Macro Lecture 11: Late 1990 s and Productivity

Macro Lecture 11: Late 1990 s and Productivity Aggregate Demand/Aggregate Supply Model: A Summary Figures 11.1-11.3 and Table 11.1 summarize the aggregate demand/aggregate supply model: π (%) π (%) LRAS AS π E AD Figure 11.1: Aggregate demand (AD) curve GDP P Figure 11.2: aggregate supply (AS) and long run aggregate supply (LRAS) curves π (%) AS AD Figure 11.3: Equilibrium Intersection of AD and AS curves AD curve downward sloping LRAS curve vertical AS curve upward sloping Shifts from Shifts from Expected Fiscal Autonomous Place mark for potential Supply policies: monetary policies: GDP (GDP P inflation rate ) shocks changes Government purchases and taxes An economy s potential GDP depends its resources and technology Table 11.1: Aggregate demand/aggregate supply model summary Intersects LRAS curve at the expected inflation rate Adaptive expectations: Expected inflation rates equals actual inflation rate in the recent past

2 Clinton Years: 1995-1998 Table 11.2 reports the data from the mid-1990 s. The adaptive expectation principle allows us to complete the expected inflation rate column. Adaptive Expectations: The expected inflation rate depends on the actual inflation rate in the recent past. More specifically, we assume that the expected inflation rate in a given year equals the actual inflation rate in the previous year. Unemp Real Actual Infl Expected Infl Govt Year Rate (%) GDP Rate (%) Rate (%) Purch 1994 2.1 1995 5.6 10,165 2.1 2.1 2,260 1996 5.4 10,550 1.8 2.1 2,280 1997 4.9 11,025 1.7 1.8 2,320 1998 4.5 11,515 1.1 1.7 2,370 Table 11.2: Clinton years macro data: 1995-1998 We begin by focusing on 1995 and 1996. First, note that a long run equilibrium existed in π (%) LRAS 1995 LRAS 1996 1995; the actual rate inflation rate and the 2.50 AS expected inflation rate were equal, they both 1995 equaled 2.1 percent. Since the aggregate supply (AS) curve intersects the long run aggregate 2.25 supply (LRAS) curve at the expected inflation rate, two aggregate supply curves intersect at 2.1 percent in 1995 as shown in figure 11.4. 2.00 1.75 1995 1996 In 1996, the actual inflation rate fell from 2.1 to 1.8 percent and GDP increased from 10,165 to 10,550. Since the aggregate supply (AS) curve is upward sloping, it had to shift down between 1.50 1995 and 1996. 10,000 10,250 10,500 How could this happen? The aggregate supply Figure 11.4: Clinton years 1995 and 1996 (AS) and long run supply (LRAS) curves intersect at the expected inflation rate. Adaptive expectation suggests that the expected inflation rate remained unchanged at 2.1 percent in 1996. Since the expected inflation rate remained unchanged, how could the aggregate supply (AS) curve shift down? This is a puzzle isn t it? As figure 11.4 illustrates, an increase in potential GDP provides the solution. Since the aggregate supply (AS) and long run aggregate supply (LRAS) curves intersect at the expected inflation rate, the long run aggregate supply (LRAS) curve had to shift right. Recall that the long run aggregate supply (LRAS) curve is a place mark for potential GDP. Since the long run aggregate supply (LRAS) curve shifted right, potential GDP had to grow. AS 1996 Question: What causes potential GDP to grow? Answer: Since an economy potential GDP depends on the resources and technology available to it, resources have grown and/or technology have advanced. To address the question table 11.3 reports population and GDP data from 1948 and 1989: Real GDP Year Population (billions of 2009 $) 1948 144,600,000 2,020 1989 246,800,000 8,475 Growth rate = 70% Growth rate = 325% Table 11.3: Population and real GDP growth data

