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POLICY GOALS: MAXIMUM PRODUCTION
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Chapter 1
General Economic Concepts
Chapter 2
What is Policy?
Chapter 3
History of Macroeconomic Policies in the United States
Chapter 4
Policy Goals: Maximum Employment
Chapter 5
Policy Goals: Maximum Production
Chapter 6
Policy Goals: Price Stability
Chapter 7
Policy Goals: External Balance
Chapter 8
Subsidiary Policy Goals
Chapter 9
Conflicting Policy Goals
Chapter 10
The Policy Makers
Chapter 11
The Policy Instruments
Chapter 12
The Decision-Making Processes
Chapter 13
The Policy Indicators
Chapter 14
The General Economic Model
Chapter 15
Monetarist Monetary and Fiscal Policies
Chapter 16
Keynesian Monetary and Fiscal Policies
Chapter 17
Debt Management Policies
Chapter 18
Incomes Policies
Chapter 19
Supply Management Policies
Chapter 20
The Long Wave
Chapter 21
Contemporary Issues
"I see nothing in the present situation that is either menacing or warrants pessimism . . . . I have every confidence that there will be a revival of activity in the spring, and that during this coming year [1930] the country will make steady progress."

Andrew W. Mellon
U.S. Treasury Secretary
December 31, 1929

"My mother brought us to Newark in January 1931. The stock market had collapsed fifteen months earlier, but though business was bad, Washington people who understood these things did not seem alarmed. President Hoover refused to use the scare word "recession" when speaking about the slump. It was merely 'a depression,' he said. Nothing to panic about. Good times were just around the corner."

Russell Baker
American Writer, Journalist, Biographer, and Humorist
Growing Up (1982)

  1. Definitions and the Problems
  2. Measuring Performance
  3. Advantages and Disadvantages of Growth
  4. Long-Run Secular Growth
  5. Productivity and Technology
  6. The Roles of Capital Formation, Productivity Growth, and Technological Change in Long-Run Real Growth
  7. Productivity Growth in the U.S.
  8. Maintaining Long-Run Growth is a "Two-Edged Sword"
  9. Short-Run Cyclical Growth
  10. Business Cycles
  11. Summary
    Readings
    Websites
top    I. Definitions and the Problems

The Employment Act of 1946 mandates maximum production as the second of three macroeconomic goals. Maximum production starts with measurement of an economy's total output. An economy's total output is measured in three ways: Gross National Product, Gross National Income, and Gross Domestic Product.

Nominal Output

Nominal output is a price-weighted measure of total output:

Y identity PQ

where Y is nominal output, Q is some measure of the quantity of output, and P is the vector of prices used to weight that quantity of output. Nominal output is also called money output. Nominal output can change if either the prices (P) or the quantity (Q) of output changes:

ΔY identity ΔP ΔQ

or

ln(Y) identity ln(P) + ln(Q)

d{ln(Y)}/dt identity d{ln(P)}/dt + d{ln(Q)}/dt

%ΔY identity %ΔP + %ΔQ

y identity p + q

where y is the growth rate of nominal output, p is the rate of change in prices (inflation/deflation) and q is the rate of change in real output (expansion or contraction). If nominal output rises (falls) because the quantity of real output rises (falls), then economic participants are better (worse) off because more (less) output is available for everyone. If nominal output rises (falls) because prices rise (fall), then economic participants are no better (worse) off, because they are still producing the same amount of real goods and services.

Gross National Product (GNP) is the total market value of all final goods and services newly produced for an economy during some time period, generally one year. As a market value it is the sum of all market transactions for final goods and services. It starts with the sale of one widget and then sums all of the sales of widgets for the year. To this sum is added the summed transactions for daggits and all other final goods and services produced during the year.

Total Output identity GNP = pwqw + pdqd + ... + pnqn
n   
GNP =  ∑ piqi = PQ = Y
i =1  

where Q is some measure of the quantity of output and P is the vector of prices used to weight that quantity of output. GNP includes net factor inflows from production abroad by domestic companies:

GNP = GDP + net factor income from abroad

Gross National Income (GNI) is the total value of all income paid to the factors of production:

GNI identity wL + iK + rR + π + sp + ibt + cca

where w is wages paid to labor (L), i is interest paid on borrowings to buy capital (K), r is rent paid for the use of land and other natural resources (R), π is profits, sp is sole proprietors' income, ibt is indirect business taxes and cca is capital consumption allowances. Ibt and cca are two non-income charges. Gross National Product is identical to Gross National Income. GNP is specifically defined so that the act of producing new final goods and services generates an equal and offsetting amount of income to the factors of production.

GNP identity Y identity GNI

Gross Domestic Product (GDP) is the total market value of all final goods and services newly produced in an economy during some time period, generally one year. It excludes income appropriate by foreign companies from domestic production. It is GNP minus net factor income from abroad:

GDP = GNP - net factor income from abroad

For years, the U.S. reported GNP, while other countries reported GDP. The U.S. reported GNP, because its GNP was larger than its GNP. The U.S. received a large inflow of net factor income from Americans working and investing abroad. Other countries reported GDP, because their GDPs were larger than their GNPs. They paid Americans to work and invest in their countries. In the mid-1980s, this U.S. net flow of factor income turned negative and in the early 1990s, the U.S. government decided to report GDP rather than GNP.

Real Output

Real output is a price-deflated measure of the real quantity of output that is produced:

Q identity Y/P

where Y is nominal output, P is a price index from some base year, and Q is the amount of real output. The FRB St. Louis currently reports real GNP and real GDP in billions of chained 2005 dollars.

