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, in the long run changes in the money supply have no effect on the real quantity of money, M/P, or on real GDP. In the long run, money—as we learned—is neutral. The classical model of the price level ignores the short - run movement from E1 to E2, assuming that the economy moves directly from one long -run equilibrium to another long - run equilibrium. In other words, it assumes that the economy moves directly from E1 to E3 and that real GDP never changes in response to a change in the money supply. In effect, in the classical model the effects of money supply changes are analyzed as if the short - run as well as the long - run aggregate supply curves were vertical. In reality, this is a poor assumption during periods of low inflation. With a low inflation rate, it may take a while for workers and firms to react to a monetary expansion by raising wages and prices. In this scenario, some nominal wages and the prices of some goods are sticky in the short run. As a result, under low inflation there is an upward -sloping SRAS curve, and changes in the money supply can indeed change real GDP in the short run. But what about periods of high inflation? In the face of high inflation, economists have observed that the short - run stickiness of nominal wages and prices tends to vanish. Workers and businesses, sensitized to inflation, are quick to raise their wages and prices in response to changes in the money supply. This implies that under high inflation there is a quicker adjustment of wages and prices of intermediate goods than occurs in the case of low inflation. So the short - run aggregate supply curve shifts leftward more quickly and there is a more rapid return to long - run equilibrium under high inflation. As a result, the classical model of the price level is much more likely to be a good approximation of reality for economies experiencing persistently high inflation The consequence of this rapid adjustment of all prices in the economy is that in countries with persistently high inflation, changes in the money supply are quickly translated into changes in the inflation rate. Let’s look at Zimbabwe. Figure 33.2 shows With a low inflation rate, it may take a while for workers and firms to react to a monetary expansion by raising wages and prices. f i g u r e 33.2 Money Supply Growth and Inflation in Zimbabwe This figure, drawn on a logarithmic scale, shows the annual rates of change of the money supply and the price level in Zimbabwe
from 2003 through January 2008. The surges in the money supply were quickly reflected in a roughly equal surge in the price level. Source: Reserve Bank of Zimbabwe. Annual percent change 1,000,000% 100,000 10,000 1,000 Money supply Consumer price index 2003 2004 2005 2006 2007 2008 Year m o d u l e 3 3 Ty 323 the annual rate of growth in the money supply and the annual rate of change of consumer prices from 2003 through January 2008. As you can see, the surge in the growth rate of the money supply coincided closely with a roughly equal surge in the inflation rate. Note that to fit these very large percentage increases—exceeding 100,000 percent— onto the figure, we have drawn the vertical axis using a logarithmic scale. In late 2008, Zimbabwe’s inflation rate reached 231 million percent. What leads a country to increase its money supply so much that the result is an inflation rate in the millions of percent? The Inflation Tax Modern economies use fiat money—pieces of paper that have no intrinsic value but are accepted as a medium of exchange. In the United States and most other wealthy countries, the decision about how many pieces of paper to issue is placed in the hands of a central bank that is somewhat independent of the political process. However, this independence can always be taken away if politicians decide to seize control of monetary policy. So what is to prevent a government from paying for some of its expenses not by raising taxes or borrowing but simply by printing money? Nothing. In fact, governments, including the U.S. government, do it all the time. How can the U.S. government do this, given that the Federal Reserve, not the U.S. Treasury, issues money? The answer is that the Treasury and the Federal Reserve work in concert. The Treasury issues debt to finance the government’s purchases of goods and services, and the Fed monetizes the debt by creating money and buying the debt back from the public through open -market purchases of Treasury bills. In effect, the U.S. government can and does raise revenue by printing money. For example, in February 2010, the U.S. monetary base—bank reserves plus currency in circulation—was $559 billion larger than it had been a year earlier. This occurred because, over the course of that year, the Federal Reserve had issued $559 billion in money or its electronic equivalent and put it into circulation mainly through open market operations. To put it another way, the
Fed created money out of thin air and used it to buy valuable government securities from the private sector. It’s true that the U.S. government pays interest on debt owned by the Federal Reserve—but the Fed, by law, hands the interest payments it receives on government debt back to the Treasury, keeping only enough to fund its own operations. In effect, then, the Federal Reserve’s actions enabled the government to pay off $559 billion in outstanding government debt by printing money. An alternative way to look at this is to say that the right to print money is itself a source of revenue. Economists refer to the revenue generated by the government’s right to print money as seignorage, an archaic term that goes back to the Middle Ages. It refers to the right to stamp gold and silver into coins, and charge a fee for doing so, that medieval lords—seigneurs, in France—reserved for themselves. Seignorage accounts for only a tiny fraction (less than 1%) of the U.S. government’s budget. Furthermore, concerns about seignorage don’t have any influence on the Federal Reserve’s decisions about how much money to print; the Fed is worried about inflation and unemployment, not revenue. But this hasn’t always been true, even in the United States: both sides relied on seignorage to help cover budget deficits during the Civil War. And there have been many occasions in history when governments turned to their printing presses as a crucial source of revenue. According to the usual scenario, a government finds itself running a large budget deficit—and lacks either the competence or the political will to eliminate this deficit by raising taxes or cutting spending. Furthermore, the government can’t borrow to cover the gap because potential lenders won’t extend loans, given the fear that the government’s weakness will continue and leave it unable to repay its debts. In such a situation, governments end up printing money to cover the budget deficit. But by printing money to pay its bills, a government increases the quantity of money in circulation. And as we’ve just seen, increases in the money supply translate into equally 324 An inflation tax is a reduction in the value of money held by the public caused by inflation In the 1920s, hyperinflation made German currency worth so little that children made kites from banknotes. large increases in the aggregate price level. So printing money to cover a budget deficit leads to inflation
. Who ends up paying for the goods and services the government purchases with newly printed money? The people who currently hold money pay. They pay because inflation erodes the purchasing power of their money holdings. In other words, a government imposes an inflation tax, a reduction in the value of the money held by the public, by printing money to cover its budget deficit and creating inflation. It’s helpful to think about what this tax represents. If the inflation rate is 5%, then a year from now $1 will buy goods and services worth only about $0.95 today. So a 5% inflation rate in effect imposes a tax rate of 5% on the value of all money held by the public. But why would any government push the inflation tax to rates of hundreds or thousands of percent? We turn next to the process by which high inflation turns into explosive hyperinflation. The Logic of Hyperinflation Inflation imposes a tax on individuals who hold money. And, like most taxes, it will lead people to change their behavior. In particular, when inflation is high, people will try to avoid holding money and will instead substitute real goods as well as interest -bearing assets for money. During the German hyperinflation, people began using eggs or lumps of coal as a medium of exchange. They did this because lumps of coal maintained their real value over time but money didn’t. Indeed, during the peak of German hyperinflation, people often burned paper money, which was less valuable than wood. Moreover, people don’t just reduce their nominal money holdings—they reduce their real money holdings, cutting the amount of money they hold so much that it actually has less purchasing power than the amount of money they would hold if inflation were low. Why? Because the more real money holdings they have, the greater the real amount of resources the government captures from them through the inflation tax. We are now prepared to understand how countries can get themselves into situations of extreme inflation. High inflation arises when the government must print a large quantity of money, imposing a large inflation tax, to cover a large budget deficit Now, the seignorage collected by the government over a short period—say, one month—is equal to the change in the money supply over that period. Let’s use M to represent the money supply and the symbol Δ to mean “monthly change in.” Then: (33-1) Seignorage = ΔM The money value of seignorage, however,
isn’t very informative by itself. After all, the whole point of inflation is that a given amount of money buys less and less over time. So it’s more useful to look at real seignorage, the revenue created by printing money divided by the price level, P: (33-2) Real seignorage = ΔM/P Equation 33-2 can be rewritten by dividing and multiplying by the current level of the money supply, M, giving us: (33-3) Real seignorage = (ΔM/M) × (M/P) or Real seignorage = Rate of growth of the money supply × Real money supply m o d u l e 3 3 Ty 325 But as we’ve just explained, in the face of high inflation the public reduces the real amount of money it holds, so that the far right - hand term in Equation 33-3, M/P, gets smaller. Suppose that the government needs to print enough money to pay for a given quantity of goods and services—that is, it needs to collect a given real amount of seignorage. Then, as people hold smaller amounts of real money due to a high rate of inflation, the government has to respond by accelerating the rate of growth of the money supply, ΔM/M. This will lead to an even higher rate of inflation. And people will respond to this new higher rate of inflation by reducing their real money holdings, M/P, yet again. As the process becomes self - reinforcing, it can easily spiral out of control. Although the amount of real seignorage that the government must ultimately collect to pay off its deficit does not change, the inflation rate the government needs to impose to collect that amount rises. So the government is forced to increase the money supply more rapidly, leading to an even higher rate of inflation, and so on. Here’s an analogy: imagine a city government that tries to raise a lot of money with a special fee on taxi rides. The fee will raise the cost of taxi rides, and this will cause people to turn to substitutes, such as walking or taking the bus. As taxi use declines, the government finds that its tax revenue declines and it must impose a higher fee to raise the same amount of revenue as before. You can imagine the ensuing vicious circle: the government imposes fees on taxi rides, which leads to less taxi use, which causes the government to raise the fee on taxi rides, which leads to
even less taxi use, and so on. Substitute the real money supply for taxi rides and the inflation rate for the increase in the fee on taxi rides, and you have the story of hyperinflation. A race develops fyi Zimbabwe’s Inflation Zimbabwe offers a recent example of a country experiencing very high inflation. Figure 33.2 showed that surges in Zimbabwe’s money supply growth were matched by almost simultaneous surges in its inflation rate. But looking at rates of change doesn’t give a true feel for just how much prices went up. The figure here shows Zimbabwe’s consumer price index from 1999 to June 2008, with the 2000 level set equal to 100. As in Figure 33.2, we use a logarithmic scale, which lets us draw equal -sized percent changes as the same size. Over the course of about nine years, consumer prices rose by approximately 4.5 trillion percent. Why did Zimbabwe’s government pursue policies that led to runaway inflation? The reason boils down to political instability, which in turn had its roots in Zimbabwe’s history. Until the 1970s, Zimbabwe had been ruled by its small white minority; even after the shift to ma- CPI (2000 = 100) 100,000,000,000,000 1,000,000,000,000 jority rule, many of the country’s farms remained in the hands of whites. Eventually Robert Mugabe, Zimbabwe’s president, tried to solidify his position by seizing these farms and turning them over to his political supporters. But because this seizure disrupted production, the result was to undermine the country’s economy and its tax base. It became impossible for the country’s government to balance its budget either by raising taxes or by cutting spending. At the same time, the regime’s instability left Zimbabwe unable to borrow 10,000,000,000 100,000,000 1,000,000 10,000 326 money in world markets. Like many others before it, Zimbabwe’s government turned to the printing press to cover the gap—leading to massive inflation. 100 1 1999 2001 2003 2005 2007 2008 Year between the government printing presses and the public: the presses churn out money at a faster and faster rate to try to compensate for the fact that the public is reducing its real money holdings. At some point the inflation rate explodes into hyperinflation, and people are unwilling to hold any money at all (and resort to trading in eggs and l
umps of coal). The government is then forced to abandon its use of the inflation tax and shut down the printing presses. Moderate Inflation and Disinflation The governments of wealthy, politically stable countries like the United States and Britain don’t find themselves forced to print money to pay their bills. Yet over the past 40 years both countries, along with a number of other nations, have experienced uncomfortable episodes of inflation. In the United States, the inflation rate peaked at 13% in 1980. In Britain, the inflation rate reached 26% in 1975. Why did policy makers allow this to happen? Using the aggregate demand and supply model, we can see that there are two possible changes that can lead to an increase in the aggregate price level: a decrease in aggregate supply or an increase in aggregate demand. Inflation that is caused by a significant increase in the price of an input with economy-wide importance is called cost-push inflation. For example, it is argued that the oil crisis in the 1970s led to an increase in energy prices in the United States, causing a leftward shift of the aggregate supply curve, increasing the aggregate price level. However, aside from crude oil, it is difficult to think of examples of inputs with economy-wide importance that experience significant price increases. Inflation that is caused by an increase in aggregate demand is known as demandpull inflation. When a rightward shift of the aggregate demand curve leads to an increase in the aggregate price level, the economy experiences demand-pull inflation. This is sometimes referred to by the phrase “too much money chasing too few goods,” which means that the aggregate demand for goods and services is outpacing the aggregate supply and driving up the prices of goods. In the short run, policies that produce a booming economy also tend to lead to higher inflation, and policies that reduce inflation tend to depress the economy. This creates both temptations and dilemmas for governments. Imagine yourself as a politician facing an election in a year, and suppose that inflation is fairly low at the moment. You might well be tempted to pursue expansionary policies that will push the unemployment rate down, as a way to please voters, even if your economic advisers warn that this will eventually lead to higher inflation. You might also be tempted to find different economic advisers, who will tell you not to worry: in politics, as in ordinary life, wishful thinking often prevails over realistic analysis. Conversely, imagine yourself as a politician in an economy suffering from inflation. Your economic advisers will probably tell
you that the only way to bring inflation down is to push the economy into a recession, which will lead to temporarily higher unemployment. Are you willing to pay that price? Maybe not. This political asymmetry—inflationary policies often produce short -term political gains, but policies to bring inflation down carry short -term political costs—explains how countries with no need to impose an inflation tax sometimes end up with serious inflation problems. For example, that 26% rate of inflation in Britain was largely the result of the British government’s decision in 1971 to pursue highly expansionary monetary and fiscal policies. Politicians disregarded warnings that these policies would be inflationary and were extremely reluctant to reverse course even when it became clear that the warnings had been correct. But why do expansionary policies lead to inflation? To answer that question, we need to look first at the relationship between output and unemployment. Cost-push inflation is inflation that is caused by a significant increase in the price of an input with economy-wide importance. Demand-pull inflation is inflation that is caused by an increase in aggregate demand. m o d u l e 3 3 Ty 327 The Output Gap and the Unemployment Rate Earlier we introduced the concept of potential output, the level of real GDP that the economy would produce once all prices had fully adjusted. Potential output typically grows steadily over time, reflecting long - run growth. However, as we learned from the aggregate demand–aggregate supply model, actual aggregate output fluctuates around potential output in the short run: a recessionary gap arises when actual aggregate output falls short of potential output; an inflationary gap arises when actual aggregate output exceeds potential output. Recall that the percentage difference between the actual level of real GDP and potential output is called the output gap. A positive or negative output gap occurs when an economy is producing more than or less than what would be “expected” because all prices have not yet adjusted. And wages, as we’ve learned, are the prices in the labor market. Meanwhile, we learned that the unemployment rate is composed of cyclical unemployment and natural unemployment, the portion of the unemployment rate unaffected by the business cycle. So there is a relationship between the unemployment rate and the output gap. This relationship is defined by two rules: ■ When actual aggregate output is equal to potential output, the actual unemploy- ment rate is equal to the natural rate of unemployment. ■ When the output gap is positive (an inflationary gap), the unemployment rate is below the natural rate. When the output gap
is negative (a recessionary gap), the unemployment rate is above the natural rate. In other words, fluctuations of aggregate output around the long - run trend of potential output correspond to fluctuations of the unemployment rate around the natural rate. This makes sense. When the economy is producing less than potential output— when the output gap is negative—it is not making full use of its productive resources. Among the resources that are not fully used is labor, the economy’s most important resource. So we would expect a negative output gap to be associated with unusually high unemployment. Conversely, when the economy is producing more than potential output, it is temporarily using resources at higher-thannormal rates. With this positive output gap, we would expect to see lower than - normal unemployment. Figure 33.3 confirms this rule. Panel (a) shows the actual and natural rates of unemployment, as estimated by the Congressional Budget Office (CBO). Panel (b) shows two series. One is cyclical unemployment: the difference between the actual unemployment rate and the CBO estimate of the natural rate of unemployment, measured on the left. The other is the CBO estimate of the output gap, measured on the right. To make the relationship clearer, the output gap series is inverted—shown upside down—so that the line goes down if actual output rises above potential output and up if actual output falls below potential output. As you can see, the two series move together quite closely, showing the strong relationship between the output gap and cyclical unemployment. Years of high cyclical unemployment, like 1982 or 2009, were also years of a strongly negative output gap. Years of low cyclical unemployment, like the late 1960s or 2000, were also years of a strongly positive output gap. 328 33.3 Cyclical Unemployment and the Output Gap Panel (a) shows the actual U.S. unemployment rate from 1949 to 2009, together with the Congressional Budget Office estimate of the natural rate of unemployment. The actual rate fluctuates around the natural rate, often for extended periods. Panel (b) shows cyclical unemployment—the difference between the actual unemployment rate and the natural rate of unemployment—and the output gap, also estimated by the CBO. The unemployment rate is measured on the left vertical axis, and the output gap is measured with an inverted scale on the right vertical axis. With an inverted scale, it moves in the same direction as the unemployment rate: when the output gap is positive, the actual unemployment rate is below its natural rate; when the output gap is
negative, the actual unemployment rate is above its natural rate. The two series track one another closely, showing the strong relationship between the output gap and cyclical unemployment. Source: Congressional Budget Office; Bureau of Labor Statistics; Bureau of Economic Analysisa) The Actual Unemployment Rate Fluctuates Around the Natural Rate... Unemployment rate 12% Actual unemployment rate 10 8 6 4 2 Natural rate of unemployment 1949 1960 1970 1980 1990 2000 2009 Year (b)... and These Fluctuations Correspond to the Output Gap. Unemployment rate 6% 4 2 0 –2 –4 1949 Cyclical unemployment Output gap 1960 1970 1980 1990 2000 2009 Year Output gap –10% –8 –6 –4 – 33 AP R e v i e w Solutions appear at the back of the book. Check Your Understanding 1. Suppose there is a large increase in the money supply in an 2. Suppose that all wages and prices in an economy are indexed to economy that previously had low inflation. As a consequence, aggregate output expands in the short run. What does this say about situations in which the classical model of the price level applies? inflation. Can there still be an inflation tax? m o d u l e 3 3 Ty 329 Tackle the Test: Multiple-Choice Questions 1. The real quantity of money is I. equal to M/P. II. the money supply adjusted for inflation. III. higher in the long run when the Fed buys government securities. a. I only b. II only c. III only d. I and II only I, II, and III e. 2. In the classical model of the price level a. only the short-run aggregate supply curve is vertical. b. both the short-run and long-run aggregate supply curves are vertical. c. only the long-run aggregate supply curve is vertical. d. both the short-run aggregate demand and supply curves are vertical. e. both the long-run aggregate demand and supply curves are vertical. Tackle the Test: Free-Response Questions 1. Use a correctly labeled aggregate supply and demand graph to illustrate cost-push inflation. Give an example of what might cause cost-push inflation in the economy. 3. The classical model of the price level is most applicable in a. the United States. b. periods of high inflation. c. periods of low inflation. d. recessions. e. depressions. 4. An inflation tax is imposed by governments to offset price increases. a. b. paid directly as a percentage of the sale
price on purchases. c. the result of a decrease in the value of money held by the public. d. generally levied by states rather than the federal government. e. higher during periods of low inflation. 5. Revenue generated by the government’s right to print money is known as a. seignorage. b. an inflation tax. c. hyperinflation. d. fiat money. e. monetary funds. 1 point: Higher equilibrium aggregate price level at new intersection of SRAS and AD 1 point: This could be caused by anything that would shift the short-run aggregate supply curve to the left, such as an increase in the price of energy, labor, or another input with economy-wide importance. Answer (9 points) Aggregate price level P2 P1 LRAS SRAS2 2. Draw a correctly labeled aggregate demand and supply graph showing an economy in long-run macroeconomic equilibrium. On your graph, show the effect of an increase in the money supply, according to the classical model of the price level. SRAS1 E2 E1 AD 1 point: Aggregate price level on vertical axis and real GDP on horizontal axis Y2 YP Real GDP 1 point: AD downward sloping and labeled 1 point: SRAS upward sloping and labeled 1 point: LRAS vertical and labeled 1 point: Potential output labeled at horizontal intercept of LRAS 1 point: Long-run macroeconomic equilibrium aggregate price level labeled on vertical axis at intersection of SRAS, LRAS, and AD 1 point: Leftward shift of the SRAS curve 330 Module 34 Inflation and Unemployment: The Phillips Curve The Short -Run Phillips Curve We’ve just seen that expansionary policies lead to a lower unemployment rate. Our next step in understanding the temptations and dilemmas facing governments is to show that there is a short-run trade-off between unemployment and inflation—lower unemployment tends to lead to higher inflation, and vice versa. The key concept is that of the Phillips curve. The origins of this concept lie in a famous 1958 paper by the New Zealand–born economist Alban W. H. Phillips. Looking at historical data for Britain, he found that when the unemployment rate was high, the wage rate tended to fall, and when the unemployment rate was low, the wage rate tended to rise. Using data from Britain, the United States, and elsewhere, other economists soon found a similar apparent relationship between the unemployment rate and the rate of inflation—that is, the rate of change
in the aggregate price level. For example, Figure 34.1 on the next page shows the U.S. unemployment rate and the rate of consumer price inflation over each subsequent year from 1955 to 1968, with each dot representing one year’s data. Looking at evidence like Figure 34.1, many economists concluded that there is a negative short -run relationship between the unemployment rate and the inflation rate, represented by the short - run Phillips curve, or SRPC. (We’ll explain the difference between the short-run and the long-run Phillips curve soon.) Figure 34.2 on the next page shows a hypothetical short - run Phillips curve. Early estimates of the short - run Phillips curve for the United States were very simple: they showed a negative relationship between the unemployment rate and the inflation rate, without taking account of any other variables. During the 1950s and 1960s this simple approach seemed, for a while, to be adequate. And this simple relationship is clear in the data in Figure 34.1. What you will learn in this Module: • What the Phillips curve is and the nature of the short -run trade-off between inflation and unemployment • Why there is no long -run trade-off between inflation and unemployment • Why expansionary policies are limited due to the effects of expected inflation • Why even moderate levels of inflation can be hard to end • Why deflation is a problem for economic policy and leads policy makers to prefer a low but positive inflation rate The short -run Phillips curve is the negative short -run relationship between the unemployment rate and the inflation rate 331 f i g u r e 34.1 Unemployment and Inflation, 1955–1968 Each dot shows the average U.S. unemployment rate for one year and the percentage increase in the consumer price index over the subsequent year. Data like this lay behind the initial concept of the Phillips curve. Source: Bureau of Labor Statistics. Inﬂation rate 5% 4 3 2 1 0 –1 1968 1967 1957 1966 1956 1964 1965 1960 1963 1962 1959 1955 1958 1961 3 4 5 6 7 8% Unemployment rate Even at the time, however, some economists argued that a more accurate short run Phillips curve would include other factors. Previously, we discussed the effect of supply shocks, such as sudden changes in the price of oil, that shift the short - run aggregate supply curve. Such shocks also shift the short - run Phillips curve: surging oil prices were an important factor in the inflation of the 1970s and also played an important role in the acceleration
