The Production Possibilities Frontier The Consumption-Investment Tradeoff And the Essence of Economic Growth 2009 Adapted from Time and Money: The Macroeconomics of Capital Structure by Roger W. Garrison London: Routledge, 2001

45 o EXPENDITURES INCOME

EXPENDITURES INCOME C = a + bY C + I 45 o Equilibrium in the simple Keynesian framework means only that income equals expenditure. The economy may be in recession or experiencing inflation. Y eq

Y eq =Y fe EXPENDITURES INCOME C = a + bY C + I INVESTMENT CONSUMPTION We assume, though, that this economy is enjoying full employment without inflation — if only by good luck. Equilibrium in the simple Keynesian framework means only that income equals expenditure. The economy may be in recession or experiencing inflation. Y eq

CONSUMPTION INVESTMENT The Production Possibilities Frontier The Production Possibilities Frontier (PPF) depicts these alternatives during a given time period, typically one year. The tradeoff between CONSUMPTION (in the present) and INVESTMENT (for the future) should be an integral part of our macroeconomic thinking. Under favorable conditions, a fully employed market economy allocates resources to both uses, making the most of the trade-off. A “fully employed market economy” allows for a so-called “natural rate of unemployment,” which is about five or six percent. That is, frictional and structural unemployment are characteristic of even a healthy economy. In any economy, some resources are devoted to producing consumables, the remaining resources being available for maintaining and expanding the economy’s productive capacity.

CONSUMPTION INVESTMENT But raw materials and capital equipment are heterogeneous. Riverboats and river barges are not readily substitutable one for the other. The heterogeneity of equipment and materials implies a convex PPF. As the tradeoff is made away from consumption and toward more investment, the scope for still more investment diminishes. Microeconomists would describe this feature of the PPF in terms of a diminishing marginal rate of substitution. If resources were characterized by perfect homogeneity, such that each unit of input is equally suitable for producing either kind of output (consumption goods or investment goods), then the PPF would be linear. PRODUCTION POSSIBILITIES FONTIER A riverboat isn’t very suitable for carrying industrial equipment. A cruise on a river barge isn’t much fun. A PPF with homogeneous inputs A PPF with heterogeneous inputs

CONSUMPTION INVESTMENT Positive net investment means that the economy is growing. The PPF shifts outward from year to year, permitting increasing levels of both consumption and investment. “Investment” in this construction represents gross investment, which includes replacement capital. Typically, the investment needed just to replace worn out or obsolete capital is substantial but something less than gross investment. This outward shifting of the PPF represents sustainable economic growth. The extent to which gross investment exceeds the “replacement” magnitude constitutes net investment and allows for the expansion of the economy. Gross Investment Replacement Capital Net Investment

Four periods of growth are shown—with consumption, as well as investment, increasing in each period. The actual rate of expansion of the PPF depends upon many factors. For instance, with economic expansion, more resources are needed for capital replacement. And the desired trade-off between consuming and investing can itself change as the economy generates more wealth. CONSUMPTION INVESTMENT Watch the economy grow. Gross Investment Replacement Capital Net Investment YEAR 0YEAR 1YEAR 2YEAR 3YEAR 4

CONSUMPTION INVESTMENT Importantly, we note that forgoing some consumption with an eye toward consuming more in the future triggers a movement along the initial PPF and hence affects the rate at which the PPF expands outward. Watch the economy grow. Watch the movement along the PPF. Four periods of growth are shown—with consumption, as well as investment, increasing in each period. The actual rate of expansion of the PPF depends upon many factors. For instance, with economic expansion, more resources are needed for capital replacement. And the desired trade-off between consuming and investing can itself change as the economy generates more wealth.

