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1 Productivity, output and unemployment in the short run
Chapter 13 Technological progress: the short, the medium and the long runs 261
the current policy rate. In this case, the demand for goods increases; the IS curve shifts to ➤ Recall our discussion of such major
inventions (in Chapter 12). This arguthe right, from IS to IS″ in Figure 13.1. The economy moves from A to A″. The short run
ment points to the role of expectations
level of output increases from Y to Y″.
in affecting consumption and investNow take the case where productivity growth comes not from the introduction of new
ment, something we have not yet
technologies but from the more efficient use of existing technologies. One of the implicastudied formally, but shall do so later
tions of increased international trade has been an increase in foreign competition. This
(in Chapter 16).
competition has forced many firms to cut costs by reorganising production and eliminating jobs (this is often called downsizing). When such reorganisations are the source of
productivity growth, there is no presumption that aggregate demand will increase. Reorganisation of production may require little or no new investment. Increased uncertainty
and job security worries faced by workers might cause them to want to save more, and so
to reduce consumption spending given their current income. In this case, the demand for
goods falls at a given real policy rate; the IS curve shifts to the left and the short-run level
of output falls from Y to Y′ as in Figure 13.1.
Let’s assume the more favourable case (more favourable from the point of view of output
and employment), that is the case where the IS curve shifts to the right from IS to IS″ as in
Figure 13.1. Equilibrium output rises, from Y to Y″. In this case, the increase in productivity,
by raising expected output growth and expected profits, unambiguously leads to an increase
in demand and thus to a higher equilibrium output.
Even in this favourable case, however, we cannot tell what happens to employment without having more information. To see why, note that equation (13.2) implies the following
➤ Start from the production funcrelation:
% change in employment = % change in output - % change in productivity
Thus, what happens to employment depends on whether output increases proportionately
more or less than productivity. If productivity increases by 2%, it takes an increase in output
of at least 2% to avoid a decrease in employment – that is, an increase in unemployment.
And without a lot more information about the slope and the size of the shift of the IS curve,
we cannot tell whether this condition is satisfied even in the more favourable case in Figure 13.1, that is when the IS curve shifts to the right and output rises to Y′. In the short run,
an increase in productivity may or may not lead to an increase in unemployment. Theory
alone cannot settle the issue.
tion Y = A/N. From Proposition 7
in Appendix 2, this relation implies
that gY = gA + gN. Or equivalently,
gN = gY - gA.
The discussion has assumed that macroeconomic policy was given. But both
fiscal policy and monetary policy can
clearly affect the outcome. Suppose
you were in charge of monetary policy
in this economy and there appeared
to be an increase in the rate of productivity growth. What would you do?
This was one of the questions the Fed
faced in the 1990s at the height of the
Interest rate, r
M13 Macroeconomics 85678.indd 261
The demand for goods in
the short run following an
increase in productivity
An increase in productivity may
increase or decrease the demand for
goods. Thus, it may shift the IS curve
to the left or to the right. What happens
depends on what triggered the increase
in productivity in the first place.
262 THE CORE The long run
The empirical evidence
Can empirical evidence help us decide whether, in practice, productivity growth increases
or decreases employment? At first glance, it would seem to. Look at Figure 13.2, which plots
the behaviour of labour productivity and the behaviour of output for the US business sector
from 1960 to 2014.
The figure shows a strong positive relation between year-to-year movements in output
growth and productivity growth. Furthermore, the movements in output are typically
larger than the movements in productivity. This would seem to imply that, when producCorrelation versus causality: if we see
a positive correlation between output
tivity growth is high, output increases by more than enough to avoid any adverse effect
growth and productivity growth, should
on employment. But this conclusion would be wrong. The reason is that, in the short run,
we conclude that high productivity
the causal relation runs mostly the other way, from output growth to productivity growth.
growth leads to high output growth, or
That is, in the short run, higher output growth leads to higher productivity growth, not the
that high output growth leads to high
➤ other way around. The reason is that, in bad times, firms hoard labour; they keep more
workers than is necessary for current production. So when demand and output decrease,
employment decreases by less than output; equivalently, labour productivity decreases.
