TOPIC C: The Economy & Economic Growth

TOPIC C:The Economy & Economic Growth TCD M.Sc.(EPS) – Ronan LYONS – EC8001 Irish Economic Policy ISSUES & Context

Module Outline

Topic C: Structure The Economy & Economic Growth • Conceptualizing the economy • National income accounts • GDP, welfare and public policy • Efficiency and production possibilities • Modern economic growth • Productivity performance

From Tactics to Strategy… • Three main tools of economic policy were mentioned in Topic B • Trade policy (τ)– historically tariffs; within EU/WTO, replaced by competitiveness policy • Monetary policy (r) – concerned with currency, interest rates, money supply; within Eurozone, replaced at national level by macro-prudential policy • Fiscal policy (G) – decisions about government revenues and spending; limits within EU but increasingly important • But these are the tools – what are the aims?

Aims of A Regional Economy • The principal aim of an economy’s policymakers is to deliver a high(er) standard of living • Most often measured through citizens’ average income • Behavioural issues: relative vs. absolute, momentum • Range of ancillary and secondary objectives • Full employment – will be reflected in higher incomes • Competitiveness – should be reflected in higher incomes • Fair distribution of income – may not be reflected • Stability – reflected in consistently high living standards (also: good/asset price stability) • Sustainability – as above, but over longer time-frame (may be at odds with higher living standards over short run)

Levels of Living Standards Source: Maddison Project Database (2013)

Growth in Living Standards Irish catch-up European slow down Source: Maddison Project Database (2013)

World’s Richest countries

Features of the top 20 • Luxembourg • Singapore • Brunei Darussalam • Kuwait • Norway • United Arab Emirates • Switzerland • Hong Kong SAR • United States • Saudi Arabia • Bahrain • Netherlands • Ireland • Australia • Austria • Germany • Sweden • Canada • Denmark • Oman Size – big or small? Location? Island/landlocked? Resources? History? Real #1 is Qatar!

Model of the entire economy • How would you go about modelling an entire economy? • Not as complicated as it sounds: ultimately, in an economy, there are only sellers and buyers • Sellers provide a service • Sometimes that service is a physical item, a commodity like copper or merchandise such as TV – but even then its value lies in the service it provides • Buyers pay money in return

A pre-Industrial Economy… No firms, so aside from subsistence production, households trade with each other through markets sell goods Markets Households buy goods

A Modern Economy… 1. Firms sell goods that are bought by households 2. Money flows in the opposite direction Goods markets Firms Households 3. Firms in turn require inputs, owned by households Factor markets Real Monetary

Notes on the circular flow • Two important features about the ‘circular flow’ model of the economy • Every real flow has a corresponding monetary flow • Some of these may be imputed, e.g. stay-at-home spouse or owner-occupier’s rent • Someone’s expenditure is someone else’s income • Adding up income should be equivalent to adding up expenditure • In an economy like this, any injection (e.g. new deposit) would circulate around economy forever • No leakages – annual impact would depend on velocity

Developing the Circular Flow Three main additions to realism of the circular flow • Government – taxation, a payment by households to government in return for public goods • Banking – saving (non-consumption) generates an income (interest); the financial system transforms into lending (saving and investment as opposites) • Trade – final ‘leakage’ is spending on imports, offset (at least in part) by income from exports • These reduce the final economic impact of any injection into an economy

Gross domestic product (GDP) Helps compare apples and oranges… everything expressed in euro “GDP is… the market value of all final goods and services produced within a country in a given period of time” Everything sold (previously just legally) in the economy To avoid double-counting, leaves out intermediate goods (e.g. paper supplies for greeting card company) Only new goods counted – e.g. not 2nd-hand cars/homes In Ireland’s case, only what’s produced here, i.e. doesn’t include any output by a French company part-owned by an Irish household Usually a year but people also pay attention to quarterly figures

Output versus Income Only GDP will include the profits of multinationals based here, such as Google or Pfizer Both GDP and GNP for Ireland will include output by firms owned by Irish residents and which operate in Ireland (including their exports). Only GNP will include the profits earned through Irish firms’ overseas plants, e.g. CRH or Ryanair. GDP is the value of all goods & services produced within a country in a given period of time GNP is the value of all income earned by a nation’s residents, regardless of where it was earned

