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TOPIC 2. The Supply Side of the Economy. Goals of Lecture 2. Introduce the supply side of the macro economy. Discuss how countries grow and why some countries grow faster than others. Discuss labor productivity What does it mean? How does it respond coming out of recessions?

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TOPIC 2

The Supply Side of the Economy

• Introduce the supply side of the macro economy.

• Discuss how countries grow and why some countries grow faster than others.

• Discuss labor productivity

• What does it mean?

• How does it respond coming out of recessions?

• Determine how wages are set in an economy. Determine why people work.

• Understand where unemployment comes from.

• GDP (Y) is produced with capital (K, price-weighted) and labor (N, hours):

Y = A F(K,N)

• Sometimes, I will modify the production function such that:

Y = A F(K,N, other inputs) – where other inputs include energy/oil!

• Realistic Example is a Cobb Douglas function for F(.):

Y = A K.3 N.7

A is Total Factor Productivity (TFP), an index of efficiency (technology)

MUST READ: NOTES 3 (my text posted on the teaching page) on the aggregate production function

• Y is GDP (measured in dollars). As noted above, we want to measure Y in “real” dollars.<<you should know what this means from Notes 1 of the text>>.

• For our Cobb Douglas production function (previous slide), N and K are both measured in dollars.

• N often is measured in total wage bill

• K often is measured as the replacement cost of capital

• However, in practice, N can be measured in different ways (hours worked, number of workers).

• Wage bill is the preferred method (takes into account “skill” differentials).

• However, we will often talk about standard of livings which is income per capita (Y/N ; where Y is income and N is some population measure).

Define MPN = Marginal Product of Labor = dY/dN

Define MPK = Marginal Product of Capital = dY/dK

Math Note: You should be comfortable taking these simple partial derivatives– if you are not, practice this for the quizzes and exams.

Diminishing Marginal Products

From Cobb-Douglas: MPN = .7 A (K/N).3 = .7 (Y/N)

Fixing A and K, MPN falls when N increases

MPK = .3 A (N/K).7 = .3 (Y/K)

Fixing A and N, MPK falls when K increases

Complementarity Across Inputs

Increasing A or K, increases MPN

Increasing A or N, increases MPK

• Labor Productivity = Y/N = A (K/N).3

Driven by A and K/N (usually reported in press)

• Total Factor Productivity (TFP) = A = Y/F(K,N)

• Basically TFP is a ‘catch-all’ for anything that affects output other than K and N.

• Work week of labor and capital

• Quality of labor and capital

• Regulation

• Infrastructure

• Competition

• Specialization

• Innovation (including innovation in management practices)

• Changes in “discrimination” or “culture”

• Some components of TFP tends to be pro-cyclical

• (Definition of Pro-cyclical: Variable increases when Y is high, decreases when Y is low)

Sub-Section A

Economic Growth

Y = A K.3 N .7 (our production function)

%ΔY = %ΔA + .3%ΔK + .7%ΔN

Output, in a country grows from:

Growth in TFP (see entrepreneurial ability, education, roads, technology, etc.)

Growth in Capital (machines, equipment, plants)

Growth in Hours (workforce, population, labor participation, etc).

Perhaps, we care about growth in Y/pop or Y/N (per capita output).

%Δ(Y/pop) = %ΔA + .3%Δ(K/pop) + .7%Δ(N/pop)

or

%Δ(Y/N) = %ΔA + .3%Δ(K/N)

Y/N evolves by:

Y falling (holding N constant) decreases Y/N

N falling (holding Y constant) increases Y/N

In recessions, both Y and N fall.

The question of interest:

Does Y or N fall more during a recession?

During recent recessions:

N falls more than Y

Y/N (a measure of productivity) actually increases

We are producing more stuff – with less workers – during the recession!

Note: The fact that productivity increases during recent recoveries is directly linked to the fact that recent recoveries have been “jobless” (discussed in lecture 1). The economy recovers but employment lags.

Why are there jobless recoveries?

Does a one time increase ininvestment today increase Y/N today? YES!

