(Short-Answer and Algebraic Questions): (The numbers in square brackets give the breakdown of the points for various parts of each question. please explain your answers.)

1. This questions is based on the article, "The pandemic could give way to an era of rapid productivity growth," published by The Economist on December 8, 2020. The article discusses the prospects of long-term economic growth after the COVID-19 pandemic subsides.

According to the article, some experts on productivity trends seem to be pessimistic about the prospects of productivity growth in the coming years, especially in the wake of the current pandemic. What is the basis of such pessimism? Discuss what the article says about the two main groupings of arguments and evidence offered by the pessimists.

a.According to the article, some experts on productivity trends seem to be pessimistic about the prospects of productivity growth in the coming years, especially in the wake of the current pandemic. What is the basis of such pessimism? Discuss what the article says about the two main groupings of arguments and evidence offered by the pessimists.

b. The article claims that "productivity is the magic elixir of economic growth". What does this statement mean? Based on what you have learned in this course and from the article, what would happen to per capita GDP growth in the long run if labor and capital increase, but there is no technological progress? Why? Please explain your answer.

c. The data presented in the article suggests that productivity growth in developed countries has declined after the global financial crisis of 2008-2009 compared to the 1990s and the first half of 2000s. As the article points out, a major "question is why new technologies like improved robotics, cloud computing and artificial intelligence have not prompted more investment and higher productivity growth." The article examines three hypotheses that contend to explain this puzzle. What is the first hypothesis noted in the article? How plausible is this hypothesis in explaining the decline in productivity despite the advent of new technologies?

d. What is the second hypothesis mentioned by the article as a potential explanation for productivity slow down despite the new technologies? How plausible is this hypothesis?

e. What is the third hypothesis mentioned by the article as a potential explanation for productivity slow down despite the new technologies? How plausible is this hypothesis?

f. The article claims that the pandemic in 2020 has quickened the pace of technology adoption and may bring about a period of rapid productivity growth. What is the evidence behind the claim that the exigencies of hard times may create opportunities for rapid change in later years? What examples of such a phenomenon are mentioned? How may the process work? What roles can governments play in ensuring that the potential productivity is realized?

g .Currently the U.S. economy is operating below its production capacity and the Fed has pledged to continue an expansionary monetary policy until the economy reaches its production capacity. Consider two scenarios about the productivity trends in the US economy in the next several years: (1) Continuation of productivity trend observed in the past decade (2010s); or (2) An enhanced productivity growth compared to the 2010s, as argued in the article. If the Fed maintains its current pledge and policy, under which of the two scenarios will it start tightening monetary policy earlier? Why?

Article

economics

Dec 10th 2020edition

Reasons to be cheerful

The pandemic could give way to an era of rapid productivity growth

Businesses have adopted new processes and technologiesand there are signs that they may pay off

T

he prospectsfor a productivity resurgence may seem grim. After all, the past decade has featured plenty of technological fatalism: in 2013 Peter Thiel, a venture capitalist, mused of the technological advances of the moment that "we wanted flying cars, instead we got 140 characters". Robert Gordon of Northwestern University has echoed this sentiment, speculating that humanity might never again invent something so transformative as the flush toilet. Throughout the decade, data largely supported the views of the pessimists.

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What is more, some studies of past pandemics and analyses of the economic effects of this one suggest that covid-19 might make the productivity performance worse. According to research by the World Bank, countries struck by pandemic outbreaks in the 21st century (not including covid) experienced a marked decline in labour productivity of 9% after three years relative to unaffected countries.

And yet, stranger things have happened. The brutal years of the 1930s were followed by the most extraordinary economic boom in history. A generation ago economists had nearly abandoned hope of ever matching the post-war performance when a computer-powered productivity explosion took place. And today there are tantalising hints that the economic and social traumas of the first two decades of this century may soon give way to a new period of economic dynamism.

Productivity is the magic elixir of economic growth. Increases in the size of the labour force or the stock of capital can raise output, but the effect of such contributions diminishes unless better ways are found to make use of those resources. Productivity growthwringing more output from available resourcesis the ultimate source of long-run increases in incomes. It's not everything, as Paul Krugman, a Nobel economics laureate, once noted, but in the long run it's almost everything.

Economists know less about how to boost productivity than they would like, however. Increases in labour productivity (that is, more output per worker per hour) seem to follow improvements in educational levels, increases in investment (which raise the level of capital per worker), and adoption of new innovations. A rise in total factor productivityor the efficiency with which an economy uses its productive inputsmay require the discovery of new ways of producing goods and services, or the reallocation of scarce resources from low-productivity firms and places to high-productivity ones.

