# 24 CHAPTER Economic Growth.

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24 CHAPTER Economic Growth

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

Transforming People’s 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?

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
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.

The Basics of Economic Growth
Applying the Rule of 70 Figure 24.1 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.

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 24.2 on the next slide illustrates.

Economic Growth Trends

Economic Growth Trends
Real GDP Growth in the World Economy Figure 24.3(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.

Economic Growth Trends
Figure 24.3(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.

Economic Growth Trends
Figure 24.4 shows growth in Asian economies. China is growing very rapidly. Other formerly low-income economies—Korea, Taiwan, Singapore, and Hong Kong are examples—have grown very rapidly and have caught up or are catching up with the United States.

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

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.

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

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.

The Sources of Economic Growth
Technological Advances Technological change—the discovery and the application of new technologies and new goods—has contributed immensely to increasing labor productivity. Figure 24.5 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.

The Sources of Economic Growth

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

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.

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.

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.

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 24.6 on the next slide illustrates.

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.

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.

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.

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

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

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.

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.

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.

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

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.

Growth Theories Figure 24.7(a) shows the change in potential GDP.
The increase in labor productivity shifts the production function upward.

Growth Theories Figure 24.7(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.

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

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.

Growth Theories Figure 24.8(a) illustrates these effects in the labor market. The labor supply curve shifts rightward. The real wage rate falls and aggregate hours increase.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

Growth Theories Figure 24.9 summarizes the ideas of new growth theory as a perpetual motion machine.

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