C hapter 24 Economic Growth, Business Cycles, and Countercyclical Fiscal Policy © 2002...

CChapter 24hapter 24

Economic Growth, Business Cycles, and Countercyclical

Fiscal Policy

© 2002 South-Western

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Economic PrinciplesEconomic Principles

• Capital-labor and capital-output ratios

• Technology and labor productivity

• Labor productivity and economic growth

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• Saving, investment, and economic growth

• External and internal theories of the business cycle

• The interaction of the multiplier and accelerator

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• Countercyclical fiscal policy

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Long-Run Economic Long-Run Economic GrowthGrowth

Economic growth

An increase in real GDP, typically expressed as an annual rate of real GDP growth.

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1. In The Wealth of Nations, Adam Smith identified four principal factors that contribute to a nation’s economic growth. What are they?

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1. Principal factors that contribute to a nation’s economic growth:

a. The size of its labor force.

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b. The degree of labor specialization.

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c. The size of its capital stock.

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c. The size of its capital stock.

d. The level of its technology.

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EXHIBIT 1 U.S. ECONOMIC PERFORMANCE: 1900–2000

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Exhibit 1: U.S. Exhibit 1: U.S. Economic Economic

Performance: 1900-Performance: 1900-9090In what time period between 1900

and 2000 was there the greatest rate of economic growth in the U.S.?

• During the first half of the 1940’s when the U.S. was fighting World War II.

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Capital-labor ratio

The ratio of capital to labor, reflecting the quantity of capital used by each laborer in production.

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EXHIBIT 2 LONG-RUN ECONOMIC GROWTH

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2. If capital is $50,000 and labor is 200, what is the capital-labor ratio?

• The capital-labor ratio is ($50,000/200) = $250.

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Labor productivity

The quantity of GDP produced per worker, typically measured in quantity of GDP per hour of labor.

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3. If real GDP increases from $10,000 to $12,000, and labor rises from 100 to 105, what has happened to labor productivity?

• Output per laborer rises from ($10,000)/100 = $100 to ($12,000)/105 = $114.29.

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Capital deepening

A rise in the ratio of capital to labor.

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4. Which of the following represents capital deepening?

a. Increased worker experience.

b. Increased worker training.

c. Increased capital-labor ratio.

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4. Which of the following represents capital deepening?

c. Increased capital-labor ratio.

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EXHIBIT 3 THE LABOR PRODUCTIVITY CURVE

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Exhibit 3: The Labor Exhibit 3: The Labor Productivity CurveProductivity Curve

How does capital deepening affect labor productivity?

• The more capital per laborer, the greater the laborer’s productivity. Moreover, new technology can shift upwards the labor productivity curve.

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Capital-output ratio

The ratio of capital stock to GDP.

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According to Adam Smith and many economists today, savings automatically convert to investment spending, so that investment-induced growth is dependent on savings.

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Changes in technology can increase labor productivity and GDP without there being any change in the value of the capital stock.

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EXHIBIT 4 THE GROWTH PROCESS

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Exhibit 4: The Growth Exhibit 4: The Growth ProcessProcess

1. According to Exhibit 4, what will happen to consumption and investment next year as a consequence of investment this year?

• Investment this year increases next year’s capital stock, which in turn generates an increase in next year’s consumption and investment spending.

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Exhibit 4: The Growth Exhibit 4: The Growth ProcessProcess

2. What will happen to potential future economic growth if more of GDP is consumed and less is invested?

• Less investment today means less economic growth in the future.

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EXHIBIT 5 GROSS NATIONAL SAVING IN THE UNITED STATES: 1960–99

Source: Council of Economic Advisers, Economic Report of the President (Washington, D.C.: U.S. Government Printing Office, 2000), p. 73.

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Exhibit 5: Gross National Exhibit 5: Gross National Savings in the United Savings in the United

States: 1960-99States: 1960-99

According to Exhibit 5, what is the relationship between personal savings and government savings?

• It appears that they may be inversely proportional.

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EXHIBIT 6 SOURCES OF US. GROWTH: 1947–2000

Source: Council of Economic Advisers, Economic Report of the President (Washington, D.C.: U.S. Government Printing Office, 1994), p. 44, and author’s estimates.

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Exhibit 6: Sources of Exhibit 6: Sources of U.S. Growth: 1947-U.S. Growth: 1947-

200020001. According to Exhibit 6, which of the following made the largest contribution to economic growth from 1947 to 1973:

a. Labor inputs.

b. Capital inputs.

c. Technological change.

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a. Labor inputs.

b. Capital inputs.


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Exhibit 6: Sources of Exhibit 6: Sources of U.S. Growth: 1947-92U.S. Growth: 1947-92


b. Capital inputs.

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200020003. According to Exhibit 6, what happened to the role of technological change as a source of U.S. economic growth across the two time periods?

• While technological change was the most important source of economic growth from 1947 to 1973, it was one of the smallest and least important sources of economic growth between 1973 and 1992.

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The Business CycleThe Business Cycle

The business cycle represents year to year deviations from the dominant, long-run path of U.S. economic growth. These deviations seem to map out a picture of recurring cycles.

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EXHIBIT 7 THE U.S. BUSINESS CYCLE RECORD: 1860–1990

Source: Ameritrust Company, Cleveland, Ohio.

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Exhibit 7: The U.S. Exhibit 7: The U.S. Business Cycle Business Cycle

Record: 1860-1990Record: 1860-19901. According to Exhibit 7, were recessions more frequent before World War II or after World War II?

