Lecture II Evolution of Lecture II Evolution of Macroeconomics: Macroeconomics:

From Classicists to KeynesFrom Classicists to Keynes

Stephen Silver, Ph.D.Stephen Silver, Ph.D.

The CitadelThe Citadel

Shandong University, November Shandong University, November 20102010

The macro economy and its The macro economy and its performanceperformance

Before there was a Keynes, there was Before there was a Keynes, there was an economicsan economics

And it was goodAnd it was good

And it was found useful for explaining And it was found useful for explaining economic fluctuationseconomic fluctuations

And then a Great Depression fell upon And then a Great Depression fell upon the Land, and economics was at a loss the Land, and economics was at a loss to explain the events that befell the to explain the events that befell the LandLand

Natural Log of Industrial Natural Log of Industrial Production: Production:

United States, 1790 - 2009United States, 1790 - 2009

y = 0.0427x + 1.7867

0

2

4

6

8

10

12

Year

Ln

(IP

)

Industrial Production with Industrial Production with polynomial trendlinepolynomial trendline

Natural Log of Industrial Production: 1790-2009

y = 0.0448x + 1.6877

y = 3E-09x4 - 2E-06x3 + 0.0002x2 + 0.0409x + 1.4245

0

2

4

6

8

10

12

17901800

18101820

18301840

18501860

18701880

18901900

19101919

19291939

19491959

19691979

19891999

2009

Year

Ln

(IP

)

Ln(IP)

Linear (Ln(IP))

Poly. (Ln(IP))

Why look at Ln(IP)?Why look at Ln(IP)?• We use IP as it is available monthly and for much We use IP as it is available monthly and for much

longer period than GDP, which also is now published longer period than GDP, which also is now published quarterly and only since 1929 quarterly and only since 1929

• If YIf Ytt = Y = Y00*e*ertrt, then ln(Y, then ln(Ytt) = A + rt, where A = ln(Y) = A + rt, where A = ln(Y00); );

• so ln(Yso ln(Ytt) is linear in t and e) is linear in t and eAA approximates Y approximates Y00

• Thus the slope of the ln(Y) is the annual rate of Thus the slope of the ln(Y) is the annual rate of change of the serieschange of the series

• Furthermore, r = [ln(YFurthermore, r = [ln(Ynn) - ln(Y) - ln(Y00)]/n)]/n

Stylized Facts of US GrowthStylized Facts of US Growth• Growth of industrial production in the U. S. averaged Growth of industrial production in the U. S. averaged

4.3% from 1790 to 2009 (the slope over that period)4.3% from 1790 to 2009 (the slope over that period)• The growth rate of industrial production has slowed The growth rate of industrial production has slowed

considerablyconsiderably– As seen on the graph, the ln(IP) has begun to flatten As seen on the graph, the ln(IP) has begun to flatten

outout– The last several years, U. S. industrial production The last several years, U. S. industrial production

has leveled off significantly.has leveled off significantly.– And as manufacturing unemployment has become And as manufacturing unemployment has become

very important in the political arena as well, the very important in the political arena as well, the series has added importance beyond its relative series has added importance beyond its relative importance in US GDPimportance in US GDP

– For China, which has come to symbolize the source For China, which has come to symbolize the source of our manufacturing job losses, this perception in of our manufacturing job losses, this perception in the US is very importantthe US is very important

U.S. Gross Domestic Procduct; U.S. Gross Domestic Procduct; 1960-20091960-2009

U.S. GDP; 1960-2009

y = 0.0279x + 9.5917

9

10

11

1960

1970

1980

1990

2000

Year

LN

(Re

al G

DP

)

US GDP: 1960-2009

Linear (US GDP: 1960-2009)

• GDP growth has slowed over the past GDP growth has slowed over the past five decades to under 3%five decades to under 3%

• And very recently, real GDP actually And very recently, real GDP actually declined as the financial crisis recession declined as the financial crisis recession deepeneddeepened

• This has led to a great deal of This has led to a great deal of dissatisfaction with Washington and with dissatisfaction with Washington and with those trading partners that are those trading partners that are perceived to be the “cause” of U. S. perceived to be the “cause” of U. S. economic woeseconomic woes

• Many have resorted to such tactics as Many have resorted to such tactics as “China bashing”“China bashing”

Historical world growth trendsHistorical world growth trends

Year 0 1000 1820 1998 0-1000 1000-1820 1820-1998Regions

Western Europe 450 400 1232 17921 -0.01% 0.14% 1.50%Western Off-shoots 400 400 1201 26146 0.00% 0.13% 1.73%Japan 400 425 669 20413 0.01% 0.06% 1.92%