of inflation in 2007–2008. In general, a negative supply shock shifts SRPC up, as the inflation rate increases for every level of the unemployment rate, and a positive supply shock shifts it down as the inflation rate falls for every level of the unemployment rate. Both outcomes are shown in Figure 34.3. But supply shocks are not the only factors that can change the inflation rate. In the early 1960s, Americans had little experience with inflation as inflation rates had been low for decades. But by the late 1960s, after inflation had been steadily increasing for a number of years, Americans had come to expect future inflation. In 1968 f i g u r e 34.2 The Short -Run Phillips Curve The short -run Phillips curve, SRPC, slopes downward because the relationship between the unemployment rate and the inflation rate is negative. Inflation rate 0 When the unemployment rate is low, inflation is high. When the unemployment rate is high, inflation is low. Short-run Phillips curve, SRPC Unemployment rate 332 34.3 The Short-Run Phillips Curve and Supply Shocks A negative supply shock shifts the SRPC up, and a positive supply shock shifts the SRPC down. Inflation rate 0 A positive supply shock shifts SRPC down. A negative supply shock shifts SRPC up. SRPC1 SRPC0 SRPC2 Unemployment rate two economists—Milton Friedman of the University of Chicago and Edmund Phelps of Columbia University—independently set forth a crucial hypothesis: that expectations about future inflation directly affect the present inflation rate. Today most economists accept that the expected inflation rate—the rate of inflation that employers and workers expect in the near future—is the most important factor, other than the unemployment rate, affecting inflation. Inflation Expectations and the Short -Run Phillips Curve The expected rate of inflation is the rate that employers and workers expect in the near future. One of the crucial discoveries of modern macroeconomics is that changes in the expected rate of inflation affect the short -run trade - off between unemployment and inflation and shift the short-run Phillips curve. Why do changes in expected inflation affect the short - run Phillips curve? Put yourself in the position of a worker or employer about to sign a contract setting the worker’s wages over the next year. For a number of reasons, the wage rate they agree to will be higher if everyone expects high inflation (including rising wages) than if everyone expects prices to be stable. The worker will want a wage rate that takes into account future declines in the purchasing
power of earnings. He or she will also want a wage rate that won’t fall behind the wages of other workers. And the employer will be more willing to agree to a wage increase now if hiring workers later will be even more expensive. Also, rising prices will make paying a higher wage rate more affordable for the employer because the employer’s output will sell for more. For these reasons, an increase in expected inflation shifts the short -run Phillips curve upward: the actual rate of inflation at any given unemployment rate is higher when the expected inflation rate is higher. In fact, macroeconomists believe that the relationship between changes in expected inflation and changes in actual inflation is one -to -one. That is, when the expected inflation rate increases, the actual inflation rate at any given unemployment rate will increase by the same amount. When the expected inflation rate falls, the actual inflation rate at any given level of unemployment will fall by the same amount. Figure 34.4 on the next page shows how the expected rate of inflation affects the short -run Phillips curve. First, suppose that the expected rate of inflation is 0%. SRPC0 is the short -run Phillips curve when the public expects 0% inflation. According to 333 f i g u r e 34.4 Expected Inflation and the Short - Run Phillips Curve An increase in expected inflation shifts the short -run Phillips curve up. SRPC0 is the initial short - run Phillips curve with an expected inflation rate of 0%; SRPC2 is the short -run Phillips curve with an expected inflation rate of 2%. Each additional percentage point of expected inflation raises the actual inflation rate at any given unemployment rate by 1 percentage point. Inflation rate 6% 5 4 3 2 1 0 –1 –2 –3 SRPC shifts up by the amount of the increase in expected inflation. 3 4 5 6 7 8% SRPC2 SRPC0 Unemployment rate SRPC0, the actual inflation rate will be 0% if the unemployment rate is 6%; it will be 2% if the unemployment rate is 4%. Alternatively, suppose the expected rate of inflation is 2%. In that case, employers and workers will build this expectation into wages and prices: at any given unemployment rate, the actual inflation rate will be 2 percentage points higher than it would be fyi From the Scary Seventies to the Nifty Nineties Figure 34.1 showed that the American experience during the 1950s and 1960s supported the belief in the existence of a short-run Phillips curve for the
U.S. economy, with a short -run trade-off between unemployment and inflation. After 1969, however, that relationship appeared to fall apart according to the data. The figure here plots the course of U.S. unemployment and inflation rates from 1961 to 1990. As you can see, the course looks more like a tangled piece of yarn than like a smooth curve. Through much of the 1970s and early 1980s, the economy suffered from a combination of above - average unemployment rates coupled with inflation rates unprecedented in modern American history. This condition came to be known as stagflation—for stagnation combined with high inflation. In the late 1990s, by contrast, the economy was experiencing a blissful combination of low unemployment and low inflation. What explains these developments? Part of the answer can be attributed to a series of negative supply shocks that the U.S. economy suffered during the 1970s. The price of oil, in particular, soared as wars and revolutions in the Middle East led to a reduction in oil supplies and as oil-exporting countries deliberately curbed production to drive up prices. Compounding the oil price shocks, there was also a slowdown in labor productivity growth. Both of these factors shifted the short-run Phillips curve upward. During the 1990s, by contrast, supply shocks were positive. Prices of oil and other raw materials were generally falling, and productivity growth accelerated. As a result, the short-run Phillips curve shifted downward. Inflation rate 14% 8 6 10 12 Equally important, however, was the role of expected inflation. As mentioned earlier, inflation accelerated during the 1960s. During the 1970s, the public came to expect high inflation, and this also shifted the short-run Phillips curve up. It took a sustained and costly effort during the 1980s to get inflation back down. The result, however, was that expected inflation was very low by the late 1990s, allowing actual inflation to be low even with low rates of unemployment. 1979 1973 1969 1990 1975 1982 4 2 1971 1961 0 3 4 5 6 7 8 9 10% Unemployment rate 334 if people expected 0% inflation. SRPC2, which shows the Phillips curve when the expected inflation rate is 2%, is SRPC0 shifted upward by 2 percentage points at every level of unemployment. According to SRPC2, the actual inflation rate will be 2% if the unemployment rate is 6%; it will be 4% if the unemployment rate is 4%. What determines the expected rate of inflation? In general, people base their
expectations about inflation on experience. If the inflation rate has hovered around 0% in the last few years, people will expect it to be around 0% in the near future. But if the inflation rate has averaged around 5% lately, people will expect inflation to be around 5% in the near future. Since expected inflation is an important part of the modern discussion about the short -run Phillips curve, you might wonder why it was not in the original formulation of the Phillips curve. The answer lies in history. Think back to what we said about the early 1960s: at that time, people were accustomed to low inflation rates and reasonably expected that future inflation rates would also be low. It was only after 1965 that persistent inflation became a fact of life. So only then did it become clear that expected inflation would play an important role in price - setting. Inflation and Unemployment in the Long Run The short - run Phillips curve says that at any given point in time there is a trade-off between unemployment and inflation. According to this view, policy makers have a choice: they can choose to accept the price of high inflation in order to achieve low unemployment, or they can reject high inflation and pay the price of high unemployment. In fact, during the 1960s many economists believed that this trade-off represented a real choice. However, this view was greatly altered by the later recognition that expected inflation affects the short - run Phillips curve. In the short run, expectations often diverge from reality. In the long run, however, any consistent rate of inflation will be reflected in expectations. If inflation is consistently high, as it was in the 1970s, people will come to expect more of the same; if inflation is consistently low, as it has been in recent years, that, too, will become part of expectations. So what does the trade-off between inflation and unemployment look like in the long run, when actual inflation is incorporated into expectations? Most macroeconomists believe that there is, in fact, no long-run trade-off. That is, it is not possible to achieve lower unemployment in the long run by accepting higher inflation. To see why, we need to introduce another concept: the long-run Phillips curve. The Long -Run Phillips Curve Figure 34.5 on the next page reproduces the two short -run Phillips curves from Figure 34.4, SRPC0 and SRPC2. It also adds an additional short - run Phillips curve, SRPC4, representing a 4% expected rate of inflation
. In a moment, we’ll explain the significance of the vertical long - run Phillips curve, LRPC. Suppose that the economy has, in the past, had a 0% inflation rate. In that case, the current short -run Phillips curve will be SRPC0, reflecting a 0% expected inflation rate. If the unemployment rate is 6%, the actual inflation rate will be 0%. Also suppose that policy makers decide to trade off lower unemployment for a higher rate of inflation. They use monetary policy, fiscal policy, or both to drive the unemployment rate down to 4%. This puts the economy at point A on SRPC0, leading to an actual inflation rate of 2%. Over time, the public will come to expect a 2% inflation rate. This increase in inflationary expectations will shift the short -run Phillips curve upward to SRPC2. Now, when the unemployment rate is 6%, the actual inflation rate will be 2%. Given this new short run Phillips curve, policies adopted to keep the unemployment rate at 4% will lead to a 4% actual inflation rate—point B on SRPC2—rather than point A with a 2% actual inflation rate 335 f i g u r e 34.5 The NAIRU and the Long - Run Phillips Curve SRPC0 is the short - run Phillips curve when the expected inflation rate is 0%. At a 4% unemployment rate, the economy is at point A with an actual inflation rate of 2%. The higher inflation rate will be incorporated into expectations, and the SRPC will shift upward to SRPC2. If policy makers act to keep the unemployment rate at 4%, the economy will be at B and the actual inflation rate will rise to 4%. Inflationary expectations will be revised upward again, and SRPC will shift to SRPC4. At a 4% unemployment rate, the economy will be at C and the actual inflation rate will rise to 6%. Here, an unemployment rate of 6% is the NAIRU, or nonaccelerating inflation rate of unemployment. As long as unemployment is at the NAIRU, the actual inflation rate will match expectations and remain constant. An unemployment rate below 6% requires ever - accelerating inflation. The long - run Phillips curve, LRPC, which passes through E0, E2, and E4, is vertical: no long - run trade - off between unemployment and inflation exists. Inflation rate 81 –2 –3 Long-run Phillips curve, LRPC C B A E4 E2 E
0 SRPC4 SRPC2 3 4 5 6 7 8% Nonaccelerating inflation rate of unemployment, NAIRU SRPC0 Unemployment rate The nonaccelerating inflation rate of unemployment, or NAIRU, is the unemployment rate at which inflation does not change over time. The long -run Phillips curve shows the relationship between unemployment and inflation after expectations of inflation have had time to adjust to experience The non-accelerating inflation rate of unemployment, or NAIRU, is the unemployment rate at which inflation does not change over time. Eventually, the 4% actual inflation rate gets built into expectations about the future inflation rate, and the short - run Phillips curve shifts upward yet again to SRPC4. To keep the unemployment rate at 4% would now require accepting a 6% actual inflation rate, point C on SRPC4, and so on. In short, a persistent attempt to trade off lower unemployment for higher inflation leads to accelerating inflation over time. To avoid accelerating inflation over time, the unemployment rate must be high enough that the actual rate of inflation matches the expected rate of inflation. This is the situation at E0 on SRPC0: when the expected inflation rate is 0% and the unemployment rate is 6%, the actual inflation rate is 0%. It is also the situation at E2 on SRPC2: when the expected inflation rate is 2% and the unemployment rate is 6%, the actual inflation rate is 2%. And it is the situation at E4 on SRPC4: when the expected inflation rate is 4% and the unemployment rate is 6%, the actual inflation rate is 4%. As we’ll learn shortly, this relationship between accelerating inflation and the unemployment rate is known as the natural rate hypothesis. The unemployment rate at which inflation does not change over time—6% in Figure 34.5—is known as the nonaccelerating inflation rate of unemployment, or NAIRU for short. Keeping the unemployment rate below the NAIRU leads to ever accelerating inflation and cannot be maintained. Most macroeconomists believe that there is a NAIRU and that there is no long - run trade - off between unemployment and inflation. We can now explain the significance of the vertical line LRPC. It is the long - run Phillips curve, the relationship between unemployment and inflation in the long run, after expectations of inflation have had time to adjust to experience. It is vertical because any unemployment rate below the NAIRU leads to ever - accelerating inflation. In other words, the long-
run Phillips curve shows that there are limits to expansionary policies because an unemployment rate below the NAIRU cannot be maintained in the long run. Moreover there is a corresponding point we have not yet emphasized: any unemployment rate above the NAIRU leads to decelerating inflation. 336 The Natural Rate of Unemployment, Revisited Recall the concept of the natural rate of unemployment, the portion of the unemployment rate unaffected by the swings of the business cycle. Now we have introduced the concept of the NAIRU. How do these two concepts relate to each other? The answer is that the NAIRU is another name for the natural rate. The level of unemployment the economy “needs” in order to avoid accelerating inflation is equal to the natural rate of unemployment. In fact, economists estimate the natural rate of unemployment by looking for evidence about the NAIRU from the behavior of the inflation rate and the unemployment rate over the course of the business cycle. For example, the way major European countries learned, to their dismay, that their natural rates of unemployment were 9% or more was through unpleasant experience. In the late 1980s, and again in the late 1990s, European inflation began to accelerate as European unemployment rates, which had been above 9%, began to fall, approaching 8%. fyi The Great Disinflation of the 1980s As we’ve mentioned several times, the United States ended the 1970s with a high rate of inflation, at least by its own peacetime historical standards—13% in 1980. Part of this inflation was the result of one -time events, especially a world oil crisis. But expectations of future inflation at 10% or more per year appeared to be firmly embedded in the economy. By the mid-1980s, however, inflation was running at about 4% per year. Panel (a) of the figure shows the annual rate of change in the “core” consumer price index (CPI)—also called the core inflation rate. This index, which excludes volatile energy and food prices, is widely regarded as a better indicator of underlying in- flation trends than the overall CPI. By this measure, inflation fell from about 12% at the end of the 1970s to about 4% by the mid - 1980s. How was this disinflation achieved? At great cost. Beginning in late 1979, the Federal Reserve imposed strongly contractionary monetary policies, which pushed the economy into its worst recession since the Great Depression. Panel (b) shows the Congressional Budget Office estimate of the
U.S. output gap from 1979 to 1989: by 1982, actual output was 7% below potential output, corresponding to an unemployment rate of more than 9%. Aggregate output didn’t get back to potential output until 1987. Our analysis of the Phillips curve tells us that a temporary rise in unemployment, like that of the 1980s, is needed to break the cycle of inflationary expectations. Once expectations of inflation are reduced, the economy can return to the natural rate of unemployment at a lower inflation rate. And that’s just what happened. At what cost? If you add up the output gaps over 1980–1987, you find that the economy sacrificed approximately 18% of an average year’s output over the period. If we had to do the same thing today, that would mean giving up roughly $2.6 trillion worth of goods and services. (a) The Core Inflation Rate in the United States Came Down in the 1980s... (b)... but Only at the Expense of a Huge Sacrifice of Output and High Unemployment. Core inflation rate 14% 12 10 8 6 4 2 1979 1981 1983 1985 1987 1989 Year Output gap (percent of potential output) 2% 0 –2 –4 –6 –8 1979 1981 1983 1985 1987 1989 Year 337 In Figure 33.3 we cited Congressional Budget Office estimates of the U.S. natural rate of unemployment. The CBO has a model that predicts changes in the inflation rate based on the deviation of the actual unemployment rate from the natural rate. Given data on actual unemployment and inflation, this model can be used to deduce estimates of the natural rate—and that’s where the CBO numbers come from. The Costs of Disinflation Through experience, policy makers have found that bringing inflation down is a much harder task than increasing it. The reason is that once the public has come to expect continuing inflation, bringing inflation down is painful. A persistent attempt to keep unemployment below the natural rate leads to accelerating inflation that becomes incorporated into expectations. To reduce inflationary expectations, policy makers need to run the process in reverse, adopting contractionary policies that keep the unemployment rate above the natural rate for an extended period of time. The process of bringing down inflation that has become embedded in expectations is known as disinflation. Disinflation can be very expensive. The U.S. retreat from high inflation at the beginning of the 1980s appears to have cost the equivalent of about 18% of a year’s real GDP,
the equivalent of roughly $2.6 trillion today. The justification for paying these costs is that they lead to a permanent gain. Although the economy does not recover the short term production losses caused by disinflation, it no longer suffers from the costs associated with persistently high inflation. In fact, the United States, Britain, and other wealthy countries that experienced inflation in the 1970s eventually decided that the benefit of bringing inflation down was worth the required suffering—the large reduction in real GDP in the short term. Some economists argue that the costs of disinflation can be reduced if policy makers explicitly state their determination to reduce inflation. A clearly announced, credible policy of disinflation, they contend, can reduce expectations of future inflation and so shift the short -run Phillips curve downward. Some economists believe that the clear determination of the Federal Reserve to combat the inflation of the 1970s was credible enough that the costs of disinflation, huge though they were, were lower than they might otherwise have been. Deflation Before World War II, deflation—a falling aggregate price level—was almost as common as inflation. In fact, the U.S. consumer price index on the eve of World War II was 30% lower than it had been in 1920. After World War II, inflation became the norm in all countries. But in the 1990s, deflation reappeared in Japan and proved difficult to reverse. Concerns about potential deflation played a crucial role in U.S. monetary policy in the early 2000s and again in late 2008. In fact, in late 2008, the U.S. experienced a brief period of deflation. Why is deflation a problem? And why is it hard to end? Debt Deflation Deflation, like inflation, produces both winners and losers—but in the opposite direction. Due to the falling price level, a dollar in the future has a higher real value than a dollar today. So lenders, who are owed money, gain under deflation because the real value of borrowers’ payments increases. Borrowers lose because the real burden of their debt rises. In a famous analysis at the beginning of the Great Depression, Irving Fisher claimed that the effects of deflation on borrowers and lenders can worsen an economic slump. Deflation, in effect, takes real resources away from borrowers and redistributes them to lenders. Fisher argued that borrowers, who lose from deflation, are typically short of cash and will be forced to cut their spending sharply when their debt burden rises. 338 Lenders, however, are less likely to increase
spending sharply when the values of the loans they own rise. The overall effect, said Fisher, is that deflation reduces aggregate demand, deepening an economic slump, which, in a vicious circle, may lead to further deflation. The effect of deflation in reducing aggregate demand, known as debt deflation, probably played a significant role in the Great Depression. Effects of Expected Deflation Like expected inflation, expected deflation affects the nominal interest rate. Consider Figure 29.6 from Section 5 (repeated here as Figure 34.6), which demonstrates how expected inflation affects the equilibrium interest rate. As shown, the equilibrium nominal interest rate is 4% if the expected inflation rate is 0%. Clearly, if the expected inflation rate is −3%—if the public expects deflation at 3% per year—the equilibrium nominal interest rate will be 1%. But what would happen if the expected rate of inflation were −5%? Would the nominal interest rate fall to −1%, meaning that lenders are paying borrowers 1% on their debt? No. Nobody would lend money at a negative nominal rate of interest because they could do better by simply holding cash. This illustrates what economists call the zero bound on the nominal interest rate: it cannot go below zero. This zero bound can limit the effectiveness of monetary policy. Suppose the economy is depressed, with output below potential output and the unemployment rate above the natural rate. Normally, the central bank can respond by cutting interest rates so as to increase aggregate demand. If the nominal interest rate is already zero, however, the central bank cannot push it down any further. Banks refuse to lend and consumers and firms refuse to spend because, with a negative inflation rate and a 0% nominal interest rate, holding cash yields a positive real rate of return. Any further increases in the monetary base will either be held in bank vaults or held as cash by individuals and firms, without being spent. A situation in which conventional monetary policy to fight a slump—cutting interest rates—can’t be used because nominal interest rates are up against the zero bound is known as a liquidity trap. A liquidity trap can occur whenever there is a sharp reduction in demand for loanable funds—which is exactly what happened during the Great Debt deflation is the reduction in aggregate demand arising from the increase in the real burden of outstanding debt caused by deflation. There is a zero bound on the nominal interest rate: it cannot go below zero. A liquidity trap is a situation in which conventional monetary policy is ineffective because nominal interest rates are up against the zero bound 34.6
The Fisher Effect D0 and S0 are the demand and supply curves for loanable funds when the expected future inflation rate is 0%. At an expected inflation rate of 0%, the equilibrium nominal interest rate is 4%. An increase in expected future inflation pushes both the demand and supply curves upward by 1 percentage point for every percentage point increase in expected future inflation. D10 and S10 are the demand and supply curves for loanable funds when the expected future inflation rate is 10%. The 10 percentage point increase in expected future inflation raises the equilibrium nominal interest rate to 14%. The expected real interest rate remains at 4%, and the equilibrium quantity of loanable funds also remains unchanged. Nominal interest rate, r 14% 4 0 Demand for loanable funds at 10% expected inﬂation Supply of loanable funds at 10% expected inﬂation E10 Demand for loanable funds at 0% expected inﬂation Supply of loanable funds at 0% expected inﬂation D10 S10 S0 D0 Quantity of loanable funds E0 Q 339 f i g u r e 34.7 The Zero Bound in U.S. History This figure shows U.S. short - term interest rates, specifically the interest rate on three - month Treasury bills, since 1920. As shown by the shaded area at left, for much of the 1930s, interest rates were very close to zero, leaving little room for expansionary monetary policy. After World War II, persistent inflation generally kept rates well above zero. However, in late 2008, in the wake of the housing bubble bursting and the financial crisis, the interest rate on three-month Treasury bills was again virtually zero. Source: Federal Reserve Bank of St. Louis. Interest rate 18% 16 14 12 10 8 6 4 2 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 Year Depression. Figure 34.7 shows the interest rate on short-term U.S. government debt from 1920 to January 2010. As you can see, starting in 1933 and ending when World War II brought a full economic recovery, the U.S. economy was either close to or up against the zero bound. After World War II, when inflation became the norm around the world, the zero bound problem largely vanished as the public came to expect inflation rather than deflation. However, the recent history of the Japanese economy, shown in Figure 34.8, provides a modern illustration of the problem of deflation and the liquidity trap. Japan experienced a huge boom in the
prices of both stocks and real estate in the late 1980s, and then saw both bubbles burst. The result was a prolonged period of economic stagnation, the so-called Lost Decade, which gradually reduced the inflation rate and eventually led to persistent deflation. In an effort to fight the weakness of the economy, the f i g u r e 34.8 Japan’s Lost Decade A prolonged economic slump in Japan led to deflation from the late 1990s on. The Bank of Japan responded by cutting interest rates—but eventually ran up against the zero bound. Source: Japanese Ministry of Internal Affairs and Communications, Statistics Bureau; Bank of Japan. Interest rate, inﬂation rate 12% 10 8 6 4 2 0 –2 1980 Interest rate Inﬂation rate 1990 2000 2010 Year 340 Bank of Japan—the equivalent of the Federal Reserve—repeatedly cut interest rates. Eventually, it arrived at the “ZIRP”: the zero interest rate policy. The “call money rate,” the equivalent of the U.S. federal funds rate, was literally set equal to zero. Because the economy was still depressed, it would have been desirable to cut interest rates even further. But that wasn’t possible: Japan was up against the zero bound. In 2008 and 2009, the Federal Reserve also found itself up against the zero bound. In the aftermath of the bursting of the housing bubble and the ensuing financial crisis, the interest on short-term U.S. government debt had fallen to virtually zero. M o d u l e 34 AP R e v i e w Solutions appear at the back of the book. Check Your Understanding 1. Explain how the short - run Phillips curve illustrates the negative relationship between cyclical unemployment and the actual inflation rate for a given level of the expected inflation rate. 2. Why is there no long - run trade - off between unemployment 3. Why is disinflation so costly for an economy? Are there ways to reduce these costs? 4. Why won’t anyone lend money at a negative nominal rate of interest? How can this pose problems for monetary policy? and inflation? Tackle the Test: Multiple-Choice Questions 1. The long-run Phillips curve is I. the same as the short-run Phillips curve. II. vertical. III. the short-run Phillips curve plus expected inflation. a. I only b. II only c. III only d. I and II only I, II, and III e.