• Recessions were more frequent before World War II.

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Record: 1860-1990Record: 1860-19902. In which of the following decades was there the greatest period of rapid and prolonged economic growth in Exhibit 6?

a. 1870 – 1880.

b. 1930 – 1940.

c. 1960 – 1970.

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Record: 1860-1990Record: 1860-19902. In which of the following decades was there the greatest period of rapid and prolonged economic growth in Exhibit 6?

c. 1960 – 1970.

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Traditional Theories Traditional Theories of the Business Cycleof the Business Cycle

1. What factors contribute to externally-induced cycles?

• Wars, changes in climate, population booms, clustering of innovations, changes in consumer confidence, changes in government spending, or changes in international exchange rates.

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2. What is the sunspot theory of the business cycle?

• According to William Stanley Jevons, years of good harvest, low food prices, and higher real income and employment, are inversely related to the number of sunspots.

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2. What is the sunspot theory of the business cycle?

• The sunspot theory mostly applies to agricultural economies, and is less relevant to modern industrialized countries.

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3. What is the war-induced theory of the business cycle?

• Wars require massive increases in government spending, which tends to increase economic growth. Marxists and others have argued that wars are sometimes engineered to get us out of economic crises.

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3. What is the war-induced theory of the business cycle?

• The decline in spending at the end of wars can contribute to economic downturns.

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You Got the Dates? You Got the Dates? We Got The Growth We Got The Growth

RatesRatesAccording to the chart on page 541 of the textbook, what was the average annual rate of economic growth between 1970 and 1996?

• Reading down from 1970 and across from 1996 we find that the average rate of economic growth was 2.8 percent.

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4. What is the housing theory of the business cycle?

• Disasters or low interest rates spur large investments in new housing, which in turn promotes increased economic growth. As housing investment slows, so too does economic growth.

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5. What is the innovation theory of the business cycle?

• Pioneering innovations promote a host of supporting innovations in clusters, and thus produce their own variety of business cycle. Steam engines, railroads, electricity, cars, and computers offer some examples.

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5. What is the innovation theory of the business cycle?

• Yet even pioneering innovations eventually exhaust their potential, creating the potential for reduced investment, demand, and employment.

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Traditional Theories Traditional Theories of the Business Cycleof the Business Cycle• Many economists believe that business cycles do not just develop from external factors.

• According to this view, the economy’s continuous motion is inherently cyclical due to internal factors.

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6. What factors contribute to internally induced business cycles?

• Changes in investment spending and changes in national income are mutually reinforcing due to the role of expectations.

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Accelerator

The relationship between the level of investment and the change in the level of national income.

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7. How does the accelerator contribute to the business cycle?

• An initial injection of new investment spending into the economy triggers the income multiplier into action, and as a result people’s income and consumption spending grow.

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7. How does the accelerator contribute to the business cycle?

• Buoyed by this growth in sales, firms expect growth to continue and increase investment spending accordingly. This creates the upward phase of the business cycle.

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7. How does the accelerator contribute to the business cycle?• Having acquired additional capital stock through investment, firms must experience even higher sales. But if consumers simply maintain their level of consumption, inventories build up and investment declines, initiating the downward phase of the cycle.

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Real Business Cycle Real Business Cycle TheoryTheory

Economists who subscribe to real business cycle theory challenge the idea that internal or external cycles exist.

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They argue that the economy is dynamic and operates near full employment. The principal factor shaping the unevenness (not cycles) in the economy’s growth path is the random occurrence of many small productivity-enhancing innovations.

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How is real business cycle theory different from the innovation cycle theory developed by Schumpeter?

• The Schumpeterian innovation cycle is based on the notion that innovations are clustered and connected, leading to cycles.

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How is real business cycle theory different from the innovation cycle theory developed by Schumpeter?

• In contrast, real business cycle theory assumes many small random innovations that lead to an uneven path of economic growth but no cycles.

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Countercyclical Fiscal Countercyclical Fiscal PolicyPolicy

Countercyclical fiscal policy

Fiscal policy designed to moderate the severity of the business cycle.

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1. Which of the following is an example of countercyclical fiscal policy?

a. More gov’t. spending when the economy is growing rapidly.

b. Higher taxes when the economy is growing rapidly.

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1. Which of the following is an example of countercyclical fiscal policy?

b. Higher taxes when the economy is growing rapidly.

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2. Why is timing such a difficult problem with effective countercyclical fiscal policy?

• Long lags between the identification of the economic problem and the execution of the policy can unintentionally lead to procyclical rather than countercyclical policy.

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2. Why is timing such a difficult problem with effective countercyclical fiscal policy?

• Thus countercyclical fiscal policy must be based on forecasts of future economic conditions, and these forecasts can be wrong.

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Administrative lag

The time interval between deciding on an appropriate policy and the execution of that policy.

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EXHIBIT 8 DESIGNING COUNTERCYCLICAL POLICY

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Exhibit 8: Designing Exhibit 8: Designing Countercyclical Countercyclical

PolicyPolicyIf the economy follows path ac instead of path ab, but countercyclical fiscal policy is designed for path ab, what is might occur?• The dynamics of the accelerator-multiplier interaction will drive the economy into inflation.

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There are many economic theories of cycles and growth, some making good sense, some less so, but all of them struggling to understand the real world.

C hapter 24 Economic Growth, Business Cycles, and Countercyclical Fiscal Policy © 2002...

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