ECO 120 Macroeconomics

Week 11

Economic Growth LecturerDr. Rod Duncan

Topics

• Long run in the AD-AS model

• Growth or macroeconomics of the long-run

Long-run in the AD-AS model

• So far, all the macroeconomics we have done is short-run.

• In terms of a story, we have:– A beginning where the economy starts off in

long-run equilibrium at the natural rate of output and some price level; and

– A middle where some shock occurs and the economy is affected, so Y shifts up or down and P shifts up or down.

Beginning and middle

• A rise in oil prices raises the cost of production for all producers and shifts the SR AS curve up/to the left.

• At the old prices, AD > AS, so prices rise and output falls.YY1

P0

AD

AS1

P

AS0

Y0

P1

Y*

A story with no end?

• And then what?• And the nothing, so far. Our story does

not have an end yet.• A good story, such as DreamWork’s

“Shrek”has:– Beginning- Shrek in his swamp;– Middle- Shrek goes on a journey and rescues

a princess;– End- Shrek returns to his swamp.

A story with no end?

• So all good stories have a circular pattern. At the end, we comes back to the beginning.

• Even in an economics story, we have to have this sort of pattern.

End Beginning

A Story

Middle

An end = Natural rate

• For the “natural rate of output” to make any sense, in the long-run the economy must return to this natural rate.

• Some design of the economy must push the economy back to the natural rate- all booms and all recessions eventually end.

• So what process pushes us back to the long-run equilibrium- wage demands!

• All booms and all recessions come to an end because companies and workers change wages.

So where are we?

• The oil price shock caused the As curve to shift. We have inflation, and a recession- cost-pull inflation.

• Unemployment is high and output is low.

• Firms are not hiring.YY1

P0

AD

P

AS0

Y0

P1

Y*

Beginning

Middle

AS1

Adjustment after a recession

• Unemployment is high, but the firms are not hiring workers because the firms’ energy and transportation bills are high.

• We have a surplus of labour at the current price of labour- what effect do surpluses have in markets?– The price of labour gets bid down. Workers

offer lower wages simply to get jobs.– The same as a surplus of oranges will lead to

a fall in price of oranges.

Adjustment after a recession

• As wages drop, the cost of production to firms drops. So we would expect that the AS curve will shift down/out to the right.

• [Remember: A shift down in the supply curve means that firms are willing to supply more at the same price or supply the same amount at a lower price.]

• As the AS curve shifts down, output rises, prices fall and unemployment drops, until we are back at the natural rate of output again.

Adjustment after a recession

• A high level of unemployment means that workers are willing to accept lower wages.

• A fall in W pushes the AS down/right, so that Y rises and unemployment falls.

• Fall in W continues until We get back to Y*.

YY1

P2

AD

PAS2

Y0

P1

Y*Middle

AS1

Alternative solution- fiscal

• So the adjustment process for an oil price boom and recession is for wages to fall.

• But this requires a period of high unemployment and falling wages. Is there another alternative?

• What if the government responded to the recession by stimulating AD through fiscal policy?

• An increase in G would shift the AD curve to the right, which would raise Y at the cost of higher P.

Alternative solution- fiscal

• During the recession, we have low output (Y1) and high unemployment.

• Fiscal policy stimulates AD0 to AD1.

• Output rises, and unemployment falls. But inflation rises, as P rises to P2.

YY1

P0

AD0

P

Y0

P1

Y*Middle

AD2

AS1

P2

Adjustment after a boom

• Our first adjustment scenario was a recession. Imagine instead that we start with a boom- an increase in I due to improved business expectations.

• Investment rises, and so the AD curve shifts to the right.

YY1

P0

AD0

P

AS0

Y0

P1

Y*

Beginning

Middle

AD1

Adjustment after a boom

• Y increases to Y1, so we have a boom with high output and low unemployment.

• We have inflation, as P rises to P1.

• A low level of unemployment and a high level of output means that there is excess demand for labour (you will hear “skills shortage”).

• Excess demand for any good will lead to a rise in prices, so the wage rate is pushed up as firms offer workers more to stay or be hired.

Adjustment after a boom

• An increase in wages will push the AS curve up/in, as firms’ production costs rise.

• As the AS curve shifts up, output falls, prices rise and we move back to Y*.

YY1

P2

AD0

P

AS0

Y0

P1

Y*

Middle

AD1

AS1

Adjustment after a boom

• So the adjustment process after a boom is for wages to rise, which will push the AS curve up.

• So a boom will lead to a wage rise, which will push inflation even higher.

• Is there a way to adjust to a boom that does not require further inflation?

Alternative solution – monetary

• If the RBA responds to the future increase in wages by raising interest rates now, we can avoid the wage inflation following a boom.

• A rise in i leads to a drop in I, which shifts the AD curve left.

• Output and prices fall today.

YY1

P2

AD2

P

AS0

Y0

P1

Y*

Middle

AD1

Long-run equilibrium

• Adjustment to a bust– AS shifts up to AS1.

– Output falls, and prices rise in the short-run.

– Wage demands shift AS down to AS2.

