slide 1

The lessons of growth theoryThe lessons of growth theory

……can make a positive difference in can make a positive difference in the lives of hundreds of millions of the lives of hundreds of millions of

people.people.These lessons help us understand why poor

countries are poor design policies that

can help them grow learn how our own

growth rate is affected by shocks and our government’s policies

slide 2

Huge effects from tiny differencesHuge effects from tiny differences

In rich countries like the U.S., if government policies or

“shocks” have even a small impact on the

long-run growth rate, they will have a huge impact

on our standard of living in the long run…

slide 3

Huge effects from tiny differencesHuge effects from tiny differences

1,081.4%243.7%85.4%

624.5%169.2%64.0%

2.5%

2.0%

…100 years…50 years…25 years

percentage increase in standard of living after…

annual growth rate of income per capita

slide 4

Huge effects from tiny differencesHuge effects from tiny differences

If the annual growth rate of U.S. real GDP per capita

had been just one-tenth of one percent higher

during the 1990s,

the U.S. would have generated an additional $449 billion of income

during that decade

slide 5

slide 6

Egypt

Chad

Pakistan

Indonesia

ZimbabweKenya

India

CameroonUganda

Mexico

IvoryCoast

Brazil

Peru

U.K.

U.S.Canada

FranceIsrael

GermanyDenmark

ItalySingapore

Japan

Finland

100,000

10,000

1,000

100

Income per person in 1992(logarithmic scale)

0 5 10 15Investment as percentage of output (average 1960–1992)

20 25 30 35 40

International Evidence on Investment International Evidence on Investment Rates and Income per PersonRates and Income per Person

slide 7

Chad

Kenya

Zimbabwe

Cameroon

Pakistan

Uganda

India

Indonesia

IsraelMexico

Brazil

Peru

Egypt

Singapore

U.S.

U.K.

Canada

FranceFinlandJapan

Denmark

IvoryCoast

Germany

Italy

100,000

10,000

1,000

1001 2 3 40

Income per person in 1992(logarithmic scale)

Population growth (percent per year) (average 1960–1992)

International Evidence on Population International Evidence on Population Growth and Income per PersonGrowth and Income per Person

slide 8

Examples of technological progressExamples of technological progress

1970: 50,000 computers in the world2000: 51% of U.S. households have 1 or more computers

The real price of computer power has fallen an average of 30% per year over the past three decades.

The average car built in 1996 contained more computer processing power than the first lunar landing craft in 1969.

Modems are 22 times faster today than two decades ago.

Since 1980, semiconductor usage per unit of GDP has increased by a factor of 3500.

1981: 213 computers connected to the Internet2000: 60 million computers connected to the Internet

slide 9

Policies to promote growthPolicies to promote growth

Four policy questions:

1. Are we saving enough? Too much?

2. What policies might change the saving rate?

3. How should we allocate our investment between privately owned physical capital, public infrastructure, and “human capital”?

4. What policies might encourage faster technological progress?

slide 10

1. Evaluating the Rate of Saving1. Evaluating the Rate of Saving

Use the Golden Rule to determine whether our saving rate and capital stock are too high, too low, or about right.

To do this, we need to compare (MPK ) to (n + g ).

If (MPK ) > (n + g ), then we are below the Golden Rule steady state and should increase s.

If (MPK ) < (n + g ), then we are above the Golden Rule steady state and should reduce s.

slide 11

1. Evaluating the Rate of Saving1. Evaluating the Rate of Saving

To estimate (MPK ), we use three facts about the U.S. economy:

1. k = 2.5 yThe capital stock is about 2.5 times one year’s GDP.

2. k = 0.1 yAbout 10% of GDP is used to replace depreciating capital.

3. MPK k = 0.3 yCapital income is about 30% of GDP

slide 12

1. Evaluating the Rate of Saving1. Evaluating the Rate of Saving

1. k = 2.5 y

2. k = 0.1 y

3. MPK k = 0.3 y

0 12 5..

k yk y

0 10 04

2 5.

..