Real output is first approximation for the total amount of output produced by an economy. However, it is an imperfect measure of an economy's real income. First of all, it is constructed from estimated quarterly tax returns. The actual GNP or GDP for any given year is not known for two or three years, because households and corporations often get extensions to file their tax returns. Second, because real output is constructed from tax returns, only reported transactions are included. Illegal transactions, cash and carry transactions, local transactions that are not part of organized markets, barter transactions, and homemade goods and services are not included. Third, "quality of life" items, like leisure time, technological advancements, and improved infrastructure, are not necessarily reflected in the raw numbers. Fourth, positive externalities are not fully included. For example, a new vaccine may cost only a few dollars to manufacture, but will save thousands of lives. Fifth, real output is not adjusted downward for negative externalities like pollution, congestion, and crime. Finally, real output does not take into account the number of mouths to feed.

Real per capita GDP is the real output produced per person. It is also the real income per person:

real output per capita identity Q/N identity real income per capita

where N is the number of persons or population of the economy. The level of living for the population as a whole is measured by the country's per capita output (income). The standard of living for the population as a whole is measured by the country's per capita output (income) to which "quality of life" factors are added and externalities are netted out. The Census Bureau estimates and reports population data.

top    II. Measuring Performance

Maximum production may be measured "statically," at a point in time, or "dynamically," over time.

Static Economic Performance

THE GDP GAP

GAP
Static economic performance is measured by the gap between an economy's actual real output and its potential real output or its natural real output:

GAP = Qa - Qp or GAP = Qa - Qn

where Qa is actual real output, Qp is potential real output, and Qn is natural real output. Actual real output (Qa) is the ex post or realized real output of an economy. Potential real output (Qp) is the ex ante or potential real output that an economy could produce if all of its resources were fully and gainfully employed. Natural real output (Qn) is the maximum amount of output that an economy can produce without an increase in the rate of inflation. It is also the amount of output at which the economy is achieving the natural unemployment rate (NRU).

In the short-run, actual real output may be less than, equal to, or greater than potential real output, depending on the actual employment rate. In the short-run, it may also be less than, equal to, or greater than natural output, depending on what is happening to the actual rate of inflation.

The amount of gap represents the economy's performance. When the economy has a negative gap (Qa < Qn), it is underperforming, and the loss of output represents a current waste of resources, above normal unemployment, and increased hardship. When the economy has a positive gap (Qa > Qn), it is overperforming; however, resources are generally strained, they burn out too quickly, and inflation increases. Therefore, "maximum performance" requires that the economy operate as close to its natural output level as possible at all time.

As can be seen in the graph above, the U.S. economy is currently underperforming. Its gap is negative. However, from 1997 to 2001, the U.S. economy overperformed. Its gap was positive.

Dynamic Economic Performance

Dynamic economic performance is measured by the percentage change in real GNP on an annual basis.

Real growth (the growth rate) is the annual percentage change in actual real output:

q identity %ΔQ identity (Q1 - Q0)/Q0

where (1) and (0) are successive time periods. When q > 0, the economy is expanding. When q < 0, the economy is contracting. When q = 0, the economy is stationery or stagnating. When the economy is contracting, output, real income, and employment are declining and everybody is worse off. When the economy is expanding, output and real income are increasing. However, even when the economy is expanding, it may not be growing fast enough to absorb all of the new labor coming into the market. Also, people may not be better off, if the population is growing at a faster rate.

Real per capita growth is the percentage change in real output given the percentage change in the population.

real per capita growth identity %ΔQ / %ΔN identity q/n

When q < n, the level of living is going down. When q > n, the level of living is going up. When q = n, the level of living is stationery or stagnant.

The long run real growth rate for the U.S. is 3.0% - 3.5% per year. Population growth has averaged between 1.0% and 1.5% per year and real per capita income has grown by 2.0% - 2.5% per year. From 2000 to 2004, U.S. real GNP growth grew, on average, 2.0% per year and U.S. real GDP growth grew, on average, 2.5% per year. Meanwhile, U.S. population growth has been less than 1.0% per year. This means that real income per person grew by more than 2.5% per year from 2000 to 2004.

Real growth induces changes in the unemployment rate. In the early 1960s, Arthur M. Okun, a member of President Kennedy's Council of Economic Advisers, discovered an empirical relationship between an annual change in the unemployment rate and the corresponding annual change in the real growth rate. This relationship is known as Okun's Law. When Okun discovered the relationship, the rule of thumb was that a 1 percentage point increase in the unemployment rate was associated with a 3 percentage point decrease in real GNP. The relationship was valid for unemployment rates between 3% and 7.5%. Subsequent studies have shown that the relationship has changed so that, today, a 1 percentage point increase in the unemployment rate is more closely associated with a 2 percentage point decrease in real GNP.

top    III. Advantages and Disadvantages of Growth

Advantages of Growth

Growth affords each person a higher material and social level of living. When real per capita growth is greater than 1, real output is rising faster than the population is growing and the population's level of living is increasing. As the level of living rises, people can enjoy more of the finer things in life, e.g., arts and entertainment, which raises their standard of living. When real per capita growth is less than 1, real output is not growing so fast as the population and the population's level of living is decreasing. Generally, a decrease in the level of living also reduces a population's standard of living.

Growth permits the formation of social overhead capital or infrastructure. Social overhead capital facilitates and promotes the free and easy access to markets and the viability of exchange through specialization and division of labor. As real output grows, more resources can be set aside to improve roads, waterways, airport facilities, and telecommunications that improve the rapidity of trade and commerce in and among nations.

Growth enables a society to have an efficient (albeit fair and impartial) judicial system. An efficient judicial system expedites the enforcement of contractual agreements necessary for trade and development. When a society has a fair and efficient mechanism for enforcement to the breach of contract, economic participants will more likely honor their contracts and trade and commerce enhanced. If contracts can be easily broken, with no penalties, then fewer parties will enter into contracts and the flow of trade will slow.

Growth permits the development of a strong military or national defense system. A strong national defense is necessary to protect accumulated wealth. Without a strong defense system, accumulated wealth could be expropriated and the owner would have no recourse. As a result, no one would have the incentive to invest and accumulate productive assets. Loss of desire leads to loss of production and decay.

