Parkin-Bade Chapter 30

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8
CHAPTER
Economic Growth
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After studying this chapter you will be able to

• Define and calculate the economic growth rate and
  explain the implications of sustained growth
• Describe the economic growth trends in the United
  States and other countries and regions
• Identify the main sources of economic growth
• Explain how we measure the effects of the sources
  of economic growth and identify why growth rates
  fluctuate
• Explain the main theories of economic growth

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Transforming Peoples Lives

• Real GDP per person in the United States almost
  tripled between 1960 and 2005.
• What causes the growth in production, income, and
  living standards?
• Elsewhere, notably in China and other parts of
  Asia, growth is even faster and technology 2,000
  years old coexists with the most modern.
• Why are incomes in Asia growing so fast?

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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.

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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.

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The Basics of Economic Growth

• 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.

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The Basics of Economic Growth

• Applying the Rule of 70
• Figure 8.1 show the doubling time for growth
  rates.
• A variable that grows at 2 percent a year doubles
  in 35 years.
• A variable that grows at 7 percent a year doubles
  in 10 years.

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Economic Growth Trends

• Growth in the U.S. Economy
• From 1905 to 2005, growth in real GDP per person
  in the United States averaged 2 percent a year.
• Real GDP per person fell precipitously during the
  Great Depression and rose rapidly during World
  War II.
• The growth rate was greater after World War II
  than it was before the Great Depression.
• Figure 8.2 on the next slide illustrates.

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Economic Growth Trends
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Economic Growth Trends

• Real GDP Growth in the World Economy
• Figure 8.3(a) shows the growth in the rich
  countries.
• Japan grew rapidly in the 1960s, slower in the
  1980s, and even slower in the 1990s.
• Growth in Europe Big 4, Canada, and the United
  States has been similar.

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Economic Growth Trends

• Figure 8.3(b) shows the growth of real GDP per
  person in group of poor countries.
• The gaps between real GDP per person in the
  United States and in these countries have
  widened.

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Economic Growth Trends

• Figure 8.4 shows growth in Asian economies.
• China is growing very rapidly.
• Other formerly low-income economiesKorea,
  Taiwan, Singapore, and Hong Kong are
  exampleshave grown very rapidly and
• have caught up or are catching up with the United
  States.

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The Sources of Economic Growth

• Real GDP growth contributes to improvements in
  our standard of living.
• But our standard of living improves only if we
  produce more goods and services.
• We begin by dividing real GDP growth into the
  forces that increase
• Aggregate hours
• Labor productivity

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The Sources of Economic Growth

• Aggregate Hours
• Aggregate hours, the total number of hours worked
  by all the people employed, change as a result
  of
• 1. Working-age population growth
• 2. Changes in the employment-to-population ratio
• 3. Changes in average hours per worker
• Population growth increases aggregate hours and
  real GDP, but to increase real GDP person, labor
  must become more productive.

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The Sources of Economic Growth

• Labor Productivity
• Labor productivity is the quantity of real GDP
  produced by an hour of labor it equals real GDP
  divided by aggregate hours.
• The growth of labor productivity depends on
• Physical capital growth
• Human capital growth
• Technological advances

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The Sources of Economic Growth

• Physical Capital Growth
• Physical capital growth results from saving and
  investment decisions.
• The accumulation of new capital increased capital
  per worker and increased labor productivity.
• Human Capital Growth
• Human capital acquired through education,
  on-the-job training, and learning-by-doing is the
  most fundamental source of economic growth.
• It is the source of increased labor productivity
  and technological advance.

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The Sources of Economic Growth

• Technological Advances
• Technological changethe discovery and the
  application of new technologies and new goodshas
  contributed immensely to increasing labor
  productivity.
• Figure 8.5 on the next slide summarizes the
  process of growth.
• It also shows that the growth of real GDP per
  person depends on real GDP growth and the
  population growth rate.

