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percent in 2007. How does this change in the tax rate, which in turn affects the net wages of individuals, affect the labor supply in Spain? 1.3 Graph the following two consumption functions: (1) C = 500 + 0.8 Y (2) C = 0.8 Y a. For each function, calculate and graph the propensity to consume (APC) when income is $200, $500, and $1,000. b. For each function, what happens to the APC as income rises? c. For each function, what is the relationship between the APC and the marginal propensity to consume? d. Under the first consumption function, a family with income of $75,000 consumes a smaller proportion of its income than a family with income of $30,000; yet if we take a dollar of income away from the rich family and give it to the poor family, total consumption by the two families does not change. Explain how this is possible. 1.4 [Related to the Economics in Practice on p. 315] From March 2012 to May 2017, the price of houses increased dramatically in many parts of the country. a. What impact would you expect increases and decreases in home values to have on the consumption behavior of home owners? Explain. b. In what ways might events in the housing market have influenced the rest of the economy through their effects on consumption spending? Be specific. *1.5 Lydia Lopokova is 40 years old. She has assets (wealth) of $80,000 and has no debts or liabilities. She knows that she will work for 30 more years and will live 10 years after that, when she will earn nothing. Her salary each year for the rest of her working career is $35,000. (There are no taxes.) She wants to distribute her consumption over the rest of her life in such a way that she consumes the same amount each year. She cannot consume in total more than her current wealth plus the sum of her income for the next 30 years. Assume that the rate of interest is zero and that Lopokova decides not to leave any inheritance to her children. a. How much will Lydia consume this year and next year? How did you arrive at your answer? b. Plot on a graph Lydia’s income, consumption, and wealth from the time she is 40 until she is 80 years old. What is the relationship between the annual increase in her wealth and her annual saving (income minus consumption)? In
what year does Lydia’s wealth start to decline? Why? How much wealth does she have when she dies? c. Suppose Lydia receives a tax rebate of $1,000 per year, so her income is $36,000 per year for the rest of her working career. By how much does her consumption increase this year and next year? d. Now suppose Lydia receives a one-year-only tax refund of $1,000—her income this year is $36,000; but in all succeeding years, her income is $35,000. What happens to her consumption this year? In succeeding years? 1.6 Explain why a household’s consumption and labor supply decisions are interdependent. What impact does this interdependence have on the way in which consumption and income are related? * Note: Problems marked with an asterisk are more challenging. MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with. M15_CASE3826_13_GE_C15.indd 327 17/04/19 4:20 AM 328 PART IV Further Macroeconomics Issues 15.2 FIRMS: INVESTMENT AND EMPLOYMENT DECISIONS 15.4 THE SHORT-RUN RELATIONSHIP BETWEEN OUTPUT AND UNEMPLOYMENT LEARNING OBJECTIVE: Describe factors that affect the investment and employment decisions of firms. LEARNING OBJECTIVE: Describe the short-run relationship between output and unemployment. 2.1 How do expectations influence investment demand? Describe the reasons for volatility of investment demand. In this context, explain the accelerator effect of expectations on output. 2.2 How can a firm maintain a smooth production schedule even when sales are fluctuating? What are the benefits of a smooth production schedule? What are the costs? 2.3 George Jetson has recently been promoted to inventory control manager at Spacely Sprockets, and he must decide on the optimal level of sprockets to keep in inventory. How should Jetson decide on the optimal level of inventory? How would a change in interest rates affect the optimal level of inventory? What costs and benefits will Spacely Sprockets experience by holding inventory? 2.4 Futurama Medical is a high-tech medical equipment manufacturer that uses custom-designed machinery and a highly skilled, well-trained labor force in its
production factory. Gonzo Garments is a mid-level clothing manufacturer that uses mass-produced machinery and readily available labor in its production factory. Which of these two firms would you expect to have more significant adjustment costs? Which firm would be more likely to hold excess labor? Excess capital? Explain your answers. 15.3 PRODUCTIVITY AND THE BUSINESS CYCLE LEARNING OBJECTIVE: Explain why productivity is procyclical. 3.1 Between June 2017 and June 2018, the employment rate in the United Kingdom increased by 5.73 percent, whereas GDP increased by 1.2 percent. How is it possible for output to increase at a lower rate than employment? 4.1 According to Statista, in 2013, the unemployment rate in Spain was 26.09 percent. In 2017, Statista reported that Spain’s unemployment rate was 17.35 percent. 4.2 In the short run, the percentage increase in output tends to correspond to a smaller percentage decrease in the unemployment rate as a result of “slippages.” Explain the three slippages between changes in output and changes in the unemployment rate. 15.5 THE SIZE OF THE MULTIPLIER LEARNING OBJECTIVE: Identify factors that affect multiplier size. 5.1 Explain the effect that each of the following situations will have on the size of the multiplier: a. An increase in personal income tax across all income brackets. b. An expansionary monetary policy that is inflationary in nature. c. Firms have excess inventories as the economy begins to recover from a recession. d. Firms draw upon existing excess labor employed instead of hiring more people to expand its output. e. An expansionary fiscal policy that is not matched by an increase in taxes. f. An economy-wide increase in wages that is caused due to a new wage law that is expected to be permanent in nature. 5.2 [Related to the Economics in Practice on p. 325] Since 1995, Transparency International has published its annual Corruptions Perceptions Index, which ranks countries by their perceived level of corruption, with corruption defined as the misuse of public power for private benefit. The 2017 index lists the three most corrupt countries as Somalia, South Sudan, and Syria. Part of this misuse of public power for private benefit involves diverting government funds from being spent to improve economic conditions to lining the pockets of government officials. Explain whether you believe this diversion of funds would likely increase or decrease the size of the
multiplier in these countries QUESTION 1 According to the Life-Cycle Theory of Consumption, an increase in income would shift the blue Income curve in Figure 15.1 upward. Would you expect this to eliminate the two periods of dissaving? QUESTION 2 Households are able to delay purchases of durable goods during bad economic times, which leads to spending on durable goods to be more volatile than spending on nondurable goods. Identify an example of this…other than cars and smartphones, which are mentioned in the text. MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with. M15_CASE3826_13_GE_C15.indd 328 17/04/19 4:20 AM Long-Run Growth Think about how many hours your great-grandparents had to work to pay for basic necessities like food and clothing. Now think about how many hours you will have to work for the same things. You will likely spend many fewer hours. Today, people on average earn more in real terms per hour than did people of previous generations. This is true in almost all economies, but certainly in all developed economies. In almost all economies the amount of output produced per worker has risen over time. Why? Why are we able to produce more per hour than prior generations did? This is the subject matter of this chapter. We explore the long-run growth process. We briefly introduced long-run growth in Chapter 7. We distinguished between output growth, which is the growth rate of output of the entire economy, and per-capita output growth, which is the growth rate of output per person in the economy. Another important measure is the growth rate of output per worker, called labor productivity growth. Output per capita is a measure of the standard of living in a country. It is not the same as output per worker because not everyone in the population works. Output per capita can fall even when output per worker is increasing if the fraction of the population that is working is falling (as it might be in a country with an increasing number of children per working-age adult). Output per capita is a useful measure because it tells us how much output each person would receive if total output were evenly divided across the entire population. Output per worker is a useful measure because it tells us how much output each worker on average is producing and how that is changing over time. We begin this chapter with a
brief history of economic growth since the Industrial Revolution. We then discuss the sources of growth—answering the question why output per worker has risen over time. We then turn to look more narrowly at the U.S. growth picture. We conclude with a discussion of growth and the environment, returning to the world perspective. 16 CHAPTER OUTLINE AND LEARNI NG OBJECTIV ES 16.1 The Growth Process: From Agriculture to Industry p. 330 Summarize the history and process of economic growth. 16.2 Sources of Economic Growth p. 331 Describe the sources of economic growth. 16.3 Growth and the Environment and Issues of Sustainability p. 339 Discuss environmental issues associated with economic growth. 329 M16_CASE3826_13_GE_C16.indd 329 17/04/19 4:22 AM 330 PART IV Further Macroeconomics Issues 16.1 LEARNING OBJECTIVE Summarize the history and process of economic growth. output growth The growth rate of the output of the entire economy. per-capita output growth The growth rate of output per person in the economy. labor productivity growth The growth rate of output per worker. The Growth Process: From Agriculture to Industry Before the Industrial Revolution in Great Britain, every society in the world was agrarian. Towns and cities existed here and there, but almost everyone lived in rural areas. People spent most of their time producing food and other basic subsistence goods. Then beginning in England around 1750, technical change and capital accumulation increased productivity significantly in two important industries: agriculture and textiles. New and more efficient methods of farming were developed. New inventions and new machinery in spinning and weaving meant that more could be produced with fewer resources. Higher productivity made it possible to feed and clothe the population and have time left to spend working on other projects and new “products,” as the British moved from being largely an agrarian society to industrial production. Peasants and workers in eighteenth-century England who in the past would have continued in subsistence farming could make a better living as urban workers. Growth brought with it new products, more output, and wider choice. The changes described here as Britain experienced productivity growth can be represented graphically. In Chapter 2, we defined a society’s production possibility frontier (ppf ), which shows all possible combinations of output that can be produced given present technology. Economic growth expands those limits and shifts society’s production possibilities frontier out to the right, as
Figure 16.1 shows. The transition from agriculture to industry has been more recent in developing countries in Asia. One of the hallmarks of current growth in China and Vietnam, for example, has been the focus on manufacturing exports as a growth strategy. A visitor to Vietnam cannot help but be struck by the pace of industrialization. Economic growth continues today in the developed world. Just as a shovel makes it possible to dig a bigger hole, new microwave towers bring cell phone service to places that had been out of range. Capital continues to bring productivity growth albeit in different form. Scientists work on finding a cure for Alzheimer’s disease using tools they couldn’t have dreamed of a decade ago. Tools available on the Web make it possible for a single law clerk in a busy law office to check hundreds of documents for the opinions of potential expert witnesses in a court case in an hour, a task that took a dozen law clerks weeks to perform just a few years ago. In each case, we have become more proficient at producing what we want and need and we have freed up resources to produce new things that we want and need. Although the nature of economic growth has changed over time, its basic building blocks are the same. Growth comes from a bigger workforce and more productive workers. Higher productivity comes from tools (capital), a better-educated and more highly-skilled workforce ▸▸ FIGURE 16.1 Economic Growth Shifts Society’s Production Possibility Frontier Up and to the Right The production possibility frontier shows all the combinations of output that can be produced if all society’s scarce resources are fully and efficiently employed. Economic growth expands society’s production possibilities, shifting the ppf up and to the right Food MyLab Economics Concept Check M16_CASE3826_13_GE_C16.indd 330 17/04/19 4:22 AM CHAPTER 16 Long-Run Growth 331 TABLE 16.1 Growth of Real GDP: 1999–2016 Country United States Japan Germany France United Kingdom China India Sub-Saharan Africa Average Growth Rates per Year, Percentage Points, 1999–2016 2.1 0.8 1.3 1.4 1.9 9.2 7.2 5.1 Source: Economic Report of the President, 2018, Table B-4. (human capital), and increasingly from innovation and technical change (new techniques of production) and newly developed products and services. Table 16.1 provides estimates of the growth of gross domestic product (GDP) for a number
of developed and developing countries for the 17 years from 1999 to 2016. One fact that should strike you as you look at these numbers is the high rates of growth of China and India relative to those of the developed countries. Some economists argue that when poorer, less developed countries begin to develop, they typically have higher growth rates as they catch-up with the more developed countries. This idea is called convergence theory because it suggests that gaps in national incomes tend to close over time. Indeed, more than 50 years ago, the economic historian Alexander Gerschenkron coined the term the advantages of backwardness as a description of the phenomenon by which less developed countries could leap ahead by borrowing technology from more developed countries. This idea seems to fit the current experience of China. In the last few years the growth rate in China has slowed from its average of 9.2 percent in Table 16.1, which some have argued reflects the progress China has already made in catching up to the technological frontier. In 2016 its growth rate was 6.7 percent. You might also note that the growth rate in sub-Saharan Africa is more modest than those in China and India, although still higher than those for the developed countries. We turn now to look at the sources of economic growth as we try to explain these patterns. Sources of Economic Growth It will be useful to begin with a simple case where the quality of labor, L, and the quality of capital, K, do not change over time. A worker is a worker is a worker, and a machine is a machine is a machine. Output, Y, is produced in a production process using L and K. In most situations it seems reasonable to assume that as labor and capital increase, so will output. The exact relationship between these inputs and output can be described with an aggregate production function, which is a mathematical relationship stating that total GDP (output) (Y) depends on the total amount of labor used (L) and the total amount of capital (K) used. (Land is another possible input in the production process, but we are assuming that land is fixed.) The numbers that are used in tables 16.2 and 16.4, which follow, are based on the simple hypothetical production function Y = 3 * K 1 3. This production function tells us that both capital and labor are needed for production (if either is equal to zero, so is output) and increases in either result in more output. The higher exponent on labor also tells us that per unit increases in labor increase
output more than similar increases in capital. Using this construct we can now explore exactly how an economy achieves higher output levels over time as it experiences changes in labor and capital. 3 L2 > > catch-up The theory stating that the growth rates of less developed countries will exceed the growth rates of developed countries, allowing the less developed countries to catch up. 16.2 LEARNING OBJECTIVE Describe the sources of economic growth. aggregate production function A mathematical relationship stating that total GDP (output) depends on the total amount of labor used and the total amount of capital used. Increase in Labor Supply MyLab Economics Concept Check In most situations, it seems logical that if we increase the number of workers in a society, output will increase. Indeed, we see this in the production function we are working with here. A key question is how much does that added labor hour add to output? Both economic theory and M16_CASE3826_13_GE_C16.indd 331 17/04/19 4:22 AM 332 PART IV Further Macroeconomics Issues Government Strategy for Growth Figure 16.1 shows how a country’s production possibility frontier shifts out with technology. Another characteristic of a country that you might want to think about is how far an individual country is from the technological frontier of the rest of the world and how distance from that frontier might influence growth strategies pursued by a country. One of the puzzles in the growth area has been the fact that government strategies for growth seem to succeed in one place and then fail dismally in another. Work by Acemoglu, Aghion, and Zilibotti suggests that one key to successful government policies is how far a country is from the world frontier.1 Suppose a country is behind relative to the world at large. A government’s job here is helping its industries to catch up. What policies work for this? Acemoglu et al. suggest that industrial policy like that used by Japan and South Korea may be helpful for this case. Here the government knows what the right technology is and just has to help its firms find the world frontier. As firms develop, however, and approach the world technological frontier, things change. Now growth comes through innovation, by finding out new ways to do things that are the best in the world. How does the government help in this task? Here, markets with sharp incentives and some encouragement of risk taking likely will be more useful. For this, policies to support entrepreneurship and improve the workings of venture capital will likely work
better. Acemoglu and his colleagues argue that governments often shift too late from policies supporting adoption of other countries’ ideas to support of their own innovative efforts. CRITICAL THINKING 1. In recent years China has begun to strengthen its laws on patents. How does this fit in with the research described here? 1Daron Acemoglu, Philippe Aghion, and Fabrizio Zilibotti, “Distance to Frontier, Selection, and Economic Growth,” Journal of the European Economic Association, March 2006, 37–74. practice tell us that in the absence of increases in the capital stock, as labor increases, less and less output will be added by each new worker. This effect is called diminishing returns. It has been discussed for well more than a hundred years, beginning with early economists like Thomas Malthus and David Ricardo who began thinking about the effects of population growth. Malthus and Ricardo focused on agricultural output for which the central form of capital was land. With land in limited supply, the economists reckoned that new farm laborers would be forced to work the land more intensively. As labor supply grew, output would increase, but at a declining rate. Increases in the labor supply would reduce labor productivity, or output per worker. In developed economies, labor works not so much with land as with other forms of capital— machines, computers, and the like. But diminishing returns occur in this setting as well. Table 16.2 provides an arithmetic example of diminishing returns using the aggregate production function discussed previously. Notice in the table the relationship between the level of output and the level of labor. With capital fixed at 100, as labor increases from 100 to eventually 130, total output increases, but at a diminishing rate. In the last column, we see that labor productivity falls. Simply increasing the amount of labor with no other changes in the economy decreases labor productivity because of diminishing returns. Although we have used a hypothetical production function here, empirical work suggests this form with its diminishing returns is typical of production more generally. We now know that increasing labor supply results in an increase in a country’s output. This is one source of growth in the United States. Table 16.3 shows the growth of the U.S. population, labor force, and employment between 1960 and 2017. In this period, the population 16 and older grew at an annual rate of 1.4 percent, the labor force grew at an annual rate of 1.5 percent, and M16_CASE3826_
13_GE_C16.indd 332 17/04/19 4:22 AM CHAPTER 16 Long-Run Growth 333 TABLE 16.2 Economic Growth from an Increase in Labor: More Output but Diminishing Returns and Lower Labor Productivity Period 1 2 3 4 Quantity of Labor L Quantity of Capital K Total Output Y Labor Productivity Y/L 100 110 120 130 100 100 100 100 300 320 339 357 3.0 2.9 2.8 2.7 Marginal Return to Labor ΔY/ΔL — 2.0 1.9 1.8 TABLE 16.3 U.S. Employment, Labor Force, and Population Growth, 1960–2017 Civilian Noninstitutional Population 16 and Older (Millions) Civilian Labor Force Number (Millions) Percentage of Population Employment (Millions) 1960 1970 1980 1990 2000 2010 2017 Total percentage change, 1960–2017 Percentage change at an annual rate 117.3 137.1 167.7 189.2 212.6 237.8 255.1 +117.5% +1.4% 69.6 82.8 106.9 125.8 142.6 153.9 160.3 +130.3% +1.5% 59.3 60.4 63.7 66.5 67.1 64.7 62.8 65.8 78.7 99.3 118.8 136.9 139.1 153.3 +133.0% +1.5% Source: Economic Report of the President, 2018, Table B-11. MyLab Economics Real-time data employment grew at an annual rate of 1.5 percent. We will come back to this table later in the chapter. We would expect that this increase in labor would, by itself, end up increasing overall output levels in the United States. Increase in Physical Capital MyLab Economics Concept Check It is easy to see how physical capital contributes to output. Two people digging a garden with one shovel will be able to do more if a second shovel is added. How much more? We saw that there are diminishing returns to labor as more and more labor is added to a fixed amount of capital. There are likewise diminishing returns to capital as more and more capital is added to a fixed supply of labor. The extra output from the garden that can be produced when a second shovel is added is likely to be smaller than the extra output that was produced when the first shovel was added. If a third shovel were added, even less extra output would likely be
produced (if any). Table 16.4 shows how an increase in capital without a corresponding increase in labor increases output. It uses the same aggregate production function employed in Table 16.2. Observe three things about these numbers. First, additional capital increases labor productivity—it rises from 3.0 to 3.3 as capital is added. Second, there are diminishing returns to capital. Increasing capital by 10 first increases output by 10—from 300 to 310. However, the second increase of 10 yields only an output increase of nine, and the third increase of 10 yields only an output increase of eight or 0.8 per unit of capital. The last column in the table shows the decline in output per capital as capital is increased. Finally, given that the exponent on capital is 1/3 while that on labor is 2/3 in this case, increasing capital increases output less than does increasing labor. Of course, a different production function would have different results in this respect. M16_CASE3826_13_GE_C16.indd 333 17/04/19 4:22 AM 334 PART IV Further Macroeconomics Issues TABLE 16.4 Economic Growth from an Increase in Capital: More Output, Diminishing Returns to Added Capital, Higher Labor Productivity Quantity of Labor L Quantity of Capital K Total Output Y Labor Productivity Y/L Output per Capital Y/K Period 1 2 3 4 100 100 100 100 100 110 120 130 300 310 319 327 3.0 3.1 3.2 3.3 3.0 2.8 2.7 2.5 Marginal Return to Capital ∆K ∆Y — > 1.0 0.9 0.8 TABLE 16.5 U.S. Fixed Private Nonresidential Net Capital Stock, 1960–2016 (Billions of 2009 Dollars) 1960 1970 1980 1990 2000 2010 2016 Total percentage change, 1960–2016 Percentage change at an annual rate Equipment Structures 706.1 1,202.0 1,994.0 2,629.0 4,039.4 5,208.2 6,248.0 +784.9% +4.0% 3,451.3 4,769.3 6,294.8 8,336.5 9,808.9 10,967.0 11,483.2 +232.7% +2.2% Source: U.S. Department of Commerce, Bureau of Economic Analysis., Fixed Asset Tables. Table 16.4 shows