This was particularly clear in 2008, at the beginning of the crisis, when firms did not
immediately realise that it would last so long. When instead demand and output increase,
This discussion is directly related to our ➤ firms increase employment by less than output, and labour productivity increases. This
discussion in the Focus box on Okun’s
is what we see in Figure 13.2, but this is not the relation we are after. Rather, we want to
law (see Chapter 9). There, we saw
know what happens to output and unemployment when there is an exogenous change in
there that a change in output leads to a
productivity – a change in productivity that comes from a change in technology, not from
smaller proportional change in employthe response of firms to movements in output. Figure 13.2 does not help us much here.
ment. This is the same as saying that
a change in output is associated with
And the conclusion from the research that has looked at the effects of exogenous movea change in labour productivity in the
ments in productivity growth on output is that the data gives an answer just as ambiguous
same direction. (Make sure you underas the answer given by the theory:
Sometimes increases in productivity lead to increases in output sufficient to maintain or
even increase employment in the short run.
Sometimes they do not, and unemployment increases in the short run.
Labour productivity and
output growth in Germany
There is a strong positive relation
between output growth and productivity growth. But the causality runs from
output growth to productivity growth,
not the other way around.
Source: OECD STAN Database for Structural
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Annual growth rate (per cent)
Chapter 13 Technological progress: the short, the medium and the long runs 263
13.2 Productivity and the natural rate of
We have looked so far at short-run effects of a change in productivity on output and, by implication, on employment and unemployment. In the medium run, the economy tends to return
to the natural level of unemployment. Now we must ask: Is the natural rate of unemployment
itself affected by changes in productivity?
Since the beginning of the Industrial Revolution, workers have worried that technological progress would eliminate jobs and increase unemployment. In early nineteenth-century
England, groups of workers in the textile industry, known as Luddites, destroyed the new
machines that they saw as a direct threat to their jobs. Similar movements took place in
other countries. Saboteur comes from one of the ways French workers destroyed machines:
by putting their sabots (their heavy wooden shoes) into the machines.
The theme of technological unemployment typically resurfaces whenever unemployment is high. During the Great Depression, a movement called the technocracy movement
argued that high unemployment came from the introduction of machinery, and that things
would only get worse if technological progress were allowed to continue. In the late 1990s,
France passed a law reducing the normal working week from 39 to 35 hours. One of the reasons invoked was that, because of technological progress, there was no longer enough work
for all workers to have full-time jobs. Thus the proposed solution: have each worker work
fewer hours (at the same hourly wage) so that more of them could be employed.
In its crudest form, the argument that technological progress must lead to unemployment
is obviously false. The large improvements in the standard of living that advanced countries
have enjoyed during the twentieth century have come with large increases in employment
and no systematic increase in the unemployment rate. In the United States, for example, output per person has increased by a factor of 9 since 1890 and, far from declining, employment
has increased by a factor of 6 (reflecting a parallel increase in the size of the US population).
Nor, looking across countries, is there any evidence of a systematic positive relation between
the unemployment rate and the level of productivity.
A more sophisticated version of the argument cannot, however, be dismissed so easily.
Perhaps periods of unusually fast technological progress are associated with a higher natural rate of unemployment, and periods of unusually slow progress associated with a lower
natural rate of unemployment. To think about the issues, we can use the model we developed
earlier (in Chapter 7).
Recall that we can think of the natural rate of unemployment (the natural rate, for short,
in what follows) as being determined by two relations: the price-setting relation and the
wage-setting relation. Our first step must be to think about how changes in productivity affect
each of these two relations.
➤ We assumed that A was constant (and
Price setting and wage setting revisited
then we conveniently set it equal to
one). We now relax this assumption.
Consider price setting first:
From equation (13.1), each worker produces A units of output; put another way, producing one unit of output requires 1/A workers.
If the nominal wage is equal to W, the nominal cost of producing one unit of output is
therefore equal to (1/A)W = W/A.
