Economics I Economic Growth and Business Cycle Theory

Economics I Economic Growth and Business Cycle Theory (4 h)

Economic Growth. Business Cycle Theory (4 h) • The aim of the first lecture is to analyze the long-term productive capacity of the economy, or to explore factors for economic growth (the growth of potential output). We focus on the resources (factors) of economic growth. Various models of economic growth within various economic streams will be outlined. The barriers of economic growth will be discussed and also sustainable development concept and pro-growth state policies will be defined. • The goal of second lecture is to characterize the economic cycle, which is an integral part of the economic development of the national economy and in the economic theory known as one of the fundamental macroeconomic instabilities. The lecture will reflect the substance of the mechanism of the business cycle, lighting effects of the economic cycle on the economy, the tools of macroeconomic policy aiming to reduce fluctuations in economic activity and at last the question of the possibility of predicting economic cycles will be answered.

Content • introduction – defining the goals • definition of economic growth • resources (factors) of economic growth • economic growth and price stability (instability) • models of economic growth • constraints – economic growth barriers • pro-growth macroeconomic policy • definition of the business cycle and its characteristics • mechanism of the business cycle • the effects of business cycles and countercyclical economic policy • conjunctural indicators • conclusion – summary, homework

Definition of economic growth • GDP growth vs. economic growth, i. e. growth of potential output (the ability of the economy to produce more output, PPF curve shifts to the right). • the growth rate of real GDP (GYt) and the growth rate of real GDP (g. Yt) • the growth rate of nominal GDP (GYNt) – roughly the sum of the growth rate of real output and the rate of growth of the price level (inflation rate). • economic power, living standard and economic development. • HDI = Human Development Index – United Nations Development Programme – Development Programme of the United Nations Organisation, http: //hdr. undp. org/en/statistics/

Resources (factors) of economic growth • the production functions Q = (amount of inputs, the quality of inputs, level of technology), it determines the production possibilities of the economy • there are two types of sources of economic growth: – extensive (quantitative) sources of economic growth → extensive economic growth – intensive (qualitative) sources of economic growth → intensive economic growth • in real economy there is mostly a combination of extensive and intensive economic growth; it depends on which sources of economic growth prevail

Economic growth and price stability (instability) • ideal conditions: potential output growth in terms of price stability (enshrined in the Act on the Czech National Bank) • price stability is not an accompanying effect of economic growth • in terms of economic growth, the price level can increase, decrease, or may remain constant • the new real product can fluctuate around the potential output in the short term

Economic growth in terms of price stability - ideal for the economy P LRAS 1 LRAS 2 SRAS 1 E 1 SRAS 2 But the price stability is not a phenomenon that economic growth would (always) accompanied. E 2 P AD 2 AD 1 Y 1* Y 2* Y 7

Economic growth where aggregate supply is dropping behind aggregate demand P LRAS 1 LRAS 2 The effect here is higher price level and lower output in comparison with potential output Y 2*. SRAS 1 SRAS 2 E 2 P 1 AD 2 E 1 AD 1 Y 1* Y a Y 2* Y 8

Economic growth where aggregate demand is dropping behind aggregate supply P LRAS 1 LRAS 2 SRAS 1 P 2 E 1 SRAS 2 E 2 AD 1 Y 1* Y a Y 2* The effect here is lower price level and lower output in comparison with potential output Y 2*. AD 2 Y 9

Models of economic growth • classic “models”: T. R. Malthus, D. Ricardo • Keynesian models – New Keynesian models: R. F. Harrod, E. D. Domar - the first growth models – Postkeynesianism (N. Kaldor, J. Robinson) - theory of income distribution • Neoclassical models (theory of exogenous and endogenous growth theory) - use the production function, growth accounting • The School of growth limits – it emphasis on limited resources, there is a respect for the environment, new variable called sustainable economic development

Constraints – economic growth barriers • the vicious circle of poverty: low income → low level of savings → insufficient supply of capital goods → low capital-labor ratio (K/L) → low income and back to the beginning • demographic trends – population explosion • capital outflow “brain outflow” = escape of skilled workforce • lack of political, legal and other institutional conditions • inadequate infrastructure • lack of natural resources, adverse weather conditions, natural disasters, wars.