Group A 443 405 1130 21470 -0.01% 0.13% 1.65%

Latin America 400 400 665 5798 0.00% 0.06% 1.22%Eastern Europe & CIS 400 400 667 4354 0.00% 0.06% 1.05%Asia 450 450 575 2936 0.00% 0.03% 0.92%Africa 125 416 418 1368 0.12% 0.00% 0.67%

Group B 444 440 573 3102 0.00% 0.03% 0.95%

World 444 435 667 5709 0.00% 0.05% 1.21%

Level and Rate of Growth of GDP per capita; world and major regions, 0-1998 ADGDP per capita GDP per capita growth rates

Based on the work of Angus Maddison, The World Economy in Millenial Perspective (2001)

Comparative GrowthsComparative Growths

Per Capita Growth for High and Low Growth Countries

0

5000

10000

15000

20000

25000

0 1000 1820 1998

Group A

Group B

World

Growth graphs for five ratesGrowth graphs for five rates

DIfferential Growth Rates over 50 Years

0

2

4

6

8

10

12

1 6 11 16 21 26 31 36 41 46

Time

Val

ue

0.50%1%2%3%5%

Rule of 70 (69.3 really)Rule of 70 (69.3 really)

Let Y = YLet Y = Y00 * e * ertrt; if Y; if Y

00 = 1 and Y = 1 and Ytt= 2, we get= 2, we get

ln[Yln[Ytt/Y/Y00] = ln(Y] = ln(Y

tt – ln(Y – ln(Y00))= ln(2) = .693))= ln(2) = .693

Thus, the annual rate r = [ln(YThus, the annual rate r = [ln(Ytt– ln(Y– ln(Y

00))/t = .693/t,))/t = .693/t,

so rt = .693t If r is expressed in percent, so rt = .693t If r is expressed in percent,

then 100rt = 69.3 or about 70then 100rt = 69.3 or about 70

Example 1: A bond pays me 5% for 20 years. How long Example 1: A bond pays me 5% for 20 years. How long

will it take to double my money? Since 70/5 = 14, will it take to double my money? Since 70/5 = 14,

so 14 yearsso 14 years

Example 2: What rate will I need to double my money in Example 2: What rate will I need to double my money in

10 years? 70/10 = 7, so 7%.10 years? 70/10 = 7, so 7%.

Rule of 70 applied to our growth Rule of 70 applied to our growth ratesratesSo what’s the difference between 1% and 5% So what’s the difference between 1% and 5%

growth over the 50 years?growth over the 50 years?

Since 5% doubles every 14 years, after 42 Since 5% doubles every 14 years, after 42 years it will have doubled three times and years it will have doubled three times and we have another 8 years of 5% growth, so we have another 8 years of 5% growth, so it’s clearly over 10it’s clearly over 10

The 1% growth path requires 70 years to The 1% growth path requires 70 years to double, so it’s not there yet, so the 5% double, so it’s not there yet, so the 5% growth path is well over 10/2 = 5 times as growth path is well over 10/2 = 5 times as bigbig

In fact, eIn fact, e.05*50.05*50/(e/(e.01*50.01*50) = e) = e2.52.5/e/e.5.5 = e = e(2.5-.5)(2.5-.5) = e = e22 = = 7.3897.389

How long until How long until 中国 中国 GDP > GDP > 美国美国的？的？

• Right now percapita GDP in US is about Right now percapita GDP in US is about US$50,000 US$50,000

• China per capita GDP is maybe US$5000China per capita GDP is maybe US$5000• With 4 times the population, therefore, US-With 4 times the population, therefore, US-

GDP/China-GDP is about 2.5GDP/China-GDP is about 2.5• Letting China’s GDP grow at 8% and the Letting China’s GDP grow at 8% and the

US at 3%, on average, China closes the US at 3%, on average, China closes the gap by 5% per year. Since it must more gap by 5% per year. Since it must more than double, it will take 70/5 = 14 years or than double, it will take 70/5 = 14 years or moremore

• Let’s say by the year 2025Let’s say by the year 2025

How long until How long until 中国 中国 GDP per capita > GDP per capita > 美国美国的？的？

• Never! Why?Never! Why?

• Some people back in the 1970’s were Some people back in the 1970’s were even predicting that Japanese GDP even predicting that Japanese GDP would overtake the US GDPwould overtake the US GDP

• But on a PPP basis even the per But on a PPP basis even the per capita GDP of Japan remains below capita GDP of Japan remains below that of the US. Why?that of the US. Why?

Factors of productionFactors of production

• A country with limited resources, A country with limited resources, even with a highly-skilled labor force, even with a highly-skilled labor force, will have a very difficult time passing will have a very difficult time passing the US, which is relatively under-the US, which is relatively under-populated; that is, with much more populated; that is, with much more resources per personresources per person

• So let’s look at a nation’s “aggregate So let’s look at a nation’s “aggregate production function”production function”

Aggregate Production Functions for U.S. and China

0

20

40

60

80

100

120

0 0.2 0.38 0.56 0.72 0.88 1.02 1.16 1.28 1.4 1.5 1.6 1.68 1.76 1.82L

Q

Y = AF(K,L) China

Y = AF(K,L) U.S.