If firms set their price equal to 1 + m times cost (where m is the mark-up), the price level
is given by:
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Price setting P = (1 + m)
264 THE CORE The long run
The only difference between this equation and the previous equation (7.3) is the presence
of the productivity term, A (which we had implicitly set to one). An increase in productivity
decreases costs, which decreases the price level given the nominal wage.
Turn to wage setting. The evidence suggests that, other things being equal, wages are typically set to reflect the increase in productivity over time. If productivity has been growing at
2% per year on average for some time, then wage contracts will build in a wage increase of 2%
per year. This suggests the following extension of our previous wage-setting equation (7.1):
Wage setting W = AeP eF(u, z)[13.4]
Look at the three terms on the right of equation (13.4):
Think of workers and firms setting the
wage so as to divide (expected) output
between workers and firms according
to their relative bargaining power. If
both sides expect higher productivity
and therefore higher output, this will be
reflected in the bargained wage.
Two of them, P e and F(u, z), should be familiar from equation (7.1). Workers care about
real wages, not nominal wages, so wages depend on the (expected) price level, P e. Wages
depend (negatively) on the unemployment rate, u, and on institutional factors captured
by the variable z.
The new term is Ae: wages now also depend on the expected level of productivity, Ae. If
workers and firms both expect productivity to increase, they will incorporate those expectations into the wages set in bargaining.
The natural rate of unemployment
We can now characterise the natural rate. Recall that the natural rate is determined by the
price-setting and wage-setting relations, and the additional condition that expectations be
correct. In this case, this condition requires that expectations of both prices and productivity
be correct, so P e = P and Ae = A.
The price-setting equation determines the real wage paid by firms. Rearranging equation
(13.3), we can write:
1 + m
The real wage paid by firms, W/P, increases one for one with productivity A. The higher
the level of productivity, the lower the price set by firms given the nominal wage, and therefore the higher the real wage paid by firms.
This equation is represented in Figure 13.3. The real wage is measured on the vertical axis.
The unemployment rate is measured on the horizontal axis. Equation (13.5) is represented
by the lower horizontal line at W/P = A/(1 + m): the real wage implied by price setting is
independent of the unemployment rate.
Turn to the wage-setting equation. Under the condition that expectations are correct – so
both P e = P and Ae = A – the wage-setting equation (13.4) becomes:
= AF(u, z)[13.6]
The real wage W/P implied by wage bargaining depends on both the level of productivity
and the unemployment rate. For a given level of productivity, equation (13.6) is represented
by the lower downward-sloping curve in Figure 13.3: the real wage implied by wage setting
is a decreasing function of the unemployment rate.
Equilibrium in the labour market is given by point B, and the natural rate is equal to un.
The reason for using B rather than A to ➤
Let’s now ask what happens to the natural rate in response to an increase in productivity.
denote the equilibrium is because we
Suppose that A increases by 3%, so the new level of productivity A′ equals 1.03 times A.
are already using the letter A to denote
the level of productivity.
M13 Macroeconomics 85678.indd 264
From equation (13.5) we see that the real wage implied by price setting is now higher by
3%: the price-setting line shifts up.
From equation (13.6), we see that at a given unemployment rate, the real wage implied
by wage setting, is also higher by 3%: the wage-setting curve shifts up.
Chapter 13 Technological progress: the short, the medium and the long runs 265
Real wage, W⁄P
AF (u, z )
Unemployment rate, u
The effects of an increase
in productivity on the natural rate of unemployment
An increase in productivity shifts both
the wage- and price-setting curves by
the same proportion and thus has no
effect on the natural rate.
Note that, at the initial unemployment rate un, both curves shift up by the same amount,
namely 3% of the initial real wage. That is why the new equilibrium is at B′, directly above
B. The real wage is higher by 3% and the natural rate remains the same.
The intuition for this result is straightforward. A 3% increase in productivity leads firms to
reduce prices by 3% given wages, leading to a 3% increase in real wages. This increase exactly
matches the increase in real wages from wage bargaining at the initial unemployment rate.
Real wages increase by 3% and the natural rate remains the same.
We have looked at a one-time increase in productivity, but the argument we have developed also applies to productivity growth. Suppose that productivity steadily increases, so
that each year A increases by 3%. Then, each year, real wages will increase by 3% and the
natural rate will remain unchanged.