Pro-growth macroeconomic policy • stimulating the creation of new creative ideas, proposals on innovation, both, in the private and government sector (endogenous growth theory) • tax incentives for expenditures on research and development of new technologies • encouraging investment in human capital • reducing budget deficits that displace private investment, promotion of investment tax incentives • removing unnecessary regulation of economic processes • investment in infrastructure

Definition of the business cycle and its characteristics • business cycle = fluctuations in the actual product around the potential product (we use the product adjusted for inflation – i. e. real product) • there are two basic tendencies (phases) of the business cycle: contraction and expansion (in some literature recession and expansion) • turning points: peaks and throughs • one business cycle and the cycle period • three basic types of cycles (per period): • • • short term Kitchins ´ cycles medium term Juglars´ cycles long term Kondratěvs´ cycles, Kuznets´cycles

The economic cycle GAP Y a, boom contraction Y* peak expansion trend, Y* Ya through recovery t (time) 14

Mechanism of the business cycle • • • Economists only agree that there are shifts of SRAS and AD different causes of economic activity changes → different theories of the business cycle, different interpretation of certain terms theory of business cycle: – – – – Keynesian theory Neokeynesian theory (principles of multiplier and accelerator) theory of Monetarism theory of School of Rational Expectations (New Classical Macroeconomics) theory of economic-political cycle innovation theory real business cycle theory other alternative theories

The link between movements in the economy and the unemployment rate • Arthur M. Okun (1928 - 1980): examined the relationship between fluctuations in real output and the unemployment rate in the US economy • Okun's Law: u = u * - σ [100. (Y - Y *) /Y *] σ = coefficient of sensitivity changes in the unemployment rate to change the coefficients of the product „One of the most credible empirical regularities of macroeconomics“. (cited by J. Tobin) 16

Classical recession P LRAS SRAS Drop in AD Y P P´ E´ Λ P E AD AD´ Y´ Y* Y 17

Slumpflation P LRAS SRAS´ SRAS Drop in SRAS E´ P´ P Y Λ P E AD Y´ Y* Y 18

Stagflation: output stagnation + inflation P LRAS SRAS´ SRAS P´ E´ P E Y* Rise in AD and drop in SRAS. Yr const. Λ AD´ AD P Stagflation can occur even if the output is lower than the potential. Y 19

Keynesian interpretation of the business cycle - multiplier principle and the principle of the accelerator • multiplier principle: ΔY = α. ΔI increase in investment → increase in output (income) α = investment multiplier • principle of the accelerator: Ii = a. ΔY increase in output (income) → increase in investment a = accelerator coefficient Ii = induced investment, induced by the increasing output Both, multiplier and accelerator, act in the same direction, the upper limit is the potential output and the lower limit represents replacement investment. 20

The effects of business cycles and countercyclical economic policy • the effects of business cycles: I. economic II. social III. political • activist Keynesian macroeconomic policy vs. macroeconomic policy of conservatism (conserv. - the effort to strengthen the ability of market selfregulation, not to support the growth of AD) 21

Conjunctural indicators • there is trying to predict the phase of the business cycle (but the future is always uncertain) • we distinguish the following types of business cycle indicators: – leading (eg. numbers of contracts for investment) – concurrent (eg. real GDP) – delayed (eg. wage levels) 22

Literature • FRANK, R. H. , BERNANKE, B. S. Principles of Macroeconomics. 3 rd Edition. Mc. Graw. Hill/Irwin: NY, 2007. ISBN 978 -0 -07 -319397 -7. 561 p. • MANKIW, G. N. Principles of Macroeconomics. 4 th ed. USA: Thomson South. Western, 2007. 583 p. ISBN 978 -0 -324 -23695 -8. • Mc. CONNELL, C. R. , BRUE, S. L. Economics: Principles, Problems, and Policies. 17 th ed. NY: Mc. Graw/Irwin. 716 p. ISBN 978 -0 -07 -312663 -0. • SAMUELSON, P. A. , NORDHAUS, W. D. Economics. 15 th ed. Mc. Graw-Hill, 1995.

Internet sources • Czech Statistical Office. Statistics. Macroeconomic data. Available at: WWW: http: //www. czso. cz. • Ministry of Finance of the Czech Republic. Menu – Public Sector. Macroeconomic prediction. Available at: WWW: http: //www. mfcr. cz.

Homework Exercise “Economic Growth” • The share of employment in manufacturing on total employment was decreasing from 30 % to 16 % between the years 1950 – 2000. However, production in industry grew at a healthy pace, higher than the total production. What can say on the basis of these facts about labor productivity in manufacturing? Was the decline in the share of industrial employment on total employment worrisome? • Assume the share of capital cost on the product of 0. 2 and the share of labor costs on the product 0. 8. Capital is growing by 10% rate and labor supply decreases by 4% rate. What rate does the potential product increase (decrease)? Consider the absence of technological progress.

Homework Exercise “Business Cycle Theory” • Assume the natural rate of unemployment in an economy of 5 %. When the size of the real product is 200 billion, the real unemployment rate rises up to 10 %. On the basis of these data, calculate the estimated amount of potential output. • Draw the growth rate development of real GDP of the Czech Republic from 1996 to the present. Use data from the Czech Statistical Office and read the text about the economic cycle on web pages of the Czech Ministry of Finance: http: //www. czso. cz (menu Statistics - Macroeconomic data); http: //www. mfcr. cz - Macroeconomic Forecast file (economic cycle).