Growth permits a country to distribute foreign aid. Foreign aid promotes and maintains international good will.

Disadvantages of Growth

Growth negatively impacts the quality of life. Pollution and the destruction of our natural environment result from the abuse of free resources, like air and water, whose use may lower production costs but increase social costs. Excessive urbanization and congested living quarters increase the probability of heart attacks, suicides, neurotic and psychotic behaviors, and crime.

Growth polarizes the lowest and the highest income recipients. Not all sectors or regions grow at the same pace, and although the average standard of living is raised, income differentials widen. Increased crime rates and social tensions result.

Growth depletes natural resources. Deforestation, for example, causes erosion of the soil and mud slides. Oil resources, once extracted from the earth, cannot be replaced and are not available for future generations.

top    IV. Long-Run Secular Growth

In the long run, economies grow as their resource bases expand, their technologies change, and their economies of scale and scope increase. Long-run real growth is a function of the growth in the resource base (land, labor, capital, and entrepreneurial ability), changes in technology, and changes in scale and scope economies. Long-run real growth is a supply-side phenomenon.

Long-Run Production Function

A production function relates the quantity and quality of the factor resources to real output. How much output can be produced depends upon the quantity and quality of the factor resource base, technology, and scale and scope economies:

Q = f(R, L, K, E) Α, Β

where R is land and other natural resources, L is labor resources, K is the stock of capital, E is the amount of entrepreneurial ability, Α is a modifier for technology (the method of production), and Β is a modifier for the scale (size) and scope (breadth) of business operations.

Land and other natural resources (R) are non-reproducible (fixed) and limited (finite). New deposits of old resources or new resources may be discovered, but in general, land and other natural resources are extractive; that is, they can be used up, but not replenished. Only through wars and the appropriation of other countries' resources can an economy expand its land and other natural resources. Alternatively, free world trade increases an economy's access to resources not indigenous to the region.

Labor (L) is human effort and is naturally reproducible through biological processes. However, this natural process does not guarantee that the necessary quantity and quality of labor will be available when needed. Birth rates vary across time, such that labor force participation may be "lumpy" (discontinuous) over time and educational opportunities vary, such that workers may not enter the labor force with the requisite education, skills, and experience.

Capital (K) is a man-made tool used to facilitate the production process. It is non-human effort and reproducible through the production process. However, no production process can guarantee that the necessary quantity and quality of capital will be available when needed. The quantity and quality of capital depends upon business expectations of the return on new capital. Thus, as business expectations alternate between optimism and pessimism, the formation of capital will also be "lumpy," and not necessarily coincident with the quantity and quality of available labor.

Entrepreneurial ability (E) is a specialized form of labor that is willing to bear the risks of financing and managing production processes. It is a by-product of labor participation. Entrepreneurial ability is partly innate, partly acquired. and partly a function of the political, social, and economic environment. Like labor and capital, entrepreneurial ability may not necessarily increase smoothly over time.

Technology (Α) is the method of production. It is the knowledge of how to combine the factors of production to achieve low-cost, efficient production. Some technologies are capital intensive, e.g., electric generation. Some technologies are labor intensive, e.g., practicing law or medicine. Some technologies have fixed technical coefficients, where labor and capital are always used in the same ratio to one another, e.g., one man, one shovel to dig a ditch. Other technologies have variable technical coefficients, where labor can be used in varying quantities to a fixed amount of capital, e.g., an automobile assembly line where the amount of capital is fixed and the company can produce more or less cars by hiring more or less labor to work with the fixed capital on the assembly line.

Economies of scale and scope (Β)

Scale of operation is the size of the business enterprise. At any given time, the business has the option of being larger or smaller. Depending upon the chosen size, the business will have a fixed amount of capital, with a given technology, and a managerial staff. It can lower its per unit costs of production if it can spread these fixed costs over a larger volume of output.
    Economies of scale are reduced per unit costs as the business expands. They occur because the business can spread its overhead costs over a wider range of output, it may be able to buy more sophisticated capital, or it may be able to make better use of by-products from its primary production. For example, a business needs only one CEO, but the CEO can over see the production of either 1 widget or 1,000,000,000 widgets. Obviously, the per unit cost of the president falls as the business gets larger.

    Diseconomies of scale are increased per unit costs as the business expands. They occur primarily because of problems in managing large amounts of labor and excessive red tape in dealing with basic production problems. Generally, the larger the business, the higher the hierarchy; and, the higher the hierarchy, the further removed are basic problems from the locus of decision-making authority. Therefore, the business sets up all sorts of rules and regulations and complex procedures for moving information up and down the hierarchy. This process reduces the efficiency of production and raises per unit costs.
Scope of operation is the extent to which businesses can engage in multi-product or multi-service operations. If the business can take advantage of synergies and reduced transaction costs, it can lower per unit costs for all business operations by expanding into other product and service lines.

Long-Run Real Growth

Long-run real growth occurs as the factor resource base, technology, and the scale and scope of business operations change:

ΔQ = f(ΔR, ΔL, ΔK, ΔE, ΔΑ, ΔΒ)

or

ln(Q) = f(ln(R), ln(L), ln(K), ln(E), ln(Α), ln(Β))

d{ln(Q)}/dt = f(d{ln(R)}/dt, d{ln(L)}/dt, d{ln(K)}/dt, d{ln(E)}/dt), d{ln(Α)}/dt, d{ln(Β)}/dt)

%ΔQ = %ΔR + %ΔL + %ΔK + %ΔE + %ΔΑ + %ΔΒ

q = r + l + k + e + α + β

Land and other resources (r), by definition, cannot grow. They are fixed in total supply and can only be used up. Therefore, land and other natural resources are not sources of long-run real growth.

The labor force (l) grows, as the population grows, and can be a source of long-run real growth. However, labor force growth lags population growth by 18-22 years. In the meantime, the increase in population means more mouths to feed. Therefore, unless the quality of the labor force increases, labor force growth alone is not a source of long-run growth in real per capita income.

