ECONOMIC GROWTH

By introducing such factors as inflation, wage increases, and growth in labor productivity into
the static model of income determination, in Chapter 15 we took the first steps away from a
purely static model of the economy toward a more dynamic view. In this chapter we move on to
a brief survey of dynamic models of economic growththe growth of potential, or fullemployment, output.
The relationship between actual and potential output is shown in Figure 17.1, which reproduces
Figure 1.1(a). The potential line in Figure 17.1 shows the economys potential output path, which
is fairly smooth given the trend growth of labor force and productivity. This is also the trend path
of full-employment output. It gives the level of output that could be attained at any given time
with the unemployment rate at its full-employment level and labor productivity at its trend value.
The actual output line in Figure 17.1 shows actual measured real GNP. When actual output is
below potential, real output is being lost. When actual output is above potential, as in 1968
1969 when the unemployment rate fell below 3.5 percent, additional output is gained, but only at
the cost of a rate of inflation that is widely thought to be unacceptable. In the presidential
campaign of 1968, all parties agreed that the 5 to 6 percent rate of inflation, which came along
with the under-3.5 percent unemployment rate, Was too high. In the 1980s, after the supply-side
inflation of 1979, a drop of the inflation rate to 5 percent would be welcomed!
The potential output path in Figure 17.1, then, does not represent an absolute physical maximum
level of output. Rather, it gives the level of output associated with a positive level of
unemployment computed to reflect both frictional unemployment, the unemployment resulting
from the normal operation of the labor market in which some people are temporarily between
jobs, and structural unemployment, the unemployment of those with no marketable skills or
those whose skills are no longer in demand. In 1970, the Council of Economic Advisers Annual
Report estimated the full-employment level of unemployment to be just under 4 percent. This
was the level that the long-run U.S. Phillips curve suggested might be compatible with
reasonable price stabilitya rate of inflation near 4 to 5 percent a year. More recent estimates
have increased to 6.0 percent or more the full employment level of unemployment. Thus, the
potential output path of Figure 17.1 can also be considered as a feasible trend path for actual
output; monetary and fiscal policy should be set to maintain actual output as close to potential
output as possible.
The stabilization policy measures discussed in Parts II and III are steps that can be taken to close
the gap between the potential and actual output paths and maintain actual output near its
potential level. Of course, when we considered time lags in Part III we recognized that once an
output gap appears, movement toward the trend line cannot be instantaneous and complete. But
the static model has shown how manipulation of such variables as government purchases, tax
rates, or the money supply can close the gap between actual and potential output. Thus, if

investment or consumer expenditure falls below its trend level associated with potential output
and income, the government can take fiscal or monetary policy steps to counterbalance the
effects of that exogenous drop in investment or consumer expenditure to keep the level of output
up to its potential.
In this chapter we assume that the government is doing its stabilization job well. That is, it is
reasonably successful in keeping the economy growing close to the trend, or potential output,
line. There will be, of course, fluctuations around the trend line. Consumption and investment
will fluctuate around their trend levels, and fiscal and monetary policy will react only with a lag.
But when private demand deviates from its trend level, we assume that the government responds
well enough to correct the deviations within a reasonable period, say, a year. Thus, on average,
the actual growth path of the economy is represented by the trend line.
Assuming this, our interest is focused on what determines the nature of the trend line: How are
its slope and height determined? In other words, what determines the potential rate and level of
growth of the economy?
Before taking up these questions, we summarize the long-run trend nature of fiscal and monetary
policy that will keep the economy growing along the trend path. To repeat, in the short run there
will always be fluctuations in private demandhigher or lower levels of investment or
consumptionwhich require higher or lower levels of government spending, tax rates, or money
supply to maintain actual output close to potential. But on average, over the long run, monetary
and fiscal policy will exhibit certain trend characteristics as the economy grows along its trend
path.