2. The short-run Phillips curve shows a relationship between a. negative b. positive c. negative d. positive e. positive. the aggregate price level and aggregate output the aggregate price level and aggregate output unemployment and inflation unemployment and aggregate output unemployment and the aggregate price level 3. An increase in expected inflation will shift a. the short-run Phillips curve downward. b. the short-run Phillips curve upward. Tackle the Test: Free-Response Questions c. the long-run Phillips curve upward. d. the long-run Phillips curve downward. e. neither the short-run nor the long-run Phillips curve. 4. Bringing down inflation that has become embedded in expectations is called a. deflation. b. negative inflation. c. anti-inflation. d. unexpected inflation. e. disinflation. 5. Debt deflation is a. the effect of deflation in decreasing aggregate demand. b. an idea proposed by Irving Fisher. c. a contributing factor in causing the Great Depression. d. due to differences in how borrowers/lenders respond to inflation losses/gains. e. all of the above. 1. a. Draw a correctly labeled graph showing a short-run Phillips curve with an expected inflation rate of 0% and the corresponding long-run Phillips curve. b. On your graph, label the nonaccelerating inflation rate of c. On your graph, show what happens in the long run if the government decides to decrease the unemployment rate below the nonaccelerating inflation rate of unemployment. Explain. unemployment 341 Answer (8 points) Inﬂation rate 8% Long-run Phillips curve, LRPC 7 6 5 4 3 2 1 0 –1 –2 –3 A 3 4 5 E0 6 SRPC’ 7 8% Nonaccelerating inﬂation rate of unemployment, NAIRU SRPC0 Unemployment rate 1 point: Vertical axis labeled “Inflation rate” 1 point: Horizontal axis labeled “Unemployment rate” 1 point: Downward sloping curve labeled “SRPC 0” 1 point: Vertical curve labeled “LRPC” 1 point: SRPC0 crosses horizontal axis where it crosses LRPC 1 point: NAIRU is labeled where SRPC0 crosses LRPC and horizontal axis 1 point: New SRPC is labeled, for example as “SRAS’”, and shown above the original SRPC0 1 point: When the unemployment rate moves below the NA
IRU, it creates inflation and moves the economy to a point such as A. This leads to positive inflationary expectations, which shift the SRPC up as shown by SRPC'. 2. Consider the accompanying diagram. Nominal interest rate, r 14% 4 0 Demand for loanable funds at 10% expected inﬂation Supply of loanable funds at 10% expected inﬂation E10 Demand for loanable funds at 0% expected inﬂation Supply of loanable funds at 0% expected inﬂation D10 S10 S0 E0 Q* D0 Quantity of loanable funds a. What is the nominal interest rate if expected inflation is 0%? b. What would the nominal interest rate be if the expected inflation rate were −2%? Explain. c. What would the nominal interest rate be if the expected inflation rate were −6%? Explain. d. What would a negative nominal interest rate mean for lenders? How much lending would take place at a negative nominal interest rate? Explain. e. What effect does a nominal interest rate of zero have on monetary policy? What is this situation called? 342 What you will learn in this Module: • Why classical macroeconomics wasn’t adequate for the problems posed by the Great Depression • How Keynes and the experience of the Great Depression legitimized macroeconomic policy activism • What monetarism is and its views about the limits of discretionary monetary policy • How challenges led to a revision of Keynesian ideas and the emergence of the new classical macroeconomics Module 35 History and Alternative Views of Macroeconomics Classical Macroeconomics The term macroeconomics appears to have been coined in 1933 by the Norwegian economist Ragnar Frisch. The timing, during the worst year of the Great Depression, was no accident. Still, there were economists analyzing what we now consider macroeconomic issues—the behavior of the aggregate price level and aggregate output— before then. Money and the Price Level Previously, we described the classical model of the price level. According to the classical model, prices are flexible, making the aggregate supply curve vertical even in the short run. In this model, an increase in the money supply leads, other things equal, to a proportional rise in the aggregate price level, with no effect on aggregate output. As a result, increases in the money supply lead to inflation, and that’s all. Before the 1930s, the classical model of the price level dominated economic thinking about the effects of monetary policy. Did classical
economists really believe that changes in the money supply affected only aggregate prices, without any effect on aggregate output? Probably not. Historians of economic thought argue that before 1930 most economists were aware that changes in the money supply affected aggregate output as well as aggregate prices in the short run—or, to use modern terms, they were aware that the short -run aggregate supply curve sloped upward. But they regarded such short -run effects as unimportant, stressing the long run instead. It was this attitude that led John Maynard Keynes to scoff at the focus on the long run, in which, as he said, “we are all dead.” 343 The Business Cycle Classical economists were, of course, also aware that the economy did not grow smoothly. The American economist Wesley Mitchell pioneered the quantitative study of business cycles. In 1920, he founded the National Bureau of Economic Research, an independent, nonprofit organization that to this day has the official role of declaring the beginnings of recessions and expansions. Thanks to Mitchell’s work, the measurement of business cycles was well advanced by 1930. But there was no widely accepted theory of business cycles. In the absence of any clear theory, views about how policy makers should respond to a recession were conflicting. Some economists favored expansionary monetary and fiscal policies to fight a recession. Others believed that such policies would worsen the slump or merely postpone the inevitable. For example, in 1934 Harvard’s Joseph Schumpeter, now famous for his early recognition of the importance of technological change, warned that any attempt to alleviate the Great Depression with expansionary monetary policy “would, in the end, lead to a collapse worse than the one it was called in to remedy.” When the Great Depression hit, the policy making process was paralyzed by this lack of consensus. In many cases, economists now believe, policy makers took steps in the wrong direction. Necessity was, however, the mother of invention. As we’ll explain next, the Great Depression provided a strong incentive for economists to develop theories that could serve as a guide to policy—and economists responded. The Great Depression and the Keynesian Revolution The Great Depression demonstrated, once and for all, that economists cannot safely ignore the short run. Not only was the economic pain severe, it threatened to destabilize societies and political systems. In particular, the economic plunge helped Adolf Hitler rise to power in Germany. The whole world wanted to know how this economic disaster could be happening and what should be done about it. But because there
was no widely accepted theory of the business cycle, economists gave conflicting and, we now believe, often harmful advice. Some believed that only a huge change in the economic system—such as having the government take over much of private industry and replace markets with a command economy—could end the slump. Others argued that slumps were natural—even beneficial—and that nothing should be done. Some economists, however, argued that the slump both could have and should have been cured—without giving up on the basic idea of a market economy. In 1930, the British economist John Maynard Keynes compared the problems of the U.S. and British economies to those of a car with a defective alternator. Getting the economy running, he argued, would require only a modest repair, not a complete overhaul. Nice metaphor. But what was the nature of the trouble? Keynes’s Theory In 1936, Keynes presented his analysis of the Great Depression—his explanation of what was wrong with the economy’s alternator—in a book titled The General Theory of Employment, Interest, and Money. In 1946, the great American economist Paul Samuelson wrote that “it is a badly written book, poorly organized.... Flashes of insight and intuition intersperse tedious algebra.... We find its analysis to be obvious and at the same time new. In short, it is a work of genius.” The General Theory isn’t easy reading, but it stands with Adam Smith’s The Wealth of Nations as one of the most influential books on economics ever written. As Samuelson’s description suggests, Keynes’s book is a vast stew of ideas. Keynesian economics mainly reflected two innovations. First, Keynes emphasized the short -run Some people use Keynesian economics as a synonym for left-wing economics—but the truth is that the ideas of John Maynard Keynes have been accepted across a broad part of the political spectrum. 344 effects of shifts in aggregate demand on aggregate output, rather than the long -run determination of the aggregate price level. As Keynes’s famous remark about being dead in the long run suggests, until his book appeared most economists had treated short run macroeconomics as a minor issue. Keynes focused the attention of economists on situations in which the short - run aggregate supply curve slopes upward and shifts in the aggregate demand curve affect aggregate output and employment as well as aggregate prices. Figure 35.1 illustrates the difference between Keynesian and classical macroeconomics
. Both panels of the figure show the short -run aggregate supply curve, SRAS; in both it is assumed that for some reason the aggregate demand curve shifts leftward from AD1 to AD2—let’s say in response to a fall in stock market prices that leads households to reduce consumer spending. f i g u r e 35.1 Classical Versus Keynesian Macroeconomics (a) The Classical View (b) The Keynesian View Aggregate price level P1 P2 Aggregate price level P1 P2 SRAS E1 E2 AD1 AD2 E1 E2 SRAS AD1 AD2 Y Real GDP Y2 Y1 Real GDP One important difference between classical and Keynesian economics involves the short -run aggregate supply curve. Panel (a) shows the classical view: the SRAS curve is vertical, so shifts in aggregate demand affect the aggregate price level but not aggregate output. Panel (b) shows the Keynesian view: in the short run the SRAS curve slopes upward, so shifts in aggregate demand affect aggregate output as well as aggregate prices Panel (a) shows the classical view: the short -run aggregate supply curve is vertical. The decline in aggregate demand leads to a fall in the aggregate price level, from P1 to P2, but no change in aggregate output. Panel (b) shows the Keynesian view: the short run aggregate supply curve slopes upward, so the decline in aggregate demand leads to both a fall in the aggregate price level, from P1 to P2, and a fall in aggregate output, from Y1 to Y2. As we’ve already explained, many classical macroeconomists would have agreed that panel (b) was an accurate story in the short run—but they regarded the short run as unimportant. Keynes disagreed. ( Just to be clear, there isn’t any diagram that looks like panel (b) of Figure 35.1 in Keynes’s General Theory. But Keynes’s discussion of aggregate supply, translated into modern terminology, clearly implies an upward -sloping SRAS curve.) Second, classical economists emphasized the role of changes in the money supply in shifting the aggregate demand curve, paying little attention to other factors. Keynes, however, argued that other factors, especially changes in “animal spirits”—these days usually referred to with the bland term business confidence—are mainly responsible for business cycles. Before Keynes, economists often argued that a decline in business confidence would have no effect on either the
aggregate price level or aggregate output, as long as the money supply stayed constant. Keynes offered a very different picture 345 Macroeconomic policy activism is the use of monetary and fiscal policy to smooth out the business cycle. Keynes’s ideas have penetrated deeply into the public consciousness, to the extent that many people who have never heard of Keynes, or have heard of him but think they disagree with his theory, use Keynesian ideas all the time. For example, suppose that a business commentator says something like this: “Because of a decline in business confidence, investment spending slumped, causing a recession.” Whether the commentator knows it or not, that statement is pure Keynesian economics. Keynes himself more or less predicted that his ideas would become part of what “everyone knows.” In another famous passage, this from the end of The General Theory, he wrote: “Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist.” Policy to Fight Recessions The main practical consequence of Keynes’s work was that it legitimized macroeconomic policy activism—the use of monetary and fiscal policy to smooth out the business cycle. Macroeconomic policy activism wasn’t something completely new. Before Keynes, many economists had argued for using monetary expansion to fight economic downturns—though others were fiercely opposed. Some economists had even argued that temporary budget deficits were a good thing in times of recession—though others disagreed strongly. In practice, during the 1930s many governments followed policies that we would now call Keynesian. In the United States, the administration of Franklin Roosevelt engaged in modest deficit spending in an effort to create jobs. But these efforts were half - hearted. Roosevelt’s advisers were deeply divided over the appropriate policies to adopt. In fact, in 1937 Roosevelt gave in to advice from fyi The End of the Great Depression It would make a good story if Keynes’s ideas had led to a change in economic policy that brought the Great Depression to an end. Unfortunately, that’s not what happened. Still, the way the Depression ended did a lot to convince economists that Keynes was right. The basic message many of the young economists who adopted Keynes’s ideas in the 1930s took from his work was that economic recovery requires aggressive fiscal expansion—deficit spending on a large scale to create jobs. And that is what they eventually got, but it wasn’t because politicians were persuaded. Instead, what happened was a
very large and expensive war, World War II. The figure here shows the U.S. unemployment rate and the federal budget deficit as a share of GDP from 1930 to 1947. As you can see, deficit spending during the 1930s was on a modest scale. In 1940, as the risk of war grew larger, the United States began a large military buildup, and the budget moved deep into deficit. After the attack on Pearl Harbor on December 7, 1941, the country began deficit spending on an enormous scale: in fiscal 1943, which began in July 1942, the deficit was 30% of GDP. Today that would be a deficit of $4.3 trillion. And the economy recovered. World War II wasn’t intended as a Keynesian fiscal policy, but it demonstrated that expansionary fiscal policy can, in fact, create jobs in the short run. Unemployment rate, budget deﬁcit (percent of GDP) 30% 20 10 0 –10 1930 Unemployment rate Budget deﬁcit War-time deﬁcit spending 1933 1936 1939 1942 1945 1947 Year 346 non - Keynesian economists who urged him to balance the budget and raise interest rates, even though the economy was still depressed. The result was a renewed slump. Today, by contrast, there is broad consensus about the useful role monetary and fiscal policy can play in fighting recessions. The 2004 Economic Report of the President was issued by a conservative Republican administration that was generally opposed to government intervention in the economy. Yet its view on economic policy in the face of recession was far more like that of Keynes than like that of most economists before 1936. It would be wrong, however, to suggest that Keynes’s ideas have been fully accepted by modern macroeconomists. In the decades that followed the publication of The General Theory, Keynesian economics faced a series of challenges, some of which succeeded in modifying the macroeconomic consensus in important ways. Challenges to Keynesian Economics Keynes’s ideas fundamentally changed the way economists think about business cycles. They did not, however, go unquestioned. In the decades that followed the publication of The General Theory, Keynesian economics faced a series of challenges. As a result, the consensus of macroeconomists retreated somewhat from the strong version of Keynesianism that prevailed in the 1950s. In particular, economists became much more aware of the limits to macroeconomic policy activism. The Revival of Monetary Policy Keynes’s General Theory suggested that monetary policy wouldn’t be very effective in depression conditions.
Many modern macroeconomists agree: earlier we introduced the concept of a liquidity trap, a situation in which monetary policy is ineffective because the interest rate is down against the zero bound. In the 1930s, when Keynes wrote, interest rates were, in fact, very close to 0%. (The term liquidity trap was first introduced by the British economist John Hicks in a 1937 paper, “Mr. Keynes and the Classics: A Suggested Interpretation,” that summarized Keynes’s ideas.) But even when the era of near - 0% interest rates came to an end after World War II, many economists continued to emphasize fiscal policy and downplay the usefulness of monetary policy. Eventually, however, macroeconomists reassessed the importance of monetary policy. A key milestone in this reassessment was the 1963 publication of A Monetary History of the United States, 1867–1960 by Milton Friedman, of the University of Chicago, and Anna Schwartz, of the National Bureau of Economic Research. Friedman and Schwartz showed that business cycles had historically been associated with fluctuations in the money supply. In particular, the money supply fell sharply during the onset of the Great Depression. Friedman and Schwartz persuaded many, though not all, economists that the Great Depression could have been avoided if the Federal Reserve had acted to prevent that monetary contraction. They persuaded most economists that monetary policy should play a key role in economic management. The revival of interest in monetary policy was significant because it suggested that the burden of managing the economy could be shifted away from fiscal policy— meaning that economic management could largely be taken out of the hands of politicians. Fiscal policy, which must involve changing tax rates or government spending, necessarily involves political choices. If the government tries to stimulate the economy by cutting taxes, it must decide whose taxes will be cut. If it tries to stimulate the economy with government spending, it must decide what to spend the money on Milton Friedman and his co-author Anna Schwartz played a key role in convincing macroeconomists of the importance of monetary policy 347 Monetarism asserts that GDP will grow steadily if the money supply grows steadily. Discretionary monetary policy is the use of changes in the interest rate or the money supply to stabilize the economy. Monetary policy, in contrast, does not involve such choices: when the central bank cuts interest rates to fight a recession, it cuts everyone’s interest rate at the same time. So a shift from relying on fiscal policy to relying on monetary policy makes macroeconomics a more technical, less political issue. In
fact, monetary policy in most major economies is set by an independent central bank that is insulated from the political process. Monetarism After the publication of A Monetary History, Milton Friedman led a movement, called monetarism, that sought to eliminate macroeconomic policy activism while maintaining the importance of monetary policy. Monetarism asserted that GDP will grow steadily if the money supply grows steadily. The monetarist policy prescription was to have the central bank target a constant rate of growth of the money supply, such as 3% per year, and maintain that target regardless of any fluctuations in the economy. It’s important to realize that monetarism retained many Keynesian ideas. Like Keynes, Friedman asserted that the short run is important and that short -run changes in aggregate demand affect aggregate output as well as aggregate prices. Like Keynes, he argued that policy should have been much more expansionary during the Great Depression. Monetarists argued, however, that most of the efforts of policy makers to smooth out the business cycle actually make things worse. We have already discussed concerns over the usefulness of discretionary fiscal policy—changes in taxes or government spending, or both—in response to the state of the economy. As we explained, government perceptions about the economy often lag behind reality, and there are further lags in changing fiscal policy and in its effects on the economy. As a result, discretionary fiscal policies intended to fight a recession often end up feeding a boom, and vice versa. According to monetarists, discretionary monetary policy, changes in the interest rate or the money supply by the central bank in order to stabilize the economy, faces the same problem of lags as fiscal policy, but to a lesser extent. Friedman also argued that if the central bank followed his advice and refused to change the money supply in response to fluctuations in the economy, fiscal policy would be much less effective than Keynesians believed. Earlier we analyzed the phenomenon of crowding out, in which government deficits drive up interest rates and lead to reduced investment spending. Friedman and others pointed out that if the money supply is held fixed while the government pursues an expansionary fiscal policy, crowding out will limit the effect of the fiscal expansion on aggregate demand. Figure 35.2 illustrates this argument. Panel (a) shows aggregate output and the aggregate price level. AD1 is the initial aggregate demand curve and SRAS is the short run aggregate supply curve. At the initial equilibrium, E1, the level of aggregate output is Y1 and the aggregate price level is P
1. Panel (b) shows the money market. MS is the money supply curve and MD1 is the initial money demand curve, so the initial interest rate is r1. Now suppose the government increases purchases of goods and services. We know that this will shift the AD curve rightward, as illustrated by the shift from AD1 to AD2; that aggregate output will rise, from Y1 to Y2, and that the aggregate price level will rise, from P1 to P2. Both the rise in aggregate output and the rise in the aggregate price level will, however, increase the demand for money, shifting the money demand curve rightward from MD1 to MD2. This drives up the equilibrium interest rate to r2. Friedman’s point was that this rise in the interest rate reduces investment spending, partially offsetting the initial rise in government spending. As a result, the rightward shift of the AD curve is smaller than multiplier analysis indicates. And Friedman argued that with a constant money supply, the multiplier is so small that there’s not much point in using fiscal policy. But Friedman didn’t favor activist monetary policy either. He argued that the problem of time lags that limit the ability of discretionary fiscal policy to stabilize the 348 35.2 Fiscal Policy with a Fixed Money Supply (a) The increase in aggregate demand from an expansionary ﬁscal policy is limited when the money supply is ﬁxed… (b) …because the increase in money demand drives up the interest rate, crowding out some investment spending. Aggregate price level P2 P1 Interest rate, r SRAS E2 E1 AD2 AD1 Y1 Y2 Real GDP r2 r1 MS M MD1 MD2 Quantity of money In panel (a) an expansionary fiscal policy shifts the AD curve rightward, driving up both the aggregate price level and aggregate output. However, this leads to an increase in the demand for money. If the money supply is held fixed, as in panel (b), the increase in money demand drives up the interest rate, reducing investment spending and offsetting part of the fiscal expansion. So the shift of the AD curve is less than it would otherwise be: fiscal policy becomes less effective when the money supply is held fixed economy also apply to discretionary monetary policy. Friedman’s solution was to put monetary policy on “autopilot.” The central bank, he argued, should follow a monetary policy rule, a formula that determines
its actions and leaves it relatively little discretion. During the 1960s and 1970s, most monetarists favored a monetary policy rule of slow, steady growth in the money supply. Underlying this view was the Quantity Theory of Money, which relies on the concept of the velocity of money, the ratio of nominal GDP to the money supply. Velocity is a measure of the number of times the average dollar bill in the economy turns over per year between buyers and sellers (e.g., I tip the Starbucks barista a dollar, she uses it to buy lunch, and so on). This concept gives rise to the velocity equation: (35-1) M × V = P × Y Where M is the money supply, V is velocity, P is the aggregate price level, and Y is real GDP. Monetarists believed, with considerable historical justification, that the velocity of money was stable in the short run and changed only slowly in the long run. As a result, they claimed, steady growth in the money supply by the central bank would ensure steady growth in spending, and therefore in GDP. Monetarism strongly influenced actual monetary policy in the late 1970s and early 1980s. It quickly became clear, however, that steady growth in the money supply didn’t ensure steady growth in the economy: the velocity of money wasn’t stable enough for such a simple policy rule to work. Figure 35.3 shows how events eventually undermined the monetarists’ view. The figure shows the velocity of money, as measured by the ratio of nominal GDP to M1, from 1960 to the middle of 2009. As you can see, until 1980, velocity followed a fairly smooth, seemingly predictable trend. After the Fed began to adopt monetarist ideas in the late 1970s and early 1980s, however, the velocity of money began moving erratically—probably due to financial market innovations. A monetary policy rule is a formula that determines the central bank’s actions. The Quantity Theory of Money emphasizes the positive relationship between the price level and the money supply. It relies on the velocity equation (M × V = P × Y ). The velocity of money is the ratio of nominal GDP to the money supply. It is a measure of the number of times the average dollar bill is spent per year 349 f i g u r e 35.3 The Velocity of Money From 1960 to 1980, the velocity of money was stable, leading monetarists to believe that steady growth in the money supply would lead to a
stable economy. After 1980, however, velocity began moving erratically, undermining the case for traditional monetarism. As a result, traditional monetarism fell out of favor. Source: Bureau of Economic Analysis; Federal Reserve Bank of St. Louis. Velocity of M1 12 10 8 6 4 Until 1980, velocity followed a smooth trend. After 1980, velocity changed erratically. 1960 1970 1980 1990 2000 2009 Year Traditional monetarists are hard to find among today’s macroeconomists. As we’ll see later, however, the concern that originally motivated the monetarists—that too much discretionary monetary policy can actually destabilize the economy—has become widely accepted. Inflation and the Natural Rate of Unemployment At the same time that monetarists were challenging Keynesian views about how macroeconomic policy should be conducted, other economists—some, but not all, monetarists—were emphasizing the limits to what activist macroeconomic policy could achieve. In the 1940s and 1950s, many Keynesian economists believed that expansionary fiscal policy could be used to achieve full employment on a permanent basis. In the 1960s, however, many economists realized that expansionary policies could cause problems with inflation, but they still believed policy makers could choose to trade off low unemployment for higher inflation even in the long run. In 1968, however, Edmund Phelps of Columbia University and Milton Friedman, working independently, proposed the concept of the natural rate of unemployment. In Module 34 we saw that the natural rate of unemployment is also the nonaccelerating inflation rate of unemployment, or NAIRU. According to the natural rate hypothesis, because inflation is eventually embedded in expectations, to avoid accelerating inflation over time, the unemployment rate must be high enough that the actual inflation rate equals the expected rate of inflation. Attempts to keep the unemployment rate below the natural rate will lead to an ever - rising inflation rate. The natural rate hypothesis limits the role of activist macroeconomic policy compared to earlier theories. Because the government can’t keep unemployment below the natural rate, its task is not to keep unemployment low but to keep it stable—to prevent large fluctuations in unemployment in either direction. The Friedman–Phelps hypothesis made a strong prediction: that the apparent trade -off between unemployment and inflation would not survive an extended period of rising prices. Once inflation was embedded in the public’s expectations, inflation would continue even in the face of high unemployment. Sure enough, that’s exactly what happened in the 1970s. This accurate
prediction was one of the triumphs of According to the natural rate hypothesis, to avoid accelerating inflation over time, the unemployment rate must be high enough that the actual inflation rate equals the expected inflation rate. 350 macroeconomic analysis, and it convinced the great majority of economists that the natural rate hypothesis was correct. In contrast to traditional monetarism, which declined in influence as more evidence accumulated, the natural rate hypothesis has become almost universally accepted among macroeconomists, with a few qualifications. (Some macroeconomists believe that at very low or negative rates of inflation the hypothesis doesn’t work.) The Political Business Cycle One final challenge to Keynesian economics focused not on the validity of the economic analysis but on its political consequences. A number of economists and political scientists pointed out that activist macroeconomic policy lends itself to political manipulation. Statistical evidence suggests that election results tend to be determined by the state of the economy in the months just before the election. In the United States, if the economy is growing rapidly and the unemployment rate is falling in the six months or so before Election Day, the incumbent party tends to be re-elected even if the economy performed poorly in the preceding three years. This creates an obvious temptation to abuse activist macroeconomic policy: pump up the economy in an election year, and pay the price in higher inflation and/or higher unemployment later. The result can be unnecessary instability in the economy, a political business cycle caused by the use of macroeconomic policy to serve political ends. An often - cited example is the combination of expansionary fiscal and monetary policy that led to rapid growth in the U.S. economy just before the 1972 election and a sharp acceleration in inflation after the election. Kenneth Rogoff, a respected macroeconomist who served as chief economist at the International Monetary Fund, proclaimed Richard Nixon, the president at the time, “the all -time hero of political business cycles.” One way to avoid a political business cycle is to place monetary policy in the hands of an independent central bank, insulated from political pressure. The political business cycle is also a reason to limit the use of discretionary fiscal policy to extreme circumstances. Rational Expectations, Real Business Cycles, and New Classical Macroeconomics As we have seen, one key difference between classical economics and Keynesian economics is that classical economists believed that the short -run aggregate supply curve is vertical, but Keynes emphasized the idea that the aggregate supply curve slopes upward in the short run. As a result, Keynes argued that demand shocks—shifts in the aggregate