what happens to output as capital increases with a hypothetical production function. Table 16.5 uses actual U.S. data to show the growth of capital equipment and capital structures between 1960 and 2016. (The increase in the capital stock is the difference between gross investment and depreciation. Remember that some capital becomes obsolete and some wears out each year.) Between 1960 and 2016 the stock of equipment grew at an annual rate of 4.0 percent and the stock of structures grew at an annual rate of 2.2 percent. Notice the growth rates of capital in Table 16.5 (4.0 percent and 2.2 percent) are larger than the growth rate of labor in Table 16.3 (1.5 percent). Capital has grown relative to labor in the United States. As a result, each U.S. worker has more capital to work with now than he or she had a hundred years ago. We see in Table 16.4 that adding more capital relative to labor increases labor productivity. We thus have one answer so far as to why labor productivity has grown over time in the United States—the amount of capital per worker has grown. You are able to produce more output per hour than your grandparents did because you have more capital to work with. In almost all economies, capital has been growing faster than labor, which is an important source of labor productivity growth in these economies. The importance of capital in a country’s economic growth naturally leads one to ask the question of what determines a country’s stock of capital. In the modern open economy, new capital can come from the saving of a country’s residents or from the investments of foreigners. Foreign direct investment is any investment in enterprises made in a country by residents outside that country. Foreign direct investment has been quite influential in providing needed capital for growth in much of Southeast Asia. In Vietnam, for example, rapid growth has been led by foreign direct investment. More recently, we have seen signs of Chinese foreign direct investment in parts of Africa and in other parts of Asia. Recent work in economics has focused on the role that institutions play in creating a capitalfriendly environment that encourages home savings and foreign investment. In a series of papers, LaPorta, Lopez de Silanes, Shleifer, and Vishny argue that countries with English common-law origins (as opposed to French) provide the strongest protection for shareholders, less corrupt governments, and better court systems. In turn, these financial and legal institutions promote growth by encouraging capital investment. Countries with poor institutions,
corruption, and Foreign Direct Investment Investment in (FDI) enterprises made in a country by residents outside that country. M16_CASE3826_13_GE_C16.indd 334 17/04/19 4:22 AM CHAPTER 16 Long-Run Growth 335 inadequate protection for lenders and investors struggle to attract capital. The World Bank calls countries with weak institutions fragile countries. Many of the World Bank’s fragile countries are in Sub-Saharan Africa. Many observers believe that the relative stagnation of some of the Sub-Saharan African nations comes in part from their relatively weak institutions. High costs of doing business, including corruption and investment risks associated with conflict, have made countries such as Zimbabwe less attractive to domestic and foreign capital. Ethnic and linguistic fractionalization have also played a role. Increase in the Quality of the Labor Supply (Human Capital) MyLab Economics Concept Check So far we have looked at what happens when an economy gets more units of identical workers. As we well know, in most societies, populations have grown more educated and healthier over time. The quality of labor has changed, as well as its quantity, and this too leads to long-run growth. When the quality of labor increases, this is referred to as an increase in human capital. If a worker’s human capital has increased, he or she can produce more output working with the same amount of physical capital. Labor input in efficiency terms has increased. Human capital can be produced in many ways. Individuals can invest in themselves by going to college or by completing vocational training programs. Firms can invest in human capital through on-the-job training. The government invests in human capital with programs that improve health and that provide schooling and job training. In many developing economies, we have seen high returns from educating women who had previously been largely unschooled. In the developing countries of Sub-Saharan Africa, health is a major issue because of the high incidence of malaria, HIV, and other diseases and the lack of available medical services. Programs to improve the health of the population increase the quality of the labor force, which increases output. In the United States, considerable resources have been put into education over the decades. Table 16.6 shows that the level of educational attainment in the United States has risen significantly since 1940. The percentage of the population with at least four years of college rose from 4.6 percent in 1940 to 34.2 percent in 2017. In 1940 fewer than one person in four had completed high school; in 2017,
89.6 percent had. This is a substantial increase in human capital. We thus have our second answer as to why labor productivity has increased in the United States—the quality of labor has increased through more education. Policymakers in many developed economies are concerned about their ability to continue to generate growth through human capital improvements. Increase in the Quality of Capital (Embodied Technical Change) MyLab Economics Concept Check Just as workers have changed in the last one hundred years, so have machines. A present-day word processor is quite different from the manual typewriter of the mid-twentieth century. TABLE 16.6 Years of School Completed by People Older Than 25 Years, 1940–2017 Percentage with Less than 5 Years of School Percentage with 4 Years of High School or More Percentage with 4 Years of College or More 1940 1950 1960 1970 1980 1990 2000 2010 2017 13.7 11.1 8.3 5.5 3.6 NA NA NA NA 24.5 34.3 41.1 52.3 66.5 77.6 84.1 87.1 89.6 4.6 6.2 7.7 10.7 16.2 21.3 25.6 29.9 34.2 NA = not available Source: Statistical Abstract of the United States, 1990, Table 215, and 2012, Table 229, and Bureau of the Census, 2017, Table 2, Educational Attainment. M16_CASE3826_13_GE_C16.indd 335 17/04/19 4:22 AM 336 PART IV Further Macroeconomics Issues Germany’s Open Border Policy How can one country’s political crisis impact another’s economy? Between 2015 and 2018, more than a million refugees sought asylum in Europe to escape the atrocities of war and turbulence in the Middle East and some African nations, an event now known as the European refugee crisis. During this crisis, Germany accommodated the largest number of migrants, increasing its population by more than 1 percent. This was bound to cost Germany; the state budget incurred over €45 billion in additional social welfare and refugee integration expenditure. Apart from monetary costs, concerns around social polarization have also been one of the main topics of debate among Germany’s politicians. Is this all there is to accommodating refugees? Germany consists of a rapidly aging native population and also has a low proportion of females in the labor force in comparison to other industrialized nations. A recent study by the World Education Services1 estimates that over 65 percent of asylum seekers during the period
between 2015 and 2017 were male and almost 75 percent were below the age of 24. According to this study, if Germany invests in providing these refugees with education, vocational training, language instruction, and integration courses, it can expand on the skills and knowledge of 20 percent of the educated and skilled refugees. As costly as the acceptance of refugees may be, properly integrating them in the society might turn out to be a solution to some of Germany’s economic challenges. CRITICAL THINKING 1. What are the long-term gains and the short-term costs of investing in an influx of human capital? 1Stefan Trines, “Lessons from Germany’s Refugee Crisis: Integration, Costs, and Benefits,” World Education News and Reviews, World Education Services, May 2, 2017. embodied technical change Technical change that results in an improvement in the quality of capital. An increase in the quality of a machine will increase output in the production process for the same amount of labor used. How does an increase in the quality of capital come about? It comes about in what we will call embodied technical change. Some technical innovation takes place, such as a faster computer chip, which is then incorporated into machines. Usually the technical innovations are incorporated into new machines, with older machines simply discarded when they become obsolete. In this case the quality of the total capital stock increases over time as more efficient new machines replace less efficient old ones. In some cases, however, innovations are incorporated into old machines. Commercial airplanes last for many decades, and many innovations that affect airplanes are incorporated into existing ones. In general, one thinks of embodied technical change as showing up in new machines rather than existing ones. An increase in the quality of capital increases labor productivity (more output for the same amount of labor). We thus have our third answer as to why labor productivity has increased over time—the quality of capital has increased because of embodied technical change. We will come back to embodied technical change, but to finish our inventory of the sources of economic growth we turn next to our last source of growth, disembodied technical change. Disembodied Technical Change MyLab Economics Concept Check In some situations we can achieve higher levels of output over time even if the quantity and quality of labor and capital don’t change. How might we do this? Perhaps we learn how to better organize the plant floor or manage the labor force. In recent years operational improvements like lean manufacturing, yield management, and vendor inventory management systems have increased the ability of many manufacturing
firms to get more output from a fixed amount and quality of labor and capital. Even improvements in information and accounting systems or incentive systems can lead to improved output levels. A type of technical change that is not M16_CASE3826_13_GE_C16.indd 336 17/04/19 4:22 AM CHAPTER 16 Long-Run Growth 337 disembodied technical change Technical change that results in a change in the production process. invention An advance in knowledge. innovation The use of new knowledge to produce a new product or to produce an existing product more efficiently. specifically embedded in either labor or capital but works instead to allow us to get more out of both is called disembodied technical change. Recent experiences in the Chinese economy provide an interesting example of what might be considered disembodied technical change broadly defined. Working at the IMF, Zuliu Hu and Mohsin Khan have pointed to the large role of productivity gains in the 20 years following the market reforms in China. In the period after the reforms, productivity growth rates tripled, averaging almost 4 percent a year. Hu and Khan argue that the productivity gains came principally from the unleashing of profit incentives that came with opening business to the private sector. Better incentives produced better use of labor and capital. Positive disembodied technical changes are our fourth answer as to why labor productivity has increased. People have figured out how to run production processes and how to manage firms more efficiently. More on Technical Change MyLab Economics Concept Check We have seen that both embodied and disembodied technical change increase labor productivity. It is not always easy to decide whether a particular technical innovation is embodied or disembodied, and in many discussions this distinction is not made. In the rest of this section we will talk in general about technical innovations. The main point to keep in mind is that technical change, regardless of how it is categorized, increases labor productivity. The Industrial Revolution was in part sparked by new technological developments. New techniques of spinning and weaving—the invention of the machines known as the mule and the spinning jenny, for example—were critical. The high-tech boom that swept the United States in the early 1980s was driven by the rapid development and dissemination of semiconductor technology. The high-tech boom in the 1990s was driven by the rise of the Internet and the technology associated with it. In India in the 1960s, new high-yielding seeds helped to create a “green revolution” in agriculture. Technical change generally takes place in two stages. First,
there is an advance in knowledge, or an invention. However, knowledge by itself does nothing unless it is used. When new knowledge is used to produce a new product or to produce an existing product more efficiently, there is innovation. Given the centrality of innovation to growth, it is interesting to look at what has been happening to research in the United States over time. A commonly used measure of inputs into research is the fraction of GDP spent. In 2011, the United States spent 2.7 percent of its GDP on research and design (R&D), down slightly from a high of 2.9 percent in the early 1960s. Over time the balance of research funding has shifted away from government toward industry. Because industry research tends to be more applied, some observers are concerned that the United States will lose some of its edge in technology unless more government funding is provided. In 2007, the National Academies of Science argued as follows: Although many people assume that the United States will always be a world leader in science and technology, this may not continue to be the case inasmuch as great minds and ideas exist throughout the world. We fear the abruptness with which a lead in science and technology can be lost—and the difficulty of recovering a lead once lost, if indeed it can be recovered at all.1 Since this report, government funding has continued to decline as a percent of all research spending, but industry spending has increased. In 2015, total research spending as a fraction of GDP was close to the all time high of the 1960s. As we suggested previously, the theory of convergence suggests that newly developing countries can leap forward by exploiting the technology of the developed countries. Indeed, all countries benefit when a better way of doing things is discovered. Innovation and the diffusion of that 1National Academies, “Rising Above the Gathering Storm: Energizing the Employing America for a Brighter Future,” National Academies Press, 2007. M16_CASE3826_13_GE_C16.indd 337 17/04/19 4:22 AM 338 PART IV Further Macroeconomics Issues innovation push the production possibility frontier outward. There is at least some evidence that a country that leads in a discovery retains some advantage in exploiting it, at least for some time. Looking at R&D as a share of GDP, the United States ranked fourth in 2015, following South Korea, Japan and Germany. In terms of absolute dollars spend on research, the United States is first. Among firms investing in
research, Amazon and Alphabet are the leading corporate funders of R&D. If we look at patenting data, which we can think of as the output of innovation, the United States is also in the lead among countries. For patents simultaneously sought in the United States, Japan, and the European Union (EU), known as triadic patents, U.S. inventors are the leading source, having taken the lead from the EU in 1989. On the output side, then, the United States still appears to be quite strong in the area of research. The Economics in Practice box on page 336 describes the economics of open border policies. U.S. Labor Productivity: 1952 I–2017 IV MyLab Economics Concept Check Now that we have considered the various answers as to why U.S. labor productivity has increased over time, we can return to the data and see what the actual growth has been. In Figure 16.2, we presented a plot of U.S. labor productivity for the 1952 I–2017 IV period. This figure is repeated in Figure 16.2. Remember that the line segments are drawn to smooth out the short-run fluctuations in productivity. We saw in the last chapter that given how productivity is measured, it moves with the business cycle because firms tend to hold excess labor in recessions. We are not interested in business cycles in this chapter, and the segments are a way of ignoring business cycle effects. There was much talk in the late 1970s and early 1980s about the U.S. “productivity problem.” Some economics textbooks published in the early 1980s had entire chapters discussing the decline in productivity that seemed to be taking place during the late 1970s. In January 1981, the Congressional Budget Office published a report, The Productivity Problem: Alternatives for Action. It is clear from Figure 16.2 that there was a slowdown in productivity growth in the 1970s. The growth rate went from 3.4 percent in the 1950s and first half of the 1960s to 2.6 percent in the last half of the 1960s and early 1970s and then to 1.6 percent from the early 1970s to the 1990s. Many explanations were offered at the time for the productivity slowdown of the late 1970s and early 1980s. Some economists pointed to the low rate of saving in the United States compared with other parts of the world. Others blamed increased environmental and government regulation of U.S. business. Still others argued that the country was not spending as much
on R&D as it should have been. Finally, some suggested that high energy costs in the 1970s led to investment designed to save energy instead of to enhance labor productivity. 1.0% 2.0% Line segments 1.6% 2.6% Output per worker hour 3.3 ( 71.0 64.0 32.0 16.0 1952 I 1955 I 1960 I 1965 I 1970 I 1975 I 1980 I 1985 I Quarters 1990 I 1995 I 2000 I 2005 I 2010 I 2015 I 2017 IV MyLab Economics Concept Check ▸▴ FIGURE 16.2 Output per Worker Hour (Productivity), 1952 I–2017 IV M16_CASE3826_13_GE_C16.indd 338 17/04/19 4:22 AM CHAPTER 16 Long-Run Growth 339 16.3 LEARNING OBJECTIVE Discuss environmental issues associated with economic growth. Productivity growth increased to 2.0 percent between 1993 and 2010, but the growth since 2010 has been low, as you can see from the figure. This slowdown is a puzzle, particularly given the continuing growth of the Internet and wireless devices. More time is needed to know what this portends for future growth rates. Will the United States return to a productivity growth rate of around 2.0 percent? Growth and the Environment and Issues of Sustainability In 2000, the United Nations (UN) unanimously adopted the Millennium Development Goals, a set of quantifiable, time-based targets for developing countries to meet. Included in these targets, as you might expect, were measures of education, mortality, and income growth. The UN resolution also included a set of environmental criteria. Specific criteria have been developed around clean air, clean water, and conservation management. The inclusion of environmental considerations in the development goals speaks to the importance of environmental infrastructure in the long-run growth prospects of a country. Policymakers are also increasingly concerned that growth will bring with it environmental degradation. Evidence of global warming has increased some of the international concerns about growth and the environment. The connections between the environment and growth are complex and remain debated among economists. The classic work on growth and the environment was done in the mid-1990s by Gene Grossman and Alan Krueger.2 It is well known that as countries develop, they typically generate air and water pollutants. China’s recent rapid growth provides a strong example of this fact. Grossman and Krueger found, however, that as growth progresses and countries become richer, pollution tends
to fall. The relationship between growth, as measured in per-capita income, and pollution is an inverted U. Figure 16.3 shows Grossman and Krueger’s evidence on one measure of air pollution. How do we explain the inverted U? Clean water and clean air are what economists call normal goods. That is, as people get richer, they want to consume more of these goods. You have already seen in the Keynesian model that aggregate consumption increases with income. As it happens, microeconomics finds that this relationship is true for most individual types of goods as well. Demand for clean water and clean air turns out to increase with income levels. As countries develop, their populace increasingly demands improvements on these fronts. We have seen an increasing number of public protests about the environment in China, for example. So although increased industrialization with growth initially degrades the environment, in the long run environmental quality typically improves 150 125 100 75 50 25 0 2 4 6 8 10 12 GDP per capita (1985 $1,000s) MyLab Economics Concept Check ▸◂ FIGURE 16.3 The Relationship Between Per-Capita GDP and Urban Air Pollution One measure of air pollution is smoke in cities. The relationship between smoke concentration and per-capita GDP is an inverted U: As countries grow wealthier, smoke increases and then declines. Source: Gene Grossman and Alan Krueger, QJE, May 1995. 2Gene Grossman and Alan Krueger, “Economic Growth and the Environment,” Quarterly Journal of Economics, May 1995. M16_CASE3826_13_GE_C16.indd 339 17/04/19 4:22 AM 340 PART IV Further Macroeconomics Issues Grossman and Krueger found this inverted U in a number of countries. Economic historians remind us that in the heyday of industrialization, northern England suffered from serious air pollution. Some of you may recall the description of air pollution in nineteenth-century English novels such as Elizabeth Gaskell’s North and South. If environmental pollution eventually declines as growth brings rising per-capita incomes, why should we be worried? First, as Grossman and Krueger point out, the inverted U represents historical experience, but it is not inevitable. In particular, if public opinion moves governments and the economy at large toward technologies that reduce pollution, this requires an empowered populace and a responsive government. Here too we see the importance of institutions in growth. A second
issue arises in cases in which high levels of current emissions produce irreversible outcomes. Some would argue that by the time nations such as China and Vietnam develop enough to reduce their emissions, it will be too late. Many believe that global warming is such an example. Another important problem comes from pollution sources that move across country boundaries. Carbon emissions associated with global warming are one such by-product of increased industrialization. Other air pollution problems move across national borders as well. In the heyday of industrialization by the Soviet Union, prevailing winds blew much of the Sovietproduced pollution to Finland. Choices that countries make about levels of growth and levels of environmental control affect the well-being of other countries’ populations. Nor is it easy for countries at different levels of GDP per capita to agree on common standards of environmental control. As we suggested previously, demand for clean air increases with income, when needs for food and shelter are better met. It should surprise no one who has studied economics that there are debates between developing countries and developed countries about optimal levels of environmental control. These debates are further complicated when we recognize the gains that consumers in developed economies reap from economic activity in the developing world. Much of the increased carbon emitted by Chinese businesses, for example, is associated with goods that are transported and traded to Europe and the United States. These consumers thus share the benefits of this air pollution through the cheaper goods they consume. Much of Southeast Asia has fueled its growth through export-led manufacturing. For countries that have based their growth on resource extraction, there is another set of potential sustainability issues. Many of the African nations are in this category. Nigeria relies heavily on oil; South Africa and the Congo are large producers of diamonds and other gems. Extraction methods, of course, may carry environmental problems. Many people also question whether growth based on extraction is economically sustainable: What happens when the oil or minerals run out? The answer is quite complicated and depends in some measure on how the profits from the extraction process are used. Because extraction can be accomplished without a well- educated labor force, whereas other forms of development are more dependent on a skilled-labor base, public investment in infrastructure is especially important. To the extent that countries use the revenues from extraction to invest in infrastructure such as roads and schools and to increase the education and health of their populace, the basis for growth can be shifted over time. With weak institutions, these proceeds may be expropriated by corrupt governments or invested outside the country, and long-run sustainable growth will not result. The
question of whether the natural resource base imposes strong natural limits on growth has been debated since the time of Malthus. Malthus as early as the 18th century worried that population growth in England would outstrip the ability of the land to provide. In that period, technology provided an answer, facilitating output growth. In 1972, the Club of Rome, a group of “concerned citizens,” contracted with a group at MIT to do a study titled The Limits to Growth.3 The book-length final report presented the results of computer simulations that assumed present growth rates of population, food, industrial output, and resource exhaustion. According to these data, sometime after the year 2000 the limits will be reached and the entire world economy will come crashing down: Collapse occurs because of nonrenewable resource depletion. The industrial capital stock grows to a level that requires an enormous input of resources. In the very process of that growth, it depletes a large fraction of the resource reserves available. As resource prices 3Donella H. Meadows et al., The Limits to Growth (Washington, D.C.: Potomac Associates, 1972). M16_CASE3826_13_GE_C16.indd 340 17/04/19 4:22 AM CHAPTER 16 Long-Run Growth 341 rise and mines are depleted, more and more capital must be used for obtaining resources, leaving less to be invested for future growth. Finally, investment cannot keep up with depreciation and the industrial base collapses, taking with it the service and agricultural systems, which have become dependent on industrial inputs (such as fertilizers, pesticides, hospital laboratories, computers, and especially energy for mechanization)... Population finally decreases when the death rate is driven upward by the lack of food and health services.4 This argument is similar to one offered almost 200 years ago by Thomas Malthus, mentioned previously in this chapter. Neither Malthus nor the Club of Rome had accounted for the role of rising prices in mitigating some of these effects. In the early 1970s, many thought that the Club of Rome’s predictions had come true. It seemed the world was starting to run up against the limits of world energy supplies. In the years since, new reserves have been found and new sources of energy, including large reserves of gas and oil produced by fracking, have been discovered and developed largely in response to rising energy prices. At present, issues of global warming and biodiversity are causing many people to question the process of growth.
