The lessons of growth theory

1. The lessons of growth theory …can make a positive difference in the lives of hundreds of millions of 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

2. Huge 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…

3. annual growth rate of income per capita percentage increase in standard of living after… Huge effects from tiny differences …25 years …50 years …100 years 2.0% 64.0% 169.2% 624.5% 2.5% 85.4% 243.7% 1,081.4%

4. Huge effects from tiny differences If the annual growth rate of U.S. real GDP per capita had been just one-tenth of one percenthigher during the 1990s, the U.S. would have generated an additional $449 billion of income during that decade

6. International Evidence on Investment Rates and Income per Person

7. International Evidence on Population Growth and Income per Person

8. Examples 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

9. Policies to promote growth Four policy questions: • Are we saving enough? Too much? • What policies might change the saving rate? • How should we allocate our investment between privately owned physical capital, public infrastructure, and “human capital”? • What policies might encourage faster technological progress?

10. 1. 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.

11. 1. Evaluating the Rate of Saving To estimate (MPK  ), we use three facts about the U.S. economy: 1. k = 2.5yThe capital stock is about 2.5 times one year’s GDP. 2.  k = 0.1yAbout 10% of GDP is used to replace depreciating capital. 3. MPKk = 0.3yCapital income is about 30% of GDP

12. 1. Evaluating the Rate of Saving 1. k = 2.5 y 2.  k = 0.1 y 3. MPK k = 0.3 y To determine  , divided 2 by 1:

13. 1. Evaluating the Rate of Saving 1. k = 2.5 y 2.  k = 0.1 y 3. MPK k = 0.3 y To determine MPK, divided 3 by 1: Hence, MPK  = 0.12  0.04 = 0.08

14. 1. 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: if we increase our saving rate, we will have faster growth until we get to a new steady state with higher consumption per capita.

15. 2. 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

16. 3. 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?

17. 4. 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)

18. Growth in output per person (percent per year) Canada 2.9 1.8 France 4.3 1.6 Germany 5.7 2.0 Italy 4.9 2.3 Japan 8.2 2.6 U.K. 2.4 1.8 U.S. 2.2 1.5 CASE STUDY: The Productivity Slowdown 1948-72 1972-95

19. 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?

20. 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.

21. The bottom line: We don’t know which of these is the true explanation, it’s probably a combination of several of them.

22. Growth in output per person (percent per year) Canada 2.9 1.8 2.7 France 4.3 1.6 2.2 Germany 5.7 2.0 1.7 Italy 4.9 2.3 4.7 Japan 8.2 2.6 1.1 U.K. 2.4 1.8 2.5 U.S. 2.2 1.5 2.9 CASE STUDY: I.T. and the “new economy” 1948-72 1972-95 1995-2000

23. CASE STUDY: 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?

24. Money supply measures, April 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

29. The 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.

30. The costs of expected inflation: 1.shoeleather 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.

31. The costs of expected inflation: 2.menu 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.

32. The costs of expected inflation: 3.relative 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.

33. The costs of expected inflation: 4.unfair 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!!

34. The costs of expected inflation: 4.General inconvenience • Inflation makes it harder to compare nominal values from different time periods. • This complicates long-range financial planning.

35. Additional cost of unexpected inflation: arbitrary 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.

36. Additional cost of high inflation: increased 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.

38. Recent episodes of hyperinflation slide 37

40. Business 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

41. Business Cycles

42. Average growth rate = 3.5% Real GDP Growth in the United States

43. Recessions in the U.S. since World War II No simple regular or cyclical pattern: output changes very considerably in size and spacing

44. Behavior of the Components of Output in Recessions Fluctuations are distributed very unevenly over the components of output

45. Cyclical Behavior of Key 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

46. Supply 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.)

47. CASE STUDY: The 1970s oil shocks • Early 1970s: OPEC coordinates a reduction in the supply of oil. • Oil prices rose 11% in 1973 68% in 1974 16% in 1975 • Such sharp oil price increases are supply shocks because they significantly impact production costs and prices.

48. LRAS P SRAS2 SRAS1 AD Y Y2 CASE STUDY: The 1970s oil shocks The oil price shock shifts SRAS up, causing output and employment to fall. B In absence of further price shocks, prices will fall over time and economy moves back toward full employment. A A

49. CASE STUDY: The 1970s oil shocks Predicted effects of the oil price shock: • inflation  • output  • unemployment  …and then a gradual recovery.

50. CASE STUDY: The 1970s oil shocks Late 1970s: As economy was recovering, oil prices shot up again, causing another huge supply shock!!!