Does a one time increase ininvestment today cause a sustained increase in Y/N into the future? No!

Back of our mind equations:

S = I + NX (From the first lecture). Notice the link between saving and investment.

K(t+1) = (1-δ) K(t) + I(t) Definition of Capital Stock Evolution

or

ΔK(t, t+1) = I(t) - δ K(t)

All else equal (i.e. holding N constant), increasing I causes K tomorrow to increase causing K/N tomorrow to increase (i.e. Y/N tomorrow increases).

K

No investment

No investment

time

t+1

Suppose there is a one time increase in investment at time t (perhaps due to an investment

tax credit). Suppose no investment either prior to or after the tax credit.

Can Higher Investment Lead to Infinite Growth?

Does a sustained increase ininvestment increase Y/N today? YES!

Does a sustained increase ininvestment cause a sustained increase in Y/N? No!

Suppose I is fixed at a high level and that K initially is sufficiently small.

K grows if I > δ K: But, notice that δK is also growing each period.

(Summary: To start, higher I will lead to higher K and Y/N will increase).

Eventually, however, I will converge towards δK More and more of the investment is going to replace outdated capital and the capital stock will grow by smaller and smaller rates. The increase in Y/N will converge back to zero.

Summary: High levels of investment will increase the capital stock and output, but both K and Y will eventually converge to a fixed level.

K

The new level of investment has successively less effect

due to growing depreciation of the capital stock.

No investment

time

t+1

Suppose there is a permanent increase in investment at time t. Suppose no investment

prior to t. In all periods after t, the level of investment remains fixed at the level in t.

Can Higher Investment Growth Cause Infinite Growth?

If a one time increase in I gives an increase in Y, why not continuously raise I to higher and higher amounts??? Answer: Diminishing MPK!!!

MPK = .3 A (N/K) .7; As K increases, MPK falls.

As K goes to infinity, MPK goes to zero (Y stops increasing).

Suppose, we keep rising I (each year), K will increase by the amount of I (after controlling for depreciation), but Y will increase by continuously smaller and smaller amounts.

Remember Y = C + I + G + NX. I/Y (investment rate) is bounded by 1 (if you invest all your output). This caps the increase in I. I cannot grow forever!

Continuously increasing I will NOT lead to sustained economic growth!

NOTE: Investment decisions are NOT made in the dark (i.e. something must drive firm investment!!!!!)

Sustained Increases in the growth of A are the only thing that can cause a sustained growth in Y/N.

Empirically, when a country exhibits faster Y/N growth …..

33% typically comes from growth in K/N

67% typically comes from growth in A

(where N = employment (not hours) - limited data).

Most developed economies grow at the same rate that the “technological frontier” grows.

Convergence – countries inside of the technological frontier move towards the technological frontier.

Divergence – countries inside of the technological frontier grow at a rate less than the technological frontier.

Reading: #102, 103 (you can read for reference – fit in with topics later in the course as well)

From Barro, 2003 – includes 147 countries. Horizontal axis is a log scale.

All data are in 1995 U.S. dollars.

From Barro, 2003 – includes 113 countries. Horizontal axis is a log scale.

All data are in 1995 U.S. dollars.

From Barro, 2003 – includes 111 countries.

U.S. is anchored at 1 in both years. Countries above the line have made gains relative to U.S.

Baseline:

Y/person in U.S. grows roughly by 2%/year (real).

Assume a constant growth rate of 2% per year (real) for next 30 years.

After 30 years, U.S. Y/person will be 81% higher than today.

Scenario 1: Major recession today

Suppose U.S. Y/person contracts 3% this year and next and then grows at 2% for

next 28 years.

After 30 years, U.S. Y/person will be 64% higher than today.

Scenario 2: Major recession today and we fight it using tax and spending

policy with little detriment to future growth

Suppose U.S. Y/person grows at -1% this year, 0% next and then grows at 1.9% for

next 28 years.

After 30 years, U.S. Y/person will be 68% higher than today.