demand curve—can cause fluctuations in aggregate output. The challenges to Keynesian economics that arose in the 1950s and 1960s—the renewed emphasis on monetary policy and the natural rate hypothesis—didn’t question the view that an increase in aggregate demand leads to a rise in aggregate output in the short run nor that a decrease in aggregate demand leads to a fall in aggregate output in the short run. In the 1970s and 1980s, however, some economists developed an approach to the business cycle known as new classical macroeconomics, which returned to the classical view that shifts in the aggregate demand curve affect only the aggregate price level, not aggregate output. The new approach evolved in two steps. First, some economists challenged traditional arguments about the slope of the short run aggregate supply curve based on the concept of rational expectations. Second, some economists suggested that changes in productivity caused economic fluctuations, a view known as real business cycle theory Election results tend to be determined by the state of the economy in the months just before the election. A political business cycle results when politicians use macroeconomic policy to serve political ends. New classical macroeconomics is an approach to the business cycle that returns to the classical view that shifts in the aggregate demand curve affect only the aggregate price level, not aggregate output 351 Rational expectations is the view that individuals and firms make decisions optimally, using all available information. According to new Keynesian economics, market imperfections can lead to price stickiness for the economy as a whole. Real business cycle theory claims that fluctuations in the rate of growth of total factor productivity cause the business cycle. Rational Expectations In the 1970s, a concept known as rational expectations had a powerful impact on macroeconomics. Rational expectations, a theory originally introduced by John Muth in 1961, is the view that individuals and firms make decisions optimally, using all available information. For example, workers and employers bargaining over long - term wage contracts need to estimate the inflation rate they expect over the life of that contract. Rational expectations says that in making estimates of future inflation, they won’t just look at past rates of inflation; they will also take into account available information about monetary and fiscal policy. Suppose that prices didn’t rise last year, but that the monetary and fiscal policies announced by policy makers made it clear to economic analysts that there would be substantial inflation over the next few years. According to rational expectations, long -term wage contracts will be adjusted today to reflect this future inflation, even though prices didn’t rise in the
past. Rational expectations can make a major difference to the effects of government policy. According to the original version of the natural rate hypothesis, a government attempt to trade off higher inflation for lower unemployment would work in the short run but would eventually fail because higher inflation would get built into expectations. According to rational expectations, we should remove the word eventually: if it’s clear that the government intends to trade off higher inflation for lower unemployment, the public will understand this, and expected inflation will immediately rise. In the 1970s, Robert Lucas of the University of Chicago, in a series of highly influential papers, used this logic to argue that monetary policy can change the level of unemployment only if it comes as a surprise to the public. If his analysis was right, monetary policy isn’t useful in stabilizing the economy after all. In 1995 Lucas won the Nobel Prize in economics for this work, which remains widely admired. However, many—perhaps most—macroeconomists, especially those advising policy makers, now believe that his conclusions were overstated. The Federal Reserve certainly thinks that it can play a useful role in economic stabilization. Why, in the view of many macroeconomists, doesn’t the rational expectations hypothesis accurately describe how the economy behaves? New Keynesian economics, a set of ideas that became influential in the 1990s, provides an explanation. It argues that market imperfections interact to make many prices in the economy temporarily sticky. For example, one new Keynesian argument points out that monopolists don’t have to be too careful about setting prices exactly “right”: if they set a price a bit too high, they’ll lose some sales but make more profit on each sale; if they set the price too low, they’ll reduce the profit per sale but sell more. As a result, even small costs to changing prices can lead to substantial price stickiness and make the economy as a whole behave in a Keynesian fashion. Over time, new Keynesian ideas combined with actual experience have reduced the practical influence of the rational expectations concept. Nonetheless, the idea of rational expectations served as a useful caution for macroeconomists who had become excessively optimistic about their ability to manage the economy. Real Business Cycles Earlier we introduced the concept of total factor productivity, the amount of output that can be generated with a given level of factor inputs. Total factor productivity grows over time, but that growth isn’t smooth. In the 1980s, a number of economists argued that slow
downs in productivity growth, which they attributed to pauses in technological progress, are the main cause of recessions. Real business cycle theory claims that fluctuations in the rate of growth of total factor productivity cause the business cycle. Believing that the aggregate supply curve is vertical, real business cycle theorists attribute the source of business cycles to shifts of the aggregate supply curve: a recession occurs when a slowdown in productivity growth shifts the aggregate supply curve leftward, and a recovery occurs when a pickup in productivity 352 growth shifts the aggregate supply curve rightward. In the early days of real business cycle theory, the theory’s proponents denied that changes in aggregate demand had any effect on aggregate output. This theory was strongly influential, as shown by the fact that two of the founders of real business cycle theory, Finn Kydland of Carnegie Mellon University and Edward Prescott of the Federal Reserve Bank of Minneapolis, won the 2004 Nobel Prize in economics. The current status of real business cycle theory, however, is somewhat similar to that of rational expectations. The theory is widely recognized as having made valuable contributions to our understanding of the economy, and it serves as a useful caution against too much emphasis on aggregate demand. But many of the real business cycle theorists themselves now acknowledge that their models need an upward sloping aggregate supply curve to fit the economic data—and that this gives aggregate demand a potential role in determining aggregate output. And as we have seen, policy makers strongly believe that aggregate demand policy has an important role to play in fighting recessions. M o d u l e 35 AP R e v i e w Solutions appear at the back of the book. Check Your Understanding 1. The figure below shows the behavior of M1 before, during, and after the 2001 recession. What would a classical economist have said about the Fed’s policy? Money supply (M1, billions of dollars) 2001 Recession $1,400 1,300 1,200 1,100 1996 1999 2001 2002 2005 Year 2. What would the figure above have looked like if the Fed had been following a monetarist policy since 1996? 3. Now look at Figure 35.3, which shows the path of the velocity of money. What problems do you think the United States would have had since 1996 if the Fed had followed a monetarist policy? 4. In addition to praising aggressive monetary policy, the 2004 Economic Report of the President says that “tax cuts can boost economic activity by raising after -tax income and enhancing incentives to work, save, and invest.” Which part
is a Keynesian statement and which part is not? Explain your answer. 5. In early 2001, as it became clear that the United States was experiencing a recession, the Fed stated that it would fight the recession with an aggressive monetary policy. By 2004, most observers concluded that this aggressive monetary expansion should be given credit for ending the recession. a. What would rational expectations theorists say about this conclusion? b. What would real business cycle theorists say 353 Tackle the Test: Multiple-Choice Questions 1. Which of the following was an important point emphasized in b. high enough that the actual rate of inflation equals the Keynes’s influential work? I. In the short run, shifts in aggregate demand affect aggregate output. II. Animal spirits are an important determinant of business expected rate. c. as close to zero as possible. d. 5%. e. left wherever the economy sets it. cycles. III. In the long run we’re all dead. a. I only b. II only c. III only d. I and II only I, II, and III e. 4. The main difference between the classical model of the price level and Keynesian economics is that a. the classical model assumes a vertical short-run aggregate supply curve. b. Keynesian economics assumes a vertical short-run aggregate supply curve. c. the classical model assumes an upward sloping long-run 2. Which of the following is a central point of monetarism? aggregate supply curve. a. Business cycles are associated with fluctuations in money d. Keynesian economics assumes a vertical long-run aggregate demand. supply curve. b. Activist monetary policy is the best way to address business e. the classical model assumes aggregate demand can not cycles. c. Discretionary monetary policy is effective while discretionary fiscal policy is not. d. The Fed should follow a monetary policy rule. e. All of the above. 3. The natural rate hypothesis says that the unemployment rate should be a. below the NAIRU. change in the long run. 5. That fluctuations in total factor productivity growth cause the business cycle is the main tenet of which theory? a. Keynesian b. classical c. rational expectations d. real business cycle e. natural rate Tackle the Test: Free-Response Questions 1. a. According to monetarism, business cycles are associated 2. For each of the following economic theories, identify its with fluctuations in what? b. Does monetarism advocate discretionary fiscal policy? Discretionary
monetary policy? c. What monetary policy does monetarism suggest? d. What is the velocity equation? Define each of the terms in the velocity equation. e. Use the velocity equation to explain the major conclusion of fundamental conclusion. a. the classical model of the price level b. Keynesian economics c. monetarism d. the natural rate hypothesis e. rational expectations f. real business cycle theory monetarism. Answer (10 points) 1 point: The money supply 1 point: No 1 point: No 1 point: A monetary policy rule 1 point: M × V = P × Y 1 point: M is the money supply. 1 point: V is the velocity of money. 1 point: P is the aggregate price level. 1 point: Y is real GDP. 1 point: Since V is stable, a steady growth of M will lead to a steady growth in GDP. 354 What you will learn in this Module: • The elements of the modern macroeconomic consensus • The main remaining disputes Module 36 The Modern Macroeconomic Consensus The Modern Consensus As we’ve seen, there were intense debates about macroeconomics in the 1960s, 1970s, and 1980s. More recently, however, things have settled down. The age of macroeconomic controversy is by no means over, but there is now a broad consensus about several crucial macroeconomic issues. To understand the modern consensus, where it came from, and what still remains in dispute, we’ll look at how macroeconomists have changed their answers to five key questions about macroeconomic policy. The five questions, and the answers given by macroeconomists over the past 70 years, are summarized in Table 36.1 on the next page. (In the table, new classical economics is subsumed under classical economics, and new Keynesian economics is subsumed under the modern consensus.) Notice that classical macroeconomics said no to each question; basically, classical macroeconomists didn’t think macroeconomic policy could accomplish very much. But let’s go through the questions one by one. Is Expansionary Monetary Policy Helpful in Fighting Recessions? As we’ve seen, classical macroeconomists generally believed that expansionary monetary policy was ineffective or even harmful in fighting recessions. In the early years of Keynesian economics, macroeconomists weren’t against monetary expansion during recessions, but they tended to believe that it was of doubtful effectiveness. Milton Friedman and his followers convinced economists that monetary policy was effective after all
. Nearly all macroeconomists now agree that monetary policy can be used to shift the aggregate demand curve and to reduce economic instability. The classical view that 355 t a b l e 36.1 Five Key Questions About Macroeconomic Policy Classical macroeconomics Keynesian macroeconomics Monetarism Modern consensus Is expansionary monetary policy helpful in fighting recessions? Is expansionary fiscal policy effective in fighting recessions? Can monetary and/or fiscal policy reduce unemployment in the long run? Should fiscal policy be used in a discretionary way? Should monetary policy be used in a discretionary way? No No No No No Not very Yes Yes Yes Yes Yes No No No No Yes, except in special circumstances Yes No No, except in special circumstances Still in dispute changes in the money supply affect only aggregate prices, not aggregate output, has few supporters today. The view once held by some Keynesian economists—that changes in the money supply have little effect—has equally few supporters. Now, it is generally agreed that monetary policy is ineffective only in the case of a liquidity trap. Is Expansionary Fiscal Policy Effective in Fighting Recessions? Classical macroeconomists were, if anything, even more opposed to fiscal expansion than to monetary expansion. Keynesian economists, on the other hand, gave fiscal policy a central role in fighting recessions. Monetarists argued that fiscal policy was ineffective as long as the money supply was held constant. But that strong view has become relatively rare. Most macroeconomists now agree that fiscal policy, like monetary policy, can shift the aggregate demand curve. Most macroeconomists also agree that the government should not seek to balance the budget regardless of the state of the economy: they agree that the role of the budget as an automatic stabilizer helps keep the economy on an even keel. Can Monetary and/or Fiscal Policy Reduce Unemployment in the Long Run? Classical macroeconomists didn’t believe the government could do anything about unemployment. Some Keynesian economists moved to the opposite extreme, arguing that expansionary policies could be used to achieve a permanently low unemployment rate, perhaps at the cost of some inflation. Monetarists believed that unemployment could not be kept below the natural rate. Almost all macroeconomists now accept the natural rate hypothesis and agree on the limitations of monetary and fiscal policy. They believe that effective monetary and fiscal policy can limit the size of fluctuations of the actual unemployment rate around the natural rate but can’t keep unemployment below the natural rate. Should Fiscal Policy Be Used in a Discretion
ary Way? As we’ve already seen, views about the effectiveness of fiscal policy have gone back and forth, from rejection by classical macroeconomists, to a positive view by Keynesian economists, to a negative view once again by monetarists. Today, most macroeconomists believe 356 that tax cuts and spending increases are at least somewhat effective in increasing aggregate demand. Many, but not all, macroeconomists, believe that discretionary fiscal policy is usually counterproductive: the lags in adjusting fiscal policy mean that, all too often, policies intended to fight a slump end up intensifying a boom. As a result, the macroeconomic consensus gives monetary policy the lead role in economic stabilization. Discretionary fiscal policy plays the leading role only in special circumstances when monetary policy is ineffective, such as those facing Japan during the 1990s when interest rates were at or near the zero bound and the economy was in a liquidity trap. Should Monetary Policy Be Used in a Discretionary Way? Classical macroeconomists didn’t think that monetary policy should be used to fight recessions; Keynesian economists didn’t oppose discretionary monetary policy, but they were skeptical about its effectiveness. Monetarists argued that discretionary monetary policy was doing more harm than good. Where are we today? This remains an area of dispute. Today there is a broad consensus among macroeconomists on these points: ■ Monetary policy should play the main role in stabilization policy. ■ The central bank should be independent, insulated from political pressures, in order to avoid a political business cycle. ■ Discretionary fiscal policy should be used sparingly, both because of policy lags and because of the risks of a political business cycle. There are, however, debates over how the central bank should set its policy. Should the central bank be given a simple, clearly defined target for its policies, or fyi Supply -Side Economics During the 1970s, a group of economic writers began propounding a view of economic policy that came to be known as “supply - side economics.” The core of this view was the belief that reducing tax rates, and so increasing the incentives to work and invest, would have a powerful positive effect on the growth rate of potential output. The supply - siders urged the government to cut taxes without worrying about matching spending cuts: economic growth, they argued, would offset any negative effects from budget deficits. Some supply - siders even argued that a cut in tax rates would have such a miraculous effect on economic growth that tax
revenues—the total amount taxpayers pay to the government—would actually rise. That is, some supply - siders argued that the United States was on the wrong side of the Laffer curve, a hypothetical relationship between tax rates and total tax revenue that slopes upward (meaning higher taxes bring higher tax revenues) at low tax rates but turns downward (meaning higher taxes bring lower tax revenues) when tax rates are very high. In the 1970s, supply - side economics was enthusiastically supported by the editors of the Wall Street Journal and other figures in the media, and it became popular with politicians. In 1980, Ronald Reagan made supply - side economics the basis of his presidential campaign. Because supply - side economics emphasizes supply rather than demand, and because the supply - siders themselves are harshly critical of Keynesian economics, it might seem as if supply - side theory belongs in our discussion of new classical macroeconomics. But unlike rational expectations and real business cycle theory, supply - side economics is generally dismissed by economic researchers. The main reason for this dismissal is lack of evidence. Almost all economists agree that tax cuts increase incentives to work and invest, but attempts to estimate these incentive effects indicate that at current U.S. tax levels they aren’t nearly strong enough to support the strong claims made by supply - siders. In particular, the supply - side doctrine implies that large tax cuts, such as those implemented by Ronald Reagan in the early 1980s, should sharply raise potential output. Yet estimates of potential output by the Congressional Budget Office and others show no sign of an acceleration in growth after the Reagan tax cuts 357 should it be given discretion to manage the economy as it sees fit? Should the central bank consider the management of asset prices, such as stock prices and real estate prices, part of its responsibility? And what actions should the central bank undertake when interest rates have hit the zero bound and conventional monetary policy has reached its limits? Central Bank Targets It may sound funny to say this, but it’s often not clear exactly what the Federal Reserve, the central bank of the United States, is trying to achieve. Clearly it wants a stable economy with price stability, but there isn’t any document setting out the Fed’s official view about exactly how stable the economy should be or what the inflation rate should be. This is not necessarily a bad thing. Experienced staff at the Fed generally believe that the absence of specific guidelines gives the central bank flexibility in coping with economic events and that history proves the Fed uses that flexibility
well. In practice, chairs of the Fed tend to stay in office for a long time—William McChesney Martin was chair from 1951 to 1970, and Alan Greenspan, appointed in 1987, served as chair until 2006. These long - serving chairs acquire personal credibility that reassures the public that the central bank’s power will be used well. Central banks in some other countries have adopted formal guidelines. Some American economists—including some members of the Federal Reserve Board of Governors—believe that the United States should follow suit. The best -known example of a central bank using formal guidelines is the Bank of England. Until 1997, the Bank of England was simply an arm of the British Treasury Department, with no independence. When it became an independent organization like the Federal Reserve, it was given a mandate to achieve an inflation target of 2.5%. (In 2003, that target was changed to 2%.) While inflation targeting is now advocated by many macroeconomists, others believe that such a rule can limit the ability of the central bank to respond to events, such as a stock market crash or a world financial crisis. Unlike the Bank of England, the Fed doesn’t have an explicit inflation target. However, it is widely believed to want an inflation rate of about 2%. Once the economy has moved past the current recession and financial crisis, there is likely to be renewed debate about whether the Fed should adopt an explicit inflation target. Asset Prices During the 1990s, many economists warned that the U.S. stock market was losing touch with reality—share prices were much higher than could be justified given realistic forecasts of companies’ future profits. Among these economists was Alan Greenspan, then chair of the Federal Reserve, who warned about “irrational exuberance” in a famous speech. In 2000, the stock market headed downward, taking the economy with it. Americans who had invested in the stock market suddenly felt poorer and so cut back on spending, helping push the economy into a recession. Just a few years later the same thing happened in the housing market, as home prices climbed above levels that were justified by the incomes of home buyers and the cost of renting rather than buying. This time, however, Alan Greenspan dismissed concerns about a bubble as “most unlikely.” But it turned out that there was indeed a bubble, which popped in 2006, leading to a financial crisis, and which pushed the economy into yet another recession. These events highlighted a long - standing debate over monetary policy:
should the central bank restrict its concerns to inflation and possibly unemployment, or should it also try to prevent extreme movements in asset prices, such as the average price of stocks or the average price of houses? One view is that the central bank shouldn’t try to second -guess the value investors place on assets like stocks or houses, even if it suspects that those prices are getting out of line. That is, the central bank shouldn’t raise interest rates to curb stock prices or housing prices if overall consumer price inflation remains low. If an overvalued stock market eventually falls and depresses aggregate demand, the central bank can deal with that by cutting interest rates The Bank of England has a mandate to keep inflation at around 2%. When the housing market fell in 2006, people began to question whether the central bank should concern itself with extreme movements in asset prices such as homes. 358 The alternative view warns that after a bubble bursts—after overvalued asset prices fall to earth—it may be difficult for monetary and fiscal policy to offset the effects on aggregate demand. After having seen the Japanese economy struggle for years with deflation in the aftermath of the collapse of its bubble economy, proponents of this view argue that the central bank should act to rein in irrational exuberance when it is happening, even if consumer price inflation isn’t a problem. The 2001 recession and the recession that started in 2007 gave ammunition to both sides in this debate, which shows no sign of ending. Unconventional Monetary Policies In 2008, responding to a growing financial crisis, the Federal Reserve began engaging in highly unconventional monetary policy. The Fed normally conducts monetary policy through open-market operations in which it buys and sells short-term U.S. government debt in order to influence interest rates. We have also seen that in 2008, faced with severe problems in the financial markets, the Fed vastly expanded its operations. It lent huge sums to a wide variety of financial institutions, and it began large-scale purchases of private assets, including commercial paper (short-term business debts) and assets backed by home mortgages. These actions and similar actions by other central banks, such as the Bank of Japan, were controversial. Supporters of the moves argued that extraordinary action was necessary to deal with the financial crisis and to cope with the liquidity trap that the economy had fallen into. But skeptics questioned both the effectiveness of the moves and whether the Fed was taking on dangerous risks. However, with interest rates up against the zero bound, it’s not clear that the Fed had
any other alternative but to turn unconventional. Future attitudes toward unconventional monetary policy will probably depend on how the Fed’s efforts play out. The Clean Little Secret of Macroeconomics It’s important to keep the debates we have just described in perspective. Macroeconomics has always been a contentious field, much more so than microeconomics. There will always be debates about appropriate policies. But the striking thing about current debates is how modest the differences among macroeconomists really are. The clean little secret of modern macroeconomics is how much consensus economists have reached over the past 70 years fyi After the Bubble In the 1990s, many economists worried that stock prices were irrationally high, and these worries proved justified. Starting in 2000, the NASDAQ, an index made up largely of technology stocks, began declining, ultimately losing two-thirds of its peak value. And in 2001 the plunge in stock prices helped push the United States into recession. The Fed responded with large, rapid interest rate cuts. But should it have tried to burst the stock bubble when it was happening? Many economists expected the aftermath of the 1990s stock market bubble to settle, once and for all, the question of whether central banks should concern themselves about asset prices. But the test results came out ambiguous, failing to settle the issue. If the Fed had been unable to engineer a recovery—if the U.S. economy had slid into a liquidity trap like that of Japan— critics of the Fed’s previous inaction would have had a very strong case. But the recession was, in fact, short: the National Bureau of Economic Research says that the recession began in March 2001 and ended in November 2001. Furthermore, if the Fed had been able to pro- duce a quick, strong recovery, its inaction dur- ing the 1990s would have been strongly vindicated. Unfortunately, that didn’t happen either. Although the economy began recovering in late 2001, the recovery was initially weak—so weak that employment continued to drop until the summer of 2003. Also, the fact that the Fed had to cut the federal funds rate to only 1%— uncomfortably close to 0%—suggested that the U.S. economy had come dangerously close to a liquidity trap. In other words, the events of 2001–2003 probably intensified the debate over monetary policy and asset prices, rather than resolving it 359 M o d u l e 36 AP R e v i e w Solutions appear at the back of the book. Check Your Understanding
1. What debates has the modern consensus resolved? What debates has it not resolved? Tackle the Test: Multiple-Choice Questions 1. Which of the following is an example of an opinion on which economists have reached a broad consensus? I. The natural rate hypothesis holds true. II. Discretionary fiscal policy is usually counterproductive. III. Monetary policy is effective, especially in a liquidity trap. a. I only b. II only III only c. d. I and II only I, II, and III e. 2. In the first FYI box of this module (p. 357) you learned about supply-side economics. Which of the following is stressed by supply siders? a. Taxes should be increased. b. Lower taxes will lead to lower tax revenues. It is important to increase incentives to work, save, and invest. c. d. The economy operates on the upward-sloping section of the Laffer curve. e. Supply side views are widely supported by empirical evidence. 3. Which of the following is true regarding central bank targets? a. The Fed has an explicit inflation target. b. All central banks have explicit inflation targets. Tackle the Test: Free-Response Questions 1. What is the consensus view of macroeconomists on each of the following: a. monetary policy and aggregate demand b. when monetary policy is ineffective c. fiscal policy and aggregate demand d. a balanced budget mandate e. the effectiveness of discretionary fiscal policy Answer (5 points) 1 point: Monetary policy can shift aggregate demand in the short run. 1 point: Monetary policy is ineffective when in a liquidity trap. 1 point: Fiscal policy can shift aggregate demand. 1 point: This is not a good idea. Fluctuations in the budget act as an automatic stabilizer for the economy. 1 point: It is usually counterproductive (for example, due to lags in implementation). c. No central banks have explicit inflation targets. d. The Fed clearly does not have an implicit inflation target. e. Economists are split regarding the need for explicit inflation targets. 4. The Fed’s main concerns are inflation and unemployment. inflation and asset prices. inflation, asset prices, and unemployment. a. b. c. d. asset prices and unemployment. e. inflation and the value of the dollar. 5. The “clean little secret of macroeconomics” is that a. microeconomics is even more contentious than macroeconomics. b. debate among macroeconomists has ended. c
