Economic Growth The Production Function Production Possibilities Growth Policies U.S. Economic Growth

FIGURE 2: Actual and Potential GDP in the United States Copyright © 2003 South-Western/Thomson Learning. All rights reserved. 1957–1958 Recession 1960–1961 Recession 1960s Boom 1974–1975 Recession 1982–1983 Recession Actual GDP Potential GDP ,000 2,500 3,000 3,500 4,000 4,500 5,000 5,500 6,000 6,500 7,000 8,000 9,000 Year 7,500 8,500 9,500 11,000 10,500 2,000 Billions of 2000 Dollars

Questions What causes long-term GDP (potential GDP) and per-capita GDP (standard of living) to grow over time? What types of economic policies can the government use to stimulate GDP growth?

Growth and Production Function The key to growth in potential GDP is growth in labor/worker productivity: Y p = L* x (Y/L*) = (Hours of work) x (Labor productivity)  What drives labor productivity growth?

Three Pillars of Productivity Growth: (i)Capital (K) (ii)Technology (TFP) (iii)Human capital (HK) - One measure is educational attainment.  Productivity Growth and shifts in the production function.

Growth Accounting in US Labor Productivity2.8%1.4% 2.8% Capital0.9%1.0% 1.7% Technology1.9%0.4% 1.1%

TABLE 4: Average Years of Schooling for Selected Countries

Growth and Production Possibilities Goods can be classified into two types: (i)Consumption goods – to be consumed (not used to make goods). (ii)Capital goods – to be used in the manufacturing of other goods (may include human capital)  GDP must be divided between consumption and capital goods.

GDP and Society’s Choices Today Capital Goods c PPF 0 b a Consumption Goods

GDP and Society’s Choices: Tomorrow (if No Capital Depreciation): Choice a Capital Goods c Consumption Goods b a PPF 0 = PPF a

GDP and Society’s Choices Tomorrow: Choice b Capital Goods c Consumption Goods b a PPF a PPF b

GDP and Society’s Choices Tomorrow: Choice c Capital Goods c Consumption Goods b a PPF a PPF c PPF b

For a given level of technology investment in physical or human capital is necessary for economic growth. Increases in TFP can increase economic growth for any given capital-consumption combination.

GDP and Society’s Choices: Growth in TFP Capital Goods c PPF 0 b a Consumption Goods PPF 1

International Comparisons What explains international differences in standard of living? How have these differences changed over time? Poorer countries  low per-capita GDP Richer countries  high per-capita GDP

Productivity and Growth in Selected Countries GDP/Hour 1998 Country(% of US)Growth US France982.5 UK792.2 Germany772.4

The convergence hypothesis: Productivity growth of poorer countries tend to be higher than richer countries. Per-capita GDP among countries tend to converge.

Productivity in Selected Countries GDP/Hour Country(% of US)(% of US)Growth US France UK Germany

Figure 2 The Convergence Hypothesis

Reasons for International Convergence (i)Diminishing Returns (ii)Learning from Richer Countries  Problem: Poorest countries are falling behind. They don’t have (i)Infrastructure, facilities (ii)Educational structure

Productivity in Selected Countries GDP/Hour Country(% of US)(% of US)Growth US France UK Germany Argentina Mexico Peru

Growth Policies Capital Formation Policies: *Lower Interest Rates *Tax Provisions (capital gains/corporate) *Political Stability/Property Rights *Direct Government Investment  Education and Training  Helping Developing Countries (foreign direct investment, World Bank Aid)

FIGURE 5: Average Productivity Growth Rates in the U.S. Copyright © 2006 South-Western/Thomson Learning. All rights reserved. 1948– – –2004 Percent per Year

Historical Record of U.S. Productivity Post WWII: *Confidence and business optimism high *Low Interest Rates *High government spending on infrastructure  Productivity Slowdown: *High energy prices *Slow pace of technical progress?

1995-present *Lower energy prices *Peace Dividend *Computing and Information Technology