How should one trade off the obvious gains from growth in terms of the lives of those in the poorer nations against environmental goals? Recognizing the existence of these tradeoffs and trying to design policies to deal with them is one of the key tasks of policymakers. 4Meadows et al., pp. 131–132. S U M M A R Y 1. In almost all countries output per worker, labor productivity, has been growing over time. 16.1 THE GROWTH PROCESS: FROM AGRICULTURE TO INDUSTRY p. 330 2. All societies face limits imposed by the resources and technologies available to them. Economic growth expands these limits and shifts society’s production possibilities frontier up and to the right. 3. There is considerable variation across the globe in growth rates. Some countries—particularly in Southeast Asia— appear to be catching up. 4. The process by which some less developed, poorer countries experience high growth and begin to catch up to more developed areas is known as convergence. 16.2 SOURCES OF ECONOMIC GROWTH p. 331 5. An aggregate production function embodies the relationship between inputs—the labor force and the stock of capital— and total national output. 6. A number of factors contribute to economic growth: (1) an increase in the labor supply, (2) an increase in physical capital—plant and equipment, (3) an increase in the quality of the labor supply—human capital, (4) an increase in the quality of physical capital—embodied technical change, and (5) disembodied technical change—for example, an increase in managerial skills. 7. The growth rate of labor productivity in the United States decreased from about 3.4 percent in the 1950s and 1960s to about 2.0 percent in the 1990s and 2000s. Since 2010 it has been quite low. 16.3 GROWTH AND THE ENVIRONMENT AND ISSUES OF SUSTAINABILITY p. 339 8. As countries begin to develop and industrialize, environ- mental problems are common. As development progresses further, however, most countries experience improvements in their environmental quality. 9. The limits placed on a country’s growth by its natural resources have been debated for several hundred years. Growth strategies based on extraction of resources may pose special challenges to a country’s growth aggregate production function, p. 331 catch-up, p. 331 disembodied technical change, p. 337 embodied technical change, p
. 336 foreign direct investment (FDI), p. 334 innovation, p. 337 invention, p. 337 labor productivity growth, p. 329 output growth, p. 329 per-capita output growth, p. 329 MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with. M16_CASE3826_13_GE_C16.indd 341 17/04/19 4:22 AM 342 PART IV Further Macroeconomics Issues P R O B L E M S All problems are available on MyLab Economics. 16.1 THE GROWTH PROCESS: FROM AGRICULTURE TO INDUSTRY LEARNING OBJECTIVE: Summarize the history and process of economic growth. 1.1 Go to a recent issue of The Economist magazine. In the back of each issue is a section called “economic indicators.” That section lists the most recent growth data for a substantial number of countries. Which countries around the world are growing most rapidly according to the most recent data? Which countries around the world are growing more slowly? Flip through the stories in The Economist to see if there is any explanation for the pattern that you observe. Write a brief essay on current general economic conditions around the world. 1.2 The data in the following table represents real GDP from 2013–2016 for five countries. a. Calculate the growth rate in real GDP for all five countries from 2013–2014. Which country experienced the highest rate of economic growth from 2013–2014? b. Calculate the growth rate in real GDP for all five countries from 2014–2015. Which country experienced the highest rate of economic growth from 2014–2015? c. Calculate the growth rate in real GDP for all five countries from 2015–2016. Which country experienced the highest rate of economic growth from 2015–2016? d. Calculate the average annual growth rate in real GDP for all five countries from 2013–2016. Which country experienced the highest average annual rate of economic growth from 2013–2016? Country 2013 2014 2015 2016 United States El Salvador Republic of South Africa Cambodia Russia 15,802.86 22.72 406.12 16,177.46 23.04 413.02 16,597.45 23.57 418.39 16,865.60 24.13 419.56 13.88 1,666.93 14.86 1,679
.12 15.90 1,631.63 17.00 1,627.96 All values are in billions of 2010 U.S. dollars. Source: United States Department of Agriculture. 1.3 The data in the following table represents real GDP per capita in 1980 and 2016 for five countries. Fill in the table by calculating the annual growth rate in real GDP per capita from 1980 to 2016. Is the data in the completed table consistent with convergence theory? Explain. Country United States El Salvador Republic of South Africa Cambodia Russia Real GDP per Capita in 1980 Real GDP per Capita in 2016 Annual Growth in Real GDP per Capita 1980–2016 28,734 2,577 6,560 234 8,282 52,152 3,919 7,727 1,065 11,436 All values are in 2010 U.S. dollars. Source: United States Department of Agriculture. 1.4 Use the data in the following table to explain what happened with respect to economic growth and the standard of living in each of the three countries. Country Thesia Tuchaka Palewen Real GDP 2017 Real GDP 2018 Population 2017 Population 2018 10,000,000 3,200,000 7,400,000 10,350,000 3,500,000 7,680,000 2,000 6,000 3,500 2,050 6,500 3,700 16.2 SOURCES OF ECONOMIC GROWTH LEARNING OBJECTIVE: Describe the sources of economic growth. 2.1 Eastern European countries, like Hungary and Poland, experienced real wage growth in 2017 and 2018, partially due to low unemployment. At the same time, chronic shortage of trained workers caused many companies, and in some cases even public administration, to automatize and simplify processes. Explain how a shortage of trained labor can lead to an increase in real wages as well as productivity? 2.2 Tables 1,2, and 3 that follow present some data on three hypothetical economies. Complete the tables by figuring the measured productivity of labor and the rate of output growth. What do the data tell you about the causes of economic growth? (Hint: How fast are L and K growing?) MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with. M16_CASE3826_13_GE_C16.indd 342 17/04/
19 4:22 AM TABLE 1 Period L 1 2 3 4 1,120 1,135 1,152 1,170 K 3,205 3,500 3,798 4,045 TABLE 2 Period L 1 2 3 4 1,120 1,175 1,255 1,344 K 3,205 3,246 3,288 3,315 TABLE 3 Period L 1 2 3 4 1,120 1,135 1,152 1,170 K 3,205 3,246 3,288 3,315 Y Y/L Growth Rate of Output 4,650 4,795 4,945 5,100 Y Y/L Growth Rate of Output 4,650 4,775 4,904 5,036 Y Y/L Growth Rate of Output 4,650 4,840 5,038 5,244 2.3 In July 2018, President Trump was considering cutting taxes on capital gains amounting to approximately $100 billion and allowing taxpayers to account for inflation when calculating tax dues on capital gains. In what ways would you expect such a policy to be favorable to economic growth? Source: “Trump Administration Eyes Capital Gains Tax Cut for Wealthy: NY Times,” www.reuters.com, July 31, 2018. 2.4 [Related to the Economics in Practice on p. 332] In a March 2013 press release, the World Bank announced its support to assist Indonesia in accelerating its economic growth through the Research and Innovation in Science and Technology Project (RISET). This project is designed to boost research and innovation in Indonesia and assist the country in evolving into a knowledge-based economy. According to Stefan G. Koeberle, World Bank Country Director for Indonesia, “Improving human resources and national capabilities in science and technology is a key pillar in Indonesia’s masterplan to accelerate and expand its economy. Shifting from a resource-based economy to a knowledge-based economy will bring Indonesia up the value chain in a wide range of sectors, with the help of homegrown innovation and a vast pool of human resources.” The press release states that a large part of CHAPTER 16 Long-Run Growth 343 the RISET program will involve assistance in raising the academic credentials of Indonesian researchers involved with science and engineering, and it is hoped that the program will eventually lead to increased investment in R&D, where as a percentage of GDP, Indonesia’s R&D investment falls significantly below many of its Asian neighbors. Using the information presented in this chapter, explain how
increasing research and innovation and raising the academic credentials of researchers can assist in increasing long-run economic growth in Indonesia. Source: “World Bank Supports Move to Accelerate Indonesia’s Economic Growth through Science, Technology, and Innovation,” www.worldbank.org, March 29, 2013. Used by permission. 2.5 Education is an area in which it has been hard to create productivity gains that reduce costs. Collect data on the tuition rates of your own college in the last 20 years and compare that increase to the overall rate of inflation using the consumer price index. What do you observe? Can you suggest some productivity-enhancing measures? 2.6 Economists generally agree that high budget deficits today will reduce the growth rate of the economy in the future. Why? Do the reasons for the high budget deficit matter? In other words, does it matter whether the deficit is caused by lower taxes, increased defense spending, more job-training programs, and so on? 2.7 Why can growth lead to a more unequal distribution of income? By assuming this is true, how is it possible for the poor to benefit from economic growth? 2.8 According to the Bureau of Labor Statistics, during the first quarter of 2015 nonfarm business productivity in the United States fell 3.1 percent and manufacturing productivity fell 1.0 percent compared to the first quarter of 2014. During this same time, real GDP in the United States increased by 2.9 percent. Explain how productivity can decrease when real GDP is increasing. 2.9 How do each of the following relate to the rates of produc- tivity and growth in an economy? a. Spending on research and development b. Government regulation c. Changes in human capital d. Output per worker hour e. Embodied technical change f. Disembodied technical change 2.10 [Related to the Economics in Practice on p. 336] Human capital has often been cited as one of the driving forces of economic growth. Go to http://ec.europa.eu/eurostat and look up the current unemployment rate. Compare this to the unemployment rates across different levels of educational attainment. What does this data suggest about changes in education requirements for jobs in the EU? Also look at the percentage of people who have completed tertiary education or more in the age band of 25–64 for the years 2003–2014. Compare this data with the unemployment data. What does this information suggest about future productivity and growth for the economy of the European Union? MyLab Economics Visit www
.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with. M16_CASE3826_13_GE_C16.indd 343 17/04/19 4:22 AM 344 PART IV Further Macroeconomics Issues 16.3 GROWTH AND THE ENVIRONMENT AND ISSUES OF SUSTAINABILITY LEARNING OBJECTIVE: Discuss environmental issues associated with economic growth. 3.1 In June 2013, President Obama’s Climate Action Plan was announced. One the main aims of this plan was to reduce carbon dioxide emissions in the United States by 17 percent from 2005 levels by 2020. Also note that America’s per capita real GDP grew by 2.4 percent from 2013 to 2014. In this context, explain how the attainment of the goals of this plan reconciles with the inverted-U relationship as theorized by Gene Grossman and Alan Krueger QUESTION 1 Many international nongovernmental organizations (NGOs) work on improving health and educational outcomes for people living in developing countries. How would you expect these efforts to affect long-run growth? QUESTION 2 The enforcement of legal contracts and property rights is essential for supporting long-run growth. Based on what you learned in this chapter, why is this so? MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with. M16_CASE3826_13_GE_C16.indd 344 17/04/19 4:22 AM Alternative Views in Macroeconomics 17 Throughout this book, we have noted that there are many open questions in macroeconomics. For example, economists disagree on whether fiscal policy can change aggregate output levels: Is the aggregate supply curve is vertical, either in the short run or in the long run, so that all attempts to change output end up with higher wages and prices instead? Is the aggregate supply curve even a useful macroeconomic concept? There are different views on whether cyclical employment exists and, if it does, what causes it. Economists disagree about whether monetary policies are effective at stabilizing the economy, and they support different views on the primary determinants of consumption and investment spending. We discussed some of these disagreements in previous chapters, but only briefly. In this chapter, we discuss in more
detail a number of alternative views of how the macroeconomy works. We begin with a little history of the early debates between Keynesians and monetarists and then move on to more modern alternative theories of the macroeconomy. CHAPTER OUTLINE AND LEARNI NG OBJECTIV ES 17.1 Keynesian Economics p. 346 Summarize Keynesian economics. 17.2 Monetarism p. 346 Explain the quantity theory of money. 17.3 Supply-Side Economics p. 349 Explain the fundamentals of supply-side economics. 17.4 New Classical Macroeconomics p. 351 Discuss the real business cycle theory and new Keynesian economics. 17.5 Behavioral Macroeconomics p. 356 What contributions has behavioral economics made to macroeconomics? 17.6 Testing Alternative Macroeconomic Models p. 356 Discuss why it is difficult to test alternative macroeconomic theories. 345 M17_CASE3826_13_GE_C17.indd 345 17/04/19 12:54 AM 346 PART IV Further Macroeconomics Issues 17.1 LEARNING OBJECTIVE Summarize Keynesian economics. 17.2 LEARNING OBJECTIVE Explain the quantity theory of money. velocity of money The ratio of nominal GDP to the stock of money. Keynesian Economics John Maynard Keynes’s General Theory of Employment, Interest, and Money, published in 1936, remains one of the most important works in economics. Although a great deal of the material in the previous nine chapters is drawn from modern research that postdates Keynes, much of the material is built around a framework constructed by Keynes. What exactly is Keynesian economics? In one sense, it is the foundation of all of macroeconomics. Keynes was the first to emphasize aggregate demand and links between the money market and the goods market. Keynes also emphasized the possible problem of sticky wages and the importance of animal spirits in business cycles. In recent years, the term Keynesian has been used more narrowly. Keynes believed in an activist federal government. He believed that the government had a role to play in fighting inflation and unemployment, and he believed that monetary and fiscal policies should be used to manage the macroeconomy. This is why Keynesian is sometimes used to refer to economists who advocate active government intervention in the macroeconomy. We begin with an old debate between Keynesians and monetarists. From an historical perspective, monetarism was the earliest challenge to the activism of Keynesian economics. Monetarism The Velocity of Money My
Lab Economics Concept Check To understand monetarism we need to go back to the fundamentals of how we use money. A key variable in monetarism is the velocity of money, which is defined as the ratio of nominal GDP to the stock of money. Suppose on January 1 you buy a new ballpoint pen with a $5 bill. The owner of the stationery store does not spend your $5 right away. She may hold it until, say, May 1, when she uses it to buy a dozen doughnuts. The doughnut store owner does not spend the $5 he receives until July 1, when he uses it (along with other cash) to buy 100 gallons of oil. The oil distributor uses the bill to buy an engagement ring for his fiancée on September 1, but the $5 bill is not used again in the remaining three months of the year. This $5 bill has changed hands four times during the year; its velocity of circulation is four. A velocity of four means that the $5 bill stays with each owner for an average of three months, or one quarter of a year. In practice, we use gross domestic product (GDP), instead of the total value of all transactions in the economy, to measure velocity1 because GDP data are more readily available. The income velocity of money (V) is the ratio of nominal GDP to the stock of money (M): V K GDP M If $12 trillion worth of final goods and services is produced in a year and if the money stock is $1 trillion, then the velocity of money is $12 trillion, $1 trillion, or 12.0. We can expand this definition slightly by noting that nominal income (GDP) is equal to real output (income) (Y) times the overall price level (P): Through substitution: or GDP 1Recall that GDP does not include transactions in intermediate goods (for example, flour sold to a baker to be made into bread) or in existing assets (for example, the sale of a used car). If these transactions are made using money, however, they do influence the number of times money changes hands during the course of a year. GDP is an imperfect measure of transactions to use in calculating the velocity of money. M17_CASE3826_13_GE_C17.indd 346 17/04/19 12:54 AM CHAPTER 17 Alternative Views in Macroeconomics 347 quantity theory of money The theory based on the identity M * V K P * Y and
the assumption that V the velocity of money is constant (or virtually 1 constant). 2 At this point, it is worth pausing to ask whether our definition has provided us with any insights into the workings of the economy. The answer is no, because we defined V as the ratio of GDP to the money supply, the statement M * V K P * Y is an identity—it is true by definition. It contains no more useful information than the statement, “A tulip is a flower.” The definition does not, for example, say anything about what will happen to P * Y when M changes. The final value of P * Y depends on what happens to V. If V falls when M increases, the product M * V could stay the same, in which case the change in M would have had no effect on nominal income. To give monetarism some economic content, we will focus on a simple version of monetarism known as the quantity theory of money. The Quantity Theory of Money MyLab Economics Concept Check The key assumption of the quantity theory of money is that the velocity of money is constant (or virtually constant) over time. If we let V denote the constant value of V, the equation for the quantity theory can be written as follows: M * V = P * Y Note that the double bar equal sign has replaced the triple bar equal sign because the equation is no longer an identity. The equation is true if velocity is constant (and equal to V) but not otherwise. If the equation is true, it provides an easy way to explain nominal GDP. Given M, which can be considered a policy variable set by the Federal Reserve (Fed), nominal GDP is just M * V. In this case, the effects of monetary policy are clear. Changes in M cause equal percentage changes in nominal GDP. For example, if the money supply doubles, nominal GDP also doubles. If the money supply remains unchanged, nominal GDP remains unchanged. If the Fed, which controls the money supply, increases that supply, nominal GDP will go up. If we are already at full employment, all that happens is that prices rise. Monetarist believed that a central cause of inflation was mismanagement by the Fed of the money supply. Is the velocity of money really constant? The logic of the monetarist argument depends on its constancy. Early economists believed that the velocity of money was determined largely by institutional considerations, such as how often people are paid and how the banking system clears transactions between banks. These factors change gradually
, leading economists to believe velocity was essentially constant. When there is equilibrium in the money market, then the quantity of money supplied is equal to the quantity of money demanded. That could mean that M in the quantity-theory equation equals both the quantity of money supplied and the quantity of money demanded. If the quantity-theory equation is looked on as a demand-for-money equation, it says that the demand for money depends on nominal income (GDP, or P * Y), but not on the interest rate. If the interest rate changes and nominal income does not, the equation says that the quantity of money demanded will not change. This is contrary to the theory of the demand for money in Chapter 10, which had the demand for money depending on both income and the interest rate. Testing the Quantity Theory of Money One way to test the validity of the quantity theory of money is to look at the demand for money using recent data on the U.S. economy. The key is this: Does money demand depend on the interest rate? Most empirical work says yes. When demand-for-money equations are estimated (or “fit to the data”), the interest rate usually turns out to be a significant factor. The demand for money does not appear to depend only on nominal income. Another way of testing the quantity theory is to plot velocity over time and see how it behaves. Figure 17.1 plots the velocity of money for the 1960 I–2017 IV period. The data show that velocity is far from constant. There was a positive trend until 2007, but also large fluctuations around this trend. For example, velocity rose from 6.4 in 1980 III to 7.0 in 1981 III, fell to 6.6 in 1983 I, rose to 7.0 in 1984 III, and fell to 5.9 in 1986 IV. Changes of a few tenths of a point may seem small, but they are actually large. For example, the money supply in 1986 IV was about $800 billion. If velocity changes by 0.3 with a money supply of this amount and if the money supply is unchanged, we have a change in nominal GDP (P * Y) of $240 billion, which is about 5 percent of the level of GDP in 1986. The change in veloc- 0.3 * +800 billion ity since 2008 has been remarkable. Velocity fell from 9.6 in 2008 I to 4.9 in 2017 IV! 1 2 M17_CASE3826_13_GE
_C17.indd 347 17/04/19 12:54 AM 348 PART IV Further Macroeconomics Issues 10.0 9.0 8.0 7.0 6.0 5.0 4..0 1960 I 1965 I 1970 I 1975 I 1980 I 1985 I 1990 I 1995 I 2000 I Quarters 2005 I 2010 I 2015 I 2017 IV MyLab Economics Real-time data ▴▴ FIGURE 17.1 The Velocity of Money, 1960 I–2017 IV Velocity has not been constant over the period from 1960 to 2017. This was a long-term positive trend, which has now reversed. The debate over monetarist theories is more subtle than our discussion so far indicates. First, there are many definitions of the money supply. M1 is the money supply variable used for the graph in Figure 17.1, but there may be some other measure of the money supply that would lead to a smoother plot. For example, many people shifted their funds from checking account deposits to money market accounts when the latter became available in the late 1970s. Because GDP did not change as a result of this shift while M1 decreased, velocity—the ratio of GDP to M1—must have gone up. Suppose instead we measured the supply of money by M2 (which includes both checking accounts and money market accounts). In this case, the decrease in checking deposits would be exactly offset by the rise in money market account deposits and M2 would not change. With no change in GDP and no change in M2, the velocity of money would not change. Whether or not velocity is constant may depend partly on how we measure the money supply. Second, there may be a time lag between a change in the money supply and its effects on nominal GDP. Suppose we experience a 10 percent increase in the money supply today, but it takes one year for nominal GDP to increase by 10 percent. If we measured the ratio of today’s money supply to today’s GDP, it would seem that one year from now, when the increase in the supply of money had its full effect on income, velocity would have been constant. The debate over the quantity theory of money is primarily empirical. It is a debate that can be resolved by looking at facts about the real world and seeing whether they are in accord with the predictions of theory. Is there a measure of the money supply and a choice of the time lag between a change in the money supply and its effects on nominal GDP such that V is in effect constant? If
so, the monetarist theory is a useful approach to understanding how the macroeconomy works and how changes in the money supply will cause a proportional increase in nominal GDP. If not, some other theory is likely to be more appropriate. (We discuss the testing of alternative theories at the end of this chapter.) The Keynesian/Monetarist Debate MyLab Economics Concept Check The debate between Keynesians and monetarists was perhaps the central controversy in macroeconomics in the 1960s. The leading spokesman for monetarism was Milton Friedman from the University of Chicago. Most monetarists, including Friedman, blamed much of the instability in the economy on the Federal Reserve, arguing that the high inflation that the United States encountered from time to time could have been avoided if only the Fed had not expanded the money supply so rapidly. Monetarists were skeptical of the Fed’s ability to “ manage” the economy—to expand the money supply during bad times and contract it during good times. A common argument against such management is the one discussed in Chapter 14: Time lags may M17_CASE3826_13_GE_C17.indd 348 17/04/19 12:54 AM CHAPTER 17 Alternative Views in Macroeconomics 349 make attempts to stimulate and contract the economy counterproductive. Friedman advocated instead a policy of steady and slow money growth. He argued that the money supply should grow at a rate equal to the average growth of real output (income) (Y). That is, the Fed should pursue a constant policy that accommodates real growth but not inflation. Many Keynesians, on the other hand, advocated the application of coordinated monetary and fiscal policy tools to reduce instability in the economy—to fight inflation and unemployment. During the 1970s and 1980s, it became clear that managing the macroeconomy was more easily accomplished on paper than in practice. The inflation problems of the 1970s and early 1980s and the seriousness of the recessions of 1974–1975 and 1980–1982 led many economists to challenge the idea of active government intervention in the economy. Some of the challenges were simple attacks on the bureaucracy’s ability to act in a timely manner. Others were theoretical assaults in the spirit of Friedman that claimed to show that monetary and fiscal policies could not have any substantial effect on the economy. Most economists now agree, after the experience of the 1970s, that neither monetary nor fiscal tools are finely calibrated Still, many believe that the experiences of the 1970s also show that stabilization policies
can help prevent even bigger economic disasters. Had the government not cut taxes and expanded the money supply in 1975 and in 1982, they argue, the recessions of those years might have been significantly worse. The same people would also argue that had the government not resisted the inflations of 1974–1975 and 1979–1981 with tight monetary policies, the inflations probably would have become much worse. The debate between Keynesians and monetarists subsided with the advent of what we will call “new classical macroeconomics.” Before turning to this, however, it will be useful to consider a minor but interesting footnote in macroeconomic history: supply-side economics. Supply-Side Economics From our discussion of equilibrium in the goods market, beginning with the simple multiplier in Chapter 8 and continuing through Chapter 12, we have focused primarily on demand. Supply increases and decreases in response to changes in aggregate expenditure (which is closely linked to aggregate demand). Fiscal policy works by influencing aggregate expenditure through tax policy and government spending. Monetary policy works by influencing investment and consumption spending through increases and decreases in the interest rate. The theories we have been discussing are “demand-oriented.” Supply-side economics, as the name suggests, focuses on the supply side. The argument of the supply-siders about the economy in the late 1970s and early 1980s was simple. The real problem, they said, was not demand, but high rates of taxation and heavy regulation that reduced the incentive to work, to save, and to invest. What was needed was not a demand stimulus, but better incentives to stimulate supply. If we cut taxes so people take home more of their paychecks, the argument continued, they will work harder and save more. If businesses get to keep more of their profits and can avoid government regulations, they will invest more. This added labor supply and investment, or capital supply, will lead to an expansion of the supply of goods and services, which will reduce inflation and unemployment at the same time. In the tax debate of 2017, we heard arguments in favor of tax cuts that had a supply side flavor. At their most extreme, supply-siders argued that the incentive effects of supply-side policies were likely to be so great that a major cut in tax rates would actually increase tax revenues. Even though tax rates would be lower, more people would be working and earning income and firms would earn more profits, so that the increases in the tax bases (profits, sales, and income) would then outweigh the decreases in
rates, resulting in increased government revenues. The Laffer Curve MyLab Economics Concept Check Figure 17.2 presents a key diagram of supply-side economics. The tax rate is measured on the vertical axis, and tax revenue is measured on the horizontal axis. The assumption behind this curve is that there is some tax rate beyond which the supply response is large enough to lead to a decrease in tax revenue for further increases in the tax rate. There is obviously some tax rate 17.3 LEARNING OBJECTIVE Explain the fundamentals of supply-side economics. M17_CASE3826_13_GE_C17.indd 349 17/04/19 12:54 AM 350 PART IV Further Macroeconomics Issues Laffer curve With the tax rate measured on the vertical axis and tax revenue measured on the horizontal axis, the Laffer curve shows that there is some tax rate beyond which the supply response is large enough to lead to a decrease in tax revenue for further increases in the tax rate. between zero and 100 percent at which tax revenue is at a maximum. At a tax rate of zero, work effort is high but there is no tax revenue. At a tax rate of 100, the labor supply is presumably zero because people are not allowed to keep any of their income. Somewhere between zero and 100 is the maximum-revenue rate. The big debate in the 1980s was whether tax rates in the United States put the country on the upper or lower part of the curve in Figure 17.2. The supply-side school claimed that the United States was around A and that taxes should be cut. Others argued that the United States was nearer B and that tax cuts would lead to lower tax revenue. The diagram in Figure 17.2 is the Laffer curve, named after economist Arthur Laffer, who, legend has it, first drew it on the back of a napkin at a cocktail party. The Laffer curve had some influence on the passage of the Economic Recovery Tax Act of 1981, the tax package put forward by the Reagan administration that brought with it substantial cuts in both personal and business taxes. Individual income tax rates were cut by as much as 25 percent over three years. Corporate taxes were cut sharply in a way designed to stimulate capital investment. The new law allowed firms to depreciate their capital at a rapid rate for tax purposes, and the bigger deductions led to taxes that were significantly lower than before. Laffer’s ideas were also used to support the 2017 tax cuts. Evaluating Supply-Side
Economics MyLab Economics Concept Check Supporters of supply-side economics claim that Reagan’s tax policies were successful in stimulating the economy. They point to the fact that almost immediately after the tax cuts of 1981 were put into place, the economy expanded and the recession of 1980–1982 came to an end. In addition, inflation rates fell sharply from the high rates of 1980 and 1981. Except for one year, federal receipts continued to rise throughout the 1980s despite the cut in tax rates. Critics of supply-side policies do not dispute these facts, but offer an alternative explanation of how the economy recovered. The Reagan tax cuts were enacted just as the U.S. economy was in the middle of its deepest recession since the Great Depression. The unemployment rate stood at 10.7 percent in the fourth quarter of 1982. It was the recession, critics argue, that was responsible for the reduction in inflation—not the supply-side policies. Also among the criticisms of supply-side economics is that it is unlikely a tax cut would substantially increase the supply of labor. In addition, in theory, a tax cut could even lead to a reduction in labor supply. Recall our discussion of income and substitution effects in Chapter 15. Although it is true that a higher after-tax wage rate provides a higher reward for each hour of work and thus more incentive to work, a tax cut also means that households receive a higher income for a given number of hours of work. Households might choose to work less because they can earn the same amount of money working fewer hours. They might spend some of their added income on leisure. Research done during the 1980s suggests that tax cuts seem to increase the supply of labor somewhat but that the increases are very modest. What about the recovery from the recession? Why did real output begin to grow rapidly in late 1982, precisely when the supply-side tax cuts were taking effect? Two reasons have been suggested. First, the supply-side tax cuts had large demand-side effects that stimulated the economy. Second, ▴▸ FIGURE 17.2 The Laffer Curve The Laffer curve shows that the amount of revenue the government collects is a function of the tax rate. It shows that when tax rates are high, an increase in the tax rate could cause tax revenues to fall. Similarly, under the same circumstances, a cut in the tax rate could generate enough additional economic activity to cause revenues to rise. 100 ) MyLab Economics Concept Check 0 Tax revenues (dollars) M17_CASE38