The empirical evidence
We have just derived two strong results. The natural rate should depend neither on the level
of productivity nor on the rate of productivity growth. How do these two results fit the facts?
An obvious problem in answering this question is the one we discussed before (in
Chapter 8): that we do not observe the natural rate. Because the actual unemployment rate
moves around the natural rate, looking at the average unemployment rate over a decade
should give us a good estimate of the natural rate for that decade. Looking at average productivity growth over a decade also takes care of another problem we discussed previously.
Although changes in labour hoarding can have a large effect on year-to-year changes in
labour productivity, these changes in labour hoarding are unlikely to make much difference
when we look at average productivity growth over a decade.
Figure 13.4 plots average US labour productivity growth and the average unemployment
rate during each decade since 1890. At first glance, there seems to be little relation between
the two. But it is possible to argue that the decade of the Great Depression is so different
that it should be left aside. If we ignore the 1930s (the decade of the Great Depression),
then a relation – although not a strong one – emerges between productivity growth and
the unemployment rate. But it is the opposite of the relation predicted by those who believe
in technological unemployment. Periods of high productivity growth, like the 1940s to the
1960s, have been associated with a lower unemployment rate. Periods of low productivity
growth, such as those the United States saw during 2010–2014, have been associated with
a higher unemployment rate.
M13 Macroeconomics 85678.indd 265
266 THE CORE The long run
Productivity growth and
by decade, 1890–2014
There is little relation between the
10-year averages of productivity
growth and the 10-year averages of the
unemployment rate. If anything, higher
productivity growth is associated with
Average annual labour productivity
growth (per cent)
Sources: Data prior to 1960: Historical Statistics of the United States. Data after 1960:
Bureau of Labor Statistics.
Average unemployment rate (per cent)
Can the theory we have developed be extended to explain this inverse relation in the
medium run between productivity growth and unemployment? The answer is yes. To see
why, we must look more closely at how expectations of productivity are formed.
Up to this point, we have looked at the rate of unemployment that prevails when both price
expectations and expectations of productivity are correct. However, the evidence suggests
that it takes a long time for expectations of productivity to adjust to the reality of lower or
higher productivity growth. When, for example, productivity growth slows down for any reason, it takes a long time for society, in general, and for workers, in particular, to adjust their
expectations. In the meantime, workers keep asking for wage increases that are no longer
consistent with the new lower rate of productivity growth.
To see what this implies, let’s look at what happens to the unemployment rate when
price expectations are correct (i.e. P e = P) but expectations of productivity (Ae) may not be
(i.e. Ae may not be equal to A). In this case, the relations implied by price setting and wage
1 + m
= AeF(u, z)
Suppose productivity growth declines. A increases more slowly than before. If expectations of productivity growth adjust slowly, then Ae will increase for some time by more than
A does. What will then happen to unemployment is shown in Figure 13.5. If Ae increases by
more than A, the wage-setting relation will shift up by more than the price-setting relation.
The equilibrium will move from B to B′ and the natural rate will increase from un to un= . The
natural rate will remain higher until expectations of productivity have adjusted to the new
reality – that is, until Ae and A are again equal. In words, after the slowdown in productivity
growth, workers will ask for larger wage increases than firms are able to give. This will lead
to a rise in unemployment. As workers eventually adjust their expectations, unemployment
will fall back to its original level.
Let’s summarise what we have seen in this and the preceding section.
There is not much support, either in theory or in the data, for the idea that faster productivity growth leads to higher unemployment:
M13 Macroeconomics 85678.indd 266
In the short run, there is no reason to expect, nor does there appear to be, a systematic
relation between movements in productivity growth and movements in unemployment.
Chapter 13 Technological progress: the short, the medium and the long runs 267
Real wage, W ⁄P
Unemployment rate, u
The effects of a decrease in
productivity growth on the
unemployment rate when
expectations of productivity growth adjust slowly
If it takes time for workers to adjust
their expectations of productivity
growth, a slowdown in productivity
growth will lead to an increase in the
natural rate for some time.
