Lecture II Evolution of Macroeconomics: From Classicists to Keynes Stephen Silver, Ph.D. The Citadel Shandong University, November 2010
The macro economy and its performance Before there was a Keynes, there was an economics And it was good And it was found useful for explaining economic fluctuations And then a Great Depression fell upon the Land, and economics was at a loss to explain the events that befell the Land
Why look at Ln(IP)? • We use IP as it is available monthly and for much longer period than GDP, which also is now published quarterly and only since 1929 • If Yt = Y0*ert, then ln(Yt) = A + rt, where A = ln(Y0); • so ln(Yt) is linear in t and eA approximates Y0 • Thus the slope of the ln(Y) is the annual rate of change of the series • Furthermore, r = [ln(Yn) - ln(Y0)]/n
Stylized Facts of US Growth • Growth of industrial production in the U. S. averaged 4.3% from 1790 to 2009 (the slope over that period) • The growth rate of industrial production has slowed considerably • As seen on the graph, the ln(IP) has begun to flatten out • The last several years, U. S. industrial production has leveled off significantly. • And as manufacturing unemployment has become very important in the political arena as well, the series has added importance beyond its relative importance in US GDP • For China, which has come to symbolize the source of our manufacturing job losses, this perception in the US is very important
GDP growth has slowed over the past five decades to under 3% • And very recently, real GDP actually declined as the financial crisis recession deepened • This has led to a great deal of dissatisfaction with Washington and with those trading partners that are perceived to be the “cause” of U. S. economic woes • Many have resorted to such tactics as “China bashing”
Rule of 70 (69.3 really) Let Y = Y0 * ert; if Y0 = 1 and Yt= 2, we get ln[Yt/Y0] = ln(Yt – ln(Y0))= ln(2) = .693 Thus, the annual rate r = [ln(Yt– ln(Y0))/t = .693/t, so rt = .693t If r is expressed in percent, then 100rt = 69.3 or about 70 Example 1: A bond pays me 5% for 20 years. How long will it take to double my money? Since 70/5 = 14, so 14 years Example 2: What rate will I need to double my money in 10 years? 70/10 = 7, so 7%.
Rule of 70 applied to our growth rates So what’s the difference between 1% and 5% growth over the 50 years? Since 5% doubles every 14 years, after 42 years it will have doubled three times and we have another 8 years of 5% growth, so it’s clearly over 10 The 1% growth path requires 70 years to double, so it’s not there yet, so the 5% growth path is well over 10/2 = 5 times as big In fact, e.05*50/(e.01*50) = e2.5/e.5 = e(2.5-.5) = e2 = 7.389
How long until 中国 GDP > 美国的？ • Right now percapita GDP in US is about US$50,000 • China per capita GDP is maybe US$5000 • With 4 times the population, therefore, US-GDP/China-GDP is about 2.5 • Letting China’s GDP grow at 8% and the US at 3%, on average, China closes the gap by 5% per year. Since it must more than double, it will take 70/5 = 14 years or more • Let’s say by the year 2025
How long until 中国 GDP per capita > 美国的？ • Never! Why? • Some people back in the 1970’s were even predicting that Japanese GDP would overtake the US GDP • But on a PPP basis even the per capita GDP of Japan remains below that of the US. Why?
Factors of production • A country with limited resources, even with a highly-skilled labor force, will have a very difficult time passing the US, which is relatively under-populated; that is, with much more resources per person • So let’s look at a nation’s “aggregate production function”
Cobb-Douglas Production Function The Cobb-Douglas ProductionFunction is Y = f(L,K) = ALbKc If we think of K as representing all other inputs to production, then doubling all inputs will necessarily double output Thus, we can use the following constant returns to scale (CRS) function Y = f(L,K) = ALbK1-b Note that if we substitute 2K and 2L for K and L we get Y = A(2L)b(2K)1-b = ALbK1-b*2b+(1-b) = 2ALbK1-b
In Per Capita Terms Now Y/L = ALb-1K1-b = A(K/L)1-b = g(K/L) So if K/L in a country is much less than in another country, then A, which is commonly referred to as total factor productivity, must be much greater in the resource poor country We can now plot against K/L or as is often done, we take K as given and plot Y against L This is how we got the plot we showed earlier; the reason China’s PF lies below that of the U.S. is that with less other factors per worker, each worker will be less productive
The derived demand for labor • In the function Y = g(L),the Marginal product of labor MPL = dY/dL is the slope of the PF • The marginal cost of labor MCL, in real terms, is W/P, where W is the “wage rate” and P is the price level • So long as MPL > MCL the economy should hire more labor and stop at the point MPL = W/P; thus the demand for labor is the slope of the aggregate production function
Walras and Pareto • The Swiss economist Leon Walras showed that general equilibrium will occur in all markets simultaneously at their equilibrium prices and quantities as market forces bid up or down prices in response to excess demand and supply conditions in those markets • The Italian economist Wilfredo Pareto also showed that in general equilibrium, no individual in the market can be made better off without necessarily making someone else worse off • This is called Pareto optimality
Aggregate versus micro • The APF in the classical model is just the summing up of all the markets, and it was assumed that is all markets are at equilibrium, where MPL = MCL, that that the APF will look just like the individual market functions • It was Samuelson that showed in Foundations of Economic Analysis that this is not necessarily the case • This struck a hole in the case laid by the classical economists and paved the way for Keynes, who had assumed that not all markets would clear at a point where MR = MC; in particular, there could be less than full employment equilibrium
Features of the Great Depression • Started at the end of 1929 – we just passed the 81st anniversary of the beginning of the most severe economic crisis in Western history. • Lasted an entire decade • At its worst more than 25% of the U. S. population (with similar numbers throughout Europe) was measured as unemployed • Counting the underemployed and discouraged workers, it was perhaps more like 50% • Prices fell 30% between the end of 1929 and 1932 • Industrial production fell over 60% from its peak in 1929 • The Dow Jones Industrial Average had lost 90% of its value by 1932
John Maynard Keynes • As we saw, Keynesian economics is based on the idea that monetary policy may be useless in creating jobs and increasing output • Fiscal policy was able to generate output directly via government purchases of goods and services • Through the multiplier effect, this additional demand and increased income increases consumer demand further, thus generating still more output • Keynes’ Law – Demand creates its own supply – versus Says’ Law – Supply creates its own demand
Key features and deficiencies of Keynesian Theory • Keynes’ general theory based on the principal that full-employment equilibrium is a polar case of a more general macroeconomics in which any employment level is possible • Naming may have been influenced by Einstein’s general theory of relativity of which was a more general form of the specific theory most people were familiar with • His analysis was based on the influence of expectations over “animal spirits” that convinced entrepreneurs to invest; such expectations cannot be considered “irrational” when the economy is experiencing “debt deflation”, the term used by Irving Fisher to describe a financial crisis • At the same time, some aspects of the model are deficient; these deficiencies include:
Deficiencies • Not accounting for disincentives created by government “giveaway” programs • Not accounting for disincentives to productivity of income taxation • Assumption that the government will act both wisely and benevolently in its actions • Ignores both the Ricardian Equivalence theorem, which points out that individuals may save more today to pay for future tax liabilities, and the monetarists’ “crowding out” effect.
Paul Solman Interviews Two Keynesian Authorities: Robert Skidelsky and Russ Roberts http://www.youtube.com/watch?v=vwsjPZgBOdU