The capital stock (k) grows as businesses invest in new capital. Its growth is a major source of long-run growth in real output as well as real per capita income. Therefore, sustaining real growth in output and per capita income requires a political, social, and economic environment that is conducive to investment and capital formation.

Entrepreneurial ability (e) is similar to labor, in that, entrepreneurs come out of the population and any increase in entrepreneurial ability also incurs maintenance costs. Therefore, increased entrepreneurial ability may be a predicate to real growth, but new entrepreneurs must be truly creative and innovative to keep real per capital income growing.

Technology (α) changes continually and it, along with capital formation, is a major source of long-run growth in real output as well as real per capita income. Therefore, sustaining real growth in output and per capita income requires a political, social, and economic environment that is conducive to invention and innovation to promote technological change.

Scale and scope economies (β) also facilitate long-run growth in real output as well as real per capita income. However, these factors require broad markets. Therefore, sustaining real growth in output and per capita income requires a political, social, and economic environment that is conducive to large uninterrupted trade areas and free trade.

top    V. Productivity and Technology

Productivity

Productivity is a measure of real output in relation to the amount of toil or effort put in by labor and capital. Labor effort can be measured in "man-hours" and capital can be measured in terms of "up-time" or hours in operation.

Average productivity is output per unit of input. Average productivity of labor is output per "man-hour" (Q/L), where L is the aggregate hours worked by labor. Average productivity of capital is the output per hour of "up-time" (Q/K), where K is the aggregate hours in operation for capital.

Technology

Technology is the method of production. The capital-labor ratio (K/L) is the ratio in which capital and labor are combined in the production process. Capital-intensive technologies employ proportionately more capital than labor. For example, the K/L ratio may be as high as 6 or 7 in electric generation, telecommunications, and rail transport. Labor-intensive technologies employ proportionately more labor than capital. With labor-intensive technologies, capital is incidental to production. For example, in the service sector, the K/L ratio may be less than 1 for legal or medical services, education, and real estate sales, although the computer and new information technologies are raising the K/L ratio in these areas.

Some production methods have a fixed technical coefficient of capital to labor, e.g. the proverbial grave digger and his shovel. An increase in the output of graves requires not only another grave digger but also another shovel. Because of the additional capital outlay, expansion of real output is more difficult and costly. Other production methods have a variable technical coefficient of capital to labor, e.g. automobile production. With a variable coefficients production method, alternate amounts of labor can work with the same capital stock to achieve varying amounts of output. Any assembly line process is a variable coefficients method of production. An increase in output requires only the expenditure on another labor unit. Thus growth of real output can be accomplished more quickly and efficiently.

Real output per labor unit (the productivity of labor) depends upon the productivity of capital (Q/K) and the technological coefficient or capital-labor ratio (K/L):

Q/L = Q/K x K/L

top    VI. The Roles of Capital Formation, Productivity Growth, and Technological Change in Long-Run Real Growth

Productivity Growth

Productivity growth is the change in factor productivity over time. It is calculated as the marginal productivity of the factor inputs.

Marginal productivity is the change in output from a change in the units of input. Marginal productivity of labor (ΔQ/ΔL) is the change in output from a change in the number of "man-hours" for labor. Marginal productivity of capital (ΔQ/ΔK) is the change in output from a change in the number of hours of "up-time" for capital. Marginal productivity ratios above 1 indicate that productivity is increasing. Marginal productivity ratios below 1 indicate that productivity is decreasing.

The incremental capital-labor ratio (ΔK/ΔL) shows the change in the relationship of capital and labor usage in the production process. We do not necessarily care how hard capital works, since it is non-human and replaceable at a nominal cost. However, we do care how hard people work. To reduce the amount of labor effort in production and to save on human exertion, the incremental capital-labor ratio must be greater than 1. If it is less than 1, more labor effort is required to produce the same amount of output.

The marginal productivity of labor is the product of the marginal productivity of capital and the incremental capital-labor ratio:

ΔQ/ΔL = ΔQ/ΔK x ΔK/ΔL

Thus productivity gains for labor are conditioned by the quantity and quality of capital used in the production process. The more capital labor has to work with (K/L) and the greater the productivity of capital (Q/K), the greater will be the productivity of labor and the greater will be real output and real per capita income. Capital widening occurs when labor works with more capital and the K/L ratio increases or the incremental capital output ratio (ΔK/ΔL) exceeds 1 and the quantity of capital with which labor works increases. Capital deepening occurs when new models are more productive than old models and the Q/K ratio increases or the marginal productivity of capital (ΔQ/ΔK) exceeds 1 and the quality of capital with which labor works increases. Thus, real growth requires a political, social, and economic environment that is conducive to capital formation, growth in the productivity of capital, and technological change.

Technological Change

Technological change is the change in the methods of production or in the knowledge of how to combine resources to achieve more efficient output. Changes in technology may be embedded in labor, through investment in education and other vocational training (ΔQ/ΔL), or in capital, through make and model changes (ΔQ/ΔK), or in entrepreneurial ability, through innovation, in recombination of labor and capital (ΔK/ΔL), or in labor-management relations.

Technological change is the end result of research and development (R & D). Research (R) is the process of discovery or invention. Development (D) is the translation of a discovery or invention into low-cost application or innovation.

Some technological change produces capital that saves on labor usage. Other technological change results in capital that requires more labor. Labor-saving capital (automation) reduces the amount of labor effort. Labor-saving capital tends to reduce employment and increase unemployment, e.g., robotics, where machines replace men on the assembly line. Labor-using capital increases the amount of labor effort. Labor-using capital tends to increase employment and reduce unemployment, e.g. computerization, where new jobs are created for hardware and software technicians. In all cases, the end result is an increase in real output and real income per capita.

top    VII. Productivity Growth in the U.S.

