LONGRUN ECONOMIC GROWTH

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LONG-RUN ECONOMIC GROWTH
PRINCIPLES OF MACROECONOMICS

• Dr. Fidel Gonzalez
• Department of Economics and Intl. Business
• Sam Houston State University

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In the previous slides, we studied how to measure
economic growth. Economic growth is measured by
Real GDP per person. In particular by the average
annual increase in the real GDP per person of a
country for a given period of time. Remember
that the average annual change in Real GDP per
person was calculated using the ACGR. We also
saw the importance of the potential GDP and the
financial system in economic growth. Savings,
investment and the financial system are
considered determinants of economic growth in the
short-run. In this slides we will study the
determinants of the growth in the real GDP per
person in the long-run.
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In the long-run the most important determinant of
growth is labor productivity. Labor productivity
is the amount of goods and services produced per
worker or by one hour of work. In words of Paul
Krugman Productivity isnt everything but in
the long-run is almost everything. A countrys
ability to improve its standard of living over
time depends almost entirely in its ability to
raise its output per worker (Paul Krugman The
Age of Diminished Expectations, MIT Press,
1994.) Remember that Y production and Lamount
of labor Hence, productivity will be measure as
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Q Why is productivity important? A
Productivity is important because it is essential
for growth. (Read Krugman handout)
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Productivity is the only long-run way to increase
living standards
The living standard of a country is measured by
both the Real GDP per person and
consumption. Remember that households main
concern is consumption. We care about Real GDP as
long as it provides a good proxy for consumption.
In simple terms, we work to produce so that we
can consume goods and services. Production by
itself does not make people happy, consumption
does. We know that higher production always leads
to higher consumption. Now, to the relationship
between productivity and consumption. Imagine,
that we want to increase consumption and that we
are in a closed economy (no international trade).
If we wanted to increase consumption there will
be only three ways (i) Increase productivity so
that each worker produces more. Production and
consumption will go up. (ii) Put a larger portion
of the population to work so that production
increases and therefore consumption also
increases. (iii) Decrease savings so that
consumption goes up today.
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Lets consider each of this strategies Increasing
productivity is actually a good strategy since it
will increase production, and it is also
sustainable in the future. The second strategy
requires that we bring more people to work. This
is feasible if there is a lot of people
unemployed or in retirement. We can bring people
form retirement to the labor force by reducing or
eliminating their social security payments or by
increasing the retirement age from 65 to 75
years. However, this strategy can not work in
the long term. Imagine that we put all the people
that can work into a job, what are we going to do
next? There is a clear limit on how much people
we can bring to the labor force. This is a
medium-term strategy. Finally, the third
alternative is also not feasible in the
long-term. If savings decrease then investment
will decrease and also capital and production.
After a few years production will go down and
consumption will have to go down as well. This
will work only for one or two years and then it
will actually backfire and consumption will go
down.
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Summarizing In a closed economy the only
sustainable way to increase consumption (and
therefore living standards) in the long-term is
by increasing labor productivity. Now, we want
to know if things will be different in an open
economy. In an open economy, in addition to the
previous three strategies to increase
consumption, we now have the following (iv)
Import more goods and services from abroad
without increasing exports. (v) Get better prices
for our exports so that we can import more
goods. Strategy (iv) will require the economy to
borrow money so that we can import more than what
we export. For instance if exports are 100 and
we want to import 150 worth of goods. We can
cover the first 100 of imports with our exports,
so how do we cover the remaining 50. The only
way is to borrow money from abroad. Clearly, (iv)
is not sustainable in the long-run because we
will eventually have to pay the money we
borrowed.
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Strategy (v) is actually a different way to state
(i). The only way to achieve (v) is to convince
foreigners to pay more for out goods. We can do
this by increasing the quality of our goods or by
decreasing the cost of our production. These two
options can only work if productivity
increases. Summarizing Even in an open economy
the only way to increase consumption (and
therefore the living standards) is to increase
labor productivity.
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If labor productivity is so important, how can we
improve labor productivity?

• There are two main ways to improve labor
  productivity.
• Increase the quantity of capital per hour
  worked
• Give workers more capital and they will produce
  more per hour of work.
• Increase the level of technology
• A) Provide workers with better machinery and
  equipment.
• B) Increase human capital
• Accumulated knowledge and skills that workers
  acquire from education and training of from their
  life experiences is called Human Capital. Workers
  with high levels of human capital are more
  productive. There is an important relationship
  between education and human capital. In general
  better educated workers are more productive.
  Educated workers are an essential assets of a
  country.
• C) Improve the way of organize and manage
  production
• Firms will be more productive if managers are
  able to get more production from workers by
  organizing and managing them better.

