Economic growth (III)
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Schools of Macroeconomics
longrun
Classical
or non-classical?
(sticky wages
and prices, rational
expectations, etc.
Short run or long run?
(full adjustment of
capital,
expectations, etc.
shortrun
yes
no
yes
Classical
or non-classical?
(sticky wages
and prices, rational
expectations, etc.
no
Neo-classical
growth
model
Marxist theories?
Behavior growth theories?
Malthusian trap models?
Real business cycle (RBC);
supply-side economics;
structural models;
misperceptions models
Keynesian model
(sloping AS,
expectationsaugmented
PC, IS-LM, etc.)
Agenda
- A savings experiment
- Theories of technological change
- Real business cycles
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Review from last week
• Growth involves potential output (not business cycles)
• Key assumptions: fixed s, labor growth at n, laboraugmenting tech change at h
• Laws of motion:
 k = s f (k )  (n  h   ) k
Test the long-run equilibrium of  k  0 :
s f ( k ) = (n  h   ) k
• Long run growth of output per person, wages, productivity at
rate
• But technological change is exogenous and not satisfactorily
explained.
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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.
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Consumption today … or … consumption tomorrow?
Two faces of saving
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The major non-cycle economic issue of
today: The federal budget deficit and debt
Important 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.
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Bowles-Simpson Report
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Why you can’t get anywhere without Econ 122:
Examples from the Commission
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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
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Basics of the deficit and growth
Assume a closed economy
I = 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?
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y**
Impact of Higher National Saving
y = f(k)
y*
i = s2f(k)
i = s1f(k)
(I/Y)*
(n+δ)k
k
k*
k**
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Numerical Example of Deficit Reduction
Assumptions:
1. Production is by Cobb-Douglas with CRTS
2. 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 GDP
b. Initial govt. savings rate = minus 6 % of GDP
c. 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
2010
2015
2020
2025
2030
35%
Consumption per capita
Percent change from baseline
30%
GDP per capita
Capital per capita
25%
20%
NNP per capita
- Note that takes 10
years to increase C
-Political
implications
- Must C increase?
- No if k>kgoldenrule
15%
10%
5%
0%
-5%
-10%
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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
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Classical themes in macroeconomics:
Real Business Cycle Theory
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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.
RBC recession
Price (P)
AS’
AS
P*
AD
Q*
Real output (Q)
RBC view of current recession
115
AS2012:Q2
114
Price level
113
112
111
110
109
108
107
12,600
12,800
13,000
13,200
Real GDP
13,400
AS2008:Q1
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
Problems in RBC models
1. Cyclical properties of classical models of the business cycle
- Hard to explain deep recessions and depressions (1930s, 200709) 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.
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
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