To determine , divided 2 by 1:

slide 13

1. Evaluating the Rate of Saving1. Evaluating the Rate of Saving

1. k = 2.5 y

2. k = 0.1 y

3. MPK k = 0.3 y

MPK 0 32 5..

k yk y

0 3MPK 0 12

2 5.

..

To determine MPK, divided 3 by 1:

Hence, MPK = 0.12 0.04 = 0.08

slide 14

1. Evaluating the Rate of Saving1. Evaluating the Rate of Saving

From the last slide: MPK = 0.08

U.S. real GDP grows an average of 3%/year,

so n + g = 0.03

Thus, in the U.S.,MPK = 0.08 > 0.03 = n + g

Conclusion: The U.S. is below the Golden Rule steady state: The U.S. is below the Golden Rule steady state: if we increase our saving rate, we will have faster if we increase our saving rate, we will have faster growth until we get to a new steady state with growth until we get to a new steady state with higher consumption per capita.higher consumption per capita.

The U.S. is below the Golden Rule steady state: The U.S. is below the Golden Rule steady state: if we increase our saving rate, we will have faster if we increase our saving rate, we will have faster growth until we get to a new steady state with growth until we get to a new steady state with higher consumption per capita.higher consumption per capita.

slide 15

2. Policies to increase the saving rate2. Policies to increase the saving rate

Reduce the government budget deficit(or increase the budget surplus)

Increase incentives for private saving: reduce capital gains tax, corporate

income tax, estate tax as they discourage saving

replace federal income tax with a consumption tax

expand tax incentives for IRAs (individual retirement accounts) and other retirement savings accounts

slide 16

3. Allocating the economy’s investment3. Allocating the economy’s investment

In the Solow model, there’s one type of capital.

In the real world, there are many types,which we can divide into three categories:– private capital stock– public infrastructure– human capital: the knowledge and

skills that workers acquire through education

How should we allocate investment among these types?

slide 17

4. Encouraging technological progress4. Encouraging technological progress

Patent laws:encourage innovation by granting temporary monopolies to inventors of new products

Tax incentives for R&D

Grants to fund basic research at universities

Industrial policy: encourage specific industries that are key for rapid tech. progress (subject to the concerns on the preceding slide)

slide 18

CASE STUDY: CASE STUDY: The Productivity SlowdownThe Productivity Slowdown

1.5

1.8

2.6

2.3

2.0

1.6

1.8

2.2

2.4

8.2

4.9

5.7

4.3

2.9

1972-951948-72

U.S.

U.K.

Japan

Italy

Germany

France

Canada

Growth in output per person(percent per year)

slide 19

Explanations?Explanations?

Measurement problemsIncreases in productivity not fully measured.– But: Why would measurement problems

be worse after 1972 than before?

Oil pricesOil shocks occurred about when productivity slowdown began.– But: Then why didn’t productivity speed

up when oil prices fell in the mid-1980s?

slide 20

Explanations?Explanations?

Worker quality1970s - large influx of new entrants into labor force (baby boomers, women).New workers are less productive than experienced workers.

The depletion of ideasPerhaps the slow growth of 1972-1995 is normal and the true anomaly was the rapid growth from 1948-1972.

slide 21

The bottom line:The bottom line:

We don’t know which of these We don’t know which of these is the true explanation, is the true explanation,

it’s probably a combination it’s probably a combination of several of them.of several of them.

We don’t know which of these We don’t know which of these is the true explanation, is the true explanation,

it’s probably a combination it’s probably a combination of several of them.of several of them.

slide 22

CASE STUDY: CASE STUDY: I.T. and the “new economy”I.T. and the “new economy”

2.9

2.5

1.1

4.7

1.7

2.2

2.7

1.5

1.8

2.6

2.3

2.0

1.6

1.8

2.2

2.4

8.2

4.9

5.7

4.3

2.9

1995-20001972-951948-72

U.S.

U.K.

Japan

Italy

Germany

France

Canada

Growth in output per person(percent per year)

slide 23

CASE STUDY: CASE STUDY: I.T. and the “new economy”I.T. and the “new economy”

Apparently, the computer revolution didn’t affect aggregate productivity until the mid-1990s.

