Econ 1000: Mod 4, Lecture 8

Econ 1000: Mod 4, Lecture 8 C. L. Mattoli (C) Red Hill Capital Corp., Delaware, USA 2008

Mod 4, part 2: Macroeconomics • Chapter 12, page 333 to end, Economic Growth, Macro policy • Chapter 13, Inflation and unemployment (C) Red Hill Capital Corp., Delaware, USA 2008

Learning Objectives • Discuss the determinants of economic growth • Briefly outline causes of both inflation and unemployment • Discuss the measurement and causes of inflation. • Discuss the objective of full employment (C) Red Hill Capital Corp., Delaware, USA 2008

Last Time • We looked at proxies for measuring macro economic growth, and we settled on real GDP as one possibility. • We also discussed the definition of GDP and other national accounting concepts, including some components: consumption, savings and investment. (C) Red Hill Capital Corp., Delaware, USA 2008

Last Time • We also discussed some of the shortcomings of measurements of national accounts and the shortcomings of using real GDP as a proxy for growth. • We then went on to discuss the general trend of economic growth and its cyclical nature, peaks and troughs, recessions and expansions. • Next we will look at the causes of growth in a simple economic modeling format. (C) Red Hill Capital Corp., Delaware, USA 2008

Last Time • After that, we will go on to discuss two other major macroeconomic variables on which people and governments focus: inflation of prices of goods and services and employment of the people within an economic society. • Both of these macroeconomic items are concerns for society. • Inflation of prices erodes the buying power of people. (C) Red Hill Capital Corp., Delaware, USA 2008

Last Time • If prices increase by 10% in a year, for example, and people are paid the same wages, they will be able to buy 10% less, in goods and services, with their money. • If people who want to work and earn a living are unable to find employment, they will not be able to buy anything or they will have to dip into their savings from past earnings, if they have any. • The person loses well-being; the society loses production that it could have had. (C) Red Hill Capital Corp., Delaware, USA 2008

Long-term Economic Growth (C) Red Hill Capital Corp., Delaware, USA 2008

Intro • The cyclical swings of the business cycle are around some sort of LT growth trend of the economy. • LT trends vary from country to country and can vary over longer periods of time for one particular country or another. • LT growth trends have a significant impact on the standard of living, the average “buying power”,of people in a society. (C) Red Hill Capital Corp., Delaware, USA 2008

Intro • For example a growth rate of 3% in per capita (per person) real GDP, a common proxy for standard of living, can mean the standard of living will double in 25 years (a generation) and will triple at 5%. • Thus, a central concern in macro is to understand the determinants of LT growth and to investigate whether or not government policies can affect it. (C) Red Hill Capital Corp., Delaware, USA 2008

(C) Red Hill Capital Corp., Delaware, USA 2008

The results in greater detail • Real per capita GDP is a common international measure of incomes and standards of living. Thus, we might ask: • Why has Japan had the greatest growth in per cap GDP, over a century, while India, until recently, and Bangladesh have had almost none? (C) Red Hill Capital Corp., Delaware, USA 2008

The results in greater detail • Australia had the highest per cap RGDP a century ago, but, then, it slipped behind the U.S. and Germany by the end of the century. • Since the 1960’s, the Asian Tigers, S. Korea, Singapore, HK, and Taiwan, have experienced incredible growth, and China has joined them since the 1980’s, increasing per cap RGDP by 500% in just one generation. (C) Red Hill Capital Corp., Delaware, USA 2008

Background • Ultimately, growth of the economy will be determined by growth in supply and demand. • In our analysis of growth we shall examine both sides, supply and demand, but we should always remember that, in the end, it is the interaction of the two that determines the quantity of output produced and consumed, invested and saved. • In a closed system, the demand cannot outstrip the productive capacity of the economy, and the productive capacity will have no reason to grow without sufficient demand. (C) Red Hill Capital Corp., Delaware, USA 2008