Four methods, same answer? • Possible to calculate economy’s size (i.e. the sum of all activity) in any one of three [four] ways • Expenditure method – add up all money spent on final goods and services • Income method – add up all money earned through all sources (wages, rents, profits) • Output method – add up value of all goods and services produced • Consumption method – add up value of all goods and services consumed [not aware of any attempts at this] • To understand why, go back to circular flow • In practice, answers across methods vary

Components of GDP and GNP GDP = Y = C + I + G + NX GNP includes “net factor income” Y = C + I + G + NX +NFI GVA = GDP - taxes/subsidies GNI = GNP + EU transfers

Components of GDP in Ireland Source: CSO National Accounts

Trends in Irish output & income Interpretation? Source: CSO National Accounts

Decomposing growth… • Mathematically, growth in per capita incomes comprises five factors • Productivity (GNP/hour) • Effort (hours/worker) • Employment (worker/ labour force) • Partipication (labour force/15-64 population) • Demography (15-64 population/full pop’n)

Jobless Growth, Growthless jobs • In addition to real GDP, key Irish policy metrics in include growth in GNP and employment • Economic contraction from mid-2008 to mid-2010 • Decline in jobs until mid-2012 • 2013: growth in jobs while GDP stagnated • GDP’s patent cliff vs. GNP’s new citizens

Can we Trust GDP or GNP?

What’s in GDP? • When measured well, GDP includes the value of amenities • GDP was recently updated to include “value added” from illegal activities • To my knowledge, value added by “house-spouses” not yet included • Is Ireland better off neighbours start minding each other’s children for €200 a week? Source: CSO National Accounts

GDP’s limits: other goods • Black market: • From 2014 on, meant to include illegal activities • How accurate will this be? • Non-market goods: • “The best things in life are free” – value of leisure time excluded • But note that parks and other amenities captured in (imputed) rents are included Source: Irish Examiner

GDP’s Limits: Distribution • GDP per capita is a mean (i.e. an average) • A single summary measure of a level • GDP says nothing about spread around mean • “First moment” vs. “second moment” • Where incomes are similar, extra measures desirable • Gini, %ile ratios (e.g. 90/10) • 90/10 OECD average: 4.3 • More in Topic F

GDP’s limits: bads “Bads” are activities that contribute to GDP but are (to some extent) unwelcome, e.g. production that pollutes

GDP’s limits: Perverse goods Japanese earthquake 2011 “Japan has said it will cost $309bn to rebuild the country after the deadly earthquake and tsunami… According to the World Bank, Japan will need up to five years to rebuild.” • Activities that are welcome but are due to things that are not welcome, e.g. post-war construction • How much does Australia spend on forest fires compared to, say, Iceland? • This matters for policy – US-EU comparisons don’t include effect of climate on GDP • ~5% of homes in Europe have AC, compared to 83% of US homes

Should we measure happiness? Ireland is happy! Ireland is unhappy! Irish Times, Dec 23 2011 "The EU Survey on Income and Living Conditions showed 79 per cent of the Irish population aged 18 and over reported themselves in 2010 to have been happy all or most of the time over the four weeks prior to the interview." Irish Times, Jan 4 2012 “The Irish are among the unhappiest of 58 nationalities, according to a poll by WIN-Gallup International of “net happiness”, or the percentage of people who considered themselves happy, minus the percentage who considered themselves unhappy." Happiness seems to be “adaptive”: people learn to cope with their circumstances… but does that mean we should leave people in poverty?

Lessons from Bhutan & OBAMA • “Happiness is outcomes minus expectations” • High happiness could be good outcomes… • … or low expectations • Or due to human quirks • Gallup: huge jump in national well-being in US shortly after Obama took office… • Compromises, e.g. UN HDI Source: Financial Times

From Expenditure to Output • So far, thinking about GDP as the sum of all expenditure – C, I, G, NX • Remember that GDP is also the sum of all income, in wages, profits, rents, etc. • GDP is the flow accruing to factors of production • Stocks vs. flows • Three main factors of production • L: Labour, or human capital • N: Land, or natural capital • K: Physical & financial capital – formed by investment • The relationship between inputs and outputs is ‘technology’, A

The production function K=100, α=2/3 • Production function, Y=AK1-αLα Diminishing marginal product Constant returns to scale • Output depends on: • Capital (100 units) • Labour (1…100 workers) • Technology • Y = f (A, K, L, N) • Here, leaving aside N