Globally, productivity growth decelerated sharply in the 1970s from scorchingly high rates in the post-war decades. A burst of higher productivity growth in the rich world, led by America, unfolded from the mid-1990s into the early 2000s. Emerging markets, too, enjoyed rapid productivity growth in the decade prior to the global financial crisis, powered by high levels of investment and an expansion of trade which brought more sophisticated techniques and technologies to the developing-economy participants in global supply chains. Since the crisis, however, a broad-based and stubbornly persistent slowdown in productivity growth has set in (see chart 1). About 70% of the world's economies have been affected, according to the World Bank.

Accounting for the slowdown is a fraught process. The World Bank reckons that slowing trade growth and fewer opportunities to adopt and adapt new technology from richer countries may have helped depress productivity advances in the emerging world. Across all economies, sluggish investment in the aftermath of the global financial crisis looks a culprit: a particular problem in places with ageing and shrinking workforces. Yet while these headwinds surely matter, the bigger question is why new technologies like improved robotics, cloud computing and artificial intelligence have not prompted more investment and higher productivity growth.

Broadly speaking, three hypotheses compete to explain these doldrums. One, voiced by the techno-pessimists, insists that for all the enthusiasm about world-changing technologies, recent innovations are simply not as transformative as the optimists insist. Though it is possible that this will turn out to be correct, continued technological progress makes it look ever less plausible as an explanation for the doldrums.aimay not have transformed the world economy at the dramatically disruptive pace some expected five to ten years ago, but it has become significantly, and in some cases startlingly, more capable.gpt-3, a language-prediction model developed by Openai, a research firm, has demonstrated a remarkable ability to carry on conversations, draft long texts and write code in surprisingly human-like fashion.

Though the potential of the web to support an economy in which the constraints of distance do not bind has long underwhelmed, cloud computing and video-conferencing proved their economic worth over the past year, enabling vast amounts of productive activity to continue with scarcely an interruption despite the shuttering of many offices. New technologies are clearly able to do more than has generally been asked of them in recent years.

That strengthens the case for a second explanation for slow productivity growth: chronically weak demand. In this view, expressed most vociferously by Larry Summers of Harvard University, governments' inability to stoke enough spending constrains investment and growth. More public investment is needed to unlock the economy's potential. Chronically low rates of interest and inflation, limp private investment and lacklustre wage growth since the turn of the millennium clearly indicate that demand has been inadequate for most of the past two decades. Whether this meaningfully undercuts productivity growth is difficult to say. But in the years before the pandemic, as unemployment fell and wage growth ticked up, American labour productivity growth appeared to be accelerating, from an annual increase of just 0.3% in 2016 to a rise of 1.7% in 2019: the fastest pace of growth since 2010.

But a third explanation provides the strongest case for optimism: it takes time to work out how to use new technologies effectively.aiis an example of what economists call a "general-purpose technology", like electricity, which has the potential to boost productivity across many industries. But making best use of such technologies takes time and experimentation. This accumulation of know-how is really an investment in "intangible capital".

Recent work by Erik Brynjolfsson and Daniel Rock, ofmit, and Chad Syverson, of the University of Chicago, argues that this pattern leads to a phenomenon they call the "productivity J-curve". As new technologies are first adopted, firms shift resources towards investment in intangibles: developing new business processes. This shift in resources means that firm output suffers in a way that cannot be fully explained by shifts in the measured use of labour and tangible capital, and which is thus interpreted as a decline in productivity growth. Later, as intangible investments bear fruit, measured productivity surges because output rockets upward in a manner unexplained by measured inputs of labour and tangible capital.

Back in 2010, the failure to account for intangible investment in software made little difference to the productivity numbers, the authors reckon. But productivity has increasingly been understated; by the end of 2016, productivity growth was probably about 0.9 percentage points higher than official estimates suggested.

This pattern has occurred before. In 1987 Robert Solow, another Nobel prizewinner, remarked that computers could be seen everywhere except the productivity statistics. Nine years later American productivity growth began an acceleration which evoked the golden age of the 1950s and 1960s. These processes are not always sexy. In the late 1990s, the soaring share prices of internet startups hogged the headlines. The fillip to productivity growth had other sources, like improvements in manufacturing techniques, better inventory management and rationalisation of logistics and production processes made possible by the digitisation of firm records and the deployment of clever software.

The J-curve provides a way to reconcile tech optimism and adoption of new technologies with lousy productivity statistics. The role of intangible investments in unlocking the potential of new technologies may also mean that the pandemic, despite its economic damage, has made a productivity boom more likely to develop. Office closures have forced firms to invest in digitisation and automation, or to make better use of existing investments. Old analogue habits could no longer be tolerated. Though it will not show up in any economic statistics, in 2020 executives around the world invested in the organisational overhauls needed to make new technologies work effectively (see chart 2). Not all of these efforts will have led to productivity improvements. But as covid-19 recedes, the firms which did transform their activities will retain and build on their new ways of doing things.