Over the last century or so, productivity growth in the industrialized world has been greater than anything ever experienced in history. From 1870 to 1980, growth in productivity ranged from 400% for Australia to 2500% for Japan. The United States had a growth rate of 1100%, just below the average. At the same time, living standards rose just as rapidly.

Walter W. Rostow, a famous "growth and development" economist, discovered an inverse relationship between the level of real output in a country and its average productivity gains and real growth. Countries at low levels of development, which start from a low per capita output base, move through the early stages of growth at a faster rate than more advanced economies. For example, Japan, which had a very low per capita output in 1870, had the highest rates of productivity gain and real growth over the subsequent 110 years. Australia, which had a very high per capita output in 1870, had the slowest gains in productivity and real growth. The United States, whose output per capita was relatively high in 1870, had an average productivity gain over the last century of 2.2% - 2.3% per year, just below average.

The U.S. trend has continued in the Post WW II period, but with varying results from decade to decade. In the 1950s, U.S. productivity increased on average about 2.0% per year. In the 1960s, that increase rose to an average of 3.2% per year. In the 1970s, productivity growth slowed to an average of 2.1%. In the 1980s, productivity growth slowed even further to a paltry 1.0% rate. There were several reasons for this slowdown.

The Slowdown

Slow down in capital formation by business A critical factor in productivity growth is a marginal capital-labor ratio above 1. In the immediate period following WW II, labor was relatively scarce. Businesses economized on costs by accumulating capital at a faster rate than it was hiring labor. Since the growth in capital per worker exceeded 1, productivity gains were very high. In the 1970s, the relative availability and cost of capital and labor shifted. With the maturing of the baby-boom generation and the tidal wave of women entering the labor force, labor became the relatively more abundant resource. Businesses economized on costs by shifting out of capital and into labor, thus lowering the marginal capital-labor ratio and productivity gains. Additionally, much investment in the 1970s went toward spending on non-capacity or non-productivity increasing capital such as pollution controls and safety equipment. Therefore, the rate of productivity growth has slowed.

Slow down in research and development The rewards of R & D are generally prolonged. First, the research effort must result in discovery or invention. Then, the development effort must result in innovation, the practical cost-efficient application of invention. To the extent that management is extremely far-sighted or has a long planning horizon, investment in research will increase. However, as business expectations are cut short and management becomes myopic, spending on R & D declines. Over the last twenty years, surveys of business indicate that management has reduced its planning horizon and increased its emphasis on short-run profit performance. Therefore, the rate of productivity growth has slowed.

STRUCTURAL SHIFT IN EMPLOYMENT IN THE UNITED STATES

Year

Agriculture

Goods-Producing Industries

Service-Providing Industries

1956
1966
1976
1986
2009
9.8%
5.5%
3.8%
2.9%
0.7%
40.3%
36.2%
29.4%
25.3%
20.3%
59.7%
63.8%
70.6%
74.7%
79.0%
Source: 1956-1986 data from "Solid Growth: Despite Big Problems, U.S. Economy Seems Surprisingly Healthy," Alfred L. Malabre, Jr. Wall Street Journal, 2 Jun 1986: 10; 2009 data from World Factbook, CIA.
Shift from capital-intensive manufacturing industries to labor-intensive service industries Since the 1970s, production in the U.S. has shifted away from agriculture and the goods-producing industries (the manufacturing, mining, and construction sectors), where capital is easily substituted for labor, toward service-producing industries (the retailing, wholesaling and distribution, finance, insurance, real estate, and government sectors), where labor is not so easily replaced by capital and where productivity gains are nominal and difficult to measure. While manufacturing productivity continued to increase throughout the 1980s, output per hour of employee in the service sector stagnated. Since 1980 productivity in the manufacturing sector has increased by one-third or 33%. Service sector productivity, on the other hand, has increased by about 2.0%! Much of the decline in productivity growth can be traced to the expanding service sector with its slower rate of capital formation.

The Pickup

In the 1990s, productivity gains increased. During the first half of the decade, productivity gains averaged only about 1.0% per year. However, the difference between the 1980s and the early 1990s is that productivity gains in the 1980s were erratic, with good years followed bad years and vice versa. In contrast, productivity growth in the early 1990s was constant and continuous. This steady pace of productivity gains has helped to promote the longest economic expansion in U.S. history.

Then, starting in 1996, productivity gains jumped. Throughout the last half of the decade, productivity gains averaged almost 3.0% per year. These gains are the result of newer and better technologies in the tele-communications and information sectors. Innovation of these new technologies has significantly increased potential output and has allowed the U.S. to continue its longest peace-time expansion, running 10 years from March 1991 to March 2001.

top    VIII. Maintaining Long-Run Growth is a "Two-Edged Sword"

Long-run real growth depends on both investment and saving decisions. Investment is spending by businesses capital goods (capital). Saving is not spending by businesses and households on newly produced final domestic goods and services. Investment is financed by saving. Households and businesses must forego the current use of resources to make provision for the future. If households and businesses do not save, no resources will be available for capital goods production.

Investment is ultimately constrained by people's unwillingness to save. Capital accumulation is limited by society's willingness and ability to forego current consumption in order to make funds available for investment. However, a high saving rate will not necessarily inspire a high investment rate, if incentive is lacking. If the expected rate of profitability on investment is falling faster than its cost of financing (the interest rate), households and businesses may oversave and underconsume. Therefore, maintaining long-run real growth requires a balancing act that encourages both investment and saving.

Investment

Investment is spending by businesses on capital. Capital is a resource. Therefore, investment adds to the resource base.

Investment also changes technology and expands scale and scope economies. New investment increases an economy's potential for producing output. Today's investment rate helps to determine how fast the economy's real output will grow in the future. The larger the rate, the greater the potential for a larger future real output.

Investment is a key component of aggregate demand: Y = C + I. The higher investment, the larger aggregate demand, and the more income and employment will be generated. Moreover, a change in investment has a multiple impact on income and employment through the marginal propensity to spend out of income.

