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Macroeconomics Issues

An increase in the quality of capital increases labor productivity (more output

for the same
amount of labor).We thus have our third answer as to why labor productivity has
increased over
time the quality of capital has increased because of embodied technical change.
We will come back to embodied technical change, but to finish the train of thoug
ht we turn
next to disembodied technical change.
Disembodied Technical Change
In some situations we can achieve higher levels of output over time even if the
quantity and quality
of labor and capital don't change. How might we do this? Perhaps we learn how to
better organize
the plant floor or manage theNote that the double equal sign has replaced the tr
iple equal sign because the equation is no
longer an identity. The equation is true if velocity is constant (and equal to V
) but not otherwise.
If the equation is true, it provides an easy way to explain nominal GDP. Given M
, which can be
considered a policy variable set by the Federal Reserve (Fed), nominal GDP is ju
st In this
case, the effects of monetary policy are clear. Changes in M cause equal percent
age changes in
nominal GDP. For example, if the money supply doubles, nominal GDP also doubles.
If the
money supply remains unchanged, nominal GDP remains unchanged.
The key is whether the velocity of money is really constant. Early economists be
lieved that
the velocity of money was determined largely by institutional considerations, su
ch as how often
people are paid and how the banking system clears transactions between banks. Be
cause these
factors change gradually, early economists believed velocity was essentially con
When there is equilibrium in the money market, then the quantity of money suppli
ed is
equal to the quantity of money demanded. That could mean that M in the quantitytheory
equation equals both the quantity of money supplied and the quantity of money de
If the quantity-theory equation is looked on as a demand-for-money equation, it
says that
the demand for money depends on nominal income (GDP, or P  Y), but not on the int
rate.2 If the interest rate changes and nominal income does not, the equation sa
ys that the
quantity of money demanded will not change. This is contrary to the theory of th
e demand
for money in Chapter 26, which had the demand for money depending on both income
the interest rate.
Testing the Quantity Theory of Money One way to test the validity of the quantit
theory of money is to look at the demand for money using recent data on the U.S.
The key is this: Does money demand depend on the interest rate? Most empirical w
says yes.When demand-for-money equations are estimated (or fit to the data ), the i

rate usually turns out to be a factor. The demand for money does not appear to d
epend only
on nominal income.
Another way of testing the quantity theory is to plot velocity over time and see
how it
behaves. Figure 33.1 plots the velocity of money for the 1960 I 2010 I period. The
data show
that velocity is far from constant. There is a long-term trend on average, velocit
y has been
rising during these years but fluctuations around this trend have also occurred an
d some
have been quite large. Velocity rose from 6.1 in 1980 III to 6.7 in 1981 III, fe
ll to 6.3 in 1983 I,
rose to 6.7 in 1984 III, and fell to 5.7 in 1986 IV. Changes of a few tenths of
a point may seem
small, but they are actually large. For example, the money supply in 1986 IV was
$800 billion.
If velocity changes by 0.3 with a money supply of this amount and if the money s
upply is
unchanged, we have a change in nominal GDP (P  Y) of $240 billion (0.3  $800 billi
which is about 5 percent of the level of GDP in 1986. The change in velocity in
2008-2009 was
remarkable. Velocity fell from 9.3 in 2008 I to 7.3 in 2009 IV!
The debate over monetarist theories is more subtle than our discussion so far in
First, there are many definitions of the money supply. M1 is the money supply va
riable used
for the graph in Figure 33.1, but there may be some other measure of the money s
upply that
would lead to a smoother plot. For example, many people shifted their funds from
account deposits to money market accounts when the latter became available in th
e late
1970s. Because GDP did not change as a result of this shift while M1 decreased,
velocity the
ratio of GDP to M1 must have gone up. Suppose instead we measured the supply of mo
by M2 (which includes both checking accounts and money market accounts). In this
case, the
decrease in checking deposits would be exactly offset by the rise in money marke
t account
deposits and M2 would not change.With no change in GDP and no change in M2, the
of money would not change. Whether or not velocity is constant may depend partly
how we measure the money supply.
Second, there may be a time lag between a change in the money supply and its eff
ects on
nominal GDP. Suppose we experience a 10 percent increase in the money supply tod
ay, but it
takes 1 year for nominal GDP to increase by 10 percent. If we measured the ratio
of today s
money supply to today s GDP, it would seem that velocity had fallen by 10 percent.
However, if we
measured today s money supply against GDP 1 year from now, when the increase in th
e supply of
money had its full effect on income, velocity would have been constant.
M * V.
2 In terms of the Appendix to Chapter 27, this means that the LM curve is vertic