YChina

Y U.S.

Cobb-Douglas Production Cobb-Douglas Production FunctionFunction

The Cobb-Douglas ProductionFunction is Y = f(L,K) The Cobb-Douglas ProductionFunction is Y = f(L,K) = AL= ALbbKKcc

If we think of K as representing all other inputs to If we think of K as representing all other inputs to production, then doubling all inputs will necessarily production, then doubling all inputs will necessarily double outputdouble outputThus, we can use the following constant returns to Thus, we can use the following constant returns to scale (CRS) function Y = f(L,K) = ALscale (CRS) function Y = f(L,K) = ALbbKK1-b1-b

Note that if we substitute 2K and 2L for K and L we Note that if we substitute 2K and 2L for K and L we get Y = A(2L)get Y = A(2L)bb(2K)(2K)1-b1-b = AL = ALbbKK1-b1-b*2*2b+(1-b)b+(1-b) = 2AL = 2ALbbKK1-b1-b

In Per Capita TermsIn Per Capita Terms

Now Y/L = ALNow Y/L = ALb-1b-1KK1-b1-b = A(K/L) = A(K/L)1-b1-b = g(K/L) = g(K/L)

So if K/L in a country is much less than in another country, So if K/L in a country is much less than in another country, then A, which is commonly referred to as total factor then A, which is commonly referred to as total factor productivity, must be much greater in the resource poor productivity, must be much greater in the resource poor countrycountry

We can now plot against K/L or as is often done, we take K as We can now plot against K/L or as is often done, we take K as given and plot Y against Lgiven and plot Y against L

This is how we got the plot we showed earlier; the reason This is how we got the plot we showed earlier; the reason China’s PF lies below that of the U.S. is that with less other China’s PF lies below that of the U.S. is that with less other factors per worker, each worker will be less productivefactors per worker, each worker will be less productive

The derived demand for The derived demand for laborlabor• In the function Y = g(L),the Marginal product In the function Y = g(L),the Marginal product

of labor MPL = dY/dL is the slope of the PFof labor MPL = dY/dL is the slope of the PF

• The marginal cost of labor MCL, in real The marginal cost of labor MCL, in real terms, is W/P, where W is the “wage rate” terms, is W/P, where W is the “wage rate” and P is the price leveland P is the price level

• So long as MPL > MCL the economy should So long as MPL > MCL the economy should hire more labor and stop at the point MPL = hire more labor and stop at the point MPL = W/P; thus the demand for labor is the slope W/P; thus the demand for labor is the slope of the aggregate production functionof the aggregate production function

Aggregate Production Function

0

0.2

0.4

0.6

0.8

1

1.2

1.4

1.6

1.8

2

L2 L1 L

Q

Y* = A*F(K,L)

Y = AF(K,L)

Q2

Q1

Qf

Demand for Labor Curves

0

0.5

1

1.5

2

2.5

L2 L1 L

MP

L =

W/P

DL1 = MP1DL2 = MP2

(W/P)1

(W/P)

(W/P)2

Walras and ParetoWalras and Pareto

• The Swiss economist Leon Walras showed The Swiss economist Leon Walras showed that general equilibrium will occur in all that general equilibrium will occur in all markets simultaneously at their equilibrium markets simultaneously at their equilibrium prices and quantities as market forces bid up prices and quantities as market forces bid up or down prices in response to excess demand or down prices in response to excess demand and supply conditions in those marketsand supply conditions in those markets

• The Italian economist Wilfredo Pareto also The Italian economist Wilfredo Pareto also showed that in general equilibrium, no showed that in general equilibrium, no individual in the market can be made better individual in the market can be made better off without necessarily making someone else off without necessarily making someone else worse offworse off

• This is called Pareto optimalityThis is called Pareto optimality

Aggregate versus microAggregate versus micro• The APF in the classical model is just the The APF in the classical model is just the

summing up of all the markets, and it was summing up of all the markets, and it was assumed that is all markets are at assumed that is all markets are at equilibrium, where MPL = MCL, that that the equilibrium, where MPL = MCL, that that the APF will look just like the individual market APF will look just like the individual market functionsfunctions

• It was Samuelson that showed in It was Samuelson that showed in Foundations of Economic AnalysisFoundations of Economic Analysis that this that this is not necessarily the caseis not necessarily the case

• This struck a hole in the case laid by the This struck a hole in the case laid by the classical economists and paved the way for classical economists and paved the way for Keynes, who had assumed that not all Keynes, who had assumed that not all markets would clear at a point where MR = markets would clear at a point where MR = MC; in particular, there could be less than MC; in particular, there could be less than full employment equilibriumfull employment equilibrium

Features of the Great Features of the Great DepressionDepression• Started at the end of 1929 – we just passed the Started at the end of 1929 – we just passed the

8181stst anniversary of the beginning of the most anniversary of the beginning of the most severe economic crisis in Western history. severe economic crisis in Western history.