Investment was a powerful engine of economic growth after WW II. This capital spending remained robust until the mid-1970s. From the mid-1970s through the mid-1990s, capital spending slowed. This spending has increased since the mid-1990s its.

Several reasons have been advanced for the sluggishness of investment during the mid-1970s to the mid-1990s:
  1. A low capacity utilization rate in the U.S. An economy is considered to be at full employment when its capacity utilization rate is about 85%. For most of the mid-1970s to mid-1990s' period, the U.S. capacity utilization rate was barely 80%. With so much excess capacity, U.S. businesses had little reason to buy more capital.

  2. Overcapacity in many foreign businesses Sufficient plant and equipment were available in foreign countries to increase output without the necessity of U.S. businesses spending to buy more capital.

  3. Increased competition from efficient, low-cost foreign producers When foreigners can sell goods more cheaply than U.S. businesses, the U.S. businesses cannot raise prices. The only way they can remain profitable and competitive is to invest in cost-reducing capital. However, fewer capital projects won approval because U.S. businesses also wanted high rates of return.

  4. Foreign businesses achieved significant economies of scale after WW II As a result, the foreign businesses were able to undercut prices on American-made goods and reduce the profit rates for U.S. businesses.

  5. U.S. businesses out-sourced their parts and supplies For many years, U.S. businesses either owned their own parts' suppliers or bought American-made parts. That was when the U.S. dollar was fixed against foreign currencies. In 1973, President Nixon decided to let the U.S. dollar float. The dollar's value rose against foreign currencies. As a result, U.S. businesses bought their parts and components from abroad, rather than making them in-house.

  6. The volatile dollar and the huge trade deficits added to the risk of capital spending An investment in capital, which may be quite profitable at one exchange rate, may be unprofitable if the dollar rises and makes American products less competitive in international markets.

  7. Businesses spent much of the 1980s automating factories and offices Investment in high tech equipment accounted for more than 30% of capital spending by 1986, up from only a 12% share in the early 1970s. Yet, productivity gains from this investment were very disappointing.

  8. The expanding service sector does not require as much capital as manufacturing The service sector's principle tool, the computer, is not so expensive as heavy machinery.

  9. The Tax Reform Act of 1986 eliminated the investment tax credit Harvard economist Lawrence H. Summers (now Director of the White House's National Economic Council for President Barack Obama) estimated that the Tax Reform Act of 1986 raised the effective tax rate on most types of investment by 20 percentage points. This increase meant that an investment's prospective yield would have to be at least 20% higher to offset the tax bite. In the long-run, this may well reduce the stock of plant and equipment by 10% - 15%.

  10. A low saving rate Since 1929, gross private domestic business investment has averaged 14.4% of GDP and gross private saving has averaged 17.8% of GDP. However, a lot of that saving accrued during World War II and gross private saving has barely covered gross private domestic business investment since 1980. See graph below. Gross private saving has been less than gross private domestic investment since 2004 and these numbers do not account for saving that is absorbed by government deficit financing. The U.S. saving rate has not been above 10% since 1980 and in 2009 it turned negative.
Saving

Saving is not spending on newly produced final domestic goods and services: Y = C + S or S = Y - C.

In equilibrium, C + I = C + S, or I S. The investment rate is d = I/Y and the saving rate is s = S/Y. For an economy to be in long-run equilibrium, d s.

If the saving rate is greater than the investment rate (s > d), aggregate spending is less than aggregate output. Businesses will have unintended inventory accumulation. They will cut back on production. Employment and income will decrease.

If the investment rate is greater than the saving rate (d > s), aggregate spending exceeds aggregate output. Businesses will have unintended inventory decumulation. They will step up production. Employment and income will increase.

The investment rate may exceed the saving rate, d > s, in the short-run, through money creation and foreign borrowing. However, in the long run, investment is constrained by society's willingness and ability to save. The domestic saving rate must eventually increase and exceed the investment rate so that businesses can repay creditors. Otherwise, inflation will outpace real growth. The monetary authority must keep the interest rate low enough to encourage investment and high enough to encourage saving.

The Optimum Growth Rate

Historically, annual real growth in the United States has been 3.0%-3.5%. Of that increase, 1.0%-1.5% came from increases in the quantity of labor and capital and 2.0%-2.5% came from increased technical efficiency and education or productivity gains. When the annual rate of growth was above the long-run average rate, inflation tended to accelerate. When the annual rate of growth was below the long-run average rate, unemployment tended to increase.

Currently, economists are debating whether or not the 3.0%-3.5% long-run growth rate is still sustainable. In the early 1970s, the average slowed to about 2.5%. In the 1990s, that rate was above 4.0%. In the 2000s, the rate has been all over the place because the U.S. experienced two contractions. At present, the Federal Reserve is conducting monetary policy based on a sustainable long-run growth rate of 3.0%.

top    IX. Short-Run Cyclical Growth

In the short run, economies grow at different rates each year. Sometimes this growth is positive; sometimes it is negative. Sometimes the economy grows at a faster rate; sometimes it grows at a slower rate.

Short-Run Production Function

The short-run production function relates the quantity and quality of labor resources to real output. In the short run, the size of business, its capital stock, and its technology are fixed. How much it produces depends on the quantity and quality of labor, raw materials, and semi-finished goods used in the production process:

Q = f(L)| R, K, E, Α, Β

Capacity Utilization

Capacity utilization is the percentage of the capital stock that is being used at any point in time. Short-run output also depends the capacity utilization rate. After all, when labor is fully employed, so is the capital stock. When labor is unemployed, so is the capital stock. Most businesses like to operate at 85% of their capacity. In any given year, individual businesses may be operating above, below, or at their optimum capacity. On average, then, an aggregate capacity utilization rate of 85% is to capital what the natural rate of unemployment is to labor.