al. labor force. In recent years operational improvements like lean manufacturin
and vendor inventory management systems have increased the ability of many manuf
firms to get more output from a fixed amount and quality of labor and capital. E
improvements in information and accounting systems or incentive systems can lead
to improved
output levels. A type of technical change that is not specifically embedded in e
ither labor or capital
but works instead to allow us to get more out of both is called disembodied tech
nical change.
Recent experiences in the Chinese economy provide an interesting example of what
might be
considered disembodied technical change broadly defined. Working at the IMF, Zul
iu Hu and
Mohsin Khan have pointed to the large role of productivity gains in the 20 years
following the market
reforms in China. In the period after the reforms, productivity growth rates tri
pled, averaging
almost 4 percent a year. Hu and Khan argue that the productivity gains came prin
cipally from the
unleashing of profit incentives that came with opening business to the private s
ector. Better incentives
produced better use of labor and capital.
Disembodied technical change can be negative. An example is environmental regula
tions that
require the whole production process to pollute less and thus, say, run less eff
iciently from a private
perspective.Another example is health and safety regulations that require the pr
oduction process to
run slower to reduce injuries to workers. There is an important caveat here, how
ever. In these examples,
output will be smaller if it does not include the increased quality of air, wate
r, health, and safety
that results from the regulations. So you can think about disembodied technical
change in these
cases as being negative regarding the usual measure of output, but not necessari
ly a broader measure
of welfare.
To the extent that disembodied technical changes are mostly positive, this is ou
r fourth answer
as to why labor productivity has increased. People have figured out how to run p
processes and how to manage firms more efficiently.
More on Technical Change
We have seen that both embodied and disembodied technical change increase labor
It is not always easy to decide whether a particular technical innovation is emb
odied or disembodied,
and in many discussions this distinction is not made. In the rest of this sectio
n we will not
make the distinction, but just talk in general about technical innovations. The
main point to keep
in mind is that technical change, regardless of how it is categorized, increases
labor productivity.
The Industrial Revolution was in part sparked by new technological developments.
New techniques
of spinning and weaving the invention of the machines known as the mule and the sp

jenny, for example were critical. The high-tech boom that swept the United States
in the early 1980s
was driven by the rapid development and dissemination of semiconductor technolog
y. The hightech
boom in the 1990s was driven by the rise of the Internet and the technology asso
ciated with it. In
India in the 1960s, new high-yielding seeds helped to create a green revolution in
Technical change generally takes place in two stages. First, there is an advance
in knowledge, or an
invention.However, knowledge by itself does nothing unless it is used.When new k
nowledge is used
to produce a new product or to produce an existing product more efficiently, the
re is innovation.
Given the centrality of innovation to growth, it is interesting to look at what
has been happening
to research in the United States over time. A commonly used measure of inputs in
to research is
the fraction of GDP spent. In 2007, the United States spent 2.6 percent of it GD
P on R&D, down
from a high of 2.9 percent in the early 1960s.Moreover, over time, the balance o
f research funding
has shifted away from government toward industry. Since industry research tends
to be more
applied, some observers are concerned that the United States will lose some of i
ts edge in technology
unless more funding is provided. In 2007, the National Academies of Science argu
ed as follows:
Although many people assume that the United States will always be a world leader
science and technology, this may not continue to be the case inasmuch as great m