CONSUMPTION INVESTMENT Now watch the economy grow. Increased thriftiness makes the difference. Let’s compare the high-growth economy with the original low-growth economy. YEAR 0YEAR 1YEAR 2YEAR 3YEAR 4

INVESTMENT Note the difference that an initial trading off of consumption for investment makes in the subsequent pattern of consumption and investment. Without an initial increase in investment, consumption and investment increase modestly from period to period. With an initial increase in investment at the expense of consumption, both consumption and investment increase dramatically from period to period. CONSUMPTION INVESTMENT By the fourth period, that initial increase in investment pays off as a higher level of consumption than would otherwise have been possible. CONSUMPTION

INVESTMENT CONSUMPTION TIME and eventually surpasses the old projected growth path. The time dimension is represented by the sequence of shifts of the PPF. We can add to our understanding if we represent time explicitly on a horizontal axis and then keep track of consumption on the vertical axis. In both representations, consumption is seen to fall as the economy is adapting to a higher growth rate, after which consumption rises more rapidly than before… Explicitly tracking the level of consumption over time allows us to see that the tradeoff is essentially an intertemporal tradeoff. Consumption in the present and near future is traded for greater consumption in the more distant future.

Net InvestmentNet Investment = 0 Gross Investment Gross Investment CONSUMPTION INVESTMENT Watch the economy not grow. Suppose that gross investment in the economy is just enough to replace worn out and obsolete capital — which means that net investment is zero. The levels of consumption and (gross) investment would be maintained, but the economy would not grow. There is nothing pre-ordained about the economy actually having a positive rate of growth. Replacement Capital YEAR 0YEAR 1YEAR 2YEAR 3YEAR 4

In a no-growth economy (meaning no net investment), would it be possible for people to increase consumption? Yes, there is still some scope for movement along the PPF in the direction of more consumption and less investment. CONSUMPTION Gross Investment INVESTMENT Watch the economy experience negative growth, i.e., watch it contract. Notice that consumption rises initially and then falls as the economy’s productive capacity diminishes over time. But what would be the consequences for the PPF in subsequent years? Replacement Capital YEAR 0YEAR 1YEAR 2YEAR 3YEAR 4

The increase in consumption in the present and near future comes at the expense of a declining rate of consumption in the more distant future. CONSUMPTION TIME As in the case of a clockwise movement along the PPF, we can add to our understanding of this counterclockwise movement by representing time explicitly on a horizontal axis and then keeping track of consumption on the vertical axis. In both representations, consumption is seen to rise as the economy is adapting to a negative growth rate, after which consumption declines — soon falling below the initial level. CONSUMPTION INVESTMENT

CONSUMPTION TIME CONSUMPTION TIME If gross investment exceeds replacement capital, the economy expands. If gross investment falls short of replacement capital, the economy contracts.

CONSUMPTION INVESTMENT Consider two separate economies, one large and one small. CONSUMPTION INVESTMENT Each PPF is broadly descriptive of two particular countries at the end of World War II. Apart from their differing sizes, one possibly relevant difference is that the small country’s economy had been wrecked by bombing to a much greater extent than the large country’s economy. On what basis can you make a prediction about the sizes of the two economies, say, two or three decades after the war? What two countries are these? Post-war United States Post-war Japan Japan grew much faster than the United States—not because it had been bombed, but because the consumption-investment tradeoff in post-war Japan was made in favor of a high level of investment. In the United States, the tradeoff was made in the opposite direction by the consumption-oriented Americans.

CONSUMPTION INVESTMENT To this point, we’ve assumed that the economy is either on its PPF or is being expeditiously moved by market forces toward a point on its shifting PPF. Suppose, though, that during a given year, some market malfunction (or some perverse policy) takes the economy off its PPF. If the economy is pushed beyond the PPF, its unemployment rate being driven below the 5-6 percent band, we say the economy is “overheated.” Points very far beyond the PPF are simply out of reach (in real terms). Strong market forces pushing in this direction will impinge on prices rather than on quantities. The economy will experience price and wage inflation. In extreme cases, it can experience hyper-inflation.