3 The U.S. population has grown thereby increasing potential GDP. But the growth of GDP outstripped the population growth indicating that American workers must have become more productive. We will now formally define what we mean by productivity: Productivity: The amount of goods and services produced in an hour by the average worker. We will now look at productivity growth more carefully. Productivity Growth: 1948-1989 Figure 11.5 plots productivity growth in the U.S. from 1948 to 1989. The overall trend was down. While the typical American worker produced more goods and services from year to year, the increase in production declined. This becomes even more apparent when we calculate average productivity growth rates for each decade. The average annual productivity growth rate is reported in table 11.4 and illustrated in figure 11.6: U. S. Productivity Growth: 1948 1989 8 6 4 2 0 2 1945 1955 1965 1975 1985 1995 2005 Figure 11.5: U.S. productivity growth: 1948-1989 Average Annual Productivity Decade Growth (%) 1950 s 2.78 1960 s 2.77 1970 s 1.92 1980 s 1.47 Table 11.4: U.S. productivity data by decades Clearly, productivity growth had slowed although you might say that the decline is not large; the growth rate declined from 2.78 percent in the 1960 s to 1.47 percent in the 1980 s. 1950 s 1960 s 1970 s 1980 s At first glance, small differences in annual changes in growth rates do not appear important, but over time they can become significant. Figure 11.6: U.S. productivity growth by decades To appreciate this, suppose you earn $50,000 a year when you graduate. You can probably expect to work about 45 years. Table 11.5 compares what your salary would be when you retire if your annual increase is 2.78 percent compared to 1.47 percent: 2.78% annual 1.47% annual growth rate growth rate First year $50,000 $50,000 Second year $51,390 $50,735 Forty-five years later $171,700 $96,400 Table 11.5: Importance of growth rates In the second year the difference is small, less than $600. But after 45 years, the difference is nearly $80,000. Even though the difference between 2.78% and 1.47% appears to be small, it accumulates over time. A small annual difference becomes huge after forty-five years. Consequently, we should be concerned with the productivity decline experienced by the U.S. economy in these decades. (%) 3 2 1 2.78 2.77 1.92 1.47

4 We shall consider the determinants of productivity to try to understand why this has occurred: Natural resources Physical capital Human capital Labor reallocation Technology Physical Capital Physical capital refers to machines, tools, factories, etc. Obviously, the more machines, tools, factories, etc. an economy has, the more productive its workers will be. Industrialized nations have large amounts of physical capital, while developing nations have little. Consequently, workers in industrialized countries are more productive. As a worker is given more capital, he/she becomes more productive; that is, as capital per worker increases, productivity increases as illustrated by figure 11.7. Note that productivity increases at a decreasing rate, however. To understand why, consider a worker, George, who is cutting grass. If you give George a sickle, it takes him quite a while to cut a lawn. A hand mower would make George more productive, a power mower even more productive, and a lawn tractor yet more productive. As George moves from a sickle to hand mower, his productivity increases dramatically. As he moves from a hand mower to a power mower his productivity increases again, but by a smaller amount. As he moves from a hand mower to a lawn tractor, his productivity increases Productivity Capital per worker Figure 11.7: Diminishing marginal product of capital once more, but this time by an even smaller amount. This phenomenon is known as diminishing marginal productivity. When a worker uses more capital, his/her productivity increases. Each additional increment of capital leads to smaller increases in productivity, however. The productivity curve is increasing, but at a decreasing rate. Figure 11.8 compares two initial situations: capital per worker is low; capital per worker is high. Larger increments of new capital are required to achieve the same amount of productivity growth when capital per worker is initially high than when it is initially low. This occurs because productivity increases at a diminishing rate. Question: What do we call new capital? Answer: Investment. Accordingly, as workers have larger amount of capital, greater levels of investment are required to achieve a constant rate of productivity growth. Productivity Capital per worker Figure 11.8: Diminishing marginal product of capital