Take Away: Y/person in the future is HIGHER relative to doing nothing!

68% > 64%

Scenario 3: Major recession today and we fight it using tax and spending

policy with BIG detriment to future growth

Suppose U.S. Y/person grows at -1% this year, 0% next and then grows at 1.7% for

next 28 years.

After 30 years, U.S. Y/person will be 59% higher than today.

Take Away: Y/person in the future is LOWER relative to doing nothing!

59% < 64%

Conclusion: Fighting recessions today may have affects on future growth.

Benefits of fighting recession depends on whether the policies

used to prevent the recession affect future growth!

Bonus Section

New Research Project:

“The Allocation of Talent and Economic Growth”

(Trying to Shed Light on the Black Box of TFP Growth)

• The way TFP (A) is usually measured is via a statistical decomposition (referred to as the “Solow Residual”).

• Remember our assumed production function: Y = AK.3N.7

• Math Note: We are going to transform the production function to make it a little easier to work with (you should get comfortable with this) by taking the logs:

• ln(Y) = ln(A) + α0ln(K) + α1ln(N) (where α0 = 1 – α1 ≈ 0.3) (1)

• Given that we measure Y, K and N in the data, we can estimate (1) using standard regression techniques.

• ln(A) is the constant from the regression. This is our standard TFP measure.

Because A (TFP) is a catch-all term for anything that affects production, the assumed production function does not impose any structure on how to measure the components of TFP.

Economists are very good at measuring the extent to which TFP changes over time within a country.

It is much harder to measure “why” TFP has changed over time.

Economists try to measure this by using detailed firm-level and household-level data to measure production and wages.

Question 1:

How much of the observed TFP growth in the U.S. since 1960 is due to better labor market outcomes (including human capital formation) for blacks and women?

o A better allocation of resources leads to higher economic growth!

o There have been HUGE changes in the allocation of women and blacks in the labor market since 1960.

Question 2:

How much of the convergence of the U.S. south to the U.S. north is due to a decline in discrimination of the south?

Occupational Sorting Over Time: An Overview

Fraction of group (white men, white women, black men, black women) aged 25-55 working in the following occupations:

Executives, Mgmt, Architects, Engineers, Math/Computer Science, Natural Scientists, Doctors, and Lawyers.

19602006-2008

White Men 21.2% 23.5%

White Women 3.0 (7.3) 17.4 (21.0)

Black Men 2.8 14.6

Black Women 1.0 (2.1) 13.0 (15.2)

Data: U.S. Census and American Community Survey

Occupational Sorting Over Time: An Overview

Where were the other groups working in 1960?

53% of working white women worked in Nursing, Teaching, Sales, Secretarial and Office Assistances, and Food Prep/Service.

o The comparable number for white men was 14% (mostly sales)

55% of working black men worked as Freight/Stock Handlers, Motor Vehicle Operators, Machine Operators, Janitorial Services, and Personal Services.

o The comparable number for white men was 19%

47% of working black women worked in Household Services, Personal Services, and Food Prep/Services.

o The comparable number for white men was 2%

Wage Gaps Over Time: An Overview

Log difference in annual earnings of full time workers, conditional on experience, hours and occupation controls (relative to White Men)

196019802008

White Women -0.56 -0.47 -0.26

Black Men -0.37 -0.21 -0.16

Black Women -0.82 -0.47 -0.31

Findings

Macro Implications:

o 15% − 20% of total wage growth in the U.S. between 1960 and 2008 was due to declining frictions for white women, black women, and black men. (Shines some light into the black box of TFP growth)

o Other interesting results:

- Wage growth in the 1970s and the 2000s would have been negative

absent the labor market improvements for blacks and women.

- About 40% of the convergence of the south to the northeast between 1960 and 1980 is due to declining labor market frictions.

- Not much remaining room for growth from this mechanism.

Counterfactual 2: 2008 δ’s

-15%

Results/Counterfactuals: Model 1

• Base Model Prediction: 76.6% income increase (1.2 percent/year)

• Increase explained by changing δ’s: 12.2 percentage points (chained weighted, avg.)