The crisis forced change

Early evidence suggests that some transformations are very likely to stick, and that the pandemic quickened the pace of technology adoption. A survey of global firms conducted by the World Economic Forum this year found that more than 80% of employers intend to accelerate plans to digitise their processes and provide more opportunities for remote work, while 50% plan to accelerate automation of production tasks. About 43% expect changes like these to generate a net reduction in their workforces: a development which could pose labour-market challenges but which almost by definition implies improvements in productivity.

Harder to assess is the possibility that the movement of so much work into the cloud could have productivity-boosting effects for national economies or at the global level. High housing and property costs in rich, productive cities have locked firms and workers out of places where they might have done more with less resources. If tech workers can more easily contribute to top firms while living in affordable cities away from America's coasts, say, then strict zoning rules in the bay area of California will become less of a bottleneck. Office space in San Francisco or London freed up by increases in remote work could be occupied by firms which really do need their workers to operate in close physical proximity. Beyond that, and politics permitting, the boost to distance education and telemedicine delivered by the pandemic could help drive a period of growth in services trade, and the achievement of economies of scale in sectors which have long proved resistant to productivity-boosting measures.

None of this can be taken for granted. Making the most of new private-sector investments in technology and know-how will require governments to engineer a rapid recovery in demand, to make complementary investments in public goods like broadband, and to focus on tackling the educational shortfalls so many students have suffered as a consequence of school closures. But the raw materials for a new productivity boom appear to be falling into place, in a way not seen for at least two decades. This year's darkness may in fact mean that dawn is just over the horizon.