26_13_GE_C17.indd 350 17/04/19 12:54 AM CHAPTER 17 Alternative Views in Macroeconomics 351 the Fed pumped up the money supply and drove interest rates down at the same time that tax cuts were being put into effect. The money supply expanded about 20 percent between 1981 and 1983, and interest rates fell. In the third quarter of 1981, the average three-month U.S. Treasury bill paid 15 percent interest. By the first quarter of 1983, the rate had dropped to 8.1 percent. Certainly, traditional theory suggests that a huge tax cut will lead to an increase in disposable income and, in turn, an increase in consumption spending (a component of aggregate expenditure). In addition, although an increase in planned investment (brought about by a lower interest rate) leads to added productive capacity and added supply in the long run, it also increases expenditures on capital goods (new plant and equipment investment) in the short run. Whether the recovery from the 1981–1982 recession was the result of supply-side expansion or supply-side policies that had demand-side effects, one thing is clear: The extreme promises of the supply-siders did not materialize. President Reagan argued that because of the effect depicted in the Laffer curve, the government could maintain expenditures (and even increase defense expenditures sharply), cut tax rates, and balance the budget. This was not the case. Government revenues fell sharply from levels that would have been realized without the tax cuts. After 1982, the federal government ran huge deficits, with about $2 trillion added to the national debt between 1983 and 1992. Most economists similarly predict that the Trump tax cuts of 2017 will lead to large deficits. New Classical Macroeconomics In recent years, the challenge to Keynesian and related theories has come from a school sometimes referred to as the new classical macroeconomics.2 Like monetarism and Keynesianism, this term is vague. No two new classical macroeconomists think exactly alike, and no single model completely represents this school. The following discussion, however, conveys the flavor of the new classical views. 17.4 LEARNING OBJECTIVE Discuss the real business cycle theory and new Keynesian economics. The Development of New Classical Macroeconomics MyLab Economics Concept Check In previous chapters we emphasized the importance of households’ and firms’ expectations about the future. A firm’s decision to build a new plant depends on its expectations of future sales. The amount of saving a household
undertakes today depends on its expectations about future interest rates, wages, and prices. Keynes himself recognized that expectations (in the form of “animal spirits”) play a big part in economic behavior. But how are these expectations formed? Many of the current debates in macroeconomics turn on this question. Traditional models assume that expectations are formed in naive ways. A common assumption, for example, is that people form their expectations of future inflation by assuming present inflation will continue. If they turn out to be wrong, they adjust their expectations by some fraction of the difference between their original forecast and the actual inflation rate. Suppose you expect 4 percent inflation next year. When next year comes, the inflation rate turns out to be only 2 percent, so you have made an error of 2 percentage points. You might then predict an inflation rate for the following year of 3 percent, halfway between your earlier expectation (4 percent) and actual inflation last year (2 percent). The problem with this somewhat mechanical treatment of expectations is that it is not consistent with the assumptions that we make in microeconomics of individual maximizing behavior. This “naïve” characterization of expectations implies that people systematically overlook information that would allow them to make better forecasts, even though there are costs to being wrong. Consumers and firms who maximize should form their expectations in a smarter way, or so the argument goes. Instead of naively assuming the future will be like the past or the present, they should actively seek to forecast the future. Operationalizing this idea of more informed expectations as part of optimizing behavior of households and firms is at the heart of new macroeconomics. 2The term new classical is used because many of the assumptions and conclusions of this group of economists resemble those of the classical economists—that is, those who wrote before Keynes. M17_CASE3826_13_GE_C17.indd 351 17/04/19 12:54 AM 352 PART IV Further Macroeconomics Issues rational-expectations hypothesis The hypothesis that people know the “true model” of the economy and that they use this model to form their expectations of the future. Rational Expectations MyLab Economics Concept Check One of the earliest theories which assumes a more sophisticated model of expectations formation is the rational-expectations hypothesis. The debate among macroeconomists is well illustrated by looking at diffferent models of how expectations change in inflationary periods. In many contexts, as in setting up a loan contract, decision makers need to forecast inflation
. Rational-expectations theorists assume that people know the “true model” that generates inflation—they know how inflation is determined in the economy—and they use this model to forecast future inflation rates. What do we do about the fact that many events that affect the inflation rate are not predictable (they are random)? Even if decision makers did know the model of the full economy, they would sometimes make mistakes, mistakes generated by these random shocks. The best one can achieve is that on average the model is correct, equally underestimating and overestimating inflation as random events occur. This is the working model used in rational expectations theory. Assuming that decision makers know the full model of the economy before they make their forecasts is thought by many other macroeconomists to be unrealistic. A slightly less ambitious definition of rational expectations assumes decision makers use “all available information” in forming their expectations. This definition is satisfied when decision makers have the true full model, but is less clear on what “all available information” means short of having the full model. A key debate among macroeconomists around the issue of expectations is the cost of decision making. If forming the correct expectations, gathering relevant data, is costly, then assuming people use a rule of thumb to project future inflation or economic growth is more reasonable. If relevant information can be obtained at no cost, people are not behaving rationally when they fail to use all available information given that there are usually costs to making a wrong forecast. Rational Expectations and Market Clearing The assumption of rational expectations has important implications for what we think should be the role of the government in the macroeconomy. If firms have rational expectations and if they set prices and wages on this basis, on average, prices and wages will be set at levels that ensure equilibrium in the goods and labor markets. When a firm has rational expectations, it knows the demand curve for its output and the supply curve of labor that it faces, except when random shocks disrupt those curves. Therefore, on average, the firm will set the market-clearing prices and wages. The firm knows the true model, and it will not set wages different from those it expects will attract the number of workers it wants. If all firms behave this way, wages will be set in such a way that the total amount of labor supplied will, on average, be equal to the total amount of labor that firms demand. In other words, on average, there will be full employment. In Chapter 13, we argued that there might
be disequilibrium in the labor market (in the form of either unemployment or excess demand for workers) because firms may make mistakes in their wage-setting behavior as a result of expectation errors. If, on average, firms do not make errors, on average, there will be equilibrium. When expectations are rational, disequilibrium exists only temporarily as a result of random, unpredictable shocks—obviously an important conclusion. If true, it means that disequilibrium in any market is only temporary because firms, on average, set market-clearing wages and prices. The assumption that expectations are rational radically changes the way we view the economy. We go from a world in which unemployment can exist for substantial periods and the multiplier can operate to a world in which (on average) all markets clear and there is full employment. In this world, there is no need for government stabilization policies. Unemployment is not a problem that governments need to worry about; if it exists at all, it is because of unpredictable shocks that, on average, amount to zero. There is no more reason for the government to try to change the outcome in the labor market than there is for it to change the outcome in the banana market. On average, prices and wages are set at market-clearing levels. The Lucas Supply Function One critique of the rational expectations model is that it seems to demand a good deal of household and firm decision makers. Another new classical approach to expectation setting that starts by recognizing difficulties in information gathering is from Robert E. Lucas of the University of Chicago. M17_CASE3826_13_GE_C17.indd 352 17/04/19 12:54 AM CHAPTER 17 Alternative Views in Macroeconomics 353 Brexit and Consumer Expectations When gauging consumer expectations, economists divide consumers by income, gender, and age group. With regard to the Brexit referendum of June 23, 2016, where the United Kingdom voted to leave the European Union (EU), several national consumer expectations surveys were conducted by renowned research institutions. Right before Brexit, a joint study by the research teams of Opinium Research, London School of Economics, and Lansons, revealed that consumers aged 18–24 years expected a decline in their annual income by £155 in the case of Brexit, while consumers above the age of 65 expected their yearly income to decline by only £6. If the United Kingdom remained with the EU, the former consumer group expected a £9 improvement in annual income, while the latter expected a deterioration of £239. However,
a vote to remain had higher future expectations of increased expenditure due to more likelihood of buying or replacing vehicles, household items, consumer durables, entertainment, and electronic goods. This was basically attributed to the uncertainty of employment and labor mobility prospects as well as scepticism regarding the future resilience of the British economy without the common European market. Post Brexit, however, a research paper by Deloitte reports that the majority of respondents anticipate no change in their personal wages and prices as a direct result of Brexit. This report explains that in spite of the negative business expectations and pessimistic media coverage, consumers were not too weary of Brexit. In fact, Brexit ranked sixth as a consumer concern, after the National Health Service, the health of the British economy, the state of the environment, inflation, and retirement plans. Why do the two reports give different results? Are they flawed? Not necessarily. The results could have changed as the consumers’ trust in their government increased with the fiscal and monetary interventions after the Brexit. In addition, the questions of each survey were posed in different ways. While the former report focused merely on financial and economic aspects, the second report took an overall view of the social and economic impact of Brexit. The Deloitte research paper included many noneconomic factors, such as the opposition to emigration and free mobility of labor within the EU, all of which were deemed as factors that could pose threats to the British workforce. This means that consumers surveyed looked at the overall picture and that any real effects are yet to be felt by individual consumers. CRITICAL THINKING 1. Right after Brexit, the Bank of England reduced interest rates. How could this have contributed to consumer expectations and behavior for each of the two surveys? Lucas begins by assuming that people and firms are specialists in production but generalists in consumption. If someone you know is a manual laborer, the chances are that she sells only one thing—labor. If she is a lawyer, she sells only legal services. In contrast, people buy a large bundle of goods—ranging from gasoline to ice cream and pretzels—on a regular basis. The same is true for firms. Most companies tend to concentrate on producing a small range of products, but they typically buy a larger range of inputs—raw materials, labor, energy, and capital. According to Lucas, this divergence between buying and selling creates an asymmetry. People know more about the prices of the things they sell than they do about the prices of the things they buy. As firms make decisions
, they care about both their own output prices and the general price level. With respect to their own output, firms quickly learn when their prices increase. But firms are slower to learn about the general price level in the economy. At the beginning of each period, a firm has some expectation of the average price level of goods in general for that period. If the actual price level turns out to be different, there is a price surprise. Suppose the average price level is higher than expected. The firm learns about the actual price level slowly, so some time goes by before it realizes that all prices have gone up. The firm perceives— incorrectly, it turns out—that its own price has risen relative to other prices, and this perception leads it to produce more output. M17_CASE3826_13_GE_C17.indd 353 17/04/19 12:54 AM 354 PART IV Further Macroeconomics Issues Lucas supply function The supply function embodies the idea that output (Y) depends on the difference between the actual price level and the expected price level. price surprise Actual price level minus expected price level. real business cycle theory An attempt to explain business cycle fluctuations under the assumptions of complete price and wage flexibility and rational expectations. It emphasizes shocks to technology and other shocks. A similar argument holds for workers. When there is a positive price surprise, workers at first believe that their “price”—their wage rate—has increased relative to other prices. Workers believe that their real wage rate has risen. We know from theory that an increase in the real wage is likely to encourage workers to work more hours.3 The real wage has not actually risen, but it takes workers a while to figure this out. In the meantime, they supply more hours of work than they would have. This increase means that the economy produces more output when prices are unexpectedly higher than when prices are at their expected level. This simple model of expectation formation leads to what has been called the Lucas supply function which yields, as we shall see, a surprising policy conclusion. The function is deceptively simple. It says that real output (Y) depends on (is a function of) the difference between the actual price level (P) and the expected price level (Pe ): Y = f P - Pe The actual price level minus the expected price level (P - Pe ) is the price surprise. 1 2 In short, the Lucas supply function tells us that unexpected increases in the price level can fool workers and firms into thinking that relative
prices have changed, causing them to alter the amount of labor or goods they choose to supply. Policy Implications of the Lucas Supply Function The Lucas supply function in combination with the assumption that expectations are rational implies that anticipated policy changes have no effect on real output. It is only policy surprises that have an effect, and that effect is temporary. Consider a change in monetary policy. In general, the change will have some effect on the average price level. If the policy change is announced to the public, people will know the effect on the price level because they have rational expectations (and know the way changes in monetary policy affect the price level). This means that the change in monetary policy affects the actual price level and the expected price level in the same way. The new price level minus the new expected price level is zero—no price surprise. In such a case, there will be no change in real output because the Lucas supply function states that real output can change from its fixed level only if there is a price surprise. The general conclusion is that any announced policy change—in fiscal policy or any other policy—has no effect on real output because the policy change affects both actual and expected price levels in the same way. If people have rational expectations, known policy changes can produce no price surprises—and no increases in real output. The only way any change in government policy can affect real output is if it is kept in the dark so it is not generally known. Government policy can affect real output only if it surprises people; otherwise, it cannot. Rational-expectations theory combined with the Lucas supply function proposes a very small role for government policy in the economy. Real Business Cycle Theory and New Keynesian Economics MyLab Economics Concept Check Research that followed Lucas’s work was concerned with whether the existence of business cycles can be explained under the assumptions of complete price and wage flexibility (market clearing) and rational expectations. This work is called real business cycle theory. As we discussed in Chapter 11, if prices and wages are completely flexible, then the AS curve is vertical, even in the short run. If the AS curve is vertical, then events or phenomena that shift the AD curve (such as changes in government spending and taxes) have no effect on real output. Real output does fluctuate over time, so the puzzle is how the fluctuations can be explained if they are not the result of policy changes or other shocks that shift the AD curve. Solving this puzzle is one of the main missions of real business cycle theory. It is
clear that if shifts of the AD curve cannot account for real output fluctuations (because the AS curve is vertical), then shifts of the AS curve must be responsible. However, the task is to come up with convincing explanations as to what causes these shifts and why they persist over 3This is true if we assume that the substitution effect dominates the income effect (see Chapter 15). M17_CASE3826_13_GE_C17.indd 354 17/04/19 12:54 AM CHAPTER 17 Alternative Views in Macroeconomics 355 new Keynesian economics A field in which models are developed under the assumptions of rational expectations and sticky prices and wages. a number of periods. The problem is particularly difficult when it comes to the labor market. If prices and wages are completely flexible, then there is never any unemployment aside from frictional unemployment. For example, because the measured U.S. unemployment rate was 4.0 percent in 2000 and 9.3 percent in 2009, the puzzle is to explain why so many more people chose not to work in 2009 than in 2000. Early real business cycle theorists emphasized shocks to the production technology. Suppose there is a negative shock in a given year that causes the marginal product of labor to decline. This leads to a fall in the real wage, which leads to a decrease in the quantity of labor supplied. People work less because the negative technology shock has led to a lower return from working. The opposite happens when there is a positive shock: The marginal product of labor rises, the real wage rises, and people choose to work more. This research was not as successful as some had hoped because it required what seemed to be unrealistically large shocks to explain the observed movements in labor supply over time. What has come to be called new Keynesian economics retains the assumption of rational expectations, but drops the assumption of completely flexible prices and wages. Prices and wages are assumed to be sticky. The existence of menu costs is often cited as a justification of the assumption of sticky prices. It may be costly for firms to change prices, which prevents firms from having completely flexible prices. Sticky wages are discussed in Chapter 13, and some of the arguments given there as to why wages might be sticky may be relevant to new Keynesian models. A main issue regarding these models is that any justification has to be consistent with all agents in the model having rational expectations. We will see another explanation for sticky wages when we discuss behavioral approaches to macroeconomics later in this chapter. Current research in new Keynesian economics broadly
defined is vast. There are many models, often called dynamic stochastic general equilibrium (DSGE) models. The properties of these models vary, but most have the feature—because of the assumption of sticky prices and wages—that monetary policy can affect real output. The government generally has some role to play in these models. Evaluating the Rational Expectations Assumption MyLab Economics Concept Check Almost all models in new classical macroeconomics—Lucas’s model, real business cycle models, new Keynesian models—assume rational expectations. A key question concerning how realistic these models are is thus how realistic the assumption of rational expectations is. If this assumption approximates the way expectations are actually formed, then it calls into question any theory that relies at least in part on expectation errors for the existence of disequilibrium. The arguments in favor of the rational expectations assumption sound persuasive from the perspective of microeconomic theory. When expectations are not rational, there are likely to be unexploited profit opportunities, and most economists believe such opportunities are rare and short-lived. The argument against rational expectations is that it requires households and firms to know too much. This argument says that it is unrealistic to think that these basic decision-making units know as much as they need to know to form rational expectations. People must know the true model (or at least a good approximation of the true model) to form rational expectations, and this knowledge is a lot to expect. Even if firms and households are capable of learning the true model, it may be costly to take the time and gather the relevant information to learn it. The gain from learning the true model (or a good approximation of it) may not be worth the cost. In this sense, there may not be unexploited profit opportunities around. Gathering information and learning economic models may be too costly to bother with, given the expected gain from improving forecasts. Although the assumption that expectations are rational seems consistent with the satisfaction-maximizing and profit-maximizing postulates of microeconomics, the rational expectations assumption is more extreme and demanding because it requires more information on the part of households and firms. Consider a firm engaged in maximizing profits. In some way or other, it forms expectations of the relevant future variables, and given these expectations, it figures out the best thing to do from the point of view of maximizing profits. Given a set of expectations, the problem of maximizing profits may not be too hard. What may be hard is forming accurate expectations in the first place. This requires
firms to know much more about the overall economy than they are likely to, so the assumption that their expectations are rational is not necessarily realistic. Firms, like the rest of us—so the argument goes—grope around in a M17_CASE3826_13_GE_C17.indd 355 17/04/19 12:54 AM 356 PART IV Further Macroeconomics Issues 17.5 LEARNING OBJECTIVE What contributions has behavioral economics made to macroeconomics? prospect theory People evaluate gains and losses from the vantage of a reference point. hyperbolic discounting People prefer immediate gratification to even slightly deferred gratification, but exhibit more patience when asked to defer gratification some time in the future. world that is difficult to understand, trying to do their best but not always understanding enough to avoid mistakes. In the final analysis, the issue is empirical. Does the assumption of rational expectations stand up well against empirical tests? This question is difficult to answer. Much work is currently being done to answer it. There are no conclusive results yet. Behavioral Macroeconomics Behavioral economics incorporates the insights of psychology and sociology into our understanding of the way agents in the economy—households as well as firm managers— make decisions. What happens to our description of the way markets work when we take into account cognitive biases, interest in fairness and social norms, concern with social status, or inconsistencies in discounting? We have already talked about a few of these issues, particularly in our discussion in Chapter 13 of why unemployment might exist. We turn now to look at some of the ideas in behavioral macroeconomics.4 We have mentioned that new Keynesian economics, while assuming that households maximize utility, firms maximize profits, and that expectations are rational, assumes that prices and wages are sticky. Why might prices and wages be sticky? Behavioral macroeconomics has weighed in on this. In particular, prospect theory provides an explanation of why wages might be sticky downward. Prospect theory suggests that people evaluate gains and losses from the vantage of a reference point (typically the current situation) and are especially averse to losses from that reference position. With loss averse workers, lowering nominal wages carries a big cost, and managers concerned about the morale of the workplace will tend to avoid inflicting those losses. Behavioral economics also has something to say about saving. In the work we have done so far on saving we have modeled savings as the optimizing choice individuals make between consumption now and consumption in the future. To be sure, people discount the future; that is
, they value today’s consumption more than consumption in the future, but they do that discounting in a consistent way. Behavioral economists like David Laibson and Matthew Rabin suggest instead that people are in fact “locally impatient,” preferring immediate gratification to even slightly deferred gratification, but exhibiting more patience when asked to defer gratification some time in the future. According to this model of hyperbolic discounting, delaying consumption for a month beginning now feels a lot harder than the prospect of delaying consumption for a month sometime in the future. The result? People save less than they should if all saving decisions are made at the moment. The policy conclusion? To increase saving we should ask people to sign up now to increase their saving in the future. Richard Thaler received the Nobel Prize in 2017 for work he did in this area.5 Finally, behavioral macroeconomics suggests that human emotions, confidence or lack thereof, pessimism or optimism, can all contribute to “irrational” upswings or downswings in the economy.6 Too much excitement and confidence can cause bubbles in markets like housing or the stock market, and once a lack of confidence sets it, it can be hard to reverse these emotions. Behavioral macroeconomics suggests that the government has a role to play in managing these expectations to keep the economy on an even keel. 17.6 LEARNING OBJECTIVE Discuss why it is difficult to test alternative macroeconomic theories. Testing Alternative Macroeconomic Models You may wonder why there is so much disagreement in macroeconomics. Why can’t macroeconomists test their models against one another and see which performs best? 4An excellent summary of the work in this area is George Akerlof, “Behavioral Macroeconomics and Macroeconomic Behavior,” American Economic Review. June 2002. 411–433. 5You might be interested in his popular book, Nudge., (coauthored with Cass Sunstein) Yale University Press, 2008. 6George Akerlof and Robert Shiller, Animal Spirits Princeton University Press, 2009. M17_CASE3826_13_GE_C17.indd 356 17/04/19 12:54 AM CHAPTER 17 Alternative Views in Macroeconomics 357 One problem is that macroeconomic models differ in ways that are hard to standardize. If one model takes the price level to be given, or not explained within the model, and another one does not, the model with the given price
level may do better in, for instance, predicting output— not because it is a better model but simply because the errors in predicting prices have not been allowed to affect the predictions of the output. The model that takes prices as given has a head start, so to speak. Another problem arises in the testing of the rational expectations assumption. Remember, if people have rational expectations, they are using the true model to form their expectations. Therefore, to test this assumption, we need the true model. There is no way to be sure that whatever model is taken to be the true model is in fact the true one. Any test of the rational expectations hypothesis is therefore a joint test: (1) that expectations are formed rationally and (2) that the model being used is the true one. If the test rejects the hypothesis, it may be that the model is wrong rather than that the expectations are not rational. Another problem for macroeconomists is the small amount of data available. Most empirical work uses data beginning about 1950, which in 2017 was about 68 years’ (272 quarters) worth of data. Although this may seem like a lot of data, it is not. Macroeconomic data are fairly “smooth,” which means that a typical variable does not vary much from quarter to quarter or from year to year. For example, the number of business cycles within this 68-year period is small, about eight. Testing various macroeconomic hypotheses on the basis of eight business cycle observations is not easy, and any conclusions must be interpreted with caution. To give an example of the problem of a small number of observations, consider trying to test the hypothesis that import prices affect domestic prices. Import prices changed very little in the 1950s and 1960s. Therefore, it would have been difficult at the end of the 1960s to estimate the effect of import prices on domestic prices. The variation in import prices was not great enough to show any effects. We cannot demonstrate that changes in import prices help explain changes in domestic prices if import prices do not change. The situation was different by the end of the 1970s because by then, import prices had varied considerably. By the end of the 1970s, there were good estimates of the import price effect, but not before. This kind of problem is encountered again and again in empirical macroeconomics. In many cases, there are not enough observations for much to be said and hence there is considerable room for disagreement. We said in Chapter 1 that it is difficult in economics to perform controlled experiments
. Economists, are for the most part, at the mercy of the historical data. If we were able to perform experiments, we could probably learn more about the economy in a shorter time. Alas, we must wait. In time, the current range of disagreements in macroeconomics should be considerably narrowed. S U M M A R Y 17.1 KEYNESIAN ECONOMICS p. 346 1. In a broad sense, Keynesian economics is the foundation of modern macroeconomics. In a narrower sense, Keynesian refers to economists who advocate active government intervention in the economy. 17.2 MONETARISM p. 346 2. The monetarist analysis of the economy places a great deal of emphasis on the velocity of money, which is defined as the number of times a dollar bill changes hands, on average, during the course of a year. The velocity of money is the ratio of nominal GDP to the stock of money, or V K GDP M * V K P * Y. M. Alternately. The quantity theory of money assumes that velocity is constant (or virtually constant). This implies that changes in the supply of money will lead to equal percentage changes in nominal GDP. The quantity theory of money equation is M * V = P * Y. The equation says that demand for money does not depend on the interest rate. 4. Most monetarists blame most of the instability in the economy on the federal government and are skeptical of the government’s ability to manage the macroeconomy. They argue that the money supply should grow at a rate equal to the average growth of real output (income) (Y)—the Fed should expand the money supply to accommodate real growth but not inflation. MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with. M17_CASE3826_13_GE_C17.indd 357 17/04/19 12:54 AM 358 PART IV Further Macroeconomics Issues 17.3 SUPPLY-SIDE ECONOMICS p. 349 5. Supply-side economics focuses on incentives to stimulate supply. Supply-side economists believe that if we lower taxes, workers will work harder and save more and firms will invest more and produce more. At their most extreme, supply-siders argue that incentive effects are likely to be so great that a major cut in taxes will actually increase tax revenues. 6.
