LBMC’s Growth Model

Previous article:  The Way the World Dollar Base Works

So far, we haven’t said much about what does cause the supply of goods (Q) to change.

In L’Ordre Social, Rueff constructs a theoretical model of the world economy. In it, output is the flow of goods and services produced by the stocks of labor and capital. His analysis includes the interaction of market prices and costs of production (net of taxation); markets for goods claims and foreign exchange, which are integrated through internal and external trade by purchasing power parity (and disparity), including transportation costs and tariffs, a monetary system which may be either gold-convertible or inconvertible, with or without reserve currencies, with or without adjustment lags (which produce overshooting effects in the price level and exchange rates); a theory of how economic policy operated through incentives and disincentives, including not only taxation but also price- and other regulation; alternate methods of financing budget spending (taxation, borrowing, monetization) and their effects – among other things.

While Rueff provides much of our theoretical framework, LBMC’s economic models are much, much simpler.

LBMS’s growth model tries to predict output (Y), a subset of the total supply of goods (Q).  Output is determined by stocks of labor (L) and capital (K) – both of which incorporate knowledge and technology – modified by their respective utilization rates (UE and UTL). The equilibrium values of the capital and labor stocks are affected by the marginal tax rates on labor (MTRL) and capital (MTRK). For example, the formula for the tax on capital (MTRK) includes the personal income tax on dividends, the capital gains tax, and the corporate income tax on profits, which takes into account the present value of depreciation allowances.

In addition, there are temporary changes in the measured utilization rates of labor (UE) and capital (UTL) from monetary and budget policy. These effects are captured with a combination of the inflation-adjusted World Dollar Base (R$), interest rates (IR), and the inflation adjusted stock of Federal debt to the public (RFD). The effect is temporary because, as we have just seen, if an expansion of the real World Dollar Base causes output to rise, any inflation that results will later reduce the “real” World Dollar Base, and so cause output to fall. Our Growth Model specifically predicts industrial production, and derive a proxy for real GNP from industrial production.

The LBMC growth model, then, is a largely a model of government “policy shocks”: the level of output at any time is always determined mostly by the supplies of labor and capital; but changes in the quantity of services that existing labor and capital are willing to supply, and therefore changes in output around the trend, are usually dominated by adjustments to changes in monetary, tax, or budget policy.

The reason we spend much of our time answering questions about the World Dollar Base, then, is not that LBMC’s econometric models are based on one variable. Rather, it is because other forecasters use some or all of the same supply- or demand-side explanatory factors we use except for the World Dollar Base. As a result, much of the difference at any time between LBMC’s forecast and that of other forecasters can be traced to the fact that we include the World Dollar Base, while no one else does.

Next installment: A Rueffian Synthesis



Kathleen M. Packard, Publisher
Ralph J. Benko, Editor

In Memoriam
Professor Jacques Rueff

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