Academic journal article Contemporary Economic Policy

Long-Run Growth Projections and the Aggregate Production Function: A Survey of Models Used by the U.S. Government

Academic journal article Contemporary Economic Policy

Long-Run Growth Projections and the Aggregate Production Function: A Survey of Models Used by the U.S. Government

Article excerpt

I. INTRODUCTION

Long-run economic growth is an area of obvious interest to both economists and policymakers. This interest is evident in the large academic literature on economic growth and the considerable effort that policymakers undertake when projecting the growth of the U.S. economy. Accurate projections of future growth have clear implications for U.S government budget policy, the soundness of the Social Security and Medicare systems, and future standards of living in the United States.

This paper examines the methodology of four prominent government models - the Congressional Budget Office (CBO), the Social Security Administration (SSA), the Office of Management and Budget (OMB), and the General Accounting Office (GAO) - and finds that all are essentially simple Solow growth models in the neoclassical tradition. While the details differ, each agency utilizes a similar framework where potential output depends on the aggregate levels of capital, labor, and technology through the familiar aggregate production function. Long-run growth then results from the accumulation of primary inputs due to demographic changes, education choices, saving and investment decisions, and exogenous increases in total factor productivity.

The Congressional Budget Office (1997a,b,c, 1996, 1995) has the most sophisticated model of long-run growth and explicitly relies on an aggregate production function. CBO uses a detailed and fully developed model of the economy where potential Gross Domestic Product (GDP) growth is determined by a two-input, Cobb-Douglas production function in the nonfarm business sector. Output grows with increases in labor hours (due to exogenous population growth and demographic shifts), endogenous capital accumulation (due to investment and national savings rates), and exogenous increases in total factor productivity.

The Social Security Administration (1996, 1992) and Board of Trustees (1996) use a long-run growth model that, implicitly at least, is in the neoclassical tradition. Since SSA is primarily interested in wage growth and labor supply, it does not explicitly model an aggregate production function, endogenize capital, or examine the sources of growth. Rather, SSA simply defines potential GDP growth as the sum of the growth in labor hours and the growth in labor productivity without modeling labor productivity growth. Labor hours are projected from internal demographic trends, and labor productivity growth is set exogenously at historical rates. This approach, however, is easily reconciled with the aggregate production function.

The Office of Management and Budget (1997a,b) projects long-run real GDP using a framework very similar to SSA. OMB also is not interested in the sources of growth and instead focuses on the relationship between real output growth and the federal budget. Long-run real GDP projections are modeled as a function of demographic factors, which determine labor supply growth, and of exogenous increases in labor productivity.

The General Accounting Office (1996, 1995, 1992a,b), like the CBO, explicitly uses an aggregate production function that depends on growth in labor hours, an endogenously determined capital stock, and total factor productivity. GAO then examines the impact of federal fiscal policy on the rate of capital accumulation and economic growth. Projections of labor hours are again taken from SSA, and total factor productivity growth is exogenous.

The biggest difference between the models involves the relationship between capital accumulation and fiscal policy. Both CBO and GAO endogenize the capital stock by incorporating feedback relationships that link fiscal policy, national savings, and capital accumulation. These models both show that, given demographic trends, current U.S. fiscal policy is not sustainable in the long run. SSA and OMB, on the other hand, simply assume labor productivity will follow previous trends without accounting for the impact of fiscal policy on capital accumulation. …

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