Notes

Long-Run Economic Performance and Short-Run Adjustments 3.1. Introduction So far, we have taken the price level as given in the short run to simplify the analysis of the movements in income, interest rate, and the exchange rate. We know that prices change in the long run. Therefore, there must be some process of price adjustment even in the short run. Also, in earlier modules we have learned how aggregate demand and income are determined in the short run given the price level and assuming that there is no supply constraint. The next step is to develop a model of the supply side of the economy, which will also offer a perspective on price adjustment. In this module, we address the following questions: o What factors drive the aggregate output in the long run? o Why do some countries produce so much more output per person than other countries do? o How does the economy adjust in the short run? o How do prices and real income interact in the adjustment process in the short run? o What determines the rate of inflation in the short run? o What are the sources of macroeconomic instability? o How can government policies contain or cause macroeconomic instability? 3.2. The Experience of Long-Term Growth around the World Figure 3.1 shows the long-term trends in real PPP GDP per capita for a wide range of countries. At top of the chart is the United States, which has experienced an average per capita growth rate of over 1.7 percent per year since World War II. Western European economy has followed a path almost parallel to that of the US, but at a lower level. WWII was a major setback for Europe, but then it grew faster than the US in the following three decades and made up the lost ground, though its pace has visibly slowed since the mid-2000s. Japan's performance has some resemblance to Europe, but its decline during WWII, its catchup in the following decades, and stagnation since the 1990s are much more pronounced. During the 1945-1990 catchup period, Japan managed to close its historical gap with Western Europe, but then started to experience a new gap since the 1990s. Source: World Development Indicators, http://databank.worldbank.org/data/databases.aspx, and Maddison Project, http://www.ggdc.net/maddison/maddison-project/home.htm for earlier years. For developing countries as a whole, the income gap with the developed countries has been quite large. However, on average their per capita growth rates have been higher than those in the developed world, especially after the 1980s. o Rapid growth in China and India in recent decades has accounted for a great deal of thatcatch-up. o Most other developing economies have had episodes of high growth, but those episodes came to an end before long and it took a while before their growth resumed. Brazil offers an example, o Some parts of the developing world that used to have relatively high incomes, such as Argentina, largely stagnated during the 20th century. o There are also a host of developing countries, especially in Africa, that experienced an output collapse in the second half of the 20th century, often as a result of wars or revolutions, and are yet to fully recover from those disasters. Figure 3.1 shows three examples of such countries, where rising internal conflicts proved calamitous to their economies. It is worth noting that the intensification of conflicts in these countries happened at the end of 1980s with the demise of the Soviet Union as a super power and the consequent decline in the interest of the United States to remain involved in the region as the need for rivalry diminished. Both the Soviet Union and the US were patrons of tyrannical regimes in the region and in their absence, challengers to those regimes saw an opportunity to overthrow them. The result was disastrous violence that lasted a long time across thecontinent. In the following sections, we examine the key factors that help shed light on the observed trends and differences in per capita income levels among various countries. 3.3. The Concept of Production Capacity At a given point in time, a firm can operate at different levels of output. o At low levels of output, some resources remain idle. o At high levels of output, some resources are "over-used" (their rate of utilization is not sustainable). The production capacity of a firm is the maximum output that it can sustain indefinitely. By analogy, the production capacity of an economy is the maximum output that it can produce on a sustained basis. The production capacity of an economy at each point in time depends on its resources, technology, and institutional capabilities. o Resources consist of human time and capabilities, physical capital stock, and natural endowments such as land, energy sources, and minerals. Having more resources permits greater production and increases the production capacity of the economy. Human capital plays a central role in bringing together other resources and putting them into productive use. Physical capital facilitates production and embodies part of the technology. When a country has the necessary technology and institutional capabilities to produce high levels of income, investment in resources has high marginal returns and there an incentive and the possibility to expand production capacity in this way. In such situations, a country can experience very rapid economic growth until its economy's potential is reached. This explains the experience of Japan and Germany after WWII and the rapid growth many countries in East Asian since 1960s. However, accumulating capital without technological progress cannot generate long term growth because as capital stock becomes larger, its depreciation also grows. As a result, whatever share of its GDP a country invests, eventually its capital stock reaches a level that its depreciation absorbs all the investment and there is not anything left to serve as new addition to the capital stock. This is exactly what happened to the Soviet Union where large investments in the 1930s brought about rapid growth for a while, but then led to stagnation because the system did not support widespread innovation and technological progress. A similar concern has been raise concerning the rapid growth in East Asia, where investment rates have been quite high and have contributed to growth in substantial ways. Some economists have argued that unless East Asian economies change their policies and institutions, further investments will have diminishing returns and not bring about much growth. However, the measurements that indicate low technological change have been challenged and do not seem to be very reliable. Of course, the point that East Asian economies need policy and institutional reform can be a valid point even if technological change in the past has been fast. o Technology is the knowledge about ways of combining resources to produce the outputs that satisfy the needs of the population. Better technology allows the economy to produce more with the same resources and, therefore, enhances production