Business Cycles, Labor Markets, Productivity

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• Business Cycles, Labor Markets, Productivity
• and Long-Term Growth

Loïc Sadoulet (loic.sadoulet_at_insead.edu)
MGE Session 11 Jan Feb 2009
Loic.Sadoulet_at_insead.edu
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Economies are hit by multitude of AD / AS Shocks
Real GDP
time
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Adjustment to shocks

• Response to adverse AS shock
• Short-term prices are sticky
• Slight Inflation and fall in output (stagflation)
• Long-term prices adjust
• Wages fall and economy adjusts back to potential
  GDP.

• Response to positive AD shock
• Short-term prices are sticky
• Slight inflation and increase in output
• Long-term prices adjust
• Wages increase and economy adjusts back to
  potential GDP

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SR Response and LR Adjustment to negative AD shock





Price level


(Inflation)

• Initial point

SRAS
SR

P

P
SR

LR
P
ADCIGNX

LR

Output/income

• 2. SR response
• Slow down in economic activity
• unemployment

(Growth)

Y
Y
FE

SR

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SR Response and LR Adjustment to adverse AS Shock



Price level

(Inflation)

• LR adjustment

SRAS
P
SR

P

ADCIGNX

Output/income

(Growth)
Y
Y

FE

SR

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Adjustment to Negative AD Shock



Price level

Negative AD shock

(Inflation)






SRAS

P
o

P
rec

ADCIGNX
AD
CIGNX

2
Output/income

Y
Y
rec

FE

(Growth)

Short-run reaction
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Adjustment to Negative AD Shock Automatic


Unemployment gt real wages fall

Price level


(Inflation)






SRAS (inputs, productivity)

P
o

P
rec

P
LR

AD
CIGNX

2
Output/income

Y
Y
rec

FE

(Growth)
Long-run reaction

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What influences the speed of adjustment?
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USING FISCAL OR MONETARY POLICY



Price level


(Inflation)






SRAS (inputs, productivity)

P
o

P
rec

P
LR

AD
CIGNX

2
Output/income

Y
Y
rec

FE

(Growth)
Long-run reaction

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Adjustment to Negative Aggregate Demand Shock


Fiscal or Monetary Policy
Automatic Adjustment






Price level

Price level


(Inflation)
(Inflation)





SRAS

SRAS
P
P
o

o

P
P
SR

SR

P
LR

AD

AD

Y
Y
Y
SR

FE

Y
SR

FE

Output/income

Output/income

(Growth)
(Growth)


UE gt real wages fall
Policy intervention to boost AD
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Adjustment to Positive Aggregate Demand Shock


Fiscal or Monetary Policy
Automatic Adjustment





Price level

Price level


(Inflation)
(Inflation)




SRAS

SRAS
P
P
o

o

AD

AD

Y
FE

Y
FE

Output/income

Output/income

(Growth)
(Growth)


Tight labor gt real wages rise
Policy intervention to cool AD
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ADVERSE SUPPLY SHOCKS a difficult problem
Price level

(Inflation)


SRAS
P

ADCIGNX

Output/income

(Growth)
Y

FE

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Adverse Supply shocks a difficult problem


Fiscal or Monetary Policy
Automatic Adjustment






Price level

Price level


(Inflation)
(Inflation)





SRAS

SRAS
P
LR

P
P
SR

SR

P
P
P
o

o

LR

AD

AD
Y
Y
FE

Y
Y
SR

SR

FE

Output/income

Output/income

Policy to boost AD or to fight inflation
(Growth)
(Growth)


UE gt real wages fall
Tradeoff unemployment vs. inflation
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From Short Run to Long Run

• Lengthy adjustment process leads to cycles in
  economic activity.
• Adjustment of sticky prices
• Falls in real wages (rarely cut eroded by
  inflation)
• Conversion of industries after supply shocks
• Role for stabilization policies can come into
  play
• Expansionary Monetary policy or Fiscal policy to
  reduce the length of recessions
• Contractionary Monetary or Fiscal policy to
  cool the economy

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Stabilization policy affects mainly AD!

• Monetary policy and fiscal policy influence the
  economy mainly through their role on aggregate
  demand.
• To the extent that interest rates or government
  spending affect aggregate supply through their
  effect on productivity, aggregate supply shifts
  too.
• Confidence in institutions affects how fast an
  economy will react (e.g. What will happen with
  Bernanke? Trichet?)