Short-Run Real Growth

Short-run real growth is a function of aggregate demand. It is a demand-side phenomenon. As demand increases, output increases. As demand decreases, output decreases. Short-run real growth may be less than, equal to, or greater than long-run real growth. In the short run, the economy can grow much faster if the unemployment rate is high and capacity utilization is low. The economy cannot grow so rapidly in the short run if the unemployment rate is low and business are running at 85% of capacity. At that point, business has to invest and add capacity, if the economy is to expand

top    X. Business Cycles

A business cycle is a periodic, repetitive change in real output. During the cycle output grows faster, then slower, eventually declines, and then recovers.

ANATOMY OF A BUSINESS CYCLE

- - - - long run secular (trend) rate of growth
____ actual growth rate over the business cycle
(1)expansiongrowth rate is positive
(2)contractiongrowth rate is negative
(3)peakgrowth rate changes from positive to negative
(4)troughgrowth rate changes from negative to positive
(5)recoveryearly stage of an expansion; growth increases at an increasing rate
(6)prosperitylate stage of an expansion; growth rate peaks and begins to decline
(7)growth recessiona positive rate of growth below the long-run average rate of growth
(8)recessiontwo (2) quarters of negative growth
(9)depressiona deeper and more protracted recession
(10)slowdowndeceleration of a positive growth rate

Stages of a Business Cycle

The expansion is the phase of a business cycle when the rate of growth of output is positive (1, 5, 6, 7, 10). Coming out of a trough, the economy goes through an initial period of "recovery" (5). The recovery is marked by a sharp upturn in economic activity and, generally, very rapid growth. The rapidity of the growth depends on how much excess capacity is left over from the previous downturn. The more excess capacity, the more rapidly the economy grows during the recovery. Once the expansion is well under way, the economy enters a period of "prosperity" (6) where the growth rate exceeds its long run average of 3.0%. An expansion is also called an "upturn" or "upswing." When the economy is expanding, but at a rate below its long-run average, the period is called a "growth recession" (7).

The peak is the point in a business cycle when the expansion slows down (10), the rate of growth goes to zero (3), and the contraction begins (8). A peak is also called "boom."

The contraction is the phase of a business cycle when the rate of growth of output is negative (2, 8, 9). First, the economy experiences a slowdown (10). Then, it stops growing (3). Then, the rate becomes negative and real output actually declines (8). A contraction is also called a "downturn" or "downswing." Contractions are sometimes distinguished by their length and severity.

A recession is generally not very long in duration nor severe in terms of the hardships it creates for the unemployed. The National Bureau of Economic Research (NBER), the official arbiter of business cycles, used to define a recession as two successive quarters (six months) of falling GDP. Now, however, the NBER uses an eclectic approach and defines a recession as "a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales." NBER (scroll to the bottom of the page)

A depression is generally longer in duration and more severe than a recession. However, the U.S. has no identifiable measure of when a recession becomes a depression and the fact is that some of the so-called "depressions" of the 19th century were shorter and milder than the more recent "recessions" of 1973-75, 1981-83, and 1989-1993. The truth is that, after the Great Depression, which lasted from 1929-1939, the term "depression" had such a negative connotation that, for political reasons, contractions were renamed "recessions."

The trough is the point in a business cycle when the contraction slows (9), the rate of growth goes to zero (4), and the expansion begins (5). A trough is also called a "bust"!

A growth recession is a period when the economy is growing, but at a rate below its historical (long-run) average rate of growth (5). In a growth recession, the unemployment rate generally increases, because the economy is not expanding fast enough to absorb all new entrants into the labor force.

Characteristics of Business Cycles

Self-propelling The economic dynamics feed on one another to make expansions more expansive and contractions more protracted.

Self-reversing The economic dynamics sow the seeds of their own destruction.

All-pervasive All sectors of the economy are affected.

Demand-side Business Cycles (spending cycles)

Kitchin cycles Named for the economist, Joseph Kitchin, Kitchin cycles are short-run, 2-4 year inventory liquidation cycles. They are usually associated with the demand for consumer durable goods that have average economic lives of 3-5 years. During the expansion, increases in consumer demand increase profitability for consumer goods producers and induce these businesses to produce more consumer goods. Employment and income increase. When consumers are satiated, consumer goods producers are left with unsold inventories. Rather than hold the goods, these businesses sell them off at deeply reduced prices. At the same time, they cut back on production until inventories are back in line with demand. Employment and income decrease.

Juglar cycles Named for the economist, Clement Juglar, Juglar cycles are medium-term 7-11 year capital spending cycles. They are usually associated with the demand for fixed capital goods that have an average economic life of 10 years. During the expansion, increases in business demand for equipment and machinery increase profitability for capital goods producers and induce these businesses to produce more capital goods. Employment and income increase. When businesses have acquired all of the desired fixed capital, demand falls and capital goods producers cut back on production until inventories are back in line with demand. Employment and income decrease.

Kuznets cycles Named for the economist, Simon Kuznets, Kuznets cycles are longer-term 15-20 year transportation and building cycles. They are usually associated with the demand for consumer durable goods and longer-lived capital goods, like houses, factories, wharehouses, office buildings, train cars, airplanes, and ships, that have average economic lives of 18-20 years. During the expansion, increases in demand for these longer-lived goods increase profitability for construction and transportation businesses and induce these businesses to produce more long-lived goods. Employment and income increase. When demand is satiated, it falls and these producers cut back on production until inventories are back in line with demand. Employment and income increase.

Supply-side Business Cycles (supply shocks)

Agricultural shocks Changes in climate and weather conditions lead periodically to crop failures, which raise the prices of agricultural commodities, or to bumper crops, which depress the prices of agricultural commodities. Such alternating periods of feast or famine induce supply-side shocks that affect the costs of final goods to consumers as well as the income of the raw materials producers.

Oil and other natural resource shocks Changes in the availability of strategic raw materials and resources affect the basic costs of production and induce the same types of supply imbalances and cyclical behavior as agricultural shocks.

