Economic growth (III)

1

Short run or long run? (full adjustment of

capital, expectations, etc.

Classical or non-classical?(sticky wages

and prices, rationalexpectations, etc.

Classical or non-classical?(sticky wages

and prices, rationalexpectations, etc.

long-run

short-run

Neo-classicalgrowthmodel

Marxist theories?Behavior growth theories?Malthusian trap models?

yes

yes

no

no

Real business cycle (RBC);supply-side economics;

structural models;misperceptions models

Keynesian model (sloping AS, expectations-augmented

PC, IS-LM, etc.)

Schools of Macroeconomics

Agenda- A savings experiment- Theories of technological change- Real business cycles

3

Review from last week• Growth involves potential output (not business cycles)• Key assumptions: fixed s, labor growth at n, labor-

augmenting tech change at h• Laws of motion:

• Long run growth of output per person, wages, productivity at rate

• But technological change is exogenous and not satisfactorily explained.

4

=s ( ) ( )

Test the long-run equilibrium of 0:

s ( ) = ( )

k f k n h k

k

f k n h k

5

Several “comparative dynamics” experiments

• Change growth in labor force (immigration or retirement policy)

• Change in rate of TC

• Change in national savings and investment rate (tax changes, savings changes, demographic changes)

Here we will investigate only a change in the national savings rate.

6

Two faces of saving

Consumption today … or … consumption tomorrow?

The major non-cycle economic issue of today: The federal budget

deficit and debtImportant background:

National Academy Sciences, Choosing the Nation’s Fiscal Future, 2010

National Commission on Fiscal Responsibility and Reform, The Moment of Truth, 2010

The fiscal cliff at 00:00:01 am, January 1, 2013

These will be studied in coming weeks.

7

8

Bowles-Simpson Report

Why you can’t get anywhere without Econ 122:

Examples from the Commission

9

10

Government debt and deficits and the economy:

What is the effect of deficit reduction on the economy?

1. In long-run (in neoclassical growth model)• Higher savings leads to higher potential output • Mechanism: higher I → K → Y, w, etc. (through

neoclassical growth model)

2. In short run (in weeks to come)• Higher savings is contractionary • Mechanism: lower S, lower AD, lower Y, inflation

Basics of the deficit and growthAssume a closed economyI = T– G + [Y – T – C(Y-T, r)] = Govt savings + private

savings = Budget surplus + Sp

At full employment and assuming that private C does not respond significantly to r, for deficits that reduce G:

ΔI = ΔS = Δ (Budget surplus)

So this is the motivation of deficit reduction for long-run growth.

Question: what is the effect?

11

12

k

y = f(k)

(n+δ)k

y*

(I/Y)*

k*

Impact of Higher National Saving

k**

y**

i = s2f(k)

i = s1f(k)

13

Numerical Example of Deficit Reduction

Assumptions:1. Production is by Cobb-Douglas with CRTS2. Labor plus labor-augmenting TC:

1. n = 1.5 % p.a.; h = 1.5 % p.a.

3. Full employment; constant labor force participation rate.

4. Savings assumption:a. Private savings rate = 22% of GDPb. Initial govt. savings rate = minus 6 % of GDPc. In 2012, govt. changes fiscal policy to a deficit of

minus 2 % of GDP.d. All of higher govt. S goes into national S (i.e.,

constant private savings rate) and closed economy

5. “Calibrate” to U.S. economy

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Impact of Lower Govt Deficit on Major Variables

-10%

-5%

0%

5%

10%

15%

20%

25%

30%

35%

2010 2015 2020 2025 2030

Pe

rce

nt c

ha

ng

e fr

om

ba

se

line

Consumption per capita

GDP per capita

Capital per capita

NNP per capita

- Note that takes 10 years to increase C- Political

implications- Must C

increase?- No if k>kgoldenrule

15

Conclusions on Fiscal Policy and Economic Growth

• Fiscal policy affects economic growth through impact of government surplus through national savings rate

• Increases potential output through:– higher capital stock for domestic investment– higher income on foreign assets for foreign

investment• Consumption decreases at first then catches up

after a decade or so

16

Classical themes in macroeconomics:Real Business Cycle Theory

Real Business Cycles

Basic idea: cycles are caused by productivity shocks; these are propagated by changes in prices and then to labor supply.

Model Details• Start with neoclassical growth model.• Remember decomposition of output growth from growth

accounting:gY = α gK + (1-α) gL + θ, where θ = T.C.

• Changes in output come from two sources:– Technological shocks: θ random.– Changes in labor force participation: assumes very high

elasticity of labor supply with respect to wages.• This then generates random output fluctuations, which RBC

school calls business cycles.

Real output (Q)

Price (P)

AD

AS

Q*

P*

RBC recessionAS’

107

108

109

110

111

112

113

114

115

12,600 12,800 13,000 13,200 13,400

Real GDP

Pri

ce le

vel

AS2008:Q1

AS2012:Q2

RBC view of current recession

Policy implications of RBC models

• Output shocks are exogenous phenomena (earthquakes, Internet revolution, terrorist strikes, wars, etc.).

• No role for monetary or fiscal policies in cycle:– Economy and unemployment are efficient; no need for policies– Cycles are supply-driven, cannot use AD policies to stabilize

output.– Money is “neutral” (M policy cannot affect real output), so

cannot use M policy

1. Cyclical properties of classical models of the business cycle- Hard to explain deep recessions and depressions (1930s,

2007-09) as technological regress. What did we forget?

2. Money and output: is money neutral?- RBC predicts money neutral- Much evidence that M is non-neutral

3. Labor market features (such as quits and Beveridge curve)

Verdict: Economists deeply divided.

Personal view: Keynesian approach has not developed a complete microeconomic justification, but it is most promising approach to understanding sources and policies for business cycles.

Problems in RBC models

22

Promoting Technological Change

Much more difficult conceptually and for policy:- TC depends upon invention and innovation- Market failure: big gap between social MP and private

MP of inventive activity- No formula for discovery analogous to increased saving

Major instruments:- Intellectual property rights (create monopoly to reduce

MP gap): patents, copyrights- Government subsidy of research (direct to Yale; indirect

through R&D tax credit)- Rivalry but not perfect competition in markets (between

Windows and Farmer Jones)- For open economy, openness to foreign technologies

and management