Chapter 6 ECONOMIC GROWTH. World 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 World Economic Growth 3 1

2 Why is Economic Growth Important? Measured as growth in real GDP per person (per capita) - real income per capita. Real GDP Real GDP per capita = Population Growth means rising living standard, a higher quality of life Clearly, not a perfect measure. want to consider items such as education, environment, good health, leisure time distribution of income 4 High Quality of Life in Wealthy Countries Goes Beyond GDP 5 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 6 2

3 Importance of Economic Growth US real GDP per capita is currently $52,000 Is been growing at 1.2% annual growth since At this rate, per capita real GDP will grow to $52,000(1.012) 20 = $66,010 in 20 years At 2% annual growth, this will grow to $52,000(1.02) 20 =$77,270 in 20 years Growth rate matters! 7 Growth Applies to Investment Returns? Suppose you have $50,000 to invest At 2% annual growth in a savings account this will grow to $50,000(1.02) 20 =$74,300 in 20 years and $90,300 at 4%. At 7%, in the stock market, $50,000(1.07) 20 =$193,480 in 20 years Growth rate matters! 8 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. 3

4 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. Long-Term Growth Trends From 1914 to 2014, growth in real GDP per person in the United States averaged 2 percent a year. Real GDP per person fell a lot during the Great Depression and rose rapidly during World War II. Growth was rapid during the 1960s. Growth slowed during the 1970s and sped up again in the 1980s and1990s. Figure on the next slide illustrates this. Long-Term Growth Trends 4

5 Long-Term Growth Trends Real GDP Growth in the World Economy Figure shows the growth in the rich countries. Japan grew rapidly in the 1960s, slower in the 1980s, and stagnated during the 1990s. Growth in Europe Big 4, Canada, and the United States has been similar. Economic Growth Trends Figure shows the growth of real GDP per person in a group of poor countries. The gaps between real GDP per person in the United States and in these countries have widened. Potential GDP What Factors Determine Potential GDP? Potential GDP is the quantity of real GDP produced when the quantity of labor employed is the full-employment quantity. To determine potential GDP we use a model with two components: An aggregate production function An aggregate labor market Potential GDP is supply driven. 5

6 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. 6

7 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. How Potential GDP Grows Two forces drive growth in potential real GDP: Growth in the supply of labor Growth in labor productivity 7

8 How Potential GDP Grows Growth in the Supply of Labor (total hours worked) The total number of hours worked by all the people employed 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 How Potential GDP Grows 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. 8

9 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) How Potential GDP Grows 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 (16/300 in our example) If labor becomes more productive, firms are willing to pay more for a given number of hours so the demand for labor increases. How Potential GDP Grows Figure shows the effect of an increase in labor productivity. The increase in labor productivity shifts the production function upward. 9

10 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. How Potential GDP Grows And with the increase in aggregate hours, potential GDP increases. Why Labor Productivity Grows The growth of labor productivity depends on: Growth in Physical Capital Growth in Human Capital Technological advances 10

11 Why Labor Productivity Grows 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. Congressional Budget Office Projection Growth in Potential GDP June 2017 Average Annual Growth Total, Projected Average Annual Growth Total, Overall Economy 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 11