• Percent of growth explained by changing δ’s: ~20%

Sub-Section B

The Labor Market

• In a competitive market, a firm can sell as much Y as it wants at the going price p, and can hire as much N as it wants at the going wage w.

• Facing w and p, a profit maximizing firm will hire N to the point were MPN = w/p (the benefit from an additional worker (in terms of additional output) must equal the cost which they are paid). <<This is straight from micro>>

• With Cobb-Douglas: MPN = .7 Y/N = .7 A (K/N).3

• If firms maximize profits: w/p = .7 Y/N = .7 A (K/N).3

• If MPN > w/p then the firm can increase profits by increasing N.

• If MPN < w/p then the firm can increase profits by decreasing N.

Reading: Notes 4 from the supplemental notes

real wage

w/p *

MPN = Nd

N

N*

• Nd slopes downward (Nd = MPN = .7A * (K/N).3)

• Nd rises with A and K (assumed complementarity across inputs)

• Assumption: Y is not Fixed! Firms optimally choose N, K, Y and (to some extent) A to maximize profits.

• Caveat: Who says that there is a demand for more Y?

• Need to look at the demand side of economy (introduced last -discussed in depth throughout the course).

• Labor Supply (Ns) Results from Individual Optimization Decisions

• Households compare benefits of working (additional lifetime resources) with cost of working (forgone leisure)

• Factors Affecting Labor Supply

• The Real Wage (w/p)

• The Household’s Present Value of Lifetime Resources (PVLR)

• The Marginal Tax Rate on Labor Income (tn)

• The Marginal Tax Rate on Consumption (tc)

• Value of Leisure (reservation wage) - non- ‘work’ status (VL)

• The Working Age Population (pop)

Ns(PVLR, tc, tn, pop, VL)

w/p

N

• In terms of ‘wages and earnings’, there is both an income and substitution effect - we will look at them separately – BUT in the real world, they often occur jointly!!!!

• The Real Wage - HOLDING PVLR fixed: A higher w/p encourages individuals to substitute away from leisure and toward work (leisure becomes more expensive). This is a substitution effect. <<This is why the labor supply curve slopes upwards!!>>

• Estimating this substitution effect is difficult since PVLR is not easily held constant. Estimates range from 0 - 2% (For a 1% increase in after-tax w/p holding PVLR fixed, labor supply either increases by 0% or 2%). Very Wide Range – little consensus.

• PVLR = initial wealth + present discounted value of earnings

• A higher PVLR induces individuals to work less (lower Ns) for a given after-tax wage, allowing them to enjoy more leisure (If leisure is preferred to work – as I get richer, I can afford to work less).

• PVLR is net of taxes and non-work governmental transfers and inclusive of all other transfers.

• Marginal tax rate on labor income - Should have same substitution effect as the before tax real wage. Studies of the 1986 U.S. Tax Reform found that only high-earning married women worked more in response to lower marginal income tax rates.

• Marginal tax rate on consumption - see above

• Value of Leisure - If leisure/no-work becomes more/less attractive, households will less/more (reservation wage). (Welfare programs, child care, etc.).

• Working Age Population: Usually defined as 16-64. (Includes changes in Labor Force Participation Rates)

• Substitution Effect:

• For a given PVLR, a higher after tax wage increases NS.

(This is why Labor Supply Curve Slopes Upward)

• Income Effect

• For a given after-tax wage, higher PVLR decreases Ns.

• Evidence:

• Weak Consensus is that, with equal (%) increase in PVLR and the after-tax wage, Ns falls (income effect dominates).

Ns(PVLR, tc, tn, pop, VL)

w/p

w/p *

N d(A,K)

N

N*

Ns(PVLR, tc, tn, pop, VL)

w/p

w/p *

N d(A,K)

N

N*

Facts: A, N, w/p are trending up over time.

N/pop is trending down (except in U.S. since 1980).

Higher A countries have higher w/p and lower N/pop.

Implications:

Adjusting for pop, higher A goes with lower N.