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Summary Business Cycles and Labor Markets

• Business cycles are created by shocks (aggregate
  demand or aggregate supply shocks) and propagated
  by rigidities in economies (contracts, menu
  costs)
• Business cycles are short-run phenomena
• In long run, prices (output and factor prices)
  adjust and economy returns to full employment
  level.
• Role for monetary policy and fiscal policy to
  speed up adjustment process
• Length and severity of business cycles depend on
• Price rigidities (flexibility of labor contracts,
  ease of changing prices)
• Convertibility of industries
• Confidence in institutions (to do the right
  thing)

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Macroeconomic performance in the long run (growth)

• Why worry about growth?
• Looking at growth experience
• Assessing growth
• The globalization challenge

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Long-term growth rates
Per capita GDP and growth rates(PPP adjusted,
1990 )
Source "The Conference Board and Groningen
Growth and Development Centre, Total Economy
Database, January 2008, http//www.ggdc.net"


Annual Growth rate
-1.8 0.2 0.2 0.5 0.9 1.2 1.3
1.7 2.7 2.2 2.2 2.3 2.3 2.4
2.4 2.7 2.7 3.3 3.8 3.9 4.2 4.5
4.5 4.6 5.5 5.7


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Differences in growth rates make a real
difference.
Ex Venezuelas GDP per capita in 1960 was
7,500 USD (in 2000 constant dollars). By 2000,
it had fallen to 6 420 USD What if Venezuela had
grown like?
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WHY SUCH LARGE GROWTH DIFFERENCES?
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DISASTER SCENARIOS
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Growth and poverty
Despite the decrease in world poverty rates,
there is one continent where the evolution has
been the opposite Africa where we find 66 of
the world population living under 1/day (in 1970
is was only 11)
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Growth Accounting

• Productivity how much an economy can produce
  with its resources
• Y real output produced in a given period of
  time
• A total factor productivity (TFP) a measure of
  technology
• K capital stock
• L labor (number of workers or number of hours)
• How do economists measure productivity?
• Short answer badly
• Long answer
• Productivity (A) is the residual growth (after L
  and K growth)

a and b estimated
Data on Y, L and K
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Contributions to growth
Real
Real
Real
growth
growth
growth
L/L
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Revisiting Goldman-Sachs BRICs report (2003)

• How did they get thesenumbers?
• Cobb-Douglas production function with a0.3
• Constant investment rate
• Constant depreciation rate of capital stock
• Convergence to US TFP growth of 1.3
• Convergence rate of TFP of b1.5
• Assumption on exchange rates

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Growth Experience
Forecasting 80 Years Ahead
(last technology revolution was in 1850)
Put yourself in 1929. You have data for income
per capita since 1870 and have been asked to
forecast income per capita in the year 2007.
Real GDP PC
log scale slope growth rate
2007
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WHAT HAS GROWTH LOOKED LIKE?
Use the fitted trend to forecast US GDP per
capita in the year 2007
Forecasting 80 Years Ahead
Fit a trend that assumes a constant growth rate
Check how well you did Forecast 35,500.
Actual 36,100. An error of less than 2!!
Real GDP PC
log scale slope growth rate
2006
2007
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DOES THIS MEAN NOTHING MATTERS?
New Economy
Forecasting 80 Years Ahead
World War II
World War I
1981 monetary contraction
Oil Shocks
Industrialization
Railroads
Constant growth (1.85), but based on continuous
effort to innovate, to improve processes, and
bounce back after shocks
Real GDP PC
The Great Depression
The Depression of the 1890s
log scale slope growth rate
2007
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The New Economy

• Evidence that TFP has grown 1995-2000.
• Information (product awareness, description)
• Reduction of transactions costs (speed,
  integrated systems, more efficient links in
  supply chain)
• However
• Mostly concentrated on computer industry and
  telecom (12 of GDP)
• Little effect on rest of economy
• What Intel giveth, Microsoft taketh away
• Most IT investment represents competition for
  market share
• (BN vs. Amazon redistribution of sales, not
  new ones)
• Not sustainable computer power is cheaper, but
  diminishing returns
• Online consumption peak hours during office hours

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New technologies

• Knowledge is key
• Reduces diminishing returns to factors (labor
  saving)
• Non-rival
• New knowledge is complementary to existing
  knowledge
• Adopters can leap-frog to the frontier
• Fewer incumbents with vested interests in old
  technology(e.g. open-hearth furnaces and
  continuous casting in Japan vs. US steel
  industry)
• but less experience with use of old technology
• Problem RD is costly and private returns lt
  social returns

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CHARACTERIZING GROWTH OVER 100 YEARS
35,000 8,000 1,500 600
US
convergence
UK
France
Real GDP PC
Italy
Germany
Japan
log scale
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Convergence of the OECD economies
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IS CONVERGENCE OVER?
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WHY DOES EUROPE LAG BEHIND?BECAUSE OF THE LABOR
MARKET
Total population
Very low female participation (49.5 vs 75.6)
Southern Europe ?60
Working age population
In 1975, all countries were around 70
Labor force
Why is this important? People who work create
demand (recall the circular flow)
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OFF-SHORING WHO SHOULD PAY THE COST?
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BIG QUESTION COMPETITIVENESS!
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Characterizing long-run growth in the OECD