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The Sources of Economic Growth
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The Sources of Economic Growth

• Preconditions for Economic Growth
• The basic precondition for economic growth is an
  appropriate incentive system.
• Three institutions are crucial to the creation of
  the proper incentives
• 1. Markets
• 2. Property rights
• 3. Monetary exchange

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Growth Accounting

• The quantity of real GDP produced, 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 calculate
  how much real GDP growth results from the growth
  of labor and capital and how much is attributable
  to technological change.

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Growth Accounting

• The identify the contribution of capital growth
  to real GDP growth, we need to know labor
  productivity changes when the quantity of capital
  changes.
• The law of diminishing returns states
• As the quantity of one input (capital) increases
  with the quantities of all other inputs (labor
  hours and technology) remaining the same, output
  increases but in ever smaller increments.
• But how much smaller are the increments?
• The answer is given by the one third rule.

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Growth Accounting

• 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 labor
  brings a 1/3 percent increase in labor
  productivity (real GDP per hour of labor).
• For example, suppose capital per hour of labor
  grows by 3 percent and labor productivity grows
  by 2.5 percent.
• The one third rule tells us that capital growth
  contributed 1/3 of 3 percent, which is 1 percent,
  to labor productivity growth.
• Human capital growth and technological change
  contributed the other 1.5 percent.

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Growth Accounting

• Accounting for the Productivity Growth Slowdown
  and Speedup
• We can use the one third rule to study
  productivity growth in the United States.
• Figure 8.6 on the next slide illustrates.

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Growth Accounting

• Part (a) shows the growth of U.S. labor
  productivity.
• Booming Sixties
• Between 1960 and 1973, labor productivity grew by
  3.7 percent a year.
• Capital growth (green bar) and technological
  change and growth of human capital (purple bar)
  contributed equally to this growth.

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Growth Accounting

• Slowdown
• Between 1973 and 1983, labor productivity slowed
  to 1.7 percent a year.
• A collapse in the contribution of technological
  change and human capital (purple bar) brought
  about this slowdown in the growth of labor
  productivity.

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Growth Accounting

• Speedup
• Labor productivity growth rate increased to 2
  percent a year between 1983 and 1993 and to 2.4
  percent between 1993 and 2005.
• Technological change and growth of human capital
  contributed most to this speedup in the growth of
  labor productivity.

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Growth Accounting

• Achieving Faster Growth
• To achieve faster economic growth we must either
  increase the growth of capital per hour of labor
  or increase the pace of technological change.
• The main suggestions for achieving these
  objectives are
• Stimulate saving
• Stimulate research and development
• Target high-technology industries
• Encourage international trade
• Improve the quantity of education

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Growth Accounting

• Stimulate Saving
• Saving finances investment. So higher saving
  rates might increase physical capital growth.
• Tax incentives might be provided to boost saving.

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Growth Accounting

• Stimulate Research and Development
• Because the fruits of basic research and
  development efforts can be used by everyone, not
  all the benefit of a discovery falls to the
  initial discoverer.
• So the market might allocate too few resources to
  research and development.
• Government subsidies and direct funding might
  stimulate basic research and development.

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Growth Accounting

• Target High-Technology Firms
• The suggestion is that by subsidizing
  high-technology industries, a nation can enjoy a
  temporary advantage over its competitors.
• This is a very risky strategy because it is
  unclear that government is better at picking
  winners than the profit-seeking entrepreneurs.

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Growth Accounting

• Encourage International Trade
• Free international trade stimulates growth by
  extracting all the available gains from
  specialization and trade.
• The fastest growing nations are the ones with the
  fastest growing exports and imports.
• Improve the Quality of Education
• The benefits from education spread beyond the
  person being educated, so there is a tendency to
  under invest in education.