The Laffer curve shows the relationship between tax rates and tax revenues. Supply-side economists use it to argue that it is possible to generate higher revenues by cutting tax rates. This does not appear to have been the case during the Reagan administration, however, where lower tax rates decreased tax revenues significantly and contributed to the large increase in the federal debt during the 1980s. 17.4 NEW CLASSICAL MACROECONOMICS p. 351 7. New classical macroeconomics uses the assumption of rational expectations. The rational expectations hypothesis assumes that people know the “true model” that generates economic variables. For example, rational expectations assumes that people know how inflation is determined in the economy and use this model to forecast future inflation rates. 8. The Lucas supply function assumes that real output (Y) depends on the actual price level minus the expected price level, or the price surprise. This function combined with the assumption that expectations are rational implies that anticipated policy changes have no effect on real output. 9. Real business cycle theory is an attempt to explain business cycle fluctuations under the assumptions of complete price and wage flexibility and rational expectations. It emphasizes shocks to technology and other shocks. 10. New Keynesian economics relaxes the assumption of complete price and wage flexibility. There is usually a role for government policy in these models. 17.5 BEHAVIORAL MACROECONOMICS p. 356 11. Behavioral economics provides an explanation for downward sticky wages using prospect theory and an explanation for saving behavior using the concept of hyperbolic discounting. 17.6 TESTING ALTERNATIVE MACROECONOMIC MODELS p. 356 12. Economists disagree about which macroeconomic model is best for several reasons: (1) Macroeconomic models differ in ways that are hard to standardize; (2) when testing the rational-expectations assumption, we are never sure that whatever model is taken to be the true model is the true one; and (3) the amount of data available is fairly small hyperbolic discounting, p. 356 Laffer curve, p. 350 Lucas supply function, p. 354 new Keynesian economics, p. 355 price surprise, p. 354 prospect theory, p. 356 quantity theory of money, p. 347 rational expectations hypothesis, p. 352 real business cycle theory, p. 354 velocity of money, p. 346 P R O B L E M S All problems are available on MyLab Economics. Equations: GDP M V K, p. 346 M *
V K P * Y, p. 346 M * V = P * Y, p. 347 17.1 KEYNESIAN ECONOMICS LEARNING OBJECTIVE: Summarize Keynesian economics. 2.1 The table gives estimates of the rate of the M2 money supply growth and the rate of real GDP growth for five countries in 2016: 1.1 Use aggregate supply and aggregate demand curves to show the predictions of Keynesian economic theory of the likely effects of a major tax cut when the economy is not operating at capacity and the Fed accommodates by increasing the money supply. Explain what happens to the level of real GDP and to the price level. 17.2 MONETARISM LEARNING OBJECTIVE: Explain the quantity theory of money. Rate of Growth in Money Supply (M2) Rate of Growth of Real GDP Canada United Kingdom Argentina Japan United States +9.0% +6.5% +53.2% +4.0% +6.5% +1.5% +1.8% -2.3% +1.0% +1.6% a. If you were a monetarist, what would you predict about the rate of inflation across the five countries? b. If you were a Keynesian and assuming activist central banks, how might you interpret the same data? MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with. M17_CASE3826_13_GE_C17.indd 358 17/04/19 12:54 AM 2.2 You are a monetarist given the following information: The money supply is $1 million. The velocity of money is four. What is nominal income? Real income? What happens to nominal income if the money supply is doubled? What happens to real income? 2.3 The following is data from 2018 for the tiny island nation of Coco Loco: money supply = $800 million; price level = 3.2; velocity of money = 3. Use the quantity theory of money to answer the following questions. a. What is the value of real output (income) in 2018? b. What is the value of nominal GDP in 2018? c. If real output doubled, by how much would the money supply need to change? d. If velocity is constant and Coco Loco was experiencing a recession in 2018, what
impact would an easy money policy have on nominal GDP? e. If the annual GDP growth rate is 12 percent in Coco Loco, by how much will the money supply need to change in 2019? 2.4 In the nation of Lower Vicuna, the velocity of money is fairly constant, and in the nation of Upper Vicuna, the velocity of money fluctuates greatly. For which nation would the quantity theory of money better explain changes in nominal GDP? Explain. CHAPTER 17 Alternative Views in Macroeconomics 359 notable economists argued against it. How would you explain the arguments for and against these tax cuts? 3.4 In a hypothetical economy, there is a simple proportional tax on wages imposed at a rate t. There are plenty of jobs around, so if people enter the labor force, they can find work. We define total government receipts from the tax as T = t * W * L where t = the tax rate, W = the gross wage rate, and L = the total supply of labor. The net wage rate is Wn = 1 - t W The elasticity of labor supply is defined as 1 2 Percentage of change in L Percentage of change in Wn = ∆L ∆Wn > ∆L Wn > Suppose t was cut from 0.25 to 0.20. For such a cut to increase total government receipts from the tax, how elastic must the supply of labor be? (Assume a constant gross wage.) What does your answer imply about the supply-side assertion that a cut in taxes can increase tax revenues? 17.3 SUPPLY-SIDE ECONOMICS LEARNING OBJECTIVE: Explain the fundamentals of supply-side economics. 3.1 In 2000, a well-known economist was heard to say, “The problem with supply-side economics is that when you cut taxes, they have both supply and demand side effects and you cannot separate the effects.” Explain this comment. Be specific and use the 1997 tax cuts or the Reagan tax cuts of 1981 as an example. 3.2 On December 22, 2017, President Trump signed the Tax Cuts and Jobs Act. According to this Act, corporate tax rate has been reduced from 35 percent to 21 percent, while the highest individual tax rate has dropped to 37 percent. According to President Trump, these cuts would improve the U.S. economy’s growth prospects. a. How would a supply-side economist evaluate the tax cuts? b. How would a Keynesian economist
evaluate the tax cuts? 3.3 In 2003, the government under George W. Bush implemented the Jobs and Growth Tax Relief Reconciliation Act, which lowered the rates on a number of taxes, including those on income from dividends and capital gains. According to the Congressional Budget Office, these tax cuts added approximately $1,500 billion to the debt and 17.4 NEW CLASSICAL MACROECONOMICS LEARNING OBJECTIVE: Discuss the real business cycle theory and new Keynesian economics. 4.1 [Related to the Economics in Practice on p. 353] Suppose you are thinking about where to live after you finish your degree. You discover that an apartment building near your new job has identical units—one is for rent and the other for sale as a condominium. Given your salary, both are affordable and you like them. Would you buy or rent? How would you go about deciding? Would your expectations play a role? Be specific. Where do you think those expectations come from? In what ways could expectations change things in the housing market as a whole? 4.2 A cornerstone of new classical economics is the notion that expectations are “rational.” What do you think will happen to the prices of single-family homes in your community over the next several years? On what do you base your expectations? Is your thinking consistent with the notion of rational expectations? Explain. 4.3 In an economy with reasonably flexible prices and wages, full employment is almost always maintained. Explain why that statement is true. 4.4 The economy of Borealis is represented by the following Lucas supply function: Y = 750 + 50(P - Pe). The current price level in Borealis is 1.45, and the expected price level is 1.70. MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with. M17_CASE3826_13_GE_C17.indd 359 17/04/19 12:54 AM 360 PART IV Further Macroeconomics Issues a. What will be the new level of real output if inflation expec- tations are correct? b. What will be the new level of real output if inflation expectations are wrong and the actual price level rises to 1.80? c. What will be the new level of real output if the actual price level does not change? d. What is the value of the �
�price surprise” in parts a, b, and c? 4.5 If households and firms have rational expectations, is it possible for the unemployment rate to exceed the natural rate of unemployment? Explain. 4.6 Assume people and firms have rational expectations. Explain how each of the following events will affect aggregate output and the price level. a. The Reserve Bank of India announces it will decrease the cash reserve ratio (CRR). b. The government of India unexpectedly passes a bill that will reduce taxes. c. The RBI announces a contraction in the money supply. d. Without notice, OPEC increases oil production by 40 percent. e. The government of India passes a previously unan- nounced bill, which causes an immediate increase in expenditure on food subsidy. 17.5 BEHAVIORAL MACROECONOMICS LEARNING OBJECTIVE: What contributions has behavioral economics made to macroeconomics? 5.1 The tiny island of Ditto contains two identical towns, East Doppelganger and West Doppelganger. Each year, the 100 citizens of each town compete in their annual New Year’s resolution challenge. In November, the mayors got together and agreed that all their townspeople could use more exercise, so for the upcoming year’s challenge, each citizen would be asked to walk around the local volcano each day, a distance of exactly 1 mile, starting January 1 for three consecutive months. The winning town, based on the total number of miles walked, would get to host the next annual Looking Glass Festival, the biggest celebration on the island. This year, the mayor of East Doppelganger decided to announce the challenge to the citizens of the town on December 1, while the mayor of West Doppelganger chose to wait until New Year’s Eve to make the announcement. Assuming that all the citizens of both towns are equally healthy, are not terribly fond of exercise even though they know it is good for their health, and are completely honest (so no one cheats as far as the number of miles walked), use the model of hyperbolic discounting to explain which town will likely win the challenge. 17.6 TESTING ALTERNATIVE MACROECONOMIC MODELS LEARNING OBJECTIVE: Discuss why it is difficult to test alternative macroeconomic theories. 6.1 The following data is for the small, recently independent island nation of Hibiscus: Tax rate: 10% flat tax on all citizens since its independence in
2015 Labor supply: 200 workers in 2015, and has grown by 3 percent each successive year Inflation rate: Has fluctuated between 2 percent and 3 percent annually since 2015 Unemployment rate: A constant 4.5 percent each year since 2015 Exchange rate: Since 2015 has fluctuated by more than 20 percent, both up and down, relative to the rates of major currencies Interest rate: Has risen from 2.5 percent to 3.5 percent since 2015 Explain why macroeconomists would find it difficult to test the following hypotheses for Hibiscus: a. Tax rates affect the supply of labor b. The inflation rate affects the unemployment rate c. The exchange rate affects the interest rate * Note: Problems marked with an asterisk are more challenging QUESTION 1 When tax rates are higher, national income falls. Is this true along the entire Laffer curve or only the downwardsloping portion? QUESTION 2 According to the Real Business Cycle Theory, the Short-Run Aggregate Supply curve is vertical, and fluctuations in Real GDP arise due to shocks that shift this curve around. Would a negative shock that shifts the curve to the left and creates a recessionary gap lead the price level to rise or fall? MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with. M17_CASE3826_13_GE_C17.indd 360 17/04/19 12:54 AM PART V THE WORLD ECONOMY International Trade, Comparative Advantage, and Protectionism Over the last 47 years, international transactions have become increasingly important to the U.S. economy. In 1970, imports represented only about 5.2 percent of U.S. gross domestic product (GDP). The share in 2017 was 15.0 percent. The increased trade we observe in the United States is mirrored throughout the world. From 1980 to 2017, world trade in real terms has grown more than sixfold. This trend has been especially rapid in the newly industrialized Asian economies, but many developing countries such as Malaysia and Vietnam have also been increasing their openness to trade. The “internationalization” or “globalization” of the U.S. economy has occurred in the private and public sectors, in input and output markets, and in firms and households. Once uncommon, foreign products are now everywhere, from the utensils we eat with to the cars we drive. Nor is it easy
to tell where products are made. The iPhone, which most people think of as an iconic U.S. product, is assembled in China from parts produced in four other countries: Korea, Germany, Japan, and the United States. Honda, which most people think of as a Japanese company, started producing Japanese motorcycles in Ohio in 1977 with 64 employees in Marysville. The company now employs many thousand workers, who assemble Honda automobiles in eleven manufacturing plants in Ohio, Georgia, and North Carolina. 18 CHAPTER O UT LINE AND LEARNING OBJECTIVE S 18.1 Trade Surpluses and Deficits p. 362 How are trade surpluses and trade deficits defined? 18.2 The Economic Basis for Trade: Comparative Advantage p. 362 Explain how international trade emerges from the theory of comparative advantage and what determines the terms of trade. 18.3 The Sources of Comparative Advantage p. 370 Describe the sources of comparative advantage. 18.4 Trade Barriers: Tariffs, Export Subsidies, and Quotas p. 371 Analyze the economic effects of trade barriers. 18.5 Free Trade or Protection? p. 375 Evaluate the arguments over free trade and protectionism. 18.6 An Economic Consensus p. 381 Outline how international trade fits into the structure of the economy. 361 M18_CASE3826_13_GE_C18.indd 361 17/04/19 4:24 AM 362 PART V The World Economy In addition to the fact that goods and services (outputs) flow easily across borders, so too do inputs: capital and labor. Certainly, it is easy to buy financial assets abroad. Millions of Americans own shares in foreign stocks or have invested in bonds issued by foreign countries. At the same time, millions of foreigners have put money into the U.S. stock and bond markets. Outsourcing is also changing the nature of the global labor market. It is now simple and common for a customer service call to a software company from a user of its product in Bend, Oregon, to be routed to Bangalore, India, where a young, ambitious Indian man or woman provides assistance to a customer over the Internet. The Internet has in essence made it possible for some types of labor to flow smoothly across international borders. To get you more acquainted with the international economy, this chapter discusses the economics of international trade. First, we describe the trends in imports and exports to the United States. Next, we
explore the basic logic of trade. Why should the United States or any other country engage in international trade? Finally, we address the controversial issue of protectionism. Should a country provide certain industries with protection in the form of import quotas or tariffs, which are taxes imposed on imports? Should a country help a domestic industry compete in international markets by providing subsidies? Trade Surpluses and Deficits Until the 1970s, the United States generally exported more than it imported. When a country exports more than it imports, it runs a trade surplus. When a country imports more than it exports, it runs a trade deficit. In the mid-1970s the United States began to run trade deficits. In 2009 the trade deficit was 5.6 percent of GDP. Since then it has fallen somewhat—to 2.9 percent in 2017. The large U.S. trade deficits have sparked political controversy. Less expensive foreign goods—among them steel, textiles, and automobiles—create competition for locally produced substitute goods, and many believe that domestic jobs are lost as a result. On the other hand, foreign trade provides Americans with a broader set of goods at lower prices. In recent times, the outsourcing of software development to India has caused complaints from white-collar workers again reflecting a concern about employment displacement. In some cases, U.S. officials blame the trade deficit on unfair support by foreign governments of their local firms and unfair pricing by those firms. This theme emerged in 2017 and 2018 when the Trump administration called for tariffs, particularly focused on Chinese goods like steel. The natural reaction to trade-related job dislocation is to call for protection of U.S. industries. Many people want the president and Congress to impose taxes and import restrictions that would make foreign goods less available and more expensive, protecting U.S. jobs. This argument is not new. For hundreds of years, industries have petitioned their governments for protection and societies have debated the pros and cons of free and open trade. For the last century and a half, the principal argument against protection has been the theory of comparative advantage, first discussed in Chapter 2 and expanded upon here. 18.1 LEARNING OBJECTIVE How are trade surpluses and trade deficits defined? trade surplus The situation when a country exports more than it imports. trade deficit The situation when a country imports more than it exports. 18.2 LEARNING OBJECTIVE Explain how international trade emerges from the theory of comparative advantage and what determines the terms of trade. Corn Laws The tariffs, subsidies
, and restrictions enacted by the British Parliament in the early nineteenth century to discourage imports and encourage exports of grain. The Economic Basis for Trade: Comparative Advantage Perhaps the best-known debate on the issue of free trade took place in the British Parliament during the early years of the nineteenth century. At that time, the landed gentry—the landowners—controlled Parliament. For a number of years, imports and exports of grain had been subject to a set of tariffs, subsidies, and restrictions collectively called the Corn Laws. Designed to discourage imports of grain and to encourage exports, the Corn Laws’ purpose was to keep the price of food high. The landlords’ incomes, of course, depended on the prices they got for what their land produced. The Corn Laws clearly worked to the advantage of those in power. With the Industrial Revolution, a class of wealthy industrial capitalists emerged. The industrial sector had to pay workers at least enough to live on, and a living wage depended greatly on the price of food. Tariffs on grain imports and export subsidies that kept grain and food prices high increased the wages that capitalists had to pay, cutting into their profits. The political battle M18_CASE3826_13_GE_C18.indd 362 17/04/19 4:24 AM CHAPTER 18 International Trade, Comparative Advantage, and Protectionism 363 theory of comparative advantage Ricardo’s theory that specialization and free trade will benefit all trading parties, even those that may be “absolutely” more efficient producers. absolute advantage The advantage in the production of a good enjoyed by one country over another when it uses fewer resources to produce that good than the other country does. comparative advantage The advantage in the production of a good enjoyed by one country over another when that good can be produced at a lower opportunity cost (in terms of other goods that must be foregone) than it could be in the other country. raged for years. However, as time went by, the power of the landowners in the House of Lords was significantly reduced. When the conflict ended in 1848, the Corn Laws were repealed. On the side of repeal was David Ricardo, a businessman, economist, member of Parliament, and one of the fathers of modern economics. Ricardo’s principal work, Principles of Political Economy and Taxation, was published in 1817, two years before he entered Parliament. Ricardo’s theory of comparative advantage, which he used to argue against the Corn Laws, claimed that trade enables countries to specialize in
producing the products they produce best. According to the theory, specialization and free trade will benefit all trading partners (real wages will rise), even those that may be absolutely less efficient producers. This basic argument remains at the heart of free-trade debates even today, as policy makers argue about the effects of tariffs on agricultural development in sub-Saharan Africa and the gains and losses from outsourcing software development to India. Absolute Advantage versus Comparative Advantage MyLab Economics Concept Check A country enjoys an absolute advantage over another country in the production of a good if it uses fewer resources to produce that good than the other country does. Suppose country A and country B produce wheat, but A’s climate is more suited to wheat and its labor is more productive. Country A will produce more wheat per acre than country B and use less labor per acre of wheat grown. Country A enjoys an absolute advantage over country B in the production of wheat. A country enjoys a comparative advantage in the production of a good if that good can be produced at a lower opportunity cost (in terms of units of other goods that must be foregone). Suppose countries C and D both produce wheat and corn and C enjoys an absolute advantage in the production of both—that is, C’s climate is better than D’s and fewer of C’s resources are needed to produce a given quantity of both wheat and corn. Now C and D must each choose between planting land with either wheat or corn. To produce more wheat, either country must transfer land from corn production; to produce more corn, either country must transfer land from wheat production. The cost of wheat in each country can be measured in foregone bushels of corn, and the cost of corn can be measured in foregone bushels of wheat. Suppose that in country C, a bushel of wheat has an opportunity cost of 2 bushels of corn. That is, to produce an additional bushel of wheat, C must give up 2 bushels of corn. At the same time, producing a bushel of wheat in country D requires the sacrifice of only 1 bushel of corn. Even though C has an absolute advantage in the production of both products, D enjoys a c omparative advantage in the production of wheat because the opportunity cost of producing wheat is lower in D. Under these circumstances, Ricardo claims, both countries will benefit from specialization in the good for which they have a comparative advantage and then trading with each other. We turn now to a discussion of that claim. G
ains from Mutual Absolute Advantage To illustrate Ricardo’s logic in more detail, suppose Australia and New Zealand each have a fixed amount of land and do not trade with the rest of the world. There are only two goods—wheat to produce bread and cotton to produce clothing. The conclusions we get from working with this two-country/two-good world can be easily generalized to many countries and many goods. To proceed, we have to make some assumptions about the preferences of the people living in New Zealand and the people living in Australia. We will assume the populations of both countries use both cotton and wheat, and preferences for food and clothing are such that before trade both countries consume equal amounts of wheat and cotton. Finally, we assume that each country has only 100 acres of land for planting and that land yields are as given in Table 18.1. New Zealand can produce 3 times the wheat that Australia can on 1 acre of land, and Australia can produce 3 times the cotton that New Zealand can in the same space. New Zealand has an absolute advantage in the production of wheat, and Australia has an absolute advantage in the production of cotton. In cases like this, we say the two countries have mutual absolute advantage. If there is no trade and each country divides its land to obtain equal units of cotton and wheat production, each country produces 150 bushels of wheat and 150 bales of cotton. New Zealand puts 75 acres into cotton but only 25 acres into wheat, while Australia does the reverse (Table 18.2). M18_CASE3826_13_GE_C18.indd 363 17/04/19 4:24 AM 364 PART V The World Economy TABLE 18.1 Yield per Acre of Wheat and Cotton New Zealand Wheat Cotton 6 bushels 2 bales Australia 2 bushels 6 bales TABLE 18.2 Total Production of Wheat and Cotton Assuming No Trade, Mutual Absolute Advantage, and 100 Available Acres New Zealand Australia Wheat Cotton 25 acres * 6 bushels/acre = 150 bushels 75 acres * 2 bales/acre = 150 bales 75 acres * 2 bushels/acre = 150 bushels 25 acres * 6 bales/acre = 150 bales We can organize the same information in graphic form as production possibility frontiers for each country. Figure 18.1 presents the positions of the two countries before trade, where each country is constrained by its own resources and productivity. If Australia put all its land into cotton, it would produce 600
bales of cotton (100 acres * 6 bales/acre) and no wheat; if it put all its land into wheat, it would produce 200 bushels of wheat (100 acres * 2 bushels/acre) and no cotton. The opposite is true for New Zealand. Recall from Chapter 2 that a country’s production possibility frontier represents all combinations of goods that can be produced, given the country’s resources and state of technology. Each country must pick a point along its own production possibility curve. We can see that both countries have the option of producing and consuming 150 units of each good, marked on the two figures. When there is mutual absolute advantage, it is easy to see that specialization and trade will benefit both. Australia should produce cotton, and New Zealand should produce wheat. Transferring all land to wheat production in New Zealand yields 600 bushels, while transferring all land to cotton production in Australia yields 600 bales. Because both countries want to consume both goods, they will then need to trade. Suppose the countries agree to trade 300 bushels of wheat for 300 bales of cotton. Prior to specialization, each country consumed 150 units of each good. Now each country has 300 units of each good. Specialization Australia New Zealand 600 150 ) 200 150 0 150 200 0 150 600 Wheat (bushels) MyLab Economics Concept Check Wheat (bushels) ▴▴ FIGURE 18.1 Production Possibility Frontiers for Australia and New Zealand Before Trade Without trade, countries are constrained by their own resources and productivity. M18_CASE3826_13_GE_C18.indd 364 17/04/19 4:24 AM CHAPTER 18 International Trade, Comparative Advantage, and Protectionism 365 TABLE 18.3 Production and Consumption of Wheat and Cotton After Specialization Production Consumption Wheat Cotton New Zealand 100 acres * 6 bushels/acre 600 bushels 0 acres 0 Australia 0 acres 0 New Zealand Australia Wheat 300 bushels 300 bushels 100 acres * 6 bales/acre Cotton 300 bales 300 bales 600 bales has allowed the countries to double their consumption of both goods! Final production and trade figures are provided in Table 18.3 and Figure 18.2. Trade enables both countries to move beyond their previous resource and productivity constraints. The advantages of specialization and trade seem obvious when one country is technologically superior at producing one product and another country is technologically superior at producing another product. However, let us turn to the case
in which one country has an absolute advantage in the production of both goods. Gains from Comparative Advantage Table 18.4 changes the land yield figures for New Zealand and Australia. Now New Zealand has a considerable absolute advantage in the production of both cotton and wheat, with 1 acre of land yielding 6 times as much wheat and twice as much cotton as 1 acre in Australia. Ricardo would argue that specialization and trade are still mutually beneficial. Again, we assume preferences imply consumption of equal units of cotton and wheat in both countries. With no trade, New Zealand would divide its 100 available acres evenly, or 50/50, between the two crops. The result would be 300 bales of cotton and 300 bushels of wheat. Australia would divide its land 75/25. Table 18.5 shows that final production in Australia would be 75 bales of cotton and 75 bushels of wheat. (Remember, we are assuming that in each country, people consume equal amounts of cotton and wheat.) Again, before any trade takes place, each country is constrained by its own domestic production possibility curve. Australia New Zealand 600 300 150 ) 300 200 150 0 150 200 300 0 150 300 600 Wheat (bushels) MyLab Economics Concept Check Wheat (bushels) ▴▴ FIGURE 18.2 Expanded Possibilities After Trade Trade enables both countries to consume beyond their own domestic resource constraints—beyond their individual production possibility frontiers. M18_CASE3826_13_GE_C18.indd 365 17/04/19 4:24 AM 366 PART V The World Economy TABLE 18.4 Yield per Acre of Wheat and Cotton New Zealand Australia Wheat Cotton 6 bushels 6 bales 1 bushel 3 bales TABLE 18.5 Total Production of Wheat and Cotton Assuming No Trade and 100 Available Acres Wheat Cotton New Zealand Australia 50 acres × 6 bushels/acre 300 bushels 50 acres × 6 bales/acre 300 bales 75 acres × 1 bushel/acre 75 bushels 25 acres × 3 bales/acre 75 bales Imagine we are at a meeting of trade representatives of both countries. As a special adviser, David Ricardo is asked to demonstrate that trade can benefit both countries. He divides his demonstration into three stages, which you can follow in Table 18.6. For Ricardo to be correct about the gains from specialization, it must be true that moving resources around in the two countries generates more than the 375 bushels of wheat and bales