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From the previous slide you can see that giving
more capital to workers is good because it allows
them to work better (more efficiently). Hence,
an important aspect of labor productivity is
going to be the amount of capital per
worker. Define K capital (remember this is
physical capital) L hours of
labor work in the economy Hence,
The capital per hour of work will be an important
variable later.
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Before we move on, we need to introduce another
important concept production function. The
production function is the relationship between
production (output) and inputs in the
economy. There are three types of inputs Labor
(L) amount or workers in the economy Capital (K)
amount of machinery and equipment in the
economy. Natural Resources (NR) amount of
natural resources such as oil, land, water, and
so on. The mathematical representation of the
production is then
We will call this the production function
equation.
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The production function equation is telling you
that production (Y) is a function (f) of labor
(L), capital (K) and natural resources (NR). The
letter f stands for function and it is telling
you that Y depends on L,K and NR. It does not
tell you how but just that K,L and NR determine
Y. Now, we will do some little manipulation of
the production function equation. We are going to
divide both sides of the equation by L.
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This last equation is important. Note that the
left hand side of the equation (Y/L) is equal to
the definition of labor productivity. Equation
(1) tells us that the labor productivity depends
on the capital per hour of work and the amount of
natural resources per hour of work. Now, I will
graph Equation (1) with (Y/L) on the y-axis and
(K/L) of the x-axis, keeping (NR/L) constant.
The graph on the left shows you how production
per hour of work changes with the amount of
capital per hour of work, keeping the amount of
natural resources per hour of work and technology
constant.
(output per hour of work or labor productivity)
(capital per hour of work)
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Key features of the graph 1) When K/L increases
also does Y/L. More capital per hour of work is
good for productivity. 2) Each additional
increase in K/L produces smaller increases in
Y/L. This is called diminishing returns of K/L.
475
350
200
20,000
30,000
40,000
The first feature of the graph easy to see. The
second feature of the graph is a result of the
Law of Diminishing Returns. Law of diminishing
returns as more of one input (capital in this
case) is added to a fixed quantity of another
(labor in this case) output increases by smaller
additional amounts.
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Note that when K/L goes up from 20,000 to 30,000,
thats an increase of 10,000. Then production
foes up from 200 to 350, thats an increase of
150. When K/L goes up from 30,000 to 40,000, an
increase of 10,000 then Y/L goes up from 350 to
475, that is an increase of 125.
475
350
200
20,000
30,000
40,000
In other words, as there is more K/L each
additional increase produces smaller increases in
Y/L. The key reason why we see diminishing
returns to capital is that all other inputs are
fixed.
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To see the effect of fixed inputs consider the
following example Imagine that SHSU does not
have any computers on campus with an student body
of 16,000 students. Then SHSU decides to add
6,000 computers on campus that students can use.
As soon as SHSU introduces the computers, the
production per students increases. Students can
take turns to use computers and they can work
faster and better than before. This will be a
great improvement for most students. Then SHSU
decides to add another 6,000 computer on campus
for a total of 12,000. This will be a good
improvement since there are more computers,
students can use them longer and they do not have
to wait as much to use a computer. Also, students
will start using computers for less productive
things. Hence, the addition to students
productivity is less than the previous purchase
of 6,000 computers. Finally, SHSU buys another
set of 6,000 computers for a total of 18,000
computers. Now, there are more computers than
students, the addition to the productivity of
this last set is smaller than the previous two
purchases of 6,000 computers. This example shows
the diminishing returns of computers in output
per student.
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Because the number of students is fixed in 16,000
more computers have a diminishing effect. Imagine
that now the number of students increases by
3,000 each time computers are added, then the
productivity of the extra computers does not have
to decrease. Summarizing When we move along the
Y/L curve we have that higher K/L produces higher
Y/L but at a diminishing rate. In order to
increase Y/L without having to increase K/L and
find diminishing returns to capital an economy
would like to shift the Y/L curve. The only way
that the Y/L curve can shift is if there is a
technological change.
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A technological improvement shifts the Y/L curve
upwards. With the same level of K/L now it is
possible to produce more per hour of work.
500
350
30,000
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Endogenous growth theory

• The main limitations with the previous model of
  growth is that it does not explain what will make
  Y/L to shift. It assumes that a technological
  change is exogenous.
• The endogenous growth theory tries to solve this
  problem. It claims that technological change
  depends on the market system. The market provides
  incentives for technological change so it is
  endogenous.
• Moreover, this theory argues that the
  accumulation of knowledge is essential for
  growth. This accumulation of knowledge has the
  following features
• Diminishing returns at the firm level the firm
  benefits for its own inventions at a decreasing
  rate.
• Increasing returns at the economy level some
  inventions benefit all the firms in the economy
  (dvd, cd, microwave ovens, etc.). That is, all
  firms can produce similar products.