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Growth Theories

• Real GDP increases if
• 1. The economy recovers from a recession.
• 2. Potential GDP increases.
• Economic growth is the sustained increase in
  potential GDP.
• Two factors that increase potential GDP are
• An increase in labor productivity
• An increase in population

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Growth Theories

• An Increase in Labor Productivity
• Three factors increase labor productivity
• An increase in physical capital
• An increase in human capital
• An advance in technology
• An increase in labor productivity shifts the
  production function upward and increases the
  demand for labor.
• The equilibrium real wage rate, quantity of
  labor, and potential GDP all increase.

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Growth Theories

• Figure 8.7(a) shows the change in potential GDP.
• The increase in labor productivity shifts the
  production function upward.

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Growth Theories

• Figure 8.7(b) illustrates these effects 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.

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Growth Theories

• And with the increase in aggregate hours,
  potential GDP increases.

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Growth Theories

• An Increase in Population
• 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.

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Growth Theories

• Figure 8.8(a) illustrates these effects in the
  labor market.
• The labor supply curve shifts rightward.
• The real wage rate falls
• and aggregate hours increase.

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Growth Theories

• The increase in aggregate hours increases
  potential GDP.
• Because the marginal product of labor diminishes,
  the increased population increases real GDP but
  decreases real GDP per hour of labor.

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Growth Theories

• We study three growth theories
• Classical growth theory
• Neoclassical growth theory
• New growth theory
• Classical Growth Theory
• Classical growth theory is the view that the
  growth of real GDP per person is temporary and
  that when it rises above the subsistence level, a
  population explosion eventually brings real GDP
  per person back to the subsistence level.

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Growth Theories

• Classical Theory of Population Growth
• There is a subsistence real wage rate, which is
  the minimum real wage rate needed to maintain
  life.
• Advances in technology lead to investment in new
  capital.
• 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.
• Population growth increases the supply of labor
  and brings diminishing returns to labor.

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Growth Theories

• As the population increases the real wage rate
  falls.
• The population continues to grow until the real
  wage rate has been driven back to the subsistence
  real wage rate.
• 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 rate is not tightly linked to
  income per person, and population growth does not
  drive incomes back down to subsistence levels.

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Growth Theories

• Neoclassical Growth Theory
• Neoclassical growth theory is the proposition
  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.

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Growth Theories

• The Neoclassical Economics of Population Growth
• The neoclassical view is that the population
  growth rate is independent of real GDP and the
  real GDP growth rate.
• Technological Change
• In the neoclassical theory, the rate of
  technological change influences the economic
  growth rate but economic growth does not
  influence the pace of technological change.
• It is assumed that technological change results
  from chance.

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Growth Theories

• Target Rate of Return and Saving
• The key assumption in the neoclassical growth
  theory concerns saving.
• Other things remaining the same, the higher the
  real interest rate, the greater is the amount
  that people save.
• To decide how much to save, people compare the
  rate of return with a target rate of return.
• If the rate of return exceeds the target rate of
  return, saving is sufficient to make capital per
  hour of labor grow.

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Growth Theories

• If the rate of return is less than the target
  rate of return, 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 rate of return equals a target rate of
  return, saving is just sufficient to maintain the
  quantity of capital per hour of labor at its
  current level.

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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 lower the real
  interest rate and eventually growth stops, unless
  technology keeps on advancing.

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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 that growth can persist
  indefinitely.
• The theory begins with two facts about market
  economies
• In a market economy, discoveries result from
  choices.
• Discoveries bring profit and competition
  destroys profit.

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Growth Theories

• Two further facts play a key role in the new
  growth theory are
• Discoveries are a public capital good.
• Knowledge is not subject to diminishing returns.
• Knowledge Capital Is Not Subject to Diminishing
  Returns
• Increasing the stock of knowledge makes capital
  and labor more productive. The fact that
  knowledge capital does not experience diminishing
  returns is the central proposition of new growth
  theory.

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Growth Theories

• Figure 8.9 summarizes the ideas of new growth
  theory as a perpetual motion machine.

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THE END