. economists have reached a significant consensus. d. macroeconomics has progressed much more than microeconomics in the past 70 years. e. economists have identified how to prevent future business cycles. 2. On the basis of the description of the Laffer curve in the FYI box on supply-side economics on page 357, draw a correctly labeled graph of the Laffer curve. Use an “x” to identify a point on the curve at which a reduction in tax rates would lead to increased tax revenue. 360 Review Summary 1. Some of the fluctuations in the budget balance are due to the effects of the business cycle. In order to separate the effects of the business cycle from the effects of discretionary fiscal policy, governments estimate the cyclically adjusted budget balance, an estimate of the budget balance if the economy were at potential output. 2. U.S. government budget accounting is calculated on the basis of fiscal years. Persistent budget deficits have long -run consequences because they lead to an increase in public debt. This can be a problem for two reasons. Public debt may crowd out investment spending, which reduces long -run economic growth. And in extreme cases, rising debt may lead to government default, resulting in economic and financial turmoil. 3. A widely used measure of fiscal health is the debt–GDP ratio. This number can remain stable or fall even in the face of moderate budget deficits if GDP rises over time. However, a stable debt–GDP ratio may give a misleading impression that all is well because modern governments often have large implicit liabilities. The largest implicit liabilities of the U.S. government come from Social Security, Medicare, and Medicaid, the costs of which are increasing due to the aging of the population and rising medical costs. 4. Expansionary monetary policy reduces the interest rate by increasing the money supply. This increases investment spending and consumer spending, which in turn increases aggregate demand and real GDP in the short run. Contractionary monetary policy raises the interest rate by reducing the money supply. This reduces investment spending and consumer spending, which in turn reduces aggregate demand and real GDP in the short run. 5. The Federal Reserve and other central banks try to stabilize their economies, limiting fluctuations of actual output to around potential output, while also keeping inflation low but positive. Under the Taylor rule for monetary policy, the target interest rate rises when there is inflation, or a positive output gap, or both; the target interest rate falls when inflation is low or negative, or when the output gap is negative, or
both. Some central banks engage in inflation targeting, which is a forward - looking policy rule, whereas the Taylor rule is a backward - looking policy rule. In practice, the Fed appears to operate on a loosely defined version of the Taylor rule. Because monetary policy is subject to fewer implementation lags than fiscal policy, it is the preferred policy tool for stabilizing the economy. Section 6 Summary 6. In the long run, changes in the money supply affect the aggregate price level but not real GDP or the interest rate. Data show that the concept of monetary neutrality holds: changes in the money supply have no real effect on the economy in the long run. 7. In analyzing high inflation, economists use the classical model of the price level, which says that changes in the money supply lead to proportional changes in the aggregate price level even in the short run. 8. Governments sometimes print money in order to finance budget deficits. When they do, they impose an inflation tax, generating tax revenue equal to the inflation rate times the money supply, on those who hold money. Revenue from the real inflation tax, the inflation rate times the real money supply, is the real value of resources captured by the government. In order to avoid paying the inflation tax, people reduce their real money holdings and force the government to increase inflation to capture the same amount of real inflation tax revenue. In some cases, this leads to a vicious circle of a shrinking real money supply and a rising rate of inflation, leading to hyperinflation and a fiscal crisis. 9. A positive output gap is associated with lower - than - normal unemployment; a negative output gap is associated with higher - than - normal unemployment. 10. Countries that don’t need to print money to cover government deficits can still stumble into moderate inflation, either because of political opportunism or because of wishful thinking. 11. At a given point in time, there is a downward -sloping relationship between unemployment and inflation known as the short - run Phillips curve. This curve is shifted by changes in the expected rate of inflation. The long - run Phillips curve, which shows the relationship between unemployment and inflation once expectations have had time to adjust, is vertical. It defines the non accelerating inflation rate of unemployment, or NAIRU, which is equal to the natural rate of unemployment. 12. Once inflation has become embedded in expectations, getting inflation back down can be difficult because disinflation can be very costly, requiring the sacrifice of large amounts of aggregate output and imposing high levels of unemployment. However
, policy makers in the United States and other wealthy countries were willing to pay that price of bringing down the high inflation of the 1970s. S u m m a r y 361 13. Deflation poses several problems. It can lead to debt deflation, in which a rising real burden of outstanding debt intensifies an economic downturn. Also, interest rates are more likely to run up against the zero bound in an economy experiencing deflation. When this happens, the economy enters a liquidity trap, rendering conventional monetary policy ineffective. 14. Classical macroeconomics asserted that monetary policy affected only the aggregate price level, not aggregate output, and that the short run was unimportant. By the 1930s, measurement of business cycles was a well established subject, but there was no widely accepted theory of business cycles. 15. Keynesian economics attributed the business cycle to shifts of the aggregate demand curve, often the result of changes in business confidence. Keynesian economics also offered a rationale for macroeconomic policy activism. 16. In the decades that followed Keynes’s work, economists came to agree that monetary policy as well as fiscal policy is effective under certain conditions. Monetarism is a doctrine that called for a monetary policy rule as opposed to discretionary monetary policy. The argument of monetarists—based on a belief that the velocity of money was stable—that GDP would grow steadily if the money supply grew steadily, was influential for a time but was eventually rejected by many macroeconomists. 17. The natural rate hypothesis became almost universally accepted, limiting the role of macroeconomic policy to stabilizing the economy rather than seeking a perma- nently low unemployment rate. Fears of a political business cycle led to a consensus that monetary policy should be insulated from politics. 18. Rational expectations suggests that even in the short run there might not be a trade off between inflation and unemployment because expected inflation would change immediately in the face of expected changes in policy. Real business cycle theory claims that changes in the rate of growth of total factor productivity are the main cause of business cycles. Both of these versions of new classical macroeconomics received wide attention and respect, but policy makers and many economists haven’t accepted the conclusion that monetary and fiscal policy are ineffective in changing aggregate output. 19. New Keynesian economics argues that market imperfections can lead to price stickiness, so that changes in aggregate demand have effects on aggregate output after all. 20. The modern consensus is that monetary and fiscal policy are both effective in the short run but that neither can reduce the unemployment
rate in the long run. Discretionary fiscal policy is considered generally unadvisable, except in special circumstances. 21. There are continuing debates about the appropriate role of monetary policy. Some economists advocate the explicit use of an inflation target, but others oppose it. There’s also a debate about whether monetary policy should take steps to manage asset prices and what kind of unconventional monetary policy, if any, should be adopted to address a liquidity trap. Key Terms Cyclically adjusted budget balance, p. 298 Inflation tax, p. 325 Fiscal year, p. 300 Public debt, p. 300 Debt–GDP ratio, p. 301 Implicit liabilities, p. 303 Target federal funds rate, p. 307 Expansionary monetary policy, p. 310 Contractionary monetary policy, p. 310 Taylor rule for monetary policy, p. 311 Inflation targeting, p. 312 Monetary neutrality, p. 317 Cost-push inflation, p. 327 Demand-pull inflation, p. 327 Short -run Phillips curve, p. 331 Non accelerating inflation rate of unemployment (NAIRU), p. 336 Long -run Phillips curve, p. 336 Debt deflation, p. 339 Zero bound, p. 339 Liquidity trap, p. 339 Macroeconomic policy activism, p. 346 Classical model of the price level, p. 322 Monetarism, p. 348 Discretionary monetary policy, p. 348 Monetary policy rule, p. 349 Quantity Theory of Money, p. 349 Velocity of money, p. 349 Natural rate hypothesis, p. 350 Political business cycle, p. 351 New classical macroeconomics, p. 351 Rational expectations, p. 352 New Keynesian economics, p. 352 Real business cycle theory, p. 352 362 Problems 1. The government’s budget surplus in Macroland has risen consistently over the past five years. Two government policy makers disagree as to why this has happened. One argues that a rising budget surplus indicates a growing economy; the other argues that it shows that the government is using contractionary fiscal policy. Can you determine which policy maker is correct? If not, why not? 2. You are an economic adviser to a candidate for national office. She asks you for a summary of the economic consequences of a balanced -budget rule for the federal government and for your recommendation on whether she should support such a rule. How do you respond? 3. In which of the following cases does the size of the government’s debt and the size of the budget deficit indicate
potential problems for the economy? a. The government’s debt is relatively low, but the government is running a large budget deficit as it builds a high-speed rail system to connect the major cities of the nation. b. The government’s debt is relatively high due to a recently ended deficit-financed war, but the government is now running only a small budget deficit. c. The government’s debt is relatively low, but the government is running a budget deficit to finance the interest payments on the debt. 4. Unlike households, governments are often able to sustain large debts. For example, in September 2007, the U.S. government’s total debt reached $9 trillion, approximately 64% of GDP. At the time, according to the U.S. Treasury, the average interest rate paid by the government on its debt was 5.0%. However, running budget deficits becomes hard when very large debts are outstanding. a. Calculate the dollar cost of the annual interest on the government’s total debt assuming the interest rate and debt figures cited above. b. If the government operates on a balanced budget before interest payments are taken into account, at what rate must GDP grow in order for the debt–GDP ratio to remain unchanged? c. Calculate the total increase in national debt if the government incurs a deficit of $200 billion in fiscal year 2008. Assume that the only other change to the government’s total debt arises from interest payments on the current debt of $9 trillion. d. At what rate must GDP grow in order for the debt–GDP ratio to remain unchanged when the deficit in fiscal year 2008 is $200 billion? e. Why is the debt–GDP ratio the preferred measure of a country’s debt rather than the dollar value of the debt? Why is it important for a government to keep this number under control? Section 6 Summary 5. In the economy of Eastlandia, the money market is initially in equilibrium when the economy begins to slide into a recession. a. Using the accompanying diagram, explain what will happen to the interest rate if the central bank of Eastlandia keeps the money supply constant at M 1. Interest rate, r r1 MS1 E1 M1 MD1 Quantity of money b. If the central bank is instead committed to maintaining an interest rate target of r1, then as the economy slides into recession, how should the central bank react? Using your diagram from part a, demonstrate the
central bank’s reaction. 6. Continuing from equilibrium E1 in the previous problem, now suppose that in the economy of Eastlandia the central bank decides to decrease the money supply. a. Using the diagram in problem 5, explain what will happen to the interest rate in the short run. b. What will happen to the interest rate in the long run? 7. An economy is in long - run macroeconomic equilibrium with an unemployment rate of 5% when the government passes a law requiring the central bank to use monetary policy to lower the unemployment rate to 3% and keep it there. How could the central bank achieve this goal in the short run? What would happen in the long run? Illustrate with a diagram. 8. In the following examples, would the classical model of the price level be relevant? a. There is a great deal of unemployment in the economy and no history of inflation. b. The economy has just experienced five years of hyperinflation. c. Although the economy experienced inflation in the 10% to 20% range three years ago, prices have recently been stable and the unemployment rate has approximated the natural rate of unemployment. 9. Answer the following questions about the (real) inflation tax, assuming that the price level starts at 1. a. Maria Moneybags keeps $1,000 in her sock drawer for a year. Over the year, the inflation rate is 10%. What is the real inflation tax paid by Maria for this year? S u m m a r y 363 b. Maria continues to keep the $1,000 in her drawer for a second year. What is the real value of this $1,000 at the beginning of the second year? Over the year, the inflation rate is again 10%. What is the real inflation tax paid by Maria for the second year? c. For a third year, Maria keeps the $1,000 in the drawer. What is the real value of this $1,000 at the beginning of the third year? Over the year, the inflation rate is again 10%. What is the real inflation tax paid by Maria for the third year? d. After three years, what is the cumulative real inflation tax paid? e. Redo parts a through d with an inflation rate of 25%. Why is hyperinflation such a problem? 10. Concerned about the crowding - out effects of government borrowing on private investment spending, a candidate for president argues that the United States should just print money to cover the government’
s budget deficit. What are the advantages and disadvantages of such a plan? 11. The accompanying table provides data from the United States on the average annual rates of unemployment and inflation. Use the numbers to construct a scatter plot similar to Figure 34.1. Discuss why, in the short run, the unemployment rate rises when inflation falls. Year 2000 2001 2002 2003 2004 2005 2006 2007 Source: IMF. Unemployment rate Inflation rate 4.0% 4.7 5.8 6.0 5.5 5.1 4.6 4.6 3.4% 2.8 1.6 2.3 2.7 3.4 3.2 2.9 13. Monetarists believed for a period of time that the velocity of money was stable within a country. However, with financial innovation, the velocity began shifting around erratically after 1980. As would be expected, the velocity of money is different across countries depending upon the sophistication of their financial systems—velocity of money tends to be higher in countries with developed financial systems. The accompanying table provides money supply and GDP information in 2005 for six countries. Country Egypt National currency Egyptian pounds South Korea Korean won Thailand Thai baht United States U.S. dollars Kenya India Kenyan pounds Indian rupees Source: Datastream. M1 (billions in national currency) Nominal GDP (billions in national currency) 101 77,274 863 1,369 231 7,213 539 806,622 7,103 12,456 1,415 35,314 a. Calculate the velocity of money for each of the countries. The accompanying table shows GDP per capita for each of these countries in 2005 in U.S. dollars. Country Egypt South Korea Thailand United States Kenya India Source: IMF. Nominal GDP per capita (U.S. dollars) $1,270 16,444 2,707 41,886 572 710 12. In the modern world, central banks are free to increase or reduce the money supply as they see fit. However, some people harken back to the “good old days” of the gold standard. Under the gold standard, the money supply could expand only when the amount of available gold increased. a. Under the gold standard, if the velocity of money was stable when the economy was expanding, what would have had to happen to keep prices stable? b. Why would modern macroeconomists consider the gold standard a bad idea? b. Rank the countries in descending order of per capita
in- come and velocity of money. Do wealthy countries or poor countries tend to “turn over” their money more times per year? Would you expect that wealthy countries have more sophisticated financial systems? 14. Module 35 explains that Kenneth Rogoff proclaimed Richard Nixon “the all -time hero of political business cycles.” Using the table of data below from the Economic Report of the President, explain why Nixon may have earned that title. (Note: 364 Section 6 Summary Nixon entered office in January 1969 and was reelected in November 1972. He resigned in August 1974.) Government receipts (billions of dollars) Government spending (billions of dollars) Government budget balance (billions of dollars) $186.9 192.8 187.1 207.3 230.8 $183.6 195.6 210.2 230.7 245.7 $3.2 −2.8 −23.0 −23.4 −14.9 Year 1969 1970 1971 1972 1973 M1 growth M2 growth 3-month Treasury bill rate 3.3% 3.7% 6.68% 5.1 6.5 9.2 5.5 6.6 13.4 13.0 6.6 6.46 4.35 4.07 7.04 15. The economy of Albernia is facing a recessionary gap, and the leader of that nation calls together five of its best economists representing the classical, Keynesian, monetarist, real business cycle, and modern consensus views of the macroeconomy. Explain what policies each economist would recommend and why. 16. Which of the following policy recommendations, if any, are consistent with the classical, Keynesian, monetarist, and/or modern consensus views of the macroeconomy? a. Since the long -run growth of GDP is 2%, the money supply should grow at 2%. b. Decrease government spending in order to decrease infla- tionary pressure. c. Increase the money supply in order to alleviate a recession- ary gap. d. Always maintain a balanced budget. e. Decrease the budget deficit as a percent of GDP when fac- ing a recessionary gap. 17. Using a set of graphs as in Figure 35.2, show how a monetarist can argue that a contractionary fiscal policy may not lead to the desired fall in real GDP given a fixed money supply. Explain. S u m m a r y 365 This page intentionally left blank s e c t i o n Module 37: Long
-run Economic Growth Module 38: Productivity and Growth Module 39: Growth Policy: Why Economic Growth Rates Differ Module 40: Economic Growth in Macroeconomic Models Economics by Example: “Why Are Some Nations Rich and Others Poor?” 7 Economic Growth and Productivity China is growing—and so are the Chinese. According to official statistics, children in China are almost 21⁄2 inches taller now than they were 30 years ago. The average Chinese citizen is still a lot shorter than the average American, but at the current rate of growth the difference may be largely gone in a couple of generations. If that does happen, China will be following in Japan’s footsteps. Older Americans tend to think of the Japanese as short, but today young Japanese men are more than 5 inches taller on average than they were in 1900, which makes them almost as tall as their American counterparts. There’s no mystery about why the Japanese grew taller— it’s because they grew richer. In the early twentieth century, Japan was a relatively poor country in which many families couldn’t afford to give their children adequate nutrition. As a result, their children grew up to be short adults. However, since World War II, Japan has become an economic powerhouse in which food is ample and young adults are much taller than before. The same phenomenon is now happening in China. Although it continues to be a relacountry, tively poor China has made great economic strides over the past 30 years. Its recent history is probably the world’s most dramatic example of economic growth—a sustained increase in the productive capacity of an economy. Yet despite its impressive performance, China is currently playing catch -up with economically advanced countries like the United States and Japan. It’s still relatively poor because these other nations began their own processes of economic growth many decades ago—and in the case of the United States and European countries, more than a century ago. Unlike a short-run increase in real GDP caused by an increase in aggregate demand or short-run aggregate supply, we’ll see that economic growth pushes the production possibilities curve outward and shifts the long-run aggregate supply curve to the right. Because economic growth is a long-run concept, we often refer to it as long-run economic growth for clarity. Many economists have argued that long run economic growth— why it happens and how to achieve it—is the single most important issue in mac roeconomics. In this section, we present some facts about long
run growth, look at the factors that economists believe determine its pace, examine how government policies can help or hinder growth, and address questions about the environmental sustainability of growth. 367 What you will learn in this Module: • How we measure long-run economic growth • How real GDP has changed over time • How real GDP varies across countries • The sources of long-run economic growth • How productivity is driven by physical capital, human capital, and technological progress Module 37 Long-run Economic Growth Comparing Economies Across Time and Space Before we analyze the sources of long - run economic growth, it’s useful to have a sense of just how much the U.S. economy has grown over time and how large the gaps are between wealthy countries like the United States and countries that have yet to achieve a comparable standard of living. So let’s take a look at the numbers. Real GDP per Capita The key statistic used to track economic growth is real GDP per capita—real GDP divided by the population size. We focus on GDP because, as we have learned, GDP measures the total value of an economy’s production of final goods and services as well as the income earned in that economy in a given year. We use real GDP because we want to separate changes in the quantity of goods and services from the effects of a rising price level. We focus on real GDP per capita because we want to isolate the effect of changes in the population. For example, other things equal, an increase in the population lowers the standard of living for the average person—there are now more people to share a given amount of real GDP. An increase in real GDP that only matches an increase in population leaves the average standard of living unchanged. Although we learned that growth in real GDP per capita should not be a policy goal in and of itself, it does serve as a very useful summary measure of a country’s economic progress over time. Figure 37.1 shows real GDP per capita for the United States, India, and China, measured in 1990 dollars, from 1908 to 2008. (We’ll talk about India and China in a moment.) The vertical axis is drawn on a logarithmic scale so that equal percent changes in real GDP per capita across countries are the same size in the graph. To give a sense of how much the U.S. economy grew during the last century, Table 37.1 shows real GDP per capita at 20-year intervals, expressed two ways: as a percentage of the 1908
level and as a percentage of the 2008 level. In 1928, the U.S. economy already produced 144% as much per person as it did in 1908. In 2008, it produced 684% as much per 368 37.1 Economic Growth in the United States, India, and China over the Past Century Real GDP per capita from 1908 to 2008, measured in 1990 dollars, is shown for the United States, India, and China. Equal percent changes in real GDP per capita are drawn the same size. India and China currently have a much higher growth rate than the United States. However, China has only just attained the standard of living achieved in the United States in 1908, while India is still poorer than the United States was in 1908. Sources: Angus Maddison, Statistics on World Population, GDP, and Per Capita GDP, 1–2008AD, http://www.ggdc.net/ maddison. Real GDP per capita (log scale) $100,000 10,000 1,000 World War II United States China India 1908 1920 1930 1940 1950 1960 1970 1980 1990 2000 2008 Year person as it did in 1908. Alternatively, in 1908, the U.S. economy produced only 15% as much per person as it did in 2008. The income of the typical family normally grows more or less in proportion to per capita income. For example, a 1% increase in real GDP per capita corresponds, roughly, to a 1% increase in the income of the median or typical family—a family at the center of the income distribution. In 2008, the median American household had an income of about $50,000. Since Table 37.1 tells us that real GDP per capita in 1908 was only 15% of its 2008 level, a typical family in 1908 probably had purchasing power only 15% as large as the purchasing power of a typical family in 2008. That’s around $8,000 in today’s dollars, representing a standard of living that we would now consider severe poverty. Today’s typical American family, if transported back to the United States of 1908, would feel quite a lot of deprivation. Yet many people in the world have a standard of living equal to or lower than that of the United States a century ago. That’s the message about China and India in Figure 37.1: despite dramatic economic growth in China over the last three decades and the less dramatic acceleration of economic growth in India, China has only just attained the standard of living that the United States
enjoyed in 1908, while India is still poorer than the United States was in 1908. And much of the world today is poorer than China or India. t a b l e 37.1 U.S. Real GDP per Capita You can get a sense of how poor much of the world remains by looking at Figure 37.2 on the next page, a map of the world in which countries are classified according to their 2008 levels of GDP per capita, in U.S. dollars. As you can see, large parts of the world have very low incomes. Generally speaking, the countries of Europe and North America, as well as a few in the Pacific, have high incomes. The rest of the world, containing most of its population, is dominated by countries with GDP less than $5,000 per capita—and often much less. In fact, today more than 50% of the world’s people live in countries with a lower standard of living than the United States had a century ago. Year 1908 1928 1948 1968 1988 2008 Percentage of 1908 real GDP per capita 100% 144 199 326 493 684 Percentage of 2008 real GDP per capita 15% 21 29 48 72 100 Source: Angus Maddison, Statistics on World Population, GDP, and Per Capita GDP, 1–2008AD, http://www.ggdc.net/maddison 369 NORTH AMERICA EUROPE ASIA AFRICA SOUTH AMERICA AUSTRALIA Low income ($899 or less) Middle-low income, less than $5,000 ($900–4,999) Middle-high income, greater than $5,000 ($5,000–10,999) High income ($11,000 or more) f i g u r e 37.2 Incomes Around the World, 2008 Although the countries of Europe and North America—along with a few in East Asia—have high incomes, much of the world is still very poor. Today, more than 50% of the world’s population lives in countries with a lower standard of living than the United States had a century ago. Source: International Monetary Fund. fyi India Takes Off India achieved independence from Great Britain in 1947, becoming the world’s most populous democracy—a status it has maintained to this day. For more than three decades after independence, however, this happy political story was partly overshadowed by economic disappointment. Despite ambitious economic development plans, India’s performance was consistently sluggish. In 1980, India’s real GDP per capita
was only about 50% higher than it had been in 1947; the gap between Indian living standards and those in wealthy countries like the United States had been growing rather than shrinking. Since then, however, India has done much year, tripling between 1980 and 2008. India now has a large and rapidly growing middle class. And yes, the well - fed children of that middle class are much taller than their parents. What went right in India after 1980? Many economists point to policy reforms. For decades after independence, India had a tightly controlled, highly regulated economy. Today, things are very different: a series of reforms opened the economy to international trade and freed up domestic competition. Some economists, however, argue that this can’t be the main story because the big policy reforms weren’t adopted until 1991, yet growth accelerated around 1980. better. As Figure 37.3 shows, real GDP per capita has grown at an average rate of 4.1% a Regardless of the explanation, India’s economic rise has transformed it into a major new 370 India’s high rate of economic growth since 1980 has raised living standards and led to the emergence of a rapidly growing middle class. economic power—and allowed hundreds of millions of people to have a much better life, better than their grandparents could have dreamed. The Rule of 70 tells us that the time it takes a variable that grows gradually over time to double is approximately 70 divided by that variable’s annual growth rate Growth Rates How did the United States manage to produce nearly seven times more per person in 2008 than in 1908? A little bit at a time. Long - run economic growth is normally a gradual process in which real GDP per capita grows at most a few percent per year. From 1908 to 2008, real GDP per capita in the United States increased an average of 1.9% each year. To have a sense of the relationship between the annual growth rate of real GDP per capita and the long -run change in real GDP per capita, it’s helpful to keep in mind the Rule of 70, a mathematical formula that tells us how long it takes real GDP per capita, or any other variable that grows gradually over time, to double. The approximate answer is: (37-1) Number of years for variable to double = 70 Annual growth rate of variable (Note that the Rule of 70 can be applied to only a positive growth rate.) So if real GDP per capita grows at 1% per year, it will take 70 years to double.
