Chapter 6 ECONOMIC GROWTH. Usual measure. Economic Growth. In this chapter-

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1 Chapter 6 ECONOMIC GROWTH In this chapter- Define and calculate the growth rate and explain the implications of sustained growth in economic activity Briefly describe the economic growth trends in the United States and other countries Explain what makes potential GDP grow Explain the sources of labor productivity growth Economic Growth Usual measure growth in real GDP per person (per capita) also called real income per capita. Real GDP Real GDP per capita = Population While growth indicates a rising living standard, its not a perfect measure of quality of life and living standard. want to consider items such as education, environment, health, leisure time distribution of income 3 1

2 High Quality of Life in Wealthy Countries Goes Beyond GDP 4 Growth Rate Growth rate is a percent change: Real GDP current year real GDP previous year x100 Real GDP previous year 51,549 51,110 For 2016: x100 = 0.85% 51,110 Small differences in GDP growth rate matter a lot over time The rule of 70 if a variable is growing by X percent per year it will double in approximately 70 / X years 70/2 = 35 years: 2% growth per year doubles in 35 years 70/4 = 17.5 years: 4% growth per year doubles in 17.5years 5 Importance of Economic Growth US real GDP per capita is currently $56,500 (2012 as the base year) Is been growing at 1.3% annual growth since At this rate, per capita real GDP will grow to $73,150 in 20 years. 56,500(1.013) 20 = $73,150 At 2% annual growth, this will grow to $56,500(1.02) 20 =$84,000 in 20 years Growth rate matters! 6 2

3 Growth Applies to Investment Returns? Suppose you have $5,000 to invest At 2% annual growth in a savings account this will grow to $5,000(1.02) 20 =$7,430 in 20 years. Grows to $10,950 at 4%. At 7%, in the stock market, $5,000(1.07) 20 =$19,350 in 20 years Growth rate matters! 7 The Basics of Economic Growth Economic Growth Versus Business Cycle Expansion Real GDP can increase for two distinct reasons: 1. The economy might be returning to full employment in an expansion phase of the business cycle. 2. Potential GDP might be increasing. The expansion of potential GDP is economic growth. The return to full employment in an expansion phase of the business cycle isn t economic growth. The Business Cycle +4% +3% peak -2% trough Long-run economic growth is in this example is 3%. In the expansion phase of the cycle, the growth rate is > the trend. 3

4 Long-Term Growth Trends Long-Term Growth Trends What Determines Potential GDP? Potential GDP is the level of real GDP produced when the labor is at fullemployment. To determine potential GDP we use a model with two components: An aggregate production function An aggregate labor market Potential GDP is supply/production driven. 4

5 What Determines Potential GDP Aggregate Production Function The aggregate production function tells us how real GDP changes as the quantity of labor changes when all other influences on production remain the same. An increase in the quantity of labor increases real GDP. Labor is measured as billions of hours worked per year. What Determines Potential GDP The Labor Market The demand for labor shows the quantity of labor demanded and the real wage rate. The real wage rate is the money wage rate divided by the price level. It s the purchasing power of the money wage. The supply of labor shows the quantity of labor supplied and the real wage rate. The labor market is in equilibrium at the real wage rate at which the quantity of labor demanded equals the quantity of labor supplied. What Determines Potential GDP Figure illustrates labor market equilibrium. Labor market equilibrium occurs at a real wage rate of $35 an hour and 200 billion hours employed. At a real wage rate above $35 an hour, there is a surplus of labor and the real wage rate falls. 5

6 What Determines Potential GDP At a real wage rate below $35 an hour, there is a shortage of labor and the real wage rate rises. At the labor market equilibrium, the economy is at full employment. What Determines Potential GDP Potential GDP The quantity of real GDP produced when the economy is at full employment is potential GDP. In this example, the economy is at fullemployment with 200 billion hours of labor employed and potential GDP is $13 trillion. Two forces drive growth in potential real GDP: Growth in the supply of labor Growth in labor productivity Note the change to growth 6

7 Growth in the Supply of Labor (measured as total hours worked) The total number of hours worked change as a result of changes in: 1. Average hours per worker 2. Employment-to-population ratio 3. Population growth (1) (2) (3) Total Hours Total Employment Total Hours = x x Population Total Employment Population The Effects of Population Growth An increase in population increases the supply of labor. With no change in the demand for labor, the equilibrium real wage rate falls and the aggregate hours increase. The increase in the aggregate hours increases potential GDP. Effect of Population Growth The labor supply curve shifts rightward. The real wage rate falls. Aggregate hours increase. 7

8 Effect of Population Growth Now we go to the production function. The increase in aggregate hours increases potential GDP. Because of the diminishing returns, the increased population increases real GDP, but decreases real GDP per hour of labor - (16/300 < 13/200) Growth of Labor Productivity Population growth increases aggregate hours and real GDP, but to increase real GDP per person, labor must become more productive. Labor productivity is the quantity of real GDP produced by an hour of labor (13/200 in our example, $65 per hour) If labor becomes more productive, firms are willing to pay more for a given number of hours so the demand for labor increases. Figure shows the effect of an increase in labor productivity. The increase in labor productivity shifts the production function upward. Workers produce 18/200, $90 per hour worked. 8

9 Growth in Labor Productivity In the labor market: An increase in labor productivity increases the demand for labor. With no change in the supply of labor, the real wage rate rises and aggregate hours increase. And with the increase in aggregate hours, potential GDP increases. Why Labor Productivity Grows The growth of labor productivity depends on: Physical Capital Growth Investment in new capital (more plant and equipment) increases capital per worker and increases labor productivity. Human Capital Growth Human capital acquired through education, on-the-job training, and learning-by-doing is the most fundamental source of labor productivity growth. Technological Advances Technological change - the discovery and the application of new technologies and new goods is a major driver increasing labor productivity. 9

10 Congressional Budget Office Projection Growth in Potential Real GDP April 2018 Projected Average Average Annual Growth Annual Growth Total, Total, Overall Economy Real Potential GDP Potential Labor Force Potential Labor Force Productivity a SKIP Growth Theories three growth theories: Classical growth theory, Neoclassical growth theory, New growth theory 10