Higher A reduces Nd and destroys jobs? - NO!

Labor Demand Increases.

Higher A increases PVLR and reduces Ns - The Effect on Labor Supply is to fall.

Ns(PVLR, tc, tn, pop, VL)

w/p

w/p *

N d(A,K)

N

N*

Temporary Increase in Taxes (tc or tn)

Ns(PVLR, tc, tn, pop, VL)

w/p

w/p *

N d(A,K)

N

N*

Permanent Increase in Taxes (tc or tn)

Ns(PVLR, tc, tn, pop, VL)

w/p

w/p *

N d(A,K)

N

N*

• We define Long Run Equilibrium in macroeconomics as occurring when the labor market clears.

• By definition, long run macro equilibrium exists when N = N*.

• At N*, labor demand = labor supply. So, by definition, all workers who want a job (the suppliers) are able to find a firm looking for a worker (the demanders).

• Implies that cyclical unemployment = zero at N*.

• Long run equilibrium is characterized by zero cyclical unemployment!

• It is an equilibrium in that there is no incentive for real wages to change at N*

• Real wages (w/p) has two components: nominal wages (w) and the price level (p).

• Note: Y* (by definition) = A K.3(N*).7

• Y* is the long run equilibrium level of output (output where labor market is in equilibrium)

• Suppose prices (p) increase. What happens in the labor market?

• In terms of equilibrium, nothing happens!

• Increasing prices have no effect on labor demand (A and K do not change).

• Increasing prices have no effect on labor supply (taxes, population, etc. do not change).

• You may ask “Doesn’t PVLR change when prices increase???” No!

• As long as nominal wages adjust, real wages will be unchanged when p increases.

• The % change in prices will be match exactly by the % change in nominal wages – real wages will not change (so PVLR will not change).

• No effect on labor supply.

• Key: Because real wages will not change, changes in prices will have NO effect on the labor market (i.e., it will have no effect on N*).

• Conclusion: Changing prices will have NO effect on Y* (since N* is constant).

LRAS – Long Run Aggregate Supply Curve

p

Y

Y*

• If labor market clears, changes in prices will lead to equal changes in nominal wages.

As a result, there will be no change in N* and hence, no change in Y*.

• Leads to a vertical LRAS curve. Prices do not affect production in the long run!

• Anything that affects the labor market will affect Y*!

• If N* increases, Y* will shift to the right.

• If N* decreases, Y* will shift to the left.

• Summary: Y* will shift right if:

• A increases

• K increases

• population increases

• labor income taxes fall (and income effect is small relative to substitution effect)

• labor income taxes rise (and income effect is large relative to substitution effect)

Note: The long run aggregate supply curve (LRAS) is NOT the labor supply curve. We have lots of different markets in this class. There will be lots of different supply and demand curves. You need to keep track of them!

• The demand side of the economy is NOT important for determining Y*!

• All we need to know is A, K and N and we know Y*!

• The demand side of the economy is not important for economic growth!

• Key: If I ever ask you about what determines Y* (i.e., output/income/expenditure in the long run), you should think about A, K and the labor market.

• As a rule, K will be fixed unless I tell you otherwise (for simplicity, you will see why soon).

• Why do we care about the demand side of the economy?

• In the long run, prices will be determined by demand.

• Also, LRAS is dependent on labor market being in equilibrium. In the short run, labor market need not be in equilibrium.

• Demand will determine output in the SHORT RUN!

• In the long run – when labor markets clear.

• Supply side of economy (labor market, K, A, other inputs like oil) determines output.

• Demand side of economy (C+I+G+NX) will determine prices.

• In the short run – when labor markets do not clear:

• Demand and Supply jointly determine prices and output (think of the simple examples I gave graphically in the lecture for topic 1).

• Three outstanding issues (we will get to them soon):

• When is the labor market NOT in equilibrium?

• What does the supply curve look like when labor market doesn’t clear?

• What determines demand?

• Labor market is in disequilibrium when labor demand is not equal to labor supply.

