1. Economic growth (III) 1

2. Short run or long run? (full adjustment of capital, expectations, etc. Classical or non-classical? (sticky wages and prices, rational expectations, etc. Classical or non-classical? (sticky wages and prices, rational expectations, etc. long- run short- run Neo-classical growth model Marxist theories? Behavior growth theories? Malthusian trap models? yes no Real business cycle (RBC); supply-side economics; structural models; misperceptions models Keynesian model (sloping AS, expectations- augmented PC, IS-LM, etc.) Schools of Macroeconomics

3. Agenda -A savings experiment -Theories of technological change -Real business cycles 3

4. Review from last week Growth involves potential output (not business cycles) Key assumptions: fixed s, labor growth at n, labor- augmenting tech change at h Laws of motion: Long run growth of output per person, wages, productivity at rate But technological change is exogenous and not satisfactorily explained. 4

5. 5 Several “comparative dynamics” experiments Change growth in labor force (immigration or retirement policy) Change in rate of TC Change in national savings and investment rate (tax changes, savings changes, demographic changes) Here we will investigate only a change in the national savings rate.

6. 6 Two faces of saving Consumption today … or … consumption tomorrow?

7. The major non-cycle economic issue of today: The federal budget deficit and debt Important background: National Academy Sciences, Choosing the Nation’s Fiscal Future, 2010 National Commission on Fiscal Responsibility and Reform, The Moment of Truth, 2010 The fiscal cliff at 00:00:01 am, January 1, 2013 These will be studied in coming weeks. 7

8. 8 Bowles-Simpson Report

9. Why you can’t get anywhere without Econ 122: Examples from the Commission 9

10. 10 Government debt and deficits and the economy: What is the effect of deficit reduction on the economy? 1. In long-run (in neoclassical growth model) Higher savings leads to higher potential output Mechanism: higher I → K → Y, w, etc. (through neoclassical growth model) 2. In short run (in weeks to come) Higher savings is contractionary Mechanism: lower S, lower AD, lower Y, inflation

11. Basics of the deficit and growth Assume a closed economy I = T– G + [Y – T – C(Y-T, r)] = Govt savings + private savings = Budget surplus + S p At full employment and assuming that private C does not respond significantly to r, for deficits that reduce G: ΔI = ΔS = Δ (Budget surplus) So this is the motivation of deficit reduction for long-run growth. Question: what is the effect? 11

12. 12 k y = f(k) (n+δ)k y* (I/Y)* k* Impact of Higher National Saving k** y** i = s 2 f(k) i = s 1 f(k)

13. 13 Numerical Example of Deficit Reduction Assumptions: 1.Production is by Cobb-Douglas with CRTS 2. Labor plus labor-augmenting TC: 1. n = 1.5 % p.a.; h = 1.5 % p.a. 3. Full employment; constant labor force participation rate. 4.Savings assumption: a. Private savings rate = 22% of GDP b. Initial govt. savings rate = minus 6 % of GDP c. In 2012, govt. changes fiscal policy to a deficit of minus 2 % of GDP. d. All of higher govt. S goes into national S (i.e., constant private savings rate) and closed economy 5. “Calibrate” to U.S. economy

14. 14 Impact of Lower Govt Deficit on Major Variables - Note that takes 10 years to increase C -Political implications - Must C increase? - No if k>k goldenrule

15. 15 Conclusions on Fiscal Policy and Economic Growth Fiscal policy affects economic growth through impact of government surplus through national savings rate Increases potential output through: –higher capital stock for domestic investment –higher income on foreign assets for foreign investment Consumption decreases at first then catches up after a decade or so

16. 16 Classical themes in macroeconomics: Real Business Cycle Theory

17. Real Business Cycles Basic idea: cycles are caused by productivity shocks; these are propagated by changes in prices and then to labor supply. Model Details Start with neoclassical growth model. Remember decomposition of output growth from growth accounting: g Y = α g K + (1-α) g L + θ, where θ = T.C. Changes in output come from two sources: –Technological shocks: θ random. –Changes in labor force participation: assumes very high elasticity of labor supply with respect to wages. This then generates random output fluctuations, which RBC school calls business cycles.

18. Real output (Q) Price (P) AD AS Q* P* RBC recession AS’

19. AS 2008:Q1 AS 2012:Q2 RBC view of current recession

20. Policy implications of RBC models Output shocks are exogenous phenomena (earthquakes, Internet revolution, terrorist strikes, wars, etc.). No role for monetary or fiscal policies in cycle: –Economy and unemployment are efficient; no need for policies –Cycles are supply-driven, cannot use AD policies to stabilize output. –Money is “neutral” (M policy cannot affect real output), so cannot use M policy

21. 1. Cyclical properties of classical models of the business cycle -Hard to explain deep recessions and depressions (1930s, 2007- 09) as technological regress. What did we forget? 2. Money and output: is money neutral? -RBC predicts money neutral -Much evidence that M is non-neutral 3. Labor market features (such as quits and Beveridge curve) Verdict: Economists deeply divided. Personal view: Keynesian approach has not developed a complete microeconomic justification, but it is most promising approach to understanding sources and policies for business cycles. Problems in RBC models

22. 22 Promoting Technological Change Much more difficult conceptually and for policy: -TC depends upon invention and innovation -Market failure: big gap between social MP and private MP of inventive activity -No formula for discovery analogous to increased saving Major instruments: -Intellectual property rights (create monopoly to reduce MP gap): patents, copyrights -Government subsidy of research (direct to Yale; indirect through R&D tax credit) -Rivalry but not perfect competition in markets (between Windows and Farmer Jones) -For open economy, openness to foreign technologies and management