If it grows at 2% per year, it will take only 35 years to double. Applying the Rule of 70 to the 1.9% average growth rate in the United States implies that it should have taken 37 years for real GDP per capita to double; it would have taken 111 years—three periods of 37 years each—for U.S. real GDP per capita to double three times. That is, the Rule of 70 implies that over the course of 111 years, U.S. real GDP per capita should have increased by a factor of 2 × 2 × 2 = 8. And this does turn out to be a pretty good approximation of reality. Between 1890 and 2008—a period of 118 years—real GDP per capita rose just about eightfold. Figure 37.3 shows the average annual rate of growth of real GDP per capita for selected countries from 1980 to 2008. Some countries were notable success stories: we’ve already mentioned China, which has made spectacular progress. India, although not matching China’s performance, has also achieved impres sive growth. Some countries, though, have had very disappointing growth. Argentina was once considered a wealthy nation. In the early years of the twentieth century, it was in the same league as the United States and Canada. But since then it has f i g u r e 37.3 Comparing Recent Growth Rates Here the average annual rate of growth of real GDP per capita from 1980 to 2008 is shown for selected countries. China and, to a lesser extent, India and Ireland have achieved impressive growth. The United States and France have had moderate growth. Despite having once been considered an economically advanced country, Argentina has had sluggish growth. Still others, such as Zimbabwe, have slid backward. Source: International Monetary Fund. Average annual growth rate of real GDP per capita, 1980–2008 10% 8 6 4 2 0 –2 8.8% 4.1% 3.9% 1.9% 1.5% 1.2% China India Ireland United States France Argentina Zimbabwe –1.8 371 fyi The Wal mart Effect After 20 years of being sluggish, U.S. productivity growth accelerated sharply in the late 1990s. What caused that acceleration? Was it the rise of the Internet? Not according to analysts at McKinsey and Co., a famous business consulting firm. They found that a major source of productivity improvement after 1995 was a surge in output per worker in retailing— stores were selling much more merchandise per worker. And why did
productivity surge in retailing in the United States? “The reason can be explained in just two syllables: Walmart,” wrote McKinsey. Walmart has been a pioneer in using modern technology to improve productivity. For example, it was one of the first companies to use computers to track inventory, to use bar code scanners, to establish direct electronic links with suppliers, and so on. It continued to set the pace in the 1990s, but, increasingly, other companies have imitated Wal mart’s business practices. There are two lessons from the “Walmart effect,” as McKinsey calls it. One is that how you apply a technology makes all the difference: everyone in the retail business knew about computers, but Walmart figured out what to do with them. The other is that a lot of economic growth comes from everyday improvements rather than glamorous new technologies. lagged far behind more dynamic economies. And still others, like Zimbabwe, have slid backward. What explains these differences in growth rates? To answer that question, we need to examine the sources of long - run growth. The Sources of Long - run Growth Long - run economic growth depends almost entirely on one ingredient: rising productivity. However, a number of factors affect the growth of productivity. Let’s look first at why productivity is the key ingredient. After that, we’ll examine what affects it. The Crucial Importance of Productivity Sustained growth in real GDP per capita occurs only when the amount of output produced by the average worker increases steadily. The term labor productivity, or productivity for short, is used to refer either to output per worker or, in some cases, to output per hour (the number of hours worked by an average worker differs to some extent across countries, although this isn’t an important factor in the difference between living standards in, say, India and the United States). In this book we’ll focus on output per worker. For the economy as a whole, productivity—output per worker—is simply real GDP divided by the number of people working. You might wonder why we say that higher productivity is the only source of long run growth in real GDP per capita. Can’t an economy also increase its real GDP per capita by putting more of the population to work? The answer is, yes, but.... For short periods of time, an economy can experience a burst of growth in output per capita by putting a higher percentage of the population to work. That happened in
the United States during World War II, when millions of women who previously worked only in the home entered the paid workforce. The percentage of adult civilians employed outside the home rose from 50% in 1941 to 58% in 1944, and you can see the resulting bump in real GDP per capita during those years in Figure 37.1. Over the longer run, however, the rate of employment growth is never very different from the rate of population growth. Over the course of the twentieth century, for example, the population of the United States rose at an average rate of 1.3% per year and employment Labor productivity, often referred to simply as productivity, is output per worker. 372 Physical capital consists of human made goods such as buildings and machines used to produce other goods and services. Human capital is the improvement in labor created by the education and knowledge of members of the workforce. Technology is the technical means for the production of goods and services If you’ve ever had doubts about attending college, consider this: factory workers with only high school degrees will make much less than college grads. The present discounted value of the difference in lifetime earnings is as much as $300,000. rose 1.5% per year. Real GDP per capita rose 1.9% per year; of that, 1.7%—that is, almost 90% of the total—was the result of rising productivity. In general, overall real GDP can grow because of population growth, but any large increase in real GDP per capita must be the result of increased output per worker. That is, it must be due to higher productivity. We have just seen that increased productivity is the key to long -run economic growth. But what leads to higher productivity? Explaining Growth in Productivity There are three main reasons why the average U.S. worker today produces far more than his or her counterpart a century ago. First, the modern worker has far more physical capital, such as tools and office space, to work with. Second, the modern worker is much better educated and so possesses much more human capital. Finally, modern firms have the advantage of a century’s accumulation of technical advancements reflecting a great deal of technological progress. Let’s look at each of these factors in turn. Physical Capital Module 22 explained that capital—manufactured goods used to produce other goods and services—is often described as physical capital to distinguish it from human capital and other types of capital. Physical capital such as buildings and machinery makes workers more productive. For example, a
worker operating a backhoe can dig a lot more feet of trench per day than one equipped with only a shovel. The average U.S. private - sector worker today makes use of around $130,000 worth of physical capital—far more than a U.S. worker had 100 years ago and far more than the average worker in most other countries has today. Human Capital It’s not enough for a worker to have good equipment—he or she must also know what to do with it. Human capital refers to the improvement in labor created by the education and knowledge embodied in the workforce. The human capital of the United States has increased dramatically over the past century. A century ago, although most Americans were able to read and write, very few had an extensive education. In 1910, only 13.5% of Americans over 25 had graduated from high school and only 3% had four -year college degrees. By 2008, the percentages were 86% and 27%, respectively. It would be impossible to run today’s economy with a population as poorly educated as that of a century ago. Analyses based on growth accounting, described later in this section, suggest that education—and its effect on productivity—is an even more important determinant of growth than increases in physical capital. Technology Probably the most important driver of productivity growth is progress in technology, which is broadly defined as the technical means for the production of goods and services. We’ll see shortly how economists measure the impact of technology on growth Workers today are able to produce more than those in the past, even with the same amount of physical and human capital, because technology has advanced over time. It’s important to realize that economically important technological progress need not be flashy or rely on cutting -edge science. Historians have noted that past economic growth has been driven not only by major inventions, such as the railroad or the semiconductor chip, but also by thousands of modest innovations, such as the flat bottomed paper bag, patented in 1870, which made packing groceries and many other goods much easier, and the Post -it note, introduced in 1981, which has had surprisingly large benefits for office productivity. Experts attribute much of the productivity surge that took place in the United States late in the twentieth century to new technology adopted by retail companies like Walmart rather than to high -technology companies 373 M o d u l e 37 AP R e v i e w Solutions appear at the back of the book. Check Your Understanding 1. Why do economists focus on real GDP
per capita as a measure of economic progress rather than on some other measure, such as nominal GDP per capita or real GDP? exceed that of the United States in the future if growth rates remained the same? Why or why not? 3. Although China and India currently have growth rates much 2. Apply the Rule of 70 to the data in Figure 37.3 to determine how long it will take each of the countries listed there to double its real GDP per capita. Would India’s real GDP per capita higher than the U.S. growth rate, the typical Chinese or Indian household is far poorer than the typical American household. Explain why. Tackle the Test: Multiple-Choice Questions 1. Which of the following is true regarding growth rates for countries around the world compared to the United States? I. Fifty percent of the world’s people live in countries with a lower standard of living than the U.S. in 1908. II. The U.S. growth rate is six times the growth rate in the rest of the world. III. China has only just attained the same standard of living the U.S. had in 1908. a. I only b. II only c. III only d. I and III only I, II, and III e. 2. Which of the following is the key statistic used to track economic growth? a. GDP b. real GDP c. real GDP per capita d. median real GDP e. median real GDP per capita Tackle the Test: Free-Response Questions 1. Refer to Figure 37.3. 10% 8.8% 8 6 4 2 0 –2 4.1% 3.9% 1.9% 1.5% 1.2% China India Ireland United States France Argentina Zimbabwe –1.8% 3. According to the “Rule of 70,” if a country’s real GDP per capita grows at a rate of 2% per year, it will take how many years for real GDP per capita to double? a. 3.5 b. 20 c. 35 d. 70 e. It will never double at that rate. 4. If a country’s real GDP per capita doubles in 10 years, what was its average annual rate of growth of real GDP per capita? a. 3.5% b. 7% c. 10% d. 70% e. 700% 5. Long-run economic growth depends almost entirely on a. technological change. b. rising productivity. c. d.
rising real GDP per capita. e. population growth. increased labor force participation. a. If growth continues at the rates shown in Figure 37.3, which of the seven countries will have a lower real GDP per capita in 2009 than in 2008? Explain. b. If growth continues at the rates shown in Figure 37.3, which of the seven countries will have the highest real GDP per capita in 2009? Explain. If growth continues at the rates shown in Figure 37.3, real GDP per capita for which of the seven countries will at least double over the next 10 years? Explain. c. 374. Increases in real GDP per capita result mostly from changes in what variable? Define that variable. What other factor could also lead to increased real GDP per capita? Why is this other factor not as significant? Answer (6 points) 1 point: Zimbabwe 1 point: It has a negative average annual growth rate of real GDP per capita. 1 point: It cannot be determined. 1 point: The figure provides data for growth rates, but not for the level of real GDP per capita. Higher growth rates do not indicate higher levels. 1 point: China 1 point: A country has to have an average annual growth rate of 7% or higher for real GDP to at least double in 10 years. China has a growth rate of 8.8%. 375 What you will learn in this Module: • How changes in productivity are illustrated using an aggregate production function • How growth has varied among several important regions of the world and why the convergence hypothesis applies to economically advanced countries Module 38 Productivity and Growth Accounting for Growth: The Aggregate Production Function Productivity is higher, other things equal, when workers are equipped with more physical capital, more human capital, better technology, or any combination of the three. But can we put numbers to these effects? To do this, economists make use of estimates of the aggregate production function, which shows how productivity depends on the quantities of physical capital per worker and human capital per worker as well as the state of technology. In general, all three factors tend to rise over time, as workers are equipped with more machinery, receive more education, and benefit from technological advances. What the aggregate production function does is allow economists to disentangle the effects of these three factors on overall productivity. A recent example of an aggregate production function applied to real data comes from a comparative study of Chinese and Indian economic growth conducted by the economists Barry Bosworth and Susan Collins of the Brookings Institution. They used the following aggregate
production function: GDP per worker = T × (physical capital per worker)0.4 × (human capital per worker)0.6 The aggregate production function is a hypothetical function that shows how productivity (output per worker) depends on the quantities of physical capital per worker and human capital per worker as well as the state of technology. An aggregate production function exhibits diminishing returns to physical capital when, holding the amount of human capital per worker and the state of technology fixed, each successive increase in the amount of physical capital per worker leads to a smaller increase in productivity. where T represented an estimate of the level of technology and they assumed that each year of education raised workers’ human capital by 7%. Using this function, they tried to explain why China grew faster than India between 1978 and 2004. About half the difference, they found, was due to China’s higher levels of investment spending, which raised its level of physical capital per worker faster than India’s. The other half was due to faster Chinese technological progress. In analyzing historical economic growth, economists have discovered a crucial fact about the estimated aggregate production function: it exhibits diminishing returns to physical capital. That is, when the amount of human capital per worker and the state of technology are held fixed, each successive increase in the amount of physical capital per worker leads to a smaller increase in productivity. Table 38.1 gives a hypothetical example of how the level of physical capital per worker might affect the level of 376 38.1 A Hypothetical Example: How Physical Capital per Worker Affects Productivity, Holding Human Capital and Technology Fixed Physical capital investment per worker Real GDP per worker $0 15,000 30,000 45,000 $0 30,000 45,000 55,000 real GDP per worker, holding human capital per worker and the state of technology fixed. In this example, we measure the quantity of physical capital in terms of the dollars worth of investment. As you can see from the table, there is a big payoff from the first $15,000 invested in physical capital: real GDP per worker rises by $30,000. The second $15,000 worth of physical capital also raises productivity, but not by as much: real GDP per worker goes up by only $15,000. The third $15,000 worth of physical capital raises real GDP per worker by only $10,000. To see why the relationship between physical capital per worker and productivity exhibits diminishing returns, think about how having farm equipment affects the productivity of farm workers. A little
bit of equipment makes a big difference: a worker equipped with a tractor can do much more than a worker without one. And a worker using more expensive equipment will, other things equal, be more productive: a worker with a $30,000 tractor will normally be able to cultivate more farmland in a given amount of time than a worker with a $15,000 tractor because the more expensive machine will be more powerful, perform more tasks, or both. But will a worker with a $30,000 tractor, holding human capital and technology constant, be twice as productive as a worker with a $15,000 tractor? Probably not: there’s a huge difference between not having a tractor at all and having even an inexpensive tractor; there’s much less difference between having an inexpensive tractor and having a better tractor. And we can be sure that a worker with a $150,000 tractor won’t be 10 times as productive: a tractor can be improved only so much. Because the same is true of other kinds of equipment, the aggregate production function shows diminishing returns to physical capital. Figure 38.1 on the next page is a graphical representation of the aggregate production function with diminishing returns to physical capital. As the productivity curve illustrates, more physical capital per worker leads to more output per worker. But each $30,000 increment in physical capital per worker adds less to productivity. By comparing points A, B, and C, you can also see that as physical capital per worker rises, output per worker also rises—but at a diminishing rate. Going from point A to point B, representing a $30,000 increase in physical capital per worker, leads to an increase of $20,000 in real GDP per worker. Going from point B to point C, a second $30,000 increase in physical capital per worker, leads to an increase of only $10,000 in real GDP per worker. It’s important to realize that diminishing returns to physical capital is an “other things equal” phenomenon: additional amounts of physical capital are less productive when the amount of human capital per worker and the technology are held fixed. Diminishing returns may disappear if we increase the amount of human capital per worker, or improve the technology, or both when the amount of physical capital per worker is increased. For example, a worker with a $30,000 tractor who has also been trained in the most advanced cultivation techniques may in fact be more than twice 377 f i g u r e 38.1
Physical Capital and Productivity Other things equal, a greater quantity of physical capital per worker leads to higher real GDP per worker but is subject to diminishing returns: each successive addition to physical capital per worker produces a smaller increase in productivity. Starting at point A, with $20,000 in physical capital per worker, a $30,000 increase in physical capital per worker leads to an increase of $20,000 in real GDP per worker. At point B, with $50,000 in physical capital per worker, a $30,000 increase in physical capital per worker leads to an increase of only $10,000 in real GDP per worker. Economists use growth accounting to estimate the contribution of each major factor in the aggregate production function to economic growth. Real GDP per worker 1. The increase in real GDP per worker becomes smaller... $60,000 50,000 30,000 B A Productivity C 0 $20,000 50,000 80,000 2.... as physical capital per worker rises. Physical capital per worker (2000 dollars) as productive as a worker with only a $15,000 tractor and no additional human capital. But diminishing returns to any one input—regardless of whether it is physical capital, human capital, or labor—is a pervasive characteristic of production. Typical estimates suggest that, in practice, a 1% increase in the quantity of physical capital per worker increases output per worker by only one-third of 1%, or 0.33%. In practice, all the factors contributing to higher productivity rise during the course of economic growth: both physical capital and human capital per worker increase, and technology advances as well. To disentangle the effects of these factors, economists use growth accounting to estimate the contribution of each major factor in the aggregate production function to economic growth. For example, suppose the following are true: ■ The amount of physical capital per worker grows 3% a year. ■ According to estimates of the aggregate production function, each 1% rise in physical capital per worker, holding human capital and technology constant, raises output per worker by one-third of 1%, or 0.33%. In that case, we would estimate that growing physical capital per worker is responsible for 1 percentage point (3% × 0.33) of productivity growth per year. A similar but more complex procedure is used to estimate the effects of growing human capital. The procedure is more complex because there aren’t simple dollar measures of the quantity of human capital. Growth accounting allows us to calculate the
effects of greater physical and human capital on economic growth. But how can we estimate the effects of technological progress? We can do so by estimating what is left over after the effects of physical and human capital have been taken into account. For example, let’s imagine that there was no increase in human capital per worker so that we can focus on changes in physical capital and in technology. In Figure 38.2, the lower curve shows the same hypothetical relationship between physical capital per worker and output per worker shown in Figure 38.1. Let’s assume that this was the relationship given the technology available in 1940. The upper curve also shows a relationship between physical capital per worker 378 38.2 Technological Progress and Productivity Growth Technological progress shifts the productivity curve upward. Here we hold human capital per worker fixed. We assume that the lower curve (the same curve as in Figure 38.1) reflects technology in 1940 and the upper curve reflects technology in 2010. Holding technology and human capital fixed, quadrupling physical capital per worker from $20,000 to $80,000 leads to a doubling of real GDP per worker, from $30,000 to $60,000. This is shown by the movement from point A to point C, reflecting an approximately 1% per year rise in real GDP per worker. In reality, technological progress shifted the productivity curve upward and the actual rise in real GDP per worker is shown by the movement from point A to point D. Real GDP per worker grew 2% per year, leading to a quadrupling during the period. The extra 1% in growth of real GDP per worker is due to higher total factor productivity. Real GDP per worker (constant dollars) $120,000 90,000 60,000 30,000 A Productivity using 2010 technology D Rising total factor productivity shifts curve up Productivity using 1940 technology C 0 $20,000 50,000 80,000 100,000 Physical capital per worker (2000 dollars) and productivity, but this time given the technology available in 2010. (We’ve chosen a 70-year stretch to allow us to use the Rule of 70.) The 2010 curve is shifted up compared to the 1940 curve because technologies developed over the previous 70 years make it possible to produce more output for a given amount of physical capital per worker than was possible with the technology available in 1940. (Note that the two curves are measured in constant dollars.) Let’s assume that between 1940 and 2010 the amount of physical capital per worker rose
from $20,000 to $80,000. If this increase in physical capital per worker had taken place without any technological progress, the economy would have moved from A to C: output per worker would have risen, but only from $30,000 to $60,000, or 1% per year (using the Rule of 70 tells us that a 1% growth rate over 70 years doubles output). In fact, however, the economy moved from A to D: output rose from $30,000 to $120,000, or 2% per year. There was an increase in both physical capital per worker and technological progress, which shifted the aggregate production function. In this case, 50% of the annual 2% increase in productivity—that is, 1% in annual productivity growth—is due to higher total factor productivity, the amount of output that can be produced with a given amount of factor inputs. So when total factor productivity increases, the economy can produce more output with the same quantity of physical capital, human capital, and labor. Most estimates find that increases in total factor productivity are central to a country’s economic growth. We believe that observed increases in total factor productivity in fact measure the economic effects of technological progress. All of this implies that technological change is crucial to Total factor productivity is the amount of output that can be achieved with a given amount of factor inputs 379 economic growth. The Bureau of Labor Statistics estimates the growth rate of both labor productivity and total factor productivity for nonfarm business in the United States. According to the Bureau’s estimates, over the period from 1948 to 2008 American labor productivity rose 2.6% per year. Only 46% of that rise is explained by increases in physical and human capital per worker; the rest is explained by rising total factor productivity—that is, by technological progress. What About Natural Resources? In our discussion so far, we haven’t mentioned natural resources, which certainly have an effect on productivity. Other things equal, countries that are abundant in valuable natural resources, such as highly fertile land or rich mineral deposits, have higher real GDP per capita than less fortunate countries. The most obvious modern example is the Middle East, where enormous oil deposits have made a few sparsely populated countries very rich. For instance, Kuwait has about the same level of real GDP per capita as South Korea, but Kuwait’s wealth is based on oil, not manufacturing, the source of South Korea’s high output per worker. But other things are often not equal.