ASSUMPTIONS UNDERLYING TREND GROWTH

As the economy grows along its full-employment trend path, the government's monetary and
fiscal policy variables will be moving to counteract changes in private demand. To find the
required trends in these policy variables wc assume the economy grows along a path with the
unemployment rate at some given average level, perhaps 6 percent, which we define as full
employment.
To describe the trends in monetary and fiscal policy variables along the full-employment path,
we make some further assumptions, each of which, as we shall see, is roughly consistent with the
historical facts.
1. Interest rates are trendless; that is, they fluctuate around some mean level.
2. The rates of labor force growth, L, and of average labor-productivity growth, y/L are fairly
steady.
3. The capital-output ratio, K/y, is roughly constant.
4. The relative shares of labor and capital in output are roughly constant.

Here we are switching from a focus on employment N, to the labor force L if the unemployment
rate u is constant, both N and L will grow at the same rate. The unemployment rate u is defined
as
u=

U LN
N
=
=1 ,
L
L
L

[1]

where U is the number of persons unemployed. Thus if u is constant, the employment rate, N/L,
is constant, and N and L both grow at the same rate L.
To draw the implications of balanced growth for static equilibrium, we examine first the labor
market to find the implied rate of growth of output, wages, and prices on average along trend.
Then we find the average growth rate of the money supply that will keep the money market in
equilibrium with real income growing and the price level rising, and interest rates remaining
constant along trend. Finally, we see what full- employment product market equilibrium implies
for the average level of the government deficit and debt.

TREND GROWTH OF OUTPUT AND PRICES

Our assumptions concerning the growth rates of the labor force and productivity can be
combined to give the growth rate of potential output. We can define potential output as average
labor force productivity y/L times the total labor force L:
y
y= . L.
L

[2]

As we showed in Chapter 15. p. 314, the percentage rate of growth of the product of two
variables can be approximated by the sum of the percentage rates of growth of the two variables
if neither is very large. Thus the growth rate of output is the sum of the growth rates or
productivity and the labor force:
y /l+ L
y=

[3]

Thus, the two assumptions give us the rate of growth of potential output. In the United States,
with total productivity growing along trend at about 1.0 percent per year and available manhours in the labor force growing at 1.5 percent, the growth rate of potential output y is at most
2.5 percent.

As we saw in Chapter 15. the assumption that relative shares remain constant along trend implies
that the rate of growth of the price level is equal to the rate of growth of the money wage rate
less that of productivity,
W y /L
P=

[4]

The rate of growth of productivity is given by assumption 2 above, and the rate of growth of
wages, W comes from the long-run Phillips curve of Chapter 15 combined with the
unemployment rate assumption. With the unemployment rate at about 6 percent, recent estimates
of the Phillips curve suggest that W would be about 9 to 10 percent. Thus, with productivity
growing at about 1.0 percent, we could expect P to be about 8 to 9 percent along trend, with
relative shares remaining constant.

If the Phillips curve could be shifted to the left by an Incomes Policy such as the
guideposts, and W held down to around 1 percent a year, then a zero rate of price increase,
maintaining relative shares constant with real wages growing as fast as productivity, could be
achieved. In fact, this has not been possible in the United States, so that to maintain constant
relative shares with real wages growing as fast as productivity, P will probably have to be at least
8 percent.

Nominal GNP growth

Adding the growth rate of real output y and the growth rate of prices P, we can obtain the trend
growth rate of money GNP, Y. Since Y = y .P, we have
Y = y + P.

[5]

Substituting the equation (3) expression for trend and equation (4) for trend P gives us
Y = y/L +1 + W y/L = L +W.

[6]

Along trend, with relative shares constant, the growth rate of nominal GNP will be the sum of the
rates of growth of the labor force, L, and of the money wage rate, W. From equation (4) the
money wage growth rate that maintains constancy of relative shares is
W = P + y/L.

[7]

so that the W term in equation (6) simply represents productivity growth plus the rate of increase
of prices, and the L term adds in the rate of growth of the labor force.

