ECONOMIC GROWTH 17 CHAPTER
The Basics of Economic Growth U.S. real GDP per person and the standard of living tripled between 1960 and 2010. We see even more dramatic change in China, where incomes have tripled not in 50 years but in the 13 years since 1999. Incomes are growing rapidly in some other economies of Asia, Africa, and South America. What are the forces that make real GDP grow?
The Basics of Economic Growth Economic growth is the sustained expansion of production possibilities measured as the increase in real GDP over a given period. Calculating Growth Rates The economic growth rate is the annual percentage change of real GDP. The economic growth rate tells us how rapidly the total economy is expanding.
The Basics of Economic Growth The standard of living depends on real GDP per person. Real GDP per person is real GDP divided by the population. Real GDP per person grows only if real GDP grows faster than the population grows.
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 return to full employment in an expansion phase of the business cycle isn t economic growth. The expansion of potential GDP is economic growth.
The Basics of Economic Growth This Figure illustrates the distinction. A return to full employment in a business cycle expansion is a movement from inside the PPF (point A) to a point on the PPF (point B). Economic growth is the outward shift of the PPF from PPF0 to PPF1 and the movement from point B on PPF0 to point C on PPF1.
Growth Rates Matter Compound Interest We all know the power of compound interest, but it is worth reminding ourselves of it. Consider a fifty year time period. The table below shows what happens to output per head at different growth rates: 2.1% per annum Increases 182.7% 1.5% per annum Increases 110.5% 3.0% per annum Increases 338.4% 1.0% per annum Increases 64.5% 4.0% per annum Increases 610.7%
Growth Rates Matter The Magic of Sustained Growth The Rule of 70 states that the number of years it takes for the level of a variable to double is approximately 70 divided by the annual percentage growth rate of the variable.
Growth Rates Matter Applying the Rule of 70 This Figure shows the doubling time for growth rates. A variable that grows at 7 percent a year doubles in 10 years. A variable that grows at 2 percent a year doubles in 35 years. A variable that grows at 1 percent a year doubles in 70 years.
Long-Term Growth Trends Real GDP Growth in the World Economy This 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 This 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.
The Causes of Economic Growth: A First Look Preconditions for Economic Growth The basic precondition or prerequisite for economic growth is an appropriate incentive system. Three institutions that help with the creation of appropriate incentives are: Markets Clear and certain property rights Monetary exchange
The Causes of Economic Growth: A First Look For economic growth to persist, society somehow needs to ensure these three activities: Saving and investment in new capital Investment in human capital Discovery of new technologies Appropriate incentives allow these activities to occur in a decentralized market, society.
The Causes of Economic Growth: A First Look Saving and Investment in New Capital The accumulation of capital dramatically increases output and productivity; one US farmer can feed many, many households. Investment in Human Capital Human capital acquired through education, on-the-job training, and learning-by-doing can also dramatically increase output and productivity. Discovery of New Technologies Technological advances contribute immensely to increasing productivity; think what you can do with a PC, things that were impossible for your parents without months of work.
Growth Accounting The quantity of real GDP supplied, Y, depends on the quantity of labor, L, the quantity of capital, K, and the state of technology, T. The purpose of growth accounting is to estimate how much real GDP growth comes from growth of labor and capital inputs, and how much is apparently because of technological change Growth accounting is based on the aggregate production function, Y = F(L, K, T ).
Growth Accounting Labor Productivity Labor productivity is real GDP per hour of labor or per unit of labor; it equals real GDP divided by aggregate hours or real GDP divided by total number of labor.
Growth Accounting Growth accounting divides growth in productivity into two sources: Growth in capital per unit of labor Technological change Any productivity growth not accounted for by growth in capital is allocated to technological change, so this category is a broad catch-all concept, which also includes for example efficiency improvements from better organization, economic system, or management.
Growth Accounting The Productivity Curve The productivity curve is the relationship between real GDP per unit of labor and the amount of capital per unit of labor, with technology held constant.
Growth Accounting This Figure illustrates the productivity curve. An increase in capital per unit of labor brings a movement along the productivity curve. Technological change shifts the productivity curve.
Growth Accounting The shape of the productivity curve reflects the law of diminishing returns. The law of diminishing returns states that, as the quantity of one input increases with the quantities of all other inputs remaining the same, output increases but eventually by ever smaller increments. Robert Solow discovered that diminishing returns are well described by the one-third rule: with no change in technology, on the average, a 1 percent increase in capital per hour of work brings a one-third of 1 percent increase in output per hour of labor.
