1. Chapter 9 Economic Growth and Rising Living Standards

3. Why is Economic Growth Important?
Economic growth means rising living standards measured as growth in real GDP per person (per capita).
Real GDP per capita = 𝑅𝑒𝑎𝑙 𝐺𝐷𝑃 𝑃𝑜𝑝𝑢𝑙𝑎𝑡𝑖𝑜𝑛
Higher real income/GDP per capita associated with a higher quality of life
Real per capita is 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. Importance of Economic Growth
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)
70/4 = 17.5 years (4% growth per year)

6. Meaning and Importance of Economic Growth
US real GDP per capita in 2013 was $50,000
At 2% annual growth, this will grow to $50,000(1.02)20 =$74,300 in 20 years
At 3% annual growth, this will grow to $50,000(1.03)20 =$90,300 in 20 years

7. How about investment returns?
Suppose you have $50,000 to invest -
At 2% annual growth, say in a savings account, this will grow to $50,000(1.02)20 =$74,300 in 20 years
At 7%, in the stock market, $50,000(1.07)20 =$193,480 in 20 years
Growth rates matter!

8. Importance of Economic Growth
A country that was once poor can become rich
Late 1960s: South Korea and Singapore began growing rapidly
1980s: China and India started experiencing economic growth

9. What Makes Economies Grow?
Four things:
1. Labor productivity – output per hour
total output divided by total hours worked
2. Average number of hours per worker
total hours divided by total employment
3. Fraction of the Population that is working.
The Employment–population ratio (EPR)
Total employment divided by total population
4. The size of the population

10. What Makes Economies Grow?
Total Output (Real GDP) -
Here’s why!

11. Growth Equation
Percentage growth rate of real GDP per capita is the sum of the growth rates of productivity, average hours, and the employment-population ratio
An increase in any of the variables on the right will create a rise in living standards

12. Factors Contributing to Growth in U.S. Real GDP Per Capita
They are not equally important
Average hours has not been an important determinant of growth

13. Growth in the EPR
Employment-population ratio, EPR, increases when total employment rises at a faster rate than the population

14. Growth in the EPR Causes for total employment to increase
increase in labor supply
increase in labor demand
Increase in labor supply
higher employment, higher EPR for a given population
equilibrium real wage drops
higher GDP
Higher real GDP per capita (for a given population)

15. An Increase in Labor Supply
Millions of Workers
Real Hourly Wage
L1S
At point A, labor supply and demand determine an employment level of 150 million workers. LD
L2S A
$25
An increase in labor supply raises employment to 180 million (at point B) although with a lower wage rate.
150 B
$20
180
Millions of Workers
Real Output F
$11.5 trillion
$10 trillion
180 E
150
With more people working, real GDP rises from $10 trillion to $11.5 trillion.
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16. Growth in the EPR Increase in labor demand
demand curve shifts to the right
higher employment
equilibrium wage rate increases
higher GDP

17. An Increase in Labor Demand
Millions of Workers
Real
Hourly
Wage LS
L2D
L1D
If firms demand more labor, employment will increase—from 150 million to 180 million—while the wage rate rises B
$28
180 A
$25
150
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18. Can Government Policy increase Employment?
Implement policies to increase the growth of labor supply
Implement policies to increase the growth of labor demand

19. Policies to Increase the Growth of Labor Supply
Decrease income tax rates (marginal tax rate)
Increase take home pay of workers.
Do people want to work more and do more people want to work if take home pay increases?
This is a Big Question!
Marginal tax rate, tax paid on each extra dollar earned.
if effective, this policy would shift the labor supply curve to the right => total output (GDP) increases

20. Policies to Increase the Growth of Labor Supply
Cut government benefit programs
Do benefit programs such as unemployment insurance and welfare payment create disincentives to work?
European countries have cut benefit programs
Clinton administration reform of welfare programs

21. Policies to Increase the Growth of Labor Demand
Increase worker productivity
Training and education
Subsidize employment
Tax benefit to employers

22. Growth in Employment - the EPR
But, government policy can increase EPR only temporarily – one shot impact.
Significant, sustained economic growth requires significant, sustained growth in the EPR (look at the Growth Equation) which is not realistic.
look at the trends
100% is the upper bound

23. EPR:

24. Rising Productivity is the Most Important Determinant of Long-Run Economic Growth

25. How to Increase productivity?
An increase the capital stock, increases capital per worker and increases productivity
Capital per worker
Total capital stock divided by total employment

26. Capital Accumulation and the Production Function
An increase in the capital stock shifts the production function upward.
At point A, 150 million workers could produce $10 trillion of real GDP. With more capital, those same workers could produce $12 trillion of real GDP. Workers are more productive.
Millions
of Workers
Real Output D
$12 trillion
150
$10 trillion A