Two reasons:1.Computer industry’s share of GDP much

bigger in late 1990s than earlier. 2.Takes time for firms to determine how to

utilize new technology most effectively

The big questions: Will the growth spurt of the late 1990s

continue? Will I.T. remain an engine of growth?

slide 24

Money supply measures, Money supply measures, April 2002April 2002

_Symbol Assets included Amount (billions)_

C Currency $598.7

M1 C + demand deposits, 1174.0 travelers’ checks, other checkable deposits

M2 M1 + small time deposits,5480.1

savings deposits, money market mutual funds, money market deposit accounts

M3 M2 + large time deposits,8054.4

repurchase agreements, institutional money market mutual fund balances

slide 25

slide 26

slide 27

slide 28

slide 29

The social costs of inflationThe social costs of inflation

…fall into two categories:

1. costs when inflation is expected

2. additional costs when inflation is different than people had expected.

slide 30

The costs of expected inflation: The costs of expected inflation: 11.. shoeleather costshoeleather cost

def: the costs and inconveniences of reducing money balances to avoid the inflation tax.

i

real money balances

Remember: In long run, inflation doesn’t affect real income or real spending.

So, same monthly spending but lower average money holdings means more frequent trips to the bank to withdraw smaller amounts of cash.

slide 31

The costs of expected inflation: The costs of expected inflation: 22.. menu costsmenu costs

def: The costs of changing prices.

Examples:– print new menus– print & mail new catalogs

The higher is inflation, the more frequently firms must change their prices and incur these costs.

slide 32

The costs of expected inflation: The costs of expected inflation: 33.. relative price distortionsrelative price distortions

Firms facing menu costs change prices infrequently.

Example: Suppose a firm issues new catalog each January. As the general price level rises throughout the year, the firm’s relative price will fall.

Different firms change their prices at different times, leading to relative price distortions…

…which cause microeconomic inefficiencies in the allocation of resources.

slide 33

The costs of expected inflation: The costs of expected inflation: 44.. unfair tax treatmentunfair tax treatment

Some taxes are not adjusted to account for inflation, such as the capital gains tax.

Example: 1/1/2001: you bought $10,000 worth of

Starbucks stock 12/31/2001: you sold the stock for $11,000,

so your nominal capital gain was $1000 (10%).

Suppose = 10% in 2001. Your real capital gain is $0.

But the govt requires you to pay taxes on your $1000 nominal gain!!

slide 34

The costs of expected inflation: The costs of expected inflation: 44.. General inconvenienceGeneral inconvenience

Inflation makes it harder to compare nominal values from different time periods.

This complicates long-range financial planning.

slide 35

Additional cost of Additional cost of unexpectedunexpected inflation: inflation: arbitrary redistributions of purchasing powerarbitrary redistributions of purchasing power

Many long-term contracts not indexed, but based on e.

If turns out different from e, then some gain at others’ expense.

Example: borrowers & lenders

• If > e, then (r ) < (r e) and purchasing power is transferred from lenders to borrowers.

• If < e, then purchasing power is transferred from borrowers to lenders.

slide 36

Additional cost of high inflation: Additional cost of high inflation: increased uncertaintyincreased uncertainty

When inflation is high, it’s more variable and unpredictable: turns out different from e more often, and the differences tend to be larger (though not systematically positive or negative)

Arbitrary redistributions of wealth become more likely.

This creates higher uncertainty, which makes risk averse people worse off.

slide 37

Recent episodes of hyperinflation Recent episodes of hyperinflation

slide 38

slide 39

slide 40

Business CyclesBusiness Cycles

Business Cycles

–Business cycles are 2-year to 5-year fluctuations around trends in real GDP and other related variables

–A recession is a large fall in the growth of real GDP and related variables

•A depression is an especially large recession

slide 41

Business CyclesBusiness Cycles

slide 42

Real GDP Growth in the United StatesReal GDP Growth in the United States

-4

-2

0

2

4

6

8

10

1960 1965 1970 1975 1980 1985 1990 1995 2000

Percent change from 4 quarters

earlierAverage growth

rate = 3.5%

slide 43

Recessions in the U.S. since World War IIRecessions in the U.S. since World War II