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Endogenous growth theory

• The government can help the accumulation of
  knowledge in three ways
• Protecting intellectual property with patents and
  property rights.
• Subsidizing research and development.
• Subsidizing education.
• The first point is clear, inventors need to get
  some benefit from their technological
  improvements in order to have an incentive to do
  it. By having property rights they are assure to
  get the benefits from their work and that
  increases the amount of people willing to provide
  technological inventions.
• Number two and three are important because in
  many cases the market will not provide the right
  amount of them. Hence, the government has to step
  in and provide them.

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Productivity in the U.S.
The highest growth rate in productivity was
between 1950-1973 and 1995-2004. The worst years
were between 1973-1995.
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• What explain the productivity growth from
  1800-1900, basically the industrial revolution,
  where new ways to produce goods and services were
  invented as well as the introduction of the
  railroads.
• The productivity growth from 1900 to 1973
  responds to an increase in the knowledge and
  capital per hour of work in the US.
• From 1973 to 1995 the productivity slowdown has
  been a source of many controversies. The main
  explanations are the following
• Measurement problems some technological
  improvement were not accounted properly such as
  ATMs.
• Introduction of environmental regulation
  environmental regulations meant that firms had to
  change the way the were doing business so they
  had to adjust their production and that could
  have hurt productivity.
• High oil prices the oil embargo of the 70s
  increase the price of oil from 3 to 10 dollars
  per barrel. This is theory, however is now
  discredited. The main reason is that if an
  increase in oil price reduce productivity then
  when price went down productivity would have
  increased again and this did not happen.

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4) Decline in the quality of labor American
workers were less educated and less productive
than in previous years. Also, workers were not
able to keep up with the skills required by firms.
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Productivity around the world
During the productivity slowdown of the US other
countries had very good years. Japan had
impressive years from 1973 to 1986.
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However, the computers and internet revolution
put the US ahead of the productivity growth.
Also, the rest of the developed countries had
small increases in productivity.
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Developed and developing countries
According to what we have studied, growth takes
place when the capital per hour of work
increases. Hence, developing countries should
increase the quantity of capital per hour or work
and use the best available technology. Capital is
more profitable in developing countries because
it is relatively scarcer. For instance one
computer in a poor country will be very helpful
but the same computer in a rich neighborhood of
the US will probably have no impact at
all. Because capital is very productive in
developing countries (where capital is scarcer)
developing countries in theory should grow faster
than developed countries. If developing countries
grow faster then they will eventually catch-up
with the developed countries.
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Developed and developing countries.
Slow growth
Y/L developed
Y/L developing
High growth
K/L developing
K/L developed
At the beginning developing countries will grow
fast and developed countries.
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• However, in practice most developing countries
  have not catch-up with developed countries.
• In the following graphs, I will show you the main
  facts about catching-up.
• There is catch-up between Asian and Western
  Europe countries with the US.
• There is catch-up between developed countries
  less developed countries have catch-up with the
  more developed countries.
• Some Asian countries have catch-up with the
  developed countries.
• Latin America not only has not catch-up but the
  difference has increased over time.

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Asia and Europes GDP per person has approached
that of the US. Also, Asia has almost catch-up
with Europe.
Figure 2 of Harold L. Cole, Lee E. Ohaninan,
Alvaro Riascos and James A Schmitz Jr., Latin
America in the Rearview Mirror, Journal of
Monetary Economics, Vol. 52, No. 1, 2005.
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There is catch-up between Western European
countries and between Western European countries
and the US.
Figure 3 from Harold L. Cole, Lee E. Ohaninan,
Alvaro Riascos and James A Schmitz Jr., Latin
America in the Rearview Mirror, Journal of
Monetary Economics, Vol. 52, No. 1, 2005.
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Asian countries are catching up with the US but
between them there is a big disparity.
Figure 4 Harold L. Cole, Lee E. Ohaninan, Alvaro
Riascos and James A Schmitz Jr., Latin America
in the Rearview Mirror, Journal of Monetary
Economics, Vol. 52, No. 1, 2005.
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Latin American countries are not catching up but
they are actually move farther away from the US.
Figure 5 from Harold L. Cole, Lee E. Ohaninan,
Alvaro Riascos and James A Schmitz Jr., Latin
America in the Rearview Mirror, Journal of
Monetary Economics, Vol. 52, No. 1, 2005.
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The labor productivity of Europe and Asia has
been increasing with respect to the US while
Latin America has been decreasing this explain
the why Europe and Asia have been catching up
with the US while Latin American has not.
Figure 6 from Harold L. Cole, Lee E. Ohaninan,
Alvaro Riascos and James A Schmitz Jr., Latin
America in the Rearview Mirror, Journal of
Monetary Economics, Vol. 52, No. 1, 2005.
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Also the cost to start businesses, government
intervention and the cost of firing workers are
very high in Latin America this explains why
growth is very small.
Table 9 to 11 from Harold L. Cole, Lee E.
Ohaninan, Alvaro Riascos and James A Schmitz Jr.,
Latin America in the Rearview Mirror, Journal
of Monetary Economics, Vol. 52, No. 1, 2005.