27. What Determines How Fast the Capital Stock Rises?
Planned investment spending (IP)
recall this is a flow variable.
the capital stock is a stock variable
A higher rate of investment spending causes:
faster growth in capital per worker which increases the growth in productivity
faster growth in GDP - the standard of living

28. Capital Stock and Investment
Suppose capital stock is $1000 billion at the beginning of 2010
Investment spending in 2010 is $100 billion
Depreciation is $20 billion.
What is the capital sock at the end of 2010?
Capital stock = $ $100 – $20
= $1080

29. Big Question - How to Increase Investment?
Government could do three things
increase incentives for businesses to invest
increase incentives for households to save
shrink the government budget deficit
Think about the loanable funds model presented in Chapter 8

30. How to Increase Investment
increase incentive for business to invest
Lower Corporate profits tax
A tax on the profits earned by corporations
Give Investment tax credit
A reduction in taxes for firms that invest in new capital

31. An Increase in Investment Spending -Increases the Demand for Loanable Funds
Government policies that make investment more profitable will increase investment spending at each interest rate. The resulting rightward shift of the investment demand curve (by the distance AF) leads to a higher level of investment spending, at point B.
Trillions of Dollars
per Year
Interest
Rate
Supply of Funds (Saving)
New Demand
for Funds (I2p)
Original
Demand for Funds (I1p) B 5%
1.75 A F 3%
1.5
2.25

32. How to Increase Investment
Increase incentive for households to save
Decrease capital gains tax rate
Capital gain is the increase in value of an asset.
Switch to a consumption tax

33. How to Increase Investment
Lower Capital Gains Tax
Tax on profits earned when a financial asset is sold at a gain
Consumption tax
rather than a tax on household income, tax the part of income that households spend. Result:
more household saving
more funds available for investment
faster growth in the capital stock
faster growth in living standards

34. An Increase in Saving
If households decide to save more of their incomes, the supply of loanable funds curve will shift rightward (by the distance AF). With more funds available, the interest rate will fall. Businesses will respond by increasing their borrowing, and investment will increase from $1.75 trillion to $2.25 trillion.
Trillions of Dollars
per Year
Interest
Rate
Original Supply
of Funds (S1)
Demand for
Funds (Ip)
New Supply
of Funds (S2) F A 5%
1.75
2.5 B 3%
2.25

35. How to Increase Investment
Decrease in the budget deficit
this will reduce the demand for loanable funds
reduce interest rates,
increase investment spending and the growth in the capital stock
But, the impact of deficit reduction on economic growth depends on which government programs are cut

36. Crowding-in. The opposite of crowding-out
Deficit Reduction and Investment Spending
Reducing the budget deficit will reduce government borrowing in the loanable funds market. The total demand for funds will fall, as will the interest rate. At a lower interest rate, businesses will increase investment spending from $1.0 trillion (point E) to $1.5 trillion (point B).
Trillions of Dollars
per Year
Interest
Rate
Supply of Funds (Saving)
[Ip + (G - T)] Ip A E 5%
1.0
1.75 B 3%
1.5
Crowding-in. The opposite of crowding-out

37. Human Capital and Economic Growth
An increase in human capital
Works like an increase in physical capital to increase output
Causes production function to shift upward
Can raise productivity and living standards
Increase of investment in human capital
investment in education
benefits take a long time to be realized.

38. Limits to Growth From New Capital
Diminishing returns
Depreciation
Thus, increases in the capital stock alone cannot create permanent high rates of economic growth

39. Technological Change Technological change
Invention and use of new inputs, new outputs, or new production methods
Extra boost to production from the new, productivity-enhancing technology.
The faster the rate of technological change
The greater the growth rate of productivity
The faster the rise in living standards

40. The Costs of Economic Growth
Nothing is Free! Unavoidable tradeoffs –
Promoting economic growth requires some groups, or the nation as a whole, to give up something else that is valued
Properly targeted tax cuts (such as capital gains or corporate profit)can increase the rate of economic growth but force us to either redistribute the tax burden or cut government programs

41. The Costs of Economic Growth
Greater investment in physical capital, human capital, and R&D
faster economic growth and higher living standards in the future
but, fewer consumer goods to enjoy in the present
Increased saving today
- means less consumption today
- higher consumption in the future.

42. Consumption, Investment, and Economic Growth
In the current period, a nation can choose to produce only consumer goods (point C), or it can produce some capital goods by sacrificing some current consumption, as at point A. If investment at point A exceeds depreciation, the capital stock will grow, and the production possibilities frontier will shift outward. After it does, the nation can produce more consumption goods (point B), more capital goods (point D), or more of both (point E).
Production of Capital Goods
Production of Consumption Goods B C E D A K