Question

Answer the following questions about the effects of total factor productivity shocks:

1. Imagine a decrease in total factor productivity (z) happens. We want to explain the effects of this in the labor, asset, and money markets. Determine the effects this shock will have on output, investment, consumption, employment, real wage, real interest rates, average labor productivity, and the price level.

2. Do these movements in part 1 correspond to the actual movement of economic variables during business cycles? In which ways does it fail to reflect the real world?

3. Would it make a difference whether the shock to z is persistent? (That is, whether decreased productivity today also is predictive of decreased productivity tomorrow) If not, why not? If so, what difference does it make?

Answer 1

Total factor productivity reflects the residual growth of an economy in the total output production of firm industry or national income which growth can not be explained by typical changes in factors opf production like changes in capital and labour. It actually measures long term growth of an economy mainly based on the technological innovation. It can explain how efficiently inputs are being used in the production. It is true measure of competitiveness also. If we take a cobb douglas production function where Y= total production or total output K=capital input, L=labour input, A= growth effect that can depict the growth over time.

First of all fall in total factor of productivity will lead to the inward shift of production possibility frontier. As TFP falls that means factors of production are not being used efficiently , there is anew bundle of factor of production consisting of more amount of input factors., Labour will be needed more to produce same unit of output as before.As there is technological dis intervention supply of the good will be less, price of the good will increase as increasing demand, worker's efficiency will be less , investment will be less along with low real wage rate and consumption.

In the case of the real world, TFP growth does not only depend upon advancement in technology but also other variables.It actually represents the condition of depression but due to the long run stability or technological invention it can not consisted always in a business cycle. It depends upon institutional, regulatory and legal operations of an economy.Thus is real life decrease in TFP is quite unreal but  according to the data US TFP has slowed down from mid-2000s mainly on IT sector.

Similarly, decreased productivity today does not predict decreasing productivity tomorrow at all because along with technological empowerment if there is some animal spirit among the investors or the govt and regulatory authority takes some measure to increase the productivity in the very next period the economy can have positive growth in TFP.