Trade imbalances Changes in the availability of imported raw materials and resources affect the basic costs of production and induce the same types of supply imbalances and cyclical behavior as agricultural, oil, and other natural resource shocks.

Other causes International tensions, political instabilities, and other external events, such as wars, that threaten to cut off strategic raw materials and supplies will, likewise, set off supply-generated recessions and business cycles. Once the instabilities are corrected, the economy returns to a more normal pattern of growth.

Long Cycles

Schumpeterian cycles are long-term 50-60 year cycles generated by waves of inventions and innovation.

Kondratieff waves are long-term 50-60 year cycles, attributed by different economists to wars, gold discoveries, population migrations, demographic changes, technological change, and invention-innovation cycles.

top     Summary

Maximum production is measured by an economy's total ouput. An economy's total output is measured in three ways: Gross National Product, Gross National Income, and Gross Domestic Product. Potential real output is the amount of output an economy could produce if all resources were fully and gainfully employed. Actual real output is the amount of goods and services actually produced. The difference — the "gap" — is the loss of real output due to unemployed or underemployed resources in the economy. Sometimes the economy produces at its potential; but more often than not an economy's actual real output falls short of its potential.

Growth is the annual percentage change in real output. On the one hand, growth requires that an economy continuously push out its production frontier and increase its potential real output. On the other hand, growth requires sufficient aggregate demand to take advantage of the production of potential real output. As aggregate demand changes, the short-run growth rate changes. These short-run growth rate changes are called business cycles. The goal is to eliminate business cycles and keep the economy growing at full employment.

Money and fiscal policies of the traditional variety are designed to maintain a sufficient level of aggregate demand to buy all of the output that the economy can practicably produce in the short run. They are ill-equipped to deal with supply-side imbalances. Long-run supply-side growth — technical efficiency — requires an improved regulatory environment as well as supply-side policies aimed at improving projected rates of return on capital to encourage investment and on R & D to encourage inovation and technological change.

top    Readings

Interactions Between the Multiplier Analysis and the Principle of Acceleration, Paul A. Samuelson, The Review of Economic Studies, 21 May 1939: 75-78

Expansion and Employment, Evsey Domar, American Economic Review, XXXVII(1) Mar 1947: 34-55

Towards a Dynamic Economics, Roy F. Harrod, Lecture 3, Macmillan, London, 1948

A New Paradigm? Bharat Trehan, Economic Letter (FRBSF), 97(29) 10 Oct 1997

A Dynamic Aggregative Model, James Tobin, The Journal of Political Economy, 63 Apr 1955: 103-15

A Contribution to the Theory of Economic Growth, Robert N. Solow, The Quarterly Journal of Economics, Harvard University Press, Cambridge, MA, 70 Feb 1956: 65-94

Domar and Dynamic Economics, Roy F. Harrod, The Economic Journal, 69 Sep 1959: 451-64

Capital and Growth, John Hicks, Oxford University Press, London, 1965

A New Model of Economic Growth, Nicholas Kaldor and James A. Mirrlees, The Review of Economic Studies, 29 Jun 1962: 174-92

Potential GNP: Its measurement and significance, Arthur M. Okun, Proceedings of the Business and Economics Section of the American Statistical Association, 1962: 98-103. [Reprinted with slight changes in Arthur M Okun, The Political Economy of Prosperity, Brookings Institution, Washington DC.]

Potential GNP: Its Measurement and Significance — A Dissenting Opinion, Charles I. Plosser and G. William Schwert, Carnegie-Rochester Conference Series on Public Policy (supplement to Journal of Monetary Economics), 10, Spring 1979, 179-186

Okun's Law Revisited: Should We Worry About Low Unemployment? David Altig, Terry Fitzgerald, and Peter Rupert, Economic Commentary (FRBClev), 15 May 1997

The Stages of Economic Growth, W.W. Rostow, Cambridge University Press, London, 1968

Chain-weighting: The New Approach to Measuring GDP, Charles Steindel, Current Issues in Economics and Finance (FRBNY), 1(9) Dec 1995

Those Vicious Business Cycles: Tamed But Not Quite Slain, Richard W. Stevenson, New York Times, 2 Jan 1997

Industrial Production and Capacity Utilization: Historical Revision and Recent Developments, Carol Corrado, Charles Gilbert, and Richard Raddock, Federal Reserve Bulletin, Feb 1997

Inventories and the Business Cycle: An Overview, Terry J. Fitzgerald, Economic Review (FRBClev), Vol. 33, No. 3, 3Q97

The Implications of Technological Changes, Alan Greenspan, Charlotte Chamber of Commerce, Charlotte, North Carolina, 10 Jul 1998

Question: Is There A New Economy? Alan Greenspan, The Haas Annual Business Faculty Research Dialogue, University of California, Berkeley, California, 4 Sept 1998

Information Technology and Productivity: Where Are We Now and Where Are We Going? Stephen D. Oliner and Daniel E. Sichel, Finance and Economics Discussion Series (FRSBOG), Jun 2002

CBO's Method for Estimating Potential Output: An Update, Congressional Budget Office, Aug 2001

A Summary of Alternative Methods for Estimating Potential GDP, Congressionbal Budget Office, Mar 2004

top    Websites

Gross Domestic Product, BEA
U.S. Economic Accounts, BEA, historical series
Gross Domestic Product and Components, FRBStL (FRED II), historical series
U.S. Economic Data, FRBDal (Source: BEA), charts and historical series.
Money Income in the United States: 1999, Census Bureau.
Productivity and Costs, BLS, current report
Technical Note, BLS, current report
Handbook of Methods, BLS
Overview of BLS Productivity Statistics, BLS, historical data
Productivity Growth Workshop, FRBStL, 8 Oct 1999
Industrial Production and Capacity Utilization, FRB BOG, current report
Industrial Production and Capacity Utilization, FRB BOG, historical data
Selected Monthly Labor Review Articles: Productivity and Technology, BLS, updated 17 May 2004

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