capacity. Technological progress accounts for a large part of per capita income growth around the world. However, technological progress does not take shape in a vacuum and requires good institutions and resources, especially well developed human capital. o Institutions are the rules that assign roles to individuals in the society and structure their interactions in political, legal, and social arenas. Institutional capabilities are crucial for production. This is because human beings are more productive (carry out their tasks more effectively) when they specialize. But once specialized, people depend on each other for the production of most goods and services that they need. As a result, to apply resources and technology efficiently, each individual must be motivated to perform and deliver the products demanded by others. o In principle this should be done by markets, but markets have a lot of imperfections and require rules to operate properly. Thus, appropriate institutions are needed to allow people to make their relationships (their implicit or explicit contracts) reliable and flexible. When the institutions in a country enable broader segments of the population to establish such relationships at the impersonal level, then the incentives to put resources and technology to best use can be stronger and the economy's production capacity will be larger. The determination of production capacity is a long-term process because developing human and physical resources, improving technologies, and building appropriate institutions take decades. Appropriate institutions are needed to allow for reliable and flexible transactions among individuals. Good institutions can help ensure that the politicians have the right incentives and the means to come up with socially beneficial policies. Institutional development has its own dynamics, a long-term collective process based on existing beliefs, norms, and social structure. Underdeveloped economies with bad institutions face daunting tasks: o Political actors and policymakers with distorted incentives trying to find solutions to difficult social problems! o However, the situation is not hopeless! o There are often policies that can trigger growth at least for several years, providing space for steps that help institution building and more sustainable growth! o Social and political entrepreneurs can play crucial roles in facilitating change. They must be willing to pursue innovative policies based on economic logic and lessons of development history. 3.4. Measuring Institutional Capabilities Ranking institutional characteristics Example: The Worldwide Governance Indicators (WGI) o Six major dimensions of governance (for the definition of these variables and methods of calculating them, see the WGI website, www.govindicators.org): Voice and Accountability Rule of Law Government Effectiveness Regulatory Quality Control of Corruption Political Stability and Absence of Violence Good and strong institutions are essential for sustaining high levels of income, but only some of them are necessary for starting the growth process in poor countries. o Appropriate policies that encourage investment and innovation are needed. o The world is complex and each country at each time requires policies tailored to its specific conditions. Figure 3.2. Government Effectiveness vs. GDP Per Capita (2006-2008 Averages) Among these institutional dimensions, the rule of law and especially government effectiveness seem to be most important for moving towards sustained growth. o Figures 3.2 and 3.3 show the correlation between these two indices and PPP GDP per capita. Note that the institutional indices are standardized to range mostly between -2.5 and +2.5. Causality between institutional capabilities and real income goes both ways, but research shows that often institutional capabilities, especially government effectiveness, come first. The correlation of voice and accountability index with per capita income is weak (Figure 3.3) and the causality often goes in the opposite direction. o Democracy is inherently valuable, but does not by itself bring about economic prosperity! Figure 3.3. Rule of Law vs. GDP Per Capita (2006-2008 Averages) Figure 3.4. Voice and Accountability vs. GDP Per Capita (2006-2008 Averages) 3.5. Price Flexibility in the Short Run and the Long Run The key difference between the short-run and the long-run in macroeconomics: o Prices are "sticky" in the short run but flexible in the long run. There are many reasons why prices are not very flexible in the short run. o Businesses need to discover the right prices for their products and that often means setting a price and keeping it at that level to assess the demand. o In case of some products, customers expect prices in particular ranges and are not very likely to buy if they see prices outside those ranges. o Price adjustment may entail some costs (e.g., the analysis needed to figure out what the new price should be. o Most importantly, price adjustments are constrained by the prevalence of implicit or explicit contracts in labor and product markets. Businesses, workers, and consumers are interested in long-term contracts because such contracts help limit potential opportunistic behavior in transactions and reduce negotiation costs. For example, if you want to produce a product during this year, you want to make sure that the inputs that you need will be available and the suppliers do not jack up the price the moment you start production. The suppliers also want to make sure that you do not drop your orders and ask for a lower price once they have produced the goods that you requested. So, it is mutually beneficial for both sides to set a price ahead of the time and specify potential adjustments according to some well-defined rules. The contract also specifies a minimum amount that you will purchase, but it typically defines a range of quantity so that you can buy more or less as the demand for your product turns out to be low or high. Outside that range, if you want to buy more, the contract usually specifies a higher price. This means that if the demand turns out to be high, you can produce more and satisfy the demand, but your cost and price will tend to go up. If demand turns out to be very low, you may have to offer discounts to your customers because you have already committed yourself to pay for a minimum amount of input. Thus, contracts make it costly for sellers and buyers to change prices except through pre-defined rules. This reduces price adjustment in the economy in response to aggregate expenditure changes. That is, both price and output actually go up and down with shifts in the aggregate expenditure, but price adjustment is small and output responds strongly. As time goes by, prices respond more and the deviation of output from capacity diminishes. Note that under-utilization of capacity when the aggregate demand is low and over-utilization when demand is high are both costly to the economy. Such costs could be avoided if prices are fully flexible and any