DMR & CRTS • For a fixed stock of capital (and land), adding more workers will lower their incomes • The “getting in the way” effect • But if K, L and N are doubled, what happens output? • Constant RTS • Or increasing or decreasing RTS?

production possibilities frontier • Production possibilities frontier • Suppose there are 2 goods in the economy: bagels (α=0.8) & iPads (α=0.4) • What does αmean? • Both have K=100 (e.g. factory dedicated to that good – can’t make other good) • “A” (technology) is the same for both • We can allocate our 100 workers any way we want -> • A curve showing all possible combinations of production

PPF & Technology Y Z X • Production possibilities frontier • An improvement in technology (A from 1 to 1.1) expands economic possibilities • Can consume more of both • Important distinction between… • Reducing inefficiency (XZ) • Reallocating resources (YZ) • Economic growth (this graph compared to last one)

PPF & Trade • In a one-economy model, the PPF contains insights about (in)efficiency and full employment • It does not say anything about whether it is preferable to produce more bagels or more iPads • About technology (supply) not preferences (demand) • Adding a second country, with a different technology, still tells us nothing about consumption • But it does reveal insights about who should produce what • Comparative advantage and opportunity cost • More on this in Topic H • International trade and competitiveness

World History in One Graph…

Pre-Modern Economic Growth • Any technological improvement goes to higher populations not higher incomes • Without sufficient food (i.e. without technology/ productivity) a larger population is “self-correcting” (war, famine) • As per Hobbes, “the life of man [is] solitary, poor, nasty, brutish & short” • Thomas Robert Malthus, 1766-1834 Malthusian

Switching growth on? • How did the trend level of growth in average incomes go from 0% to 2-3%? • Technological progress – in the cotton industry first – is at the heart of the first escape from the Malthusian Trap • Britain in the late 1700s and early 1800s – cf. Topic A • Modern economic growth has spread to most parts of the world in the last two centuries • What does this tell us about how less developed countries today can embark on economic growth? • Need a conceptual framework and theory of economic growth

production functions AGAIN… K=100, α=2/3 • Production function, Y=AK1-αLα • Output depends on: • Capital (100 units) • Labour (1…100 workers) • Technology • For given stocks of capital and labour, economic growth = A (improvement in technology)

Aggregate vs. Per Capita • Aggregate GDP • Y = f (A, K, L, N) • An increase in L leads to an increase GDP (US vs. Ireland) • Per capita GDP • Y/L = f (A, K, N) • With N fixed, growth in per capita output comes from A, K • Hence the focus on… • Attracting capital • Technological progress • Remember that A = “broad technology” • E.g. reducing inefficient processes increases A

Exogenousgrowth models • Roots in 1950s (Robert Solow, MIT) • Based on production function • Diminishing returns means growth can’t come from physical capital • Adding extra capital to fixed stock of labour is just like the reverse (Burdock’s example) • Per-capita incomes: growth can’t come from labour either • Assuming constant returns to scale… • Growth instead comes from technological progress, which is simply assumed • Not a very satisfying view of the world!

endogenous growth models • Popular in/since 1990s (Paul Romer, Stanford) • Aim: where do technological progress come from? • Together with fluctuations (boom/bust cycles), understanding trend growth rates a key concern of macroeconomics • A number of strands of endogenous growth model • One strand abandons diminishing returns to accumulating capital • Another tries to explain technological progress; new ideas rewarded -> innovation • A third focuses on “human capital” (skills): as important as physical capital

Can Growth Continue Forever? • Scale of growth matters – 0.2% vs. 0.8% vs. 2% vs 3% • €50,000 vs. €750,000 in 100 years time • Note also imprecision with which GDP is measured • Type of goods consumed matters also • Services now 75-80% of developed economies • What is resource footprint of service (vs. good)? • Is it possible to improve things 1% a year?

Labour’s Marginal Product • Ultimately, per capita incomes depend on the value of output a worker produces • Economics often assumes that wages reflect the ‘marginal product of labour’ • An increase in MPL could come about due to changes in the price of what they produce • The difficulty with measuring productivity in domestically traded and public services • Balassa-Samuelson effect : the economics of hairdressers’ wages • Strictly, though, productivity is about the quantity of output (of a fixed quality) produced in, say, 1 hour

TOPIC C: The Economy & Economic Growth