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CHAPTER 10 © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard The Facts of Growth Prepared by: Fernando Quijano and Yvonn Quijano

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Chapter 10: The Facts of Growth © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard2 of 30 The Facts of Growth We now turn from the determination of output in the short and medium run—where fluctuations dominate—to the determination of output in the long run—where growth dominates. Growth is the steady increase in aggregate output over time.

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Chapter 10: The Facts of Growth © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard3 of 30 Growth in Rich Countries Since 1950 U.S. GDP Since 1890 Aggregate U.S. output has increased by a factor of 39 since 1890. The logarithmic scale on the vertical axis allows for the same proportional increase in a variable to be represented by the same distance. 10-1 Figure 10 - 1

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Chapter 10: The Facts of Growth © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard4 of 30 Growth in Rich Countries Since 1950 Output per capita equals GDP divided by population. The standard of living depends on the evolution of output per capita, not total output. To compare GDP across countries, we use a common set of prices for all countries. Adjusted real GDP numbers are measures of purchasing power across countries, also called purchasing power parity (PPP) numbers.

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Chapter 10: The Facts of Growth © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard5 of 30 Growth in Rich Countries Since 1950 The straightforward method of taking a country’s GDP expressed in that country’s currency, and then using the current exchange rate to express it in terms of dollars does not always work for two reasons: First, exchange rates can vary a lot. The second reason goes beyond fluctuations in exchange rates. In general, the lower a country’s output per capita, the lower the prices of food and basic services in that country.

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Chapter 10: The Facts of Growth © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard6 of 30 Growth in Rich Countries Since 1950 Table 10-1 The Evolution of Output per Capita in Five Rich Countries Since 1950 Annual Growth Rate Output per Capita (%) Real Output per Capita (1996 dollars) 1950-19731974-2000 195020002000/1950 France 4.01.85,51922,3714.1 Japan 7.42.32,41724,67110.2 United Kingdom 2.41.87,64122,1882.9 United States 2.42.110,60133,3083.1 Average 4.12.06,54425,6343.9

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Chapter 10: The Facts of Growth © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard7 of 30 Growth in Rich Countries Since 1950 From the data in table 10-1 we conclude that: The standard of living has increased significantly since 1950. Growth rates of output per capita have decreased since the mid-1970s.. There has been convergence, that is, the levels of output per capita across the five countries have become closer over time. The Construction of PPP Numbers The construction of variables across countries using a common set of prices underlies PPP estimates.

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Chapter 10: The Facts of Growth © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard8 of 30 The Large Increase in the Standard of Living Since 1950 Real output per capita has increased by a factor of 3.1 since 1950 in the United States, by a factor of 4.1 in France, and by a factor of 10.2 in Japan. These numbers show what is sometimes called the force of compounding.

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Chapter 10: The Facts of Growth © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard9 of 30 The Decrease in Growth Rates Since the Mid-1970s A very useful rule is the “rule of 70.” If a variable grows at x% a year, then it will take approximately 70/x years for the variable to double. At a growth rate of 4.1% per year – the average growth rate across the countries from Table 10-1 from 1950 to 1973 – it takes only 16 years for the standard of living to double. At a growth rate of 2.0% per year – the average from 1973 to 2000 – it takes 35 years, more than twice as long.

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Chapter 10: The Facts of Growth © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard10 of 30 The Convergence of Output per Capita Growth Rate of GDP per Capita Since 1950 Versus GDP per Capita in 1950; OECD Countries Figure 10 - 1 Countries with lower levels of output per capita in 1950 have typically grown faster. The convergence of levels of output per capita across countries is not specific to the four countries we are looking at, it also extends to the set of OECD countries.

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Chapter 10: The Facts of Growth © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard11 of 30 A Broader Look Across Time and Space You should remember three basic facts about growth in rich countries since 1950: The large increase in the standard of living The decrease in growth since the mid-1970s Convergence of output per capita 10-2 These are the three facts we shall keep in mind and try to explain in the following chapters.

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Chapter 10: The Facts of Growth © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard12 of 30 Looking Across Two Millennia There is agreement among economic historians about the main economic evolutions over the last 2,000 years: From the end of the Roman Empire to roughly year 1500, there was essentially no growth of output per capita in Europe. From about 1500 to 1700, growth of output per capita turned positive, about 0.1% per year Even during the Industrial Revolution, growth rates were not high by current standards. On the scale of human history, the growth of output per capita is a recent phenomenon.

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Chapter 10: The Facts of Growth © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard13 of 30 Looking Across Two Millennia Since 1870, the United States has been the world’s economic leader. However, if history is any guide, the United States may not remain the lead forever. History looks more like leapfrogging (in which countries get close to the leader and then overtake it) than like convergence (in which the race becomes closer and closer).