demand shift simply raises or lowers all prices, rather than affecting the output. Businesses are willing to incur such costs because they value being able to use contracts as a means of improving performance incentives in their transactions. An important issue here is that the total costs of reduced flexibility to the economy as a whole is much higher than the cost that each individual business perceives. This is because of aggregate demand externality: When the equilibrium income determined by the IS and LM curves declines below the economy's production capacity a decline in the price level is needed to restore income back to the production capacity. Each producer has some incentive to reduce her price because a price cut helps the producer increase her profits. But, this increase in profit is only part of the benefit to the economy as a whole. This is because a price cut leaves the customers with more of their income to spend on goods sold by other producers. As a result, each producer does not receive the full benefit of her actions. This diminished the incentives of producers to cut prices. In particular, small costs in adjusting contract terms may discourage price reductions because individual businesses ignore the benefits of their price reduction for others in the economy. This can cause the total output to fall, imposing a large cost on all, while everyone thinks that they are doing the best thing for themselves by sticking to their contracts and keeping price adjustments small. The same arguments apply to price "stickiness" in the face of an increase in demand or changes in production capacity. To summarize, long-term contracts are useful for the economy because they can help raise productivity by reducing negotiation costs and by limiting potential opportunistic behavior in transactions. But, long-term contracts also entail costs for the macroeconomy because they make wages and prices less flexible and allow output to deviate from production capacity, which either leaves some resources idle or leads to over-use of some resources for a while. A key part of the problem is that sellers and buyers do not bear all the costs of making their contracts inflexible. They do what they see as good for their own contracts, but when price movement is limited and they adjust their output in response to macroeconomic shocks, they impose costs on the rest of the economy. This is because when a producer layoffs workers and underutilizes other factors of production, she also reduces demand for the products of other firms and causes them to layoff workers and underutilize other factors of production. Similarly, over-production creates too much demand for others and, in the face of inflexible prices, leads to over- utilization of some resources. 3.6. Equilibrium Income and Production Capacity: The Short Run vs. the Long Run In the long run, in the absence of shocks to resource, technology, and institutions, the output of an economy, Y, must equal its production capacity, Y , which is also known as the natural level of output. In the following, we go through the arguments that make the case for this proposition. As we discussed in the previous section, a key feature of the long run is full flexibility of prices, in contrast to the short run, when prices are often inertial (or sticky) and do not respond much to supply and demand conditions. The main reasons are price discovery and adjustment costs as well as the prevalence of implicit and explicit contracts. But, over time it becomes worthwhile to find new prices and adjust them. Also, there is time to revise and change contracts, hence allowing prices to respond to excess supply or excess demand in a flexible fashion. Recall that the equilibrium expenditure in the economy is determined by the crossing point of the IS and LM curves. Figure 3.5. A Temporary Rise in the Price Level Lowers Income Y1 Y0 Income, Y If P rises temporarily, the LM curve rotates upward, because for each given level of interest rate (and, therefore, given level of nominal exchange rate determined by the interest parity condition) money demand rises. Also, the IS curve shifts back, because the real exchange rate appreciates and net exports decline. If the expected future price level remains unchanged, the temporary rise in the current price level also means a reduction in expected inflation, which lowers investment and may lead to postponement of some consumption expenditures, thus shifting the IS curve further to the left. o Therefore, income declines, but the change in the interest rate is ambiguous. (See Figure 3.5.) This is indeed what happens when the equilibrium income happens to be above the production capacity by a relatively small margin. Consider the situation depicted in Figure 3.6, where output is above production capacity. In this situation, there are some overused resources in the economy ("capacity shortage" or "excess demand") and some costs and prices will be rising. If the excess demand is small and is expected to disappear in the short run, there will not be any expectation of heightened future inflation. As a result, as shown in Figure 3.6, the temporary rise in the price level will lower aggregate expenditure (similar to the situation in Figure 3.5) until the equilibrium expenditure matches the production capacity. If excess demand is large, it will take time for the economy to adjust and the expected inflation rate may continue to rise. This could cause investment to rise and some types of consumption expenditure to be accelerated, causing the IS curve to shift rightward. In that case, equilibrium output would continue to remain above production capacity and inflation may persist or even accelerate. See Figure 3.7. Figure 3.6. Small "Excess Demand" Raises Inflation and Shifts IS and LM Leftward Figure 3.7. Large "Excess Demand" Could Lead to Persistence or Acceleration of Inflation Now, let's consider the opposite situation, where at a point in time output is below production capacity. In that situation, there will be some idle resources in the economy ("excess capacity") and producers will have an incentive to lower their prices to be able to sell more and at least earn something for the idle resources. If the output gap is small and is expected to be closed in the short run, there will not be any expectation of continued disinflation. As a result, over time, as shown in Figure 3.8, the temporary decline in the price level will raise aggregate expenditure by shifting the IS and LM curves to the right until equilibrium expenditure matches the production capacity. Figure 3.8. Small "Excess Capacity" Causes Disinflation and Shifts IS and LM Rightward Figure 3.9. Large "Excess Capacity" Causes Disinflation and Shifts LM Rightward, But, Could Shift IS to the Left If the gap between output and production capacity is large, it will take time for the economy to adjust and the expected inflation rate may also decline. This could cause investment to decline. If the effect leads to deflation, some types of consumption