If the guideposts were followed, P would be zero, so that Y = y, and the rate of growth of money
wages would simply represent productivity growth. Thus, under the guideposts,
Y = L + y/1 = y

[8]

Equilibrium growth on the supply side

Equations (3) and (4), which give the growth rates of output and the price level along the
potential GNP path, can be conveniently interpreted as the conditions for equilibrium growth on
the supply side. Given the growth rates of the labor force and productivity, equation (3) shows
the growth rate of output that will maintain constant employment and unemployment rates. The
assumed unemployment rate then fixes the rate at which wage rates increase-the rate at which the
labor supply curve shifts up.
With the rate of growth of output which will maintain a given rate of unemployment and the rule
at which the labor supply curve shifts up both fixed, equation (4) gives the rate of increase of the
price level, P. that will keep the supply. side of the economy in equilibrium. The next step in the
analysis of trend growth in the static model is to determine the monetary and fiscal policies that
will shift the economys demand curve out along trend at just the rate that will maintain both
demand and supply equilibrium along the growth path of y and P described by equations (3) and
(4).
The problem is illustrated in Figure 17.2. Starting from an initial equilibrium P 0, Yo point,
where y0 is potential output at time 0, the growth of the labor force and productivity raise y to Y 1
and y2 in time periods 1 and 2, following equation (3). With unemployment maintained at 4
percent as y moves to y1 and y2, the labor supply curve shifts up faster than productivity growth,
so that the price level must rise from P0 to P1 to P2 to maintain equilibrium on the supply side.
This analysis fixes points 0, 1, and 2 in Figure 17.2 as the equilibrium P, y points on the
supply side as y and P grow according to equations (3) and (4). This means that the economys
supply curve is shifting out from S0S0 to S1S1, to S2S2 in Figure 17.2 as the economy grows along
trend. The problem now is to find the path of the demand-side variables, especially the money
supply M and the government budget deficit d = g t(y), that will shift the demand curve D 0D0
of Figure 17.2 out just fast enough to pass through points I and 2 , so that the economy remains
in equilibrium as y and P grow according to equations (3) and (4).

TREND GROWTH OF THE MONEY SUPPLY

We will begin on the demand side by finding the trend rate of growth of the money supply that
will hold interest rates constant along trend as y and P grow according to equations (3) and (4).
Then we can determine the movements of the governments fiscal policy variables that will
maintain the product market in equilibrium. These results can then be modified by assuming that
interest rates are not constant along trend. This will change the M path and the movement of
investment along trend, changing the fiscal policy path that will maintain product market
equilibrium.

The equilibrium condition in the money market from Part III is

M
=m(r . y)
P

[9]

In Chapter 12, we suggested that the long-run elasticity for real balances with respect to changes
in real income is about 1. Thus, if the rate of change in real balances is equal to the rate of
change in real income, the money market equilibrium condition expressed in equation (9) will
remain satisfied with no change in interest rates. Thus to hold interest rates. constant, we have
M
=y
P

[10]

Since the term on the left can be rewritten as

M
=M P
P

[11]

then (10) implies that growth of the nominal-money stock given by

M=y+P

[12]

will hold interest rates constant along the trend growth path of y and P. If nominal income
grows at 8 percent or so along trend, the money supply also must grow at about 8 percent with a
Unitary income elasticity of demand for money to keep the money market in equilibrium with
constant r. This money supply behavior will also hold velocity v = Y/M constant as the economy
grows along trend.
Equation (12) gives the growth in the money supply that will shift the LM curve of
Figure 17.3 out fast enough to maintain money market equilibrium as y grows according to
equation (3) with r constant. As y grows at rate y, the LM curve must shift out at the same rate to
maintain money market equilibrium at the initial interest rate r 0. To shift the LM curve out at that

rate, the money supply must grow at the rate Y = y + P, given by equation (12), to supply the
increased transactions demands stemming from both the p and y increase.
This section has given us the rule for trend growth in the money supply. To keep the money
market in equilibrium constantor, more precisely. trendlessinterest rates with y and P
growing along the trends given by equations (3) and (4), the trend growth rate of the money
supply should be about the same as that of nominal GNP. If the price level grows at about 8
percent per year, this indicates a trend money supply growth rate of about 10 percent. If prices
are constant, the money supply should show a trend growth rate of about 1.0 to 1.5 percent to
hold interest rates constant. Again, we should note that this is the rule for the long-run average,
or trend, growth in the money supply to keep the economy near Its potential growth path. As
private demand fluctuates about its long-run trend, policy variables will also have to fluctuate to
maintain total demand at the full-employment level, as we saw in Parts II and Ill. Here we are
developing the long-run average outcome for the policy variables given the trend growth in
private demand. Now we can turn to the fiscal policy prescription that shifts the IS curve nit just
fast enough to maintain demand-side equilibrium as y grows from y0 to y1 in Figure 17.3.