In the medium run, if there is a relation between productivity growth and unemployment,
it appears to be, if anything, an inverse relation. Lower productivity growth leads to higher
unemployment. Higher productivity growth leads to lower unemployment.
Given this evidence, where do fears of technological unemployment come from? They
probably come from the dimension of technological progress we have neglected so far,
namely structural change, the change in the structure of the economy induced by technological progress. For some workers – those with skills no longer in demand – structural
change may indeed mean unemployment, or lower wages, or both. Let’s now turn to that.
13.3 Technological progress, churning and
Technological progress is a process of structural change. This theme was central to the work
of Joseph Schumpeter, a Harvard economist who, in the 1930s, emphasised that the process
of growth was fundamentally a process of creative destruction. New goods are developed,
making old ones obsolete. New techniques of production are introduced, requiring new
skills and making some old skills less useful. The essence of this churning process is nicely
reflected in the following quote from a past president of the Federal Reserve Bank of Dallas
➤The Churn: The Paradox of Progress
in his introduction to a report titled The Churn:
My grandfather was a blacksmith, as was his father. My dad, however, was part of the (1993).
evolutionary process of the churn. After quitting school in the seventh grade to work for
the sawmill, he got the entrepreneurial itch. He rented a shed and opened a filling station
to service the cars that had put his dad out of business. My dad was successful, so he bought
some land on the top of a hill, and built a truck stop. Our truck stop was extremely successful
until a new interstate went through 20 miles to the west. The churn replaced US 411 with
Interstate 75, and my visions of the good life faded.
Many professions, from those of blacksmiths to harness makers, have almost vanished for
ever. For example, there were more than 11 million farm workers in the United States at the
beginning of the last century, but because of high productivity growth in agriculture, there
are less than a million today. By contrast, there are now more than 3 million truck, bus and
taxi drivers in the United States; there were none in 1900. Similarly, today, there are more
than 1 million computer programmers; there were practically none in 1960. Even for those
with the right skills, higher technological change increases uncertainty and the risk of unemployment. The firm in which they work may be replaced by a more efficient firm, the product
their firm was selling may be replaced by another product. This tension between the benefits
M13 Macroeconomics 85678.indd 267
268 THE CORE The long run
of technological progress for consumers (and, by implication, for firms and their shareholders) and the risks for workers is well captured in the cartoon here. The tension between the
large gains for all of society from technological change and the large costs of that technological change for the workers who lose their jobs is explored in the following Focus box.
© Chappatte in Die Weltwoche, Zurich, www.globecartoon.com
Job destruction, churning and earnings losses
Technological progress may be good for the economy,
but it is tough on the workers who lose their jobs. This is
documented in a study in 2011 by Steve Davis and Till von
Wachter, who used records from the social security system
between 1974 and 2008 to look at what happens to workers who lose their job as a result of a mass layoff.
Davis and von Wachter first identified all the firms with
more than 50 workers where at least 30% of the workforce was laid off during one quarter, an event they call a
mass layoff. Then they identified the laid-off workers who
had been employed at that firm for at least three years.
These are long-term employees. They compared the labour
market experience of long-term employees who were laid
off in a mass layoff to other similar workers in the labour
force who did not leave in the layoff year or in the next
two years. Finally, they compared the workers who experienced a mass layoff in a recession to those who experienced a mass layoff in an expansion.
M13 Macroeconomics 85678.indd 268
Figure 13.6 summarises their results. The year 0 is the
year of the mass layoff. Years 1, 2, 3, and so on are the
years after the mass layoff event. The negative years are
the years prior to the layoff. If you have a job and are a
long-term employee, your earnings rise relative to the
rest of society prior to the mass layoff event. Having a
long-term job at the same firm is good for an individual’s wage growth. This is true in both recessions and
Look at what happens in the first year after the layoff. If you experience a mass layoff in a recession, your
earnings fall by 40 percentage points relative to a worker
who does not experience a mass layoff. If you are less
unfortunate and you experience your mass layoff in an
expansion, then the fall in your relative earnings is only
25 percentage points. The conclusion: mass layoffs cause
enormous declines in relative earnings whether they
occur in a recession or an expansion.