may also be postponed. The net effect could push the IS curve to the left, which would slow down the convergence towards production capacity. See Figure 3.9. If the adjustment process is prolonged, the LM curve could become quite flat and any leftward shift in the IS curve would move the economy away from production capacity. This situation, which is part of what happened during the Great Depression, is called "liquidity trap" because changes in real liquidity have no impact on aggregate expenditure and price level decline could be counter-productive. An example of this is depicted in Figure 3.10. Figure 3.10. "Liquidity Trap" 3.7. Long-Run Output, Production Capacity, and Macroeconomic Policies and An important conclusion of the above analysis is that in the long run, when prices are completely flexible and all markets clear, the equilibrium level of income and expenditure equals the economy's production capacity, Y . The process of adjustment of short-run output towards production capacity may be slow or fast, depending on the situation. But, eventually the short-run equilibrium output tends towards production capacity. The production capacity itself is determined in long-run processes that shape resources, technology, and institutions. Rarely the production capacity experiences abrupt shifts. One implication of this result is that under a given institutional setup and its associated policy framework, short-run changes in macroeconomic policies have little impact on the long-run real output. If, for example, given other policies and parameters, money supply goes up temporarily and shifts the LM curve downwards, income may rise above production capacity in the short run. But, before long inflation rises and drives output back to its long-run equilibrium path, which is that of production capacity. o The trend in production capacity would not be affected much by temporary change in the short run equilibrium output. This is, of course, based on the assumption that institutional underpinnings of monetary policy remain intact. If there are institutional changes that affect the way monetary policy is made, the production capacity may be affected, especially if the change influences the public's confidence in the policymaking process. A similar argument applies to year-to-year fluctuations in fiscal policy. However, as in the case of monetary policy, If there are institutional changes in the design and implementation of fiscal policy, then there may be consequences for production capacity. o Fiscal policy may have an impact on the long run aggregate output if the government reallocates expenditure in ways that affect resources, technology, or institutions. For example, if the government increases its expenditure on education or technological development, after several years the impact will show up in production capacity and change the long run output path. o In our analysis in this course, we take the allocation of public funds as given and we assume that the government is already putting its resources where there are high returns. (That allocation is very important and not always optimal in the real world, but it is the subject of public finance literature, not macroeconomics.) Under this assumption, marginal changes in fiscal policy only affect the allocation of expenditure between the government and the rest of the economy and have little consequence for long run production capacity. In other words, we assume that if there are good potentials for expenditure on areas that increase productivity, the government has already taken advantage of them. And if the government has difficulties taking advantage of such possibilities, then changes in spending will not induce the government to allocate resources in ways enhance or impede productivity any more than the status quo. 3.8. Aggregate Demand Shocks and Macroeconomic Stabilization Policies 3.8.1. Aggregate Demand Shocks Demand shocks are changes in investment, consumption, or net exports caused by exogenous factors. The main causes of such shocks are: o Changes in expectations about future income or employment trends o Changes in expectations about future high inflation or deflation o Major shifts in the structure of aggregate demand o Malfunctioning of the financial system For example, reductions in foreign income or price level, or pessimism among investors about the future of the economy can reduce the expenditure on an economy's products. Such shocks would be considered as adverse or negative demand shocks. When the opposite happens and expenditure on an economy's products increases, the demand shock is favorable or positive. As we have seen before, aggregate demand shocks shift the IS curve. Negative demand shocks lead to excess capacity and positive demand shocks cause excess demand. Because of price stickiness and inability of all firms and workers in the economy to quickly adjust prices and restore income to production capacity, the economy may bear under-utilization or over-utilization costs for some time. o If the shock is large, the adjustment process may become prolonged and the economy may suffer instability for a while. 3.8.2. Macroeconomic Policy Response to Aggregate Demand Shocks When the economy deviates from its long-run output path by significant margin, the government and the central bank may be able to help restore equality between aggregate expenditure and production capacity by shifting the IS and LM curves. In doing this, the government and central bank essentially coordinate the economy in the short run and help it avoid prolonged recession or overheating. Countercyclical fiscal and monetary policies can be helpful in case of large shocks. o Stabilization can be viewed as use of policy tools rather than inflation and deflation to move toward long-run output, while maintaining price and output stability. o Stabilization can help the economy avoid major disruptions and inefficiencies. It also can facilitate long-term contracting and greater production capacity in the long run US government and the Fed adopted major expansionary macroeconomic policies in the aftermath of the 2008 financial crisis and manage to cut short a deep recession that could have turned into an economic depression. (See Figure 3.12 below.) Countercyclical fiscal and monetary policies should be used with care! o Because the government and the central bank can affect aggregate expenditure, their policies themselves may act as sources of instability. This happens when the rules governing policymaking fail to provide the politicians with the right incentives to conduct policy in ways that ensure stability and growth. More on this in the next module. o The case for stabilization policy must be clear. o Attempts to keep output above production capacity could cause hyper-inflation. o Over-zeal to keep inflation low could lead to deep recession and possibly liquidity trap. Over-use of stabilization policies could be counter-productive. o The government and the central bank may run out of policy tools to help