PRODUCT MARKET EQUILIBRIUM AND THE BUDGET

The equilibrium condition in the product market can be written as
c + i + g = c + s + t.

[13a]

or
i + g = S + t.

[13b]

Here each variable is set at its ex ante. or planned level; product market equilibrium is
maintained when planned I + g = planned s + t. Equation (13b) can be divided through by y to
obtain the product market equilibrium condition with all items stated as fractions of real output,
i g s t
+ = +
y y y y

[14]

Rearranging the terms in equation (14), we obtain the necessary equality between net privatesector saving s i, and net public-sector expenditure, the deficit d = g t, to maintain the
product market in equilibrium:
gt d si
= =
y
y
y

[15]

This just restates the fact that in equilibrium the government deficit d must equal the excess of
private saving over investment in the economy. If the saving fraction s/y and the investment
fraction i/y have fairly stable trend values, equation (15) will give us the trend ratio of the deficit
to output that will be needed to keep the product market in equilibrium as the economy grows
along trend.

The saving-income ratio

In Chapter 10 we saw that the long-run data on consumption and income and the three
main theories of the consumption function all say that the ratio of real consumption to real
income Is roughly constant over the long run. If c/y is roughly constant along trend and the tax
structure is proportional so that t(y) = ty, then the ratio of planned saving to income must also be
constant along trend.
One way to write the product market equilibrium condition is
y = c + s + t,

[16]

so that the ratios of c, s, and t to income must add to unity,

1=

c s t
+ +
y y y

[17]

If c/y and t/y are constant, then sly must also be constant. A permanent increase in tax rates,
raising t/y, will reduce both c/y and s/y, presumably in the same proportions that consumption
and saving come out of disposable income. Thus, in the fiscal policy equation (15) sly will be
roughly constant with any given tax structure which determines t/y. An increase in t/y will yield a
smaller decrease in s/y, as perhaps 10 percent of the i increase comes out of saving.

The investment-income ratio

In Chapter 11 we found that empirical estimates show a long-run elasticity of investment
demand with respect to changes in output of unity. This implies a constant ratio of investment to
real output along trend, as increases in output call forth equal percentage increases in investment.
This result can also be obtained by assuming that the capital-output ratio, K/y, is constant,
as shown in assumption 3 above. If K/y is equal to a constant v (here v is the capital-output
ratio), then we have
Net investment = 1,, = K = v . y

as an expression for net investment, which is just the rate of increase of the capital stock.
Dividing the net-investment expression by y yields
in
y
=v .
=v . y
y
y

[18]

If both v and y, the trend growth rate of output, are constant along trend, then the ratio of net
investment to output will also be constant along trend.
Replacement investment is generally assumed to be a fraction 6 of the capital stock K. so
that replacement investment is given by
ir = K = v . y

[19]

and the ratio of replacement investment to output, along trend, will just be the constant

v. If

both net and replacement investment are roughly constant fractions of output, then total
investment i will also be a constant fraction of y along trend.
Both net and replacement investment, in equations (18) and (19), depend on the capital-output
ratio v. This gives the desired capital stock at any given level of y. The level of this stock then
determines replacement investment through and the rate of growth of this stock is net
investment. Thus, equations (18) and (19) show that for any given v there is a constant long-run
average ratio of investment to output.
As we saw in Chapter 11, the desired capital-output ratio should, in turn, depend on the interest
rate through the cost of capital. The higher the interest rate, the lower the desired capital-output
ratio v. Thus if the economy moves from one roughly constant level of the interest rate r o to
another lower level r1, there will be a corresponding increase in the capital output ratio v from v0
to v1 and an increase in the investment-output ratio from (i/y) 0 to (i/y)1. This says that for any
given level of interest rates there will be given equilibrium capital-output and investment-output
ratios. A change in rates will change the ratios to new equilibrium levels.