– Output rises and prices fall as we adjust to long-run.

– In long-run, output back to natural rate, and prices return to initial levels. YY1

P0

AD

AS1

P

AS0=AS2

Y0

P1

Y*

Long-run equilibrium

• Adjustment to a boom– AD shifts out to AD1.– Output and prices rise

in the short-run.– Wage demands shift

AS left to AS2.– Output falls and prices

rise as we adjust to long-run.

– In long-run, output back to natural rate, and prices higher.

YY1

P0

AD0

P

AS0

Y0

P1

Y*

Beginning

Middle

AD1

AS2End

P2

Long-run growth

• We are ultimately interested in the level of resources each individual in society has access to. The level of resources will then somewhat determine what opportunities each person has.

• So we are ultimately interested in GDP per person of an economy. Growth is the increase of GDP per capita over time.

• Y / N = output per person

Long-run growth

• But not every person in an economy is “economically productive”, so if we want to link “worker productivity” and GDP per capita , we need:

• Y / N = (Y/Nw) (Nw/N)

• Y/Nw = output per worker depends on labour productivity, which depends on skills in workforce, capital, tech

• Nw/N = labour force participation rate which depends on cultural attitudes and aging of the population

Labour force participation

• Growth in GDP per capita can come from increasing Nw/N. – As people move from subsistence farming on

rural areas to paid employment in urban areas, labour force participation rises.

– As women move out of unpaid domestic work to paid domestic work, labour force participation rises.

• But obviously there is a limit to this sort of growth.

Labour force participationAustralian Labour Force Part'n

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Labour force participation

• And as the Australian population ages, we will eventually see this LFP start to decline, as the population of retirees increases.

• This will be a major challenge for Australia in the relatively near future.

Output per worker

• Output per worker, Y/Nw, is the main source of growth in Australia.

• So growth in Australia depends on increasing the productivity of our workers. What determines how productive a worker is?– The skills of the worker.– The physical capital the worker uses. – The level of technology the worker and capital have

access to.

Output per workerAustralian Real GDP per Worker

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Output per worker

• Output per worker was $22,000 in 1950 and $52,000 in 2000 in constant dollars. (Once we remove the effects of inflation.)

• So how are Australian workers today over twice as productive as workers in 1950?– New technologies (mechanization, robotics,

computers, etc)– More capital (powered floor polishers instead

of mops)

Output per capita

• So once we combine labour force changes and worker productivity changes, we wind up with change in output per capita over time.

• Real GDP per capita was $9,200 in 1950 and $25,500 in 2000.

• Australians in 2000 have almost twice as much resources per person than Australians did in 1950.

Long-run growth in AustraliaAustralian Real GDP per Capita

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Long-run growth in Australia

• While there was a temporary blip in GDP in early 1950s, 1980s and 1990s, the overall picture is one of steadily increasing GDP per person over time.

• What can be done to ensure growth in Australia?– Increasing productivity per worker.

• Increasing skill levels, increasing capital and increasing technology.

But remember…

• Remember what it is that GDP measures: the market value of all goods and services sold in the economy.– Ignores non-market goods, such as domestic

work and pollution.– Does not include black market goods.– Having longer holidays might make for a

happier workforce, but would lower GDP.

Growth and economic development

What about other countries?

• Relative to the rest of the developed world, Australia is a fast-growing economy.

• Australia is behind the United States, but ahead of countries such as the UK and NZ.

• Relative to our neighbours (East Asia), Australia is a very prosperous country.

Relative to developed countries

Relative Real GDP per Capita

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Australia

USA

UK

NZ

Relative to our neighbours

Relative Real GDP per Capita

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Australia

Japan

Hong Kong

Indonesia

Convergence

• “Convergence” is the idea that we would expect countries that are initially poorer should grow faster than countries that are richer.

• Why?– Technology- Poor countries can piggy-back

for free off the technology developed by rich countries.

– Capital flow- We expect investors to rush to invest in countries with cheap wages.

Convergence

• Over time, we expect poor countries to grow faster than rich countries, so GDP per capita across different countries should “converge” over time.

• Is this idea true?

• We saw that certain countries like Japan and South Korea started off poorer than Australia but caught up.

Catching up?East Asian Miracle?

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Australia

Japan

USA

S Korea

China

Malaysia

But look!African development?

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Australia

USA

Kenya

Nigeria

Uganda

Malawi

Log graphLog scale graph of African problems

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Australia

USA

Kenya

Nigeria

Uganda

Malawi

Consequences of growthLife Adult

Enrollment GDP

Expectancy Literacy in Edu per capita HDI Rank

Norway 78.5 100 97 29,918 0.942 1

Australia 78.9 100 116 25,693 0.939 5

USA 77 100 95 34,142 0.939 6

Japan 81 100 82 26,755 0.933 9

Indonesia 66.2 86.9 65 3,043 0.684 110

Kenya 50.8 82.4 51 1,022 0.513 134

Uganda 44 67.1 45 1,208 0.444 150

Malawi 40 60.1 73 615 0.4 163