Solow Growth Model and Unemployment

The concept of the business cycle is that the rate of growth in an economy will shift over time, but in a more or less repeatable pattern. The structure of the pattern is, roughly, that economies will grow quickly, then a turning point will occur and the economy will turn into recession. After a trough, the business cycle will begin anew with a fresh period of growth.

For most Western economies, characterized by rising populations, intensive resource exploitation and continuous technological improvements, are on a long-run growth trend in their GDP. The business cycle should be identifiable outside of that trend. The degree of influence between business cycles and the trend is subject to debate. For example, in the United States the recession of 2008-2009 is believed by some to have permanently set the country's growth trajectory below where the previous trendline was -- so the business cycle will have a long-run influence on the trend, even once the recession has ended and the growth stage renewed.

Different economic schools have their own takes on the role that business cycles play in the macroeconomic environment. The real business theory school of thought holds that economic agents are rational and optimising. Another key assumption is that wages and prices are flexible, something for which there is little evidence in the real world for most goods, and certainly for labour. Business cycles, therefore, arise as the result of shocks to the economy. Because agents are always optimising each transaction, a business cycle change is the result of agents changing their views about future economic outcomes, and the implications thereof on current transactions.

Changes often occur from outside the economic sphere. For example, Brexit will result in a change to economic conditions. If that in turn results in a change to the course of the business cycle, that would simply be the net result of millions of rational, optimising transactions. When the circumstances change, then economic agents will change their activities in turn.

There is no role for aggregate demand stimulus from government in this view of economics. Business cycles are the result of changes in the external environment, and agents' reactions to those changes. The government is an agent, but where market agents are viewed as strictly rational, government is perhaps not viewed this way, because government is not necessarily seeking to optimise for itself, but for the economy as a whole, with it intervenes to stimulate an increase in aggregate demand.

The Keynesian view has a couple of different assumptions, the first being wage and price stickiness. We know that wages are sticky because most Western countries have minimum wage laws. But further, "labour," is not a commodity class. Rather, it is a set of specialized markets, only a few of which can be genuinely viewed as commodities with little market friction. In specialized labour markets, there is naturally friction. Keynesians also accept the link between wages and prices. Prices are less sticky than wages because consumers generally have more choice, and fewer barriers to choice, but there is some price stickiness in most markets, and some of that is likely related to wage stickiness.

The Keynesian view understands shocks as either demand or supply shocks. There can be instances where supply fails to meet to demand, but in other times an economy can become misaligned when there is a shortfall of demand. An example might be a situation where consumers decide to save more -- as occurred in 2009 -- so that some of the shock that year was related to demand-side issues, while supply-side issues precipitated that recession, in particular the tightening of lending by banks.

Thus, business cycles can derive from shocks either to demand or to supply. Such shocks will affect major macroeconomic variables. Wages are stickier than some other variables, and stickier even than prices, and that has an influence over the business cycle as well. If wages are sticky, then that friction means that business cannot adjust to a recession simply by cutting wages to hold profits steady. They can only cut wages by laying off workers. The equilibrium point on real wages therefore moves only a little in response to a recession, different from what an RBC theorist would predict.

As such, there is a case in this school of thought for government intervention to stimulate aggregate demand. Government intervenes either through fiscal or monetary policy, both serving to create new demand by either lowering the cost of money or in the case of fiscal simply borrowing against future earnings in order to spend today. This stimulus spending is viewed unfavourable by RBC supporters, because they do not see a case for it; but favourably by Keynesians who feel that there is a case, that new money put into the economy today will increase aggregate demand, and that in turn will stabilize an economy, compressing the business cycle.

2. Since 1975, Europe has had higher rates of unemployment, while other major economies (US, Japan and Canada) have typically had lower rates of unemployment than European nations. Within Europe, there is considerable variability in unemployment rates, with Spain showing particular volatility in its rate, but also France and Italy having persistently higher unemployment rates Most unemployment in the UK is composed of unemployed women, though there has been a general decline in long-term unemployment, implying a shift towards more unemployment, but that being more temporary in nature. Youth unemployment rates have increased since 1985 in the UK.

The price and wage setting framework can be used to understand the determinants of unemployment. Prices in an economy are set by marginal cost of production, firm markup and short-run demand, in addition to tax. Wages are set based on the worker's markup, income tax, and the reservation wage, or more specifically the difference between the reservation wage and the real wage. Wages are included in the marginal cost of production, so there is a relationship between prices and wages in an economy.

As such, wages can be affected by a shift in productivity, changes to the tax structure (either VAT or income tax), changes to worker markups, and the different factors that might influence these things. So technological advancements that affect productivity will influence wages, but conversely so will trade unions and employment protections. Those affect worker markups and the reservation wage differential.