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Chapter 10: The Facts of Growth © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard14 of 30 Looking Across Countries Growth Rate of GDP per Capita 1960-1990, Versus GDP per Capita in 1960 (1996 dollars); 99 countries There is no clear relation between the growth rate of output since 1960 and the level of output per capita in 1960. Figure 10 - 3

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Chapter 10: The Facts of Growth © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard15 of 30 Looking Across Countries Growth Rate of GDP per Capita 1960-1990, Versus GDP per Capita in 1960: OECD, Africa, and Asia Asian countries are converging to OECD levels. There is no evidence of convergence for African countries. The four triangles on the top left corner correspond to the four tigers: Singapore, Taiwan, Hong Kong, and South Korea. All four have had average annual growth rates of GDP per capita in excess of 5% over the last 30 years. Figure 10 - 4

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Chapter 10: The Facts of Growth © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard16 of 30 Looking Across Countries Let’s review the three basic facts discussed earlier for the OECD: Growth is not a historical necessity. The convergence of output per capita in many OECD countries toward the U.S. level may well be the prelude to leapfrogging, a stage when output per capita in one or more countries increases above output per capita in the United States. Finally, in a longer historical perspective, it is not so much the lower growth since 1973 in the OECD that is unusual.

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Chapter 10: The Facts of Growth © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard17 of 30 Thinking About Growth: A Primer To think about the facts presented in the previous sections, we use the framework of analysis developed by Robert Solow, from MIT, in the late 1950s. Particularly: What determines growth? What is the role of capital accumulation? What is the role of technological progress? 10-3

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Chapter 10: The Facts of Growth © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard18 of 30 Happiness and Output per Capita Across Countries Growth and Happiness Figure 1

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Chapter 10: The Facts of Growth © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard19 of 30 Growth and Happiness Table 1 Distribution of Happiness in the United States Over Time (Percent) 19751996 Very happy3231 Pretty happy5558 Not too happy1311 Table 2 Distribution of Happiness in the United States Across Income Groups (Percent) Income LevelTop QuarterBottom Quarter Very happy3716 Pretty happy5753 Not too happy631 Economists take for granted that higher output per capita means higher utility and increased happiness. The evidence on direct measures of happiness, however, points to a more complex picture.

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Chapter 10: The Facts of Growth © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard20 of 30 The Aggregate Production Function The aggregate production function is a specification of the relation between aggregate output and the inputs in production. Y = aggregate output. K = capital—the sum of all the machines, plants, and office buildings in the economy. N = labor—the number of workers in the economy. The function F, tells us how much output is produced for given quantities of capital and labor.

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Chapter 10: The Facts of Growth © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard21 of 30 The Aggregate Production Function The aggregate production function depends on the state of technology. The higher the state of technology, the higher for a given K and a given N. The state of technology is a set of blue prints defining the range of products and the techniques available to produce them.

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Chapter 10: The Facts of Growth © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard22 of 30 Returns to Scale and Returns to Factors Constant returns to scale is a property of the economy in which, if the scale of operation is doubled—that is, if the quantities of capital and labor are doubled—then output will also double. Or more generally, for any number,

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Chapter 10: The Facts of Growth © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard23 of 30 Returns to Scale and Returns to Factors Decreasing returns to capital refers to the property that increases in capital lead to smaller and smaller increases in output as the level of capital increases. Decreasing returns to labor refers to the property that increases in labor, given capital, lead to smaller and smaller increases in output as the level of labor increases.

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Chapter 10: The Facts of Growth © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard24 of 30 Output per Worker and Capital per Worker Constant returns to scale implies that we can rewrite the aggregate production function as: The amount of output per worker, Y/N depends on the amount of capital per worker, K/N. As capital per worker increases, so does output per worker.

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Chapter 10: The Facts of Growth © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard25 of 30 Output per Worker and Capital per Worker Output and Capital per Worker Increases in capital per worker lead to smaller and smaller increases in output per worker. An increase in capital per worker, K/N, causes a move along the production function. Figure 10 - 5

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Chapter 10: The Facts of Growth © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard26 of 30 The Sources of Growth The Effects of an Improvement in the State of Technology An improvement in the state of technology shifts the production function up, leading to an increase in output per worker for a given level of capital per worker. Figure 10 - 6

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Chapter 10: The Facts of Growth © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard27 of 30 The Sources of Growth Using the above equation, we can now determine where growth comes from: Increases in output per worker (Y/N) can come from increases in capital per worker (K/N). Or they can come from improvements in the state of technology that shift the production function, F, and lead to more output per worker given capital per worker.

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Chapter 10: The Facts of Growth © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard28 of 30 The Sources of Growth Growth comes from capital accumulation and from technological progress. Because of decreasing returns to capital, capital accumulation by itself cannot sustain growth.

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Chapter 10: The Facts of Growth © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard29 of 30 The Sources of Growth We can think of growth as coming from capital accumulation and from technological progress, but these two factors play very different roles in the growth process: Capital accumulation by itself cannot sustain growth. Saving rate is the proportion of income that is saved. Sustained growth requires sustained technological progress. The rate of growth of output per capita is eventually determined by the economy’s rate of technological progress.

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Chapter 10: The Facts of Growth © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard30 of 30 Key Terms growth logarithmic scale output per capita standard of living standard of living purchasing power, purchasing power parity (PPP), convergence purchasing power, purchasing power parity (PPP), Malthusian era leapfrogging four tigers aggregate production function state of technology constant returns to scale decreasing returns to capital decreasing returns to labor capital accumulation technological progress saving rate

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