of cotton that we had before specialization. To see how this is managed, we move in stages. In Stage 1, let Australia move all its land into cotton production, where it is least disadvantaged. Australia would then produce 300 bales of cotton, as we see in Stage 1 of Table 18.6. Now the question is whether Ricardo can help us use New Zealand’s land to add at least 75 bales of cotton to the total while producing more than the original 375 bushels of wheat. In Stage 2, Ricardo tells New Zealand to use 25 acres to produce cotton and 75 acres for wheat production. With that allocation of land, New Zealand produces 450 bushels of wheat (far more than the total produced in the nonspecialization case by both countries) and 150 bales of cotton, leaving us with 450 bales of cotton as well. Specialization has increased the world production of both wheat and cotton by 75 units! With trade, which we show in Stage 3 for the case in which both countries prefer equal consumption of the two goods, both countries can be better off than they were earlier. TABLE 18.6 Realizing a Gain from Trade when One Country Has a Double Absolute Advantage STAGE 1 New Zealand Australia Wheat Cotton 50 acres × 6 bushels/acre 300 bushels 50 acres × 6 bales/acre 300 bales 0 acres Wheat 0 100 acres × 3 bales/acre 300 bales Cotton STAGE 3 STAGE 2 New Zealand Australia 75 acres × 6 bushels/acre 450 bushels 0 acres 0 25 acres × 6 bales/acre 150 bales 100 acres × 3 bales/acre 300 bales New Zealand Australia 100 bushels (trade) h Wheat 350 bushels 100 bushels (after trade) 200 bales (trade) v Cotton 350 bales 100 bales (after trade) M18_CASE3826_13_GE_C18.indd 366 17/04/19 4:24 AM CHAPTER 18 International Trade, Comparative Advantage, and Protectionism 367 Why Does Ricardo’s Plan Work? To understand why Ricardo’s scheme works, let us return to the definition of comparative advantage. The real cost, which is an opportunity cost, of producing cotton is the wheat that must be sacrificed to produce it. When we think of cost this way, it is less costly to produce cotton in Australia than to produce it in New Zealand, even though an acre of land produces more cotton in
New Zealand. Consider the “cost” of 3 bales of cotton in the two countries. In terms of opportunity cost, 3 bales of cotton in New Zealand cost 3 bushels of wheat; in Australia, 3 bales of cotton cost only 1 bushel of wheat. Because 3 bales are produced by 1 acre of Australian land, to get 3 bales, an Australian must transfer 1 acre of land from wheat to cotton production. Because an acre of land produces a bushel of wheat, losing 1 acre to cotton implies the loss of 1 bushel of wheat. Australia has a comparative advantage in cotton production because its opportunity cost, in terms of wheat, is lower than New Zealand’s. This is illustrated in Figure 18.3. Conversely, New Zealand has a comparative advantage in wheat production. A unit of wheat in New Zealand costs 1 unit of cotton, whereas a unit of wheat in Australia costs 3 units of cotton. When countries specialize in producing goods in which they have a comparative advantage, they maximize their combined output and allocate their resources more efficiently. Terms of Trade MyLab Economics Concept Check We see that specialization and trade increases the size of the pie to be shared between the two countries. Our next question is how that bigger pie is to be divided up between the two countries. In stage three above we have offered one possibility for this division, which benefitted both parties. But this is only one of many possible ways to divide the pie. What would we expect to see happen in practice? The ratio at which a country can trade domestic products for imported products is the terms of trade. The terms of trade determine how the gains from trade are distributed among trading partners. In the case just considered, the agreed-to terms of trade were 1 bushel of wheat for 2 bales of cotton. Such terms of trade benefit New Zealand, which can get 2 bales of cotton for each bushel of wheat. If it were to transfer its own land from wheat to cotton, it would get only 1 bale of cotton. The same terms of trade benefit Australia, which can get 1 bushel of wheat for 2 bales of cotton. A direct transfer of its own land would force it to give up 3 bales of cotton for 1 bushel of wheat. If the terms of trade changed to 3 bales of cotton for every bushel of wheat, only New Zealand would benefit. At those terms of trade, all the gains from trade would flow to New Zealand. Such terms do not
benefit Australia at all because the opportunity cost of producing wheat domestically is exactly the same as the trade cost: A bushel of wheat costs 3 bales of cotton. If the terms of trade went the other way—1 bale of cotton for each bushel of wheat—only Australia would benefit. New Zealand gains nothing because it can already substitute cotton for wheat at that terms of trade The ratio at which a country can trade domestic products for imported products. Opportunity “cost” of wheat Opportunity “cost” of cotton New Zealand Australia New Zealand Australia MyLab Economics Concept Check ▴◂ FIGURE 18.3 Comparative Advantage Means Lower Opportunity Cost The real cost of cotton is the wheat sacrificed to obtain it. The cost of 3 bales of cotton in New Zealand is 3 bushels of wheat (a half-acre of land must be transferred from wheat to cotton—refer to Table 18.4). However, the cost of 3 bales of cotton in Australia is only 1 bushel of wheat. Australia has a comparative advantage over New Zealand in cotton production, and New Zealand has a comparative advantage over Australia in wheat production. M18_CASE3826_13_GE_C18.indd 367 17/04/19 4:24 AM 368 PART V The World Economy ratio. To get a bushel of wheat domestically, however, Australia must give up 3 bales of cotton, and one-for-one terms of trade would make wheat much less costly for Australia. Both parties must have something to gain for trade to take place. In this case, you can see that both Australia and New Zealand will gain when the terms of trade are set between 1:1 and 3:1, cotton to wheat. Exchange Rates MyLab Economics Concept Check The examples used thus far have shown that trade can result in gains to both parties. When trade is free—unimpeded by government-instituted barriers—patterns of trade and trade flows result from the independent decisions of thousands of importers and exporters and millions of private households and firms. Private households decide whether to buy Toyotas or Chevrolets, and private firms decide whether to buy machine tools made in the United States or machine tools made in Taiwan, raw steel produced in China or raw steel produced in Pittsburgh. But how does this trade actually come about? In international markets, as in domestic markets, barter is rarely used. Instead trade happens with money. But in the international marketplace, there are a number
of different types of currency or money. Before a citizen of one country can buy a product made in another country or sold by someone in another country, a currency swap must take place. Someone who buys a Toyota built in Japan from a dealer in Boston pays in dollars, but the Japanese workers who made the car receive their salaries in yen. Somewhere between the buyer of the car and the producer, a currency exchange must be made. The regional distributor probably takes payment in dollars and converts them into yen before remitting the proceeds to Japan. To buy a foreign-produced good, a consumer, or an intermediary, has to buy foreign currency. The price of a Toyota in dollars depends on the price of the car stated in yen and the dollar price of yen. You probably know the ins and outs of currency exchange very well if you have ever traveled in another country. In April 2018, the British pound was worth $1.37. Now suppose you are in London having dinner. On the menu is a nice bottle of wine for 25 pounds. How can you figure out whether you want to buy it? You know what dollars will buy in the United States, so you have to convert the price into dollars. Each pound will cost you $1.37, so 25 pounds will cost you $1.37 * 25 = $34.25. The attractiveness of foreign goods to U.S. buyers and of U.S. goods to foreign buyers depends in part on the exchange rate, the ratio at which two currencies are traded. In May 2008, the British pound was worth $1.97, and that same bottle of wine would have cost $49.25. In the last decade it has become more attractive for American tourists to visit Great Britain (and the rest of Europe as well) because the dollar is strong relative to other currencies. So how are these exchange rates determined? Why is the dollar stronger now than it was 10 years ago? Exchange rate determination is complicated, but we can say a few things. First, for any pair of countries, there is a range of exchange rates that can lead automatically to both countries’ realizing the gains from specialization and comparative advantage. Second, within that range, the exchange rate will determine which country gains the most from trade. In short, exchange rates determine the terms of trade. Trade and Exchange Rates in a Two-Country/Two-Good World Consider first a simple two-country/two-good model. Suppose both the United States and Brazil produce only two goods—raw timber and
rolled steel. Table 18.7 gives the current prices of both goods as domestic buyers see them. In Brazil, timber is priced at 3 reals (R) per foot and steel is priced at 4 R per ton. In the United States, timber costs $1 per foot and steel costs $2 per ton. Suppose U.S. and Brazilian buyers have the option of buying at home or importing to meet their needs. The options they choose will depend on the exchange rate. For the time being, we will ignore transportation costs between countries and assume that Brazilian and U.S. products are of equal quality. Let us start with the assumption that the exchange rate is +1 = 1 R. From the standpoint of U.S. buyers, neither Brazilian steel nor Brazilian timber is competitive at this exchange rate. A dollar buys a foot of timber in the United States, but if converted into a real, it will buy only exchange rate The ratio at which two currencies are traded. The price of one currency in terms of another. M18_CASE3826_13_GE_C18.indd 368 17/04/19 4:24 AM CHAPTER 18 International Trade, Comparative Advantage, and Protectionism 369 TABLE 18.7 Domestic Prices of Timber (per Foot) and Rolled Steel (per Ton) in the United States and Brazil Timber Rolled steel United States $1 $2 Brazil 3 Reals 4 Reals one-third of a foot. The price of Brazilian timber to an American is $3 because it will take $3 to buy the necessary 3 R. Similarly, $2 buys a ton of rolled steel in the United States, but the same $2 buys only half a ton of Brazilian steel. The price of Brazilian steel to an American is $4, twice the price of domestically produced steel. At this exchange rate, however, Brazilians find that U.S.-produced steel and timber are less expensive than steel and timber produced in Brazil. Timber at home—Brazil—costs 3 R, but 3 R buys $3, which buys 3 times as much timber in the United States. Similarly, steel costs 4 R at home, but 4 R buys $4, which buys twice as much U.S.-made steel. At an exchange rate of +1 = 1 R, Brazil will import steel and timber and the United States will import nothing. However, now suppose the exchange rate is 1 R = +0.25. This means that $1 buys 4 R. At
this exchange rate, the Brazilians buy timber and steel at home and the Americans import both goods. At this exchange rate, Americans must pay a dollar for a foot of U.S. timber, but the same amount of timber can be had in Brazil for the equivalent of $0.75. (Because 1 R costs $0.25, 3 R can be purchased for $0.75.) Similarly, steel that costs $2 per ton in the United States costs an American half as much in Brazil because $2 buys 8 R, which buys 2 tons of Brazilian steel. At the same time, Brazilians are not interested in importing because both goods are cheaper when purchased from a Brazilian producer. In this case, the United States imports both goods and Brazil imports nothing. So far we can see that at exchange rates of +1 = 1 R and +1 = 4 R, we get trade flowing in only one direction. Let us now try an exchange rate of +1 = 2 R, or +1 R = 0.50. First, Brazilians will buy timber in the United States. Brazilian timber costs 3 R per foot, but 3 R buys $1.50, which is enough to buy 1.5 feet of U.S. timber. Buyers in the United States will find Brazilian timber too expensive, but Brazil will import timber from the United States. At this same exchange rate, however, both Brazilian and U.S. buyers will be indifferent between Brazilian and U.S. steel. To U.S. buyers, domestically produced steel costs $2. Because $2 buys 4 R, a ton of imported Brazilian steel also costs $2. Brazilian buyers also find that steel costs 4 R, whether domestically produced or imported. Thus, there is likely to be no trade in steel. What happens if the exchange rate changes so that $1 buys 2.1 R? Although U.S. timber is still cheaper to both Brazilians and Americans, Brazilian steel begins to look good to U.S. buyers. Steel produced in the United States costs $2 per ton, but $2 buys 4.2 R, which buys more than a ton of steel in Brazil. When $1 buys more than 2 R, trade begins to flow in both directions: Brazil will import timber, and the United States will import steel. If you examine Table 18.8 carefully, you will see that trade flows in both directions as long as the exchange rate settles between +1 = 2 R and +1 = 3
R. Stated the other way around, trade will flow in both directions if the price of a real is between $0.33 and $0.50. Notice this ratio is between the United States to Brazil price of steel and the United States to Brazil price of timber. Exchange Rates and Comparative Advantage If the foreign exchange market drives the exchange rate to anywhere between 2 and 3 R per dollar, the countries will automatically adjust and comparative advantage will be realized. At these exchange rates, U.S. buyers begin buying all their steel in Brazil. The U.S. steel industry finds itself in trouble. Plants close, and U.S. workers begin to lobby for tariff protection against Brazilian steel. At the same time, the U.S. timber industry does well, fueled by strong export demand from Brazil. The timber-producing sector expands. Resources, including capital and labor, are attracted into timber production. The opposite occurs in Brazil. The Brazilian timber industry suffers losses as export demand dries up and Brazilians turn to cheaper U.S. imports. In Brazil, lumber companies turn to the government and ask for protection from cheap U.S. timber. However, steel producers in Brazil are happy. They are not only supplying 100 percent of the domestically demanded steel but also M18_CASE3826_13_GE_C18.indd 369 17/04/19 4:24 AM 370 PART V The World Economy TABLE 18.8 Trade Flows Determined by Exchange Rates Exchange Rate Price of Real Result +1 = 1 R +1 = 2 R +1 = 2.1 R +1 = 2.9 R +1 = 3 R +1 = 4 R $1.00.50.48.34.33.25 Brazil imports timber and steel. Brazil imports timber. Brazil imports timber; United States imports steel. Brazil imports timber; United States imports steel. United States imports steel. United States imports timber and steel. selling to U.S. buyers. The steel industry expands, and the timber industry contracts. Resources, including labor, flow into steel. With this expansion-and-contraction scenario in mind, let us look again at our original definition of comparative advantage. If we assume that prices reflect resource use and resources can be transferred from sector to sector, we can calculate the opportunity cost of steel/timber in both countries. In the United States, the production of a ton of rolled steel consumes twice the resources that the production of a foot of timber consumes. Assuming
that resources can be transferred, the opportunity cost of a ton of steel is 2 feet of timber (Table 18.7). In Brazil, a ton of steel uses resources costing 4 R, while a unit of timber costs 3 R. To produce a ton of steel means the sacrifice of only four-thirds (or one and one-third) feet of timber. Because the opportunity cost of a ton of steel (in terms of timber) is lower in Brazil, we say that Brazil has a comparative advantage in steel production. Conversely, consider the opportunity cost of timber in the two countries. Increasing timber production in the United States requires the sacrifice of half a ton of steel for every foot of timber—producing a ton of steel uses $2 worth of resources, while producing a foot of timber requires only $1 worth of resources. Nevertheless, each foot of timber production in Brazil requires the sacrifice of three-fourths of a ton of steel. Because the opportunity cost of timber is lower in the United States, the United States has a comparative advantage in the production of timber. If exchange rates end up in the right ranges, the free market will drive each country to shift resources into those sectors in which it enjoys a comparative advantage. Only in a country with a comparative advantage will those products be competitive in world markets. 18.3 LEARNING OBJECTIVE Describe the sources of comparative advantage. factor endowments The quantity and quality of labor, land, and natural resources of a country. Heckscher-Ohlin theorem A theory that explains the existence of a country’s comparative advantage by its factor endowments: A country has a comparative advantage in the production of a product if that country is relatively well endowed with inputs used intensively in the production of that product. The Sources of Comparative Advantage Specialization and trade can benefit all trading partners, even those that may be inefficient producers in an absolute sense. If markets are competitive and if foreign exchange markets are linked to goods-and-services exchange, countries will specialize in producing products in which they have a comparative advantage. So far, we have said nothing about the sources of comparative advantage. What determines whether a country has a comparative advantage in heavy manufacturing or in agriculture? What explains the actual trade flows observed around the world? Various theories and empirical work on international trade have provided some answers. Most economists look to factor endowments—the quantity and quality of labor, land, and natural resources of a country—as the principal sources of comparative advantage. Factor endowments
seem to explain a significant portion of actual world trade patterns. The Heckscher-Ohlin Theorem MyLab Economics Concept Check Eli Heckscher and Bertil Ohlin, two Swedish economists who wrote in the first half of the twentieth century, expanded and elaborated on Ricardo’s theory of comparative advantage. The Heckscher-Ohlin theorem ties the theory of comparative advantage to factor endowments. It assumes that products can be produced using differing proportions of inputs and that inputs are mobile between sectors in each economy, but that factors are not mobile between economies. According M18_CASE3826_13_GE_C18.indd 370 17/04/19 4:24 AM CHAPTER 18 International Trade, Comparative Advantage, and Protectionism 371 to this theorem, a country has a comparative advantage in the production of a product if that country is relatively well endowed with inputs used intensively in the production of that product. This idea is simple. A country with a great deal of good fertile land is likely to have a comparative advantage in agriculture. A country with a large amount of accumulated capital is likely to have a comparative advantage in heavy manufacturing. A country well-endowed with human capital is likely to have a comparative advantage in highly technical goods. Other Explanations for Observed Trade Flows MyLab Economics Concept Check Comparative advantage is not the only reason countries trade. It does not explain why many countries import and export the same kinds of goods. The United States, for example, exports Velveeta cheese and imports blue cheese. Just as industries within a country differentiate their products to capture a domestic market, they also differentiate their products to please the wide variety of tastes that exists worldwide. The Japanese automobile industry, for example, began producing small, fuel-efficient cars long before U.S. automobile makers did. In doing so, the Japanese auto industry developed expertise in creating products that attracted a devoted following and considerable brand loyalty. BMWs, made mostly in Germany, and Lexus, made mostly in Japan, also have their champions in many countries. Just as product differentiation is a natural response to diverse preferences within an economy, it is also a natural response to diverse preferences across economies. Paul Krugman did some of the earliest work in this area, sometimes called new trade theory. New trade theory also relies on the idea of comparative advantage. If the Japanese developed skills and knowledge that gave them an edge in the production of fuel-efficient cars, that knowledge can be thought of as a very specific kind of
capital that is not currently available to other producers. Toyota in producing the Lexus, invested in a form of intangible capital called goodwill. That goodwill, which may come from establishing a reputation for performance and quality over the years, is one source of the comparative advantage that keeps Lexus selling on the international market. Some economists distinguish between gains from acquired comparative advantages and gains from natural comparative advantages. Trade Barriers: Tariffs, Export Subsidies, and Quotas We have seen the capacity for specialization and trade to increases the size of the economic pie for nations. Nevertheless, most countries impose some barriers to trade principally on the grounds of protecting domestic jobs. Trade barriers—also called obstacles to trade—take many forms. The three most common are tariffs, export subsidies, and quotas. All are forms of protection shielding some sector of the economy from foreign competition. In addition, in many countries complex regulatory rules and standards make it difficult for foreign competitors to enter and compete; in recent years economists and policy makers have paid more attention to these soft trade barriers. A tariff is a tax on imports. The average tariff on imports into the United States is less than 5 percent. Certain protected items have much higher tariffs. For example, the United States levies tariffs of 30 percent and more on solar panels imported from China. In 2018, President Trump indicated that he would levy a 25 percent tariff on imported steel. Export subsidies—government payments made to domestic firms to encourage exports— can also act as a barrier to trade. One of the provisions of the Corn Laws that stimulated Ricardo’s musings was an export subsidy automatically paid to farmers by the British government when the price of grain fell below a specified level. The subsidy served to keep domestic prices high, but it flooded the world market with cheap subsidized grain. Foreign farmers who were not subsidized were driven out of the international marketplace by the artificially low prices. Farm subsidies remain a part of the international trade landscape today. Many countries continue to appease their farmers by heavily subsidizing exports of agricultural products. The political power of the farm lobby in many countries has had an important effect on recent international trade negotiations aimed at reducing trade barriers. The prevalence of farm subsidies in the 18.4 LEARNING OBJECTIVE Analyze the economic effects of trade barriers. protection The practice of shielding a sector of the economy from foreign competition. soft trade barriers Regulatory standards and requirements that make foreign competition more difficult. tariff A tax on imports. export subsidies Government payments made to domestic firms to encourage exports. M18
_CASE3826_13_GE_C18.indd 371 17/04/19 4:24 AM 372 PART V The World Economy dumping A firm’s or an industry’s sale of products on the world market at prices below its own cost of production. developed world has become a major rallying point for less developed countries as they strive to compete in the global marketplace. Many African nations, in particular, have a comparative advantage in agriculture. In producing agricultural goods for export to the world marketplace, however, they must compete with food produced on heavily subsidized farms in Europe and the United States. Countries such as France have particularly high farm subsidies, which, it argues, helps preserve the rural heritage of France. One side effect of these subsidies, however, is to make it more difficult for some of the poorer nations in the world to compete. Some have argued that if developed nations eliminated their farm subsidies, this would have a much larger effect on the economies of some African nations than is currently achieved by charitable aid programs. Closely related to subsidies is dumping. Dumping occurs when a firm or industry sells its products on the world market at prices lower than its cost of production. Charges of dumping are often brought by a domestic producer that believes itself to be subject to unfair competition. In the United States, claims of dumping are brought before the International Trade Commission. In 2007, for example, a small manufacturer of thermal paper charged China and Germany with dumping. In 2006, the European Union charged China with dumping shoes. In 2009, China brought a dumping charge against U.S. chicken producers. Determining whether dumping has actually occurred can be difficult. Domestic producers argue that foreign firms will dump their product in the United States, drive out U.S. competitors, and then raise prices, thus harming consumers. Foreign exporters, on the other hand, claim that their prices are low simply because their costs are low and that no dumping has occurred. Figuring out the costs for German thermal paper or Chinese shoes is not easy. In the case of the Chinese shoe claim, for example, the Chinese government pointed out that shoes are a labor-intensive product and that given China’s low wages, it should not be a surprise that it is able to produce shoes cheaply. In other words, the Chinese claim that shoes are an example of the theory of comparative advantage at work rather than predatory dumping Globalization Improves Firm Productivity Earlier in the chapter we described the way in which free trade allows countries to make the
most of what they do well. Recent work in the trade area has also described the way in which free trade improves the productivity of firms within a country.1 Within a country we typically see firms of varying productivity. If firms were in fact all producing exactly the same product, we would expect higher-cost firms to be driven out of business. In fact, firms are often producing products that are close substitutes, but not identical. Matchbox cars are like Hot Wheels cars but not identical. Under these conditions, industries will have firms with a range of productivity levels because some people will pay a little more for the particular product a firm supplies. What happens when trade opens up? Now competition grows. Firms with good products and low costs can expand to serve markets elsewhere. They grow and often improve their cost through scale economies while doing so. Less productive firms find themselves facing tough competition from both foreign producers and from their domestic counterparts who now look even more productive than before. Melitz and other economists have found that when we look at the distribution of firm productivity after big trade changes (like the free trade agreement between the United States and Canada in 1989) we see a big drop-off in the less productive firms. Trade not only exploits comparative advantage of countries, but it improves the efficiency of firms more generally. CRITICAL THINKING 1. What do you expect to see happen to average prices after trade opens up? 1Marc Melitz at Harvard did much of the early work in this area. For a review see Marc Melitz and Daniel Trefler, “Gains from Trade when Firms Matter,” Journal of Economic Perspectives, Spring 2012, 90–117. See also Andrew B. Bernard, Jonathan Eaton, J. Bradford Jensen and Samuel Kortum, “Plants and Productivity in International Trade,” American Economic Review, Winter 2003, 1268–90. M18_CASE3826_13_GE_C18.indd 372 17/04/19 4:24 AM CHAPTER 18 International Trade, Comparative Advantage, and Protectionism 373 A quota is a limit on the quantity of imports. Quotas can be mandatory or “voluntary,” and they may be legislated or negotiated with foreign governments. The best-known voluntary quota, or “voluntary restraint,” was negotiated with the Japanese government in 1981. Japan agreed to reduce its automobile exports to the United States by 7.7 percent, from the 1980 level of 1