• Any time labor demand = labor supply, there is no cyclical unemployment (by definition)!

• Nominal wages do not adjust to clear the labor market

• We refer to this as ‘sticky’ wages.

• Because of wage contracts (and uncertainty), nominal wages do not always adjust immediately.

• Need a model for short-run disequilibrium --- we will do that in Topic 6.

• When do we get cyclical unemployment in our models?

• Cyclical unemployment occurs when there are no jobs available (labor demand) for those with the skills and the desire to work (labor supply) at current wages.

• Cyclical unemployment occurs only in disequilibrium! (when desired labor demand < desired labor supply - at given wages)

Ns

a

b

w’/p’

Nd

Unemployment

N(1)

N(0)

• There are microeconomic fundamentals to the supply side of the economy –

• Capital accumulation, Labor and TFP are important for production AND Growth!!!

• Some countries grow faster than others because they have rapid growth in TFP or K/N.

• Only growth in TFP can lead to sustained growth in Y/N

• How Labor Markets Work - The Role of Taxes, Technological Progress, Capital Accumulation, And Demographics on Wages and Employment.

• Demand is not important for determining long run output (i.e., income, standard of livings, etc.). Supply (production) is the only thing that determines output in the long run!

Some Facts: Wages and Local Economic Activity Cycle Effects of Labor MarketsVariation Across U.S. States

Some Facts: Wages and Local Economic Activity Cycle Effects of Labor MarketsVariation Across U.S. States

My Recent Research on Housing/Manufacturing Cycle Effects of Labor Markets

• Two new papers with Kerwin Charles (Harris School) and Matt Notowidigdo (Booth).

• Exploit regional patterns in:

o Manufacturing declines during 2000s (predicted by initial share of manufacturing in metropolitan area in year 2000).

o Housing booms during 2000s (predicted by discrete changes in housing prices in metropolitan area during early 2000s).

• Analyze effects of changes on overall employment rates, wages, employment by sector, migration, human capital attainment, etc.

Intuition of the Model: Labor Supply and Labor Demand Cycle Effects of Labor Markets

Labor Supply

Wages

(W/P)1

(W/P)2

Labor Demand

N2

N

N1

Predicted Manufacturing Change vs. Cycle Effects of Labor MarketsChange in Non-Employment, Non College Men 2000-2007

Bigger Manufacturing Decline

Predicted Manufacturing Change vs. Cycle Effects of Labor MarketsChange in Non-Employment, Non College Men 2000-2007

Increase in Non-Employment

Bigger Manufacturing Decline

Predicted Housing Demand Change vs. Cycle Effects of Labor MarketsChange in Non-Employment, Non College Men 2000-2007

Bigger Housing Demand Shock

Counterfactuals From Our Paper Cycle Effects of Labor Markets

Estimated Effect of Manufacturing Decline on Non-Employment Cycle Effects of Labor Markets

~42%

Explained

Estimated Effect of Housing Cycle on Non-Employment Cycle Effects of Labor Markets

Manufacturing Decline

Housing Cycle (Construction and Other)

The Housing Boom Cycle Effects of Labor MarketsMasked The Manufacturing Decline in 2000s

Data

Manufacturing

Housing + Manufacturing

The Housing Boom Cycle Effects of Labor MarketsMasked The Manufacturing Decline in 2000s

Data

34%

During

Recession

Manufacturing

Housing + Manufacturing

Two Other Papers Using Regional Variation Cycle Effects of Labor Markets

Disability and Regional Economic Performance Cycle Effects of Labor Markets(From Carolyn’s (the TA’s) Dissertation)

Slope = .1633

Home Production and Leisure Changes Over the Business Cycle (Aguiar, Hurst, and Karabarbounis)

• Analyze changes in time use over business cycle.

• Important for understanding how individuals adjust their time in response to

• temporary labor market shocks.

• Each circle (observation) on subsequent figures is a U.S. state during a

• given time period.

• State level averages come from individual data where observations are

• collapsed to state level (conditioning on demographics)