• OECD economies have been converging to similar
  levels of GDP per capita.
• Some countries are further along the process
  while others still have room to converge
• As countries converge to US levels of GDP per
  capita, their growth rates decline. Countries are
  approaching their steady state.
• The steady state might not be the same for all
  countries. For example, a very patient society
  (one that values the future more relative to the
  present) will be willing to invest more than a
  less patient society. As a result, its steady
  state will be higher.
• Countries that stop investing cannot maintain the
  steady state.

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Is there convergence?
Ireland
US
Argentina
Mexico
Chile
Japan
China
Brazil
Korea
India
log scale
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Characterizing long-term growth in the rest of
the worldIs there convergence?
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Are the poor catching up?
The lack of convergence among countries does not
mean that the distribution of income in the world
is becoming more polarized. If we give proper
weight to large countries, there is convergence
on average poor individuals see their incomes
grow faster than those of the rich (but this is
not true for all continents)

• 2.8 b people live on less than 2 a day and 1.2 b
  on less than 1 a day(2/3 of SSA population).
• 8 of every 100 infants die before reaching 5 yrs
  old.
• 9 of every 100 boys and 14 of every 100 girls do
  not attend school.

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What drives growth differences?

• Production is the result of two factors
• Inputs in the production process hours, capital
  (a result of investment in physical, human,
  knowledge)
• Their productivity, which is also driven by
  investment in capital, knowledge, technology.
• Hypothesis Countries that invest more grow
  faster.

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Investment and Growth
The main determinant of growth is accumulation of
capital. Countries with higher investment rates
have outperformed countries with low investment
rates.
or have they?
Korea
Hong Kong
Japan
Spain
Thailand
Italy
Brazil
Canada
USA
France
UK
Kenya
Bolivia
Australia
Mexico
S.Afr.
Argentina
Cameroon
1960-1998
Same picture, whole sample
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Determinants of Economic Growth

• Productivity (technological progress)
• Investment (in physical capital, in education).
• Countries that are more open to international
  trade make more productive investments and import
  new technologies from other countries.
• Also, countries with very high population rates
  have done relatively worse.
• Institutions property rights, absence of
  corruption, good governments, Stability
  (macroeconomic and political)

But what drives investment?
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THE 4 Is OF ECONOMIC GROWTH
or the 5 Is it depends if you consider
International Openness as an Institution or as
separate
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PRIVATE SECTOR AND ECONOMIC GROWTH
Institutions
Ideas / know-how
Initial conditions
Investment in innovation
Demography
Geography
Resources input markets
Private Sector
Market
Infrastructure
InternationalOpenness
Access to returns
Institutions policies
Politics / governance
Culture
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The World Banks Doing Business series(www.
doingbusiness.org)
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THE BIG UNKNOWN WHAT BRINGS SUSTAINABLE GOOD
INSTITUTIONS?
Institutions diminish the cost and risk of doing
business
Being able to create AND capture value

• a virtuous/vicious cycle
• Four tenants of good institutional environment
• Rule of Law
• Property rights
• Transparency and quality of bureaucracy
• Stability (political and macro)

Institutions
Investment
Growth
?
What drives institutions?
? DO COMPANIES HAVE A ROLE TO PLAY?
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Institutions
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Summary the Search for Growth
Next time Exchange rates

• Why care about growth? Firm strategy in global
  market
• Size of market (local or international pricing?),
  income, productivity
• Circular flow more growth creates more income
  creates more demand
• What influences growth? (The 4 Is of Growth)
• Initial conditions resources, market size,
  access to markets
• Infrastructure physical, telecom, legal,
  financial (reduces transactions costs)
• Investment in innovation sustaining competitive
  advantage
• Institutions and policies laws, rules and
  regulation (property rights, rule of law, ), and
  policies (macro and micro) reduce the cost and
  risk of doing business (including
  internationalization openness to foreign
  capital, ideas, products, and markets)
• Beware of industrial policies
• Government tend to be poor at choosing winners
• but can serve as an important coordination
  mechanism (externalities)
• The globalization challenges what is the role of
  companies? How to communicate to shareholders?
• Rising trade and investment, but low wage
  competition plays a secondary role to
  technological change. However, how do we
  compensate losers?
• Economic development
• Changing business models and processes to enter
  new markets
• How to get institutions conducive to growth? What
  is the role of the private sector?