When examining Europe's higher unemployment, there are a number of institutional factors that have had an influence. European workers -- especially in relation to workers in the US -- have stronger worker protections. These include unemployment insurance, legal protections and other elements that drive up the price of wages in Europe. These labour market institutions have been proposed as contributing to higher unemployment. Essentially, the costs that such protections place on business are hypothesized to reduce employment, as European firms must find ways to balance out these higher wages with the prices that they can charge. The higher cost of labour in Europe makes it harder for European companies to price their products competitively on the global market, and this in turn creates lower employment. European companies are also forced to be more innovative -- higher wages drive more productivity innovations.

The strength of this argument is rooted the correlation between worker protections and rights that Europe has, and the continent's persistently higher unemployment rates, especially when juxtaposed against the United States. There is intuitive logic, knowing that wages are a part of marginal cost of production, that higher such costs are going to result in higher prices, and that this reduces global competitiveness. However, there is weakness, in that the numbers are sort of viewed selectively in this argument. Germany and Japan have high levels of worker protections, but they have used innovation to drive their economies. Those countries have relatively low levels of unemployment. The other major weakness of the argument is that it assumes that employment is the end. In the United States, that might well be the case. But in Europe, employment has long been viewed as a means for workers, a means to living a good life. So employment for employment's sake has never been public policy in most European nations; they have structured their labour systems to have higher unemployment benefits, knowing that there will be higher unemployment as the result of greater worker protections.

It is also possible that shocks have some explanatory power over European employment. The European Union has changed over time, with a major shift coming with the fall of the Iron Curtain. That brought a large pool of workers into the European labour market, especially in Germany first, but then later when many Eastern European nations were admitted into the EU. The creation of the Schengen Zone increased labour mobility at the same time -- Europe's labour pools are no longer national, but transnational. The emergence of China (and other Asian nations) as economic powers, and the rise of global trade, have also had an influence on European labour markets, resulting in dramatic changes to key variables, changes that happened much faster than labour markets can adjust for naturally.

3. Some of the key questions about economic growth pertain to rising living standards. Growth models have sought to explain how some countries have been able to grow more rapidly than others. Looking at a few countries, it is easy to see that the US had a better starting point, but questions arise how a resource-poor country like Japan can grow at a much faster rate than a resource-rich country like Argentina in the 20th century. This is a matter of wealth creation -- how economies create their wealth, in general terms. There is also the matter of wealth distribution -- how the living standards of the average citizen have increased.

The Solow Growth Model seeks to explain where growth comes from in an economy. The four basic assumptions of the SGM are that growth is exogenous, that the main driver of growth is factor accumulation (physical capital), that diminishing marginal products apply to each factor (especially capital) and that "convergence" follows. So an economy grows by accumulating capital, but there are diminishing marginal returns. Capital, for example, will be employed for a high rate of return initially, but over time it will be more difficult to find high rates of return on capital. Labour can enjoy a high rate of growth when moving from a non-educated state to one of high-education. But as labour forces become increasingly productive, their ability to become more productive is constrained.

What this means is that initially a country can experience a dramatic increase in living standards, by experiencing rapid increases in productivity. But over time, living standards will level off, and grow at a slower rate, as the economy is reaching the point of diminishing marginal returns on labour and capital. The capitalisation ratio can be diminished through a number of means -- anything that absorbs resources. Thus, if population rates grow too quickly, that will typically reduce the capitalisation ratio, and this can be seen in developing nations with very high population growth rates and low education rates -- they simply cannot achieve rising living standards because even if they grow their economies, that growth is not based on productivity gains and is not shared among all the new workers.

The idea of convergence is that over time there will be a "catching-up" of living standards of all countries. Because poorer countries have the ability to grow faster than wealthier countries, they are able to catch up. This process takes a long time, and it relies on the other elements of the SGM holding, but over time it should occur. In particular, a developing nation needs to undertake good governance over the long run, and there needs to be greater freedom of movement for labour (as great as that for capital or goods), so that people are not forced to live in areas where growth options are currently poorer. The process of convergence occurs when capital flows from richer countries to poorer countries.

The principle of convergence has driven efforts to liberalize trade, and in the past several years, there has been some empirical evidence for convergence. In particular, there is a lowering of the GINI coefficient globally, and a reduction of the number of people in the world who live in abject poverty, despite rising global population. The evidence of recent years supports the argument of convergence.

The Solow Growth Model explains why. The model is based on the idea that as a country gets richer, it will have lower marginal returns on capital and labour. Some of that capital will be redeployed where the growth is, and that is the developing nations. Those nations will be able to experience higher rates of growth, catching them up to the wealthier nations. There are examples of former developing nations that are now entirely developed -- South Korea and Singapore are two. There are many examples of nations where development is easy to see in wealthy cities, but has yet to reach all corners of the country (China is the classic one, but this occurs in many places). There are still countries that lack any development (notably in sub-Saharan Africa). The SGM makes the case that as capital moves to higher-growth economies, it will create convergence, as those countries will be spurred to grow at a much higher rate, catching them up. So income inequality -- which is rising in some developed countries -- will decrease globally, and this is occurring today even when the global population is rising and productivity in increasing, both of which should have a negative effect on the capitalisation ratio.