ECO 104: Introduction to Macroeconomics Lecture 10 Chapter 17: Economic Growth 1Naveen Abedin

Economic Growth There are two ways to represent economic growth: Absolute real economic growth: an increase in Real GDP from one period to the next. Per capita economic growth: an increase in per capita (per head) Real GDP from one period to the next. 2Naveen Abedin

Production Function A country’s production function enables us to measure the value of final goods and services that can be produced in an economy when all of its resources – land, labor, capital – are fully employed. A production function specifies the relation between technology and quantity of factor inputs to output or Real GDP. The production function can be written as Real GDP = T (L,K) where L = labor, K = capital and T is the country’s given level of technology. 3Naveen Abedin

Production Function (cont.) Technology does not only mean innovation and scientific advancement, but it also represents the production capabilities of existing factors of production. Technology can also be defined as being able to produce more output (Real GDP) with a given level of resources, such as labor and capital. Example: L = 4, K = 2 and T = 0.4. Using this, we can find Real GDP. Real GDP = 0.4 (4 + 2) = 2.4 units of output 4Naveen Abedin

Production Function (cont.) The production function can also be represented graphically: Naveen Abedin5

Production Function (cont.) The graph shows that at any given level of labor, L, the Real GDP we get is Q1. Suppose labor force has expanded, due to an increase in population, or more immigration – this will cause labor level L to increase, which increases Real GDP, keeping capital and technology constant. Naveen Abedin6

Production Function (cont.) If capital or level of technology increases, this causes an upward shift of the production function. In this figure, capital level has increased (keeping technology and labor constant), which has caused the production function to shift upward. Naveen Abedin7

Production Function (cont.) The level of technology has improved, keeping capital and labor constant, which has allowed the Real GDP curve to shift upward. Naveen Abedin8

Production Function and LRAS Changes in the production function can be related to changes in Long-run Aggregate Supply curve. If Real GDP increases due to the expansion of the labor force that causes the LRAS curve to shift to the right and match the new Real GDP value. Naveen Abedin9

Production Function and LRAS If the production curve shifts upward due to changes in capital or technology, then for a given level of labor that causes the Real GDP to increase. Once again, the long-run aggregate supply curve shifts right to match that change in Real GDP. Naveen Abedin10

Factors of Production and Economic Growth Increasing the factors of production – labor and capital considered here – helps to achieve economic growth. Also improving the level of technology will allow a country’s resources to be used more efficiently, which will help to increase output. Labor: According to supply-side fiscal policy reducing the marginal income tax rate of people motivates them to work more, and produce more output that helps to increase output and thus Real GDP. This can be represented by the following diagram: Naveen Abedin11

Factors of Production and Economic Growth (cont.) Capital: If taxes on returns from capital decline, then more capital will be utilized in the production process, thus shifting the production function upward and shifting the LRAS curve rightward. Also, if interest rates decline, this may encourage firms to borrow more money to purchase more capital goods. This will shift the production function upward and shift the LRAS curve upward by the new Real GDP amount. A more comprehensive production function would include natural resources (NR) and human capital (H). Natural Resources: wood, water, fuel etc. The resource of land is simply another name for natural resource. Human capital is the skills and knowledge of the labor force, acquired through higher education, training, and experience. Therefore, a more fuller production function can be depicted as such: Real GDP = T(L,K,NR,H) Increases in NR and H also causes Real GDP. Naveen Abedin12

Factors of Production and Economic Growth (cont.) New Growth Theory: A growth policy oriented towards the promotion of technology, ideas, institutions and education. This theory states that the amount and quality of technology that is developed depend on the amount of resources we devote to it – the more resources that go to develop technology, the more and better technology that is developed. Naveen Abedin13