Determinants of Growth: the Solow model • In lecture 5 (chapter 6), we introduced the idea of the production function for a company. Now, we imagine a production function for a whole economy. • From the supply side, output growth is the result of change over time in the factor inputs of (productive) land, and capital, mixed with improvements in technology, into the production process. • In the following discussion, we shall refer to the non-labor inputs to production as, just, production factors. (C) Red Hill Capital Corp., Delaware, USA 2008

Determinants of Growth: the Solow model • Then, the aggregate production function, Y, of the country is output per worker versus the quantity of production factors per worker, QPF. • As shown in the next several slides, the output per worker increases but at a decreasing rate as diminishing marginal productivity operates on the macro scale. • In the next slide we show the production function and how it will change with improved production technology. (C) Red Hill Capital Corp., Delaware, USA 2008

The Production Function and Technological Change Aggregate Production Function (output/worker), fixed technology Aggregate Production Function (output/worker), changed technology Y Y Y2 Y2 Y1 Y1 1 2 1 QPF QPF More input: more output Same input + techno advance = more output (C) Red Hill Capital Corp., Delaware, USA 2008

Graph Analysis • In the preceding slide, we show how output per person might vary with factor inputs for an economy and that an improvement in technological methods of production would move the whole curve, upward, so that more output could be produced per person with given factor inputs. • We can also use such graphical displays to analyze the differences in outputs of different countries (economies). (C) Red Hill Capital Corp., Delaware, USA 2008

Graph Analysis • In the next slide, we use production function graphs to show how the outputs of 2 different countries might turn out to be different. • The comparisons are revealing because they adjust for size of the economies by focusing on output per person. • The graphs examine how differences might come from differences in the other input factors available to workers (factor accumulation), labor productivity differences, or both. (C) Red Hill Capital Corp., Delaware, USA 2008

Output per person differences for 2 Economies, A & B Differences due to Factor Accumulation Differences due to Labor productivity Differences due To Both Y Y Y YB YA QPF Country A Country B QPF Both countries QPF Country A Country B (C) Red Hill Capital Corp., Delaware, USA 2008

Graphical Implications • In the first graph, we see that countries with the same production technologies can have different outputs per person (per capita real GDP) if they have different amounts of other input factors per person. • The second graph shows that 2 countries can have different outputs per person, even if they have the same amounts of other input factors per person but one is more technologically advanced than the other. (C) Red Hill Capital Corp., Delaware, USA 2008

Application to Growth • Thus, we can explain, in simple terms, the reasons that one country might experience different growth in real per capita GDP than another. • It might be that one country manages to accumulate more production factors per worker than another. • Alternatively, one country might be able to improve its worker productivity (better technology) more than another country. (C) Red Hill Capital Corp., Delaware, USA 2008

Application to Growth • Most probably, both have been factors that have accounted for differing growth of countries. • In order to discover how countries have managed different growth rates over time, we must examine how countries can increase the quantity of productive factors available per person, or how they might improve productivity. (C) Red Hill Capital Corp., Delaware, USA 2008

Production factor accumulation & the Golden Rule • Our previous discussion focused on the supply side of the economic equation. • If we want to consider how a country might increase its production factors, we must look at the question of (economic) investment per person. • Then, we are really asking about the demand side of the economic growth equation. • In that regard, a nation’s output is either consumed or used for investment. (C) Red Hill Capital Corp., Delaware, USA 2008

Consumption, savings & investment • The output that is not part of consumption is the savings of the people, and their savings can be used by firms to make investment (forgetting about foreign savings, for simplicity). Thus, savings is crucial for investment. • Then, higher savings results in higher investment results in a greater quantity of production factors per worker and higher levels of output per person. (C) Red Hill Capital Corp., Delaware, USA 2008

Consumption, savings & investment • This begs the question: is there an optimal level of per capita savings for an economy, which would allow the community to maximize its consumption over time? • In fact, since savings is foregone present consumption, the motivation for savings is to increase ones future standard of living (recall Tin tin's savings from a previous lecture). (C) Red Hill Capital Corp., Delaware, USA 2008