In the modern world, natural resources are a much less important determinant of productivity than human or physical capital for the great majority of countries. For example, some nations with very high real GDP per capita, such as Japan, have very few natural resources. Some resource - rich nations, such as Nigeria (which has sizable oil deposits), are very poor. Historically, natural resources played a much more prominent role in determining productivity. In the nineteenth century, the countries with the highest real GDP per capita were those abundant in rich farmland and mineral deposits: the United States, Canada, Argentina, and Australia. As a consequence, natural resources figured prominently in the development of economic thought. In a famous book published in 1798, An Essay on the Principle of Population, the English economist Thomas Malthus made the fixed quantity of land in the world the basis of a pessimistic prediction about future productivity. As population grew, he pointed out, the amount of land per worker would decline. And this, other things equal, would cause productivity to fall. His view, in fact, was that improvements in technology or increases in physical capital would lead only to temporary improvements in productivity because they would always be offset by the pressure of rising population and more workers on the supply of land. In the long run, he concluded, the great majority of people were condemned to living on the edge of starvation. Only then would death rates be high enough and birth rates low enough to prevent rapid population growth from outstripping productivity growth. It hasn’t turned out that way, although many historians believe that Malthus’s prediction of falling or stagnant productivity was valid for much of human history. Population pressure probably did prevent large productivity increases until the eighteenth century. But in the time since Malthus wrote his book, any negative effects on productivity from population growth have been far outweighed by other, positive factors—advances in technology, increases in human and physical capital, and the opening up of enormous amounts of cultivatable land in the New World. It remains true, however, that we live on a finite planet, with limited supplies of resources such as oil and limited ability to absorb environmental damage. We address the concerns these limitations pose for economic growth later in this section. The offerings at markets such as this one in Lagos, Nigeria, are shaped by the available natural resources, human and physical capital, and technology. 380 fyi The Information Technology Paradox From the early 1970s through the mid - 1990s, the United States went through a slump in
total factor productivity growth. The figure shows Bureau of Labor Statistics estimates of annual total factor productivity growth since 1949. As you can see, there was a large fall in the productivity growth rate beginning in the early 1970s. Because higher total factor productivity plays such a key role in long - run growth, the economy’s overall growth was also disappointing, leading to a widespread sense that economic progress had ground to a halt. Many economists were puzzled by the slowdown in total factor productivity growth after 1973, since in other ways the era seemed to be one of rapid technological progress. Modern information technology really began with the development of the first microprocessor—a computer on a chip—in 1971. In the 25 years that followed, a series of inventions that seemed revolutionary became standard equipment in the business world: fax machines, desktop computers, cell phones, and e - mail. Yet the rate of growth of productivity remained stagnant. In a famous remark, MIT economics professor and Nobel laureate Robert Solow, a pioneer in the analysis of economic growth, declared that the infor- mation technology revolution could be seen everywhere except in the economic statistics. Why didn’t information Total factor productivity growth from previous year 8% 6 4 2 0 –2 –4 technology show large rewards? Paul David, a Stanford University economic historian, offered a theory and a prediction. He pointed out that 100 years earlier another miracle technology—electric power—had spread through the economy, again with surprisingly little impact on productivity growth at first. The reason, he suggested, was that a new technology doesn’t yield its full potential if you use it in old ways. For example, a traditional factory around 1900 was a multistory building, with the machinery tightly crowded together and designed to be powered by a steam engine in the basement. This design had problems: it was very difficult to move people and materials around. Yet owners who electrified their factories initially maintained the multistory, tightly packed layout. Only with the switch to spread - out, one - story factories that took advantage of the flexibility of 1949 1960 1970 1980 1990 2000 2008 Year electric power—most famously Henry Ford’s auto assembly line—did productivity take off. David suggested that the same phenomenon was happening with information technology. Productivity, he predicted, would take off when people really changed their way of doing business to take advantage of the new technology—such as replacing letters and phone calls with e-mail. Sure enough, productivity growth accelerated dramatically in the second half of the 1990s
. And, a lot of that may have been due to the discovery by companies like Walmart of how to effectively use information technology. Success, Disappointment, and Failure Rates of long - run economic growth differ markedly around the world. Let’s look at three regions that have had quite different experiences with economic growth over the last few decades. Figure 38.3 on the next page shows trends since 1960 in real GDP per capita in 2000 dollars for three countries: Argentina, Nigeria, and South Korea. (As in Figure 37.1, the vertical axis is drawn in logarithmic scale.) We have chosen these countries because each is a particularly striking example of what has happened in its region. South Korea’s amazing rise is part of a larger success story in East Asia. Argentina’s slow progress, interrupted by repeated setbacks, is more or less typical of the disappointment that has characterized Latin America. And Nigeria’s unhappy story—real GDP per capita is barely higher now than it was in 1960—is, unfortunately, an experience shared by many African countries 381 f i g u r e 38.3 Success and Disappointment Real GDP per capita from 1960 to 2008, measured in 2000 dollars, is shown for Argentina, South Korea, and Nigeria, using a logarithmic scale. South Korea and some other East Asian countries have been highly successful at achieving economic growth. Argentina, like much of Latin America, has had several setbacks, slowing its growth. Nigeria’s standard of living in 2008 was only barely higher than it had been in 1960, an experience shared by many African countries. Source: World Bank. Real GDP per capita (log scale) $100,000 10,000 1,000 Argentina South Korea Nigeria 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2008 Year East Asia’s Miracle In 1960, South Korea was a very poor country. In fact, in 1960 its real GDP per capita was lower than that of India today. But, as you can see from Figure 38.3, beginning in the early 1960s, South Korea began an extremely rapid economic ascent: real GDP per capita grew about 7% per year for more than 30 years. Today South Korea, though still somewhat poorer than Europe or the United States, looks very much like an economically advanced country. South Korea’s economic growth is unprecedented in history: it took the country only 35 years to achieve growth that required centuries elsewhere. Yet South Korea is only part of a broader phenomenon, often referred to
as the East Asian economic miracle. High growth rates first appeared in South Korea, Taiwan, Hong Kong, and Singapore but then spread across the region, most notably to China. Since 1975, the whole region has increased real GDP per capita by 6% per year, three times America’s historical rate of growth. How have the Asian countries achieved such high growth rates? The answer is that all of the sources of productivity growth have been firing on all cylinders. Very high savings rates, the percentage of GDP that is saved nationally in any given year, have allowed the countries to significantly increase the amount of physical capital per worker. Very good basic education has permitted a rapid improvement in human capital. And these countries have experienced substantial technological progress. Why hasn’t any economy achieved this kind of growth in the past? Most economic analysts think that East Asia’s growth spurt was possible because of its relative backwardness. That is, by the time that East Asian economies began to move into the modern world, they could benefit from adopting the technological advances that had been generated in technologically advanced countries such as the United States. In 1900, the United States could not have moved quickly to a modern level of productivity because much of the technology that powers the modern economy, from jet planes to computers, hadn’t been invented yet. In 1970, South Korea probably still had lower labor productivity than the United States had in 1900, but it could rapidly upgrade Countries in East Asia have enjoyed unprecedented growth since the 1970s, thanks largely to the adoption of modern technology and the accumulation of human capital. 382 its productivity by adopting technology that had been developed in the United States, Europe, and Japan over the previous century. This was aided by a huge investment in human capital through widespread schooling. The East Asian experience demonstrates that economic growth can be especially fast in countries that are playing catch -up to other countries with higher GDP per capita. On this basis, many economists have suggested a general principle known as the convergence hypothesis. It says that differences in real GDP per capita among countries tend to narrow over time because countries that start with lower real GDP per capita tend to have higher growth rates. We’ll look at the evidence for the convergence hypothesis later in this section. Even before we get to that evidence, however, we can say right away that starting with a relatively low level of real GDP per capita is no guarantee of rapid growth, as the examples of Latin America and Africa both demonstrate. Latin America’s Disappointment In 1900, Latin
America was not regarded as an economically backward region. Natural resources, including both minerals and cultivatable land, were abundant. Some countries, notably Argentina, attracted millions of immigrants from Europe in search of a better life. Measures of real GDP per capita in Argentina, Uruguay, and southern Brazil were comparable to those in economically advanced countries. Since about 1920, however, growth in Latin America has been disappointing. As Figure 38.3 shows in the case of Argentina, it has remained disappointing to this day. The fact that South Korea is now much richer than Argentina would have seemed inconceivable a few generations ago. According to the convergence hypothesis, international differences in real GDP per capita tend to narrow over time Why has Latin America stagnated? Comparisons with East Asian success stories suggest several factors. The rates of savings and investment spending in Latin America have been much lower than in East Asia, partly as a result of irresponsible government policy that has eroded savings through high inflation, bank failures, and other disruptions. Education— especially broad basic education—has been underemphasized: even Latin American nations rich in natural resources often failed to channel that wealth into their educational systems. And political instability, leading to irresponsible economic policies, has taken a toll. In the 1980s, many economists came to believe that Latin America was suffering from excessive government intervention in markets. They recommended opening the economies to imports, selling off government - owned companies, and, in general, freeing up individual initiative. The hope was that this would produce an East Asian–type economic surge. So far, however, only one Latin American nation, Chile, has achieved rapid growth. It now seems that pulling off an economic miracle is harder than it looks. R d i v a D Relatively low rates of savings, investment spending, and education, along with political instability, have hampered economic growth in Latin America. Africa’s Troubles Africa south of the Sahara is home to about 780 million people, more than 21⁄2 times the population of the United States. On average, they are very poor, nowhere close to U.S. living standards 100 or even 200 years ago. And economic progress has been both slow and uneven, as the example of Nigeria, the most populous nation in the region, suggests. In fact, real GDP per capita in sub - Saharan Africa actually fell 13 percent from 1980 to 1994, although it has recovered since then. The consequence of this poor growth performance has been intense and continuing poverty. This is a very disheartening picture. What
explains it? Perhaps first and foremost is the problem of political instability. In the years since 1975, large parts of Africa have experienced savage civil wars (often with outside powers 383 fyi Are Economies Converging? In the 1950s, much of Europe seemed quaint and backward to American visitors, and Japan seemed very poor. Today, a visitor to Paris or Tokyo sees a city that looks about as rich as New York. Although real GDP per capita is still somewhat higher in the United States, the differences in the standards of living among the United States, Europe, and Japan are relatively small. Many economists have argued that this convergence in living standards is normal; the convergence hypothesis says that relatively poor countries should have higher rates of growth of real GDP per capita than relatively rich countries. And if we look at today’s relatively well - off countries, the convergence hypothesis seems to be true. Panel (a) of the figure shows data for a number of today’s wealthy economies measured in 1990 dollars. On the horizontal axis is real GDP per capita in 1955; on the vertical axis is the average annual growth rate of real GDP per capita from 1955 to 2008. There is a clear negative relationship. The United States was the richest country in this group in 1955 and had the slowest rate of growth. Japan and Spain were the poorest countries in 1955 and had the fastest rates of growth. These data suggest that the convergence hypothesis is true. But economists who looked at similar data realized that these results depended on the countries selected. If you look at successful economies that have a high standard of living today, you find that real GDP per capita has converged. But looking across the world as a whole, including countries that remain poor, there is little evidence of convergence. Panel (b) of the figure illustrates this point using data for regions rather than individual countries (other than the United States). In 1955, East Asia and Africa were both very poor regions. Over the next 53 years, the East Asian regional economy grew quickly, as the convergence hypothesis would have predicted, but the African regional economy grew very slowly. In 1955, Western Europe had substantially higher real GDP per capita than Latin America. But, contrary to the convergence hypothesis, the Western European regional economy grew more quickly over the next 53 years, widening the gap between the regions. So is the convergence hypothesis all wrong? No: economists still believe that countries with relatively low real GDP per capita tend to have higher rates of growth than countries with relatively high real GDP per capita, other things equal
. But other things—education, infrastructure, rule of law, and so on—are often not equal. Statistical studies find that when you adjust for differences in these other factors, poorer countries do tend to have higher growth rates. This result is known as conditional convergence. Because other factors differ, however, there is no clear tendency toward convergence in the world economy as a whole. Western Europe, North America, and parts of Asia are becoming more similar in real GDP per capita, but the gap between these regions and the rest of the world is growing. (a) Convergence among Wealthy Countries... (b)... But Not for the World as a Whole Real GDP per capita annual growth rate 1955–2008 5% 4 3 2 1 0 Real GDP per capita annual growth rate 1955–2008 5% 4 3 2 1 0 Japan Spain Italy France United States Germany United Kingdom $5,000 10,000 15,000 Real GDP per capita in 1955 East Asia Western Europe United States Latin America Africa $5,000 10,000 15,000 Real GDP per capita in 1955 384 backing rival sides) that have killed millions of people and made productive investment spending impossible. The threat of war and general anarchy has also inhibited other important preconditions for growth, such as education and provision of necessary infrastructure. Property rights are also a problem. The lack of legal safeguards means that property owners are often subject to extortion because of government corruption, making them averse to owning property or improving it. This is especially damaging in a country that is very poor. While many economists see political instability and government corruption as the leading causes of underdevelopment in Africa, some—most notably Jeffrey Sachs of Columbia University and the United Nations—believe the opposite. They argue that Africa is politically unstable because Africa is poor. And Africa’s poverty, they go on to claim, stems from its extremely unfavorable geographic conditions—much of the continent is landlocked, hot, infested with tropical diseases, and cursed with poor soil. Sachs, along with economists from the World Health Organization, has highlighted the importance of health problems in Africa. In poor countries, worker productivity is often severely hampered by malnutrition and disease. In particular, tropical diseases such as malaria can be controlled only with an effective public health infrastructure, something that is lacking in much of Africa. At the time of this writing, economists are studying certain regions of Africa to determine whether modest amounts of aid given directly to residents for the purposes of increasing crop yields, reducing malaria, and increasing school attendance can produce self
-sustaining gains in living standards. Although the example of African countries represents a warning that long - run economic growth cannot be taken for granted, there are some signs of hope. Mauritius has developed a successful textile industry. Several African countries that are dependent on exporting commodities such as coffee and oil have benefited from the higher prices of those commodities. And Africa’s economic performance since the mid-1990s has been generally much better than it was in preceding decades 38 AP R e v i e w Solutions appear at the back of the book. Check Your Understanding 1. Explain the effect of each of the following on the growth rate of c. How much has growing physical capital per worker productivity. a. The amounts of physical and human capital per worker are unchanged, but there is significant technological progress. b. The amount of physical capital per worker grows, but the level of human capital per worker and technology are unchanged. 2. The economy of Erehwon has grown 3% per year over the past 30 years. The labor force has grown at 1% per year, and the quantity of physical capital has grown at 4% per year. The average education level hasn’t changed. Estimates by economists say that each 1% increase in physical capital per worker, other things equal, raises productivity by 0.3%. a. How fast has productivity in Erehwon grown? b. How fast has physical capital per worker grown? contributed to productivity growth? What percentage of total productivity growth is that? d. How much has technological progress contributed to productivity growth? What percentage of total productivity growth is that? 3. Multinomics, Inc., is a large company with many offices around the country. It has just adopted a new computer system that will affect virtually every function performed within the company. Why might a period of time pass before employees’ productivity is improved by the new computer system? Why might there be a temporary decrease in employees’ productivity 385 Tackle the Test: Multiple-Choice Questions 1. Which of the following is a source of increased productivity growth? I. increased physical capital II. increased human capital III. technological progress a. I only b. II only c. III only d. I and II only I, II, and III e. 2. Which of the following is an example of physical capital? a. machinery b. healthcare c. education d. money e. all of the above 3. The following statement describes which area of the world? “This area has experienced growth rates
unprecedented in history and now looks like an economically advanced country.” a. North America b. Latin America Tackle the Test: Free-Response Questions 1. a. Draw a correctly labeled graph of an aggregate production function that illustrates diminishing returns to physical capital. b. Explain how your aggregate production function illustrates diminishing returns to physical capital. c. On your graph, illustrate the effect of technological progress. d. How is the level of human capital per worker addressed on your graph? Answer (7 points) Real GDP per worker Productivity after technological progress Productivity before technological progress Physical capital per worker c. Europe d. East Asia e. Africa 4. Which of the following is cited as an important factor preventing long-run economic growth in Africa? a. political instability b. c. unfavorable geographic conditions d. poor health e. all of the above lack of property rights 5. The “convergence hypothesis” a. states that differences in real GDP per capita among countries widen over time. b. states that low levels of real GDP per capita are associated with higher growth rates. c. states that low levels of real GDP per capita are associated with lower growth rates. d. contradicts the “Rule of 70.” e. has been proven by evidence from around the world. 1 point: Vertical axis is labeled “Real GDP per worker.” 1 point: Horizontal axis is labeled physical capital per worker. 1 point: Upward-sloping curve is labeled “Aggregate production function” or “Productivity.” 1 point: Curve increases at a decreasing rate (the slope is positive and decreasing). 1 point: Equal increases in physical capital per worker lead to smaller increases in real GDP per worker. 1 point: Upward shift of production function is labeled to indicate technological progress. 1 point: Human capital per worker is held constant. 2. Assume that between 1940 and 2010: The amount of physical capital per worker grows at 2% per year. Each 1% rise in physical capital per worker (holding human capital and technology constant) raises output per worker by 1⁄2 of a percent, or 0.5%. There is no growth in human capital. Real GDP per capita rises from $30,000 to $60,000. a. Growing physical capital per worker is responsible for how much productivity growth per year? Show your calculation. b. By how much did total factor productivity grow over the time period? Explain. 386 What you will learn in this Module
: • The factors that explain why long-run growth rates differ so much among countries • The challenges to growth posed by scarcity of natural resources, environmental degradation, and efforts to make growth sustainable Module 39 Growth Policy: Why Economic Growth Rates Differ Why Growth Rates Differ In 1820, according to estimates by the economic historian Angus Maddison, Mexico had somewhat higher real GDP per capita than Japan. Today, Japan has higher real GDP per capita than most European nations and Mexico is a poor country, though by no means among the poorest. The difference? Over the long run, real GDP per capita grew at 1.9% per year in Japan but at only 1.2% per year in Mexico. As this example illustrates, even small differences in growth rates have large consequences over the long run. So why do growth rates differ across countries and across periods of time? Capital, Technology, and Growth Differences As one might expect, economies with rapid growth tend to be economies that add physical capital, increase their human capital, or experience rapid technological progress. Striking economic success stories, like Japan in the 1950s and 1960s or China today, tend to be countries that do all three: that rapidly add to their physical capital, upgrade their educational level, and make fast technological progress. Adding to Physical Capital One reason for differences in growth rates among countries is that some countries are increasing their stock of physical capital much more rapidly than others, through high rates of investment spending. In the 1960s, Japan was the fastest -growing major economy; it also spent a much higher share of its GDP on investment goods than other major economies. Today, China is the fastest -growing major economy, and it similarly spends a very large share of its GDP on investment goods. In 2009, investment spending was 44% of China’s GDP, compared with only 18% in the United States 387 Research and development, or R & D, is spending to create and implement new technologies Where does the money for high investment spending come from? We have already analyzed how financial markets channel savings into investment spending. The key point is that investment spending must be paid for either out of savings from domestic households or by an inflow of foreign capital—that is, savings from foreign households. Foreign capital has played an important role in the long -run economic growth of some countries, including the United States, which relied heavily on foreign funds during its early industrialization. For the most part, however, countries that invest a large share of their GDP are able to do so
because they have high domestic savings. One reason for differences in growth rates, then, is that countries have different rates of savings and investment spending. Adding to Human Capital Just as countries differ substantially in the rate at which they add to their physical capital, there have been large differences in the rate at which countries add to their human capital through education. A case in point is the comparison between Latin America and East Asia. In both regions the average educational level has risen steadily over time, but it has risen much faster in East Asia. As shown in Table 39.1, East Asia had a significantly less educated population than Latin America in 1960. By 2000, that gap had been closed: East Asia still had a slightly higher fraction of adults with no education— almost all of them elderly—but had moved well past Latin America in terms of secondary and higher education. t a b l e 39.1 Human Capital in Latin America and East Asia Latin America 2000 1960 East Asia 1960 2000 Percentage of population with no schooling 37.9% 14.6% 52.5% 19.8% Percentage of population with high school or above 5.9 19.5 4.4 26.5 Source: Barro, Robert J. and Lee, Jong-Wha (2001) “International Data on Educational Attainment: Updates and Implications,” Oxford Economic Papers vol. 53(3), p. 541–563. Technological Progress The advance of technology is a key force behind economic growth. What drives technology? Scientific advances make new technologies possible. To take the most spectacular example in today’s world, the semiconductor chip—which is the basis for all modern information technology—could not have been developed without the theory of quantum mechanics in physics. But science alone is not enough: scientific knowledge must be translated into useful products and processes. And that often requires devoting a lot of resources to research and development, or R&D, spending to create new technologies and prepare them for practical use. Although some research and development is conducted by governments, much R&D is paid for by the private sector, as discussed below. The United States became the world’s leading economy in large part because American businesses were among the first to make systematic research and development a part of their operations. Developing new technology is one thing; applying it is another. There have often been notable differences in the pace at which different countries take advantage of new technologies. America’s surge in productivity growth after 1995, as firms learned
to make use of information technology, was at least initially not matched in Europe. 388 fyi Inventing R&D Thomas Edison is best known as the inventor of the light bulb and the phonograph. But his biggest invention may surprise you: he invented research and development. Before Edison’s time, there had, of course, been many inventors. Some of them worked in teams. But in 1875 Edison created something new: his Menlo Park, New Jersey, laboratory. It employed 25 men full - time to generate new products and processes for business. In other words, he did not set out to pursue a particular idea and then cash in. He created an organization whose purpose was to create new ideas year after year. Edison’s Menlo Park lab is now a museum. “To name a few of the products that were developed in Menlo Park,” says the museum’s website, “we can list the following: the carbon button mouthpiece for the telephone, the phonograph, the incandescent light bulb and the electrical distribution system, the electric train, ore separation, the Edison effect bulb, early experiments in wireless, the grasshopper telegraph, and improvements in telegraphic transmission.” You could say that before Edison’s lab, technology just sort of happened: people came up with ideas, but businesses didn’t plan to make continuous technological progress. Now R&D Thomas Alva Edison in his laboratory in East Orange, New Jersey, in 1901. operations, often much bigger than Edison’s original team, are standard practice throughout the business world. The Role of Government in Promoting Economic Growth Governments can play an important role in promoting—or blocking—all three sources of long -term economic growth: physical capital, human capital, and technological progress. Governments and Physical Capital Governments play an important direct role in building infrastructure: roads, power lines, ports, information networks, and other parts of an economy’s physical capital that provide an underpinning, or foundation, for economic activity. Although some infrastructure is provided by private companies, much of it is either provided by the government or requires a great deal of government regulation and support. Ireland, whose economy really took off in the 1990s, is often cited as an example of the importance of government -provided infrastructure: the government invested in an excellent telecommunications infrastructure in the 1980s, and this helped make Ireland a favored location for high -technology companies. Roads, power lines
, ports, information networks, and other underpinnings for economic activity are known as infrastructure © Poor infrastructure—for example, a power grid that often fails, cutting off electricity to homes and businesses—is a major obstacle to economic growth in some countries. To provide good infrastructure, an economy must be able to afford it, but it must also have the political discipline to maintain it and provide for the future. Perhaps the most crucial infrastructure is something we rarely think about: basic public health measures in the form of a clean water supply and disease control. As we’ll see in the next section, poor health infrastructure is a major obstacle to economic growth in poor countries, especially those in Africa Governments also play an important indirect role in making high rates of private investment spending possible. Both the amount of savings and the ability of an economy to direct savings into productive investment spending depend on the economy’s institutions, notably its financial system. In particular, a well functioning banking system is very important for economic growth because in most countries it is the principal way in which savings are channeled into business investment spending. If a country’s citizens trust their banks, they will place their savings in bank deposits, which the banks will then lend to their business customers. But if people don’t Governments play a vital role in health maintenance. A child is vaccinated against the influenza A (H1N1) virus during a mass vaccination in Schiedam, Netherlands, in late 2009 389 trust their banks, they will hoard gold or foreign currency, keeping their savings in safe deposit boxes or under their mattresses, where it cannot be turned into productive investment spending. A well -functioning financial system requires appropriate government regulation that assures depositors that their funds are protected. Governments and Human Capital An economy’s physical capital is created mainly through investment spending by individuals and private companies. Much of an economy’s human capital, in contrast, is the result of government spending on education. Governments pay for the great bulk of primary and secondary education, although individuals pay a significant share of the costs of higher education. As a result, differences in the rate at which countries add to their human capital largely reflect government policy. As we saw in Table 39.1, East Asia now has a more educated population than Latin America. This isn’t because East Asia is richer than Latin America and so can afford to spend more on education. Until very recently, East Asia was, on average, poorer than Latin America. Instead, it reflects