• Lasted an entire decadeLasted an entire decade• At its worst more than 25% of the U. S. population At its worst more than 25% of the U. S. population

(with similar numbers throughout Europe) was (with similar numbers throughout Europe) was measured as unemployedmeasured as unemployed

• Counting the underemployed and discouraged Counting the underemployed and discouraged workers, it was perhaps more like 50%workers, it was perhaps more like 50%

• Prices fell 30% between the end of 1929 and 1932Prices fell 30% between the end of 1929 and 1932• Industrial production fell over 60% from its peak Industrial production fell over 60% from its peak

in 1929in 1929• The Dow Jones Industrial Average had lost 90% of The Dow Jones Industrial Average had lost 90% of

its value by 1932its value by 1932

U. S. Industrial Production: Natural Logs, 1919-1959

y = 0.0036x + 0.6755

00.5

11.5

22.5

33.5

Month

IP

Stock Market Dow-Jones Industrial Stock Market Dow-Jones Industrial Avg.Avg.

Official Unemployment Rates: Official Unemployment Rates: Great Depression and TodayGreat Depression and Today

Following are scenes typical of the Following are scenes typical of the Depression in the United StatesDepression in the United States

““Soup Line”Soup Line”

Broken Down on the way to Broken Down on the way to CaliforniaCalifornia

““Shanty”Shanty”

““Will work for food”Will work for food”

““Don’t Stop Here”Don’t Stop Here”

““Dust Bowl”Dust Bowl”

““Job Opening – one position Job Opening – one position only”only”

John Maynard KeynesJohn Maynard Keynes• As we saw, Keynesian economics is based on the As we saw, Keynesian economics is based on the

idea that monetary policy may be useless in idea that monetary policy may be useless in creating jobs and increasing outputcreating jobs and increasing output

• Fiscal policy was able to generate output directly Fiscal policy was able to generate output directly via government purchases of goods and servicesvia government purchases of goods and services

• Through the multiplier effect, this additional Through the multiplier effect, this additional demand and increased income increases consumer demand and increased income increases consumer demand further, thus generating still more outputdemand further, thus generating still more output

• Keynes’ Law – Demand creates its own supply – Keynes’ Law – Demand creates its own supply – versus Says’ Law – Supply creates its own demandversus Says’ Law – Supply creates its own demand

Key features and deficiencies Key features and deficiencies of Keynesian Theoryof Keynesian Theory• Keynes’ general theory based on the principal that full-Keynes’ general theory based on the principal that full-

employment equilibrium is a polar case of a more general employment equilibrium is a polar case of a more general macroeconomics in which any employment level is possiblemacroeconomics in which any employment level is possible

• Naming may have been influenced by Einstein’s general Naming may have been influenced by Einstein’s general theory of relativity of which was a more general form of the theory of relativity of which was a more general form of the specific theory most people were familiar withspecific theory most people were familiar with

• His analysis was based on the influence of expectations His analysis was based on the influence of expectations over “animal spirits” that convinced entrepreneurs to over “animal spirits” that convinced entrepreneurs to invest; such expectations cannot be considered “irrational” invest; such expectations cannot be considered “irrational” when the economy is experiencing “debt deflation”, the when the economy is experiencing “debt deflation”, the term used by Irving Fisher to describe a financial crisisterm used by Irving Fisher to describe a financial crisis

• At the same time, some aspects of the model are deficient; At the same time, some aspects of the model are deficient; these deficiencies include:these deficiencies include:

DeficienciesDeficiencies

- Not accounting for disincentives created Not accounting for disincentives created by government “giveaway” programsby government “giveaway” programs

- Not accounting for disincentives to Not accounting for disincentives to productivity of income taxationproductivity of income taxation

- Assumption that the government will act Assumption that the government will act both wisely and benevolently in its actionsboth wisely and benevolently in its actions

- Ignores both the Ricardian Equivalence Ignores both the Ricardian Equivalence theorem, which points out that individuals theorem, which points out that individuals may save more today to pay for future tax may save more today to pay for future tax liabilities, and the monetarists’ “crowding liabilities, and the monetarists’ “crowding out” effect.out” effect.

Paul Solman Interviews Two Paul Solman Interviews Two Keynesian Authorities: Robert Keynesian Authorities: Robert Skidelsky and Russ RobertsSkidelsky and Russ Roberts

http://www.youtube.com/watch?v=vwsjPZgBOhttp://www.youtube.com/watch?v=vwsjPZgBOdUdU