Year and quarter of peak in RGDP

Number of quarters until trough in RGDP

Change in RGDP, peak to trough (%)

1948:4

1953:2

1957:3

1960:1

1970:3

1973:4

1980:1

1981:3

1990:2

2

3

2

3

1

5

2

4

3

-1.7

-2.7

-3.7

-1.6

-1.1

-3.4

-2.2

-2.9

-1.5

No simple regular or cyclical pattern: output changes very considerably in size and spacing

slide 44

Behavior of the Components of Behavior of the Components of Output in RecessionsOutput in Recessions

Component of GDP

Average Share in GDP (%)

Average Share in fall in GDP in recessions relative to normal growth (%)

Consumption Durables Nondurables Services

Investment Residential Business Fixed Inventories

Net Export

Gov’t Purchases

8.425.829.5

4.710.70.7

-0.4

20.6

15.611.29.1

20.911.740.6

-12.3

3.3

Fluctuations are distributed very unevenly over the components of output

slide 45

Cyclical Behavior of Cyclical Behavior of Key Macroeconomic VariablesKey Macroeconomic Variables

Procyclical variable

– An economic variable that moves in the “same” direction as aggregate economic activity

industrial production, consumption, investment, employment, real wage, inflation, stock prices

Countercyclical variable

– An economic variable that moves in the “opposite” direction as aggregate economic activity

unemployment

slide 46

Supply shocksSupply shocks

A supply shock alters production costs, affects the prices that firms charge. (also called price shocks)

Examples of adverse supply shocks: Bad weather reduces crop yields, pushing up

food prices. Workers unionize, negotiate wage increases. New environmental regulations require firms

to reduce emissions. Firms charge higher prices to help cover the costs of compliance.

(Favorable supply shocks lower costs and prices.)

slide 47

CASE STUDY: CASE STUDY: The 1970s oil shocksThe 1970s oil shocks

Early 1970s: OPEC coordinates a reduction in the supply of oil.

Oil prices rose11% in 1973 68% in 1974 16% in 1975

Such sharp oil price increases are supply shocks because they significantly impact production costs and prices.

slide 48

1P SRAS1

Y

P

AD

LRAS

YY2

The oil price shock shifts SRAS up, causing output and employment to fall.

A

BIn absence of further price shocks, prices will fall over time and economy moves back toward full employment.

2P SRAS2

CASE STUDY: CASE STUDY: The 1970s oil shocksThe 1970s oil shocks

A

slide 49

CASE STUDY: CASE STUDY: The 1970s oil shocksThe 1970s oil shocks

Predicted effects of the oil price shock:• inflation • output • unemployment

…and then a gradual recovery.

0%

10%

20%

30%

40%

50%

60%

70%

1973 1974 1975 1976 1977

4%

6%

8%

10%

12%

Change in oil prices (left scale)

Inflation rate-CPI (right scale)

Unemployment rate (right scale)

slide 50

CASE STUDY: CASE STUDY: The 1970s oil shocksThe 1970s oil shocks

Late 1970s:

As economy was recovering, oil prices shot up again, causing another huge supply shock!!!

0%

10%

20%

30%

40%

50%

60%

1977 1978 1979 1980 1981

4%

6%

8%

10%

12%

14%

Change in oil prices (left scale)

Inflation rate-CPI (right scale)

Unemployment rate (right scale)

slide 51

CASE STUDY: CASE STUDY: The 1980s oil shocksThe 1980s oil shocks

1980s: A favorable supply shock--a significant fall in oil prices.

As the model would predict, inflation and unemployment fell:

-50%

-40%

-30%

-20%

-10%

0%

10%

20%

30%

40%

1982 1983 1984 1985 1986 1987

0%

2%

4%

6%

8%

10%

Change in oil prices (left scale)

Inflation rate-CPI (right scale)

Unemployment rate (right scale)