INTRODUCTION TO ECONOMIC GROWTH. Dongpeng Liu Department of Economics Nanjing University

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1 INTRODUCTION TO ECONOMIC GROWTH Dongpeng Liu Department of Economics Nanjing University

2 ROADMAP INCOME EXPENDITURE LIQUIDITY PREFERENCE IS CURVE LM CURVE SHORT-RUN IS-LM MODEL AGGREGATE DEMAND AGGREGATE SUPPLY INTERMEDIATE-RUN AS-AD MODEL SOLOW MODEL LONG-RUN w/ CAPITAL ACCUMULATION LONG-RUN AS-AD MODEL LONG-RUN w/o CAPITAL ACCUMULATION LABOR MARKET PHILLIPS CURVE MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 2

3 ECONOMIC GROWTH In previous lectures, we have not considered economic growth In the short-run and intermediate-run, the economy fluctuates around the natural level of output In the long-run, the economy returns to its long-run equilibrium (natural rate of unemployment and natural output) As long as the natural rate of unemployment rate remains unchanged, the long-run equilibrium stays the same We can reach this conclusion because we have not considered capital accumulation, population growth and technological progress In the following lectures, we are going to consider how capital accumulation, population growth and technological progress may affect long-run economic outcomes MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 3

4 ECONOMIC GROWTH Economic growth is the steady increase in aggregate output over time. Economic growth is a long-run trend Cyclical fluctuations are temporary deviations from this longrun trend MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 4

5 ECONOMIC GROWTH MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 5

6 DEFINITIONS Output per capita equals GDP divided by population The standard of living depends on the evolution of output per capita, not total output To compare GDP across countries, we use a common set of prices for all countries. Adjusted real GDP numbers are measures of purchasing power across countries, also called purchasing power parity (PPP) numbers. If a Big Mac costs a customer 24 yuan in China and the exchange rate is 6yuan/USD, then USD denominated Chinese GDP will increase by $4 when the Big Mac is sold If the same Big Mac costs $5 in the USA, then the incremental PPP adjusted Chinese GDP is $5 when a Big Mac is sold. MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 6

7 PURCHASING POWER PARITY The straightforward method of taking a country s GDP expressed in that country s currency, and then using the current exchange rate to express it in terms of dollars does not always work for two reasons 1. Exchange rates can vary a lot. 2. In general, the lower a country s output per capita, the lower the prices of non-tradable goods and thus the general price level. Calculating the USD denominated GDP by directly applying the exchange rate will under estimate the output of less developed countries. MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 7

8 ECONOMIC GROWTH IN DEVELOPED COUNTRIES Average Annual Growth Rate of Real Output Per Capita Real Output Per Capita (1996 Dollars) /1950 France ,489 21, Germany ,642 21, Japan ,940 22, UK ,321 21, USA ,903 30, Average ,259 23, MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 8

9 ECONOMIC GROWTH IN DEVELOPED COUNTRIES MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 9

10 ECONOMIC GROWTH IN DEVELOPED COUNTRIES Since 1950s, living standards in developed countries improved significantly Since 1970s, the growth rate of real output per capita dropped significantly Real output per capita of the 5 countries listed in the table have been converging. In other words, countries with lower initial output per capita in 1950 experienced faster growth From a static or dynamic point of view, growth rate of real output per capita is seemingly negatively related to the level of real output per capita. MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 10

11 A LOOK ACROSS TIME AND SPACE On the scale of human history, the growth of output per capita is a recent phenomenon From the end of the Roman Empire to roughly year 1500, there was essentially no growth of output per capita in Europe From about 1500 to 1700, growth of output per capita turned positive, about 0.1% per year Even during the Industrial Revolution, growth rates were not high by current standards MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 11

12 GROWTH THEORY Economic growth theory should be capable of explaining the stylized facts What are the factors determining the rate of economic growth? What are the roles played by capital accumulation? What are the impacts of technological progress? MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 12

13 THE AGGREGATE PRODUCTION FUNCTION The aggregate production function is a specification of the relation between aggregate output and the inputs in production Y = F(K, N) Y: Aggregate output K: Capital stock (machines, plants, office buildings and etc.) N: Labor (the number of workers in the economy) The function F, tells us how much output is produced for given quantities of capital and labor MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 13

14 RETURNS TO SCALE We assume that the aggregate production function exhibits constant returns to scale (Why?) Constant returns to scale is a property of the production function in which, if the quantities of inputs increase by μ times, total output will also increase by μ times. Y = F K, N μy = F μk, μn MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 14

15 DIMINISHING RETURNS TO FACTORS We assume there returns to inputs are diminishing Diminishing returns to capital refers to the property that increases in capital, given labor, lead to smaller and smaller increases in output as the level of capital increases Diminishing returns to labor refers to the property that increases in labor, given capital, lead to smaller and smaller increases in output as the level of labor increases MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 15

16 OUTPUT PER WORKER AND CAPITAL STOCK PER WORKER Constant returns to scale implies Y N = F K N, N N = F K, 1 = y = f(k) N Output per worker depends on capital stock per worker Higher capital stock per worker means higher output per worker MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 16

17 OUTPUT PER WORKER AND CAPITAL STOCK PER WORKER We emphasize on output per worker because it is a much better indicator of living standard than total output Note: In the models to be presented later, the output is averaged on employed population rather than the total population. Given a stable structure of the population and constant labor force participation rate, output per worker and output per capita exhibit similar properties (e.g. same growth rate). Hence, we often use the two terms interchangeably for the purpose of qualitative analysis. MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 17

18 OUTPUT PER WORKER AND CAPITAL STOCK PER WORKER MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 18

19 OUTPUT PER WORKER AND CAPITAL STOCK PER WORKER The figure in the last slide characterizes per worker production function The slope of the curve is f k Note: f k = F K (K, N) (Why?). Due to the diminishing returns to capital, f k is a decreasing function of k. As k increases, output per worker will move along the curve Technological progress will shift the curve upwards MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 19

20 SOURCES OF ECONOMIC GROWTH MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 20

21 SOURCES OF ECONOMIC GROWTH Economic growth, especially the growth of output per capita, is fueled by Capital accumulation Technological Progress Due to diminishing returns to capital, capital accumulation by itself cannot generate sustainable economic growth Sustainable growth requires continuous technological progress Growth rate of output per capita ultimately hinges on the rate of technological progress We are going to discuss how capital accumulation and technological progress affect economic growth in the following lectures MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 21

22 SUMMARY Stylized facts about economic growth Aggregate production function and per worker production function Sources of economic growth MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 22