Consumption, savings & investment • So, what is an optimal level of savings? • It is not zero because, then, factors would actually wear out and the result would be a decrease in factors. • Nor would it be 100% because people will want to consume and there is no reason to invest for only investment sake. • Finding if there is an optimal level is an important question since government policy can actually influence savings. (C) Red Hill Capital Corp., Delaware, USA 2008

Factor accumulation & the Golden Rule • The so-called Golden Rule quantity of productions factors/capita will induce an optimal savings rate. • We shall examine the logic behind the golden rule. • The larger the store of an economy’s production factors, the larger will be the amount wearing out (depreciating) in each period. • Thus, a higher level of output will be requiredeach period, just to cover depreciating production factors. (C) Red Hill Capital Corp., Delaware, USA 2008

Factor accumulation & the Golden Rule • In turn, a higher level of investment will be required, in each period, inducing a higher level of per capita savings. • With a higher capital stock, the economy will also have the capability to produce more output, so the society might also enjoy higher consumption per capita, resulting in a higher standard of living. • There is a logical limit to which the per cap production factors can be raised because of decreasing marginal productivity. (C) Red Hill Capital Corp., Delaware, USA 2008

Factor accumulation & the Golden Rule • As a result, we can conclude that as the total stock of factors increases, the marginal output that can be achieved by increasing the capital stock decreases. • Therefore, there will also be a point where the marginal savings/capita out of the higher output that will be required to simply replace the existing stock of production factors will result in a decrease in consumption/capita, leaving the society worse off. (C) Red Hill Capital Corp., Delaware, USA 2008

Factor accumulation & the Golden Rule • Thus, it will not be rational to increase the savings rate beyond that point. • The point where consumption/capita cannot be increased by increasing savings is referred to as the Golden Rule savings rate. • Indeed, there is no reason that a country would naturally arrive at this perfect savings rate, and it is one place that policy might be necessary to induce it. (C) Red Hill Capital Corp., Delaware, USA 2008

Factor accumulation & the Golden Rule • However, it might be difficult, even policy-wise, because arrival at this golden perfection might require raising the savings rate, which will lower current consumption. • People might be averse to the current sacrifice, even if it means that they would be better off in the long run. (C) Red Hill Capital Corp., Delaware, USA 2008

Factor accumulation & the Golden Rule • Moreover, it might be difficult, politically, for a politician to try to change, by force, the current consumption habits of the populace since he will not want to alienate them and lose a future election. • There are examples of such situations in Southeast Asia of countries below the golden rule savings rate, while Japan, in the last century, is an example of a country that has been above the perfect savings rate. (C) Red Hill Capital Corp., Delaware, USA 2008

Factor accumulation & the Golden Rule • In the latter case, not only would it be good, in the long run, for a country that is above the perfect rate, but an immediate increase in consumption would also be a benefit. (C) Red Hill Capital Corp., Delaware, USA 2008

Technological Change • Our discussion of the golden rule assumed that technology is constant. • In fact, as the economy moves towards the golden rule savings rate, output per cap will increase as savings and investment per cap increase, and eventually, a level of consumption per cap would be reached beyond which the economy could not move, and growth would stop. (C) Red Hill Capital Corp., Delaware, USA 2008

Technological Change Plus.. • The factors of production per cap, having increased will get to a point at which savings per cap will just replace existing per cap stock, and consumption per cap will become a constant. • Fortunately, technological change can move the production function to a new path by affecting the other factor of production, labor, and labor productivity will increase output per worker given the other factors of production per cap and will result in growth. (C) Red Hill Capital Corp., Delaware, USA 2008

Technological Change Plus.. • It is simply the shifting out of the PPF per cap that we attributed, earlier, to changing technology. • Models of growth, like the Solow model, implicitly assume technological advancement, in that they allow that new investment in factors can include more technologically-advanced equipment that replaces the old. (C) Red Hill Capital Corp., Delaware, USA 2008

Technological Change Plus.. • This technological change that increases per cap labor productivity results in increased per cap output, which is increased standard of living, over time. • In addition, other things, beyond technology, per se, can result in increased per cap output. • Although we shall group such extra-technological things under the broad heading of techno change, they include things, like better labor organization, better management, and better education and training of the workforce. (C) Red Hill Capital Corp., Delaware, USA 2008

