Transcript Lecture 7: Macro: Growth of the National Economy

Economics for CED
Noémi Giszpenc
Spring 2004
Lecture 7: Macro: Growth
of 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:
1. More stuff produced
2. Prices rise with no change in quality
3. Prices rise with increase in quality
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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?
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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
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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.
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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
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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 goods
whose prices have risen less to achieve
same levels of well-being.
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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:
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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
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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%
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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."
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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.
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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?
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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…
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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:
in
2 yrs
=
4.04% 22%
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10 yrs
20 yrs
35 yrs 50 yrs
49%
twice
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2.7 times
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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
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Visualizing economic growth
• Real GDP growth is
supposed to measure
an increase in the
ability to produce
many different
things (a shift
outward in the
production possibilities frontier)
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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
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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
–
•
•
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Because of different bargaining power
Thus free trade is rational for winners but not for everybody.
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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.
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Classical Economists
•
Adam Smith (1723-1790):
1. Increasing division of labor increases the
productivity of labor.
2. “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
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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.
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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.
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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.
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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.
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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.
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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
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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.
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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.
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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.
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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
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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
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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:
•
1.
2.
–
–
–
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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.
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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.
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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.
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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
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–
–
–
–
–
–
–
Entrepreneurship
Tolerance of innovation
Work culture
Saving and investment
Foreign exchange
External markets and terms of trade
Opportunity costs for the educated
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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 
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