.82 million units to 1.68 million units. Many quotas limit trade around the world today. Perhaps the best-known recent case is the textile quota imposed in August 2005 by the European Union (EU) on imports of textiles from China. Because China had exceeded quotas that had been agreed to earlier in the year, the EU blocked the entry of Chinese-produced textiles into Europe; as a result, more than 100 million garments piled up in European ports. In the Economics in Practice box below we look at the effects of lifting quotas. quota A limit on the quantity of imports. U.S. Trade Policies, GATT, and the WTO MyLab Economics Concept Check The United States has been a high-tariff nation, with average tariffs higher than 50 percent, for much of its history. The highest were in effect during the Great Depression following the Smoot-Hawley tariff, which pushed the average tariff rate to 60 percent in 1930. The SmootHawley tariff set off an international trade war when U.S. trading partners retaliated with tariffs of their own. Many economists say the decline in trade that followed was one of the causes of the worldwide depression of the 1930s.1 Smoot-Hawley tariff The U.S. tariff law of the 1930s, which set the highest tariffs in U.S. history (60 percent). It set off an international trade war and caused the decline in trade that is often considered one of the causes of the worldwide depression of the 1930s What Happens When We Lift a Quota? Prior to 2005, textiles and clothing from China and much of the emerging world, heading for the United States, Canada, and the European Union, were subject to quotas. In an interesting new paper, Peter Schott from Yale and Amit Khandelwal and Shang-Jin Wei from Columbia University, investigated what happened once the quota was lifted.1 It should come as no surprise that lifting the quota increased the textiles and clothing exported to all three areas. A more interesting question is what happened to the composition of the firms doing the exporting after quotas were lifted. Did the same firms just send more goods, for example? When an exporting country faces a quota on its products, someone has to decide which firms get the privilege of sending their goods abroad. Typically, governments make this decision. In some cases, governments auction off the rights to export, seeking to maximize public revenue; here we might expect that more efficient firms would be the most likely exporters because
they could bid the most due to their cost advantage in selling the goods. In other cases, governments may give export rights to friends and family. In this case, Schott et al. did not know how China had allocated the export rights or what objective it had in mind. But the results they found were instructive. After quotas were lifted in 2005, exports did increase dramatically. Moreover, most of the exports were produced not by the older firms which had dominated the quota-laden era, but by new entrants! Without quotas, firms need to be efficient to export and most of the older firms now subject to the new competition rapidly lost market share. The evidence of this paper tells us that however China was allocating its licenses, it was not to the most efficient firms. CRITICAL THINKING 1. If in fact the Chinese government was allocating the rights to export under a quota to the most productive firms, what would you expect to see happen once the quota is lifted? 1Amit Khandelwal, Peter Schott, Shang-Jin Wei, “Trade Liberalization and Embedded Institutional Reform: Evidence from Chinese Exporters,” American Economic Review, October 2013, 2169–95. 1See especially Charles Kindleberger, The World in Depression 1929–1939 (London: Allen Lane, 1973). M18_CASE3826_13_GE_C18.indd 373 17/04/19 4:24 AM 374 PART V The World Economy General Agreement on Tariffs and Trade (GATT) An international agreement signed by the United States and 22 other countries in 1947 to promote the liberalization of foreign trade. World Trade Organization (WTO) A negotiating forum dealing with rules of trade across nations. Doha Development Agenda An initiative of the World Trade Organization focused on issues of trade and development. In 1947, the United States, with 22 other nations, agreed to reduce barriers to trade. It also established an organization to promote liberalization of foreign trade. The General Agreement on Tariffs and Trade (GATT) proved to be successful in helping reduce tariff levels and encourage trade. In 1986, GATT sponsored a round of world trade talks known as the Uruguay Round that were focused on reducing trade barriers further. After much debate, the Uruguay Round was signed by the U.S. Congress in 1993 and became a model for multilateral trade agreements. In 1995, the World Trade Organization (WTO) was established as a negotiating forum to deal with the rules
of trade established under GATT and other agreements. It remains the key institution focused on facilitating freer trade across nations and negotiating trade disputes. The WTO consists of 153 member nations and serves as a negotiating forum for countries as they work through complexities of trade under the Uruguay Round and other agreements. At this time, the WTO is the central institution for promoting and facilitating free trade. In 2015, the WTO heard international tariff and subsidy disputes ranging from disputes between China and Indonesia on flat rolled steel, to China and the EU on poultry, to Indonesia versus the United States on paper. Although the WTO was founded to promote free trade, its member countries clearly have different incentives as they confront trade cases. In recent years, differences between developed and developing countries have come to the fore. In 2001, at a WTO meeting in Doha, Qatar, the WTO launched a new initiative, the Doha Development Agenda, to deal with some of the issues that intersect the areas of trade and development. In 2007, the Doha Development Agenda continued to struggle over the issue of agriculture and farm subsidies that were described in this chapter. The less-developed countries, with sub-Saharan Africa taking the lead, seek to eliminate all farm subsidies currently paid by the United States and the EU. The EU has, for its part, tried to push the less-developed countries toward better environmental policies as part of a broader free trade package. While the Doha Round continues in theory, there has been essentially no progress made since 2013. Until recently, the movement in the United States has been away from tariffs and quotas and toward freer trade. The Reciprocal Trade Agreements Act of 1934 authorized the president to negotiate trade agreements on behalf of the United States. As part of trade negotiations, the president can confer most-favored-nation status on individual trading partners. Imports from countries with most-favored-nation status are taxed at the lowest negotiated tariff rates. In addition, in recent years, several successful rounds of tariff-reduction negotiations have reduced trade barriers to their lowest levels ever. In late 2015, the U.S. Congress heavily debated the passage of the Trans Pacific Partnership, a new trade pact designed to lower tariffs among the United States and eleven Pacific rim countries. The agreement was signed in 2016, although not ratified by Congress, and shortly after being elected, President Trump withdrew the United States from the agreement. The agreement continues among the Pacific Rim countries under the title Comprehensive and Progressive Agreement for Trans Pacific Partnership. Most U.S. presidents in the
last 50 years have made exceptions in their trade policies to protect one economic sector or another. Eisenhower and Kennedy restricted imports of Japanese textiles; Johnson restricted meat imports to protect Texas beef producers; Nixon restricted steel imports; Reagan restricted automobiles from Japan. In early 2002, President George W. Bush imposed a 30 percent tariff on steel imported from the EU. In 2003, the WTO ruled that these tariffs were unfair and allowed the EU to slap retaliatory tariffs on U.S. products. Shortly thereafter, the steel tariffs were rolled back, at least on EU steel. In 2009, President Obama put a tariff of 35 percent on Chinese tires, only to have China retaliate by putting a tariff on U.S. chicken parts. President Trump in the early period of his administration imposed high tariffs on solar panels and steel. Again, these tariffs were met with retaliation, via tariffs on U.S. agricultural products. For the most part, tariff support has been fueled by an interest in job protection. As we will see shortly in our discussion of the case for and against free trade, the role of tariffs in raising domestic prices and the employment effect of retaliation have often gotten less play politically. economic integration Occurs when two or more nations join to form a free-trade zone. Economic Integration Economic integration occurs when two or more nations join to form a free-trade zone. In 1991, the European Community (EC, or the Common Market) began forming the largest free-trade zone in the world. The economic integration process began that December, when the 12 original members (the United Kingdom, Belgium, France, Germany, Italy, the Netherlands, Luxembourg, Denmark, Greece, Ireland, Spain, and Portugal) signed the M18_CASE3826_13_GE_C18.indd 374 17/04/19 4:24 AM CHAPTER 18 International Trade, Comparative Advantage, and Protectionism 375 European Union (EU) The European trading bloc composed of 28 countries (of the 28 countries in the EU, 17 have the same currency—the euro). U.S.-Canada Free Trade Agreement An agreement in which the United States and Canada agreed to eliminate all barriers to trade between the two countries by 1998. North American Free Trade Agreement (NAFTA) An agreement signed by the United States, Mexico, and Canada in which the three countries agreed to establish all North America as a freetrade zone. Maastricht Treaty. The treaty called for the end of border controls, a common currency, an end to all
tariffs, and the coordination of monetary and political affairs. The European Union (EU), as the EC is now called, has 28 members (for a list, see the Summary, p. 381). On January 1, 1993, all tariffs and trade barriers were dropped among the member countries. Border checkpoints were closed in early 1995. Citizens can now travel among member countries without passports. The United States is not a part of the EU. However, in 1988, the United States (under President Reagan) and Canada (under Prime Minister Mulroney) signed the U.S.-Canada Free Trade Agreement, which removed all barriers to trade, including tariffs and quotas, between the two countries by 1998. During the last days of the George H. W. Bush administration in 1992, the United States, Mexico, and Canada signed the North American Free Trade Agreement (NAFTA), with the three countries agreeing to establish all of North America as a free-trade zone. The agreement eliminated all tariffs over a 10- to 15-year period and removed restrictions on most investments. During the presidential campaign of 1992, NAFTA was hotly debated. Both Bill Clinton and George Bush supported the agreement. Industrial labor unions that might be affected by increased imports from Mexico (such as those in the automobile industry) opposed the agreement, while industries whose exports to Mexico might increase as a result of the agreement—for example, the machine tool industry—supported it. Another concern was that Mexican companies were not subject to the same environmental regulations as U.S. firms, so U.S. firms might move to Mexico for this reason. NAFTA was ratified by the U.S. Congress in late 1993 and went into effect on the first day of 1994. The U.S. Department of Commerce estimated that as a result of NAFTA, trade between the United States and Mexico increased by nearly $16 billion in 1994. In addition, exports from the United States to Mexico outpaced imports from Mexico during 1994. In 1995, however, the agreement fell under the shadow of a dramatic collapse of the value of the peso. U.S. exports to Mexico dropped sharply, and the United States shifted from a trade surplus to a large trade deficit with Mexico. Aside from a handful of tariffs, however, all of NAFTA’s commitments were fully implemented by 2003, and an 8-year report signed by all three countries declared the pact a success. The report concludes, “Eight years of expanded trade, increased employment and investment, and enhanced opportunity for the citizens of
all three countries have demonstrated that NAFTA works and will continue to work.” In 2018, President Trump began a process of renegotiating NAFTA, blaming the agreement for loss of manufacturing jobs to Mexico and Canada. The economics evidence on this claim is weak. Free Trade or Protection? One of the great economic debates of all time revolves around the free-trade-versus-protection controversy. We briefly summarize the arguments in favor of each. 18.5 LEARNING OBJECTIVE Evaluate the arguments over free trade and protectionism. The Case for Free Trade MyLab Economics Concept Check In one sense, the theory of comparative advantage is the case for free trade. Trade has potential benefits for all nations. A good is not imported unless its net price to buyers is below the net price of the domestically produced alternative. When the Brazilians in our example found U.S. timber less expensive than their own, they bought it, yet they continued to pay the same price for homemade steel. Americans bought less expensive Brazilian steel, but they continued to buy domestic timber at the same lower price. Under these conditions, both Americans and Brazilians ended up paying less and consuming more. At the same time, resources (including labor) move out of steel production and into timber production in the United States. In Brazil, resources (including labor) move out of timber production and into steel production. The resources in both countries are used more efficiently. Tariffs, export subsidies, and quotas, which interfere with the free movement of goods and services around the world, reduce or eliminate the gains of comparative advantage. M18_CASE3826_13_GE_C18.indd 375 17/04/19 4:24 AM 376 PART V The World Economy We can use supply and demand curves to illustrate this. Suppose Figure 18.4 shows domestic supply and demand for textiles. In the absence of trade, the market clears at a price of $4.20. At equilibrium, 450 million yards of textiles are produced and consumed. Assume now that textiles are available at a world price of $2. This is the price in dollars that Americans must pay for textiles from foreign sources. If we assume that an unlimited quantity of textiles is available at $2 and there is no difference in quality between domestic and foreign textiles, no domestic producer will be able to charge more than $2. In the absence of trade barriers, the world price sets the price in the United States. As the price in the United States
falls from $4.20 to $2.00, the quantity demanded by consumers increases from 450 million yards to 700 million yards, but the quantity supplied by domestic producers drops from 450 million yards to 200 million yards. The difference, 500 million yards, is the quantity of textiles imported. The argument for free trade is that each country should specialize in producing the goods and services in which it enjoys a comparative advantage. If foreign producers can produce textiles at a much lower price than domestic producers, they have a comparative advantage. As the world price of textiles falls to $2, domestic (U.S.) quantity supplied drops and resources are transferred to other sectors. These other sectors, which may be export industries or domestic industries, are not shown in Figure 18.4a. It is clear that the allocation of resources is more efficient at a price of $2. Why should the United States use domestic resources to produce what foreign producers can produce at a lower cost? U.S. resources should move into the production of the things it produces best. Now consider what happens to the domestic price of textiles when a trade barrier is imposed. Figure 18.4b shows the effect of a set tariff of $1 per yard imposed on imported textiles. The tariff raises the domestic price of textiles to +2 + +1 = +3. The result is that some of the gains from trade are lost. First, consumers are forced to pay a higher price for the same good. The quantity of textiles demanded drops from 700 million yards under free trade to 600 million yards because some consumers are not willing to pay the higher price. Notice in Figure 18.4b the triangle labelled ABC. This is the deadweight loss or excess burden resulting from the tariff. Absent the tariff, these 100 added units of textiles would have generated benefits in excess of the $2 that each one cost. a. Domestic supply and demand for textiles b. Effect of $1 tariff per unit S D e c i r P Tariff = $1 $3 $2 S A C B D $4.20 e c i r P $2.00 0 200 450 700 0 200 300 600 700 Imports = 500 Imports after tariff = 300 Millions of yards MyLab Economics Concept Check Millions of yards ▴▴ FIGURE 18.4 The Gains from Trade and Losses from the Imposition of a Tariff A tariff of $1 increases the market price facing consumers from $2 per yard to $3 per yard
. The government collects revenues equal to the gray shaded area in b. The loss of efficiency has two components. First, consumers must pay a higher price for goods that could be produced at lower cost. Second, marginal producers are drawn into textiles and away from other goods, resulting in inefficient domestic production. The triangle labeled ABC in b is the deadweight loss or excess burden resulting from the tariff. M18_CASE3826_13_GE_C18.indd 376 17/04/19 4:24 AM CHAPTER 18 International Trade, Comparative Advantage, and Protectionism 377 At the same time, the higher price of textiles draws some marginal domestic producers who could not make a profit at $2 into textile production. (Recall that domestic producers do not pay a tariff.) As the price rises to $3, the quantity supplied by domestic producers rises from 200 million yards to 300 million yards. The result is a decrease in imports from 500 million yards to 300 million yards. Finally, the imposition of the tariff means that the government collects revenue equal to the shaded area in Figure 18.4b. This shaded area is equal to the tariff rate per unit ($1) times the number of units imported after the tariff is in place (300 million yards). Thus, receipts from the tariff are $300 million. What is the final result of the tariff? Domestic producers receiving revenues of only $2 per unit before the tariff was imposed now receive a higher price and earn higher profits. However, these higher profits are achieved at a loss of efficiency. Trade barriers prevent a nation from reaping the benefits of specialization, push it to adopt relatively inefficient production techniques, and force consumers to pay higher prices for protected products than they would otherwise pay. In a more complicated, real world setting, tariffs have at least two other problems. In some cases, tariffs are imposed not on final goods but on intermediate goods, goods used in the production of other products. Steel, the subject of President Trump’s tariff proposal in 2018, is used to produce cars, cans, buildings, and many other products. A tariff that raises the domestic price of steel makes it harder for domestic car manufacturers to compete with foreign car companies. In the spring of 2018, Ford Motor Company made precisely this point in opposing proposed steel tariffs. Secondly, as we have already suggested, tariffs by one country rarely go unchallenged. When the United States puts a tariff on steel or tires, other countries will tax its exports, causing job losses
in those industries. In the end, the tariff war distorts employment patterns across trading partners. The Case for Protection MyLab Economics Concept Check A case can also be made in favor of tariffs and quotas. Over the course of U.S. history, protectionist arguments have been made so many times by so many industries before so many congressional committees that it seems all pleas for protection share the same themes. We describe the most frequently heard pleas next. Protection Saves Jobs The main argument for protection is that foreign competition costs Americans their jobs. When Americans buy imported Toyotas, U.S.-produced cars go unsold. Layoffs in the domestic auto industry follow. When Americans buy Chinese textiles, U.S. workers may lose their jobs. When Americans buy shoes or textiles from Korea or Taiwan, the millworkers in Maine and Massachusetts, as well as in South Carolina and Georgia, lose their jobs. It is true that when we buy goods from foreign producers, domestic producers suffer. However, there is no reason to believe that the workers laid off in the contracting sectors will not ultimately be reemployed in expanding sectors. Foreign competition in textiles, for example, has meant the loss of U.S. jobs in that industry. Thousands of textile workers in New England lost their jobs as the textile mills closed over the last 40 years. Nevertheless, with the expansion of high-tech industries, the unemployment rate in Massachusetts fell to one of the lowest in the country in the mid-1980s, and New Hampshire, Vermont, and Maine also boomed. The employment case is made more complex when we recognize that protection of intermediate products can result in higher costs for the domestic industries who use those intermediate products, thus making those firms less competitive. Protecting the U.S. domestic tire or steel industry raises the costs of the domestic auto industry, potentially costing the economy jobs in that sector. Employment problems coming from open trade can be handled in several ways. We can ban imports and give up the gains from free trade, acknowledging that we are willing to pay premium prices to save domestic jobs in industries that can produce more efficiently abroad, or we can aid the victims of free trade in a constructive way, helping to retrain them for jobs with a future. In some instances, programs to relocate people in expanding regions may be in order. Some programs deal directly with the transition without forgoing the gains from trade. Some Countries Engage in Unfair Trade Practices Attempts by U.S. firms to monopolize an industry are illegal
under the Sherman and Clayton acts. If a strong company decides M18_CASE3826_13_GE_C18.indd 377 17/04/19 4:24 AM 378 PART V The World Economy to drive the competition out of the market by setting prices below cost, it would be aggressively prosecuted by the Antitrust Division of the Justice Department. However, the argument goes, if we will not allow a U.S. firm to engage in predatory pricing or monopolize an industry or a market, can we stand by and let a German firm or a Japanese firm do so in the name of free trade? This is a legitimate argument and one that has gained significant favor in recent years. How should we respond when a large international company or a country behaves strategically against a domestic firm or industry? Free trade may be the best solution when everybody plays by the rules, but sometimes we have to fight back. The WTO is the vehicle currently used to negotiate disputes of this sort. Cheap Foreign Labor Makes Competition Unfair Let us say that a particular country gained its “comparative advantage” in textiles by paying its workers low wages. How can U.S. textile companies compete with companies that pay wages that are less than a quarter of what U.S. companies pay? Questions like this are often asked by those concerned with competition from China and India. First, remember that wages in a competitive economy reflect productivity: a high ratio of output to units of labor. Workers in the United States earn higher wages because they are more productive. The United States has more capital per worker; that is, the average worker works with better machinery and equipment and its workers are better trained. Second, trade flows not according to absolute advantage, but according to comparative advantage: All countries benefit, even if one country is more efficient at producing everything. Protection Safeguards National Security Beyond saving jobs, certain sectors of the economy may appeal for protection for other reasons. The steel industry has argued for years with some success that it is vital to national defense. In the event of a war, the United States would not want to depend on foreign countries for a product as vital as steel. Even if we acknowledge another country’s comparative advantage, we may want to protect our own resources. This is one of the arguments made in 2017–2018 by the Trump administration. Virtually no industry has ever asked for protection without invoking the national defense argument. Testimony that was once given on behalf of the scissors and shears
industry argued that “in the event of a national emergency and imports cutoff, the United States would be without a source of scissors and shears, basic tools for many industries and trades essential to our national defense.” The question lies not in the merit of the argument, but in just how seriously it can be taken if every industry uses it. Protection Discourages Dependency Closely related to the national defense argument is the claim that countries, particularly small or developing countries, may come to rely too heavily on one or more trading partners for many items. If a small country comes to rely on a major power for food or energy or some important raw material in which the large nation has a comparative advantage, it may be difficult for the smaller nation to remain politically neutral. Some critics of free trade argue that larger countries, such as the United States, Russia, and China have consciously engaged in trade with smaller countries to create these kinds of dependencies. Therefore, should small, independent countries consciously avoid trading relationships that might lead to political dependence? This objective may involve developing domestic industries in areas where a country has a comparative disadvantage. To do so would mean protecting that industry from international competition. Environmental Concerns In recent years, concern about the environment has led some people to question advantages of free trade. Some environmental groups, for example, argue that the WTO’s free trade policies may harm the environment. The central argument is that poor countries will become havens for polluting industries that will operate their steel and auto factories with few environmental controls. The absence of environmental controls gives firms in these countries, it is argued, a phantom advantage. These issues are quite complex, and there is much dispute among economists about the interaction between free trade and the environment. One relatively recent study of sulphur dioxide, for example, found that in the long run, free trade reduces pollution, largely by increasing the income of M18_CASE3826_13_GE_C18.indd 378 17/04/19 4:24 AM CHAPTER 18 International Trade, Comparative Advantage, and Protectionism 379 Reshaping the Global Trade Order The twenty-first century has witnessed several global economic and geopolitical changes that have impacted the global trade order. The recent volatility in global politics has caused many developed nations and emerging market economies to favor economic nationalism, state capitalism, and protectionism. In the wake of the financial crisis of 2008–2009 and the European sovereign debt crisis, governments had to intervene to help their economies recover. Monetary and fiscal stimulus packages were
introduced and several industries received financial assistance from their governments. Some governments increased their stake in large firms to protect jobs. At the time of implementation, these measures were thought to be temporary, but the fissures in the global geopolitical system turned out to be deep enough to slow global trade integration down and increase trade-restrictive measures like tariffs, quotas, export restrictions, etc. The most notable examples are the United Kingdom’s Brexit vote to leave the European Union, the United States’ withdrawal from the Trans-Pacific Partnership (TPP), its expected renegotiation of the North American Free Trade Agreement (NAFTA), and the rise in the average number of trade-restrictive measures by the G-20 to 20 measures per month.1 On the other hand, several emerging market economies are expected to become the largest consumer markets in the world. Propelled by their increasing GDP and rapid growth of young populations, they are expected to become large sources of demand. At the same time, the young and educated labor force in these economies is also improving productivity and supply. By 2021, the Chinese consumer economy is expected to outweigh the combined consumer markets of Germany, the United Kingdom, and France. India is projected to be the third largest consumer market by 2025, and Africa is expected to have 1.1 billion consumers by 2020.2 Combined with an increasingly digitized global economy, these predictions suggest that intra-regional trade among emerging market economies is expected to flourish during the next few decades. China plans to take advantage of the burgeoning intra-regional trade with its Belt and Road Initiative (BRI), a €3–4 trillion project that is planned to connect 68 countries through harbors, airports, highways, railways, power plants, and oil pipelines. Once completed, the BRI is expected to further increase China’s productivity and trade, particularly benefiting emerging market economies. Thus, the increasingly protectionist approach in developed economies is a far cry from the perspective of these emerging market economies, which are actively developing trade partnerships outside the influence of developed markets. CRITICAL THINKING 1. Explain how the BRI is expected to change future global trade relations among the nations connected by the route. 1WTO (2017), World Trade Report: Trade, Technology and Jobs. World Trade Organization, Geneva. 2Kasey Maggard, Dinesh Khanna, Justin Rose, and Jeff Walters, “ Adapting to a New Trade Order,” The Boston Consulting Group, July 14, 2017.