Technological Change Plus.. • The Solow model assumes that all such technological innovation is exogenous, i.e., they come from without (“exo” means outside), not within the economic system. It is not part of the model. • That is one of the faults of the model, which we shall patch up with a look at the endogenous possibilities for technological advancement. • This endogenous growth model is a more up-to-date model of macro growth. (C) Red Hill Capital Corp., Delaware, USA 2008

The Endogenous Growth Model: knowledge as a factor of production • While the Solow model did not include an internal mechanism to create technological development to promote growth, a more modern view is that technological innovation is endogenous to the economic growth, itself. • In that regard, not only does new technology increase productivity, it also adds to the knowledge base of the society. (C) Red Hill Capital Corp., Delaware, USA 2008

The Endogenous Growth Model: knowledge as a factor of production • This increased knowledge base, in turn, might provide a framework for inventing even more advanced technology. • For example, space technology of the 1960’s led to the development of microprocessors to build better mainframe computers in the 1970’s which led to development of PC’s in the 1980’s, which has resulted in many new technologies in production and communications in the 1990’s. (C) Red Hill Capital Corp., Delaware, USA 2008

The Endogenous Growth Model: knowledge as a factor of production • In light of that, it may be possible for government to have a positive impact in the process. • In order to create new knowledge, large expenditures may be required for R&D, but it is difficult to maintain a monopoly on knowledge once it becomes part of the economic process. (C) Red Hill Capital Corp., Delaware, USA 2008

The Endogenous Growth Model: knowledge as a factor of production • Thus, governments can encourage knowledge development through the issue of patents to grant temporary monopolies to the developers of knowledge. • Even so, there might be spillovers from knowledge that represent positive externalities for society but that might be disincentives for a firm who created the knowledge. (C) Red Hill Capital Corp., Delaware, USA 2008

The Endogenous Growth Model: knowledge as a factor of production • In that regard, governments might also offer tax incentives to encourage R&D. • If we consider knowledge as a true factor of production, its character is different from other factors of production. • Normally, adding production factors will increase production at a decreasing rate, but the same is not true for the addition of knowledge. (C) Red Hill Capital Corp., Delaware, USA 2008

The Endogenous Growth Model: knowledge as a factor of production • The acquisition of new knowledge might, instead of having diminishing returns, have increasing returns. • Thus, there might be justification for governments to actually subsidize development of knowledge, as in the case of publicly funded basic research at universities. (C) Red Hill Capital Corp., Delaware, USA 2008

The Endogenous Growth Model: knowledge as a factor of production • Even though some of that research is esoteric, it might have long term benefits to the community. • For example, the internet evolved as a result of some university researchers wanting to find a faster way of communicating with one another using their computers and telephone lines. (C) Red Hill Capital Corp., Delaware, USA 2008

Government policy and growth (C) Red Hill Capital Corp., Delaware, USA 2008

Overview • Governments are concerned both about long-term economic growth and the ups and downs of the shorter-term business cycles. • First, in the business cycle, it is a concern to limit the severity of downturns because they cause unemployment. • In addition, many economists believe that there are long-term effects from downturns because of the affects on both the capital stock and the skills of the workforce, which may have an affect on the long-term growth path of the economy. (C) Red Hill Capital Corp., Delaware, USA 2008

Overview • When machinery sits idle, it can dusty and creaky. • When people sit idle, their skills can dull. • It is also important to not allow an economy to overheat in the expansion phase because that can lead to poor investment decisions that will, eventually, lead to wasted money or a recession. (C) Red Hill Capital Corp., Delaware, USA 2008

Overview • Government policies should, therefore, be pursued that will aid the economy in achieving its proper long-term growth trajectory: not too fast but not too slow. • Policies to affect long-term growth will be macroeconomic and microeconomic, in nature: targeting the whole economy, in some cases, and specific industries that can help growth. (C) Red Hill Capital Corp., Delaware, USA 2008

Econ 1000: Mod 4, Lecture 8