On macroeconomics, asset pricing, and growth
Can you learn economics in one self-taught lesson? Maybe.
In this column, I attempt to explain the economics of aggregate income (also known as gross domestic product or GDP) and inflation, the pricing of assets, and what drives economic growth.
Role of expectations
Expectations and trust determine real GDP by driving contracts in the goods and labor markets. Expectations also drive the prices of assets. This explains the foreign exchange market as well as the stock and bond markets.
The Keynesian model
Firms buy labor and supply goods on their expectations of (aggregate) demand for final product. Households buy goods on expectations of future income from selling labor. Viewing the circularity of production, income, and consumption as economic activity on a dance floor makes sense. It takes two — firms and households — to tango. And the dancing is based on expectations. But there is a third player— the government. This third player can make or break the economic mood music. Government also plays a role in promoting competition and equality in the economy.
Inflation and growth
Where are prices and inflation in the Keynesian model?
Wages and prices are correlated. This is unsurprising because consumer goods (the bulk of final production) and leisure are substitutes and because the wage rate is leisure’s price or opportunity cost. Adam Smith taught us that we produce to consume.
The Adam Smith market model explains how the labor market determines wages but with a twist.
The labor supply curve is flat at the subsistence wage (or its modern equivalent) but slopes upward above that level. Supply then becomes vertical or even bends backward at full employment. This view of the labor supply lies behind the textbook concepts (called the Phillips Curve and the IS-LM model) that predict or assume zero wage and price inflation during recessions.
Wages are sticky downwards because of workers’ expectations that they can find jobs at the latest known level and because firms do not expect workers to work if they cannot survive (The Iron Law of Wages).
Demand for labor reflects its marginal product, which in turn is determined by technology. This means that technological advances drive up wages in the long run. Technological advances also explain economic growth and poverty reduction over time.
Since labor supply becomes vertical at full employment, wage and price inflation emerges when government policy aims at achieving economic growth beyond the economy’s capacity to produce. Unfortunately, changes in such capacity are typically latent, and policymakers’ errors will result in recessions or inflation. These errors are observed as ‘incorrect forecasts’ of GDP and inflation.
Demand for goods slopes downward, although it shifts according to expectations and government policy. Absent ‘shocks,’ the supply of goods responds to aggregate demand. However, there can be cases when firms incorrectly anticipate shifts in demand in the short run. Real wages (adjusted for inflation) will rise in the long run because workers will tend to ‘capture’ their increased productivity.
Differing views of inflation
A ‘shock’ that reduces economic capacity, as during wars and epidemics, results in ‘cost-push’ inflation if aggregate demand is unchanged. When the shock dissipates, so does inflation.
Central banks ‘print money’ when they buy government bonds. This often happens when politicians encounter taxpayer resistance. If the economy is already at full capacity, expansionary monetary policy results in what we call ‘demand-pull’ inflation.
Whatever category we put inflation in — cost-push or demand-pull — it arises only when aggregate demand exceeds economic capacity.
The downward stickiness of wages also applies to consumer prices. Goods prices will fall only in extreme cases, such as when firms produce too much. Thus, inflation is a positive number, and modern central banks aim for a ‘low’ target, such as 2 percent or 3 percent. They want to avoid being responsible for demand-pull inflation.
Econ growth not a mystery
As noted, economic growth is driven by technological advances. But what drives the latter? We can import technology at a cost. We can give incentives to foreign direct investment that brings in advanced technology. We can incentivize Filipino talent abroad to return (good luck with that). We can also grow technology at home through better education and stronger support for local research. In sum, today’s optimistic forecasts of a growing economy are hype. They remind us of the song about rain never falling in Southern California: ‘.. had offers but didn’t know which one to take.’ Yes, right.
Competition policy, inequality also matter
What happens when firms have pricing power? Can firms have a macro ‘corner’ in that they behave as a monopsony in the labor market and as a monopoly in the goods market?
When firms have too much pricing power, abnormal profits arise. Over time, there will be a persistent and high level of income inequality. An IMF study (Philip Gerson, 1998) documented this inequality finding for the Philippines after World War II.
A more recent study published by the World Bank in 2022 gives a more optimistic analysis. The study reports that inequality has started to fall in recent years. This is partly due to increased competition and ‘safety nets’ for the poor.
Growth, inequality intertwined
It is worth noting, however, that there are two kinds of equality. One is that of opportunity. The other equality is that of outcomes in terms of income and wealth.
Economic growth requires incentives via equality of opportunity. However, growth also results in inequality of outcomes, which stifles incentives. This is because newly formed elites turn to preserving rather than enhancing the overall wealth of the economy. Historically, we have seen cycles of economic progress and stagnation.
The way out of these cycles is to aim more at equality of opportunity than equality of outcomes.
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Author’s email: [email protected]; Twitter: @ORoncesvalles