CONSUMPTION INVESTMENT To this point, we’ve assumed that the economy is either on its PPF or is being expeditiously moved by market forces toward a point on its shifting PPF. Suppose, though, that during a given year, some market malfunction (or some perverse policy) takes the economy off its PPF. If the economy is pushed beyond the PPF, its unemployment rate being driven below the 5-6 percent band, we say the economy is “overheated.” Points very far beyond the PPF are simply out of reach (in real terms). Strong market forces pushing in this direction will impinge on prices rather than on quantities. The economy will experience price and wage inflation. If the economy is pushed inside its PPF, its unemployment rate rising above the 5–6 percent band, we say that the economy is in a recession. If the economy is pushed far inside its PPF for an extended period of time, we say that the economy is in a depression. In extreme cases, it can experience hyper-inflation.

Economists who believe that “markets work” argue that market forces can move the economy along the PPF in response to changes in intertemporal preferences. They argue that movements off the PPF are largely a consequence of perverse macroeconomic policy. Economists who believe that the market economy is inherently flawed argue that market forces will move the economy along the linear path producing periodic bouts of unemployment and inflation. They argue that “stimulus packages” and interest-rate manipulation are needed to restore macroeconomic health. CONSUMPTION INVESTMENT Notice that, together with the locus of the fully employed economy, the various possible market malfunctions (or consequences of perverse policy) are arrayed along a linear path: What do you suppose is the significance of the straight line that passes through these points? fully employed over-heated inflated recessed depressed hyper-inflated A depressed economy A recessed economy A fully employed economy An over-heated economy An inflated economy A hyper-inflated economy

The nature of the Keynesian-styled spiraling associated with recession, depression and inflation becomes more transparent with the production possibility frontier in play. Also, the PPF helps to show how the Keynesian framework is related to pre-Keynesian ideas. Y fe EXPENDITURES INCOME C = a + bY N W S D C + I INVESTMENT CONSUMPTION

EXPENDITURES INCOME N W S D C + I C = a + bY INVESTMENT CONSUMPTION A waning of animal spirits causes investment to decrease and with it income and consumption. The economy falls inside its PPF. Y fe

Note that if investment were to fall to zero, the economy would settle into an income-expenditure equilibrium with Y = C. Thus, the vertical intercept of the Keynesian demand constraint is aligned with the intersection of the consumption function and the 45 o line. EXPENDITURES INCOME N S D W C = a + bY C + I INVESTMENT CONSUMPTION A further waning sends the economy deeper into the PPF’s interior. Movements inside the frontier (and beyond it) trace out a linear relationship, showing how consumption varies with investment. The straight line that passes through these points is the Keynesian demand constraint. Y fe INVESTMENT

CONSUMPTION The straight line that passes through these points is the Keynesian demand constraint. INVESTMENT Y = C + I C = a + bY C = a + b(C + I) C = a + bC + bI C – bC = a + bI (1–b)C = a + bI C = + I a b (1-b) (1-b)

“The formula is not, of course, quite so simple as in this illustration…. But there is always a formula, more or less of this kind, relating the output of consumption goods which it pays to produce to the output of investment goods…. This conclusion appears to me to be quite beyond dispute. Yet the consequences which follow from it are at the same time unfamiliar and of the greatest possible importance.” “If, for example, the public are in the habit of spending nine-tenths of their income on consumption goods, it follows that if entrepreneurs were to produce consumption goods at a cost more than nine times the cost of the investment goods they are producing, some part of their output could not be sold at a price which covered its cost of production.” + I b (1 – b) a (1 – b) EXPENDITURES INCOME C = a + bY C + I INVESTMENT CONSUMPTION a (1 – b) b 1 – b C = For simplicity, let a = 0 and b = Then C = a + bY becomes C = 0.90Y. And C = a/(1-b) + b/(1-b) I becomes C = 9(I), which led Keynes to write: Y fe

The Production Possibilities Frontier The Consumption-Investment Tradeoff And the Essence of Economic Growth 2009 Adapted from Time and Money: The Macroeconomics of Capital Structure by Roger W. Garrison London: Routledge, 2001