5 Let us focus on investment in the U.S. during the last sixty years. Table 11.6 reports on the average amount of investment per worker during the 1950 s, 1960 s, etc. Figure 11.9 illustrates the data with a bar chart. Annual Average of Real Investment per Decade Worker (2005 $) 1950 s 4,970 1960 s 6,870 1970 s 8,690 1980 s 8,870 1990 s 12,680 2000 s 17,050 Table 11.6: Investment per worker by decades Real investment per worker has increased during the last several decades (figure 11.9). It is possible, however, that the increase has not been enough to maintain a constant rate of productivity growth. Empirical studies suggest that this is probably not the case, however; that is, investment per worker has increased by so much that had nothing else occurred, productivity growth would had risen, rather than fallen. (2009 $) 20,000 16,000 12,000 1950 s 1960 s 1970 s 1980 s 1990 s Figure 11.9: U.S. investment per worker by decades Natural Resources Workers fortunate enough to live in economies rich in natural resources tend to have higher productivity. For example, American farmers in the American Midwest are perhaps the most productive farmers in the world. The soil and climate in the Midwest is largely responsible for the large amount of food that American farmers produce. Farmers in less endowed areas are not as productive. For example, farmers in New England are not as productive as their counterparts in the Midwest because New England weather and soil are not as good. We cannot attribute the decline in productivity growth in the U.S. to fewer natural resources, however. The U.S. has an abundance of natural resources. Human Capital Human capital refers to the education, skills, training, etc. that a worker accumulates over the years. As an economy s work force becomes more educated, more skilled, better trained, etc. its workers should become more productive. 8,000 4,000 2000 s On the one hand, there has been much concern about the U.S. educational system. Compared to children in some nations, Americans do not achieve the same level of performance. There is particular concern about mathematics in view of the fact that we live in an increasingly technological world. On the other hand, few doubt that the American higher education system is superb. College and graduate students from nearly all nations come to the U.S. to take advantage of the educational opportunities offered by American colleges and universities. Reallocating labor Moving labor from sectors with high productivity growth to sectors with low growth would reduce overall productivity growth. During the last few decades, labor has moved from the manufacturing sector to the service sector. Historically, service industries have experienced low rates of productivity growth. Consequently, moving labor to service industries would reduce overall productivity growth.

6 Technology Technology plays a large role in productivity. Technological advances explain much of our productivity increases. Communications provide a good example. Over the last century or so, we have progressed from handwritten letters, to typewritten letters, to word processing, to e-mail, etc. Improved communications has allowed us all to become more productive. Conclusion Empirical studies conclude that when we account for the effect of natural resources, physical capital, human capital, and the reallocation of labor we cannot explain the decline in productivity growth. That leaves us with one last source of growth: technology. It is difficult, if not impossible, to quantify technological change. Many argue that this has been perhaps the most important source of productivity growth. Consider American agriculture. In 1900, 40 percent of all American workers labored on farms. Today the figure is 3 percent. Despite the fact that fewer Americans work on farm, our farms produce much more food today than in 1900. Some believe that there has been a slowdown in technological innovations from the 1950 s to the 1980 s. With a fewer innovations, the productivity of American workers would not grow as rapidly. Note that there is no direct evidence here: there is no smoking gun. Some believe that technology must be the culprit because we cannot explain the slowdown in productivity in any other way. U. S. Productivity Growth: 1948 1989 If technology is the culprit, what could the government do to help promote innovations? There are a number of policies the government could adopt. For example, the government could finance more research and development; it could provide tax incentives for private firms to undertake research and development, etc. 8 6 4 2 0 2 1945 1955 1965 1975 1985 1995 2005 The reasons for the U.S. Figure 11.10: U.S. productivity growth: 1948-1989 productivity slowdown from the 1950 s to the 1980 s, as illustrated in figure 11.10, are not fully understood. We can point to various factors, but there is no smoking gun. Furthermore, in view of the trend, most believed that the outlook for the 1990 s was dim.