Growth Accounting Achieving Faster Growth Growth accounting suggests if we increase the growth rate of capital per hour of labor, or increase the pace of technological advance, we should be able to achieve faster economic growth. Some ways to do this are: Stimulate saving Higher saving rates may increase the growth rate of capital. Tax incentives might be provided to boost saving.
Growth Accounting Stimulate research and development Because new discoveries can be used by everyone, not all the benefit of a discovery is captured by the initial discoverer. So there can be a tendency to underinvest in research and development activity, i.e. to do less than would be socially optimal. Government financing or subsidies of research and development might counter this tendency to underinvestment.
Growth Accounting Encourage international trade Free international trade stimulates growth by extracting all the available gains from specialization and exchange, and increasing competition to innovate and be efficient. The fastest growing nations tend to be the ones with the fastest growing exports and imports. Improve the quality of education Benefits from education extend beyond the person being educated. Improvement in quality of education results in improvement in human capital and hence improves productivity
Growth Theories Classical Growth Theory Classical growth theory came to the conclusion that real GDP growth was temporary; when real GDP per person rises above the subsistence level, a population explosion brings real GDP per person back to the subsistence level. This may sound stupid now, but in the early 1800s it was a not unreasonable conclusion it was not clear that living standards in most of the world were any higher than in Roman times.
Growth Theories The basic classical idea There is a subsistence real wage rate, which is the minimum real wage rate needed to maintain life and match births to deaths. Advances in technology shifts the productivity curve up. Labor productivity increases and the real wage rate rises above the subsistence level. When the real wage rate is above the subsistence level, the population grows births exceed deaths. Population growth increases the supply of labor, which lowers the real wage rate.
Growth Theories The population continues to increase until the real wage rate has been driven back down to the subsistence real wage rate, where deaths match births again. At this real wage rate, both population growth and economic growth stop. Contrary to the assumption of the classical theory, the historical evidence is that population growth is not tightly linked to income per person, and rising incomes do not result in population growth driving incomes back down to subsistence levels.
Growth Theories This Figure illustrates the classical growth theory.
Growth Theories Neoclassical Growth Theory Neoclassical growth theory posits that real GDP per person grows because technological change induces a level of saving and investment that makes capital per hour of labor grow. Growth ends only if technological change stops.
Growth Theories The neoclassical economics of population growth The neoclassical view is that the population growth rate is independent of both real GDP per person and its growth rate. The population growth rate equals the birth rate minus the death rate. The birth rate is influenced by the opportunity cost of a woman s time. As women s wage rates have increased, the opportunity cost of having children has also increased and the birth rate has fallen.
Growth Theories The death rate is influenced by nutrition, sanitation, public health policy, and the quality and availability of health care. As the quality and availability of health care has improved, the death rate has fallen. The falls in both the birth rate and the death rate have tended to offset each other and to make the population growth rate independent of the level of income; in most high-income societies the death rate exceeds the birth rate and population is tending to fall [immigration and an unusually high birth rate make the US an exception].
Growth Theories Target Rate of Return and Saving Ceteris paribus, the higher the real interest rate, the greater is the amount that people save. To decide how much to save, people compare the real interest rate with a target rate of return. If the real interest rate exceeds the target rate of return, saving is sufficient to make capital per hour of labor grow. If the target rate of return exceeds the real interest rate, saving is not sufficient to maintain the current level of capital per hour of labor, so capital per hour of labor shrinks. And if the real interest rate equals a target rate of return, saving is just sufficient to maintain the quantity of capital per hour of labor at its current level.
Growth Theories The basic neoclassical idea Technology begins to advance more rapidly. New profit opportunities arise. Investment and saving increase. As technology advances and the capital stock grows, real GDP per person rises. Diminishing returns to capital per hour of labor lower the real interest rate and eventually growth stops unless technology keeps on advancing.
Growth Theories This Figure illustrates neoclassical growth theory.
Growth Theories New Growth Theory New growth theory holds that real GDP per person grows because of choices that people make in the pursuit of profit and concludes that growth can persist indefinitely. The theory emphasizes that People are always in pursuit of profit Discoveries bring profit In a market economy, profit brings competition and competition destroys profit People look for more profit, more discoveries take place, more knowledge is gathered, more growth takes place Knowledge is not subject to diminishing returns
Growth Theories This Figure illustrates new growth theory.
Growth Theories This Figure summarizes the ideas of new growth theory as a perpetual motion machine.