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