stabilize the economy when really needed. o There is also the so-called "Minsky moment" problem: If economic agents come to believe that policymakers will always come to the rescue and stabilize the economy, they may take risks that are individually rational for them, assuming that the economy will indeed remain stable, but in the aggregate the risks destabilize the economic system as a whole! An example of this is the sub-prime mortgage lending in the 2000s, which assumed that house prices would not decline because of stabilization. This assumption made it rational for creditors to lend with zero down payment, but since millions of such mortgages were being issued, house prices were bid up beyond levels that could be sustainable for the economy as a whole. At some point, house price trend started to reverse and the system collapsed. Fiscal and monetary policies need to be coordinated. o Normally, monetary policy should take precedence as the main instrument for macroeconomic stabilization. o Fiscal policy should accompany monetary policy in cases of very large shocks. o In normal times, fiscal debt should be kept relatively low to ensure "fiscal space". o Fiscal policy is crucial in cases of liquidity trap! See Figure 3.11. Figure 3.11. Macroeconomic Policy Options in Cases of "Liquidity Trap" 3.9. Aggregate Supply Shocks and Macroeconomic Stabilization Policies 3.9.1. Aggregate Supply Shocks Not all fluctuations in the economy are caused by demand shocks and macroeconomic mismanagement. Some shocks, known as supply shocks, affect the production capacity of the economy. Changes in production capacity could be due to o Technological change o Institutional and political disruptions (wars, coups, uprisings, revolutions, ...) o Changes in resource availability Oil price shocks Major earthquakes Agricultural pest or weather shocks A rise in factor costs, or resource loss, or institutional breakdown that reduces production capacity and productivity is called a negative or adverse supply shock. If the economy's equilibrium expenditure is close to the pre-shock production capacity, then the post-shock situation would be similar to those in Figures 3.6 and 3.7, depending on the size of the shock. o Inflation would rise and may even accelerate. o Since at the same time output shrinks, the outcome has been termed as stagflation. o A prime example of an adverse supply shock is a rise in oil prices in oil importing countries, which raises the cost of production and reduces the ability of the economy to produce out with its existing resources and technology. For instance, when oil prices sharply jumped up in 1973-1974, many businesses in oil-importing countries found it too costly to produce at prices that they had set before. They ended up raising their prices and cutting on their output. A similar shock affected the oil-importing countries and caused another stagflation in 1979-1980. These shocks and their impacts on inflation and output in the US economy can be seen in Figure 3.12. Such effects became much weaker after the early 1980s for reasons that we discuss below. o Natural disasters or exceptionally bad weather can also have similar supply effects. Figure 3.12. Economic Growth, Inflation, and Oil Price in the United States Source: Economic Research at the St. Louis Fed, https://research.stlouisfed.org/fred2. Figure 3.13. The Responses of log(GDP) and log(CPI) of the US Economy to a 10 Percent Increase in the Price of Oil" Figure 3.13 shows the results of a study of the impact of supply shocks due to oil price rises on the US economy before and after 1984. o The study shows that in the 1960s and 1970s, the US economy's production capacity would shrink substantially as a result of an oil price shock, while inflation would go up considerably for a few years. o These effects were more than halved after the mid-1980s because production in the US economy shifted toward less energy-intensive activities, especially services, and adjusted to the possibility of oil price shocks. The opposite of the situation discussed above is when the economy experiences a decline in costs or rise in productivity (positive or favorable supply shocks). Examples are a decline in oil prices or a burst of technological progress. o Such events cause the production capacity to move to the right and, if the initial equilibrium is close to the old level of production capacity, it tends to lower the inflation rate and boost economic activity. o The situation would look like Figures 3.8-3.10. o This is partly what happened in the US economy during 1998 and 1999 when oil prices declined as a result of the East Asian crisis that lowered the world demand for oil. (See Figure 3.12.) In the case of that crisis, however, the favorable supply shock was combined with some adverse demand effect due the decline of Asian demand for US exports, which shifted the IS curve leftward somewhat. The net result was a boost to GDP growth combined with a sizable drop in inflation (between 1997 and 1998, this decline in inflation was about 0.75 percentage points). 3.9.2. Macroeconomic Policy Response to Aggregate Supply Shocks Dealing with supply shocks calls for different policies than those employed in response to demand shocks. o Expansionary policy response to a recession induced by an adverse supply shock would exacerbate instability! This is what the Fed tried to do in the mid-1970s after the first oil shock and ended up fueling inflation and causing stagflation in 1977-1978 well before the second oil shock towards the end of 1970s (Figure 3.12). o Response to large supply shocks must focus on price stability. "Extinguishing policy": Helping the economy reach its new production capacity without major change in the inflation rate. See Figure 3.14 for an illustration of such a policy. This is the approach that the Fed adopted in 1980 under its new chairman at the time, Paul Volker. The result was an enormous success in controlling inflation and driving down the price of oil, so enabling the economy to rebound without much inflation (Figure 3.12). Similar policies were adopted in 1990, 2000, and 2008 in response to adverse supply shocks, ensuring price stability. Figure 3.14. "Extinguishing" Policy Response to a Large Adverse Supply Shock An important implication of the price stability approach delineated above is that macroeconomic policy must become expansionary during favorable supply shocks. This is needed particularly to avoid deflation, which could have adverse effect on the IS curve and possibly on the output. o An example of such a policy is the Fed's reaction to the East Asian crisis during 1998, when commodity prices declined and brought down inflation (Figure 3.12). In that case, the Fed pursued an expansionary monetary policy to ensure that inflation does not go down too much. However, once East Asian economies recovered and commodity prices rebounded in 1999 and 2000, the Fed switched course and raised its target interest rate to slow down the economy and ease the upward pressure on prices.