The New View of Growth and Business Cycles

By Fisher, Jonas D. M. | Economic Perspectives, Spring 1999 | Go to article overview

The New View of Growth and Business Cycles


Fisher, Jonas D. M., Economic Perspectives


Introduction and summary

Two central concerns of economic policy are growth and business cycle stabilization. There is considerable interest in devising government policies and institutions to influence prospects for economic growth and mitigate the distress associated with economic downturns. Proper evaluation of the benefits and costs of a given policy proposal requires knowledge of the determinants of growth and business cycles. This is one reason for the considerable body of research aimed at understanding these phenomena.

The last two decades have seen considerable advances in this research. Recent empirical evidence, however, brings into question two of its basic assumptions-first, that technological change is homogeneous in nature, in that it affects our ability to produce all goods symmetrically, including consumption and investment goods; and second, that business cycles are driven by shocks which affect the demand for investment goods.

In this article, I document the key evidence that challenges the conventional views of growth and business cycles. I then discuss the plausibility of alternative theories that have been advanced to meet the challenge. To date, the evidence seems to support a new view of growth and business cycles, one that is based on technical change biased toward new investment goods like capital equipment.

The key evidence involves two observations on the behavior of the relative price of business equipment over the last 40 years. First, in almost every year since the end of the 1950s, business equipment has become cheaper than the previous year in terms of its value in consumption goods. This means that if one had to trade restaurant meals for a piece of equipment that makes the same number and quality of, say, bicycles, one would forgo fewer meals in 1998 than in 1958. Second, this relative price tends to fall the most when the economy, and investment expenditures in particular, are growing at relatively high rates, that is, it is countercyclical.

The first piece of evidence is striking because it suggests that much of post-WWII economic growth can be attributed to technological change embodied in new capital equipment. This conflicts with conventional views on what drives economic growth. A piece of capital equipment is a good that is used to produce another good, such as a crane or a computer. An improvement in capital-embodied technology is the invention of equipment that takes the same amount of labor and preexisting equipment to produce as the old equipment but that produces more goods when combined with the same amount of labor as before. If a new production process yields the same units of capital equipment with less factor inputs, then this has the same economic implications as if the capital equipment produced were itself more efficient. Hence, an equivalent interpretation of what constitutes capital-embodied technical change is that it involves an improvement in the technology that produces capital equipment.

To understand the relationship between capital-embodied technical change and the trend in the equipment price, suppose the technology for producing consumption goods is fixed. With improvements in technology embodied in equipment, the supply of (quality-adjusted) investment goods increases relative to consumption goods, so the equipment price falls. Greenwood et al. (1997) build on this insight to show that a large ffaction of economic growth can be attributed to capital-emhodied technical change. This conflicts with the conventional view that most growth is due to disembodied technical change, or multifactor productivity. Improvements in disembodied technology, usually measured as the Solow (1957) residual, make it possible to produce all kinds of goods, not just capital goods, with less capital and labor.(1) If this were the dominant source of growth, then we should not have seen such a large drop in the price of equipment over the last 40 years. …

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