ECO 120 Macroeconomics Week 11 Economic Growth Lecturer Dr. 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. Y Y1Y1 P0P0 AD AS 1 P AS 0 Y0Y0 P1P1 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. Y Y1Y1 P0P0 AD P AS 0 Y0Y0 P1P1 Y* Beginning Middle AS 1

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*. Y Y1Y1 P2P2 AD P AS 2 Y0Y0 P1P1 Y* Middle AS 1

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 (Y 1 ) and high unemployment. Fiscal policy stimulates AD 0 to AD 1. Output rises, and unemployment falls. But inflation rises, as P rises to P 2. Y Y1Y1 P0P0 AD 0 P Y0Y0 P1P1 Y* Middle AD 2 AS 1 P2P2

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. Y Y1Y1 P0P0 AD 0 P AS 0 Y0Y0 P1P1 Y* Beginning Middle AD 1

Adjustment after a boom Y increases to Y 1, so we have a boom with high output and low unemployment. We have inflation, as P rises to P 1. 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*. Y Y1Y1 P2P2 AD 0 P AS 0 Y0Y0 P1P1 Y* Middle AD 1 AS 1

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. Y Y1Y1 P2P2 AD 2 P AS 0 Y0Y0 P1P1 Y* Middle AD 1

Long-run equilibrium Adjustment to a bust –AS shifts up to AS 1. –Output falls, and prices rise in the short-run. –Wage demands shift AS down to AS 2. –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. Y Y1Y1 P0P0 AD AS 1 P AS 0 =AS 2 Y0Y0 P1P1 Y*

Long-run equilibrium Adjustment to a boom –AD shifts out to AD 1. –Output and prices rise in the short-run. –Wage demands shift AS left to AS 2. –Output falls and prices rise as we adjust to long-run. –In long-run, output back to natural rate, and prices higher. Y Y1Y1 P0P0 AD 0 P AS 0 Y0Y0 P1P1 Y* Beginning Middle AD 1 AS 2 End P2P2

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/N w ) (N w /N) Y/N w = output per worker depends on labour productivity, which depends on skills in workforce, capital, tech N w /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 N w /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 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/N w, 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 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 Australians in 2000 have almost twice as much resources per person than Australians did in 1950.

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 to our neighbours

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?

But look!

Log graph

Consequences of growth LifeAdult Enrollm entGDP ExpectancyLiteracyin Eduper capitaHDIRank Norway , Australia , USA , Japan , Indonesia , Kenya , Uganda , Malawi