Unit 3 Notes

Economic Growth and Development

For most of us, the lives of our ancestors from 250 years ago were not all that different from our ancestors of 500 or 1000 years ago.  Most people were farmers, raising crops and tending livestock, and who may have supplemented their diet by hunting and fishing.  Beginning about 250 years ago, that all began to change, with the rise of entrepreneurship and the application of science to the production of goods and services.  The resulting Industrial Revolution continues today and researchers will sometimes describe the present time as Phase 4 (cyber systems), with Phase 1 being water and steam powered mechanical manufacturing, Phase 2 adding the use of electricity, and Phase 3 adding the use of electronics and computers/IT.  What some people call “automation” today is just the current stage of the Industrial Revolution, which has been going on for more than 250 years. 

About production, economists talk in terms of output or product, and of inputs like land (and other natural resources), labor power, capital equipment, technology, human capital (education and know how), social overhead capital (infrastructure), and entrepreneurship.  These inputs might be called resources or factors of production.  So for our farmer of 250 years ago, the main factors of production included land, labor, and a small amount of capital equipment like farm tools. 

The term Economic Development refers to expanding and improving the factors of production, so as to increase Economic Growth.  We could also say that expanding and improving factors of production increases Productivity, the output available for a given set of inputs. 

To give a concrete example of productivity, about 25 years ago, I took my Chinese friend Ben to visit a typical Massachusetts dairy farm.  It had about 100 or 150 cows, automated milking machines, cows with ear tags to track their milk output via computer, horizontal silage, and tractors.  Two or three people ran the farm, so say 50 cows per worker.  Ben told me in China that one person would take care of 10 cows, without the modern capital equipment, of course.  So that’s 10 cows per worker, and thus the difference in labor productivity is five times greater in the US, comparing farm to farm. To use a term from Chapter 7 in your text, the productivity of the Massachusetts farm is owing to “capital deepening” among other factors. 

The flip side of researching Economic Development is research into the lack of development.  A recent book on this topic is titled Why Nations Fail.  Here is a summary:

Daron Acemoglu and James Robinson conclusively show that it is man-made political and economic institutions that underlie economic success (or the lack of it). Korea, to take just one of their fascinating examples, is a remarkably homogeneous nation, yet the people of North Korea are among the poorest on earth while their brothers and sisters in South Korea are among the richest. The south forged a society that created incentives, rewarded innovation, and allowed everyone to participate in economic opportunities. The economic success thus spurred was sustained because the government became accountable and responsive to citizens and the great mass of people. Sadly, the people of the north have endured decades of famine, political repression, and very different economic institutions—with no end in sight. The differences between the Koreas is due to the politics that created these completely different institutional trajectories.  (Source:  http://whynationsfail.com/summary Links to an external site. )

Robinson has also written a short paper called “Why Regions Fail,” which I have placed in Unit 3 as optional reading. 

Unemployment and Inflation

Good news and bad news:  The US economy is among the most productive in the world, and has good long-term prospects of continued strength, in general. (Many problems with productivity are regional or in specific industries, like health care, but they can be fixed.)  The bad news is that macroeconomic problems like unemployment and inflation must constantly be monitored and addressed.  (The ups and downs of the macroeconomy are called the Business Cycle.)   

As a rough measurement, economists have proposed a “Misery Index,” which adds together the unemployment rate and inflation rate.  The ideal “Goldilocks” situation is low unemployment and low inflation. So far, in the 21^st century, unemployment has been the more serious problem, reaching 9.6% in 2010, part of the lingering “Great Recession” of 2008.  (Full employment, in the macro sense, is 5% or less.) 

Inflation has been much less of a 21^st century problem, and has usually been lower than 2%, which is considered acceptable.  But between 1979 and 1981, inflation was in double digits, quite a serious problem. (The success in managing inflation is owing, in part, to the Monetary Policies adopted by the Federal Reserve since the mid 1980s.  We will examine that in a future unit.) 

International Trade and Finance

Taking an historic view, international trade has greatly accelerated since the end of World War Two.  Immediately following the war, the US had a leading position in exports, because most of the world had been blown to smithereens, to put it bluntly.  By about 1980, the rest of the world had rebuilt to the point that the US became a net importer of goods and services.  This reverse of the Balance of Trade was seen as a problem to some, or even many people, but not to economists.  That is because of the Law of Comparative Advantage, which says that economies should focus on producing the goods and services where they are most relatively efficient, and import goods and services where other economies are more relatively efficient. Gains from Trade are enjoyed by all parties, as each follows its Comparative Advantage. And the logical implication is that the best approach to international trade is Free Trade, where tariffs and quotas do not restrict imports and exports.    

Toward the beginning of the 21^st century, the US saw the emergence of what are called the Twin Deficits.  This is an ongoing research project and I want to mention it as an example of the sort of theoretical work that economists do.  To put it simply, the Twin Deficit Hypothesis says that increasing the US Federal Budget Deficit is connected to, and may help increase, the Trade Deficit.  Also keeping it simple, that Budget Deficit is funded by the US Treasury issuing billions of dollars worth of bonds.  (A bond is a sort of IOU.)  In the meantime, assume that China has a Trade Surplus with the US, in the billions of dollars.  What can China do with those billions of dollars?  Yup, buy Treasury Bonds.  I’ve uploaded a research paper about Twin Deficits in Unit 3, which is optional reading.  

NOTE:  Please watch the 5-minute TED Talk video on "What Causes Recessions"