the fact that Asian governments made broad education of the population a higher priority. Governments and Technology Technological progress is largely the result of private initiative. But much important R&D is done by government agencies. For example, Brazil’s agricultural boom was made possible by government researchers who discovered that adding crucial nutrients to the soil would allow crops to be grown on previously unusable land. They also developed new varieties of soybeans and breeds of cattle that flourish in Brazil’s tropical climate. Political Stability, Property Rights, and Excessive Government Intervention There’s not much point in investing in a business if rioting mobs are likely to destroy it. And why save your money if someone with political connections can steal it? Political stability and protection of property rights are crucial ingredients in long -run economic growth. Long - run economic growth in successful economies, like that of the United States, has been possible because there are good laws, institutions that enforce those laws, and a stable political system that maintains those institutions. The law must say that your property is really yours so that someone else can’t take it away. The courts and the police must be honest so that they can’t be bribed to ignore the law. And the political system must be stable so that the law doesn’t change capriciously. Americans take these preconditions for granted, but they are by no means guaranteed. Aside from the disruption caused by war or revolution, many countries find that fyi The Brazilian Breadbasket A wry Brazilian joke says that “Brazil is the country of the future—and always will be.” The world’s fifth most populous country has often been considered a possible major economic power yet has never fulfilled that promise. In recent years, however, Brazil’s economy has made a better showing, especially in agriculture. This success depends on exploiting a natural resource, the tropical savanna land known as the cerrado. Until a quarter century ago, the land was considered unsuitable for farming. A combination of three factors changed that: technological progress due to research and development, improved economic policies, and greater physical capital. The Brazilian Enterprise for Agricultural and Livestock Research, a government- run agency, developed the crucial technologies. It showed that adding lime and phosphorus made cerrado land productive, and it developed breeds of cattle and varieties of soybeans suited for the climate. (Now they’re working on wheat.) Also, until the 1980s, Brazilian international trade
policies discouraged exports, as did an overvalued exchange rate that made the country’s goods more expensive to foreigners. After economic reform, investing in Brazilian agriculture became much more profitable and companies began putting in place the farm machinery, buildings, and other forms of physical capital needed to exploit the land. What still limits Brazil’s growth? Infrastruc- ture. According to a report in the New York Times, Brazilian farmers are “concerned about the lack of reliable highways, railways and barge routes, which adds to the cost of doing business.” Recognizing this, the Brazilian government is investing in infrastructure, and Brazilian agriculture is continuing to expand. The country has already overtaken the United States as the world’s largest beef exporter and may not be far behind in soybeans. 390 Long - run economic growth is sustainable if it can continue in the face of the limited supply of natural resources and the impact of growth on the environment their economic growth suffers due to corruption among the government officials who should be enforcing the law. For example, until 1991 the Indian government imposed many bureaucratic restrictions on businesses, which often had to bribe government officials to get approval for even routine activities—a tax on business, in effect. Economists have argued that a reduction in this burden of corruption is one reason Indian growth has been much faster in recent years than it was in the first 40 years after India gained independence in 1947. Even when governments aren’t corrupt, excessive government intervention can be a brake on economic growth. If large parts of the economy are supported by government subsidies, protected from imports, or otherwise insulated from competition, productivity tends to suffer because of a lack of incentives. As we saw in Module 38, excessive government intervention is one often -cited explanation for slow growth in Latin America. Is World Growth Sustainable? Earlier we described the views of Thomas Malthus, the nineteenth-century economist who warned that the pressure of population growth would tend to limit the standard of living. Malthus was right—about the past: for around 58 centuries, from the origins of civilization until his own time, limited land supplies effectively prevented any large rise in real incomes per capita. Since then, however, technological progress and rapid accumulation of physical and human capital have allowed the world to defy Malthusian pessimism. But will this always be the case? Some skeptics have expressed doubt about whether long -run economic growth is sustainable—whether it can continue in the face of the limited supply of natural resources
and the impact of growth on the environment. Natural Resources and Growth, Revisited In 1972, a group of scientists called the Club of Rome made a big splash with a book titled The Limits to Growth, which argued that long -run economic growth wasn’t sustainable due to limited supplies of nonrenewable resources such as oil and natural gas. These “neo - Malthusian” concerns at first seemed to be validated by a sharp rise in resource prices in the 1970s, then came to seem foolish when resource prices fell sharply in the 1980s. After 2005, however, resource prices rose sharply again, leading to renewed concern about resource limitations to growth. Figure 39.1 shows the real price f i g u r e 39.1 The Real Price of Oil, 1949–2008 The real price of natural resources, like oil, rose dramatically in the 1970s and then fell just as dramatically in the 1980s. Since 2005, however, the real prices of natural resources have soared. Source: Energy Information Administration. Real domestic U.S. oil price (2000 dollars, per barrel) $80 70 60 50 40 30 20 10 1949 1960 1970 1980 1990 2000 2008 Year 391 of oil—the price of oil adjusted for inflation in the rest of the economy. The rise and fall of concerns about resource - based limits to growth have more or less followed the rise and fall of oil prices shown in the figure. Differing views about the impact of limited natural resources on long -run economic growth turn on the answers to three questions: ■ How large are the supplies of key natural resources? ■ How effective will technology be at finding alternatives to natural resources? ■ Can long - run economic growth continue in the face of resource scarcity? It’s mainly up to geologists to answer the first question. Unfortunately, there’s wide disagreement among the experts, especially about the prospects for future oil production. Some analysts believe that there is so much untapped oil in the ground that world oil production can continue to rise for several decades. Others—including a number of oil company executives—believe that the growing difficulty of finding new oil fields will cause oil production to plateau—that is, stop growing and eventually begin a gradual decline—in the fairly near future. Some analysts believe that we have already reached that plateau. The answer to the second question, whether there are alternatives to certain natural resources, will come from engineers. There’s no question that there are many alternatives to the natural resources currently
being depleted, some of which are already being exploited. For example, “unconventional” oil extracted from Canadian tar sands is already making a significant contribution to world oil supplies, and electricity generated by wind turbines is rapidly becoming big business in the United States—a development highlighted by the fact that in 2009 the United States surpassed Germany to become the world’s largest producer of wind energy. The third question, whether economies can continue to grow in the face of resource scarcity, is mainly a question for economists. And most, though not all, economists are optimistic: they believe that modern economies can find ways to work around limits on the supply of natural resources. One reason for this optimism is the fact that resource scarcity leads to high resource prices. These high prices in turn provide strong incentives to conserve the scarce resource and to find alternatives. For example, after the sharp oil price increases of the 1970s, American consumers turned to smaller, more fuel - efficient cars, and U.S. industry also greatly intensified its efforts to reduce energy bills. The result is shown in Figure 39.2, which compares the growth rates of real GDP per capita and oil consumption before and after the 1970s energy crisis. Before 1973, there seemed to be a more or less one - to-one relationship between economic growth and oil consumption, but after 1973 the U.S. economy continued to deliver growth in real GDP per capita even as it substantially reduced its use of oil. This move toward conservation paused after 1990, as low real oil prices encouraged consumers to shift back to gas -greedy larger cars and SUVs. A sharp rise in oil prices from 2005 to 2008 encouraged renewed shifts toward oil conservation, although these shifts lost some steam as prices started falling again in late 2008. Given such responses to prices, economists generally tend to see resource scarcity as a problem that modern economies handle fairly well, and so not a fundamental limit to long - run economic growth. Environmental issues, however, pose a more difficult problem because dealing with them requires effective political action. Economic Growth and the Environment Economic growth, other things equal, tends to increase the human impact on the environment. For example, China’s spectacular economic growth has also brought a spectacular increase in air pollution in that nation’s cities. It’s important to realize The Tehachapi Wind Farm, in Tehachapi, California, is the second largest collection of wind generators in the world. The turbines are operated by several private companies and collectively produce enough electricity
to meet the needs of 350,000 people every year. 392 39.2 U.S. Oil Consumption and Growth over Time Until 1973, the real price of oil was relatively cheap and there was a more or less one -to -one relationship between economic growth and oil consumption. Conservation efforts increased sharply after the spike in the real price of oil in the mid -1970s. Yet the U.S. economy was still able to grow despite cutting back on oil consumption. Sources: Energy Information Administration; Bureau of Economic Analysis. Oil consumption (thousands of barrels per day) 25,000 20,000 15,000 10,000 5,000 Oil consumption Real GDP Real GDP per capita (2005 dollars) $45,000 40,000 35,000 30,000 25,000 20,000 15,000 10,000 5,000 1949 1960 1970 1980 1990 2000 2008 Year however, that other things aren’t necessarily equal: countries can and do take action to protect their environments. In fact, air and water quality in today’s advanced countries is generally much better than it was a few decades ago. London’s famous “fog”—actually a form of air pollution, which killed 4,000 people during a two - week episode in 1952—is gone, thanks to regulations that virtually eliminated the use of coal heat. The equally famous smog of Los Angeles, although not extinguished, is far less severe than it was in the 1960s and early 1970s, again thanks to pollution regulations. Despite these past environmental success stories, there is widespread concern today about the environmental impacts of continuing economic growth, reflecting a change in the scale of the problem. Environmental success stories have mainly involved dealing with local impacts of economic growth, such as the effect of widespread car ownership on air quality in the Los Angeles basin. Today, however, we are faced with global environmental issues—the adverse impacts on the environment of the Earth as a whole by fyi Coal Comfort on Resources Those who worry that exhaustion of natural resources will bring an end to economic growth can take some comfort from the story of William Stanley Jevons, a nineteenthcentury British economist best known today for his role in the development of marginal analysis. In addition to his work in economic theory, Jevons worked on the real - world economic problems of the day, and in 1865 he published an influential book, The Coal Question, that foreshadowed many modern concerns about resources and growth. But his pessimism was proved wrong
. The Industrial Revolution was launched in Britain, and in 1865 Britain still had the world’s richest major economy. But Jevons argued that Britain’s economic success had depended on the availability of cheap coal and that the gradual exhaustion of Britain’s coal resources, as miners were forced to dig ever deeper, would threaten the nation’s long - run prosperity. He was right about the exhaustion of Britain’s coal: production peaked in 1913, and today the British coal industry is a shadow of its former self. But Britain was able to turn to alternative sources of energy, including imported coal and oil. And economic growth did not collapse: real GDP per capita in Britain today is about seven times its level in 1865 393 worldwide economic growth. The biggest of these issues involves the impact of fossilfuel consumption on the world’s climate. Burning coal and oil releases carbon dioxide into the atmosphere. There is broad scientific consensus that rising levels of carbon dioxide and other gases are causing a greenhouse effect on the Earth, trapping more of the sun’s energy and raising the planet’s overall temperature. And rising temperatures may impose high human and economic costs: rising sea levels may flood coastal areas; changing climate may disrupt agriculture, especially in poor countries; and so on. The problem of climate change is clearly linked to economic growth. Figure 39.3 shows carbon dioxide emissions from the United States, Europe, and China since 1980. Historically, the wealthy nations have been responsible for the bulk of these emissions because they have consumed far more energy per person than poorer countries. As China and other emerging economies have grown, however, they have begun to consume much more energy and emit much more carbon dioxide. f i g u r e 39.3 Climate Change and Growth Greenhouse gas emissions are positively related to growth. As shown here by the United States and Europe, wealthy countries have historically been responsible for the great bulk of greenhouse gas emissions because of their richer and faster-growing economies. As China and other emerging economies have grown, they have begun to emit much more carbon dioxide. Source: Energy Information Administration. Carbon dioxide emissions (millions of metric tons) 7,000 6,000 5,000 4,000 3,000 2,000 1,000 United States Europe China 1980 1985 1990 1995 2000 2006 Year Is it possible to continue long - run economic growth while curbing the emissions of greenhouse gases? The answer, according to most economists who have studied the issue, is yes. It should be possible
to reduce greenhouse gas emissions in a wide variety of ways, ranging from the use of non -fossil -fuel energy sources such as wind, solar, and nuclear power; to preventive measures such as carbon sequestration (capturing carbon dioxide and storing it); to simpler things like designing buildings so that they’re easier to keep warm in winter and cool in summer. Such measures would impose costs on the economy, but the best available estimates suggest that even a large reduction in greenhouse gas emissions over the next few decades would only modestly dent the long-term rise in real GDP per capita. The problem is how to make all of this happen. Unlike resource scarcity, environmental problems don’t automatically provide incentives for changed behavior. Pollution is an example of a negative externality, a cost that individuals or firms impose on others without having to offer compensation. In the absence of government intervention, individuals and firms have no incentive to reduce negative externalities, which is why it took regulation to reduce air pollution in America’s cities. And as Nicholas Stern, the author of an influential report on climate change, put it, greenhouse gas emissions are “the mother of all externalities.” 394 So there is a broad consensus among economists—although there are some dissenters—that government action is needed to deal with climate change. There is also broad consensus that this action should take the form of market - based incentives, either in the form of a carbon tax—a tax per unit of carbon emitted—or a cap and trade system in which the total amount of emissions is capped, and producers must buy licenses to emit greenhouse gases. There is, however, considerable dispute about how much action is appropriate, reflecting both uncertainty about the costs and benefits and scientific uncertainty about the pace and extent of climate change. There are also several aspects of the climate change problem that make it much more difficult to deal with than, say, smog in Los Angeles. One is the problem of taking the long view. The impact of greenhouse gas emissions on the climate is very gradual: carbon dioxide put into the atmosphere today won’t have its full effect on the climate for several generations. As a result, there is the political problem of persuading voters to accept pain today in return for gains that will benefit their children, grandchildren, or even great - grandchildren. The added problem of international burden sharing presents a stumbling block for consensus, as it did at the United Nations Climate Change Conference in 2009. As Figure 39.3 shows
, today’s rich countries have historically been responsible for most greenhouse gas emissions, but newly emerging economies like China are responsible for most of the recent growth. Inevitably, rich countries are reluctant to pay the price of reducing emissions only to have their efforts frustrated by rapidly growing emissions from new players. On the other hand, countries like China, which are still relatively poor, consider it unfair that they should be expected to bear the burden of protecting an environment threatened by the past actions of rich nations. Despite political issues and the need for compromise, the general moral of this story is that it is possible to reconcile long - run economic growth with environmental protection. The main question is one of getting political consensus around the necessary policies. fyi The Cost of Climate Protection At the time of this writing, there were a number of bills before the U.S. Congress, some of them with bipartisan sponsorship, calling for ambitious, long - term efforts to reduce U.S. emissions of greenhouse gases. For example, a bill sponsored by Senators Joseph Lieberman and John McCain would use a cap and trade system to gradually reduce emissions over time, eventually—by 2050—reducing them to 60% below their 1990 level. Another bill, sponsored by Senators Barbara Boxer and Bernie Sanders, called for an 80% reduction by 2050. Would implementing these bills put a stop to long - run economic growth? Not according to a comprehensive study by a team at MIT, which found that reducing emissions would impose significant but not overwhelming costs. Using an elaborate model of the interaction between environmental policy and the economy, the MIT group estimated that the Lieberman– McCain proposal would reduce real GDP per capita in 2050 by 1.11% and the more stringent Sanders –Boxer proposal would reduce real GDP per capita by 1.79%. These may sound like big numbers—they would amount to between $200 billion and $250 billion today—but they would hardly make a dent in the economy’s long - run growth rate. Remember that over the long run the U.S. economy has on average seen real GDP per capita rise by almost 2% a year. If the MIT group’s estimates are correct, even a strong policy to avert climate change would, in effect, require that we give up less than one year’s growth over the next four decades 395 M o d u l e 39 AP R e v i e w Solutions appear at the back of the book. Check Your Understanding 1. Explain the link between a country’s growth rate
, its investment spending as a percent of GDP, and its domestic savings. 2. Which of the following is the better predictor of a future high long -run growth rate: a high standard of living today or high levels of savings and investment spending? Explain your answer. 3. Some economists think the best way to help African countries is for wealthier countries to provide more funds for basic infrastructure. Others think this policy will have no long -run Tackle the Test: Multiple-Choice Questions effect unless African countries have the financial and political means to maintain this infrastructure. What policies would you suggest? 4. What is the link between greenhouse gas emissions and growth? What is the expected effect on growth from emissions reduction? Why is international burden sharing of greenhouse gas emissions reduction a contentious problem? 1. Economies experience more rapid economic growth when they 4. Which of the following statements is true of environmental do which of the following? I. add physical capital II. promote technological progress III. limit human capital a. I only b. II only c. III only d. I and II only I, II, and III e. 2. Which of the following can lead to increases in physical capital increased investment spending increased savings by domestic households increased savings from foreign households in an economy? a. b. c. d. an inflow of foreign capital e. all of the above 3. Which of the following is true of sustainable long-run economic growth? a. Long-run growth can continue in the face of the limited supply of natural resources. b. It was predicted by Thomas Malthus. c. Modern economies handle resource scarcity problems poorly. d. It is less likely when we find alternatives to natural resources. e. All of the above are true. quality? a. It is typically not affected by government policy. b. Other things equal, it tends to improve with economic growth. c. There is broad scientific consensus that rising levels of carbon dioxide and other gases are raising the planet’s overall temperature. d. Most economists believe it is not possible to reduce greenhouse gas emissions while economic growth continues. e. Most environmental success stories involve dealing with global, rather than local impacts. 5. According to the MIT study discussed in the module, a cap and trade system to reduce greenhouse gas emissions in the United States would lead to a. no significant costs. b. significant but not overwhelming costs. c. a loss of roughly three year’s real GDP over the next 40 years. d. a reduction in real GDP
per capita of over 10%. e. a loss of 5 years’ worth of economic growth over the next 40 years. 396 Tackle the Test: Free-Response Questions 1. List and explain five different actions the government can take 2. What roles do physical capital, human capital, technology, to promote long-run economic growth. and natural resources play in influencing long -run economic growth of aggregate output per capita? Answer (10 points)—10 points for 5 of the 6 possible actions/descriptions 1 point: Build infrastructure. 1 point: The government can provide roads, power lines, ports, rail lines, and related systems to support economic activity. 1 point: Invest in human capital. 1 point: The government can improve access to quality education. 1 point: Invest in research and development. 1 point: The government can promote technological progress by having government agencies support and participate in R&D. 1 point: Provide political stability. 1 point: The government can create and maintain institutions that make and enforce laws that promote stability. 1 point: Establish and protect property rights. 1 point: Growth is promoted by laws that define what property belongs to whom and by institutions that defend those property rights. 1 point: Minimize government intervention. 1 point: The government can limit its intervention in the economy and promote competition 397 What you will learn in this Module: • How long-run economic growth is represented in macroeconomic models • How to model the effects of economic growth policies Module 40 Economic Growth in Macroeconomic Models Long-run economic growth is fundamental to solving many of today’s most pressing economic problems. It is even more critical in poorer, less developed countries. But the policies we have studied in earlier sections to address short-run fluctuations and the business cycle may not encourage long-run economic growth. For example, an increase in household consumption can help an economy to recover from a recession. However, when households increase consumption, they decrease their savings, which leads to decreased investment spending and slows long-run economic growth. In addition to understanding short-run stabilization policies, we need to understand the factors that influence economic growth and how choices by governments and individuals can promote or retard that growth in the long-run. Long-run economic growth is the sustained rise in the quantity of goods and services the economy produces, as opposed to the short-run ups and downs of the business cycle. In Module 18, we looked at actual and potential output in the United States from 1989 to 2009. As shown in Figure 40.
1, increases in potential output during that time represent long-run economic growth in the economy. The fluctuations of actual output compared to potential output are the result of the business cycle. As we have seen throughout this section, long-run economic growth depends almost entirely on rising productivity. Good macroeconomic policy strives to foster increases in productivity, which in turn leads to long-run economic growth. In this module, we will learn how to evaluate the effects of long-run growth policies using the production possibilities curve and the aggregate demand and supply model. Long-run Economic Growth and the Production Possibilities Curve Recall from Section 1 that we defined the production possibilities curve as a graph that illustrates the trade-offs facing an economy that produces only two goods. In our example, we developed the production possibilities curve for Tom, a castaway facing a 398 40.1 Actual and Potential Output from 1989 to 2009 Real GDP (billions of 2005 dollars) $14,000 13,000 12,000 11,000 10,000 9,000 8,000 7,000 6,000 Actual aggregate output exceeds potential output. Potential output exceeds actual aggregate output. Actual aggregate output roughly equals potential output. Potential output Actual aggregate output 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Year This figure shows the performance of actual and potential output in the United States from 1989 to 2009. The black line shows estimates, produced by the Congressional Budget Office, of U.S. potential output. The blue line shows actual aggregate output. The purple-shaded years are periods in which actual aggregate output fell below potential output, and the green shaded years are periods in which actual aggregate output exceeded potential output. As shown, significant shortfalls occurred in the recessions of the early 1990s and after 2000. Actual aggregate output was significantly above potential output in the boom of the late 1990s. Sources: Congressional Budget Office, Bureau of Economic Analysis. trade-off between producing fish and coconuts. Looking at Figure 40.2 on the next page, we see that economic growth is shown as an outward shift of the production possibilities curve. Now let’s return to the production possibilities curve model and use a different example to illustrate how economic growth policies can lead to long-run economic growth. Figure 40.3 on the next page shows a hypothetical production possibilities curve for a fictional country we’ll call Kyland. In our previous production possibilities examples, the trade-off was between producing quantities of two
different goods. In this example, our production possibilities curve illustrates Kyland’s trade-off between two different categories of goods. The production possibilities curve shows the alternative combinations of investment goods and consumer goods that Kyland can produce. The consumer goods category includes everything purchased for consumption by households, such as food, clothing, and sporting goods. Investment goods include all forms of physical capital. That is, goods that are used to produce other goods. Kyland’s production possibilities curve shows the trade-off between the production of consumer goods and the production of investment goods. Recall that the bowed-out shape of the production possibilities curve reflects increasing opportunity cost. Kyland’s production possibilities curve shows all possible combinations of consumer and investment goods that can be produced with full and efficient use of all of Kyland’s resources. However, the production possibilities curve model does not tell us which of the possible points Kyland should select 399 f i g u r e 40.2 Economic Growth Economic growth results in an outward shift of the production possibilities curve because production possibilities are expanded. The economy can now produce more of everything. For example, if production is initially at point A (20 fish and 25 coconuts), it could move to point E (25 fish and 30 coconuts). Quantity of coconuts 35 30 25 20 15 10 5 0 E A 10 20 25 30 Original PPC New PPC 40 50 Quantity of ﬁsh Figure 40.3 illustrates four points on Kyland’s production possibilities curve. At point A, Kyland is producing all investment goods and no consumer goods. Investment in physical capital, one of the economy’s factors of production, causes the production possibilities curve to shift outward. Choosing to produce at a point on the production possibilities curve that creates more capital for the economy will result in greater production possibilities in the future. Note that at point A, there are no consumer goods being produced, a situation which the economy cannot survive. At point D, Kyland is producing all consumer goods and no investment goods. While this point provides goods and services for consumers in Kyland, it does not include the production of any physical capital. Over time, as an economy produces more goods and services, some of its capital is used up in that production. A loss in the value of physical capital due to wear, age, or obsolescence is called depreciation. If Kyland were to produce at point D year after year, it would soon find its stock of
physical Depreciation occurs when the value of an asset is reduced by wear, age, or obsolescence. f i g u r e 40.3 The Trade-off Between Investment and Consumer Goods This production possibilities curve illustrates Kyland’s trade-off between the production of investment goods and consumer goods. At point A, Kyland produces all investment goods and no consumer goods. At point D, Kyland produces all consumer goods and no investment goods. Quantity of investment goods A 400 PPC D Quantity of consumer goods capital depreciating and its production possibilities curve would shift inward over time, indicating a decrease in production possibilities. Points B and C represent a mix of consumer and investment goods for the economy. While we can see that points A and D would not be acceptable choices over a long period of time, the choice between points B and C would depend on the values, politics, and other details related to the economy and people of Kyland. What we do know is that the choice made by Kyland each year will affect the position of the production possibilities curve in the future. An emphasis on the production of consumer goods will make consumers better off in the short run but will prevent the production possibilities curve from moving farther out in the future. An emphasis on investment goods will lead the production possibilities curve to shift out farther in the future but will decrease the quantity of consumer goods available in the short run. So what does the production possibilities curve tell us about economic growth? Since long-run economic growth depends almost entirely on rising productivity, a country’s decision regarding investment in physical capital, human capital, and technology affects its long-run economic growth. Governments can promote long-run economic growth, shifting the country’s production possibilities curve outward over time, by investing in physical capital such as infrastructure. They can also encourage high rates of private investment in physical capital by promoting a well-functioning financial system, property rights, and political stability © Investments in capital help the economy reach new heights of productivity. Long-run Economic Growth and the Aggregate Demand-Aggregate Supply Model The aggregate demand and supply model we developed in Section 4 is another useful tool for understanding long-run economic growth. Recall that in the aggregate demand-aggregate supply model, the long-run aggregate supply curve shows the relationship between the aggregate price level and the quantity of aggregate output supplied when all prices, including nominal wages, are flexible. As shown in Figure 40.4, the f i g u r e 40.4 The Long-
run Aggregate Supply Curve The long run aggregate supply curve shows the quantity of aggregate output supplied when all prices, including nominal wages, are flexible. It is vertical at potential output, YP, because in the long run a change in the aggregate price level has no effect on the quantity of aggregate supplied. Aggregate price level A fall in the aggregate price level… P1 P2 Long-run aggregate supply curve, LRAS …leaves the quantity of aggregate output supplied unchanged in the long run. Potential output YP Real GDP 401 long-run aggregate supply curve is vertical at the level of potential output. While actual real GDP is almost always above or below potential output, reflecting the current phase of the business cycle, potential output is the level of output around which actual aggregate output fluctuates. Potential output in the United States has risen steadily over time. This corresponds to a rightward shift of the long-run aggregate supply curve, as shown in Figure 40.5. Thus, the same government policies that promote an outward shift of the production possibilities curve promote a rightward shift of the long-run aggregate supply curve. f i g u r e 40.5 Long-run Growth and the LRAS Curve The growth in potential output over time can be shown as a rightward shift of the long-run aggregate supply curve. Aggregate price level LRAS1 LRAS2 LRAS3 1 YP 2 YP 3 YP Real GDP Distinguishing Between Long-run Growth and Short-run Fluctuations When considering changes in real GDP, it is important to distinguish long-run growth from short-run fluctuations due to the business cycle. Both the production possibilities curve model and the aggregate demand-aggregate supply model can help us do this. The points along a production possibilities curve are achievable if there is efficient use of the economy’s resources. If the economy experiences a macroeconomic fluctuation due to the business cycle, such as unemployment due to a recession, production falls to a point inside the production possibilities curve. On the other hand, long-run growth will appear as an outward shift of the production possibilities curve. In the aggregate demand-aggregate supply model, fluctuations of actual aggregate output around potential output are illustrated by shifts of aggregate demand or shortrun aggregate supply that result in a short-run macroeconomic equilibrium above or below potential output. In both panels of Figure 40.6, E1 indicates a short-run equilibrium that differs from long-run equilibrium due to the business cycle. In the case

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