capital Nassau William Senior (1790-1864) • Investment in capital raises labor productivity (& thus output). • So there is a demand for investment. Where does supply come from? • People prefer to have goods and services now rather than in the future. (BIG ASSUMPTION) • So people will supply investment funds only if they are rewarded by more goods and services in the future than they can get now. • Return on investment must overcome other preferences of lenders of capital. Economics for CED: Lecture 7, Noémi Giszpenc

Marx (1818-1883) • Prime mover of economic growth is human ingenuity, which leads to… • …changing means of production, that need appropriate forms of organization • I.e., forces of production matched by relations of production • Relations of production full of conflict Economics for CED: Lecture 7, Noémi Giszpenc

Roy Harrod(1900-1978) Evsey Domar(1914-1997) Modern growth theories • Harrod-Domar growth model • Based on work by J.M. Keynes • Posits that the rate of economic growth depends on the growth of capital • and thus on the proportion of income saved and invested • Growth also depends on growth of labor supply and of labor productivity • necessary for demand to grow as fast as labor supply plus labor productivity to avoid growth of unemployment • If capital and labor out of balance  problems. Economics for CED: Lecture 7, Noémi Giszpenc

Neoclassical Growth Theory • Of course capital and labor won’t be out of balance, though, silly! • Because of diminishing marginal productivity, capital and labor do not have independent productivities. • Holding one input fixed, adding more of the other will yield diminishing marginal returns. • If capital grows faster than labor then the ratio of capital to labor increases,  so the profitability of investment decreases,  and investment slows down. • This continues until an equilibrium is reached. • The equilibrium ratio of capital to labor is denoted k. Economics for CED: Lecture 7, Noémi Giszpenc

Are things really that stable? • As described so far, neoclassical model predicts no growth in labor productivity. • Though the ideas were developed in 1950s and 60s, period of greatest increases in productivity • Innovation to the Rescue! • With innovation, marginal productivity of capital increases,  so investment increases,  so marginal productivity of labor increases too. Economics for CED: Lecture 7, Noémi Giszpenc

What does growth bring? • First off, more growth often stimulates more invention (and education) • So innovation is “endogenous” to growth • Secondly, increasing all the factors of production may not be subject to diminishing returns • Choices are: increasing returns to scale, constant returns, or decreasing returns • Reasoning from Smith’s virtuous circle, Marshall, Pigou, and Kaldor said: increasing returns! • Beside greater ÷ of labor, gains from learning-by-doing Economics for CED: Lecture 7, Noémi Giszpenc

What could slow or halt growth? • Infant Industry Problem • Profitable industries may not be able to get big enough or learn enough in time to survive • Spillover Problem • Benefits of innovation accrue to others, so why invest? • Big Business Problem • Companies can achieve economies of scale, too • Turn into monopolies, use power to push profits up instead of expanding production Economics for CED: Lecture 7, Noémi Giszpenc

A version of Harrod-Domar in practice • Used by international development economists throughout the 1950s and 60s • The model said that the rate of growth should follow from: • The rate at which a nation saved, and • The productivity of the capital provided by savings • Proportion of income that nation saves (and invests): savings/income ratio • Value of capital is related to value of goods produced per year with the capital/output ratio • Annual rate of economic growth: first divided by second. Economics for CED: Lecture 7, Noémi Giszpenc

Did it work? • Governments were convinced that to grow they must increase saving, • chiefly by cutting the consumption by already-poor peasants, • and invest savings in industries with highest capital/output ratios: • heavy industry and large-scale farming • No. It did not work. • Industries complement and need each other • Poor can also save--and do so more readily if consumption is not cut. Economics for CED: Lecture 7, Noémi Giszpenc

Another theory of growth: trade • The Economic Benefits of Trade (Bush) • Expands and spurs growth in overseas markets for American goods and services; • Creates higher-paying American jobs; • Supports America's small- and medium-size businesses; • Trade agreements like the NAFTA and the Uruguay Round have given American consumers greater choice and generated benefits for a typical family of $1,300 to $2,000 each year. • Economists say that lowering barriers to trade by even one-third will boost the world economy by as much as $613 billion--and boost the U.S. economy by $177 billion a year. • Is it really so? • Not really, say Francisco Rodríguez and Dani Rodrik • “We find little evidence that open trade policies–in the sense of lower tariff and non-tariff barriers to trade–are significantly associated with economic growth.” • Thomas Balogh and other pragmatic institutional economists observed long ago that international trade & investment can increase inequalities--but doesn’t have to if done right. Economics for CED: Lecture 7, Noémi Giszpenc

What’s wrong with these theories? • All assume one or a few causes, abstracting from all the rest in ahistorical, faux-scientific fashion. • There is not one path to growth. • A country’s own path is rarely blocked by one barrier only. • Economic growth is likely to be affected by at least the following: • Natural resources • Appropriate government • Education • Health care • Birth control • Appropriate technology • Appropriate skill & know-how • Entrepreneurship • Tolerance of innovation • Work culture • Saving and investment • Foreign exchange • External markets and terms of trade • Opportunity costs for the educated Economics for CED: Lecture 7, Noémi Giszpenc

Conclusions • Economic systems are neither mechanical nor organic • Growth is not a process by which a few specifiable inputs regularly produce predictable outputs, even given congenial conditions • Growth is history • “growth” is a misleading metaphor for economic development • It is complex, inventive, conflict-ridden, partly repetitive but partly different every time • Read “Cities and the Wealth of Nations” by Jane Jacobs  Economics for CED: Lecture 7, Noémi Giszpenc

Economics for CED