countries; richer countries typically choose policies to improve the environment.2 Thus, although free trade and increased development initially may cause pollution levels to rise, in the long run, prosperity is a benefit to the environment. Many also argue that there are complex trade-offs to be made between pollution control and problems such as malnutrition and health for poor countries. The United States and Europe both traded off faster economic growth and income against cleaner air and water at earlier times in their development. Some argue that it is unfair for the developed countries to impose their preferences on other countries facing more difficult trade-offs. 2Werner Antweiler, Brian Copeland, and M. Scott Taylor, “Is Free Trade Good for the Environment?” American Economic Review, September, 2001. M18_CASE3826_13_GE_C18.indd 379 17/04/19 4:24 AM 380 PART V The World Economy infant industry A young industry that may need temporary protection from competition from the established industries of other countries to develop an acquired comparative advantage. Nevertheless, the concern with global climate change has stimulated new thinking in this area. A study by the Tyndall Centre for Climate Change Research in Britain found that in 2004, 23 percent of the greenhouse gas emissions produced by China were created in the production of exports. In other words, these emissions come not as a result of goods that China’s population is enjoying as its income rises, but as a consequence of the consumption of the United States and Europe, where most of these goods are going. In a world in which the effects of carbon emissions are global and all countries are not willing to sign binding global agreements to control emissions, trade with China may be a way for developed nations to avoid their commitments to pollution reduction. Some have argued that penalties could be imposed on high-polluting products produced in countries that have not signed international climate control treaties as a way to ensure that the prices of goods imported this way reflect the harm that those products cause the environment.3 Implementing these policies is, however, likely to be complex, and some have argued that it is a mistake to bundle trade and environmental issues. As with other areas covered in this book, there is still disagreement among economists as to the right answer. Protection Safeguards Infant Industries Young industries in a given country may have a difficult time competing with established industries in other countries. In a dynamic world, a protected infant industry might mature into a strong industry worldwide because of an acquired, but real, comparative
advantage. If such an industry is undercut and driven out of world markets at the beginning of its life, that comparative advantage might never develop. Yet efforts to protect infant industries can backfire. In July 1991, the U.S. government imposed a 62.67 percent tariff on imports of active-matrix liquid crystal display screens (also referred to as “flat-panel displays” used primarily for laptop computers) from Japan. The Commerce Department and the International Trade Commission agreed that Japanese producers were selling their screens in the U.S. market at a price below cost and that this dumping threatened the survival of domestic laptop screen producers. The tariff was meant to protect the infant U.S. industry until it could compete head-on with the Japanese. Unfortunately for U.S. producers of laptop computers and for consumers who purchase them, the tariff had an unintended (although predictable) effect on the industry. Because U.S. laptop screens were generally recognized to be of lower quality than their Japanese counterparts, imposition of the tariff left U.S. computer manufacturers with three options: (1) They could use the screens available from U.S. producers and watch sales of their final product decline in the face of higher-quality competition from abroad, (2) they could pay the tariff for the higher-quality screens and watch sales of their final product decline in the face of lower-priced competition from abroad, or (3) they could do what was most profitable for them to do—move their production facilities abroad to avoid the tariff completely. The last option is what Apple and IBM did. In the end, not only were the laptop industry and its consumers hurt by the imposition of the tariff (due to higher costs of production and to higher laptop computer prices), but the U.S. screen industry was hurt as well (due to its loss of buyers for its product) by a policy specifically designed to help it. Changes in Openness to Trade over Time across the World Advanced economies Latin America and the Caribbean Middle East and North Africa Sub-Saharan Africa Newly industrialized Asian economies Developing Asia 100 90 80 70 60 50 40 1980 85 90 95 2000 05 MyLab Economics Concept Check ▴▴FIGURE 18.5 Trade Openness across the World (Index is 100 minus the average effective tariff rate in the region.) 3Judith Chevalier, “A Carbon Cap That Starts in Washington,” New York Times, December 16, 2007. M18_CASE3826_13_GE_C
18.indd 380 17/04/19 4:24 AM CHAPTER 18 International Trade, Comparative Advantage, and Protectionism 381 18.6 LEARNING OBJECTIVE Outline how international trade fits into the structure of the economy. An Economic Consensus Critical to our study of international economics is the debate between free traders and protectionists. On one side is the theory of comparative advantage, formalized by David Ricardo in the early part of the nineteenth century. According to this view, all countries benefit from specialization and trade. The gains from trade are real, and they can be large; free international trade raises real incomes and improves the standard of living. The case for free trade has been made across the world as increasing numbers of countries have joined the world marketplace. Figure 18.5 traces the path of tariffs across the world from 1980 to 2005. The lines show an index of trade openness, calculated as 100 minus the tariff rate. (So higher numbers mean lower tariffs.) We see rapid reductions in the last 25 years across the world, most notably in countries in the emerging and developing markets. On the other side are the protectionists, who point to the loss of jobs and argue for the protection of workers from foreign competition. Although foreign competition can cause job loss in specific sectors, it is unlikely to cause net job loss in an economy and workers will, over time, be absorbed into expanding sectors. Foreign trade and full employment can be pursued simultaneously. Although economists disagree about many things, the vast majority of them favor free trade. S U M M A R Y 1. All economies, regardless of their size, depend to some extent on other economies and are affected by events outside their borders. 18.1 TRADE SURPLUSES AND DEFICITS p. 362 2. Until the 1970s, the United States generally exported more than it imported—it ran a trade surplus. In the mid-1970s, the United States began to import more merchandise than it exported—a trade deficit. 18.2 THE ECONOMIC BASIS FOR TRADE: COMPARATIVE ADVANTAGE p. 362 3. The theory of comparative advantage, dating to David Ricardo in the nineteenth century, holds that specialization and free trade will benefit all trading partners, even those that may be absolutely less efficient producers. 4. A country enjoys an absolute advantage over another country in the production of a product if it uses fewer resources to produce that product than the other country does. A country has a comparative advantage in the production
of a product if that product can be produced at a lower opportunity cost in terms of other goods foregone. 5. Trade enables countries to move beyond their previous resource and productivity constraints. When countries specialize in producing those goods in which they have a comparative advantage, they maximize their combined output and allocate their resources more efficiently. 6. When trade is free, patterns of trade and trade flows result from the independent decisions of thousands of importers and exporters and millions of private households and firms. 7. The relative attractiveness of foreign goods to U.S. buyers and of U.S. goods to foreign buyers depends in part on exchange rates, the ratios at which two currencies are traded for each other. 8. For any pair of countries, there is a range of exchange rates that will lead automatically to both countries realizing the gains from specialization and comparative advantage. Within that range, the exchange rate will determine which country gains the most from trade. This leads us to conclude that exchange rates determine the terms of trade. 9. If exchange rates end up in the right range (that is, in a range that facilitates the flow of goods between nations), the free market will drive each country to shift resources into those sectors in which it enjoys a comparative advantage. Only those products in which a country has a comparative advantage will be competitive in world markets. 18.3 THE SOURCES OF COMPARATIVE ADVANTAGE p. 370 10. The Heckscher-Ohlin theorem looks to relative factor endowments to explain comparative advantage and trade flows. According to the theorem, a country has a comparative advantage in the production of a product if that country is relatively well endowed with the inputs that are used intensively in the production of that product. 11. A relatively short list of inputs—natural resources, knowl- edge capital, physical capital, land, and skilled and unskilled labor—explains a surprisingly large portion of world trade patterns. However, the simple version of the theory of comparative advantage cannot explain why many countries import and export the same goods. 12. Some theories argue that comparative advantage can be acquired. Just as industries within a country differentiate their products to capture a domestic market, they also differentiate their products to please the wide variety of tastes that exists worldwide. This theory is consistent with the theory of comparative advantage. MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with. M18_
CASE3826_13_GE_C18.indd 381 17/04/19 4:24 AM 382 PART V The World Economy 18.4 TRADE BARRIERS: TARIFFS, EXPORT SUBSIDIES, AND QUOTAS p. 371 13. Trade barriers take many forms. The three most common are tariffs, export subsidies, and quotas. All are forms of protection through which some sector of the economy is shielded from foreign competition. 14. Although the United States has historically been a high-tariff nation, the general movement is now away from tariffs and quotas. The General Agreement on Tariffs and Trade (GATT), signed by the United States and 22 other countries in 1947, continues in effect today; its purpose is to reduce barriers to world trade and keep them down. Also important are the U.S.-Canada Free Trade Agreement, signed in 1988, and the North American Free Trade Agreement, signed by the United States, Mexico, and Canada in the last days of the George H. W. Bush administration in 1992, taking effect in 1994. 15. The World Trade Organization (WTO) was set up by GATT to act as a negotiating forum for trade disputes across countries. 16. The European Union (EU) is a free-trade bloc composed of 28 nations: Austria, Belgium, Bulgaria, Croatia, Cyprus, the Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, the Netherlands, Poland, Portugal, Romania, Slovakia, Slovenia, Spain, Sweden, and the United Kingdom. Many economists believe that the advantages of free trade within the bloc, a reunited Germany, and the ability to work well as a bloc will make the EU the most powerful player in the international marketplace in the coming decades. 18.5 FREE TRADE OR PROTECTION? p. 375 17. In one sense, the theory of comparative advantage is the case for free trade. Trade barriers prevent a nation from reaping the benefits of specialization, push it to adopt relatively inefficient production techniques, and force consumers to pay higher prices for protected products than they would otherwise pay. 18. The case for protection rests on a number of propositions, one of which is that foreign competition results in a loss of domestic jobs, but there is no reason to believe that the workers laid off in the contracting sectors will not be ultimately reemployed in other expanding sectors. This adjustment process is far from costless, however
. 19. Other arguments for protection hold that cheap foreign labor makes competition unfair; that some countries engage in unfair trade practices; that free trade might harm the environment; and that protection safeguards the national security, discourages dependency, and shields infant industries. Despite these arguments, most economists favor free trade absolute advantage, p. 363 comparative advantage, p. 363 Corn Laws, p. 362 Doha Development Agenda, p. 374 dumping, p. 372 economic integration, p. 374 European Union (EU), p. 375 exchange rate, p. 368 export subsidies, p. 371 factor endowments, p. 370 General Agreement on Tariffs and Trade (GATT), p. 374 Heckscher-Ohlin theorem, p. 370 infant industry, p. 380 North American Free Trade Agreement (NAFTA), p. 375 protection, p. 371 quota, p. 373 Smoot-Hawley tariff, p. 373 soft trade barriers, p. 371 tariff, p. 371 terms of trade, p. 367 theory of comparative advantage, p. 363 trade deficit, p. 362 trade surplus, p. 362 U.S.-Canada Free Trade Agreement, p. 375 World Trade Organization (WTO), p. 374 P R O B L E M S All problems are available on MyLab Economics. 18.1 TRADE SURPLUSES AND DEFICITS LEARNING OBJECTIVE: How are trade surpluses and trade deficits defined? 1.1 India’s top five trading partners are China, United States, Saudi Arabia, United Arab Emirates (UAE), and the Republic of Korea. Go to www.infodriveindia.com and look up “India’s Trading Partners.” Find the total value of exports, imports, and the balance of trade with each of these countries for the most recent year. For which of these countries is India running a trade surplus? Trade deficit? Do an Internet search and find some of the main goods and services India imports from and exports to these five countries. Comment on your findings. 18.2 THE ECONOMIC BASIS FOR TRADE: COMPARATIVE ADVANTAGE LEARNING OBJECTIVE: Explain how international trade emerges from the theory of comparative advantage and what determines the terms of trade. 2.1 Suppose Latvia and Estonia each produce only two goods, tractors and bobsleds. Both are produced using labor alone. Assuming both countries are at full employment, you are
given the following information: MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with. M18_CASE3826_13_GE_C18.indd 382 17/04/19 4:24 AM CHAPTER 18 International Trade, Comparative Advantage, and Protectionism 383 Latvia: Estonia: 12 units of labor required to produce 1 tractor 4 units of labor required to produce 1 bobsled Total labor force: 900,000 units 16 units of labor required to produce 1 tractor 8 units of labor required to produce 1 bobsled Total labor force: 600,000 units a. Draw the production possibility frontiers for each country in the absence of trade. b. If transportation costs are ignored and trade is allowed, will Latvia and Estonia engage in trade? Explain. c. If a trade agreement is negotiated, at what rate (number of tractors per bobsled) would they agree to exchange? 2.2 India and Pakistan each produce only wheat and rice. Domestic prices are given in the following table: Wheat Rice India 400 INR/kg 700 INR/kg Pakistan 600 PKR/kg 900 PKR/kg If 1 Indian Rupee (INR) = 1 Pakistani Rupee (PKR), a. Which country has an absolute advantage in the produc- tion of wheat? Rice? b. Which country has a comparative advantage in the pro- duction of wheat? Rice? c. If India and Pakistan were the only two countries in trade, what adjustments would you predict assuming exchange rates are freely determined by the laws of supply and demand? 2.3 The following table gives recent figures for yield per hectare (in kg/ha) in India and China: India China Wheat 1,000 4,000 Paddy 3,500 6,600 a. If we assume that farmers in India and China use the same amount of labor, capital and fertilizer, which state has an absolute advantage in the wheat production? Paddy? b. lf we transfer land out of wheat into paddy, how many kilograms of wheat do we give up in India per additional kilogram of paddy produced? In China? c. Which country has a comparative advantage in wheat production? In paddy production? d. Which country would divert more of its land to the pro- a. If the price ratios within each country reflect resource use, which country has
a comparative advantage in the production of cheddar cheese? blue cheese? b. Assume that there are no other trading partners and that the only motive for holding foreign currency is to buy foreign goods. Will the current exchange rate lead to trade flows in both directions between the two countries? Explain. c. What adjustments might you expect in the exchange rate? Be specific. d. What would you predict about trade flows between Great Britain and the United States after the exchange rate has adjusted? 2.5 The nation of Pixley has an absolute advantage in everything it produces compared to the nation of Hooterville. Could these two nations still benefit by trading with each other? Explain. 2.6 Evaluate the following statement: If lower exchange rates increase a nation’s exports, the government should do everything in its power to ensure that the exchange rate for its currency is as low as possible. 18.3 THE SOURCES OF COMPARATIVE ADVANTAGE LEARNING OBJECTIVE: Describe the sources of comparative advantage. 3.1 The following table shows imports and exports of goods during the 2014–2015 period for India: Electrical machinery and equipment Petroleum products Drugs & pharmaceuticals Textile yarn/made up articles All values are in Rupee crores. Source: http://commerce.gov.in Exports Imports 6,200 20,276 18,074.41 8,824.50 2,605 47,876.78 2,921.99 990 What, if anything, can you conclude about India’s comparative advantage? What stories can you tell about the wide disparities in textiles and electrical machinery? duction of wheat? Why? 3.2 You can think of the United States as a set of 50 separate 2.4 Great Britain and the United States produce cheddar cheese and blue cheese. Current domestic prices per pound for each type of cheese are given in the following table: Great Britain United States Cheddar cheese Blue cheese £3 £6 $6 $9 Suppose the exchange rate is £1 = $1. economies with no trade barriers. In such an open environment, each state specializes in the products that it produces best. a. What product or products does your state specialize in? b. Can you identify the source of the comparative advantage that lies behind the production of one or more of these products (for example, a natural resource, plentiful cheap labor, or a skilled labor force)? MyLab Economics Visit www.pearson.com/mylab/
economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with. M18_CASE3826_13_GE_C18.indd 383 17/04/19 4:24 AM 384 PART V The World Economy c. Do you think that the theory of comparative advantage and the Heckscher-Ohlin theorem help to explain why your state specializes the way that it does? Explain your answer. 3.3 Some empirical trade economists have noted that many countries are both importers and exporters of the same products. For example, India both imports and exports sports goods. How do you explain this? 18.4 TRADE BARRIERS: TARIFFS, EXPORT SUBSIDIES, AND QUOTAS LEARNING OBJECTIVE: Analyze the economic effects of trade barriers. 4.1 [Related to the Economics in Practice on p. 372] As is stated in the text, NAFTA was ratified by the U.S. Congress in 1993 and went into effect on January 1, 1994, and aside from a few tariffs, all of NAFTA’s commitments were fully implemented by 2003. Go to http://www.usa. gov and do a search for “NAFTA: A Decade of Success” to find a document from the Office of the United States Trade Representative which details the benefits of this free-trade agreement between the United States, Canada, and Mexico. Describe what happened to the following in the NAFTA countries by 2003, when NAFTA’s commitments were fully implemented: economic growth, exports, total trade volume, and productivity. Now conduct a Web search to find any disadvantages of NAFTA and see how they relate to the arguments for protectionism in the text. Explain whether you believe any of these disadvantages outweigh the benefits you described regarding economic growth, exports, trade volume, and productivity. 4.2 The following graph represents the domestic supply and demand for coal. a. In the absence of trade, what is the equilibrium price and equilibrium quantity? b. The government opens the market to free trade, and Indonesia enters the market, pricing coal at $40 per ton. What will happen to the domestic price of coal? What will be the new domestic quantity supplied and domestic quantity demanded? How much coal will be imported from Indonesia? c. After numerous complaints from domestic coal producers, the government imposes a $10 per ton tariff on all imported coal. What will happen to the domestic price of
coal? What will be the new domestic quantity supplied and domestic quantity demanded? How much coal will now be imported from Indonesia? d. How much revenue will the government receive from the $10 per ton tariff? e. Who ultimately ends up paying the $10 per ton tariff? Why100 55 50 40 0 S 75 150 180 240 340 Millions of tons D 450 4.3 Refer to the previous problem. Assume the market is opened to trade and Indonesia still enters the market by pricing coal at $40 per ton. But as a response to complaints from domestic coal producers, instead of imposing a $10 per ton tariff, the government imposes an import quota of 90 million tons on Indonesian coal. How will the results of the quota differ from the results of the tariff? 4.4 [Related to the Economics in Practice on p. 373] In 2015, the United States and Cuba re-established diplomatic relations, reopening embassies in each other’s capitals for the first time since 1961. Since the early 1960s, the United States has had an embargo in place on Cuba, virtually eliminating all trade between the two countries. With diplomatic relations restored, the Cuban government is seeking an end to this embargo and is urging the U.S. government to resume trade between the two countries. Suppose the United States decided to lift the embargo on exports to Cuba while maintaining the embargo on Cuban imports. Explain whether this one-sided change would benefit neither country, just one country, or both countries? 18.5 FREE TRADE OR PROTECTION? LEARNING OBJECTIVE: Evaluate the arguments over free trade and protectionism. 5.1 [Related to the Economics in Practice on p. 379] The China–Australia Free Trade Agreement (ChAFTA) is a bilateral Free Trade Agreement (FTA) between the Governments of Australia and China. It is strongly opposed by Australian trade unions and industrial groups. What are the possible pros and cons of this agreement on the Australian economy QUESTION 1 The Theory of Comparative Advantage and the Heckscher-Ohlin Theorem both treat the factors of production as being immobile between economies. Why is this a crucial assumption in explaining international trade patterns? QUESTION 2 Reducing imports through protectionist policies leads the prices of imported goods paid by domestic consumers to rise. Economists have tried to quantify these price increases and compare them to the salary of jobs in that sector. Why would economists be interested in this comparison? MyLab Economics Visit www.pearson.com/mylab
/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with. M18_CASE3826_13_GE_C18.indd 384 17/04/19 4:24 AM Open-Economy Macroeconomics: The Balance of Payments and Exchange Rates The growth of international trade has made the economies of the world increasingly interdependent. U.S. imports now account for about 15 percent of U.S. gross domestic product (GDP) and billions of dollars flow through the international capital market each day. In the previous chapter we explored the gains that come to countries from trade, as they exploit comparative advantage and gain access to new goods. The ubiquity of this trade also means that economic problems in one part of the world can often be felt by their trading partners elsewhere. In this chapter we explore the ways in which the openness of the economy affects macroeconomic policy making. From a macroeconomic point of view, the main difference between an international transaction and a domestic transaction concerns currency exchange. When people in countries with different currencies buy from and sell to each other, an exchange of currencies must also take place. 19 CHAPTER OUTLINE AND LEARNI NG OBJECTIV ES 19.1 The Balance of Payments p. 386 Explain how the balance of payments is calculated. 19.2 Equilibrium Output (Income) in an Open Economy p. 389 Discuss how equilibrium output is determined in an open economy, and describe the trade feedback effect and the price feedback effect. 19.3 The Open Economy with Flexible Exchange Rates p. 393 Discuss factors that affect exchange rates in an open economy with a floating system. An Interdependent World Economy p. 402 Appendix: World Monetary Systems since 1900 p. 405 Explain what the Bretton Woods system is. 385 M19_CASE3826_13_GE_C19.indd 385 17/04/19 4:26 AM 386 PART V The World Economy exchange rate The ratio at which two currencies are traded. The price of one currency in terms of another. 19.1 LEARNING OBJECTIVE Explain how the balance of payments is calculated. foreign exchange All currencies other than the domestic currency of a given country. balance of payments The record of a country’s transactions in goods, services, and assets with the rest of the world; also the record of a country’s sources (supply) and uses (demand) of foreign exchange. Brazilian coffee exp
orters cannot spend U.S. dollars in Brazil; they need Brazilian reals. A U.S. wheat exporter cannot use Brazilian reals to buy a tractor from a U.S. company or to pay the rent on warehouse facilities. Somehow international exchange must be managed in a way that allows both partners in the transaction to wind up with their own currency. The amount of trade between two countries depends on the exchange rate—the price of one country’s currency in terms of the other country’s currency. If the Japanese yen were expensive (making the dollar cheap), both Japanese and Americans would buy from U.S. producers. If the yen were cheap (making the U.S. dollar expensive), both Japanese and Americans would buy from Japanese producers. As we saw in the last chapter, within a certain range of exchange rates, trade flows in both directions. Each country specializes in producing the goods in which it enjoys a comparative advantage, and trade is mutually beneficial. We begin our discussion of open-economy macroeconomics by looking at the balance of payments—the record of a nation’s transactions with the rest of the world. We then go on to consider how our model of the macroeconomy changes when we allow for the international exchange of goods, services, and capital. Finally, we explore the determination of the rate of exchange of one currency for another and how the exchange rate system affects the economy, including fiscal and monetary policy. The Balance of Payments All foreign currencies—euros, Swiss francs, Japanese yen, Brazilian reals, and so forth—can be grouped together as “foreign exchange.” Foreign exchange is simply all currencies other than the domestic currency of a given country (in the case of the United States, the U.S. dollar). U.S. demand for foreign exchange arises because its citizens want to buy things whose prices are quoted in other currencies, such as Australian jewelry, vacations in Mexico, and bonds or stocks issued by Sony Corporation of Japan. Whenever U.S. citizens make these purchases, foreign currencies must first be purchased. Typically this happens indirectly without most customers thinking about it at all. Where does the supply of foreign exchange come from? The answer is simple: The United States (actually U.S. citizens or firms) earns foreign exchange when it sells products, services, or assets to another country. Some of these foreign exchange transactions are transparent to the consumer. When Mexican tourists visit Disney World, they go to an ATM, which
takes pesos from their banks in Mexico and converts them to dollars dispensed in Florida. Other transactions are less transparent. Saudi Arabian purchases of stock in General Motors and Colombian purchases of real estate in Miami also increase the U.S. supply of foreign exchange although the currency exchange is often done by a middleman. The record of a country’s transactions in goods, services, and assets with the rest of the world is its balance of payments. The balance of payments is also the record of a country’s sources (supply) and uses (demand) of foreign exchange.1 The Current Account MyLab Economics Concept Check The balance of payments is divided into two major accounts, the current account and the financial account. These are shown in Table 19.1, which provides data on the U.S. balance of payments for 2017. We begin with the current account. The first two items in the current account are exports and imports of goods. Among the biggest exports of the United States are commercial aircraft, chemicals, and agricultural products. U.S. exports earn foreign exchange for the United States and are a credit item on the current account. U.S. imports use up foreign exchange and are a debit item. In 2017 the United States exported $1,550.7 billion in goods and imported $2,361.9 billion, thus using up more foreign exchange than it earned regarding trade in goods. Next in the current account is trade in services. Like most other countries, the United States buys services from and sells services to other countries. For example, a U.S. firm shipping wheat 1Bear in mind the distinction between the balance of payments and a balance sheet. A balance sheet for a firm or a country measures that entity’s stock of assets and liabilities at a moment in time. The balance of payments, by contrast, measures flows, usually over a period of a month, a quarter, or a year. Despite its name, the balance of payments is not a balance sheet. M19_CASE3826_13_GE_C19.indd 386 17/04/19 4:26 AM CHAPTER 19 Open-Economy Macroeconomics: The Balance of Payments and Exchange Rates 387 balance of trade A country’s exports of goods and services minus its imports of goods and services. trade deficit The situation when a country imports more than it exports. balance on current account The sum of income from exports of goods and services and income from investments and transfers minus payments for

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